What are the key risks facing the Australian economy?

By Gareth Aird, senior economist at CBA:

Re-published with kind permission from Macrobusiness.

Key Points:

  • GDP growth has lifted in 2017 and the labour market has tightened.
  • Our base case has these trends continuing over the next two years, but there are a number of downside risks.
  • The ability of monetary policy to support the economy in the event of a negative shock is more limited than in the past thereby exacerbating the potential impact that any negative shock may bring.

On some important metrics it’s been a reasonably good for year the Australian economy. The labour market has tightened courtesy of very strong employment growth and real GDP growth has lifted. At the same time, nominal GDP growth has been buoyant due to firmer commodity prices when compared to a year earlier. Wages growth, however, remains soft and real wages are barely in positive territory.

The house view is that the improvement in the labour market continues over the next two years and the unemployment rate should continue to grind lower. But there are plenty of risks that would change the outlook if they were to materialise.

This note discusses some of the key global and domestic risks to the Australian economy. It begins with an outline of CBA’s base case for the economy over the next two years before delving into some of the potential risks. This is not an exhaustive list, but rather it covers a few areas that the author considers to be the most acute risks to our central scenario. They are: (i) the capacity to respond to a negative shock with monetary policy (and to a lessor extent fiscal policy), (ii) a solid fall in commodity prices; (iii) a sharp correction in dwelling prices; (iv) a policy “mistake”; and (v) a fall in net migration via a policy change.

CBA’s central scenario

CBA’s base case for the economy over the next two years is a benign one. It is broadly similar to the RBA’s forecast profile for the economy which is also not dissimilar to the consensus view.

On the key components, we see output growth continuing to lift to a pace of around 3%pa in 2018 (chart 1). We put potential growth at 2¾% (population plus productivity growth) which means our forecast profile has a gradual decline in the unemployment rate as spare capacity recedes (chart 2). In 2018, most of the key components of the economy are expected to contribute to growth, with dwelling investment the exception.


Our base case has inflation remaining soft due to elevated slack in the labour market which is suppressing wages growth. We have core inflation tracking at the bottom of the RBA’s target band (chart 3). This means that a rate rise still looks a long way off. We have commodity prices drifting a little lower which means that we expect the terms-of-trade to ease over the next few years, but to remain above its trough in early 2016. As a result, nominal GDP growth should step down.


We don’t explicitly forecast dwelling price growth. But the most likely outcome, in our view, is for dwelling price growth to slow and converge with household income growth (i.e. a low single digit annual growth rate). Such an outcome would also represent a best case outcome from a financial stability perspective.

We expect housing credit growth to continue to slow driven by a further easing in lending growth to investors.

The capacity to respond to a negative shock with monetary and fiscal policy

Monetary policy: While strictly speaking not a risk to the economic outlook per se, in many ways the reduced capacity to respond to a negative shock, particularly via monetary policy, is the biggest risk to the economy outlook.

Over the past 30 year the interest rate lever has been used to smooth out business cycles. When output and employment growth have fallen and/or the outlook for inflation has been lowered, interest rates have come down.

Conversely, the policy rate has been raised when it’s been necessary to slow the pace of growth and inflation in the economy. That process has worked relatively well. But it may have a limited shelf life because it’s required a structural decline in interest rates to support the economy over the past 30 years (chart 4).


The amount of fire power the central bank has on the cash rate front is effectively the difference between the current policy rate and the lower bound. We aren’t at the lower bound yet. But with a current cash rate of 1.5% we are close. In our view, a policy rate of around 0.75% would probably be the lower bound in Australia, which is higher than the lower bound of many other advanced and bigger economies. In the Eurozone and Japan, for example, policy rates have gone negative. But these regions run current account surpluses which probably gives them greater scope to take rates down without causing a massive fall in their currencies (chart 5). In Australia, it may not be possible to cut the cash rate below 0.75% because the current account deficit has been sizeable in the past as a share of GDP and must be funded (note that the current account deficit would blow out if there was a negative commodity price shock). As a result, there may only be a few rate cut ‘bullets’ left if we are right. The RBA will hope that if/when the next shock arrives the cash rate is a fair bit higher than it is today to allow them scope to cut and provide stimulus to the economy. But while the cash rate sits at 1.5% the economy is more vulnerable than usual to a shock.

