3 Headwinds facing the ASX 200

The ASX 200 broke through stubborn resistance at 5800 but is struggling to reach 6000.

ASX 200

There are three headwinds that make me believe that the index will struggle to break 6000:

Shuttering of the motor industry

The last vehicles will roll off production lines in October this year. A 2016 study by Valadkhani & Smyth estimates the number of direct and indirect job losses at more than 20,000.

Full time job losses from collapse of motor vehicle industry in Australia

But this does not take into account the vacuum left by the loss of scientific, technology and engineering skills and the impact this will have on other industries.

…R&D-intensive manufacturing industries, such as the motor vehicle industry, play an important role in the process of technology diffusion. These findings are consistent with the argument in the Bracks report that R&D is a linchpin of the Australian automotive sector and that there are important knowledge spillovers to other industries.

Collapse of the housing bubble

An oversupply of apartments will lead to falling prices, with heavy discounting already evident in Melbourne as developers attempt to clear units. Bank lending will slow as prices fall and spillover into the broader housing market seems inevitable. Especially when:

  • Current prices are supported by strong immigration flows which are bound to lead to a political backlash if not curtailed;
  • The RBA is low on ammunition; and
  • Australian households are leveraged to the eyeballs — the highest level of Debt to Disposable Income of any OECD nation.

Debt to Disposable Income

Falling demand for iron ore & coal

China is headed for a contraction, with a sharp down-turn in growth of M1 money supply warning of tighter liquidity. Falling housing prices and record iron ore inventory levels are both likely to drive iron ore and coal prices lower.

China M1 Money Supply Growth

Australia has survived the last decade on Mr Micawber style economic management, with something always turning up at just the right moment — like the massive 2009-2010 stimulus on the chart above — to rescue the economy from disaster. But sooner or later our luck will run out. As any trader will tell you: Hope isn’t a strategy.

“I have no doubt I shall, please Heaven, begin to be more beforehand with the world, and to live in a perfectly new manner, if — if, in short, anything turns up.”

~ Wilkins Micawber from David Copperfield by Charles Dickens

Seven Signs Australians Are Facing Economic Armageddon

Economics advisor John Adams warns that Australia faces “economic Armageddon” because of “significant structural imbalances” not seen since the lead up to the Great Depression in the 1920s.

Here are his seven signs:

Seven Signs Australians Are Facing Economic Armageddon

Sign 1: Record Australian Household Debt

According to the Reserve Bank of Australia, Australia’s household debt as a proportion of disposable income now stands at a record high of 187%.

The two closest episodes were the 1880s and the 1920s, which both preceded the only two economic depressions ever experienced in Australian history in 1890 and 1929.

Sign 2: Record Australian Net Foreign Debt

Australia’s net foreign debt now stands at more than $1 trillion and as a proportion of Gross Domestic Product was at a record high of 63.3% in June 2016.

This makes Australians much more vulnerable to international economic developments such as higher global interest rates, international financial crises or major government or corporate bankruptcies.

Sign 3: Record Low Interest rates

Australia has its lowest official interest rates on record with the Reserve Bank of Australia’s cash rate sitting at 1.5%. The current low rate of interest is not sustainable over the medium term and will inevitably rise.

Australians, particularly in Sydney and Melbourne, who have borrowed record amounts of money are very susceptible to higher interest rates.

4: Australian Housing Bubble

The expansion of credit by the Reserve Bank of Australia has been pumped into the Australian housing market over the past 25 years. Credit, which has been directed to Housing as a proportion of Australia’s GDP, has exploded from 21.07% in June 1991 to 95.06% in June 2016.

Over the same period, credit which has been directed at the business sector or to other personal expenses has remained relatively steady as a proportion of GDP.

5: Significant Increases in Global Debt

The General Manager of the Bank for International Settlements stated on 6 February 2017:

“Total debt in the global economy, including public debt, has increased significantly since the end of 2007 … Over the past 16 years, debt of governments, households and non-financial firms has risen by 63% in the United States, the euro area, Japan, the United Kingdom, Canada and Australia, 52% in the G20 and 85% in emerging economies. Heavy debt can only leave less room for manoeuvre in responding to future challenges.”

Sign 6: Major International Asset Bubbles

There are significant asset bubbles in bonds, stocks and real estate in major economies such as the United States and China, which has been fueled by the significant increases in global debt.For example, the Shiller PE Index in the United States which measures the price of a company’s stock relative to average earnings over the past 10 years is now at 28.85. This is the third highest recorded behind the Tech Bubble in 1999 and “Black Tuesday” in 1929.

