Fallout!, Frayed HEM, Latticework, Cashflow, Seminar alert, and more

Fallout!
Frayed HEM
Latticework
Cash: breaking free
Brexit Update
Seminar alert: Myths that can hurt your wealth
Research and Diversions
Facebook Live
Next Week
Last Week

Fallout!

Goodness. I feel like we’ve lived a year in a week. On Monday, we get Hayne’s final report, with a flurry of politicians trying to take credit and dodge blame. Then, four days later, we get the news that NAB has sacked its chairman and its CEO, and now Phil Chronican, ex Westpac and ANZ, is running the bank. NAB shareholder heads will be spinning.

It’s the second time NAB lost both its CEO and Chairman at the same time. The first time was in February 2004, when Frank Cicutto and Charles Allen both walked the plank after some foreign exchange traders in the bank lost $360 million and tried to cover it up.

The traders got the sack promptly of course, but the CEO and Chairman had to go too because the then brand new APRA chairman, John Laker, said that “cultural issues were at the heart of the failings” that had led to the losses, and after inspecting the other banks he concluded that NAB was the worst of them. Director Cathy Walter led a board revolt against Allen and Cicutto and toppled them.

The incoming CEO, John Stewart and new chairman Graham Kraehe got the reforming of NAB off to a bad start, in fact no start at all, by heaping praise on their predecessors as well as on the bank: “The National is a first-rate financial institution with strong performance and growth prospects,” said Kraehe.

In announcing Cicutto’s departure, Charles Allen said: “Mr Cicutto has made a very significant contribution to the National …”, and Cicutto himself said: “I am proud of the contribution I have made to its development as Australia’s leading banking and wealth management business. I am comfortable in the knowledge that I am handing over a company that is well positioned for future growth.”

So none of them got it, no doubt (in their minds) blaming that bloody Cathy Walter for over-reacting! And then all the subsequent CEOs and Chairmen since then didn’t get it either.

Fourteen years later, inevitably, a new scandal emerges – this time charging fees for no service – that is, gouging customers instead of losing lots of money on an out of control trading desk. But the issues are the same as they were then: poor culture and weakness of internal governance, with the bank too focused on profit at the expense of prudence and customer service. Nothing changed.

And now once again NAB has been singled out for special mention, and once again CEO and Chairman have taken one for the team.

Was it fair to have singled out NAB in the way that Ken Hayne did? I think history tells us that NAB did deserve it. It isn’t just the events of 2004, but its disastrous foray into the UK and persistent underperformance over years.

And anyway Ken Henry and Andrew Hagger really pissed off Ken Hayne with their performances in the witness box. Neither of those men read the situation they were in very well, and simply didn’t realise they were in it for their careers. They made bad mistakes.

Fundamentals

But let’s move on to some of the more fundamental issues that arise from the events of this week.

When the banks finally threw in the towel and asked Treasurer Scott Morrison to appoint a royal commission into them in 2017, and he and PM Malcolm Turnbull then threw in their own towels and agreed to do it, they all had some wistful, if half-formed, ideas about what would come out of it.

The banks thought, or at least they said they thought, that it would end the political uncertainty, bolster their unfairly sullied reputations and “provide certainty”; the Government slipped superannuation into the terms of reference and hoped the hated industry super funds would cop it.

In the end, of course, both were disappointed, although Scott Morrison is stoutly pointing out that he did, in the end, actually appoint the royal commission, and aren’t the banks terrible bastards, which I always knew they were, etc.

And it is generally agreed that the banks, having walked through the Valley of the Shadow of Death in 2018, have got off pretty lightly in the end, if you look past the smoking corpses of Ken Henry and Andrew Thorburn.

Not as lightly as the industry funds mind, which are laughing all the way to the … oh, never mind.

Industry Super Funds

Seriously though, at least two very significant matters have been left hanging after the royal commission big climax this week: first, a group of not-for-profit institutions that are not owned by anyone (industry funds) are becoming the most powerful financial organisations Australia has ever known. In fact, they probably already are. And second, the post-Hayne shift to responsible lending raises the question of what about all the loans that were irresponsibly lent in the past 10 years?

These are not entirely unrelated matters.

• Industry funds have been all over the bank-owned funds because their performance has been better;
• Part of that performance has come from them heaping pressure on corporate boards, through proxy advisers, to lift total shareholder return (TSR);
• That has involved watching remuneration reports to make sure executive incentives were focused on TSR, and not soft stuff like customer satisfaction and culture;
• Bank executives, in their efforts to increase TSR and thus their salaries, among other things ignored the responsible lending provisions of the National Consumer Credit Protection Act and paid no attention to borrowers’ actual income and expenses, lending instead on the basis of statistical mumbo jumbo (as well as charging fees for no service, charging dead people, and all the other misdeeds for which they have rightly been in the stocks).

