Author: Colin Twiggs

Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He founded PVT Capital (AFSL number 546090), which provides income and growth strategies to wholesale clients. Colin also co-founded Incredible Charts and writes the popular Patient Investor newsletter. Using a top-down approach, Colin identifies macro trends in the global economy and then combines fundamental and technical analysis to evaluate opportunities in sectors that stand to benefit. Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
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Structural Trends and Affected Industries

Discussion of major structural trends in the global economy and the impact they have on specific sectors or industries. A full list of identified trends is available at Structural Trends. I will focus each month on changes to existing trends, the latest statistics, and their impact on sectors or industries.

Cyber Security

Rapid growth of the Internet and online services has spawned a whole new array of threats to governments, corporations and private individuals. Data breaches and identity theft are growing.

Statistic: Annual number of data breaches and exposed records in the United States from 2005 to 2016 (in millions) | Statista

The type of cyber attacks has evolved from early blunt instrument, denial-of-service attacks — where co-opted servers are used to overload the target with bogus traffic — or destructive viruses, to more sophisticated penetration of security networks using phishing, worms and trojans.

Statistic: Types of cyber attacks experienced by companies in the United States as of August 2015 | Statista

Opportunity

Growth of cyber attacks and data breaches has established a niche for specialized security software and consultancies to protect client networks from external threats. First Trust have a Cybersecurity ETF (CIBR) that illustrates sector performance. Their top 10 holdings are not a comprehensive list of companies in the industry but offer a good start.

Threats

All industries are vulnerable but Trend Micro identifies the most targeted industries as:

  • Health Care
  • Education
  • Government
  • Retail
  • Financial

Serious security breaches are capable of destroying shareholder value as with the September 2017 Equifax (EFX) announcement of a major data breach. The credit reporting specialist recorded a 37% fall in stock value.

Equifax (EFX)

But at this stage security breaches are considered unlikely to blight an entire industry.

Social Media

Social media giant Facebook (FB) dominates social networks with three of the top five networks ranked by number of users: Facebook, WhatsApp and Facebook Messenger. The other two are Youtube (Google) and China’s WeChat (Tencent).

Statistic: Most famous social network sites worldwide as of August 2017, ranked by number of active users (in millions) | Statista

Social media is dominated by mobile users. Approximately 90% of active users connect via mobile, according to We Are Social global stats for January 2017, and mobile social network users grew 30% over the previous 12 months.

Opportunity

Statistic: Number of monthly active Facebook users worldwide as of 2nd quarter 2017 (in millions) | Statista

Social media growth is expected to continue over the next three years but is then expected to slow as saturation increases. Mobile usage growth has already slowed to 5% (Asia-Pacific: 4%) and should act as a constraint on long-term social media growth.

Statistic: Annual social network user growth worldwide from 2014 to 2020 | Statista

Threats

Proliferation of fake news and misinformation threatens the industry.  The motto of early Internet adopters was “Information is free” according to Mike Elgan at Computerworld, but it has now become “Information is fake”.

He explains:

The rise of false information online is caused by five factors:

1. The Internet allows anyone anywhere to publish anything everywhere.

2. Digital content is easy to counterfeit or modify.

3. Many people have powerful incentives to spread false information.

4. It’s easier for social network algorithms to favor emotionally reactive content than true content.

5. The public increasingly relies upon digital internet content for “knowledge.”

Facebook, Twitter and Google claim that they’re taking active measures against the rise of fake information. But previous efforts have failed.

Reaction from major advertisers and governments is likely to impose greater responsibility on online media to restrict publication of misleading information on their platforms, or face onerous penalties.

Online Retail

E-Commerce retail sales are growing rapidly and now exceed 9% of total retail sales or $110 billion on a quarterly basis.

Online as a percentage of Total Retail Sales

US online retail giant Amazon has announced plans to open its first major Australian warehouse in suburban Melbourne, according to ABC News.

Australian Retailers Association, Russell Zimmerman, played down the threat (to Wesfarmers and Woolworths) saying traders had been planning for Amazon’s arrival.

But Amazon operates on a lower cost structure than traditional bricks-and-mortar retailers and their margins are bound to come under pressure.

Opportunity

Online retail is expected to grow significantly as a percentage of total retail sales over the next few decades.

Threats

Medium-term: Bricks-and-mortar retail margins are likely to shrink.
Medium-term: Shopping center vacancies are expected to rise.

Electric Motor Vehicles

Adoption of electric battery-powered vehicles is accelerating in Europe, with several countries targeting zero sales of internal combustion engines in the next decade.

Opportunities

Huge amounts of money are being poured into battery research and development but there are no clear winners as yet. The rewards will be massive.

Threats

Australia lags far behind in the adoption of electric vehicles but the long-term threat to automotive groups is diminishing revenue. Not only from new vehicle sales, with manufacturers like Tesla selling direct to the consumer, but also falling service revenue as electric vehicles have far lower service requirements.

