Bill Evans at Westpac sums up their outlook for the Australian economy:
….Constraints on growth next year are likely to centre on a lack lustre consumer who struggles under the weight of weak wages growth; high energy prices and excessive leverage. Conditions in housing markets, particularly in the eastern states, are likely to soften while the residential construction boom will turn down.
We are also less euphoric about growth prospects for our major trading partners than seems to be the current consensus. We expect China’s growth rate to slow from 6.7% to 6.2% as the authorities step up policies to slow its long running credit boom.
Yet the ASX 200 broke out of its line formed over the last 4 months, signaling a primary advance.
Miners are advancing, with the ASX 300 Metals & Mining Index breaking resistance at 3300.
The ASX 300 Banks Index is headed for a test of 8800. Upward breakout would complete a bullish outlook for the ASX 200.
By David Llewellyn-Smith (“Houses & Holes”)
Reproduced with kind permission from Macrobusiness:
Great stuff today from the always entertaining and cross-disciplinary Viktor Shvets at Macquarie:
Investors seem to be residing in a world without any notable perceived risks. It is an extraordinary and unprecedented situation, particularly given unresolved issues of over leveraging and associated over capacity as well as profound disruption of business and economic models, which are not just depressing inflation but also causing extreme political and electoral outcomes while feeding Maslowian-type disappointments across labour markets.
What can explain such lack of concern regarding potential risks?
In our view, the only answer is one of investors’ perception that, as we discussed in our preview of 2H’17, ‘slaves must remain slaves’ and hence, neither Central Banks nor other public institutions can afford to step aside but need to continue to guarantee asset price inflation. In its turn, this can only be achieved by ensuring that volatilities are contained (as they are the deadliest enemy of an ongoing leveraging) and liquidity is expanding at a sufficient pace to accommodate nominal demand.
The optimists would argue that the productivity slowdown that the world experienced over the last decade was primarily caused by the global financial crisis (GFC) and that we are starting to turn the corner. Hence, optimists argue that velocity of money is likely to improve, and this would allow Central Banks to gradually (and very carefully) withdraw liquidity and rate supports. While this is the ‘dream outcome’ from Central Banks’ perspective, we don’t see any convincing evidence that this is occurring.
We maintain that the best explanation for investors’ perception that risks are low is that a combination of Central Banks’ liquidity (still running at ~US$1.5-2.0 trillion per annum), an assumption that Central Banks would swiftly reverse their policies at the slightest sign of volatility reemerging, and China’s real estate and infrastructure investment, act as ‘risk buffers’. Investors seem to believe that liquidity cannot be withdrawn, volatility must be arrested and cost of capital cannot go up, and hence, financial assets are in many ways underwritten. While Central Banks would like to have a little bit more volatility and a little bit more price discovery, they would be highly averse to shocking what is the highly financialized and leveraged global economy.
While it is hard to back what is essentially a long-term ‘doomsday’ machine, nevertheless, the above describes our view. We remain constructive on financial assets (both equities and bonds), not because we expect a return to self-sustaining private sector led recovery and growth but because we believe that an ongoing financialization is the only politically and socially acceptable answer. In our view, therefore, the greatest risk is one of policy miscalculation.
We remain constructive on financial assets, not because we believe in a sustainable recovery, but because we back the perpetual leveraging ‘doomsday’ machine.
Shvets has been pushing the “long grinding cycle” narrative for a number years now:
Despite all these challenges, Shvets still recommends his clients to invest in certain types of stocks. “The outcomes of the next 10-15 years could be quite dramatic. How do you invest in that climate? There are only two ways of investing. The first is: Assume non-mean reversion. The private sector will never recover. The only thing left would be the public sector cycle.”
This means we can conveniently forget about corporate profits, or valuations like the price-earnings ratio of the S&P 500, as many investors already have done. The only thing that matters is public sector activity in the form of central bank intervention or government stimulus programs.
An extreme example of this cycle is perhaps Venezuela. While the country is going up in flames, people don’t have enough food, and the currency is dissolving itself in a vicious hyperinflation, the stock market actually went up 10 times since the beginning of 2012. Only recently has reality caught up with stocks and the market gave up 15 percent of its gains since the beginning of the year.