Sign 7: Global Derivatives Bubble

According to the Bank for International Settlements, the value of the over the counter derivatives market (notional amounts outstanding) stood at US$544 trillion.

Much of these derivatives contracts are concentrated on the balance sheets of leading global financial and banking institutions such as Deutsche Bank. The concentration of complex derivative contracts on bank balance sheets poses significant risks to both individual institutions and the global financial system.

Veteran Investor Warren Buffet has repeatedly warned that derivatives are “financial weapons of mass destruction” and could pose as a “potential time bomb”.

Household debt is too high. Rising foreign debt and record low interest rates are fueling a housing bubble. Global debt is too high and rising, while stocks are over-priced. Throw in the global derivatives “bubble” with some truly terrifying numbers just to scare the punters out of their wits.

Nothing new here. Nothing to see. Move along now. The global economy is in good hands…..

Or is it? Aren’t these the same hands that created the current mess we are in?

John Adams is right to warn of the dangers which could have a truly apocalyptic effect, that makes the global financial crisis seem like a mild tremor in comparison.

Some of the risks may be overstated:

The derivatives “bubble” is probably the least of our worries as most of these positions offset each other, giving a net position a lot closer to zero.

Defensive stocks like Consumer Staples and Utilities are over-priced but there still appears to be value in growth stocks. And earnings are growing. So the stock “bubble” is not too alarming.

Global debt is too high but poses no immediate threat except to countries with USD-denominated debt — or Euro-denominated debt in the case of Greece, Italy, etc. — that cannot issue new currency to repay public debt (and inflate their way out of the problem).

But that still leaves four major risks that need to be addressed: Household debt, $1 Trillion foreign debt, record low interest rates and a housing bubble.

From Joe Hildebrand at News.com.au:

Mr Adams called on the RBA to take pre-emptive action by raising interest rates and said the government needed to rein in tax breaks like negative gearing as well as welfare payments.

This, he admitted, would result in “a mild controlled economic recession” but would stave off “uncontrolled devastating depression”.

The problem is that the Australian government appears to be dithering, with one eye on the next election. These are not issues you can “muddle through”.

If not addressed they could turn into the four horsemen of the apocalypse.

Source: Apocalyptic warning for Australian families

Intent as the enemy of truth | On Line Opinion

From Jennifer Marohasy:

When all 1,655 maximum temperature series for Australia are simply combined, and truncated to begin in 1910 the hottest years are 1980, 1914, 1919, 1915 and 1940.

…..Considering land temperature across Australia, 1914 was almost certainly the hottest year across southern Australia, and 1915 the hottest across northern Australia – or at least north-east Australia. But recent years come awfully close – because there has been an overall strong warming trend since at least 1960, albeit nothing catastrophic.

……there is compelling evidence that the Bureau of Meteorology remodels historical temperature data until it conforms to the human-caused global warming paradigm.

I would like to see more open debate around this issue rather than the typical “trust me I’m an expert” or “the science is settled” response.

Source: Intent as the enemy of truth – On Line Opinion – 9/1/2017

Australia: Say goodbye to growth

Business investment in Australia continues its sharp descent since the end of the mining boom, falling below 14% of GDP for the first time since the Dotcom crash.

Australia Business Investment
Source: RBA Chart Pack

Apart from the expected “cliff” in Engineering, investment in Machinery and Equipment has fallen to record lows.

Australia Business Investment - Components
Source: RBA Chart Pack

Without investment, growth is likely to contract. The impact on Australian wages is an ominous warning.

Australia Wage Growth
Source: RBA Chart Pack

Australian democracy is in very serious jeopardy | Macrobusiness

By Houses and Holes on November 4, 2016:

Australian democracy is in very serious jeopardy. China is making great strides towards it and its intentions are not benevolent. It’s obvious in local, regional and global trends and if we do not do something soon to protect our freedoms they are going to be sold into the burgeoning Chinese empire, as well as political hegemony, by a corrupt oligarchy.

Some of you will tell me to take off my tin foil hat for writing this. To you I say ‘listen up’.

For the next few decades the global political economy will be a contest between post-cultural free moving capital and deeply cultural labour. This will mean ebbs and flows between investment and regulation in an overall trend towards de-globalisation.

As nation states rise from the past few decades of globalisation to protect their respective labour pools, there will be an increasing Balkanisation of trade and investment flows, particularly in terms of regions. One can foresee a time when a European trading bloc competes with American and Asian trading blocs as each’s respective hegemon – US, China and Germany – muscles out its sphere of influence.