The limited capacity to stimulate the economy further via rate cuts means that the ability of household leverage to increase further is also hamstrung. As interest rates have come down over the past 30 years the stock of household debt relative to income has risen (chart 6). That is because households have been able to borrow more for a given level of income. As a result, Australia has
the second most indebted household sector in the world.


In previous downturns rate cuts both encouraged and made it possible for households to increase debt relative to income. That debt initially went into higher dwelling prices, but ultimately the new credit created found its way into consumption. But with very little capacity to take interest rates lower and with the household sector already very stretched, the consumer is not going to absorb the next economic shock by borrowing through it.

Fiscal policy: There is some scope to stimulate the economy via fiscal policy if/when a negative shock arrives. In fact, the Government’s balance sheet looks in a much better condition than most other advanced countries when assessed on a debt to GDP basis. But we should not get too carried away because Australia has a structural deficit which means debt to GDP will rise quite quickly if/when the next negative shock arrives. From here, any downturn in the economy would almost certainly see the Government’s triple A credit rating stripped. While there is some conjecture over the precise implications of losing the triple A, its loss would certainly carry some weight from a symbolic perspective given it’s been the proud boast of successive Treasurers.

A commodity price shock

From an external perspective, a commodity price shock carries the greatest risk to the Australian economy. Australia continues to be heavily reliant on commodities for its resource revenue (chart 7). And a huge chunk of our exports go to China (chart 8). As such, the biggest threat to commodity prices is a slowdown in China that would lead to lower investment growth (or possibly a fall in investment). Such a slowdown could occur it if the Chinese authorities accept a lower level of output growth for the sake of financial stability given the rapid build-up of corporate debt. It could also happen if a greater emphasis is placed on delivering growth through services rather than investment. And it could of course come via a China hard landing (a Trump-led lift in tariffs in the US, for example, could be the trigger). In any event, commodity prices get hit and that would have implications for the Australian economy.


A sizeable fall in commodity prices would pull Australia’s terms-of-trade substantially lower. Roughly speaking, a 40% fall in commodity prices would see Australia’s terms-of-trade fall by 30% (chart 9). This is an illustrative example, but it is also represents a plausible outcome if there was a material slowdown in investment growth in China. In such a scenario the AUD could fall to the low-mid US 50 cent mark (chart 10).


A terms-of-trade shock would weigh on income across the economy more broadly given the strong correlation between commodity prices and nominal GDP (chart 11). In addition, Government revenue would be hit because of the relationship between the terms-of-trade and the tax take. Finally, unemployment would rise. While a lower AUD would provide some support to the economy, the limited capacity of monetary policy to absorb a commodity price shock from here would see the unemployment rate rise faster than would otherwise have been the case.

The capacity of wages growth to slow further from here is also limited in the event of a commodity price shock. That is because wages growth is already at record lows and wages growth is sticky downwards. A fall in wages growth was able to cushion the most recent terms-of-trade shock (late-2011 to early 2016) because growth in wages slowed in line with the weakness in commodity prices. This helped to support the labour market and keep the unemployment rate from rising as much as it otherwise might have. But this time, a fall in wages growth will not be able to absorb the shock to the same extent given wages growth is already so low.

A sharp correction in dwelling prices

The single biggest risk to the domestic outlook looks to be a sharp correction in dwelling prices. In our view, this carries a greater risk to the real economy than it does to financial stability given the banking system is well capitalised.

There is a commonly held belief in Australia that the main trigger for a fall in dwelling prices is a rise in unemployment. This seems logical because rising unemployment would generally be associated with a lift in mortgage delinquencies which would put downward pressure on prices. But the data suggests that employment is more likely to lag changes in dwelling prices rather than lead (chart 12). The obvious question to then ask is why? We attribute the answer, in part, to the wealth effect and the recent track record of monetary policy in smoothing out the business cycle.

In periods when employment growth is slowing, the RBA is generally easing policy. When this is occurring, as long as the RBA can fend off a recession, falling interest rates tend to push up dwelling prices via cheaper credit which in turn encourages spending and supports employment growth. Of course, it’s a different story if employment growth falls too fast and unemployment rises sharply. But so far, at the national level, this hasn’t happened since the recession of the early 90s.

