Iron ore spot prices plunged from $120 to $106.50/tonne in two days. Penetration of the rising trendline is highly likely and would warn of a strong correction. A spike up is often followed by a spike down.
The ASX 200 retreated from its 2007 high at 6830. Penetration of the rising trendline is now likely and would warn of a correction. The first line of support is 6350, with stronger support at 6000.
We have increased the level of cash in our Australian Growth portfolio.
We have just completed a review of Australia’s four major banks — Commonwealth, Westpac, ANZ and NAB — and conclude that they are collectively overpriced by 23.5 percent. Our review is based on APRA’s quarterly reports, where the four banks can be viewed as a collective unit.
The ASX 300 Banks Index ($XBAK) is in a primary down-trend and we expect it to re-test support at 7000.
We estimate forward PE at 17.2. Allowing a 20% margin of safety — for increases in capital and risks associated with under-performing assets — we calculate a combined fair value of $310.7 billion, compared to current market cap of $406.1 bn, based on a 13-year payback period.
Our conclusion is to wait for $XBAK to re-test support at 7000.
Total assets are the base which generates most bank revenue. Heady growth of the last two decades is unlikely to continue. Growth in total assets has lagged GDP since 2015. Private credit growth for Australia slowed to 4.4% in FY18 and 3.3% in FY19.
Private borrowers are near saturation point, with household debt at an eye-watering 190% of disposable income.
David Ellis at Morningstar writes:
Many investors are concerned about a potential sharp downturn or crash in the Australian housing market. While Australian housing is expensive and debt/household income ratios are high, we remain comfortable for several reasons despite recent weakness in house prices. Tight underwriting standards, lender’s mortgage insurance, low average loan/valuation ratios, a high incidence of loan prepayment, full recourse lending, a high proportion of variable rate home loans, and the scope for interest-rate cuts by the Reserve Bank of Australia, or RBA, combine to mitigate potential losses from mortgage lending. Average house prices in Australia are falling, with the national average declining 5% during the 12 months to end December 2018 based on CoreLogic data. But investors who readily compare the Australian residential real estate market to that of the U.S. and other markets are ignoring fundamental differences.
The counter-argument is that loose lending policies exposed by the Royal Commission, vulnerable mortgage insurers with concentrated exposure in a single sector and low bank capital ratios have created a banking sector “more likely to act as an accelerant in a down-turn rather than a shock absorber” in the words of FSI Chair David Murray.
Nominal GDP is growing at an annual rate of 5.0% (March 2019) and we expect this to act as a constraint on book growth. We project long-term book growth of 4.0%.
Net interest margins declined to 1.73% for Q1 2019 and we expect a long-term average of 1.70%.
Expenses declined to 1.10% of average total assets but non-interest income has fallen a lot faster, to 0.60%. The decline in non-interest income is expected to continue and we project a long-term average of 0.50%.
Fees and commissions — the major component of non-interest income — have suffered the largest falls, with transaction-based fees the worst performer. Lending-based fees are likely to be impacted by declining credit growth.
Operating expenses have also fallen but sticky personnel costs are declining at a slower rate.
Charges for bad and doubtful debts remain low but we expect an up-tick in the next few years and project a long-term average of 0.20%.
Common equity Tier 1 capital (CET1) remains low, with a CET1 capital ratio of 10.7% in March 2019, based on risk-weighted assets. If we calculate CET1 as a percentage of total assets, the ratio falls to 4.9%. Leverage ratios, which calculate CET1 against total credit exposure, are even lower because of off-balance sheet exposure.
The Reserve Bank of New Zealand has asked the big four Australian banks for “more skin in the game” and to increase their capital holdings in New Zealand subsidiaries by $12 billion:
The RBNZ proposal calls for systemically important banks to hold a minimum of 16% Tier 1 capital against risk-weighted assets, of which 6% would be a regulatory minimum and 10% would act as a counter-cyclical buffer to absorb losses without triggering “resolution or failure options”.
