Gottliebsen's Week: CBA, Oil, Yellen, US election

Last Night

Dow Jones, up ~1.9%
S&P 500, up ~1.9%
Nasdaq, up ~1.7%
Aust dollar, US71c

CBA

As I began to research this weekend's missive to Eureka Report readers it was Friday morning and European and US markets had fallen sharply, but overnight global markets bounced back, rallying as the oil price surged on talk of production cutbacks. There has been heavy shorting of oil so any sign of production cutback sends shorters scrambling to cover their positions and the price skyrockets. 

I will come back to the volatility and the problems becoming evident in global markets later but now I want to take you away from the global mire and into Australia's largest company, Commonwealth Bank.

In particular I want to take you into a future of this organisation which is different to almost every other corporation in the country.

The first point I must emphasise is that if we have a global recession and international bank collapses there is no way the Commonwealth Bank will escape the flow on because its overseas money will be more expensive, its customers will be hard hit and the Australian housing market will fall. But the bank will survive and if the world can muddle through the current situation it's probably the best placed bank in the world to prosper in the decade ahead. 

It is better placed than any other bank in Australia, although this is recognised in the sharemarket by its premium. 

Why is the Commonwealth Bank the strongest? There is a simple answer to that – about 34 per cent of its business is in the retail sector, where it reaches something like 12 million Australians. 

No other bank goes anywhere near that level of market penetration. In the past the retail banking area has been seen as a non-exciting part of the bank and often the focus is on CBA's exposure to the mortgage market. 

But take a step back and look at what is happening to technology. In the next five years it is going to be possible to service those retail customers at a fraction of the current costs. 

Moreover, customers of organisations like banks are increasingly looking for better experiences and I can see the day when Commonwealth Bank links with other large databases such as Westfield and Coles and offers a much more comprehensive package of services and goods. 

The day is coming when if a person gets a deposit in their bank account they will have the choice of allocating it to a term deposit, share investment, a superannuation account, or other areas, almost at the press of a button. No more silly forms and labour-intensive procedures. 

The cost of servicing retail clients is set to go through the floor and the ability to offer them different experiences will escalate. That makes the Commonwealth Bank's retail customer base one of the best assets in Australia. The lower cost in servicing those retail clients will reflect in lower charges but the profits will rise. 

Similarly, in due course the myriad government regulations that require paper copies of banking-style transactions will be eliminated and the bank systems will go fully into the cloud, which again will absolutely slash costs. 

However, the amount of cost reduction under the current parameters is beginning to reach an end and that's why quantum computing is going to be important and why Commonwealth Bank, along with Telstra, is anxious to be a global leader in its development. Watch out for references to quantum computing in the next year or so.

Australian banks are priced on a much higher price-to-earnings ratio than their global counterparts. This is clearly a weakness in our index.

But our banks point out that in the US the major banks do not necessarily have a national footprint. For example, if you are a Citibank customer you can't do your banking in Philadelphia. Instead there are hundreds, or even thousands, of small banks. Surprising as it may seem US banks are falling behind Australia in these new cost-reduction technologies. 

The massive problems in Europe's banking system means that again the investments have not been made in technology so most European banks are behind Australia. Countries such as Canada are in much better shape.

And so, while it is true that the dividend payments from Australian banks have played a big role in making our banks more expensive than overseas banks, they have an advantage that does warrant a premium. One of the risks for our banks, in my view, is that we pay out so much of our profits in dividends that if there a global reversal there is no profit cushion to avoid reducing dividends.

And I would argue that our banks have a very good case to put to their shareholders that they should step up their investment in technology to gain greater returns rather than give the money to shareholders via dividends. I know that a great many of my Eureka Report readers will disagree with this. 

But at this point no bank has presented its shareholders with a reasoned case to allocate more money to technology investment, so in this sort of discussion we are way ahead of bank boards.

Oil

As we've discussed in Eureka Report many times, the Russian plan is to sort Syria out and then join with OPEC. Any sign that Syria is improving hastens that plan. In any event oil is so low that the need to get the price up is becoming more acute and may have to precede the Syrian solution.

What is fascinating is that Russia is becoming not only the main driver in the Middle East but also the oil power broker.

