Still cautious

Inflationary pressures are easing, with average hourly earnings growth declining to 3.35% in June, for Production and Non-Supervisory Employees, and 3.14% for Total Private sector.

Average Wage Rates

But this warns that economic growth is slowing. Annual growth in hours worked has slowed to 1.25%, suggesting a similar decline in GDP growth for the second quarter.

Real GDP and Hours Worked

Jobs growth held steady at 1.5% for the 12 months ended June 2019, after a decline from 2.0% in January.

Payroll Growth

Further decline in jobs growth is likely in the months ahead and a fall below 1.0% would warn that recession is imminent.

The Case Shiller index warns that growth in housing prices is slowing.

Case Shiller Index

Growth in construction expenditure (adjusted for inflation) has stalled.

Construction Expenditure/CPI

Retail sales growth is faltering.

Retail Sales

Units of light vehicle sales has stalled.

Light Vehicle Sales

And capital goods orders (adjusted for inflation) are faltering.

Manufacturers Orders for Capital Goods

One of the few bright spots is corporate bond spreads — the difference between lowest investment grade (Baa) and equivalent Treasury yields — still low at 2.3%, indicating that credit risk is benign.

Corporate Bond spreads

The S&P 500 broke through 2950 and is testing 3000. The 3000 level is an important watershed, double the 2000 and 2007 highs at 1500 (1552 and 1576 to be exact), and I expect strong resistance.

S&P 500

A rising Trend Index indicates buying pressure but this seems to be mainly stock repurchases and institutional buying. Retail money, as indicated by investment flows into ETFs, favors fixed income over equities despite the low yields.

ETF Flows source: ETF.com

It’s still a good time to be cautious.

The prevailing wisdom is that markets are always right. I take the opposite position. I assume that markets are always wrong……I watch out for telltale signs that a trend may be exhausted. Then I disengage from the herd and look for a different investment thesis. Or, if I think the trend has been carried to excess, I may probe going against it. Most of the time we are punished if we go against the trend. Only at an inflection point are we rewarded.

~ George Soros

ASX 200 gravestone

Australian housing prices are falling.

Australia: Housing Prices

Fueled by declining credit growth.

Australia: Housing Credit growth

With falling contribution to GDP growth from dwelling investment, and mining investment shrinking….

Australia: GDP Contribution

GDP growth is expected to weaken further.

Australia: GDP growth

The gravestone candlestick on the ASX 200 weekly chart warns of selling pressure. The primary trend is down and the index unlikely to break through resistance at 6300. Expect a correction to test support at 5650; breach would warn of another decline.

ASX 200

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

Why the RBA shouldn’t cut interest rates

There are growing cries in local media for the RBA to cut interest rates in order to avoid a recession. House prices are falling and shrinking finance commitments point to further price falls. Declining housing values are likely to lead to a negative wealth effect, with falling consumption as household savings increase. Employment is also expected to weaken as household construction falls. Respected economist Gerard Minack thinks “a recession in Australia is becoming more likely”.

The threat should not be taken lightly, but is cutting interest rates the correct response?

Let’s examine the origins of our predicament.

A sharp rise in commodity prices in 2004 to 2008.

Commodity Prices

Led to a massive spike in the Trade-weighted Index.

Australia Trade Weighted Index

And a serious case of Dutch Disease: the destructive effect that offshore investment in large primary sector projects (such as the 1959 Groningen natural gas fields in the Netherands) can have on the manufacturing sector.

Business investment in Australian has fallen precipitously since 2013.

Australia Business Investment

With wages growth in tow.

Wages Index

Instead of addressing the underlying cause (Dutch Disease), Australia tried to alleviate the pain by stimulating the housing market. Housing construction boosted employment and the banks were only to happy to accommodate the accelerating demand for credit.

Leading Index

But house prices have to keep growing and banks have to keep lending else the giant Ponzi scheme unwinds. When house prices and construction slows, the economy is susceptible to a severe backlash as Gerard Minack pointed out.

How to fix this?

The worst response IMO would be to pour more gasoline on the fire: cut interest rates and reignite the housing bubble. Low interest rates have done little to stimulate business investment over the last five years, so further cuts are unlikely to help.

The only long-term solution is to lift business investment which creates secure long-term employment. To me there are three pillars necessary to achieve this:

  1. Accelerated tax write-offs for new business investment;
  2. Infrastructure investment in transport and communications projects that deliver long-term productivity gains; and
  3. A weaker Australian Dollar.