The risk of a material correction in dwelling prices looks higher now than it has been for a long time given: (i) the incredible lift in dwelling prices over the past five years; (ii) mortgage rates are probably unlikely to go lower and indeed can’t go much lower; (iii) household debt to income is at a record high; and (iv) dwelling supply is in the process of lifting quite significantly in some jurisdictions.

A soft correction in dwelling prices would probably have no material negative impact on the labour market. But there is a risk that a hard correction in prices (a fall of 20% or more) would lead the economy into a downturn via the wealth effect (i.e. the notion that changes in demand are influenced by changes in the value of assets). Since income to one person comes via the spending of another, there is a risk that falling home prices leads households to put the brakes on spending which ultimately drags consumption and employment growth lower.

A policy “mistake”

We consider a policy mistake by the central bank to be a risk to the economy given how much debt the household sector is carrying. Specifically, if the RBA hikes too early it could derail the improvement in the labour market that has been underway over the past two years. The record level of debt being carried by the household sector means that interest payments as a share of income will rise quickly if/when rates move higher (chart 13).


We consider a policy mistake to be a risk because the RBA has been overly bullish on wages and the consumer over the past five years (charts 14 & 15).


The apparent bias in their forecasts towards a lift in wages and consumer spending means there is a risk that they hike too early if/when wages growth starts to rise.

Here we note that the RBA puts the neutral cash rate at 3.5% which is 200bpts above current settings (this is higher than our estimate of 3.0%). This means that on their own numbers, the RBA would be tightening to 3.5% if it thought the economy was on a sustained path to full employment and inflation at the mid-point of their target band. That to us looks too aggressive and therefore
there is a risk that the central bank hikes too early or too quickly.

A change in immigration policy

Australia’s population growth rate is significantly higher than most other OECD countries. Australia’s population grew by a strong 1.6% (i.e. 373k) in 2016. Net overseas migration accounted for 56% of that increase (chart 16).


A strong population growth rate boosts the potential growth rate of the economy (not output per person, however) as well as puts upward pressure on dwelling prices through stronger demand for housing. It also, over time, alters the industry composition of the economy (chart 17).

The construction sector in Australia, for example, is proportionately bigger than the construction sector in most other advanced economies because strong growth in people means that more needs to be built – dwellings, roads, schools, hospitals, ports etc. Finally, at the margin, a strong population growth rate at a time when there is labour market slack is likely to be putting downward pressure on wages as workers from offshore add competition to domestic labour.

At present, both major sides of politics (i.e. the Liberal-National Coalition and the Labor party) support maintaining a high permanent migrant intake every year. But there is a risk that one of the major parties opts for a different policy stance. The example here is to be found in New Zealand where there has been a change in immigration policy following the recent election outcome that means migration should drop substantially over the next few years. As a result, a change in immigration policy cannot and should not be ruled out in Australia.

A material reduction in net migration to Australia would increase the risk of a fall in dwelling prices as well as weigh on total output growth (not GDP per capita) and negatively impact the construction sector. But it would also likely put upward pressure on wages growth by reducing the pool of workers in many occupations. In that context, it’s not so much a downside risk, but rather one that would see a shift in the economic outlook that would have both winners and losers. From a policy perspective it’s about assessing whether there is a net societal benefit. But that’s a question for another day.

Felix Zulauf: China, the Fed and the evolution of markets

The bull market in equities is aging | Bob Doll

Great summary of market conditions by Bob Doll:

Weekly Top Themes

  1. Last week’s elections signal possible trouble for Republicans in 2018. We caution against reading too much into the results. But Democratic gains in Virginia and elsewhere confirm signals from national polling that suggest the GOP will struggle to hold the House next year.
  2. We expect a tax bill to be passed in 2018, which should help the economy and equity markets. While there are significant differences between the two plans, the simple reality is that it would be political suicide for Republicans if they don’t pass tax reform before next year’s elections. Depending on the details of the final bill, we expect individual tax cuts to be a plus for consumption, while repatriation and corporate tax cuts should contribute to corporate revenues and earnings.
  3. Despite some views to the contrary, we believe the global economy should continue to improve. Some argue the world is in a period of secular stagnation. After all, growth remains very slow despite years of low or even negative interest rates. In our view, the world economy is enjoying a period of reflation and should experience more synchronized growth in 2018.
  4. Stronger global growth is benefiting multinational companies. These companies have reported stronger revenue and earnings results than domestically oriented companies this quarter.
  5. The bull market in equities is aging but remains very much intact. The current bull market is closing in on nine years, which makes it natural to ask how much longer it can continue. In our experience, there are several reasons for a bull market to end, including advanced Federal Reserve tightening, the flattening of the yield curve, slower levels of money growth, widening credit spreads and rising inflation. We are watching these factors closely, and don’t see signals yet that would point to the end of the current run.