‘Buy quality sustainable growth, high returns on equity. Companies capable to generate a high return on equity through margins and without leverage. Don’t worry about the price to earnings ratio, there is no mean reversion,” says Shvets. And don’t own any financials. Good advice. The stock price of the likes of Deutsche Bank and Credit Suisse have been decimated this year.
The share prices of Deutsche Bank AG (DBK) and Credit Suisse AG (CSGN) have both lost almost 50 percent of their value this year (Source: Google Finance).
The other option is to invest along some pretty grim themes which benefit from the new trends identified by Shvets. “People are still going back to 20th-century thematics, it’s so old-fashioned.”
None of the new trends can be described as inspirational or uplifting, but the Macquarie portfolio reflecting the themes has bested the MSCI World Index by almost 30 percent since the beginning of 2015.
“The biggest theme is declining return on humans, the replacement of humans, biotech, augmentation of humans, opium for the people, like computer games and gambling,” Shvets said.
Then there are themes catering to geopolitical risk and potential regional war or civil uprisings, like detention and prison centers, weapons, and drones. Another theme supports the aging demography in the West, so companies holding hospitals, funeral operators, and psychiatric institutions should do well.
On the positives, Shvets notes technological disruptors like Amazon and Google. All those companies should be independent of the government and long-term structural shifts. “They go on no matter what.”
“If you think of gold, the only way gold loses is if normal business and private sector cycles come back. If that is the case, gold goes back $100 per ounce. The other outcomes: deflation, stagflation, hyperinflation are all good for gold.” As for a return to a gold standard, Shvets has more bad news: “Gold standards come back after the war, not before the war.”
In principle I agree therefore the MB Fund is long:
US stocks despite the valuations;
we are underweight Australian assets given interest rates will go to zero or the equivalent in a world of endless oversupply;
investment becomes a matter of discerning the most potent disruptors or the most embedded rent-seekers at the best prices.
Where I disagree is that the business cycle is entirely dead. To my mind, this is a process not a one-off shift, driven by successive crises that shunt de-globalisation and de-privatisation forward with each convulsion. After all, we have not yet had an earnings-destroying event in the US in this cycle so the lack of risk has been real.
Next year China is going to slow and the Fed tighten, at some point one two many times. Mean reversion will come but then so will our next round of socialisation.
US hourly wages continue to grow at a subdued 2.5% per year. The Fed will normally only move to tighten monetary policy when annual growth exceeds 3.0%.
Currency in circulation, growing at a healthy annual rate of 7.3%, shows the Fed stance remains supportive.
Turning to corporations (excluding the financial sector), employee compensation remains low relative to net value added (below 70%), while corporate profits are high at 12%. Economic contractions are normally preceded by rising employee compensation and falling profits as in 1999/2000.
The rising Freight Services Index indicates that economic activity is strong.
While a low corporate bond spread — lowest investment-grade (Baa) minus the equivalent Treasury yield — indicates the absence of stress in financial markets.
The Consumer Price Index (CPI) and Core CPI (excluding food and energy) both came in at a low 1.7% p.a. for the 12 months ended July 2017.
Source: St Louis Fed, BLS
Long-term interest rates are trending lower as CPI moderates. Breach of support at 2.10% by 10-Year Treasury Yields would signal another primary decline with a target of 1.80%*.
Target: 2.10% – (2.40% – 2.10%) = 1.80%
Bank credit growth is slowing, to the level where it is tracking nominal GDP growth, avoiding some of the excesses of previous cycles. But if bank credit falls below GDP growth that would warn of tighter monetary conditions and the economy is likely to slow.
Source: St Louis Fed, FRB, BEA
The S&P 500 is testing its long-term rising trendline, while bearish divergence on Twiggs Money Flow warns of selling pressure. But the market appears to have shrugged off Donald Trump’s promises of North Korean “fire and fury” and both of these movements seem secondary in nature. A correction is likely but the primary trend remains on track for further gains.
