Category: Banks & Interest Rates

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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

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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.

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Nasdaq breaks resistance

Real GDP growth came in at a healthy 3.2% for the 12 months ended 31 March 2019. Growth in total hours worked is lagging below 2.0%, suggesting that further acceleration is unlikely.

Real GDP and Total Hours Worked

Growth in total non-farm payrolls continues at close to 2.0%, minimizing the chance of an interest rate cut by the Fed.

Payroll Growth

The S&P 500 is testing its previous high at 2940, while a rising Trend Index (13-week) indicates buying pressure.

S&P 500

The Nasdaq 100 broke resistance at 7700, signaling another advance. Expect retracement to test the new support level. The long-term target is 9000.

Nasdaq 100

A rapid advance would outstrip earnings growth, with high earnings multiples warning of elevated risk. The market is quite capable of continuing this behavior for an extended time but I urge readers to be cautious and look for rising sales and earnings to support the stock price.

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S&P 500: Expect slower earnings growth but no sign of recession

Credit growth in the US above 5% shows no signs of tighter credit conditions from an inverted yield curve. Growth in the broad money supply (MZM plus time deposits) has also not slowed, remaining close to 5%.

Credit Growth and Broad Money Supply

Growth in hours worked has slowed to 1.71%, suggesting that real GDP growth will dip below 2% in 2019 but remain positive.

Hours Worked and Real GDP growth

The Fed is unlikely to cut interest rates when average hourly earnings are growing at 3.2% (Total Private for the 12 months ended March 2019).

Average Hourly Wage Rate

The Leading Index from the Philadelphia Fed fell below 1%, giving an early warning that GDP growth will slow.

Philadelphia Fed Leading Index

A similar dip below 1% occurred ahead of the last three recessions. A second, stronger dip would warn of recession ahead.

Philadelphia Fed Leading Index

The S&P 500 is advancing to test resistance at 2950/3000, while the Volatility Index crossed below 1%, signaling that risk is no longer elevated.

Treasury Yields

Real GDP is likely to slow this year but remain positive. S&P 500 earnings growth is expected to slow and the index is likely to meet stubborn resistance at 2950/3000. The Fed is still a long way off cutting interest rates (a strong bear signal) and there is no sign of recession on the 2019 horizon. An extended top is the most likely outcome.

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Inverted yield curve is no cause for panic….yet

10-Year Treasury yields continue to fall. A Trend Index peak below zero signals strong selling pressure (purchases of bonds).  Target for the decline is primary support at 2.0%.

10-Year Treasury Yields

The spread between 10-Year and 3-Month Treasury yields is at zero, warning that the yield curve is about to invert. While there is no cause for panic, an inverted yield curve is a reliable predictor of recession within 12 to 18 months, preceding every recession since 1960*.

*1966 is an arguable exception. Initially classed as a recession by the NBER, it was later reversed and airbrushed out of history.

10-Year minus 2-Year Treasury Yields & Bank Credit

The 10-year/3-Month spread last crossed below zero in August 2006 and was followed by a recession in December 2007. While credit conditions tighten when the yield curve inverts, there is considerable lag and the chart below shows that credit growth remains high while the yield curve is inverted.

Yield Curve Inversions & Bank Credit

A far more imminent warning (of recession) is when the yield differential recovers above zero.

Why does a recovering yield curve warn of impending recession?

First, you need to understand what causes the yield curve to invert. Economic prospects weaken to the extent that bond investors are prepared to accept lower long-term yields than the current short-term yield, in anticipation that interest rates will fall. The inverted yield curve will continue for as long as rates are expected to fall but will rapidly recover when the Fed starts to cut rates.

Treasury Yields

Falling short-term yields flag that the Fed is cutting interest rates, confirming bond investors earlier suspicions of a weakening economy. That serves as a reliable warning, after an inverted yield curve, of impending recession.

We are not there yet. The Fed may have eased off on further rate rises but is still some way off from cutting rates.

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S&P 500: Treasuries warn of a bear market

10-Year Treasury yields plunged Friday, to close at 2.45%, warning of a decline to test primary support at 2.0%.

10-Year Treasury Yields

The yield curve is now likely to turn negative. The 10-Year/2-Year yield differential has already fallen to 0.13%. Below zero signals a negative yield curve, a reliable predictor of oncoming recession within the next 12 to 18 months.

10-Year minus 2-Year Treasury Yields

The S&P 500 retreated Friday and is likely to breach its new support level at 2800. Follow-through below 2600 would warn of a bear market.

S&P 500

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“Stocks rebound but sentiment soft”

From Bob Doll at Nuveen Investments. His weekly top themes:

1. We think the odds of a U.S. recession are low, but we also believe growth will remain soft for a couple of quarters. U.S. growth may bottom in the first half of 2019 following a relatively disappointing fourth quarter and the recent government shutdown. We expect growth will improve in the second half of the year.

Agreed, though growth is likely to remain soft for an extended period. The Philadelphia Fed Leading Index is easing but remains healthy at above 1.0% (December 2018).

Leading Index

2. Inflation remains low, but upward pressure is mounting. With unemployment under 4% and average hourly earnings rising to an annual 3.6% level, we may start to see prices rise. So far, better productivity growth has kept the lid on prices, but this trend bears watching.

