Gottliebsen's Week: Negative rates, Eaton Vance, Shares and oil

Last Night

Dow Jones, down ~0.3%
S&P 500, down ~0.2%
Nasdaq, up ~0.2%
Aust dollar, US71.4c

Negative rates

This weekend I want to take you into a world that none of us have seen before and yet it is very much an integral part of what is taking place in 2016 and it will be a major force for at least the rest of the decade.

I am talking about negative interest rates.

When I first saw isolated countries and currencies moving into negative interest rates I tended to classify it as an aberration. But now more than 20 countries with five currencies are issuing government securities that carry a negative interest rate. That represents about a quarter of the world's output.

Among the countries are Japan, Germany, Switzerland, Sweden and even Malta. In those countries it means that, at least in ‘risk-free' transactions, money is a cost rather than an asset that produces a return. 

Recently the Swiss issued two-year bonds that carried a negative interest rate of just over 1 per cent, which means you are investing in a government bond in the full knowledge you will lose money. Negative interest rates are most common in central bank financing and they are causing considerable disruption in the banking and insurance communities, where suddenly holding cash becomes a cost. 

Now that negative interest rates have permeated so much of the world they are going to be with us for quite a while – at least until the end of the decade. It is not going to be easy to switch from negative to positive rates.

At this point of time the world's biggest economy, the US, is not planning a move to negative interest rates but it is certainly the subject of wide discussion and Federal Reserve chair Janet Yellen was recently closely questioned about it. If the US recovery were to slip back, negative interest rates would hit the horizon. I don't think that is likely.

Nevertheless, the wide spread of negative interest rates will keep a lid on global interest rates and particularly US interest rates for some years.

Negative interest rates create bizarre changes in spending habits. For example, you pay your bills as fast as you can so you can rid yourself of cash. Discount for prompt payments becomes a thing of the past. Once money becomes a cost people will, of course, store some in notes but that carries a security risk, so services will become available to store money on a secure basis.

But more and more people in countries where there are negative interest rates will be looking to invest in assets.

At this stage, negative interest rates for companies are rare, although recently Nestle was able to issue securities on the basis of negative interest rates.

But the borrowing costs for sound borrowers will be very low indeed. So that means that acquisitions are going to rise as corporations seek returns, not so much from growth but from rationalising assets and lowering costs.

There will also be a scramble for a variety of assets. We have already seen benefits in the gold market and if negative interest rates continue, as I expect they will, gold will become even more popular.

I am sure Eureka Report readers will come up with other bizarre changes to communities that embrace negative interest rates. We are in uncharted territory.

The groups that need to be very careful include banks. Currently they are paying money to depositors and lending that money to clients but the money they must keep as a liquidity buffer becomes a cost which they must super-impose on depositors and/or borrowers. It could affect profits. The techniques in banking will change, while insurance companies, required to hold large sums in liquid assets, will also see these become a cost and they will need to adjust premiums, so it could impact on profitability. It is a very different world and one we have rarely seen before. 

However, it makes Australian interest rates look way out of line and this is inflating our currency. it increases the likelihood of rate falls.

Eaton Vance

During the week I was yarning to the London-based asset managers, Eaton Vance. Their group manages a wide range of investment assets but I was yarning to Aidan Farrell, who concentrates on smaller companies. But of course in overseas markets their definition of smaller companies starts at around $1.4 billion market capitalisation. And in that arena Australia has around 130 companies. Although there are a large number of smaller miners it is still a healthy and vibrant list of companies.

Farrell says that in the current environment the shares in the large companies are buffeted by the major waves of market speculation and in a low-growth economic environment they don't usually invest in expanding existing operations but rather concentrate on lowering costs and buying other businesses (this trend towards acquisition by large companies of course blends into the negative interest rate environment). By contrast, smaller companies can focus on niche parts of the market and invest in their business.

What Farrell likes about the Australian market is that there is an average of about seven analysts for every mid-cap stock which makes it possible for institutions investing in that arena to gain a wide range of research material so that they can assess value.