The move by RBNZ has exposed ineffectual supervision of major banks in Australia. A new chairman at APRA could see increased pressure on Australian banks to improve their capital ratios.
Australian regulator APRA is suffering from regulatory capture. There have been calls in Parliament and the media for APRA chairman, Wayne Byers, to resign after the Royal Commission revealed numerous shortcomings in bank culture and supervision.
A 146-page capability review, stemming from David Murray’s Financial System Inquiry found APRA “slow, opaque, inefficient, and in urgent need of a culture and leadership overhaul.”
Clancy Yeates at SMH weighs in:
A rare public intervention from banking royal commissioner Kenneth Hayne could be aimed at ensuring his recommendations are not watered down by financial sector lobbying, former watchdog Allan Fels says….
“It’s very unusual for a royal commissioner, especially a former High Court judge, to speak after a report, but probably he is concerned about weak implementation of his report due to enormous pressure from the financial institutions, an enormously powerful lobby.”
There have been several recent changes at major banks whose poor conduct was exposed by the Royal Commission. NAB CEO Andrew Thorburn and Chair Ken Henry resigned in the wake of the findings. Earlier, in 2018 Ian Narev resigned as CEO of Commonwealth after an APRA investigation into money-laundering found there was “a complacent culture, dismissive of regulators, [and] an ineffective board that lacked zeal and failed to provide oversight.”
A change at the head of APRA could have even more long-lasting consequences for the banks.
We project:
That delivers a forward PE of 17.2. Allowing a 20% margin of safety — for increases in capital and risks associated with under-performing assets — we arrive at a combined fair value of $310.7 billion (current market cap is $406.1 bn) based on a 13-year payback period.
The ASX 300 Banks index, dominated by the big four, reflects a primary down-trend. The recent rally is currently testing resistance at the descending trendline. Reversal below 7000 would warn of another decline. The previous false break below 7000 suggests strong support.
Expect another test of support at 7000. Respect of support would provide an entry point at close to fair value.
Valuations are sensitive to assumptions: LT book growth of 5% and a 0.1% increase in net profit (% of average total assets) would increase intrinsic value to $387.4 bn (4.6% below current prices). At present we favor a conservative fair value of $310.7 billion, 23.5% below current market capitalization.
We currently have no exposure to the four major banks in our Australian Growth portfolio.
Staff of The Patient Investor may directly or indirectly own shares in the above companies.
Further increases in iron ore prices are predicted. Enrico de la Cruz at Mining.com reports:
Singapore-based steel and iron ore data analytics firm Tivlon Technologies is keeping its price forecast of $150 a tonne by October.
“We expect the launch of infrastructure projects in China to peak in the third quarter and further uplift demand for steel,” it said in a note.
Narrow consolidation is a bullish sign, suggesting another advance.
The Materials index continues its up-trend. A Trend Index above zero would signal increased buying pressure.
Financials continue to test resistance at 6450 but face headwinds from the housing market and construction.
The ASX 200 is testing its 2007 high at 6800. A rising Trend index indicates buying pressure. Penetration of the rising trendline on the index chart is unlikely but would warn of a correction.
We maintain a high level of cash in our Australian Growth portfolio because of expected headwinds from housing and construction.
The ASX continues to enjoy a massive tailwind, with iron ore spot prices holding above $120/tonne. Prices are expected to moderate, with Brazilian exports recovering. Clyde Russell at Mining.com comments:
“Even if Brazil’s exports do remain slightly below normal, it may be the case that the iron ore forward curve is currently too optimistic. The Singapore Exchange front-month contract closed at $121.24 a tonne on Wednesday, while the six-month contract was at $100.52 and the 12-month at $89.52. This shows traders do expect prices to moderate…”
The Materials index continues to climb, with rising troughs on the Trend Index signaling buying pressure.
REITs continue their strong up-trend, in expectation of lower interest rates. The equity (dividend) yield on VAP/ASX 300 REITs has fallen to 4.3%.