It would be going too far to blame the industry funds for the bad behaviour of the banks, but it’s also true that the system is circular.

Boards and management work for the shareholders, and the shareholders compete for business by trying to get better returns out of the boards and managers of the companies they own.

Note also that if the Productivity Commission has its way, that competition between funds will increase, which means the pressure for higher returns will also increase. APRA and ASIC, trying to fulfil their new Hayne mandate of steering the banks away from excessive focus on TSR and more towards culture and the best interests of customers, will be up against it.

Stand by for another royal commission in a decade or so.

Actually, my guess is that the next royal commission will be in response to an industry fund scandal, as these strange, unowned organisations, governed by the inexpert and the ungoverned, compete to be on the Productivity Commission’s list of the ten best funds and eventually, of course, since everyone always does, do something dodgy to achieve it.

For the moment, though, industry funds are both squeaky clean and top performers, so money is pouring into them from bank funds. Their power will soon be untrammelled and as they compete for higher returns, they will be in a sort of silent war with the regulators who are trying to moderate returns in the name of culture and “unquestionably strong”, as they search for higher TSRs.

Ultimately it will be the industry fund trustees, a motley crew if ever there was one, who will decide whether the banks do truly reform themselves and become less focused on profit.

Meanwhile there may be a large lump of loans sitting on the banks’ balance sheets that were not lent responsibly, or at least that must be the implication of now requiring them to lend responsibly.

Most of the focus about this subject is on the question of whether a credit drought and further collapse in house prices will result from a sudden attack of responsible lending (that is, that the amount of responsible lending is likely to be much less than the amount of irresponsible lending), which is definitely a good question.

But another good question is whether there are any parallels with what happened in the United States leading up to the 2007-08 financial crisis. The GFC resulted from the large mass of NINJA loans (no income, no job or assets) that had been made by mortgage brokers working for commissions, and which had been buried in securitised products like Collateralised Debt Obligations (CDOs).

In Australia the NINJA loans are hiding in plain sight, on the bank balance sheets, with low mortgage risk-weightings.

What’s more, I’d say that no one wants to draw back the veil and look at this – not APRA, not the bank boards and definitely not their shareholders – either institutional or the army of retirees that owns the banks for the franked dividends, or do before the ALP wins the election.

In my view the quality of the banks’ loan books is now the key issue for investors to focus on.

I don’t have an answer for you – no one does – but I’m flagging it as the thing to watch, along with the rise and rise of the industry funds.

Bottom line: there may be loan write-offs to come over the next year or two, but long term, if the banks do genuinely reform themselves, they will be good investments – basically they will become infrastructure stocks, providing a boring, utility service known as banking.

Frayed HEM

Here’s a rare reason to give NAB a tick.

Further on the question of whether the banks are holding bad loans that were “irresponsibly lent”, for about ten years they have been using the Household Expenditure Measure (HEM) to determine borrower capacity repay.

HEM is a statistical calculation based on family size, location and lifestyle and is a copy of what the Australian Bureau of Statistics does. In other words, it’s not actually what the borrower is earning and spending, but what a typical borrower like that would be earning and spending.

Hayne didn’t recommend banning the use of the HEM in his final report, mainly because APRA has already told the banks to stop it, so they are.

The analysts at Macquarie Wealth have been doing some work on this and have come up with the following chart:

Note the huge difference in the use of HEM between NAB and the others – about half.

Does that mean NAB will have fewer crook loans on its books? Maybe it does. Although the Macquarie analysts don’t go there.

All the analysis on the shift from HEM to using borrowers’ actual income and expenses has been focusing on what it means for the future – whether it will result in a tightening of the credit squeeze – so no one, including Macquarie, has thought about what it means for the banks’ existing loan books.

I suspect that as time goes on, that will become more of an issue, and if that chart above is anything to go by, this time it will be NAB dodging the bullet.

Latticework

And now for something completely different.

You might be wondering why I include such a wide variety of stuff in my Research & Diversions section at the bottom, and often cover things that might seem at a tangent to investing.

It’s because of what Charlie Munger (Warren Buffett’s 95-year-old offsider) calls “Latticework”.

One of the things to which Charlie attributes the success that he and Warren have had over the years at Berkshire Hathaway is that they’ve accumulated a tremendous amount of worldly wisdom, through the process of creating what he calls a “latticework of mental models”.

This comes from a wide array of academic topics such as physics and mathematics, economics and psychology, philosophy and law, among others. 

Munger is an advocate of a broad liberal arts education. One of his favourite sayings is: “to a man with a hammer, every problem is a nail”. If you are trained as a lawyer, as Munger was, and all you ever studied was law, you would not bring as much to the table as a lawyer who had also studied economics, psychology, biology, sociology, physics and so on.