Corporate tax write-offs

Accelerated corporate tax write-offs were a critical element of the US economic recovery under Barack Obama. They encourage business to bring forward planned investment spending, stimulating job creation.

Infrastructure

Government and private infrastructure spending is important to fill the hole left by falling consumption. But this must be productive investment that generates a market-related return on investment. Else you create further debt with no income streams to service the interest and capital repayments.

A weaker Australian Dollar

Norway is probably the best example of how an economy can combat Dutch Disease. They successfully weathered an oil-driven boom in the 1990s, protecting local industry while establishing a sovereign wealth fund that is the envy of its peers. Their fiscal discipline set an example to be followed by any resource-rich country looking to navigate a sustainable path through a commodities boom.

In Australia’s case that would be closing the gate after the horse has bolted. The benefits of the boom have long since been squandered. But we can still protect what is left of our manufacturing sector, and stimulate new investment, with a weaker exchange rate.

I doubt that the three steps are sufficient to avert a recession. But the same is true of further interest rate cuts. And at least we would be addressing the root cause of the problem, rather than encouraging further malinvestment in an unsustainable housing bubble.

Deal or no deal

Brexit

No one knows what the outcome of Brexit will be but, whatever the outcome, it is unlikely to send global markets into a tail-spin. There is bound to be short-term pain on both sides but the long-term costs and benefits are unclear.

China

Far more likely to send investors scuttling for shelter is a ‘no deal’ outcome on US trade negotiations with China. I would be happy to be proved wrong but I believe that a deal is highly unlikely. There may be press photos with beaming officials shaking hands and tweets from the White House promising a rosy future for all (with or without a wall). But what we are witnessing is not straight-forward negotiations between trading partners, which normally take years to resolve, but a hegemonic power struggle between two super-powers, straight out of Thucydides.

Thucydides wrote “When one great power threatens to displace another, war is almost always the result.” In his day it was Athens and Sparta but in the modern era, war between great powers, with mutually assured destruction (MAD), is most unlikely. Absent the willingness to use military force, the country with the greatest economic power is in the strongest position.

One of the key battlefronts is technology.

“China is now almost wholly dependent on foreign chipsets. And that makes leaders nervous, especially given a series of actions by foreign governments to limit the ability of Huawei and ZTE to operate internationally and acquire Western technology.” ~ Trivium China

“To address this risk, President Xi Jinping aims to increase China’s semiconductor self-sufficiency to 40% in 2020 and 70% in 2025 as part of his ‘Made in China 2025’ initiative to modernize domestic industry.” ~ Nikkei

Xi is unlikely to abandon his ‘Made in China 2025’ plans and the US is unlikely to settle for anything less.

USA

The US economy remains robust despite the extended government shutdown and concerns about Fed tightening.

“Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they had expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.” ~ The Wall Street Journal

This is just spin. As I explained last week. Fed run-down of assets is more than compensated by repayment of liabilities (excess reserves on deposit) on the other side of the balance sheet. Liquidity is unaffected.

Charts remain bearish as the market views global risks.

Volatility is high and a large (Twiggs Volatility 21-day) trough above zero on the current S&P 500 rally would signal a bear market. Retreat below 2600 would strengthen the signal.

S&P 500

Asia

Hong Kong’s Hang Seng Index is in a bear market but shows a bullish divergence on the Trend Index. Breakout above 27,000 would signal a primary up-trend. This seems premature but needs to be monitored.

Hang Seng Index

India’s Nifty has run into stubborn resistance at 11,000. Declining peaks on the Trend Index warn of selling pressure. Retreat below 10,000 would complete a classic head-and-shoulders top but don’t anticipate the signal.

Nifty Index

Europe

DJ Stoxx Euro 600 is in a primary down-trend. Reversal below 350 would warn of another decline.

DJ Stoxx Euro 600 Index

The UK’s Footsie has retreated below primary support at 6900. Declining Trend Index peaks warn of selling pressure. This is a bear market.

FTSE 100 Index

This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

War is a matter not so much of arms as of money.

~ Thucydides (460 – 400 B.C.)

Significant divergence

Market commentators are sifting through the data, looking for reasons to explain the sharp sell-off in stocks over the last two months. But everything they examine is likely to be shaded by their bear-tinted spectacles after the S&P 500 broke primary support at 2550.

S&P 500

The Nasdaq 100 also broke primary support, confirming the bear market.