Financials are testing resistance at 6450 but face headwinds from declining house prices and construction work.
The ASX 200 is headed for a test of its 2007 high at 6830, with a rising Trend index indicating buying pressure. Penetration of the rising trendline on the index chart is not likely but would warn of a correction to test support at 6000.
We continue to maintain a high level of cash in our Australian Growth portfolio.
The ASX continues to enjoy a massive external tailwind, with iron ore spot prices holding at $120/tonne.
Headwinds stem mainly from domestic sources. Low employment and disposable income growth have slowed consumption, especially of durables such as housing and motor vehicles. Construction work done in the private engineering sector (mainly mining and energy related) continues to decline after a dramatic fall in 2013-2015. Public sector spending is also tailing off as the NBN roll-out winds down.
Private sector building still shows some resilience but is expected to fall as approvals for new residential construction decline (source: ABS).
My concern is that the headwinds will outlast the tailwind, in which case all three construction sectors could fall to 2006 levels.
The ASX 200 continues to advance, headed for a test of its 2007 high at 6830. A declining Trend index would warn of rising selling pressure, while penetration of the rising trendline on the index chart would signal a correction to test support at 6000.
We continue to maintain a high level of cash in our Australian Growth portfolio.
The ASX is still enjoying a massive tailwind from iron ore prices, with spot prices close to $120/tonne.
My concern is how long this tailwind will last. But the ASX 200 advances unperturbed, heading for a test of its 2007 high at 6830. Penetration of the rising trendline is unlikely but would warn of a correction to test support at 6000.
I continue to maintain a high level of cash in my Australian Growth portfolio because of long-term headwinds.
Iron ore tailwinds show no signs of abating, with spot prices close to $110/tonne.
It’s all plain sailing, with the ASX 200 advancing towards its 2007 high at 6830. Penetration of the rising trendline is unlikely but would warn of a correction to test support at 6000.
I continue to maintain a high level of cash in my Australian Growth portfolio because of long-term headwinds.
Ross Gittins, Economics Editor at The Sydney Morning Herald, sums up Australia’s predicament:
“The problem is, the economy seems to be running out of puff because it’s caught in a vicious circle: private consumption and business investment can’t grow strongly because there’s no growth in real wages, but real wages will stay weak until stronger growth in consumption and investment gets them moving.
Policy has to break this cycle. But, as [RBA governor] Lowe now warns in every speech he gives, monetary policy (lower interest rates) isn’t still powerful enough to break it unaided. Rates are too close to zero, households are too heavily indebted, and it’s already clear that the cost of borrowing can’t be the reason business investment is a lot weaker than it should be.
That leaves the budget as the only other instrument available. The first stage of the tax cuts will help, but won’t be nearly enough…..”
Cutting already-low interest rates is unlikely to cure faltering consumption and business investment. Low wage growth and a deteriorating jobs market are root causes of the downward spiral and not much will change until these are addressed.
Low unemployment is misleading. Underemployment is growing. Trained barristers working as baristas may be an urban legend but there is an element of truth. The chart below shows underemployment in Australia as a percentage of total employment.
Tax cuts are an expensive sugar hit. The benefit does not last and may be frittered away in paying down personal debt or purchasing imported items like flat-screen TVs and smart phones. Tax cuts are also expensive because government is left with debt on its balance sheet and no assets to show for it.
Infrastructure spending can also be wasteful — like school halls and bridges to nowhere — but if chosen wisely can create productive assets that boost employment and build a healthy portfolio of income-producing assets to offset the debt incurred.
The RBA has already done as much as it can — and more than it should. Further rate cuts, or God forbid, quantitative easing, are not going to get us out of the present hole. What they will do is further distort price signals, leading to even greater malinvestment and damage to the long-term economy.
What the country needs is a long-term infrastructure plan with bipartisan support. Infrastructure should be a national priority. There is too much at stake for leadership to take a short-term focus, with an eye on the next election, rather than consensus-building around a long-term strategy with buy-in from both sides of the house.