If you broaden your education to study a range of disciplines, you can draw on lessons learned from each and therefore are better equipped.

A study of investing will normally cover fundamental analysis of companies, industries and perhaps economies, it may extend to technical analysis of individual stocks and the market as a whole. And it may extend to investment psychology - of crowds, groups, and individuals.

Your knowledge of these things might constitute the vertical strands of your investing knowledge. But Charlie Munger says from the study of a range of disciplines you develop a series of concepts or “mental models” and you overlay these models in a “latticework” fashion on the vertical strands of your investment analysis.

The first book on this was by Robert Hagstrom, an excellent financial writer. In 2000 he published “Latticework”, a wonderful book which has chapters on physics, biology, sociology, psychology, philosophy and so on, although it seems that the title might have been a turn off, because it was re-published in 2002 as “Investing: The Last Liberal Art”.

One can read more about latticework and mental models in “Poor Charlie’s Almanack”, a huge book edited by Peter Kaufman. There is also ”Charlie Munger - The Complete Investor” by Tren Griffin.

To give you an idea, the inventory of mental models you develop from wide reading might lead to the following ideas: circle of competence, margin of safety, bell curves, normal distributions, randomness, reversion to the mean and regression to the mean, inversion (reverse thinking), reflexivity, the Pareto Principle (that is, the 80/20 rule – here’s a link the Wikipedia entry on it), Ponzi schemes, business life cycles, product life cycles and so on. There is one website on mental models which lists 109.

So it can become a huge area of study, from which, as a well-rounded investor, you can draw on as needed and apply them in a latticework fashion to your decisions.

One example is “reflexivity”. This concept was introduced by George Soros in his 1987 book The Alchemy of Finance.

A company and its share price have a “reflexive” relationship, that is, a company’s operating performance affects its share price but it also works the other way.

The establishment of a record of consistent earnings growth will likely result in a high P/E re-rating meaning the share price should be higher which in turn makes using its shares to raise fresh equity or for an acquisition less expensive.

If a company needs to raise equity capital then its share price level is critical. If the share price is low then equity financing is expensive. You can look at the company and its share price - there is a “reflexive” relationship between the two, which becomes important if the company is using its shares to raise equity or make acquisitions. So shares prices both affect and reflect fundamentals in a feedback loop. That is reflexivity. 

There are many more, of course. But the main thing is ensure that you are not locked into one way thinking. Good investing requires mental flexibility and a variety of mental models, so you’re able to respond to changed circumstances.

It’s all grist to the investing mill, even if sometimes it doesn’t seem that way.

Cash: breaking free

Mason Stevens had an interesting note this week quoting Citi Global Research that’s worth passing on, about free cash flow (FCF) yield.

Free cash flow is calculated as operating cash flow minus capex. It represents the surplus cash flow that a company generates after laying out the capital required to maintain or expand its asset base. This can then be retained on the balance sheet or distributed to shareholders.

Obviously the way for a company to boost its FCF is to maximize profits, while minimising reinvestment back into the business.

FCF Yield = (FCF per share / Share price) x 100.

FCF-driven strategies tend to favour high-margin/low-capex companies. 

What Citi wanted to find out is: what’s been the best investing strategy over the past 20 years.

It is well known that traditional valuation-driven investment strategies have struggled through this market cycle. The MSCI All Country World Value index has underperformed the Growth index by 16% since 2010. Recent signs of improved performance have raised hopes among value investors that the tide may be turning. But Citi think that this perennial Value/Growth debate misses the point. There has been a value strategy that has consistently delivered in this cycle, and that is Free Cash Flow (FCF) Yield. 

Brexit Update

The second best show in town (Trump is still the best) continues to steadily approach its denouement, to the sounds of a scary score composed by John Williams (who turned 87 yesterday, by the way – he wrote the music to Jaws, and all Star Wars movies, among many other films).

Theresa May seems to have outfoxed her opponents and confounded my earlier prediction that Parliament would take over the Brexit process and either delay or cancel the March 29 departure from the EU, and call another referendum.

It has been a truly remarkable performance but as always we should also follow the money: the pound has since resumed its decline, falling back below US$1.30.

That seems to be because the market remembers Greece trying to negotiate with the EU using a gun aimed at its own head, and that’s what the British PM is effectively doing. It rarely works.

It remains possible that the Parliament will vote next week to take the process away from her, but at this stage she has some wind in her sails and some strength on her side.

That’s because Germany and the other EU countries currently watching their economies turn downwards towards recession cannot afford to lose one of their largest trading partners outside the Eurozone itself, and the concessions demand by May are not that big a deal.

It’s hard to believe the EU leadership will hold out, and refuse to keep the Irish border open, which is the last sticking point.