Interesting paper by Michael Bauer at the San Francisco Fed:
….The difficulty of predicting changes in interest rates mainly arises from two features that characterize their evolution over time. First, like other financial variables, interest rates vary widely from day to day, which makes them difficult to link to economic fundamentals such as monetary or fiscal policy. This well-documented “excess volatility,” was first pointed out in Shiller (1979), and it reflects the importance of frequent changes in investor sentiment due to a never-ending stream of economic data releases and other news.
Second, as evident from 10-year Treasury yields since 1971, seen in Figure 1, interest rates have not fluctuated around a stable average level over this period. Instead of “mean reversion” around a constant average, they exhibit slow-moving trends, such as the rise during the “Great Inflation” period of the 1970s, and the long-lasting decline since then.
….the gap model does not assume that the level of the series will revert to some constant mean, but instead that the gap between the series and its trend component will revert to zero. Estimating trend components and gaps underlies most macroeconomic forecasting, and Faust and Wright (2013) recently demonstrated the gap model’s excellent performance for inflation forecasting.
….Since inflation is ultimately determined by monetary policy, the long-run inflation trend corresponds to the perceived inflation target of the central bank. This can be estimated reasonably well from surveys. Figure 1 plots the publicly available and mostly survey-based inflation trend estimate (red line) that underlies the Federal Reserve Board’s structural model of the U.S. economy, FRB/US. For the trend in the real interest rate, also called the natural or equilibrium real interest rate, Laubach and Williams (2003) suggested a way to estimate it from macroeconomic data and popularized its use in policy analysis (see also Williams 2016). Figure 1 includes an estimate of the equilibrium real interest rate (green line) taken as the average of several popular estimates, as discussed in Bauer and Rudebusch (2017).
Figure 1 also plots the sum of these two trends (red line); this estimate of the trend component in interest rates has exhibited a very pronounced decline since the 1980s. The 10-year yield generally fluctuated near this trend, and both are currently very low in historical comparison, with important consequences for policymaking (Williams 2016). Figure 1 suggests that it may be useful to take into account the level of the trend when forecasting interest rates.
….the final piece required for a practical forecast rule is an assumption about the transition of interest rates to their trend. Based on how quickly interest rates have historically reverted back to the trend, a reasonable assumption to make for this forecasting exercise is that 20% of the remaining gap is closed each quarter. But the precise speed of reversion to the trend is typically not crucial for forecasting performance (Faust and Wright 2013). Furthermore, it becomes essentially irrelevant for long-horizon forecasts, since forecasts are approximately equal to the estimated trend…..
Bob Doll at Nuveen makes a good point about Trump’s failure to get infrastructure spending through the House.
Washington, D.C. seems mired in gridlock, despite the fact that Republicans control the House, Senate and White House. No significant economic legislation has been passed, and the optimism from January about health care reform, infrastructure spending and tax cuts has all but vanished. Political attention will soon be focused on the 2018 midterm elections, and the window for pro-growth policy action is closing.
The lack of fiscal stimulus is disappointing, but it comes with a silver lining: We are unlikely to see the significant and sharp advance in interest rates or in the U.S. dollar that would probably result from such stimulus. The lost opportunity on the political front might therefore have the ironic effect of prolonging the bull market in stocks.
It seems crazy when you consider that both Clinton and Trump campaigned on a platform of major infrastructure programs to boost the economy. Just shows how dysfunctional Washington has become.
But I agree with the silver lining. Infrastructure spending would have boosted employment — the US is already below its long-term natural rate of unemployment — and upward pressure on wage rates. Which would have drawn a sharp increase in interest rates from the Fed, to combat inflation. Populist policies often ignore the hidden/unforeseen consequences and can produce the opposite result to that intended.
Jens Meyer at the AFR says that a stronger Dollar and low inflation are likely to prevent the RBA from raising interest rates for some time:
Inflation is expected to remain below the Reserve Bank’s comfort zone when second-quarter CPI data is unveiled on Wednesday. Despite a jump in vegetable prices due to damage caused by Cyclone Debbie, economists predict consumer prices rose just 0.4 per cent over the second quarter and 2.2 per cent over the year.
More importantly for the central bank, ongoing softness in wages growth is tipped to have kept a cap on the less volatile core inflation, coming in at 0.5 per cent over the quarter and 1.8 per cent over the year, below the Reserve Bank’s target band of 2 to 3 per cent.