Telecommunications

The telecommunications industry typically requires massive capital investment to deliver low marginal costs, whether that be for mobile phone calls or Internet connections. It is dominated by a few large players, whose size delivers cost advantages over competitors.

Australia

In Australia, the natural order has been disrupted by the government-funded National Broadband Network (NBN) which delivers fiber-to-the-home in some areas of the country and fiber-to-the-node to the rest where fixed line copper or co-axial cable (Foxtel) is used to bridge the last 500 meters to the home. The NBN supplies broadband Internet connections at the same basic cost to large and small telcos alike, allowing smaller players to undercut large competitors such as Telstra, who have traditionally dominated fixed line and broadband, eroding industry profit margins.

Broadband

Growth in numbers of broadband subscribers has slowed but download volumes are growing exponentially.

ABS broadband usage

Already there are complaints of slow download speeds on NBN as telcos overload purchased bandwidth to compensate for narrow margins.

Telstra and Optus have announced plans to commence the roll-out of 5G mobile broadband in 2018. At 10 Gigabits per second, speeds are expected to be up to 100 times faster than the existing 4G network and 10 times quicker than the fastest NBN plans.

Mobile

Growth in the number of mobile handset subscribers (26.3 million) in Australia has slowed, to 3.4% for the six months to June 2017. But download volumes increased 44.5% for the year ended 30 June 2017.

Threat & Opportunity

The telecommunication industry faces a profit squeeze in the medium-term (say 3 to 5 years) as the NBN disrupts profit margins but the long-term future looks bright as data downloads in both broadband and mobile are expected to grow exponentially.

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The big shrink commences

“The Federal Reserve left its benchmark interest rate unchanged and said Wednesday that it would begin to withdraw some of the trillions of dollars that it invested in the US economy after the 2008 financial crisis.” ~ Binyamin Applebaum

The Federal Reserve balance sheet ballooned in the last decade to current holdings of $2.5 trillion of US Treasury securities and $1.8 trillion of mortgage-backed securities.

Hourly Wage Growth

Fed total assets of $4.5 trillion (the red line on the above chart) does not give the full picture. Of the cash injected into the economy, $2.2 trillion found its way back to the Fed by way of excess reserves deposited by banks (the blue line). These deposits earn interest at the rate of 1.25% p.a., providing a secure return on surplus funds. What this means is that the net effect of the balance sheet expansion is the difference between the two lines, or $2.3 trillion.

Even $2.3 trillion is a big number and any meaningful sale of securities by the Fed would contract the supply of money, tipping the economy into recession. So how does the Fed propose to manage “normalization of its balance sheet” without disrupting the economy?

Firstly, the Fed does not intend to sell securities. It will simply decrease the “reinvestment of principal repayments it receives from securities held” according to its June 2017 Normalization Plan.

The amount withheld from reinvestment will commence at $10 billion per month ($6bn US Treasuries and $4bn MBS) and step up by $10 billion each quarter until it reaches a total of $50 billion per quarter.

That means that $100 billion will be withheld in the first year and $200 billion in each year thereafter….”so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”

Second, the Fed will reduce the level of excess reserves by an appreciable amount in order to soften the impact of the first step. So a $100 billion reduction in investments may only result in a net reduction of say half that figure, after taking into account the decline in reserves.

Third, the federal funds rate will remain the primary tool of monetary policy and will be used to fine tune monetary policy to fit economic conditions.

It appears that the Fed will start quite tentatively, withholding only $30 billion in the first quarter, but the longer term targets seem ambitious.

With currency in circulation now growing at an annual rate of $100 billion, even a $50 billion reduction in the first year (net of excess reserves) could leave a big hole.

Currency in Circulation

This is bound to take some of the heat out of the stock market. The plus side is it may restore some sanity to market valuations, but any sudden moves could cause an overreaction.

Added later:

Even if we compare the reduction to the annual change in M1 money supply, it takes a big bite.

M1 money supply

M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.

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Reform universities by cutting their bureaucracies

Insight into the growth of bureaucracy in universities from The Conversation:

In earlier times, Oxford dons received all tuition revenue from their students and it’s been suggested that they paid between 15% and 20% for their rooms and administration. Subsequent central collection of tuition fees removed incentives for teachers to teach and led to the rise of the university bureaucracy.

Today, the bureaucracy is very large in Australian universities and only one third of university spending is allocated to academic salaries.

Across all the universities in Australia, the average proportion of full-time non-academic staff is 55%……….Australia is not alone as data for the United Kingdom shows a similar staffing profile with 48% classed as academics.

This is a fine example of Parkinson’s Law, first proposed by Cyril Northcote Parkinson in a light-hearted essay in The Economist in 1955:

Work expands so as to fill the time available for its completion.