In a nutshell: the bull market will continue until the Fed tightens monetary policy in response to rising inflation. When this will happen, no one is sure.

Read the rest of his report here: Nuveen Weekly Investment Commentary

Dollar finds resistance as bond yields meander

Long-term Treasury yields continue to move sideways, building a base, with 10-year yields oscillating between 2.0% and 2.6%. Breakout above the 2014 high of 3.0% appears a long way off despite the Fed gradually raising short-term rates. Rising yields increase the opportunity cost of holding gold, reducing demand.

10-year Treasury Yield

Higher interest rates would be likely to strengthen the Dollar. The bear rally on the Dollar Index has run into resistance at 95. Reversal below the rising trendline at 94 would warn of another test of primary support.

Dollar Index

Should central banks adopt a nominal GDP target? | MacroBusiness

Leith van Onselen questions whether the RBA should target a flat growth rate of say 5% for nominal GDP rather than inflation:

I am not convinced that the RBA and RBNZ should necessarily set interest rates around nominal GDP. As shown in the below charts, setting interest rates in this manner would likely see the cash rate rise significantly from current levels which, given anaemic wages growth and high underemployment in both nations, would seem unwise:

Let’s look at the graph of GDP growth a bit closer. If we target 5% GDP growth:

  • From 2001 to 2007 rates were too low. That would have softened the sharp fall in 2008
  • Rates in 2008 were too high
  • Rates were not too low in 2009 to 2010 because of the growth undershoot in 2008
  • Rates were too high 2011 to 2016
  • Again, rates are not too low in 2017 because GDP has undershot its growth target for the last 6 years

I believe that targeting nominal GDP would help to stabilize growth with higher rates in the boom to prevent the need for lower rates in an ensuing bust.

Where I do agree with Leith is that banks need to re-focus from financing largely speculative (housing) assets to financing productive investment. In fact, not just the banks but the entire economy.

Source: Should central banks adopt a nominal GDP target? – MacroBusiness

Australian dwelling prices: slowdown continues | Westpac

From Matthew Hassan at Westpac:

The CoreLogic home value index held flat in Oct taking annual growth to 7%yr, an abrupt slowdown from the 11.4%yr peak in May.

Policy measures continue to have a material impact. Although official rates remain near historic lows, regulators introduced a new round of ‘macro prudential’ tightening measures in late March. Meanwhile a range of other changes have also seen a progressive tightening of conditions facing foreign buyers.

….Sydney continues to record the sharpest turnaround in conditions, annual price growth slowing to 7.7%yr in Oct, essentially halving since Jul. Melbourne continues to see a much milder turn with price growth still tracking at 11%yr.

….The houses vs units breakdown shows a more pronounced slowdown for houses with annual price growth slowing to 7.2%yr from 12.4% in May. Our monthly seasonally adjusted estimates suggest prices have been declining at about a 2% annualised pace over the last 3mths. ….Notably, the detail suggests the pace of unit price declines in Brisbane and Perth is moderating while price growth in Melbourne units has shown essentially no slowing to date.

The slowdown is likely to carry through to year end. However, the next few months will be a critical gauge of whether markets are starting to stabilise. To date, the timeliest market measures – buyer sentiment, auction clearance rates and prices – are showing few signs of levelling out. However, some of the pressure from macro-prudential measures may ease off a little.

China’s crackdown on capital flight seems to be having an impact on housing prices in Australia. Whether this is sufficient to cause a collapse of the property bubble is doubtful unless there is a general decline in prices, causing mortgage lenders to tighten credit standards.

The banking sector remains my major concern. With CET1 leverage ratios between 4 and 5 percent, the sector could act as an accelerant rather than a buffer (Murray Inquiry) in an economic downturn.