In terms of the magnitude of these respective spheres, the biggest loser will be the United States as it is increasingly contested in North Asia. Europe may also lose as the eurozone either disintegrates or shrinks. China will win big.

Don’t get me wrong, I am not arguing that China will grow to rule the world, nor that the US will decline and fall. In fact, I expect US economic dominance to outlast China’s great leap forward owing to its immense sophistication, markets, research capability and excellent demographics. On the other hand, China faces an extremely difficult transition through the ‘middle income trap’ and terrible demographics.

Nonetheless, the sheer magnitude of these economies and powers mean that the great regional Balkanisation will transpire.

Thus Australia will find itself an object of contest within a region caught between respectively receding and advancing Super Powers. We are already seeing this very clearly in the shifts undertaken by both the Philippines and Malaysia. Both nations are led by highly dubious democratic leaders under intense pressure from a traditional US ally to come clean on corruption.

Yet both have instead turned to China to prop up their respective regimes with enormous investment deals that have come with fabulous reciprocal endorsements for Beijing, Manila and Kuala Lumpur. This while the US’s rather foolishly self-serving TPP dies on the shelf.

At the risk of stereotyping, these new Asian power relationships much more resemble a Confucian model that privileges patronage and filial bonds above the probity and meritocracy of democracy.  China’s goals here are very obviously to undermine not just US influence but to empower local entities that are sympathetic to its interests. It may or not be an explicit goal to undermine democracies as well but if promoting local ‘strongmen’ does so then all the better!

Now turn to our local circumstances. Australia is the midst of a terms of trade boomlet engineered exclusively in Beijing. After decades of stupidly pro-cyclical policy-making Australia is now little more than a southern province of Chinese economic policy. With the flick of a pen in an obscure public service department, China delivers tens of billions to our shores in coal revenues and our monumental trade deficit evaporates overnight.

There is no other economy on earth that I know of that works with this dependence. We call it lucky. And it is. But it also comes with strings attached and they have been on display for a decade or more. Australian policy attitudes towards China have morphed steadily from a middle power engagement that included dialogues on human rights and democratic process to today’s pragmatic “do what you like boss” attitude.

I’m not writing to judge that. The kids of Tibet and Tienanmen are not Australian and there are limits to how much anyone can care about far flung folk. Especially when you’re offered a hundred billion dollar blindfold. Moreover, China needs Australian dirt to power its development so the power transmission is not all one way. The natural asymmetry of the political relationship is counter-balanced by the natural asymmetry of the economic one.

That’s the past. The future is very different indeed. China is going to need less and less dirt over time as it grows richer and more regionally powerful. And that’s where the recent events in the Philippines and Malaysia are a very important cautionary tale for Australian democracy. As we’ve seen, the next phase of Chinese development will be to throw off enormous sums of capital and people. Australia is happily gobbling up both at the moment to offset the declines in its dirt fortunes.

But this wave comes with much more explicit power compromises than we have already seen in action. The Sam Dastayari donations and rampaging property developer corruption scandals are the tip of the iceberg. Since then we’ve seen more and more Chinese bids for Australian strategic assets. This week we saw barely former trade minister Andrew Robb take a job advising the Landbridge Group, the owner of the Darwin Port. Landbridge is a shadowy firm involved in all sorts of stuff from chemicals to armed militias. It is widely considered to be beholden to Beijing in some way. At the very least the Darwin Port is the butt end of Beijing’s One Belt, One Road trade bloc monster. So here we have a trade minister out of the job for six months, a job that involved intimate consultation on the US’s competing regional trade deal, the TPP, tipping his intelligence directly into the Beijing trade bloc.

A less generous analyst might see this as some form of commercial treason. I will say that it is indicative of just how unprepared Australian parliaments are to address Chinese soft power influence in its manifold forms. Indeed, with the current crop of money-grubbing mock-libertarian ideologues in charge, we are a complete bloody pushover. Our checks and balances appear gossamer-thin in the executive. The intelligentsia is under assault from the Chinese student pipeline and pseudo-intellects like Bob Carr and his Chinese apologism. Nor can we rely on the media to hold any to account. Of the duopoly, Murdoch will give China the nod the moment the deal is good enough. Fairfax is dying and in its death throes has grabbed for a real estate lifeline that is itself China dependent.

It is not at all hard to imagine a circumstance like that that has engulfed the politics of the Philippines and Malaysia happening here. An Australian PM finds himself under siege and turns to Chinese patronage to bail him out. Explicitly or otherwise it will only take one desperate narcissist and Australia too will be welcomed into the waiting arms of Beijing patronage with all of its carrots and sticks determining precisely who wins and who loses Downunder. The following election would be fought between a candidate armed with hundreds of billions of dollars of firepower versus a guy promising recession.

