Australia: Bearish apart from mining

Household disposable income lifted in response to the recent tax cuts but households remain risk-averse, with consumption still falling and extra income going straight to debt repayment — reflected by a jump in the Saving ratio below.
Australia Household Saving

Housing prices are recovering despite high levels of mortgage stress in the outer suburbs but building approvals for new housing continue to fall. Construction expenditure is likely to follow.

Australia Building Approvals

GDP growth is falling, while corporate profits (% of GDP) remain in the doldrums apart from the mining sector.

Australia Corporate Profits

Low household disposable income and corporate profit growth in turn lead to low business investment (% of GDP).

Australia Business Investment

Low investment leads to low job creation. Job vacancies and job ads both warn of declining employment growth.

Australia Job Ads

Cyclical employment growth is expected to slow in line with the fall in the Leading Indicator over the past year.

Australia Leading Employment Indicator

We maintain a bearish outlook for the Australian economy, though Mining continues to surprise to the upside.

Australia: Leading Index of Employment in 16th month of decline

The Department of Employment, Skills, Small and Family Business released their Monthly Leading Indicator of Employment for September 2019, recording its 16th straight month of decline.

Hat tip to Macrobusiness, this is a peach of an indicator, predicting Australia’s economic performance.

I have added % retracement in the ASX 200 to the graph below. Each of the significant past troughs in the Leading Index coincides with a drawdown of more than 20% in the ASX 200.

Leading Index of Employment

Is the current fall in the Leading Index a false alarm, as in the 2005/2006 raging commodities bull market, or are we in for another retracement?

Leading Index of Employment - Components

My money is on the retracement.

Australian banks: Still overpriced

Summary

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.

Future Growth

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.

Majors: Total Assets to Nominal GDP

Private borrowers are near saturation point, with household debt at an eye-watering 190% of disposable income.

Australia: Household Debt to 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%.

Margins

Net interest margins declined to 1.73% for Q1 2019 and we expect a long-term average of 1.70%.

Majors: Income & Expenses

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 & Commissions

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.

Majors: Fees & Commissions

Expenses

Operating expenses have also fallen but sticky personnel costs are declining at a slower rate.

Majors: Expenses

Non-Performing Assets

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%.

Majors: Provisions for Bad & Doubtful Debts

Capital

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.

Management & Culture

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.

Valuation

We project:

  • long-term asset growth at 4.0% p.a.;
  • net interest margins at 1.7% of average total assets;
  • non-interest operating income of 0.5%;
  • operating expenses at 1.1%;
  • provisions for bad/doubtful debts averaging 0.2%; and
  • a 30% tax rate.

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.

Technical Analysis

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.

ASX 300 Banks Index

Conclusion

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.

Disclosure

Staff of The Patient Investor may directly or indirectly own shares in the above companies.

Australia: Headwinds persist

From Elliot Clarke & Simon Murray at Westpac:

…the take home from Budget 2019 is that, while supportive of activity over the long-term, the near-term impact on incomes and activity is limited. Labor’s alternative proposals, as per the budget reply, are also spread out over time. So no matter which party wins in May, the headwinds of persistent weak income growth and declining house prices are set to hold growth well below trend through 2019. This is clear justification for interest rate cuts from the RBA, which Westpac believes will come in August and November.

While the RBA is yet to adopt an easing bias, the April meeting decision statement did emphasise the fluidity of the situation…

The last sentence is important: the RBA has not yet adopted an easing bias. Perhaps because of the housing debt bubble.

Australia: Household Debt and Disposable Income

Business investment has already failed to respond to interest rate cuts.

Australia: Business Investment

10-Year AGB yields are already below US Treasuries but have failed to significantly weaken the Australian Dollar.

Australia: Difference to US 10-Year Bond Yield

House prices are falling.

Australia: Housing Prices

Plunging high-density housing approvals promise a sharp slow-down in housing construction.

Australia: Building Approvals

Dwelling Investment is likely to join Mining Investment in the red, detracting from GDP growth. Windfall iron ore prices (Exports) are keeping the economy afloat, while they last.

Australia: GDP Components

Bank’s impaired and total non-performing assets are low, but likely to rise if the housing fall (and construction down-turn) continues.

Australia: Bank Non-Performing Assets

Bank capital ratios are modest at just over 10% of common equity (CET1) against risk-weighted assets. But that falls to about 5.5% without risk-weighting (leverage ratio). Not a lot of room for comfort.

Australia: Bank Capital

Australian households are spending more than they are earning | ABC

Interesting chart from Stephen Letts at the ABC:

Thomson Reuters: Australian Consumption v. Disposable Income

Household consumption is growing at a faster rate than disposable income, with savings rates (net savings / disposable income) falling. This is clearly unsustainable. Savings rates, which include compulsory super contributions, fell to just 1.0% in Q2, with savings outside of super being rapidly eroded.

That relationship is even more unsustainable now house prices are falling, according to Deutsche bank’s Phil Odonaghoe.

“Strengthening housing wealth accrued by the household sector has been an important factor supporting the decline in saving. With house prices now falling, that support has been removed.”

From Households are now spending more than they are earning — and that’s not sustainable | Stephen Letts | ABC.

Hat tip to Macrobusiness.

ACCC bells the cat on electricity | Graham Young

While on the fringe of our normal investment sphere, this article by Graham Young on energy costs, published today in Online Opinion, poses some serious questions for the Australian economy.

In an inversion of the social hierarchy of Yes Minister, it would appear that Australia has at least one courageous public servant – ACCC Chair Rod Sims.

When it comes to energy generation Sims has shown remarkable fortitude and has belled the cat a number of times, including calling-out the price gouging of the Queensland government through their publicly-owned electricity utilities.