A note on Leverage Ratios:

I use Tier 1 Common Equity (CET1) to calculate leverage rather than the more commonly used Common Equity which includes certain classes of bank hybrids — convertible to common equity in the event of a crisis — as part of capital. Inclusion of hybrids as capital is misleading as conversion of a single hybrid would be likely to panic the entire financial system (rather like a money market fund “breaking the buck”). In the recent banking crisis in Italy, regulators chose not to exercise the conversion option for fear of financial contagion. Instead the Italian government was called on to bail out the distressed banks. Same could happen here.

Source: Westpac IQ – world-class thinking in real time.

Trump to Tap Jerome Powell as Next Fed Chairman – WSJ

WASHINGTON—The White House has notified Federal Reserve governor Jerome Powell that President Donald Trump intends to nominate him as the next chairman of the central bank, according to a person familiar with the matter….

Source: Trump to Tap Jerome Powell as Next Fed Chairman – WSJ

Seven Weeks of Gains, Seven Equity Themes | Bob Doll

Great market summary from Bob Doll at Nuveen Asset Management:

  1. Economic data remains strong and hurricane effects have been surprisingly muted. Real third quarter gross domestic product was reported to be 3.0%, with nominal growth hitting 5.2%. Both numbers came in higher than expected, with nominal growth reaching its strongest pace since 2006.
  2. Home sales are increasing, demonstrating that economic growth remains broad. New home sales hit their highest level since 2007.
  3. The Federal Reserve is on track to increase rates again in December. We expect the central bank will enact its third hike of the year, while continuing to reduce its balance sheet. Fed policy remains accommodative, but is clearly normalizing.
  4. Corporate earnings are on track for another strong quarter. We are past the halfway point of reporting season, and the vast majority of companies have beaten expectations. On average, companies are ahead of earnings growth expectations by 4.9%.
  5. Stock buybacks appear to have slowed, but companies are still deploying cash in shareholder-friendly ways. From our vantage point, we are seeing companies pour more resources into hiring and modest amounts of capital expenditures.
  6. Tax reform prospects still appear uncertain, but we have seen progress on the regulatory front. While President Trump has struggled to enact his pro-growth legislative agenda, he has had success in rolling back regulatory enforcement. The financial and energy sectors in particular appear to be benefiting from less scrutiny.
  7. It is possible that tax reform will focus on corporate rather than individual rates. The most controversial aspects of tax reform are focused on possible changes to individual tax rates (such as arguments over the deductibility of state and local taxes). In contrast, corporate tax reform appears less controversial, as Congress seems to have broad agreement on the need to reduce corporate taxes and solve the issue of overseas profits. While still a small probability, Republicans may choose to separate the two issues and proceed solely on a corporate tax bill.

Economic growth remains muted but earnings are exceeding expectations. High levels of stock buybacks in the last few years must be playing a part.

Rising home sales are a bullish sign.

The Fed remains accommodative for the present but I expect increasing inflationary pressure to temper this next year.

Slow rates of investment remain a cause for concern and could hamper future growth — buybacks are cosmetic and won’t solve the low growth problem in the long-term.

Corporate tax reform would be a smart move, creating a more level playing field, while avoiding the acrimony surrounding individual tax rates.

Stage 3 of the bull market continues…..

Source: Weekly Investment Commentary from Bob Doll | Nuveen

China’s bank chief warns of a ‘sharp correction’

Ambrose Evans-Pritchard reports on a statement by Zhou Xiaochuan, the governor of the People’s Bank (PBOC):

Mr Zhou told China Daily that asset speculation and property bubbles could pose a “systemic financial risk”, made worse by the plethora of wealth management products, trusts, and off-books lending.

He warned that corporate debt had reached disturbingly high levels and that local governments were using tricks to evade credit curbs.”If there is too much pro-cyclical stimulus in an economy, fluctuations will be hugely amplified. Too much exuberance when things are going well causes tensions to build up. That could lead to a sharp correction, and eventually lead to a so-called Minsky Moment. That’s what we must really guard against,” he said.

The function of the central bank is to remove the punch bowl just as the party really gets going (William McChesney Martin jr., Fed chair 1951 – 1970). It looks like the PBOC may have left it too late:

Non-financial debt has galloped up to 300 per cent of gross domestic product – uncharted territory for a big developing economy.

The International Monetary Fund says debts in the shadow banking system grew by 27 per cent last year.