In markets like Europe and the US fewer analysts study mid-cap companies, so selection becomes harder. And of course one of the ways returns are generated in the smaller capital companies is via large corporations being prepared to pay more than the market value for acquisitions. They need these smaller enterprises to achieve their growth. 

Interestingly, Eaton Vance says they are very wary in participating in IPOs because there are usually a lot of forces out there that push prices higher than their true worth.

In Australia we have seen a large number of IPOs coming out of private equity stables and there have been some unfortunate market outcomes. Eaton Vance says that it is better to wait and let the market settle down rather than get swept up in the excitement of the IPO market. This is advice that many Australians need to remember.

Of course, in years gone by new floats were priced at a discount to the market and often worthwhile profits for those lucky enough to get an allocation.

Shares and oil

After so much turmoil in stockmarkets we are now experiencing a rally in shares as immediate concerns about the global banking sector fade and the higher price of oil stimulates demand for energy companies.

The current energy-induced rally stems from the production discussions between Russia, Iran, Saudi Arabia and Iraq. It is important to realise that the preliminary agreements do not solve the over-production and heavy stocks that plague the oil market. What makes them significant and gives the markets encouragement is that Saudi, Russia, Iran and Iraq actually could agree on something. It's a small step, but with Russia, Iran and Iraq on one side of the Syrian war and Saudi on the other, any agreement is an important step.

One agreement on its own will carry limited impact but it is a pointer that the four countries, even though they are on different sides of a war, realise they have to come together on the oil market.

The long-term plan of Russian President Vladimir Putin is to gradually rationalise production and then form a cartel that divides up the oil market among the various producers.

It is an ambitious plan, made more urgent as both Russia and Saudi Arabia's economies start to struggle under lower oil prices.

Readings & Viewings

Closing developing countries' capital drain.

Watch James Kirby's two-minute guide to proposed negative gearing and CGT changes.

Are central banks out of ammo?

Gerard Minack certainly seems to think so. He says a recession is on the way.

The Apple standoff should make us rethink our surrender to the phone.

Analysing Trump Inc: From the tower to the White House.

Cash is waning, but not done yet.

How much money are people making from the sharing economy?

Kerr Neilson: China is a big risk, but we're not headed for another 2008.

Community banks in Japan are bucking negative rates.

The inequality puzzle.

Auction houses: Art market on the block.

Japan's vanishing golf courses sum up Abenomics.

Understanding the revival of Qantas.

Last Week

By Shane Oliver, AMP Capital

The past week saw the rebound in shares and other risk assets continue. Most share markets saw gains, bond yields were mixed in core countries but fell in peripheral Europe, oil moved a bit higher along with other commodity prices but the Australian dollar was little changed.

The rebound in risk assets has been supported by a number of factors. First, a speech by ECB President Mario Draghi was dovish and reassuring indicating the ECB is watching the impact of financial turmoil on banks closely and "will not hesitate to act". Expect more QE and cheap bank funding from the ECB.

Second, Russia and various OPEC oil producers agreed to cap oil production at current levels. They need to do more but it's a step in the right direction and the oil price continues to look like it's trying to build a base.

Third, PBOC Governor Zhou's comments left the impression that without a major surge in the value of the US dollar, a sharp fall in the value of the Renminbi against the US dollar is unlikely. In fact with the US dollar drifting off lately the Renminbi has been rising, with no sign of recession.

Fourth, US manufacturing production data has been looking healthier and the overall flow of US March quarter data so far points to reasonable GDP growth.

Finally, after falling hard share markets had become oversold and several had fallen to technical support levels.

With periodic sharp bounces in shares normal in bear markets it's premature to say that the current rebound means the bottom has been seen. But if we are right and recession is avoided then there is a good chance that either we have or may have come close to the bottom.