Nasdaq 100

Of the big five tech stocks, Apple and Google are both testing primary support, threatening to follow Facebook into a primary down-trend. If the two break primary support, that would further strengthen the bear signal.

Big Five tech stocks

Volatility (21-day) is now close to 2% but the key is how volatility behaves on the next multi-week rally. If volatility forms a trough above 1% that would confirm the elevated risk.

S&P 500

Divergence? What Divergence?

Why do I say there is a significant divergence? Look at the fundamentals.

Fedex has just released stats for its most recent quarter, ended November 30. Package volumes are rising, not falling.

Fedex Stats

Supported by a very bullish Freight Transportation Index.

Freight Transportation Index

Consumption is strong, with Services and Non-durable goods rebounding. No sign of a recession here.

Consumption

Light vehicle sales are at a robust annual rate of 17.5 million.

Light Vehicle Sales

Retail sales growth (ex motor vehicles and parts) weakened in the last month but is still in an up-trend.

Retail

Housing starts and authorizations are still climbing.

Housing

Real construction spending (adjusted by CPI) is strong.

Construction

Manufacturers new orders (ex defense and aircraft) have rebounded after a weak 2015 – 2016.

Manufacturers New Orders

Corporate investment is growing at a faster rate than the economy, with rising new capital formation over GDP.

New Capital Formation

The Fed is shrinking its balance sheet which is expected to impact on liquidity. But commercial banks are running down excess reserves on deposit at the Fed at a faster rate, so that Fed assets net of excess reserves (green line) is actually rising. Hardly a drain on liquidity.

Fed Balance Sheet

Market pundits are watching the yield curve with bated breath, waiting for the 10-year to cross below the 2-year yield.

Yield Differential 10-Year minus 2-Year

In the past this has served as a reliable early warning, normally 12 to 24 months ahead of a recession. But the St Louis Fed Financial Stress Index is well below zero, signaling an accommodative financial environment.

Financial Stress Index

Why the mismatch? Fed actions — QE, Operation Twist, and even steps to shrink its balance sheet — have all suppressed long-term interest rates. We need to be wary of taking signals from a distorted yield curve.

Why have stocks reacted?

This is not a Pollyanna outlook. Never argue with the tape — we are clearly in a bear market. So why are stocks diverging from the economy?

The answer is China.

The impact of a trade war with the US would most likely cause a recession in China. Oil prices are already plunging in anticipation of falling demand.

Nymex Light Crude and Brent Crude

Commodities are likely to follow.

DJ UBS Commodities Index

The impact of a Chinese recession would be felt around the globe. Europe has its own problems and could easily follow.

DJ Europe Financial Index

The US is likely to emerge relatively unscathed but Wall Street is going to be exceedingly cautious until some semblance of normality is restored.

I do not suggest selling all your stocks but make sure that there is enough cash in the portfolio to take advantage of opportunities when they arise.

Australia: Good news and bad news

First, the good news from the RBA chart pack.

Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Business investment remains weak and is likely to impact on long-term growth in both profits and wages.

Australia: Business Investment

The decline is particularly steep in the Manufacturing sector and not just in Mining.

Australia: Business Investment by Sector

But government investment in infrastructure has cushioned the blow.

Australia: Public Sector Investment

Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.

Australia: Non-Financial Sector Profits

Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.

Australia: Job Vacancies

The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.

Australia: Housing Prices and Household Debt

House prices are shrinking despite record low interest rates.

Australia: Housing Prices

Broad money and credit growth are slowing, warning of a contraction.

Australia: Broad Money and Credit Growth

Bank profits remain strong.

Australia: Bank Profits

But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.

Australia: Bank Capital Ratios

One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.

The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.

I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.

I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.

China: Activity

12 Charts on the Australian economy

Australian GDP grew at a robust 3.1% for the year ended 31 March 2018 but a look at the broader economy shows little to cheer about.

Wages growth is slowing, with the Wage Price Index falling sharply.

Australia: Wage Price Index Growth

Falling growth in disposable income is holding back consumption (e.g. retail spending) and increasing pressure on savings.

Australia: Consumption and Savings

Housing prices are high despite the recent slow-down, while households remain heavily indebted, with household debt at record levels relative to disposable income.

Australia: Housing Prices and Household Debt

Housing price growth slowed to near zero and we are likely to soon see house prices shrinking.

Australia: Housing Prices

Broad money growth is falling sharply, reflecting tighter financial conditions, while credit growth is also slowing.