Agreed. Average hourly earnings are rising and inflation may follow.

Hourly Earnings Growth

3. Trade issues remain a wildcard. The U.S./China trade dispute appears to be making progress, but the timeline is slipping and significant disagreement remains over tariff levels and intellectual property protections.

This is the dominant issue facing global markets. Call me skeptical but I don’t see a happy resolution. There is too much at stake for both parties. Expect a drawn out conflict over the next two decades.

4. We do not expect Brexit to cause widespread market issues. We think the risk of a hard Brexit is low, since no one wants to see that outcome. Some sort of soft separation or even a Brexit vote redo appears more likely.

Agreed. Hard Brexit is unlikely. Soft separation is likely, while no Brexit is most unlikely.

5. The health care sector may remain under pressure due to political rhetoric. Health care stocks in general, and managed care companies in particular, have struggled in light of talk about ending private health care coverage. We think Congress lacks the votes to enact such legislation. But this issue, as well as drug pricing policies, are likely to remain at the center of the political dialogue through the 2020 elections.

Health care is a political football and may take longer to resolve than the trade war with China.

6. Downward earnings revisions may present the largest risk for stocks. As recently as September 30, expectations for first quarter earnings growth were +7%. That slipped to +4% by January 1 and has since fallen to -3%.

A sharp fall in earnings would most likely spring from a steep rise in interest rates if the Fed had to combat rising inflation. That doesn’t seem imminent despite rising average hourly earnings. The Fed is maintaining money supply growth at close to 5.0%, around the same level as nominal GDP, keeping a lid on inflationary pressures.

Money Supply & Nominal GDP growth

7. Equity returns may be modest over the next decade compared to the last. Since the bull market began 10 years ago, U.S. stocks have appreciated over 400%. It’s nearly impossible to imagine that pace will be met again, but we feel confident that stocks will outperform Treasuries and cash over the next 10 years.

Expect modest returns on stocks, low interest rates, and low returns on bonds and cash.

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Aussie banks get a wake up call from across the Tasman

I have long called for Australian banks to increase their equity capital in order to withstand a potential banking crisis in Australia. The Murray Commission found that banks, in a crisis, would act as “an accelerant rather than a shockabsorber”.

Now the RBNZ has announced plans to force the big four banks to hold more capital in their New Zealand banking operations. From Clancy Yeates at the Sydney Morning Herald:

The Reserve Bank of New Zealand has mounted a firm defence of its plan to force Australia’s major banks to hold $NZ12.5 billion ($A12.12 billion) more in capital in their banking operations across the Tasman, saying the “highly profitable” businesses would have to accept lower returns.

In an interview on Wednesday, RBNZ deputy governor Geoff Bascand also justified the plan to bolster bank balance sheets by emphasising the social costs of banking crises and arguing New Zealand could not rely on Australian parent companies for a bail-out in severe shock.

……The big four Australian banks made $4.4 billion in cash profits from their New Zealand operations in 2018 representing about 15 per cent of their total combined profit with ANZ tipped to experience the most significant hit.

Mr Bascand said the central bank had estimated the big four’s NZ return on equity, until recently 14 to 15 per cent, would decline by between and 1 and 3 percentage points as a result of the change.

Earlier, Bascand said:

“At one time, the owners of a bank had plenty of skin in the game; in fact, there was a time when banks got most, or all, of their money from their owners. However, over the last century, banks have started to use less of their own money and more of other people’s, and the balance has almost entirely reversed. While we are not attempting to turn back the clock …..We believe that more ‘skin in the game’ for banks will result in:

  • Banks being better able to absorb large, unexpected losses
  • Society being less at risk from banking crises
  • Reduced fiscal risk…..As the global financial crisis illustrated, when banks fail there can be a severe domino effect that puts pressure on governments to step in with financial support
  • Bank shareholders and management being less inclined to take excessive risks”

(Gareth Vaughan, Interest.co.nz)

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”. Bear in mind that risk-weighting significantly understates total assets and that leverage ratios, reflecting un-weighted assets, are about 55% of the above (i.e. 8.8%).

The banks have protested, warning that increasing capital will raise interest rates to borrowers.

…..The RBNZ has acknowledged interest rates charged by banks will probably rise as a result of the change, but Mr Bascand said it estimated the impact would be about half a standard 0.25 percentage point move in official interest rates.

If banks’ borrowing rates did rise more sharply than expected, he said the RBNZ could offset this through monetary policy…..

What the banks failed to consider (or mention) is that investors are prepared to accept lower returns on equity if there is lower associated risk. Also banks with strong balance sheets have historically experienced stronger growth. Both lower risk and stronger growth would help mitigate the costs of additional capital.

Question is, why are RBNZ raising concerns about bank capital and not APRA? Another case of regulatory capture?

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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.

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‘It could be on the scale of 2008’ | SMH

Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.

“People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.

“China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told UK’s The Daily Telegraph, speaking before the World Economic Forum in Davos.

“There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.

Read the full article from Ambrose Evans-Pritchard at smh.com.au: ‘It could be on the scale of 2008’: Expert sends warning on China downturn

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