Less widely known is that the “augmented” budget deficit – including local government spending and the deficits of quasi-state entities – has jumped to 13 per cent of GDP. This is an astonishing level of fiscal stimulus at this stage of the economic cycle. It was around 6 per cent in 2010….

What this means is that public and quasi-public debt in China is growing at the rate of 13% of GDP. China has achieved its growth targets but at what cost to economic stability? There are no free lunches, especially from the “perpetual leveraging doomsday debt machine”.

Source: China’s bank chief warns of a ‘sharp correction’

ASX 200 meets resistance as miners retreat

The ASX 300 Metals & Mining index breached its new support level at 3300, warning of a bull trap. Penetration of the rising trendline would test primary support at 3100.

ASX 300 Metals and Mining

The divergence between iron ore and miners was bound to end and a correction of the Metals & Mining index is now likely. Iron ore below support at $62 warns of a test of primary support at $53. Declining Twiggs Trend Index signals selling pressure.

Iron ore

The ASX 200 encountered resistance at 5900. Retracement is likely to test the new support level at 5800 (top of the narrow ‘line’ formed over the last four months). Twiggs Money Flow reversal below zero would be a bearish sign.

ASX 200

The ASX 300 Banks index are testing resistance at 8800. Respect of resistance would warn of another test of primary support at 8000.

ASX 300 Banks

If banks and miners both turn bearish, the index is likely to follow.

The truth about our debt

Stephen Koukoulas says Australians have little to worry about high household debt:

….According to the latest data complied by the RBA, household assets are growing very strongly, aided by a building up in savings, unrelenting growth in superannuation holdings, growth in bank deposits and of course, from rising house prices.

While household debt is indeed just under 200 per cent of disposable income, household holdings of financial assets, which includes superannuation, direct share holdings and deposits, is now over 400 per cent of income…..

….The total value of housing in Australia is …. over 500 per cent of disposable income.

…. for every $1 of debt that the house sectors has, they have $5 of assets, which is a loan to value ratio of 20 per cent.

…..while the asset side of the household balance sheet remains healthy, the debt side will remain a non-problem.

That’s the problem with averages, they conceal a multitude of sins. Many Australians own houses without a mortgage. Probably the same group own most of Australia’s financial assets. They are financially secure, no doubt, and help to make the averages look reasonable.

But there are vast numbers of Australians in the mortgage belt with low financial assets and high loan-to-value ratios (LVRs) on their household mortgage. Any rise in interest rates would cause them financial stress and the impact of this would flow through the entire economy.

From Elizabeth Tilley at the Courier Mail:

Almost 50,000 households are at risk of defaulting on their home loans in the next 12 months and nearly a third of homeowners are in mortgage stress, new figures show.

The latest mortgage stress and default modelling from Digital Finance Analytics for the month of September reveals more than 905,000 households are estimated to be in mortgage stress — 45,000 more than there were the month prior.

….Of those households, 18,000 are in severe stress, which means they are unable to meet home loan repayments with their current income.

Not quite as rosy as the averages may seem.

Source: The truth about our debt

Hat tip to Macrobusiness.

Why is Macquarie long the “perpetual leveraging doomsday machine” | Macrobusiness

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.

Performance of the Macquarie Group Thematics portfolio (Macquarie Group)

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 readers shy away from profiting from these themes, there is always gold.

“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.

The big shrink commences

“The Federal Reserve left its benchmark interest rate unchanged and said Wednesday that it would begin to withdraw some of the trillions of dollars that it invested in the US economy after the 2008 financial crisis.” ~ Binyamin Applebaum

The Federal Reserve balance sheet ballooned in the last decade to current holdings of $2.5 trillion of US Treasury securities and $1.8 trillion of mortgage-backed securities.

Hourly Wage Growth

Fed total assets of $4.5 trillion (the red line on the above chart) does not give the full picture. Of the cash injected into the economy, $2.2 trillion found its way back to the Fed by way of excess reserves deposited by banks (the blue line). These deposits earn interest at the rate of 1.25% p.a., providing a secure return on surplus funds. What this means is that the net effect of the balance sheet expansion is the difference between the two lines, or $2.3 trillion.

Even $2.3 trillion is a big number and any meaningful sale of securities by the Fed would contract the supply of money, tipping the economy into recession. So how does the Fed propose to manage “normalization of its balance sheet” without disrupting the economy?