Parkinson cited the British Colonial Office as an example: the number of staff continued to grow even when Britain had divested itself of most of its colonies. He explained the growth as due to two factors in a bureaucracy:

  1. An official wants to multiply subordinates, not rivals; and
  2. Officials make work for each other.

He noted that bureaucracies tended to grow by between 5% and 7% a year “irrespective of any variation in the amount of work (if any) to be done” — even if the amount of work is declining.

Read more at Reform Australian universities by cutting their bureaucracies .

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ASX 200: Testing support at 5000

The ASX 200 weakened towards the close and is testing medium-term support at 5000. Breakout below 4980 would warn of a correction. Declining 21-day Twiggs Money Flow, indicating medium-term selling pressure, makes this likely. The index is in a strong primary up-trend and a 5 or 10 percent correction would not alter this. It is merely a case of one step back then two steps forward.
ASX 200 Index

* Target calculation: 5000 + ( 5000 – 4500 ) = 5500

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Fed NGDP targeting would greatly increase global financial stability | Market Monetarist

Lars Christensen describes how NGDP targeting would help the global economy withstand shocks like another eurozone crisis:

Lets look at two different hypothetical US monetary policy settings. First what we could call an ‘adaptive’ monetary policy rule and second on a strict NGDP targeting rule.

‘Adaptive’ monetary policy – a recipe for disaster

By an adaptive monetary policy I mean a policy where the central bank will allow ‘outside’ factors to determine or at least greatly influence US monetary conditions and hence the Fed would not offset shocks to money velocity…..

In that sense under an ‘adaptive’ monetary policy the Fed is effective[ly] allowing external financial shocks to become a tightening of US monetary conditions. The consequence every time that this is happening is not only a negative shock to US economic activity, but also increased financial distress – as in 2008 and 2011.

NGDP targeting greatly increases global financial stability

If the Fed on the other hand pursues a strict NGDP level targeting regime the story is very different.

Lets again take the case of an European sovereign default. The shock again – initially – makes investors run for safe assets. That is causing the US dollar to strengthen, which is pushing down US money velocity (money demand is increasing relative to the money supply). However, as the Fed is operating a strict NGDP targeting regime it would ‘automatically’ offset the decrease in velocity by increasing the money base (and indirectly the money supply) to keep NGDP expectations ‘on track’. Under a futures based NGDP targeting regime this would be completely automatic and ‘market determined’.

Hence, a financial shock from an euro zone sovereign default would leave no major impact on US NGDP and therefore likely not on US prices and real economic activity…..

Read more at Fed NGDP targeting would greatly increase global financial stability | The Market Monetarist.

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Asia finds relief

Japan found relief from the overnight selling. Dow Jones Japan Index is back testing resistance at 70. Breakout would signal continuation of the primary advance.

Dow Jones Japan Index

Dow Jones Hong Kong Index is undergoing a correction but found support at yesterday’s low of 464.
Hang Seng Index

India is falling today. The Sensex is likely to re-test support at 18800. Breakout above 20200 would signal a primary advance to 21000*, but bearish divergence on 13-week Twiggs Money Flow continues to warn of selling pressure. Reversal below 19000 would warn of a correction to the primary trendline at 18000. Failure of 18800 would confirm.

Sensex Index

* Target calculation: 20 + ( 20 – 19 ) = 21

China is neutral Tuesday, but the Shanghai Composite broke support at 2250 on Monday, warning of a down-swing to primary support at 1950/2000.
Shanghai Composite Index

* Target calculation: 2450 + ( 2450 – 2250 ) = 2650

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S&P 500 and Europe: Likely to blow over

Question: Is the outcry in Europe going to tip the S&P 500 into a correction?

Answer: The outcome is uncertain. While there is a strong case for giving depositors and bondholders a haircut, the timing — so soon after an inconclusive Italian election — could not be worse. But let’s see what the market are saying….

Longish tail on the S&P 500 shows buying support at the close. Mild bearish divergence (mild because TMF has leveled out rather than falling sharply) on 21-day Twiggs Money Flow indicates medium-term selling pressure. We are likely to see retracement to the first line of support — at the previous high of 1525/1530 — but only breach of this level and the rising trendline would warn of a correction. Target for the current advance is 1600*.

S&P 500 Index

* Target calculation: 1525 + ( 1525 – 1475 ) = 1575

VIX Volatility Index remains low — near its 2005 lows at 0.10. Breakout above 0.20 would be a warn of rising uncertainty.
VIX Index
The FTSE 100 exhibits an even longer tail, but bearish divergence on 21-day Twiggs Money Flow also indicates medium-term selling pressure. Reversal below the latest rising trendline (6400) would warn of a correction, while breakout above 6550 would continue the advance to 6800*.
FTSE 100 Index

* Target calculation: 6400 + ( 6400 – 6000 ) = 6800

The DAX showed even greater resilience, closing back above 8000. Follow-through above 8100 would signal a fresh primary advance. Rising 21-day Twiggs Money Flow indicates medium-term buying pressure.
DAX Index

Conclusion

There is bound to be some turbulence but markets are showing resilience and the storm is likely to blow over.