Yellen

Meanwhile, I was fascinated with the discussions that were linked to Federal Reserve chair Janet Yellen's presentation this week. A great many of the questions were concentrated on the negative interest rates in Europe and Japan. This is a very serious problem for banks. But it means that our global bond markets are signalling that interest rates are not going to go up and may fall.

Indeed the US 10-year bond rate is now down to 1.64 per cent, a far cry from the 2.3 per cent late last year. This means that it is quite dangerous to leave too much of your money in simple cash because the markets are signalling that the returns are going to fall.

We have seen a rush to gold because it is cheaper to hold gold in Europe and Japan than to hold cash.

The decline in Australian and global bank shares shows that it is dangerous to simply translate the prospect of interest rate restraint in the US and lower rates in Australia into buying high-yield securities such as bank shares. As you know from my writing over the last year I have been a strong believer that the rate of interest rate increases will be less than the market believes and I have locked in higher longer-term corporate bond rates. So far that has worked. 

I think it is a strategy those with larger portfolios need to consider. If the current smashing of bank shares in Europe and the US continues we are going to see some bank failures. I have always been nervous about European banks, so the worsening of the mire in Europe once again is very dangerous.

I really don't know where to start in terms of issuing alerts but it is clear yet another rescue package is required for Greece and there will be more again. At some point Europe will have to bite the bullet.

And we are seeing in Germany the rise in right-wing parties and that will increase as the horror of what Angela Merkel has done by taking in so many refugees at once permeates though the community. Against that, I think that China is going to get through its debt and slowdown pressures – perhaps by deferring them to be tackled in better global times. If that's right it is good news for Australia.

US election

In the US the income recession and the hollowing of the middle class is beginning to have a clear effect on the way people vote in the presidential election. I expected this to become more apparent in 2020 than in 2016. I was wrong – it is happening now.

So we are seeing a person from the hard left giving Hillary Clinton a substantial challenge in the Democrat arena, while on the Republican side we have candidates that you would never have predicted would have a chance – like Donald Trump – emerging as front runners.

The political class in a great many countries has not yet realised the effect of hollowing out the middle class on the community. That's the downside of those cost reductions in the Commonwealth Bank because they can and will be repeated in large areas of corporate and public service communities. 

For the most part the cost reductions involve retrenching the middle class, and in a democracy that will effect politicians and I believe longer term the current profit share of the cake is probably under threat. But that is not a prediction that has any immediate relevance. We are lucky in Australia to have a company as sound as Commonwealth Bank as our largest company.

Readings & Viewings

A surprisingly upbeat assessment of both oil prices and the outlook for Middle Eastern economies from the ever cautious investors at Franklin Templeton.

George Soros: Putin is no ally against ISIS.

Greece....will it ever go off the radar? Oliver Marc Hartwich returns to a favourite subject. 

These companies have all been the world's most-valuable. What else do they have in common?

The battle over Brexit matters to the world.

This woman has a unique perspective on making money ... actually it's on losing money. 

How Telegram is blocking extremist messages (the Pope is using this messaging app over Lent, he's switched from WhatsApp): 

App makers are the major beneficiaries of cheap smartphones.

Twitter tweaks the timeline, but it's not the end.

On Twitter's major growth issues.

Watch this robot hit a hole in one on the PGA tour.

It's been too long since we had a funny puppy video...

Last Week

By Shane Oliver, AMP

Investment markets and key developments over the past week

The turmoil in financial markets continued over the last week as worries about global growth, and specifically the exposure of global banks to energy loans and rising bad debts if there is a recession, continue to build. As a result share markets saw more sharp falls, sovereign bonds in core countries continued to collapse, credit markets remained under pressure, commodity prices excluding gold fell with the oil price making a new low. Despite this the Australian dollar rose slightly as the US dollar continued to slide.

The continuing slump has seen Australian shares tip over into bear market territory (albeit using the rather arbitrary 20 per cent decline line in the sand definition) joining many other markets that were already there. From last year's highs to most recent lows US shares have had a fall of -14 per cent, Australian shares -20 per cent, Eurozone shares -27 per cent, Japanese shares -27 per cent, Emerging market shares -27 per cent and Chinese shares -49 per cent.