His latest act of heroism is the ACCC Electricity supply and prices inquiry final report which is a tacit acknowledgement that current strategies for CO2 abatement will not work at an affordable price.

It is the best analysis of the energy market that we have, and must lead to a rethink of the role of the AEMO, AER and AEMC. These bodies have comprehensively failed and pushed Australian power prices up to unsustainable levels.

The report also calls into question the NEG, proposing a role for the federal government to provide stability through the provision of stable baseload power generation.

The role of the Chief Scientist, Mr Finkel, must also be under review as it shows how ineffective his Review into the Future Security of the National Electricity Market was.

It also means that the states should wind-down their subsidy schemes for wind and solar and hand control of these matters to the Commonwealth government. With a national electricity network the decisions in one state impact on the prices paid by consumers in all states.

Many on the left, including the Opposition, are pointing to market failure as a problem, but what the ACCC reveals is the real problem is regulator failure.

In an ideal world the ACCC proposal for the federal government to underwrite the construction of new baseload power is suboptimal, but a regrettable necessity in the current situation. It is likely to be less costly than building Snowy 2.0 to deal with the vagaries of increased penetration of wind and solar.

Another implication of the report is that Australia, and the world, also needs to adopt a new approach to CO2 abatement: intermittent energy will not power the world, even with storage.

Not only has the current approach led to unsustainably high power prices, but CO2 world emissions are still growing, and after an approximate 10% decrease since 2005, so too are Australia’s.

It’s likely that any decrease in Australian emissions is due to higher power prices creating a degree of de-industrialisation. But as we consume at ever increasing levels, the amount of CO2 embedded in our economic production and consumption is probably higher than it was in 2005.

All that has happened is there has been a flight of production from Australia to countries with lower electricity prices, and higher CO2 emissions.

The world has been running a number of real world experiments on renewable energy over the last 13 years since the Kyoto Climate Agreement came into effect. Those experiments prove conclusively that with present technologies renewables are not viable, even if the politicians of Germany and California, to mention two, haven’t worked it out yet.

Everywhere that penetration of renewables has exceeded 25% or so, prices have increased. This is because, while the collection of energy is relatively cheap, with the raw materials of wind and sunlight being provided free by nature, the systems components are phenomenally expensive, requiring investment in networks, standby power generation and storage, at the same time pushing the price of baseload power higher.

The only form of renewables that provide reliable power at reasonable prices are hydro schemes, and some of them run out of water at times as well.

The definitive proof of this failure is that, if it were possible to power an economy using renewables only, and if they were, as Mark Butler claimed yesterday, cheaper than alternatives, then the Communist People’s Republic of China, a brownfields site for industrialisation, would take this opportunity to provide all future power through renewable energy.

Instead of that, our chief strategic rival is building nuclear reactors (17 under construction and a total of 100 operational by 2030), and coal-fired power stations (299 units under construction in China today, according to the Australian Parliamentary Library).

They are then using that power to manufacture and then dump photovoltaic cells on the Western World which we are then using to deindustrialise, giving them a further industrial and strategic advantage.

If Butler is right they wouldn’t waste their time building a “more expensive” system with baseload power generators which they will then have to decommission, and retrofit the system for “cheaper” renewables – it just wouldn’t make sense.

The ACCC report gives us a chance to take account of these realities and recalibrate our approach to the Paris Accord.

In the first place we need to get a real feel for the CO2 intensity of world economies, and that can’t be measured just on domestic emissions, when much of our consumption is imported. We need to measure the CO2 actually embedded in our consumption.

This will provide a better discipline and put an end to the Ponzi scheme where we shuffle our emissions off somewhere else without actually changing much more than place of production.

Then we need to accept the reality that Bronze Age technologies like wind, and novelties like solar, cannot provide reliable grid-scale power, and increase actual electricity costs and that the only technology that has a chance of solving the energy trilemma (cost, reliability and emissions) is nuclear. So if we are serious about emissions we need to be serious about nuclear.

Given the issues with nuclear a sensible use of the resources being poured into “clean” energy should be redirected to researching nuclear power and handling spent nuclear fuel.

Australia is already a leader in one of these areas, having developed Synrock for safe storage of spent nuclear fuel in 1978.

An alternative to storage is reprocessing. As a country which already mines uranium and turns it into yellow cake we have advantages there as well.

While developing a nuclear program we need holding and bridging strategies to limit emissions. Efficiency is probably the lowest cost strategy, and an increased use of gas, which emits half as much CO2 as coal, another.

Finally we need to understand that storage will never be suitable for a large scale grid without repealing the Second Law of Thermodynamics – that’s the one that put paid to perpetual motion machines.

Battery enthusiasts draw comparisons between computers and batteries and predict that, just as computers have dived in cost and soared in computing power, the same will happen to batteries and power output.

But computers have done this by miniaturising and using less power to do the same work. Batteries are all about producing energy, and only so much efficiency can be wrung out of this process.

A more realistic model for how much increased efficiency is available is the motor vehicle. While it is true to say that the modern car is a significant refinement on the Model T, that refinement is nothing like the one that occurred between a pioneering computer like ENIAC, and the laptop on which I am typing this article.

The only step change in energy production comparable to that in computing is contained in the equation e=mc2, where Einstein showed that changing a small amount of mass into energy released huge amounts of energy.

Which brings us back to nuclear.

While the ACCC report doesn’t mention nuclear, it does open up the conversation. Politicians need to grab the opportunity. Otherwise they face a grinding political death between the stones of increasing electricity costs and decreasing reliability, all while CO2 emissions continue to rise.

This article was first published in The Spectator. Republished under a Creative Commons License.

Graham Young is chief editor and the publisher of On Line Opinion. He is executive director of the Australian Institute for Progress, an Australian think tank based in Brisbane, and the publisher of On Line Opinion.

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