The most worrying aspect of rising Australian debt is that most of it is coming from offshore.
Domestic borrowing is fairly benign, but an increase in international liabilities suggests the country is living beyond its means. Has been for a while.
RBA strategy: Fight fire with gasoline
This is just plain wrong.
The Australian economy is sitting atop an enormous housing bubble caused by credit expansion from 1995 to 2007. To counter the end of the mining boom, the RBA lowered interest rates to stimulate the economy. While this may be necessary to relieve pressure on borrowers, what we don’t need is another credit expansion. That would simply make the economy more unstable and increase the risk of a crash. Banks are moving to curb lending to speculators, with lower LVRs, but not fast enough in my view. We can’t afford a credit contraction, but the RBA needs to impose sufficient discipline to keep credit growth at/below the inflation rate — so that it gradually declines in real terms as the economy grows.
Global economy: No surprises
The global economy faces deflationary pressures as the vast credit expansion of the last 4 decades comes to an end.
Commodity prices test their 2009 lows. Breach of support at 100 on the Dow Jones UBS Commodity Index would warn of further price falls.
The dramatic fall in bulk commodity prices confirms the end of China’s massive infrastructure boom.
Crude oil, through a combination of increased production and slack demand has fallen to around $60/barrel.
Falling prices have had a sharp impact on global Resources and Energy stocks….
But in the longer term, will act as a stimulus to the global economy. Already we can see an up-turn in the Harpex index of container vessel shipping rates, signaling an increase in international trade in finished goods.
The latest OECD export statistics show who the likely beneficiaries will be. Primary producers like Brazil and Russia have suffered the most, while finished goods manufacturers like China and the European Union display growth in exports. The US experienced a drop in the first quarter of 2015, but should rebound provided the Dollar does not strengthen further.
Australia and Japan offer a similar contrast.
Oil-rich Norway (-5.8%,-13.3%) has also been hard hit. Primary producers are only likely to recover much later in the economic cycle.
Are US stocks really over-valued?
Stock Market Capitalization
Let us start with Warren Buffet’s favorite market valuation ratio: stock market capitalization to GDP. I have modified this slightly, replacing GDP with GNP, because the former excludes offshore earnings — a significant factor for multinationals.
The ratio of stock market capitalization to GNP now exceeds the highs of 2005/2006, suggesting that stocks are over-valued — approaching the heady days of the Dotcom era.
Corporate Profits
If we dig a bit deeper, however, while the ratio of market cap to sales is also high, market cap to corporate profits remains low.
Clearly profit margins have widened, with corporate profits increasing at a faster rate than sales. The critical question: is this sustainable?
Sustainability of Profits
At some point profit margins must narrow in response to rising costs. Increases in aggregate demand may lift employment and sales, but also drive up labor costs.
The brown line above depicts labor costs as a percentage of net value added, compared to corporate profits (blue) as a percentage of net value added. There is a clear inverse relationship: when labor costs rise, profit margins fall (and vice versa). At first the effect of narrower margins is masked by rising sales, but eventually aggregate profits contract when sales growth slows (gray stripes indicate past recessions).
Interest Rates and Taxes
Other contributing factors to high corporate profits are interest rates and taxes. Corporate profits (% of GNP) have soared over the last 30 years as bond yields have fallen. The benefit is two-fold, with lower interest rates reducing the cost of corporate debt and lower finance costs boosting sales of consumer durables.
Lower effective corporate tax rates (gray) have also contributed to the surge in profits as a percentage of GNP.
The most enduring of these three factors (labor costs, interest rates, and tax rates) is likely to be taxes. Corporate tax rates have fallen in most jurisdictions and US rates are high by comparison. Even if a long-overdue overhaul of corporate taxation is achieved in the next decade (don’t hold your breath), the overall tax rate is likely to remain low.
If Not Now, When?
The other two factors (labor costs and interest rates) may not be sustainable in the long-term but it will take time for them to normalize.
Treasury yields are rising, with the 10-year at 2.37 percent. Breakout above 3.0 percent still appears some way off, but would confirm the end of the 35-year secular down-trend.
Interest rates are likely to remain low until rising labor costs force the Fed to adopt a restrictive stance.
Labor markets have tightened to some extent, as indicated by the higher trough on the right of the above graph. But this is likely to be slowed by the low participation rate, with potential employees returning to the workforce, and a strong dollar enhancing the attraction of cheap labor in emerging markets.
Hourly earnings growth in the manufacturing sector remains comfortably below the Fed’s 2.0 percent inflation target. Any breakout above this level, however, would be cause for concern. Not only would the Fed be likely to raise interest rates, but profit margins are likely to shrink.
For the present
None of the macroeconomic and volatility filters that we monitor indicate elevated market risk. I expect them to rise over the next two to three years as the labor market tightens and interest rates increase, but for the present we maintain full exposure to equities.
Interest rates and inflation hurt gold prices
Where is inflation headed? The five-year breakeven rate (5-Year Treasury Yield minus 5-year TIPS) is hovering around 1.80 percent, close to the latest readings for core CPI. The market is anticipating low inflation for the next few years.
Long-term interest rates are rising in anticipation of Fed tightening. 10-Year Treasury yields, in a primary up-trend, are retracing to test their new support level at 2.25%. Respect is likely and would signal an advance to long-term resistance at 3.0 percent. Rising 13-week Twiggs Momentum crossed above zero, strengthening the signal.