The slump in share markets is increasingly looking to be feeding on itself – as eg investors fret that financial turmoil will bring on a recession and cause big problems for banks which in turn drives more selling of shares.

Our assessment is that another GFC-style credit and banking crisis is unlikely: banks in the US, Europe and Australia are better capitalised now; US and European bank exposure to energy loans at around 2-4 per cent of total assets is a fraction of their exposure to housing loans which were at the centre of the GFC; new restrictions on proprietary trading have limited banks' exposure to riskier corporate debt; and the issues of low transparency and complexity that plagued the sub-prime mortgage market are not really an issue in corporate debt markets now.  So far we are not seeing any blow out in interbank lending rates relative to official interest rates in contrast to what we saw in 2007-2008 as bank funding costs soared. Similarly we remain of the view that a US or global recession is unlikely, albeit with a 25 per cent probability.

However, it does seem that markets need to see some sort of circuit breaker to end the negative feedback loop that is now developing. Central banks are most likely source of this. On this front, Janet Yellen's comments in the past week indicate that while the Fed is aware of the risks it is not yet at the point of reversing course and providing more monetary stimulus, the Bank of Japan is likely still mulling its next steps after negative interest rates seemingly backfired but the ECB is likely getting closer to action, particularly with Eurozone bank share prices now down 42 per cent from last year's high and back to levels seen in the 1990s. This is likely to take the form of increased quantitative easing, probably focussed on corporate debt, and maybe more cheap financing for banks.

With Australian shares having entered a bear market, the following table provides some historic perspective on them.

The average bear market since 1950 has lasted 14 months with a decline of 34 per cent. It's then taken an average 39 months to get back up to and exceed the previous high with an average 28 per cent gain in the first 12 months after the low. Of course this masks a wide range but generally speaking the deeper and longer bear markets have been associated with recessions in either Australia or the US or both.

RBA Governor Steven's Parliamentary testimony highlighted the improvement in non-mining activity in the Australia, labour market strength and low inflation. But he also reiterated the RBA's easing bias and the uncertainty around the impact from recent global financial turbulence. Right now the RBA remains in wait and see mode, but our view is that it will cut interest rates again sometime in the months ahead.

Major global economic events and implications

US economic news was mixed with a slight fall in small business optimism but solid readings for job openings, hirings and employees quitting their jobs for new jobs and another decline in jobless claims.

So far the US December quarter earnings reporting season is about 75 per cent complete. 76 per cent of results have beaten on earnings but the size of positive surprises has been lower than in prior quarters and so earnings are still down 4.3 per cent year on year. Only 48 per cent have beaten on sales. The manufacturing slump and the strong $US have clearly weighed.

Japanese economic data was mixed with weak machine tool orders and economic sentiment but stronger bank lending and weaker bankruptcies.

China was pretty quiet over the last week being closed for the Lunar New Year holiday. The PBOC's foreign exchange reserves reportedly fell another $US99bn in January consistent with ongoing capital outflow but interestingly the decline was less than in December.

One BRIC at least is continuing to do better than expected with India seeing 7.3 per cent GDP growth through 2015, helped by strong domestic demand.

Australian economic events and implications

Despite the global turmoil recent the NAB and Westpac surveys put recent business and consumer confidence readings around long term average levels – flat for business and up a bit for consumers. On the housing front, housing finance remained solid driven largely by refinancing activity by owner occupiers as investor finance remained weak and new home sales rose strongly in December according to the Housing Industry Association, albeit the trend remains down from last year's highs.

It's early days in the December half profit reporting season for Australia with only 17 per cent of major companies having reported but so far so good with 52 per cent of results coming in better than expected, 63 per cent seeing profits up on a year ago and 70 per cent raising their dividends relative to a year ago. It's about horrible as expected for resources stocks with RIO's profits down sharply and it warned that its dividend will be cut as has long seemed inevitable, but conditions seem okay for the much of the rest of the market. Of course the good results have a habit of coming out early in the reporting season.