The rational thing for the EU to do would be to remove the March 29 hard deadline and say that while they don’t concede anything about the terms of Britain’s exit, they are happy to negotiate for as long as it takes, which would take away Theresa May’s main bargaining tool – the deadline.

It’s like a hostage negotiation, and as someone who has watched plenty of hostage movies, the first thing the negotiator has to do is remove the deadline. If the EU had any sense they would do that so everyone would be able to calmly work out a way forward without the threat of crashing out hanging over them.

But of course they might not have any sense.

Seminar alert: Myths that can hurt your wealth

I’m doing a series of seminars around Australia over the next few weeks with my boss, the CEO of InvestSMART Ron, portfolio manager Nathan Bell and market strategist Evans Lucas, and I’d love to see you there!

We’ll be talking about “myths that can hurt your wealth” - they’re free, and should be both fun and informative.

Here are the topics & speakers:

• Myth: Higher fees mean higher returns and fees are too small to even matter with me, Alan Kohler, InvestSMART Editor-in-Chief;
• Myth: You can time the market with Ron Hodge, InvestSMART CEO;
• Myth: Only buy good stocks when prices are going up with Nathan Bell/Evan Lucas (depending on venue).

And here are the venues and dates:

Research and Diversions

Research

This is amazing: Jeff Bezos has put a post on Medium in which he describes an extortion threat from the publisher of the National Inquirer, in which they threaten to publish dirty pictures of him, including copies of emails they sent. “Of course I don’t want personal photos published, but I also won’t participate in their well-known practice of blackmail, political favors, political attacks, and corruption. I prefer to stand up, roll this log over, and see what crawls out.”

Here’s an interim reporting calendar, so you can know when your stocks are going to report. (PDF)

This is pretty funny: banking yoga. “Now just be as one with the banking regulator, and watch as we transition to Toothless Tiger.”

A good, briefish, summary of the Hayne report.

There is a financial scandal and royal commission every 10-15 years. The latest one conducted by Kenneth Hayne doesn’t go far enough to break that cycle.

Hayne’s difficulty in defining culture. “It might be the most important question but one that will attract little attention, as there are doubts to what he can do in a practical sense.”

Hayne’s failure to tackle bank structure means that in 10-15 years there’ll have to be another royal commission.

Michael Pascoe: Who would have guessed? The banks have emerged as relative winners from the royal commission’s final report.

8 things Hayne missed.

In my interview on Thursday, Warren Hayne referred to a Bank for International Settlements (BIS) report on zombie firms. Here it is, in case you’d like to dig deeper.

Some blunt advice from Marcus Padley about finance: for goodness sake get your head around your finances – it’ll only take an hour.

And here’s Marcus on “The problem with buy and hold”. (Podcast)

Here’s a fact check of Trump’s state of the union speech.

Donald Trump has spent 60% of his time in the months after the 12018 midterms in what the White House calls “executive time”; 15% in meetings and 8% in public events. Previous presidents have not had “executive time”. It’s spent “watching television, reading newspapers, and making unlogged phone calls”.

Another piece on “executive time”: “One of the most closely guarded and worst-kept secrets of Donald Trump’s presidency is his extraordinary laziness. Despite efforts to project a manly ardor, the current leader of the free world spends most of his free time tweeting, calling friends, and watching Fox News.”

Time magazine published a story during the week that is supposedly sourced from intelligence officers who give Trump his daily briefing. “The officials… describe futile attempts to keep his attention by using visual aids, confining some briefing points to two or three sentences, and repeating his name and title as frequently as possible.” And…”the President is endangering American security with what they say is a stubborn disregard for their assessments.”

Here’s a very funny puppet encounter between Donald Trump and Elizabeth Warren.

Russia is attacking the US system from within: “A new filing by Special Counsel Robert Mueller shows how Russia uses the federal courts to go after its adversaries.”

"In my own lifetime, I’ve seen socialism fail in China, fail in the Soviet Union, fail in Eastern Europe, fail on the island of Cuba, and fail in Nicaragua under the Sandinistas. And now the world is watching it fail in Venezuela"

Six “high conviction” stock ideas from Morgans. “We take a scorecard approach which evaluates the stock candidate's earnings and dividend profile, industry structure and susceptibility to earnings risk, with a minimum score required to be considered for inclusion.”

A cautionary tale: A crypto exchange CEO died unexpectedly holding, in his head, the only passwords that can unlock $200 million in customer coins.

“Many tech startups are vastly overvalued and will one day vanish, leaving nothing but the ghost of a smile.”

The infrastructural humiliation of America. “I just spent two weeks in Singapore and Thailand; last year I spent time in Hong Kong and Shenzhen; and compared to modern Asia, so much American infrastructure is now so contemptible that it’s hard not to wince when I see it.”