Gold
Low inflation reduces demand for gold as an inflation-hedge, while rising interest rates increase its carrying cost for speculators and the opportunity cost for investors. These factors are exerting downward pressure on gold prices. The spot price recovered above medium-term support at $1180/ounce, but the breach continues to warn of a test of the primary level at $1140. 13-Week Twiggs Momentum peaking below zero also suggests continuation of the primary down-trend. Failure of $1140 would offer a long-term target of $1000*.
* Target calculation: 1200 – ( 1400 – 1200 ) = 1000
The Gold Bugs Index, representing un-hedged gold stocks, is testing primary support at 155. Breach of support would strengthen the warning.
The key to economic prosperity is good governance
Podcast: Francis Fukuyama on the importance of good governance [05:23].
It is time we started raising the bar for our own political system.
Why Fixed Investment is Critical to the US Recovery
The financial sector normally acts as a conduit, channeling savings from private investors to the corporate sector. When the conduit works effectively, the injection of demand from corporate Investment is sufficient to offset the ‘leakage’ from demand caused by Savings. Savings patterns alter during a financial crisis, however, with concerned households cutting back on expenditure and using any surplus to pay down debt, rather than depositing with the bank or buying stocks. Household Savings rise but corporate Investment contracts. The resulting ‘leakage’ from demand causes GDP to spiral downward.
When Investment contracts, unemployment rises. The relationship is evident on the graph below, but it could also be said that Investment rises when employment grows — businesses invest in anticipation of rising demand. Either way, it is safe to conclude that rising investment and job growth go hand-in-hand.
Fixed Investment and Corporate Profits
Rising corporate profits also lead to increased investment. The lag on the graph below — investment growth follows profit growth — clearly illustrates the causative relationship.
This is an encouraging sign, as the current surge in corporate profits is likely to be followed by rising investment — and further job growth.
Weekly Earnings and GDP
Rising weekly earnings already point to improving aggregate demand and consequent investment growth.
All that is missing is for the federal government to increase investment in productive* infrastructure to further boost job growth.
*Infrastructure investment needs to generate a sufficient return to repay debt incurred to fund the spending. Something many politicians seem to forget when preoccupied with buying votes for the next election.
RIP ZIRP | PIMCO
From Marc Seidner:
At this point, the evidence is close to overwhelming that the Federal Reserve will embark on a tightening cycle this year. The base case for markets should be a move in September. While the pace of tightening should be very shallow and the ultimate destination for interest rates considerably lower than historical experience, investors should not underestimate the potential volatility emanating from the first interest rate increase in nine years and the first move off of the zero bound in six years….
Read more at RIP ZIRP | PIMCO Blog.
How much longer can the global trading system last? | Michael Pettis
Michael Pettis quotes a Brazilian economist on the dilemna facing the US:
….As the US becomes a declining share of the globalized world, the costs of imposing stability (and I have no illusions that this is done for charity) rise, and its share of the benefits decline. It is only a matter of arithmetic that at some point the costs will exceed the benefits.
Pettis describes how other countries have gamed the system – notably Germany and France in the 1960s, Japan in the 1980s, and China in the 2000s – and argues that the costs to the US already outweigh the benefits.
….Many economists may disagree with me that the costs of the current role the US plays in the global trade regime exceeds the benefits, but the point of this essay is to show that even if I am wrong, as long as the world grows faster than the US, more of the world is incorporated into the global trading system, and more countries design growth models that suppress domestic consumption in order to subsidize domestic growth, there must of necessity be a point at which it makes sense for the US to opt out of its role as shock absorber, and – by raising tariffs, intervening actively in the currency, restricting foreign purchases of US assets and especially US government bonds, or otherwise reducing capital inflows – become simply one more member of a system with no automatic adjustment process.
The current system, in other words, is inherently unstable and will sooner or later force the US economy into a position of choosing either to take on excessive risk or to abdicate its role as shock absorber….
Sustained current and capital account imbalances are unhealthy except for the few rare instances where capital-rich economies invest or loan money to a capital-poor recipient. In most cases capital is used to purchase secure Treasury investments in the US in order to offset a domestic current account surplus. This has a destabilizing effect not only on the US economy, which has shed millions of manufacturing jobs and created a housing bubble of epic proportions, but on the global economy as a whole, destroying any benefit to the perpetrator.
Read more at How much longer can the global trading system last? | Michael Pettis' CHINA FINANCIAL MARKETS.
Gold breaks $1180 support
Core CPI continues to track close to the Fed target of 2.0 percent (CPI All Items is distorted by falling oil prices).
Long-term interest rates are in a primary up-trend, with 10-year Treasury note yields breakout above resistance at 2.25% offering a target of 3.0 percent. Rising 13-week Twiggs Momentum above zero strengthens the signal.
The Dollar Index continues to test support at 95. Breach would warn of a test of the primary level (and rising trendline) at 93. A sharp decline on 13-Week Twiggs Momentum indicates this is likely.
Gold
A weakening dollar would boost demand for gold, but rising interest rates counter this. Spot gold broke medium-term support at $1180/ounce, warning of a test of the primary level at $1140. 13-Week Twiggs Momentum peaks below zero suggest continuation of the primary down-trend. Failure of $1140 would offer a long-term target of $1000*.
* Target calculation: 1200 – ( 1400 – 1200 ) = 1000