Next Week

By Craig James, CommSec

Job market in the spotlight

Only a spattering of economic statistics will be released in Australia in the coming week. But dominating proceedings are minutes of the last Reserve Bank Board meeting and employment data. In the US, similarly minutes of the Federal Reserve meeting will be dissected while key data is released in China.

The week kicks off on Monday with data on new motor vehicle sales. Underpinned by the best affordability figures on record, new vehicle sales are at record highs with sports utility vehicles the driving force. The data are the Bureau of Statistics estimates on sales, based on earlier industry sales figures.

On Tuesday, minutes of the last Reserve Bank Board meeting are released. The RBA has a ‘conditional easing bias', but it doesn't appear keen to act on that bias any time soon and cut rates.

Also on Tuesday the lending finance data is released by the ABS — the broadest measure of new loans being taken up by consumers and businesses. The latest data shows lending commitments are at 7½-year highs, primarily underpinned by business and housing loans. Weekly consumer confidence data is also released.

The highlight in terms of economic data is the monthly employment report on Thursday. The resilience of the job market has been the main positive piece of economic news in 2015/16. Unemployment is at a 2-year low of 5.76 per cent with over 300,000 jobs created in 2015.

CommSec expects that 15,000 jobs were created in January with the jobless rate largely unchanged near 5.8 per cent. The Reserve Bank believes unemployment could trend lower in coming months, a forecast backed up by the latest data on job ads.

Also on Thursday, Reserve Bank Assistant Governor Malcolm Edey delivers a speech.

US and Chinese data; Spotlight on US Federal Reserve

There is the usual bevy of economic indicators to be released in the US in the coming week. And China emerges from the Lunar New Year holidays with the release of key economic data.

The week kicks off on Monday with the January trade figures to be released in China. Analysts are tipping the trade surplus to have narrowed from US$60.09 billion to US$58.85bn in January.

US markets are closed on Monday for the Presidents' Day holiday.

On Tuesday in the US, the National Association of Home Builders index is released with the New York Federal Reserve index (Empire State index), capital flows data and weekly chain store figures.

On Wednesday most interest will be in the minutes of the last US Federal Reserve meeting. Economists are largely giving up on a March rate hike, but the commentary will be closely dissected.

Also on Wednesday in the US, the producer price index is issued with industrial production and housing starts. The usual weekly data on mortgage finance is also released. Housing starts may have lifted 2 per cent in January but production may have only crept 0.1 per cent higher in the month.

On Thursday in China the January inflation figures are released — both consumer and producer prices. Low inflation gives Chinese authorities flexibility to boost economic stimulus if required.

In the US on Thursday, the influential Philadelphia Federal Reserve index is released together with the leading index and the usual weekly data on new claims for unemployment insurance (jobless claims). The leading index may have eased 0.2 per cent in January.

And on Friday in the US, the January consumer price index is scheduled. The core measure (excludes food and energy) is expected to have lifted by 0.2 per cent in the month and 2.1 per cent over the year. The relative absence of inflation is the key reason that the Federal Reserve can take its time in lifting interest rates.

Sharemarkets, interest rates, exchange rates and commodities

The local profit reporting season gets into full swing in the coming week. As always the focus is on the latest earnings result, forward guidance and decisions made on dividends.

Among those reporting on Monday are Aurizon, Newcrest and Argo.

On Tuesday earnings results are expected from CSL, Bendigo & Adelaide Bank, GWA, Challenger, Star Entertainment, Reckon, Invocare, Pacific Brands and Paladin. A quarterly update is scheduled from National Australia Bank.

On Wednesday, among those expected to issue results are Amcor, A2 Milk, The Reject Shop, Insurance Australia, Lend Lease, Independence Group, Domino's Pizza, Sonic Healthcare, Arrium, Coca Cola Amatil, Primary Health Care, Woodside Petroleum and Mount Gibson Iron. ANZ releases a trading update.

On Thursday, companies that are scheduled to report include GPT, Seven West Media, Telstra, Tatts Group, AMP, Webjet, Sydney Airport, QBE Insurance, Charter Hall and Origin Energy.

And on Friday, earnings are expected from Western Areas, Santos, Iluka, Fairfax Media, James Hardie, Medibank Private and Transpacific.