So, I worry. I worry a lot, actually, that Australia is on the verge of giving away its most prized possession – its freedom – quietly in the dark for a few pieces of silver. To stop it we must move now, not tomorrow. We need:

  • a big to cut the immigration intake and a rein the “citizenship exports sector”;
  • an overhaul of the Chinese investment regime such that it be placed alongside the nation’s strategic objectives;
  • a ban on foreign political donations (where is it?) and a Federal ICAC;
  • a proper enforcement of rules governing foreign buying of real estate;
  • a reboot of foreign policy that engages the US much more heavily in Asia.

Another couple of years of current policies and a few more Andrew Robbs and Aussie democracy as we know it is toast.

Reproduced with kind permission from Macrobusiness.

Beware of recency bias

Every the year the 2016 Russell Investments/ASX Long-term Investing Report provides an invaluable summary of before and after-tax returns on various asset classes for Australian investors, over 10 and 20 years.

Naive investors are likely to automatically pursue the asset classes that offer the highest yields. Recent performance is more likely to attract our attention than more stable longer-term performance. Josh Brown highlighted last year that mutual funds that attracted the most new investment tended to underperform funds that attracted the least new inflows. I suspect that the same applies to asset classes.

If we consider each of the asset classes highlighted, it is clear that performance over the next 10 years is likely to be substantially different from the last decade.

Australian Asset Classes 10-year Performance to 31 December 2015

Source: 2016 Russell Investments/ASX Long-term Investing Report

Australian Shares

Australian Shares endured a (hopefully) once-in-a-lifetime financial crisis in 2008. 10-Year performance is going to look a lot different in two years time (20-years is 8.7% p.a.). Prices of Defensive stocks, on the other hand, have since been inflated by record low interest rates.

Residential Property

Residential property prices boomed on the back of low interest rates and an influx of offshore investors. But growth is now slowing.

RBA: Australian Housing Growth

Listed Property

REITS were smashed in 2008 (20-years is 7.7% p.a.). But before contrarians leap into this sector they should consider the impact of low interest rates, with many trading at substantial premiums to net asset value.

Bonds & Cash

Low interest rates again are likely to impact future returns.

Global Shares

Global Shares also weathered the 2008 financial crisis (20-year performance (unhedged) is 6.4% p.a.). Subsequent low interest rates had the greatest impact on Defensives, while Growth & Cyclicals trade at more conservative PEs.

I won’t go through the rest of the classes, but there doesn’t seem to be many attractive alternatives. It may be a case of settling for the cleanest dirty shirt, and the least smelly pair of socks, in the laundry basket.

Janet Yellen on financial market turmoil

Federal Reserve chair Janet Yellen before the House Financial Services Committee:

Janet Yellen

“…..As is always the case, the economic outlook is uncertain. Foreign economic
developments, in particular, pose risks to U.S. economic growth. Most notably,
although recent economic indicators do not suggest a sharp slowdown in
Chinese growth, declines in the foreign exchange value of the renminbi have
intensified uncertainty
about China’s exchange rate policy and the prospects for
its economy.

This uncertainty led to increased volatility in global financial markets and, against the
background of persistent weakness abroad, exacerbated concerns about the outlook for
global growth
. These growth concerns, along with strong supply conditions and high
inventories, contributed to the recent fall in the prices of oil and other commodities. In
turn, low commodity prices could trigger financial stresses in commodity-exporting
economies, particularly in vulnerable emerging market economies, and for commodity-
producing firms in many countries
. Should any of these downside risks materialize,
foreign activity and demand for U.S. exports could weaken and financial market
conditions could tighten further…..”

…No rate rises any time soon.

Iron ore headed for the smelter

Bloomberg News quotes Zhu Jimin, deputy head of the China Iron & Steel Association, representing major steel producers, at their quarterly briefing on Wednesday:

“Production cuts are slower than the contraction in demand, therefore oversupply is worsening.”

“China’s steel demand evaporated at unprecedented speed as the nation’s economic growth slowed,” Zhu said. “As demand quickly contracted, steel mills are lowering prices in competition to get contracts.”

Little wonder that bulk commodity prices are falling sharply.

RBA: Bulk Commodity Prices

Australian producers have been ramping up production to compensate for lower prices.

