ASX 200: Materials rocket but Financials fade

Last week I wrote that I had zero confidence in the ASX 200 breakout but you can’t argue with the tape. The ASX 200 retracement respected its new support level at 6350 and commenced a fresh advance. Money Flow completed a trough high above zero, signaling strong buying pressure.

ASX 200

Iron ore is a big contributor, rocketing to $106/tonne.

Iron Ore

Materials followed suit, breaking resistance at 13,500 suggesting a fresh advance.

ASX 200 Materials

The housing rally in response to the recent RBA rate cut has fizzled out, with CoreLogic reporting lower auction clearance rates last weekend:

The combined capital city final auction clearance rate came in at 48.3 per cent last week, which was lower than the 58 per cent the previous week. The lower clearance rate was across a lower volume of auctions over what was the Queen’s birthday long weekend, which saw 805 homes taken to auction, down on the 1,661 auctions the prior week.

The Financials advance has also lost impetus, with lower peaks on the Money Flow Index warning of increased selling pressure. Reversal below 6000 would warn of another correction.

ASX 200 Financials

The market is discounting the potential impact of a US-China trade war on Australia, relying on a large Chinese injection of fiscal stimulus to steady the ship. They may be right but Chinese officials have been talking this down for the past few months.

We hold 46% of our Australian Growth portfolio in cash and fixed income securities because of high uncertainty from (1) the US-China trade war; and (2) declining house prices and their potential impact on under-capitalised banks leveraged at nearly 20 times common equity (CET1).

ASX 200: Zero confidence

The ASX 200 has been buoyed by an RBA rate cut, recovering above resistance at 6350. I have zero confidence that this signals the start of a new up-trend.

ASX 200

Rate cuts normally precede a contraction and I am wary of committing further funds to the equity market at present.

RBA Cash Target Rate

My own view is that rate cuts are wasteful. If they have not worked to date, we are pushing on a string. Rather than doubling down, we need to try something else (boost infrastructure spending for example).

Cash and fixed income securities represent 46% of my Australian Growth portfolio for two reasons: (1) the potential impact of a US-China trade war on Australia; and (2) declining house prices and their potential impact on undercapitalised banks leveraged at nearly 20 times common equity (CET1).

ASX 200 false break

The ASX 200 is headed for a correction. Bearish divergence on the Trend Index warns of selling pressure. Breach of the new support level at 6350 would signal a false breakout, confirming a correction.

ASX 200

I have increased cash and fixed income securities to 46% of my Australian Growth portfolio for two reasons: (1) the impact of a US-China trade war on Australia; and (2) declining house prices and their potential impact on under-capitalised banks.

ASX 200 rises despite falling Dollar

The Aussie Dollar was trading above 80 US cents 18 months ago but has now broken support at 70 US cents. The immediate target is 68 cents but our long-term target is 60 cents, the lows of 2008.

AUD/USD

While this may benefit mining and other export-led sectors, the medium-term impact may be increased cost of offshore funding for the major banks. The chart below, sourced from the RBA, shows major banks rely on offshore funding of close to $650 billion (between 18% and 19% of total funding of $3.4 trillion).

Major Bank Funding

The ASX 200, buoyant after a surprise election result, broke resistance at 6400. Expect retracement to test the new support level, shown at 6350/6400 below on the daily chart. Respect would confirm a fresh advance.

ASX 200

I remain cautious of Australian stocks because of two factors: (1) potential fallout from a US-China trade war; and (2) declining housing prices and construction activity in Australia. With (common equity Tier 1) leverage ratios close to 5%, banks are under-capitalized and could act as “an accelerant rather than a shock-absorber” with any external shocks.

ASX 200 recovers as Aussie Dollar plunges

The Aussie Dollar broke long-term support at 70 US cents (as shown on the quarterly chart below), closing below 69 cents. Target for the decline is 60 cents.

AUD/USD

The ASX 200, reflecting the counter-balance between its two largest sectors, recovered to test resistance at 6350. The Trend Index trough above zero signals buying pressure.

ASX 200

Financials (32% of the ASX 200) penetrated its rising trendline to warn of a correction. Follow-through below 5800 would indicate a test of primary support at 5300.

ASX 200 Financials

Materials (18% of the index), on the other hand, rallied strongly after respecting support at 12500. Follow-through above 13500 would signal another advance.

ASX 200 Materials

I would be cautious of any breakout on the ASX 200 and would wait for retracement (respecting the new support level) to confirm the advance.

ASX 200 and the Banks

The ASX 200 retreat below support level at 6350 has been gentle, with a long tail indicating that buying support remains. The Trend Index likewise shows only a moderate decline. Respect of support at 6000 would be a bullish sign.

ASX 200

Financials are the largest sector, comprising 32.1% of the ASX 200 according to S&P Indices. Retracement has so far been gentle and respect of the new support level at 6000 would be a bullish sign.