Australia: Broad Money and Credit Growth

Mining profits are up, while non-mining corporation profits (excluding banks and the financial sector) have recovered to about 12% of GDP.

Australia: Corporate Profits

But business investment remains weak, which is likely to impact on future growth in both profits and wages.

Australia: Investment

Exports are strong, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Iron ore export tonnage continues to grow, while demand for coal has leveled off in recent years.

Australia: Bulk Commodity Exports

Our dependence on China as an export market also continues to grow.

Australia: Exports by Country

Corporate bond spreads — the risk premium over the equivalent Treasury rate charged to non-financial corporate borrowers — remain low, reflecting low financial risk.

Australia: Non-financial Bond Spreads

Bank capital ratios are rising but don’t be fooled by the risk-weighted percentages. Un-weighted Common Equity Tier 1 leverage ratios are closer to 5% for the four major banks. Common Equity excludes bank hybrids which should not be considered as capital. Conversion of hybrids to common equity was avoided in the recent Italian banking crisis, largely because of the threat this action posed to stability of the entire financial system.

Australia: Bank Capital Ratios

Low capital ratios mean that banks are more likely to act as “an accelerant rather than a shock-absorber” in times of crisis (2014 Murray Inquiry). Professor Anat Admati from Stanford University and Neel Kashkari, President of the Minneapolis Fed are both campaigning for higher bank capital ratios, at 4 to 5 times existing levels, to ensure stability of the financial system. This is unlikely to succeed, considering the political power of the bank sector, unless the tide goes out again and reveals who is swimming naked.

The housing boom has run its course and consumption is slowing. The banks don’t have much in reserve if the housing market crashes — not yet a major risk but one we should not ignore. Exports are keeping us afloat because we hitched our wagon to China. But that comes at a price as Australians are only just beginning to discover. If Chinese exports fail, Australia will need to spend big on infrastructure. And infrastructure that will generate not just short-term jobs but long-term growth.

Australia: Housing, Incomes & Growth

A quick snapshot of the Australian economy from the latest RBA chart pack.

Disposable income growth has declined to almost zero and consumption is likely to follow. Else Savings will be depleted.

Disposable Income & Consumption

Residential building approvals are slowing, most noticeably in apartments, reflecting an oversupply.

Residential Building Approvals

Housing loan approvals for owner-occupiers are rising, fueled no doubt by State first home-buyer incentives. States do not want the party, especially the flow from stamp duties, to end. But loan approvals for investors are topping after an APRA crackdown on investor mortgages, especially interest-only loans.

Housing loan approvals

The ratio of household debt to disposable income is precarious, and growing worse with each passing year.

Household debt to disposable income

House price growth continues at close to 10% a year, fueled by rising debt. When we refer to the “housing bubble” it is really a debt bubble driving housing prices. If debt growth slows so will housing prices.

House price growth

Declining business investment, as a percentage of GDP, warns of slowing economic growth in the years ahead. It is difficult, if not impossible, to achieve productivity growth without continuous new investment and technology improvement.

Business investment

Yet declining corporate bond spreads show no sign of increased lending risk.

Corporate bond spreads

Declining disposable income and consumption growth mean that voters are unlikely to be happy come next election. With each party trying to ride the populist wave, responsible economic management has taken a back seat. Throw in a housing bubble and declining business investment and the glass looks more than half-empty.

Every great cause begins as a movement, becomes a business, and eventually degenerates into a racket.

~ Eric Hoffer

China holds its head above water

A quick snapshot from the latest RBA chart pack.

Manufacturing is holding its head above water (50 on the PMI chart) and industrial production shows a small upturn but investment growth is falling, as in many global economies including the US and Australia. Retail sales growth has declined but remains healthy at 10% a year.

China

Electricity generation continues to climb but steel, cement and plate glass production all warn that real estate and infrastructure development are slowing.

China

Interest rates remain accommodative.

China

Real estate price growth is slowing but remains an unhealthy 10% a year. Real estate development investment rallied in response to lower interest rates but is clearly in a long-term decline.

China

There are no signs of an economy in immediate trouble but there are indications that the real estate and infrastructure boom may be ending. Through a combination of fiscal stimulus and accommodative monetary policy the Chinese have managed to stave off a capitalism-style correction. But failure to clear some of the excesses of the past decade will mean that the inevitable correction, when it does come, is likely to display familiar Asian severity (Japan 1992, Asian Crisis 1997).