RBA: Bulk Commodity Exports

But with further production due to come on line, the market looks ready for a meltdown. This from David Llewellyn-Smith at Macrobusiness:

Yes, China is still shutting in supply and is on track for 270 million tonnes this year but it’s not going to drop enough in the future (at the very best down to 200mt) as Roy Hill, Sino, Anglo, Vale and India (and possibly Tonkolili as well) continue the great ramp up, adding another 200mt plus in the next two years even as Chinese steel production keeps falling at 2-3% per year, taking 40mt per annum out of demand….. the total seaborne iron ore market is about to peak and then shrink….

The ASX 300 Metals & Mining Index is testing its 2008 low. Breach appears likely and would offer a target of 1700*.

ASX 300 Metals & Mining Index

* Target calculation: 2200 – ( 2700 – 2200 ) = 1700

North America

The S&P 500 respected support at 2050 and is headed for a test of the previous high at 2130 on the back of strong earnings performance. Rising 21-day Twiggs Money Flow indicates medium-term buying pressure but expect strong resistance at 2130. Reversal below 2050 is unlikely, but would warn of another test of primary support at 1870.

S&P 500 Index

* Target calculation: 2000 + ( 2000 – 1870 ) = 2130

A declining CBOE Volatility Index (VIX) indicates market risk is easing.

S&P 500 VIX

NYSE short sales remain subdued.

NYSE Short Sales

Dow Jones Industrial Average is similarly headed for a test of 18300, with 13-week Twiggs Money Flow rising steeply.

Dow Jones Industrial Average

Canada’s TSX 60 continues to test stubborn resistance at 825. Weak 13-week Twiggs Momentum, below zero, indicates the market remains bearish. Breakout would signal an advance to 900, but reversal below the former primary support level at 800 is as likely and would warn of another decline.

TSX 60 Index

* Target calculation: 775 – ( 825 – 775 ) = 725

Europe

Germany’s DAX is testing resistance at 11000. Recovery of 13-week Twiggs Money Flow above zero indicates medium-term buying pressure. Breakout above the descending trendline would suggest another test of the previous high at 12400. Expect stubborn resistance, however, and reversal below 10000 would warn of another decline.

DAX

The Footsie is similarly testing resistance at 6500. Breakout above the descending trendline would suggest another test of the previous high at 7100. 13-Week Twiggs Money Flow troughs above zero indicate long-term buying pressure. Reversal below 6250 is unlikely, but would warn of another test of primary support at 6000.

FTSE 100

Asia

The Shanghai Composite Index continues to test resistance at 3500. Respect is likely and would indicate a re-test of government-backed support at 3000.

Dow Jones Shanghai Index

Hong Kong’s Hang Seng Index is retracing to test support at 22500. Respect would indicate a rally to 24000, but failure remains as likely and would test primary support at 21000. A 13-week Twiggs Money Flow trough above zero would indicate (long-term) buying pressure.

Hang Seng Index

Japan’s Nikkei 225 is testing resistance at 19000. Breakout would signal another test of 21000. Respect is less likely, but would warn of another test of primary support at 17000.

Nikkei 225 Index

* Target calculation: 19000 + ( 19000 – 17000 ) = 21000

India’s Sensex encountered resistance at 27500. Rising 13-week Twiggs Money Flow troughs above zero indicate long-term buyiong pressure. Expect another test of 26500 but respect is likely and would indicate continuation of the rally. Reversal below 26500 would warn of another (primary) decline.

SENSEX

* Target calculation: 25000 – ( 27500 – 25000 ) = 22500

Australia

The ASX 200 is retracing to test medium-term support between 5200 and 5300. Reversal of 21-day Twiggs Money Flow below its rising trendline indicates (medium-term) selling pressure; decline below zero would strengthen the signal. Breach of 5200 would warn of another test of primary support at 5000. Recovery above the descending trendline is unlikely at this stage, but would suggest another test of 6000.

ASX 200

* Target calculation: 5000 – ( 5400 – 5000 ) = 4600

CBA, ANZ, NAB and Westpac: The incredible shrinking big four banks | afr.com

Great article by Chris Joye:

Welcome to the world of that beautiful $140 billion behemoth, the Commonwealth Bank, which has inverted the axiom that there is a trade-off between risk and return. Years ago I highlighted a perversion embedded at the heart of our financial system: the supposedly lowest (highest) risk banks were producing the highest (lowest) returns. Normally it works the other way around.

…..contrary to some optimistic reports, the capital-raising game has only just begun.

The terrific news for shareholders is that this belated deleveraging will transform the majors into some of the safest banks in the world, which will be able to comfortably withstand a 1991-style recession, exacerbated by a 20 per cent decline in house prices.