ASX 200 Financials

Apart from a declining housing market and the RBNZ call for more than $8 billion in additional equity capital (estimated by S&P Global Ratings), the four major banks face declining margins.

Net Interest Income (as % of Total Assets) has rallied since 2015 but remains in a long-term down-trend, with a projected average of 1.7%. Fee income (right-hand scale) has declined to below 0.50% of total assets, while other income (RHS) fluctuates around 0.20%.

Banks Income as % of Total Assets

Source: APRA – Major Banks

If we compare income to operating expenses, the gap between non-interest income (fees, commissions & other income) and operating expenses is widening. Combined with declining net interest margins and increasing capital requirements, the heady days of strong profit growth may be nearing an end.

Banks Income & Expenses as % of Total Assets

Source: APRA – Major Banks

I am cautious of Australian banks, more because of the headwinds they face over the next two years than the long-term outlook, but declining margins do not help. We hold more than 40% in cash and fixed interest in the Australian Growth portfolio.

Materials (the second largest sector at 18.1%) are undergoing a modest correction. Respect of support at 12500 would be a bullish sign. Declining Money Flow peaks, however, warn of strong selling pressure and a test of 12000 remains likely.

ASX 200 Materials

Australia’s irrelevant election

Satyajit Das spells out the challenges facing the Australian economy in the next decade:

The centerpiece of both major contenders’ campaigns are large tax cuts and significant government spending on infrastructure and welfare. Both parties pay lip service to sound public finance. But the sustainability of policies based on outbidding political opponents and financing permanent expenditure with impermanent revenues is questionable.

….This striking lack of control that Australia has over its economy is grounded in four factors.

….Sadly, no party’s manifesto addresses these fundamental challenges. Tax cuts will not reform a system which needs to be overhauled. Infrastructure spending provides a short-term increase in demand. Bad choice of projects and poor delivery, evidenced by the disappointing National Broadband Network which is over-budget and slow by the best international standards, may not enhance longer-term efficiency and productivity.

The narrowness of the economic base is ignored. No political party is willing to address over-investment in housing, the total value of which is around $6 trillion or around 4 times gross domestic product and constitutes a large proportion of household wealth. Encouraged by complex subsidies, capital is locked up in property, unavailable for more productive activities such as new industries. Leaders are reluctant to champion forceful structural reforms to improve education and skill levels as well as streamline regulation. Instead, all contenders seem happy to rely on windfalls to finance the nation’s living standards through ever shorter electoral cycles.

Worth reading the full article at Nikkei Asian Review

Hat tip to Macrobusiness.

Australian bank growth expected to slow

Last week I observed:

…the RBA will resist cutting rates unless the situation gets really desperate. Ultra-low interest rates encourage risk-taking and speculative behavior, offering short-term gain but courting long-term disaster. Walter Bagehot, editor of The Economist, observed more than 100 years ago: “John Bull can stand many things, but he cannot stand 2%.” Sound economic management requires that central bankers make the hard choices, resisting pressure from commercial banks and politicians.

Total assets of the four major banks grew at a much faster rate than nominal GDP from 2004 to 2014. This was only achieved through rapid expansion of debt in the economy.

Major Banks Total Assets and Nominal GDP

The sharp rise in debt pushed households into a precarious position, with record levels of debt to disposable income and a serious bubble in house prices.

Australian Household Debt to Disposable Income

The RBA and APRA have used macro-prudential measures over the last few years to rein in debt growth, with some success. The ratio of major bank total assets, mainly debt, to nominal GDP declined considerably since 2015.

Major Banks Total Assets over Nominal GDP

This is a major policy success by the RBA and APRA and they are unlikely to want to reverse course. But they may decide to slow, or even for a time halt, the decline in order to prevent a downward spiral in the housing market. Expect total asset growth of the big four to match nominal GDP growth, at around 5.0%, over the next decade. Comprising 3.0% real GDP growth and 2.0% inflation. A far cry from the heady days of 10% annual growth between 2004 and 2014.

ASX 200 bull trap

The ASX 200 retreated below its new support level at 6350, warning of a bull trap. Declining Money Flow peaks indicate selling pressure. Expect retracement to test support at 6000.

ASX 200

With the Aussie Dollar testing support at 70 US cents, international investors are noticeably skittish, as illustrated by price action in REITs over the past few weeks. Penetration of the rising trendline warns of a correction.

ASX 200 REITs

ASX 200 Financials is also retracing, to test its new support level at 6000. Lower peaks on the Money Flow indicator warn of secondary selling pressure.

ASX 200 Financials

Banks face headwinds from a declining housing market and the RBNZ call for an additional $8.1 billion in common equity capital (as estimated by S&P Global Ratings).

Materials have started a correction after penetrating its rising trendline. Expect a test of support at 12000. Declining Money Flow peaks warn of strong selling pressure.

ASX 200 Materials

I remain cautious on Australian stocks, especially banks, and hold more than 40% in cash and fixed interest in the Australian Growth portfolio.