Facebook is 15. "… in taking stock of the effects of its decade and a half of existence on people's social lives, this is what stands out the most: Facebook is where friendships go to never quite die." (But privacy does...) 

The rise of discordant retirement (that is, when married couples don’t retire at the same time). Not that there any surprises in this piece, but it’s interesting.

Who’s at fault for the drying up of the Darling River, and all the fish deaths? Not us, say the cotton growers.

Australia’s political donations system is hopeless. “Contributions to political parties are revealed up to 19 months after the event, and sometimes not at all. With most states now operating far more transparent regimes, the only conceivable explanation for the current Commonwealth system is that our political leaders don’t want us to see where the money is coming from. And the information contained in (the latest) data dump gives clues as to why that might be.”

Global warming may seem like a distended morality tale playing out over several centuries and inflicting a kind of Old Testament retribution on the great-great-grandchildren of those responsible, since it was carbon burning in 18th-century England that lit the fuse of everything that has followed. But that is a fable about historical villainy that acquits those of us alive today – and unfairly. The majority of the burning has come in the last 25 years – since the premiere of Seinfeld. Since the end of the second world war, the figure is about 85%. The story of the industrial world’s kamikaze mission is the story of a single lifetime.

Five things Paul Krugman gets wrong about crypto.

The end of economics: “In the three decades since the end of the Cold War, economics has enjoyed a kind of intellectual hegemony. 
That hegemony is now over. Things started to change during the 2008 global financial crisis, which had a far greater impact on the discipline of economics than is commonly understood. As Paul Krugman noted in a September 2009 essay in the New York Times Magazine, “Few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the very possibility of catastrophic failures in a market economy.”

Here’s an idea that would definitely transform the cryptocurrency market – a Facebook coin.

Diversions

Curcumin seems to reverse memory problems associated with ageing. This is a peer-reviewed paper in the journal ScienceDirect, so not easy reading, but may be worthwhile.

A generic Presidential campaign TV ad. “Did I mention that I’m super capable? I can stand behind a podium. I can look out a window. I can shake hands. I can make the skin around my eyes crinkle when I smile.”

A description of the business of selling blood in America. “What is the blood of a poor person worth? Desperate people can make $30 donating plasma, up to 104 times a year, in this $20 billion industry.”

How a chef sees a dishwasher. “There is nothing more annoying than someone who does everything to avoid annoying you. Why are they so often sloppy and irritating? Because they are scared. Because year after year, chef after chef has blamed them for the very fact that they exist.”

The ten best Superbowl 2019 ads (according to this Llama).

And some of the best Superbowl ads of all time. Yes, it’s a way to waste time.

Long an underfunded, fringe field of science, the search for extraterrestrial intelligence may be ready to go mainstream.

The End of Affordable Travel: “While the rich traverse the globe in an instant, the rest of us will be staying put.”

A scientific look at fences and, yes, walls. It’s called "Good Fences: The Importance of Setting Boundaries for Peaceful Coexistence," which more or less sums up the point of the paper.

Hannah Gadsby making a telling point about good men. They don’t step over the line, but they also decide where the line is.

This is truly horrifying: “Colonisation of the Americas at the end of the 15th Century killed so many people, it disturbed Earth's climate. That's the conclusion of scientists from University College London, UK. The team says the disruption that followed European settlement led to a huge swathe of abandoned agricultural land being reclaimed by fast-growing trees and other vegetation.”

The philosophy of Josiah Royce. When evaluating your life, don’t ask, “How happy am I?” Ask, “How loyal am I, and to what?”

Towards a unified theory of the doughnut. “Like most works of art, doughnuts are defined by an absence. They are modest and hollow. They belong to anyone.”

A blind man with one foot robs a bank in Austin, Texas — then waits outside for police to arrive. He is Edward Averill, 58, a computer programmer who was doing pretty well in life until his girlfriend died, his health failed, and he ran down his savings. He needs eye surgery, and jail is the only place he can hope to get it. He is charged with robbery, a felony punishable by up to 20 years in prison. Mission accomplished — or so he thinks. But judges and prosecutors, touched by his plight, want to set him free.

Queueing theory. Suppose a small bank has only one teller. Customers take an average of 10 minutes to serve and they arrive at the rate of 5.8 per hour. What will the expected waiting time be? Five hours. But if you add a second teller, the average waiting time is not just cut in half; it goes down to about 3 minutes. The waiting time is reduced by a factor of 93x.

Forgive me Lord, for I have virtue-signalled. It is a “nauseating vice”.

This is amazing: Madrid's Atocha Station features a sprawling indoor garden with 7,000 plants from more than 260 species around the world.