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ASIC: High-frequency trading taskforce—Key findings

Findings of the recent ASIC investigation into dark liquidity and high-frequency trading.

The high-frequency trading taskforce found that:

(a) some of the commonly held negative perceptions about high-frequency trading are not supported by our analysis of Australian markets—for example:

(i) that high-frequency traders exhibit unacceptably high order-to-trade ratios. Increases in order-to-trade ratios in Australia have been moderate compared with overseas markets, and other algorithmic traders operate at similar levels; and
(ii) that high-frequency traders’ holding times are often a matter of seconds and therefore that they make no contribution to deep, liquid markets. Our analysis shows that only 1.2% of high-frequency traders held positions for an average of two minutes or less, 18% for less than 10 minutes and 51% for less than 30 minutes; and

(b) there is some basis in fact for other perceptions (e.g. about high-frequency trading creating excessive noise and exhibiting predatory or ‘gaming’ behaviours), but other traders are also contributing to the problem.

Both [the HFT and Dark Pools] taskforces have found evidence of potential breaches of ASIC Market Integrity Rules and the Corporations Act 2001 (Corporations Act), and some matters have been referred to our Enforcement teams for investigation. We have also seen a change in behaviour as a result of our inquiries. For example:

(a) fundamental investors are asking more questions about where and how their orders are executed;
(b) there have been improvements to automated trading risk management controls; and
(c) at least one high-frequency trader has ceased trading in Australia.

The main problem with HFT is investor perceptions that they are paying more for stocks than they should be. HFT trading profits can only come out of investors pockets. While the ASX receives massive fees from HFT traders, the erosion of investor trust in fair pricing is too serious to ignore. Failure to address this could see investors migrate to other exchanges or platforms, especially if there is a transparent auction process where HFT traders are unable to intercede.

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Cyprus: Deposit insurance and moral hazard

The outcry over Cyprus levy on depositors in defaulting banks raises the question: Why were depositors not more wary of where they deposited their funds? Not all banks are created equal. The reason is deposit insurance for deposits under €100,000 implied that the government would stand behind its banks and rescue depositors should the banks ever default. The problem is that no one considered the possibility that all the banks would suffer losses sufficient that the government would be forced to default on both its explicit and implied obligations.

Some time ago I wrote about the moral hazard of deposit insurance:

Deposit Insurance: When too much of a good idea becomes a bad idea

Deposit insurance was introduced in the 1930s and saved the US banking system from extinction. Administered by the FDIC, and funded by a levy on all banking institutions, deposit insurance, however, encourages moral hazard. Depositors need not concern themselves with the solvency of the bank where they deposit their funds so long as deposits are FDIC insured. High-risk institutions are able to compete for deposits on an equal footing with well-run, low-risk competitors. This inevitably leads to higher failure rates, as in the Savings & Loan crisis of the 1980s.

The FDIC does a good job of policing deposit-takers, but no regulator can substitute for market forces. Deposit insurance is critical during times of crisis, but should be scaled back when the crisis has passed. Either limit insured deposits to say $20,000 or only insure deposits to say 90% of value, where the depositor takes the first loss of 10%. That should be sufficient to keep depositors mindful as to where they bank. And restore the competitive advantage to well-run institutions.

Requiring depositors to take the first loss of 10 percent should be standard practice for deposit insurance. The same should hold true for bank creditors. But we need to distinguish between insolvency — where liabilities exceed assets — and a liquidity event where the central bank is only called on to provide temporary respite. If the bank is rescued from insolvency by the regulator, bond holders should be required to take an equivalent haircut — painful yet not life-threatening. No one is entitled to a free ride. And bank shareholders, if a there is a bail-out, should lose everything — similar to the Swedish approach in the 1990s.

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Cyprus Deposit Levy: No Panic Yet But Scary Long-Term Consequences – Forbes

Karl Whelan, Professor of Economics at University College, Dublin reminds us:

….the fact that we don’t see lines at ATMs in Spain and Italy doesn’t mean there isn’t a bank run going on. The Northern Rock episode was a complete anomaly. Modern bank runs stem from people pushing buttons to execute electronic withdrawals of large amounts of funds. For example, I was living in Ireland in 2010 when non-residents pulled €186 billion out of Irish banks between the end of July and the end of December. This was over 100% of Irish GDP and yet there wasn’t a single sign of panic among retail depositors.

Read more at Cyprus Deposit Levy: No Panic Yet But Scary Long-Term Consequences – Forbes.

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