The ASX 200 is advancing to test its all-time (2007) high at 6830, having respected its new support level at 6350.
Shane Oliver, AMP economist, argues that an Australian recession is unlikely as the economy has tailwinds as well as headwinds:
The tailwinds can be summed up in two words: iron ore. Without high ore prices, our current account deficit and fiscal deficit would be much larger, limiting the ability of government to stimulate the economy.
Australian headwinds, on the other hand, can be summed up by one words: jobs. High ore prices do not create many jobs.
Job growth is falling and unemployment is expected to rise.
Australia online job ads fall for a 5th consecutive month in May (and 11th in past 13), according to the government's IVI. Annual drop, at 5.7%, is the steepest since December 2013 #ausbiz pic.twitter.com/4pbmgFf3zU
— David Scutt (@Scutty) June 19, 2019
Low jobs growth is eroding consumer confidence, flagged by falling spending on durables such as motor vehicles.
And housing.
The critical question is: will the iron ore tailwind last long enough to save the Australian economy from recession?
High iron ore prices are unlikely to last long. From Reuters on Thursday:
Mining giant Rio Tinto on Thursday lowered its guidance on volumes of iron ore it expects to ship from the key Pilbara producing region in Australia for the third time since April, citing operational problems.
The guidance cut came just hours after Brazilian miner Vale, the world’s No. 1 iron ore producer, said late on Wednesday that it will fully resume Brucutu operations within 72 hours, after a favourable ruling from an appeals court…..Brucutu, which has been operating at only a third of its capacity, was shuttered in February as Vale’s mine operations came under close scrutiny after a tailings dam collapsed in Brazilian town of Brumadinho, killing more than 240 people…..The full operation of Brucutu “should help alleviate concerns about tightness in the market,” said ANZ Research analysts in a note. “However, issues at Rio Tinto’s operations suggest the market still has some challenges ahead.”
Rio Tinto said it now expects shipments from Pilbara at between 320 million tonnes and 330 million tonnes, mostly lower-grade and lower-margin product. Its previous target was between 333 million tonnes and 343 million tonnes.
Vale at the same time reaffirmed its 2019 iron ore and pellets sales guidance of 307 million to 332 million tonnes, saying sales should be around the midpoint of that range, instead of the low end of the range as previously expected.
Chinese steel production is strong.
Housing construction is rising.
But rising housing inventories warn that construction is running ahead of demand, which is likely to exert downward pressure on prices.
While Chinese automobile production is faltering. From WSJ:
Auto sales in China declined for an 11th straight month in May, with the slump in demand showing no sign of easing and the country’s automotive industry bracing for losses tied to new emissions standards.
Sales for the latest month fell 16% from a year earlier, to 1.91 million vehicles….
I am not sure how long the iron ore shortfall will last but I wouldn’t bet on high prices by the end of the year. Nor would I bet on the G20 meeting between Donald Trump and Xi Jinping resolving US-China trade differences.
That leaves uncertain tailwinds and far more certain headwinds.
Markets are buoyant with the S&P 500 headed for another test of its all-time high at 2950. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure but the overall technical outlook looks promising.
So why should it not be a good time to invest in stocks?
First, the yield curve warns of a recession in the next 6 to 18 months. The 10-year Treasury yield is below the yield on 3-month T-bills, indicating a negative yield curve. This is our most reliable recession signal, with 100% accuracy since the early 1960s.
Annual jobs growth has declined since January. Further declines in the next few months would further strengthen the recession warning.
Small cap stocks in the Russell 2000 lag well behind the S&P 500, indicating that investors are de-risking.
Cyclical sectors like Automobiles & Components also offer an early warning, anticipating slower consumer spending on durables such as housing, clothing and automobiles.
Lastly, the historic Price-Earnings ratio is above 20 (PE and PEmax are equal at present), indicating stocks are over-priced.
It’s a good time to be cautious.