The recent success in presidential primaries of populist candidates Donald Trump (Republican) and Bernie Sanders (Democrat) raise the concern that this year's US presidential election will result in a less business friendly president. This is certainly a risk and would only add to market nervousness. However, there is still a long way to go in the primaries so hopefully more centrist candidates like Hillary Clinton or Marco Rubio will prevail and even if a populist does get up centrist dominance of the broad rump of Republicans and Democrats in Congress (with Republicans likely controlling both houses) should limit the power of the president to enact extreme or less business friendly policies

The debate over negative gearing in Australia has reached fever pitch. My views on this are as follows:

1/ negative gearing is not to blame for expensive Australian housing – it's due to a lack of supply;

2/ negative gearing does not reflect a distortion in the tax system but as the Treasury has pointed out reflects a basic feature of the tax system that allows deductions for expenses incurred in earning income;

3/ if we are going to restrict access to negative gearing it makes more sense to limit the dollar value of negative gearing concessions per tax payer rather than force all investors into new housing as this could avoid making it harder for first home buyers to get a new home and avoid complications around when a new property becomes an old property for tax purposes;

4/ the capital gains tax discount is the real distortion in the tax system  as it enables capital gains to be taxed at half the rate of regular income;

5/ limiting access to negative gearing to just new property will also affect investment in other assets like shares and commercial property – is this something we really want?;

6/ curtailing negative gearing and the capital gains tax discount needs to be offset by income tax cuts as the Australian tax system is already highly progressive with just 17 per cent of workers providing around 63 per cent of the income tax revenue provided to Canberra. Cutting back on concessions without cutting tax rates will only see this rise acting as a further disincentive to work effort which is the last thing Australian needs now.

Major global economic events and implications

US economic news was mostly okay. Housing starts and home builder conditions were down slightly but this may be weather related with permits to build new homes little changed. Meanwhile manufacturing conditions were slightly less negative according to a couple of regional surveys, industrial production rose nicely in January and jobless claims continue to fall. The minutes from the Fed's last meeting simply reiterated that it's aware of the risks flowing from tighter financial conditions and so a March hike looks very unlikely.

Japanese December quarter GDP contracted again, highlighting that Japan is still yet to escape the pattern of on and off again recessions it's been having since the 1990s.

Chinese trade data was poor in January but this may be due to distortions associated with the floating Lunar New Year and disguised capital flows. And against this money supply and credit growth was much stronger than expected for January. While inflation rose in January, this was mainly food related with non-food inflation remaining low at 1.2 per cent year on year.

Australian economic events and implications

After several months of unbelievably strong jobs reports, employment surprised on the downside for January pushing unemployment back up to 6 per cent. It's dangerous to read too much into one month's jobs data and the trend in the ABS jobs data and various other labour market indicators still suggest the jobs market is solid.

However, our view remains that the RBA will act on its easing bias in the months ahead with another rate cut as growth remains sub-par and as a delay in Fed tightening puts upwards pressure on the Australian dollar. But the RBA is unlikely to move till May.

The Australian December half profits reporting season is now more than half done and overall results have continued to come in much better than feared. Fifty-four per cent of results have bettered expectations (against a norm of 44 per cent), 68 per cent have seen profits up on a year ago and 69 per cent have raised their dividends relative to a year ago (against a norm of 62 per cent).

It's tough out there for resources stocks but no more than expected. While they are cutting their dividends note that mining stocks are now less than 10 per cent of the market (believe it or not RIO is just 1.5 per cent of the market and BHP just 4.2 per cent!).

Meanwhile, most of the big banks are seeing reasonable results and stocks exposed to the Australian economy, led by housing and the consumer are doing well. Company guidance has had a slight positive skew. The better than feared nature of the results to date has been reflected in 66 per cent of stocks seeing their share price outperform the market the day results were released.

Of course, there is still a way to go and good results have a habit of coming out early in the reporting season.

Next Week

By Craig James, CommSec

The December quarter economic growth data is released on March 2. But in the coming week, pieces of the puzzle start to be put together. The other focus domestically is on wages.