Rising iron ore prices helped the Aussie Dollar break long-term resistance at 78 cents, testing 80 against the greenback. This goes against the wishes of the RBA who need a weaker Dollar to assist exports and boost import substitution.
But the RBA is in a cleft stick. It cannot lower rates in order to weaken the Dollar as this would encourage speculative borrowing and aggravate the property bubble. It also can’t raise rates when inflation is low, the Aussie Dollar is strong and the economy is weak. Like Mister Micawber in Charles Dickens’ David Copperfield, the RBA has to sit and wait in the hope that something turns up.
ABS June figures reflect solid gains for the labor market. Justin Smirk at Westpac writes:
“….The annual pace of employment growth has lifted from 0.9%yr in February to 2.0%yr in May and it held that pace in June. In the year to Feb there was a 106.9k gain in employment; in the year to June this has lifted to 240.2k. The Australian labour market went through a soft patch in 2016 that was particularly pronounced through August to November when the average gain in employment per month was a paltry 2.2k. We have clearly bounced out of this soft patch and now holding a firmer trend.”
My favorite measure, monthly hours worked, jumped (year-on-year) by 3.1%.
Infrastructure spending, particularly in NSW and Victoria, is doing its best to offset weakness in other areas.
Wage rate growth remains subdued, indicating little pressure on the RBA to lift rates.
U.S. monetary policy should remain equity-market friendly. In her comments last week, Janet Yellen stated that the neutral rate for the fed funds rate is “currently quite low,” and rates would not have to rise much more to become neutral. In our view, a neutral fed funds rate is closer to 2% than the 3% currently implied by the fed funds futures market. If this is accurate, it would likely be good news for economic growth, corporate earnings and the stock market.
Global monetary policy is starting to normalize, but still supports stocks. The Bank of China raised rates by 25 basis points last week and other central banks are becoming less dovish. We think this is good news since it reflects improving global economic growth, while overall policy remains easy. Central banks are still promoting liquidity, which should support equities and other risk assets.
Inflation remains surprisingly low. Although economic growth is improving and the Fed is normalizing, inflation has not increased similarly. Inflation should eventually react to tightening labor markets, but the process is taking a long time.
If the “Goldilocks” environment persists, we think equities can continue to make all-time highs. Low inflation, slow-but-positive economic growth, climbing earnings and a cautious Fed have contributed to record-high stock prices. We think these conditions should remain in place for at least the next 6 to 12 months.
Active fund manager performance has improved. According to Merrill Lynch, 54% of active large cap U.S. equity managers outperformed their benchmarks for the first half of the year and more than half also outperformed for the last four months. This is the longest such streak since Merrill Lynch began tracking this data in 2009, and it marks the first time a majority of managers outperformed for the first half of a year.
Global monetary policy supportive of stocks, low inflation and slow-but-stable earnings growth. Nothing much wrong here. Inflation is the one to watch though. A surge in wage rates as the labor market tightens would tighten monetary policy, with a domino effect on earnings and stock performance.
U.S. employers picked up their pace of hiring in June. Nonfarm payrolls rose by a seasonally adjusted 222,000 from the prior month, the Labor Department said. The unemployment rate ticked up to 4.4% from 4.3% the prior month as more people joined the workforce…..
Source: St Louis Fed & BLS
Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.
Source: St Louis Fed, BLS & BEA
Declining corporate profits as a percentage of net value added (RHS) is typical of mid-cycle growth, while employee compensation (% of net value added) is rising at a modest pace. Peaks in employee compensation are normally accompanied by troughs in corporate profits…..and followed by a recession.
Source: St Louis Fed & BEA
Average wage rate growth, both for production/non-supervisory and all employees, remains below 2.5% per year. Absence of wage rate pressure suggests that the Fed will be in no hurry to hike interest rates to curb inflationary pressure.
I don’t attach much significance to the Gold-Oil ratio on its own but it’s back in overbought territory, above 25.
The chart below — plotting inflation-adjusted prices (over CPI) — far better depicts the relationship between gold and crude oil. Each major spike in crude prices over the last 50 years has been followed by a rising gold price.