Philosopher discusses whether intelligent machines could become conscious; how we might seek to discover if they were conscious or not; and what would follow if they did appear to be conscious.

There’s a new translation of the Hebrew Bible into English, would you believe, the fruit of twenty years’ work, by Robert Alter - “a … literary feat that puts Alter in the company of Jerome and Martin Luther”. Alter’s Bible “preserves the simplicity and directness of Hebrew grammar”, staying close to the “concrete language” of the biblical writers, and thus restoring the Bible’s “internal diversity”. 

Happy Birthday Carole King, 77 today. She’s so nice! Can she really be that nice? Here she is doing “So Far Away” in 1971 at the tender age of 29. I was 19 then.

But best of all, here’s Aretha Franklin doing the Carole King song, “You Make Feel (Like a Natural Woman” in 2015. Carole King is in the audience, they’re both 73. There’s a long boring intro by someone, sorry about that, but the song worth waiting for.

This is there because I’m a big fan of Gavin and Stacey, and Stacey comes from Barry.

Facebook Live

If you missed #AskAlan on our Facebook group this week (or if you don’t have access to Facebook) you can catch up here. And we’ve given the Facebook Livestream its own page where you can also opt to just listen to the questions and answers.

If you’re not on Facebook and would like to #AskAlan a question, please email it to askalan@investsmart.com.au (new email!) then keep an eye out for the Facebook Live video in next week’s Weekend Briefing.

Next Week

By Craig James, Chief Economist, CommSec.

Australia: Business and consumer confidence in focus

• In the coming week an eclectic mix of economic data and events is expected.
• The week kicks off on Tuesday when the Australian Bureau of Statistics (ABS) releases the new publication, Lending to Households & Businesses. The data includes all new lending commitments and may show further softening of home loan demand.
• Also on Tuesday, the January business survey will be issued from National Australia Bank. There was a pronounced softening of conditions and subdued reading on sentiment in the December survey.
• The business conditions index fell from 10.6 points in November to four-year lows of 2.2 points in December. The long-term average is 5.8 points. The NAB business confidence index eased slightly from 3.4 points to near three-year lows of 2.8 points in December, below the long-term average of 6.0 points.
• The weekly reading of consumer confidence is also issued on Tuesday with Reserve Bank figures on credit and debit card lending.
• On Wednesday, Reserve Bank Head of the Economic Analysis Department, Alexandra Heath, delivers remarks at the Australian Business Economists Forecasting Conference.
• Also on Wednesday, the Westpac/Melbourne Institute monthly survey of consumer confidence. This report is more of a “check” on the weekly consumer sentiment data.
• On Friday a speech is expected from Christopher Kent, Assistant Governor (Financial Markets), Reserve Bank at a breakfast event hosted by foreign exchange provider XE.

Overseas: Focus in Chinese economic data

• The US Government shutdown is still playing havoc with the release dates for key economic data. Still, investors will also have to contend with Chinese data over the week including trade and inflation. And trade talks continue between the US and China.
• The week begins on Tuesday in China with the January reading on foreign direct investment. In 2018, investment rose by 0.8 per cent in yuan terms with analysts estimating that this equated to a 3 per cent lift in US dollar terms over the year. Data on vehicle sales for January is also expected.
• On Tuesday in the US, weekly chain store sales data is issued along with the JOLTS job openings report and NFIB business optimism index. The number of unfilled jobs in November fell to the lowest level since June, though openings still exceeded unemployed Americans.
• On Wednesday in the US, the monthly budget statement is released with weekly data on home loan applications and the consumer price Index. The core rate of inflation may have eased from 2.2 per cent to 2.1 per cent in January.
• On Thursday in the US, the weekly jobless claims data (claims for unemployment insurance) is issued alongside producer prices and durable goods orders. The annual rate of core producer prices may have eased from 2.7 per cent to 2.6 per cent in January.
• On Thursday in China the January data on exports and imports is expected with lending growth figures.
• On Friday, retail sales, industrial production, consumer sentiment, export/import prices, construction spending and the Empire State index are all scheduled for release.
• According to Adobe Analytics, e-commerce holiday season sales lifted by 16.5 per cent from a year earlier signalling that overall retail sales were positive in December. Retail sales may have lifted 0.2 per cent.
• And on Friday in China the latest inflation data is due – consumer and producer prices. Consumer prices are seen expanding at a 2 per cent annual rate in January.

Financial markets

• The Australian corporate reporting season moves into top gear with a bevy of major companies expected to release earnings results.
• Companies reporting on Monday include Amcor, Bendigo & Adelaide Bank, Aurizon, GPT, Charter Hall Long WALE REIT and JB Hi-Fi.
• On Tuesday results include: Challenger, Reckon and Transurban.
• On Wednesday results include: Aveo Group, Bapcor, Computershare, CSL, Skycity Entertainment Group, and Tabcorp.
• On Thursday, earnings include: AMP, ASX, Evolution Mining, Goodman Group, IPH Limited, Magellan Financial Group, Newcrest, Suncorp, Tassal, Telstra, Treasury Wine Estate and Woodside Petroleum.
• On Friday, reports include: Abacus Property Group, Domain, Medibank, Healius, URB Investments and Whitehaven.