In the past I have been critical of APRA’s failure to properly police Australia’s vastly-undercapitalized banking system but must now give them credit for their leadership towards creating a world-class system that will be able to withstand serious endogenous or exogenous economic shocks.

Shareholders face lower returns from reduced leverage but will benefit from improved valuations due to lower risk premiums and stronger, more stable, long-term growth.

Read more at CBA, ANZ, NAB and Westpac: The incredible shrinking big four banks | afr.com.

APRA confirms further capital adequacy measures

From Robin Christie:

The Australian Prudential Regulation Authority (APRA) has confirmed that the country’s largest banks will face increased capital adequacy requirements for residential mortgage exposures – and hasn’t ruled out further rises.

The regulator made it clear yesterday that the new rules would be an interim measure based on the Financial System Inquiry’s (FSI) recommendations – and that it was keenly awaiting guidance from the Basel Committee on Banking Supervision before making any further changes.

The new measures, which come into effect on 1 July 2016, mandate that authorised deposit-taking institutions (ADIs) that are accredited to use the internal ratings-based (IRB) approach to credit risk must increase their average risk weight on Australian residential mortgage exposures to at least 25 per cent. According to APRA, the current average risk weight figure sits at around 16 per cent….

This is a welcome first step. Increases in bank capital will improve economic stability. Even at 25 percent, however, a capital ratio of 10% would mean that banks are holding 2.5 percent capital against residential mortgages. Further increases over time will be necessary.

Read more at APRA hints at further capital adequacy measures.

Federal budget 2015: worst cumulative deficits in 60 years | Chris Joye

Chris Joye (AFR) on the budget deficit:

There are two critical differences in 2015 that make Australia’s current debt burden [42.2% of GDP] much more troubling than that serviced by previous generations. Back in the 1977 and 1983 recessions, the household debt-to-income ratio was only 34 per cent and 37 per cent, respectively. Even in the 1991 recession, it was just 48 per cent, which is one reason why home loan arrears were so benign. Yet by 2015, the household debt-to-income ratio had jumped 3.2 times to an incredible 154 per cent, which is above its pre-GFC climax because families haven’t deleveraged….

Public Debt to GDP and Household Debt to Income

Public and private debt levels are important to our economic health, but where the money is borrowed domestically it is far less serious than when it is borrowed offshore. In the former case, net debt in the economy is effectively zero — one sector runs a surplus while the other runs a deficit — but where money is borrowed offshore, the nation as a whole becomes a net debtor. Which is why short-term borrowing in international markets by Australian banks — used to fund the housing bubble in the run up to the GFC — was so dangerous.

From Greg McKenna (House & Holes) at Macrobusiness:

“….The funding gap is estimated to be $600 billion. In a speech on Friday, Westpac deputy chief executive Phil Coffey cited research from PwC which estimated the gap could grow to $1.325 trillion if there was a pick-up in credit growth.”

Here is the latest chart from the RBA showing the rising borrowing, it’s quarterly and likely lagging:

International Liabilities of Australian Banks

Notice how the article is focused entirely upon the “funding gap” as a tactical challenge in which the banks are innocent players. In reality there is no “funding gap”. Rather, our financial system is addicted to unproductive mortgage-lending and that crowds out the kind of business lending that would generate income growth and local savings. The “funding gap” is created by the banks not serviced by them.

International borrowing to fund a domestic property bubble is double trouble.

Read more at Federal budget 2015: worst cumulative deficits in 60 years | afr.com.

And at Macrobusiness: Australia ramps the risk as banks borrow abroad

Goldman describes Australia’s lost decade | Macrobusiness

Posted by Houses and Holes. Reproduced with kind permission from Macrobusiness.

Goldman’s Tim Toohey has quantified the unwinding commodity super-cycle for ‘Straya’:

Lower commodity prices risk $0.5trn in forgone earnings
The outlook for revenues from Australian LNG and bulk commodities shipments – which account for almost half of total export earnings – has deteriorated significantly. To be clear, overall revenues are still forecast to increase substantially over the coming years – underpinned by a broadly unchanged strong outlook for physical shipments (particularly for LNG). However, in a nominal sense, the outlook is far less positive than before. This owes to a structurally weaker price environment, with GS downgrades of 18% to 25% to key long term price forecasts for LNG and bulk commodities suggesting that cumulative earnings over the years to 2025 are on track to be ~$0.5trn lower than previously forecast.