Falling crude prices are likely to weaken demand for gold over the next few years, both through lower inflation and declining foreign reserves of major oil producing nations.
The Dollar Index continues to test support at 96.50. The primary trend is down and breach of support is likely, signaling a decline to test the 2016 low at 92/93.
Spot Gold found support at $1250. A weaker Dollar and rising political uncertainty both favor an up-trend but rising interest rates are expected to weaken demand. Respect of support at $1250 would confirm the up-trend, while breach of $1200 would warn of another decline.
Growth of currency in circulation is also slowing. The fall below 5% warns of a contraction.
One piece of good news is that Chinese monetary policy seems to be easing. After a sharp contraction of M1 money stock growth in January, February shows a partial recovery. Collapse of the Chinese property bubble may be deferred a while longer.
Which is good news for iron ore exporters. At least in the short-term.
Headline jobs growth came in well below expectations, and weather played some part in suppressing job growth, both in construction and retail.
But the jobless rate dropped to 4.5%, its lowest reading since 2007, so the Fed’s “full-employment” mandate has been met.
Their other mandate is on inflation, and over the past year I’ve discussed our U.S. Future Inflation Gauge, which anticipated the inflation cycle upturn shown by the chart. Today the forward looking USFIG remains near an 8¾ -year high.
The chart shows the year-over-year PCE inflation rising sharply to a 5-year high, and breaching the Fed’s 2% inflation target which is defined by this inflation measure.
For those who might think this is just about oil prices, please note that core PCE inflation, ex-food and energy, has also been rising, and now above 1¾%, the highest reading in over 2½ years.
This is what a cyclical upswing in inflation looks like.
Moreover, the U.S. economy has a good tailwind from rising global growth.
All of this helps explain why the Fed is finally able to implement a full-fledged rate hike cycle.
I frequently come across stocks such as Netflix [NFLX], trading on a forward PE of 137 (Morningstar), or even Coca Cola [KO] and Procter & Gamble [PG] that leave me muttering about unrealistic valuations.
Nobel laureate Robert Shiller this week commented that he was no longer buying stocks as he believed they were overvalued. His justification is the CAPE index which compares current stock prices to the 10-year average of inflation-adjusted earnings.
The index is below its Dotcom high but is approaching the same level that it peaked at in 1929. Is the CAPE index flawed or does this portend disaster?
Bear in mind that Shiller is not selling all his existing stocks — he has merely stopped buying — and is the first to point out that the CAPE index is a poor tool for timing market tops and bottoms.
Before we make any rash decisions let us compare Shiller’s index to a few other handy measures of market valuation.
Warren Buffett’s favorite
Warren Buffett’s favorite measure of market value is to compare total stock market capitalization to GDP. The higher the ratio, the more the stock market is overvalued.
This looks even worse than the CAPE index, with market cap to GDP well above its 2007 high and well on its way to Dotcom levels.
Adapting the ratio to include offshore earnings of multinational companies makes very little difference to the results. Here I compare market cap to GNP as well as GDP. GNP, or gross national product, includes offshore earnings of domestioc companies rather than just domestic earnings as with GDP. The end result is much the same.
Market Cap to Corporate Profits
When we compare market capitalization to current profits after tax, however, valuations are still high but nowhere near the irrational exuberance of the Dotcom era.
The current peak resembles earlier peaks in the 1980s and 1960s.
What this tells us is that corporate profits are rising faster than GDP. And that a 10-year average may be a poor reflection of future sustainable earnings.
Are current earnings sustainable? There is no clear answer to this. But there are some key criteria if earnings are to remain at current levels of GDP.
First, wage rate growth remains low. The graph below illustrates how profits fall when employee compensation rises (per unit of value added).
Second, that interest rates stay low. The Fed is doing its best to normalize interest rates but monetary tightening would spoil the party. That is, deliberate tightening by the Fed to subdue rising inflationary pressures.
A third element is corporate taxes but there seems little risk of rising taxes in the current climate.
The key variable for both #1 and #2 is wage rates. At present these are subdued, so no cause for alarm.