Last Week

By Shane Oliver, Head of Investment Strategy and Chief Economist, AMP Capital.

Investment markets and key developments over the past week

• Global shares were flat to down over the past week not helped by weak economic data and trade uncertainty. Australian shares saw a strong rise though as the banks saw a Royal Commission relief rally, the prospect of RBA rate cuts provided a boost to retailers, industrial stocks and yield sensitives and miners continued to benefit from the surging iron ore price. Bond yields generally fell on the back of soft data. While the oil price fell, the iron ore price continued to surge on the back of production cuts due to Vale’s problems. And the $A fell below $US0.71 on the prospect of RBA rate cuts and as the $US rebounded.
• Our view on global and Australian share markets hasn’t changed. They have run hard and fast since their December lows and some sort of short term pull back is likely. There are plenty of potential triggers for a pull back including ongoing trade uncertainty, a risk of a resumption of the shutdown in the US and ongoing soft economic data globally – most notably in Europe over the last week. And in Australian shares look to have run too far too fast – economic growth looks to be slowing and while we expect the RBA to cut rates its probably still a way off.
• But as global policy swings to being more stimulatory and growth indicators improve shares should perform well for the year as a whole. Key to watch for will be further policy support globally and rate cuts in Australia, a decisive end to the US government shutdown dispute and signs the US debt ceiling will be raised relatively smoothly, a bottoming in profit revisions and good earnings reporting seasons globally and in Australia, stronger than expected economic data and a bottoming in PMIs and share markets breaking through resistance on strong breadth.
• RBA downgrades the outlook and moves to a neutral bias on interest rates. In the past week it acknowledged increased downside risks globally and in Australia and its Statement on Monetary Policy revised down its Australian growth and inflation forecasts. And consistent with this its dropped its mild tightening bias (the mantra that the next move in the cash rate is “more likely to be an increase than a decrease”) and replaced it with a neutral bias, ie the next move could be up or down. We think the RBA’s downwardly revised growth forecasts for 3% this year and 2.75% next year are still too optimistic and see it closer to 2.5% at most as the housing downturn depresses housing construction and consumer spending. This in turn will mean that inflation will stay even lower for longer than the RBA is forecasting.
• We continue to see the RBA cutting the cash rate this year and its now moving in this direction, but there is still a way to go yet. In the absence of a signficant negative shock this was never going to happen over night but would occur as part of a process starting with the RBA revising down its forecasts (done), moving to a neutral bias on rates (done), more downwards revisions to its forecasts, moving to an easing bias and then easing. It’s likely this will require several more months of soft data and the RBA is likely to prefer to see what sort of tax cuts/fiscal stimulus will flow from the upcoming April Budget and the outcome of the election. So they will likely prefer to wait till after the budget and election. Which is why we thought the first easing is likely to be around August, but it could come as early as June. Our view remains that the cash rate will be cut to 1% by year end in two moves of 0.25% each.
• While the Final Report from the banking Royal Commission does not point to a further tightening in lending standards it did put a stamp of approval on the APRA driven tightening by the banks that is continuing and there is nothing to suggest it will be reversed even though RBA Governor Lowe continues to express concern that it may have gone too far. There is still more to go in shifting away from using benchmarks to assess borrower spending and in terms of debt to income limits particularly with the start up of Comprehensive Credit Reporting this year. So with the housing downturn having further to go and the economy slowing the RC relief rally seen in bank share prices may have gone a bit too far too fast. One worry from the RC recommendations is in relation to mortgage brokers – they have played a huge roll in injecting competition into the mortgage market by making it possible for small lenders without a big shopfront presence to take mortgage business away from the big banks via the mortgage brokers. Moving to having borrowers pay for the services of mortgage brokers at a time when they are cash strapped is likely to significantly reduce competition in the mortgage market which would be bad for borrowers. So its understandable that the Government is not so sure about this recommendation.
• Gong Xi Fa Cai…Happy Lunar New Year for the Year of the Pig. Out of interest the average return in the US S&P 500 back to 1930 in years of the Pig is 18.1%, the best of all Chinese zodiac years. For Australian shares the average return in years of the Pig since 1930 has been 26.5% and its been positive in every one.