1

3

… and will erode Australia’s trade/fiscal positions
The deterioration in the earnings environment naturally has direct implications for Australia’s international trade and fiscal positions. On the former, a return to surplus by CY18 no longer looks feasible, and we now expect a deficit of ~$15bn. On the latter, relative to the 2014 Commonwealth Budget, we estimate that weaker commodity prices will cause a ~$40bn shortfall in tax revenues over the next four years. Given our expectation that Australia’s LNG sector will deliver no additional PRRT revenues over the coming decade, and the ~$18bn downgrade to commodity-related tax in the December MYEFO, we therefore see a risk of further material revenue downgrades at May’s 2015 Budget.

5

Resulting in changed GDP, RBA cash rate and FX forecasts
Although the commodity export changes mainly manifest through the nominal economy, there are significant impacts back through to the real economy. Lower export earnings result in lower profits, lower tax receipts, lower investment and lower employment. We continue to expect just 2.0% GDP growth in 2015 but have lowered our 2016 to 2018 real GDP forecasts by an average of 50ppts in each calendar year. As a consequence, we have moved forward the timing of the next RBA rate cut to May 2015, where we see the cash rate remaining at 2.0% until Q416, where we expect a 25bp hike. We now expect just 75bps of hikes in 2017 to 3.0% and rates on hold  in 2018. Despite the recent move in the A$ towards our 75c 12 month target, the reassessment of the medium term forecast outlook argues for a new lower target 12 month target of 72c.

OK, that’s quite a piece of work and congratulations to Tim Toohey for getting so far ahead of pack. I have just two points to add.

The LNG forecasts look good but as gloomy as his iron ore outlook is, it is not gloomy enough. $40 is a more reasonable price projection for 2016-18 and we’ll only climb out of that very slowly. That makes the dollar and interest rate forecasts far too bullish and hawkish.

Second, even after these downgrades, Mr Toohey still has growth of 3.25% GDP penned in for 2016 and 3.5% for 2017. We’ll have strong net exports and is about it. With the capex unwind running right through both years, housing construction to stop adding to growth by next year, the car industry wind-down at the same time, political strife destroying the public infrastructure pipeline, the terms of trade crashing throughout and households battered half to death by all of it, those targets are of the stretch variety, to say the least.

The analysis is exceptional, The conclusions, sadly, overly optimistic.

Murray has endorsed macroprudential | Macrobusiness.com.au

Posted by Houses and Holes
At 12:52pm on December 8, 2014
Published with permission from Macrobusiness.com.au.

From Callam Pickering:

The one glaring problem with the Financial System Inquiry is that it didn’t push hard for the introduction of macroprudential policies. That takes the heat off both the RBA and APRA.

The truth is that higher capital requirements — combined with higher risk weighting on mortgages and tax reform — would have a similar (potentially larger) effect as macroprudential policies. In the long term financial system and tax reform is clearly the better approach to creating an efficient and sustainable housing and financial sector, but these reforms will take longer to implement.

That’s right. Murray’s principle recommendations are macroprudential. APRA is now free (and is being urged) to implement higher capital requirements. They do not require anything from government to go ahead. This is basically the model of MP envisaged by Prof Ross Garnaut.

A more interesting question is whether or not APRA will still act on specific areas of risk such as interest-only loans. These are a menace, as the US bust showed, and are surging. Murray did not mention them, being too granular, but said the following on MP more particularly:

The global financial crisis (GFC) prompted policy makers and regulators around the world to reconsider their approach to maintaining financial stability. Some countries at the epicentre of the crisis have since expanded their prudential perimeters and adopted more formal and centralised institutional arrangements. This includes establishing single entities with responsibility for macro-prudential regulation. Australia has long adopted what could be called a ‘macro-prudential’ approach to supervision under the rubric of financial stability. Yet, Australia’s institutional structure is relatively informal and decentralised. The Reserve Bank of Australia (RBA) and APRA each have responsibility for financial stability. However, most macro-prudential tools can only be deployed by APRA. This places a strong premium on cooperation between the two agencies.

Against the background of developments overseas, the Inquiry has considered whether Australia should change its institutional arrangements for making and implementing financial stability policy.

However, the Inquiry does not see a strong case for change in this area. Although approach has advantages and disadvantages, alternative institutional approaches are yet to be tested — as indeed is the effectiveness of many macro-prudential tools. For this reason, the Inquiry recommends no fundamental change to the current institutional arrangements for financial stability policy and no change to the prudential perimeter at this time.

That is neither here nor there and APRA will still be free to raise capital requirements for specific loans if it sees fit.