Firstly, the Fed does not intend to sell securities. It will simply decrease the “reinvestment of principal repayments it receives from securities held” according to its June 2017 Normalization Plan.

The amount withheld from reinvestment will commence at $10 billion per month ($6bn US Treasuries and $4bn MBS) and step up by $10 billion each quarter until it reaches a total of $50 billion per quarter.

That means that $100 billion will be withheld in the first year and $200 billion in each year thereafter….”so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.”

Second, the Fed will reduce the level of excess reserves by an appreciable amount in order to soften the impact of the first step. So a $100 billion reduction in investments may only result in a net reduction of say half that figure, after taking into account the decline in reserves.

Third, the federal funds rate will remain the primary tool of monetary policy and will be used to fine tune monetary policy to fit economic conditions.

It appears that the Fed will start quite tentatively, withholding only $30 billion in the first quarter, but the longer term targets seem ambitious.

With currency in circulation now growing at an annual rate of $100 billion, even a $50 billion reduction in the first year (net of excess reserves) could leave a big hole.

Currency in Circulation

This is bound to take some of the heat out of the stock market. The plus side is it may restore some sanity to market valuations, but any sudden moves could cause an overreaction.

Added later:

Even if we compare the reduction to the annual change in M1 money supply, it takes a big bite.

M1 money supply

M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler’s checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.

Australia: Economy needs more support

Low corporate bond spreads (BBB-Treasury) indicate the absence of financial stress.

Corporate Bond Spread

Australian wage growth is also low, but declining.

Wage Index

And shrinking currency growth suggests the economy needs even more support than the large recent spend on public infrastructure.

Currency Growth

It’s a bull market

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%.

Hourly Wage Growth

Currency in circulation, growing at a healthy annual rate of 7.3%, shows the Fed stance remains supportive.

Currency in Circulation

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.

Employee Compensation & Corporate Profits Relative to Net Value Added

The rising Freight Services Index indicates that economic activity is strong.

Freight Services Index

While a low corporate bond spread — lowest investment-grade (Baa) minus the equivalent Treasury yield — indicates the absence of stress in financial markets.

Corporate Bond Spreads

What more can I say: It’s a bull market.

Australia: Housing bubbles and declining business investment

The Australian housing bubble is alive and kicking, with house prices growing at close to 10% per year.

House Prices

Loan approvals are climbing, especially for owner-occupiers. Fueled by record low interest rates.

Loan Approvals

Causing household debt to soar relative to disposable income.

Loan Approvals

Business Investment

Nominal GDP growth of 6.34% for the 2017 FY is a rough measure of the average return on capital investment.

Australia Nominal GDP

With a mean of close to 5% over the last two decades, it is little wonder that business investment is falling. Not only in mining-related engineering but in machinery and equipment.

Australia Business Investment

Capital Misallocation

More capital is being allocated to housing than to business investment.

Australia Credit Growth

Returns on housing are largely speculative, premised on further house price growth, and do little to boost GDP growth and productivity.

The result of soaring house prices and household debt is therefore lower business investment and lower GDP and wages growth.

Australia Wages Growth

You don’t have to be the sharpest tool in the shed to recognize that soaring household debt and shrinking wage growth is likely to end badly.

S&P 500 Bull Market Continues

The S&P 500 continues with a secondary correction that is likely to test the long-term rising trendline and support at 2400. Bearish divergence on Twiggs Money Flow warns of selling pressure but this seems secondary in nature.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500

Twiggs Volatility (21-day), at 0.63% for the S&P 500, is way below the 1.5% warning level for elevated market risk.

S&P 500 with Twiggs Volatility

The yield curve is flattening, with the 10-year minus 3-month Treasury Yield Differential close to 1.0%. But this is still well above the 0.5% early-warning level. A negative yield curve, where the Yield Differential falls below zero, is normally followed by a recession within 6 to 12 months.

Yield Differential

Fed monetary policy remains accommodative, with currency in circulation expanding at a healthy annual rate of 6.9%.

Currency in Circulation

The bull market remains on track for further gains.

US: Low CPI and soft Treasury Yields

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.

Consumer Price Index (CPI) and Core CPI

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%*.

10-Year Treasury Yields

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.

Bank Credit and GDP growth

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.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500