Major global economic events and implications

• US data was a bit light on. The non-manufacturing conditions ISM index for January slowed consistent with slowing growth but its still solid at 56.7. The trade deficit also fell with weaker imports. Meanwhile, the Fed’s latest bank lending officer survey showed some tightening in lending standards for corporate loans and less demand for both corporate and consumer loans. All of this is consistent with the Fed’s pause on rates.
• The US December quarter earnings reporting season has been stronger than expected but its not as good as previous quarters as the tax boost and underlying earnings growth has slowed. 325 S&P 500 companies have now reported with 72% beating on earnings with an average beat of 3.1% and 59% beating on sales. Earnings growth is running at 17.9% year on year for the quarter. As can be seen in the next chart the level of surprises and earnings growth is slowing down. US earnings growth is likely to be around 5% this year.

Source: Bloomberg, AMP Capital

• Eurozone data continues to weaken with falls in German factory orders and German and Spanish industrial production and the European Commission revising down its growth forecasts. While the ECB may be dithering as to what to do next we remain of the view that another round of cheap bank financing (LTRO) is on the way soon.
• The Bank of England left monetary policy on hold as expected and also downgraded its growth forecasts with Brexit uncertainty weighing.
• Japanese wages growth slowed to 1.4% year on year in December and household spending growth improved but only to 0.1% year on year.
• China’s private sector Caixin services conditions PMI for January confirmed the impression from the official PMIs, which is that while manufacturing has slowed sharply the services sector is holding up well. This is important as the services sector is now far bigger than the manufacturing sector.

Australian economic events and implications

• Australia has just seen yet another week of soft data with a further sharp fall in home building approvals, very weak retail sales, a sharp fall in the services sector conditions PMI, a fall in job ads and the Melbourne Institute’s inflation gauge showing continuing weak inflation in January. Sure the December trade surplus was much better than expected but this was due to a slump in imports. Retail sales and trade look like making a zero contribution to December quarter GDP growth suggesting another quarter of weak GDP growth. The bottom line is that the housing construction cycle is turning down, the downturn in house prices looks to be weighing on retail sales, the labour market appears to be starting to slow and inflation remains MIA.

Source: ABS, AMP Capital

What to watch over the next week?

• In the US, its going to be back to politics to see whether Trump and the Democrats can resolve their squabble over the Wall and avoid a restart of the government shutdown from Friday – it appears that Congressional negotiators are making some progress on a compromise. Meanwhile US Treasury Secretary Mnuchin and Trade Representative Lighthizer will be in Beijing for another round of trade talks, with the March 1 deadline for the talks likely to be extended until President’s Trump and Xi next meet. On the data front expect core CPI inflation for January (Wednesday) to fall slightly to 2.1% year on year, December retail sales (Thursday) to show reasonable underlying growth and industrial production (Friday) to show a reasonable gain. It will also be another busy weak in the US earnings reporting season.
• Japanese December quarter GDP (Thursday) is expected to show a gain of 0.3% quarter on quarter or 0.1% year on year.
• Chinese January data is expected to show a further fall in exports and imports (Thursday), continued benign inflation (Friday) and credit data will be watched for a further pick up.
• In Australia, expect a further fall in housing finance (Tuesday). The NAB business survey (Tuesday) and the Westpac Melbourne Institute’s consumer confidence survey (Wednesday) are expected to remain softish.
• The flow of Australian December half earnings results will start to pick up with 44 major companies reporting including JB HiFi and GPT (Monday), Transurban and Amcor (Tuesday), Cochlear and CSL (Wednesday), South32, Woodside and AMP (Thursday) and Sonic Healthcare (Friday). 2018-19 consensus earnings growth expectations have fallen to around 4% for the market as a whole not helped by slower growth globally as well as locally with a large number of Australian companies warning of tough trading conditions, with resources profit growth running around 8% and the rest of the market around 2%. Resources, building materials, insurance and healthcare look to be the strongest with telcos, discretionary retail, media and transport the weakest and banks constrained. Key issues will be around the impact of the housing downturn, possible changes to franking credits and how the consumer is holding up.

Outlook for investment markets

• Shares are likely to see volatility remain high with the high risk of a short term pull back, but valuations are okay, and reasonable growth and profits should support decent gains through 2019 as a whole helped by more policy stimulus in China and Europe and the Fed pausing.
• Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier.
• Unlisted commercial property and infrastructure are likely to see a slowing in returns over the year ahead. This is likely to be particularly the case for Australian retail property.
• National capital city house prices are expected to fall another 5-10% this year led again by 15% or so price falls in Sydney and Melbourne on the back of tight credit, rising supply, reduced foreign demand, price falls feeding on themselves and uncertainty around the impact of tax changes under a Labor Government.
• Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 1% by end 2019.
• The $A is likely to fall into the $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will likely push further into negative territory as the RBA moves to cut rates. Being short the $A remains a good hedge against things going wrong globally.