Why Australian Consumers Are Happy With Their Finances But Aren’t Spending | Business Insider

From Greg McKenna:

There is a lot of focus on the wealth of Australians through property and super but many Australian households and Australian households in aggregate are still carrying a large amount of debt. A stock of debt which must be repaid with a flow of earnings no matter how wealthy they might be on paper.

So consumers are more confident about their finances and their financial future but they aren’t spending — yet.

Something that puzzles me is why household debt as a percentage of disposable income is constant. If consumers have accelerated their credit card and mortgage debt repayments, surely this figure should be falling.

Read more at Here's The Best Explanation Of Why Australian Consumers Are Happy With Their Finances But Aren't Spending | Business Insider.

Irrational Exuberance Down Under | Bloomberg View

From William Pesek:

Lindsay David’s new book on Australia deserves a medical disclaimer: Reading this will greatly raise your blood pressure.

In “Australia: Boom to Bust” David sounds the alarm about an Australian housing bubble he argues makes the 12th-biggest economy a giant Lehman Brothers. His thesis can be boiled down to the number 9 — the ratio of home prices to income in Sydney. The multiple compares unfavorably to 7.3 in London, 6.2 in New York and 4.4 in Tokyo. Melbourne is 8.4.

Read more at Irrational Exuberance Down Under – Bloomberg View.

Houses overvalued by up to 30 per cent, says ex-RBA official

From Christopher Joye:

One of Australia’s top economic experts, Jeremy Lawson, says the ­housing market is 20 per cent to 30 per cent overvalued and has left Australia vulnerable to a big international ­economic shock.

Mr Lawson is the global chief ­economist of Standard Life, a massive British fund manager with $460 billion in assets under management. He was previously a senior economist at the Reserve Bank of Australia and the OECD, and in 2007 advised then ­opposition leader Kevin Rudd…

Read more at Houses overvalued by up to 30 per cent, says ex-RBA official.

Bank chiefs in last-ditch plea to David Murray on tougher rules | The Australian

From Richard Gluyas at The Australian:

THE four major-bank chief executives have each made an eleventh-hour appeal to members of the Murray financial system inquiry ahead of Tuesday’s closing date for final submissions, as concerns mount that the sector could be forced to hold even higher ­levels of bank capital due to the ­inquiry’s emphasis on resilience. The closed-door meetings with the inquiry panel members come as Steven Munchenberg, chief executive of peak lobby group the Australian Bankers’ Association, said the industry was “jittery” about the inquiry’s focus on ­balance-sheet resilience because more onerous capital requirements would affect the banks’ ability to lend and serve the ­economy.

I disagree. Banks with strong balance sheets are better able to serve the needs of the economy. Highly leveraged banks leave the economy vulnerable to a financial crisis and are more likely to contract lending during periods of economic stress.

The shrill outcry may have something to do with the impact on bankers bonuses. Incentives based on capital employed would shrink if shareholder’s capital is increased.

Bank shareholders on the other hand are likely to benefit from stronger balance sheets. Reduced default risk is likely to enhance market valuation metrics like price-earnings multiples. Reduced risk premiums will also lower cost of funding and enhance lending margins. And shareholders are also likely to benefit from enhanced growth prospects. Analysis by the Bank for International Settlements in the post crisis period shows banks with higher capital ratios experience higher asset and loan growth.

Australia’s Major Banks Say The Murray Enquiry Used The Wrong Numbers… | Business Insider

From Greg McKenna:

The AFR reports ….the Australian Bankers Association CEO Steven Munchenberg said the banks are “concerned that if some of the statements in the interim report – that Australia’s capital is middle of the road, that housing is a ­systemic risk – are allowed to remain unchallenged and are then taken out of context that is going to cause us a lot of future grief”.

Munchenberg says the Inquiry hasn’t calculated the capital ratios correctly.

“The approach was simplified and didn’t take into account the complexities and nuances of how capital is determined in Australia, including deductions required by APRA and some of the areas where APRA has adopted a more conservative approach, and as a result underestimated the amount of capital in Australia relative to overseas”, he told the AFR.

Forget the nuances and comparisons to the plight of other banks. Australian banks need to almost double their capital and adopt a more conservative approach to home mortgage lending if they are to withstand future shocks. 3 to 5 percent capital against total exposure doesn’t get you very far. The history of low mortgage failures over the last 3 decades, in an expansionary phase of the credit market, is unlikely to be repeated during a contraction.

Read more at Australia's Major Banks Say The Murray Enquiry Used The Wrong Numbers To Calculate Capital | Business Insider.