The week kicks off on Monday with the release of the business sales index from Commonwealth Bank. In contrast to the retail trade data from the Bureau of Statistics (ABS), the BSI is a measure of economy-wide spending.

Also on Monday, Reserve Bank (RBA) Assistant Governor (Financial Markets), Guy Debelle, delivers a speech.

On Tuesday, another senior official delivers a speech — Tony Richards, Head of Payment Policy Department, at the Payments Innovation 2016 Conference.

Also on Tuesday the weekly consumer confidence data is released. Consumer sentiment rose 2 per cent last week.

On Wednesday, the ABS releases the Wage Price Index — the main measure of wage costs in Australia. We expect that wages remained tame in the December quarter, lifting by 0.6 per cent in the quarter and by 2.3 per cent on the year.

The jobless rate has eased from around 6.3 per cent to 5.8 per cent. If annual wage growth remains near record lows of 2.3 per cent, that isn't a concern. But if wages show signs of lifting, then the Reserve Bank will start rethinking traditional relationships of economic growth, wages and inflation.

Also on Wednesday, preliminary data on construction work is released for the December quarter. The data on residential work completed is an input into the calculation of economic growth.

On Thursday, the ABS will release the December quarter estimates on business investment. This data is also an input into the calculation of economic growth. But also insightful are the estimates of planned investment for the coming year.

Overall we expect that investment fell by 7.5 per cent in the quarter, reflecting the winding down of the mining construction boom. The Reserve Bank will be interested in estimates of non-mining investment.

Also on Thursday, more detailed demographic and regional estimates on employment will be released alongside the semi-annual estimates of average weekly earnings — the dollar estimates of wages in the economy.

On Friday the ABS issues the estimates of business entries and exists — timely estimates on the number and type of businesses that exist in Australia.

US housing sector under the spotlight

In the US, there is the usual bevy of economic indicators to be released with the focus on the housing sector. The only data of note in China are the January estimates of home prices, released on Friday.

The week kicks off in the US on Monday with the National Activity index and the Markit ‘flash' estimates of manufacturing activity in US, Japan and Europe.

On Tuesday in the US, the CaseShiller home price series is issued alongside consumer confidence, existing home sales and the influential Richmond Federal Reserve index. The annual growth rate of home prices may have edged up from 5.8 per cent to 5.9 per cent in December. But consumer confidence may have fallen from 98.1 to 97.3 in February. And home sales may have eased by 1.5 per cent in January.

On Wednesday, data on new home sales is issued. And just like existing homes, sales may have fallen in January — down 4 per cent after a near 11 per cent gain in December.

In the US on Thursday, the estimates on durable goods orders — a proxy for business investment — are released together with the usual weekly data on new claims for unemployment insurance (jobless claims) and FHFA home price series.

And on Friday in the US, the second (preliminary) estimate of economic growth is released with personal income and spending data and consumer sentiment. US economic growth slowed to 0.7 per cent in the December quarter. And the Federal Reserve's preferred inflation estimate is contained in the personal income release.

Sharemarkets, interest rates, exchange rates and commodities

The local profit reporting season winds down in the coming week. As always the focus is on the latest earnings result, forward guidance and decisions made on dividends. So far the surprise has been the fact that companies are still keen to either lift or maintain dividends.

Among those reporting on Monday are Brambles, BlueScope Steel and UGL.

On Tuesday earnings results include those from BHP Billiton, Qantas, Oil Search, Caltex and Healthscope.

On Wednesday, among those expected to issue results are Flight Centre, Wesfarmers, Worley Parsons, Asciano, Macquarie Telecom, MacMahon and Fortescue Metals.

On Thursday, companies that are scheduled to report include Seven Group, Ramsay Health Care, Alumina, South32, Blackmores, Nine Entertainment, Crown Resorts, Adelaide Brighton, APN News and Media and Breville Group.

And on Friday, earnings are expected from Woolworths, Westfield, Prime Media, Cabcharge, Billabong and Fantastic Holdings.