Gottliebsen's Week: The markets, Housing risks, Donald Trump

Last Night

Dow Jones, up 1.2%
S&P 500, up 1.5%
Nasdaq, up 1.7%
Aust dollar, US75.7c

The markets

Put down in your diary a little tick beside Saturday March 12. For that was the day that significant events took place on world markets that show signs of ushering in a new set of rules.

To understand the importance of what took place last night I’m going to show you a first draft of what I had planned to write 24 hours ago. But when I woke up this morning, it was clear that was the wrong message.

Before I go into detail I want to say how much I have enjoyed replacing Alan Kohler each weekend while he was on long service leave. And I have good news for you: Alan will be back next weekend.

In my final weekend commentary I want to take you from the markets to mining, negative gearing and housing, and then Donald Trump. 

So here is my 24-hours ago draft: 

Most mornings one of the first figures I look at is the US 10-year bond rate and this week while the sharemarket was rising the bonds were yielding between 1.8 and 1.9 per cent.

If you make some sort of adjustment for inflation that is not far off a negative yield and, at least on the surface, it indicates the US bond market is expecting an American recession.

I am indebted to Richard Morrow from Baillieu Holst for his calculation that the US S&P 500 price earnings ratio equates to a yield of 4.5 per cent from the top 500 American equities.

That means we are looking at around a 2.5 per cent difference, so clearly the US sharemarket is also worried about the future, although the 10-year yield increased towards the end of the week, narrowing the gap.

The US economy continues to grow, although it is a little staggered, and almost certainly the next interest rate move will be up. In the last few days of this week the indications were that it might move higher in the current half year. But clearly there is a confidence gap.

Of course the very low bond rate partly reflects the fact that the world is awash with cash and investors see US bonds as “risk free” and are prepared to accept very low yields, which are better than those available in Europe.

Then came this morning.

The US 10-year bond yield had risen again (that means that bond prices are falling) and had reached 1.98 per cent.

That’s still a fair way from the 2.15 per cent that the bonds reached last year but it shows that there’s an exodus of money from US bonds. So that earlier bond market prediction of a looming US recession is fading.

And with the higher bond yields came a rise in sharemarkets across both Europe and the US.

Then comes the Australian dollar, which rose to US75.7c overnight. A week ago it was around US72c.

The fact that the US is not going into recession, that China is planning to stimulate its economy and the further stimulation in Europe reinforces the message that there’s no recession on the horizon and commodities are moving upwards, including oil and iron ore. The Australian dollar is particularly tied to iron ore.

That rise in the Australian dollar will send huge rumbles through the Reserve Bank at Martin Place in Sydney.

When our dollar first started to rise it was clearly short covering, and this latest rise will again have had the input of those shorters who didn’t cover earlier being forced into buying back the Aussie currency. But the rise is too big for just that, and at these levels the high dollar will damage our export industries and the rebalancing of the Australian economy away from mining.

Lower Australian interest rates are now back on the agenda.

The rise in the dollar underlines an important feature of this week which we should not forget: Firstly, against most predictions, iron ore skyrocketed in price and more significantly, the Australian dollar rose with it, confirming that the two are closely linked. 

Most people expect the iron ore price to slip because there is a substantial surplus, which will get worse as Roy Hill comes into production. Oil is similar. The doomsayers expected the black gold to keep falling but it too rose sharply on the back of lower US production and the continuing talks between Russia, Saudi Arabia, Iran and Iraq, which we have been discussing regularly in Eureka.

Predicting short-term moves in commodities and particularly iron ore and oil is too hard for me. But the current movement indicates that there is a significant turn in the mining business and long-term investors need to make sure they have an exposure. My guess is that iron ore will stabilise at levels above the crisis.

In the case of oil I have been watching with amazement at just how tactical Russian President Vladimir Putin has been. The simple situation is that American production is cutting back and Iran is looking as if it’s going to take a long time to ramp up its production.

Oil is no longer in oversupply and that’s what’s really giving the market a boost. At any price over $US40 a barrel for Brent crude Origin Energy is looking at paying a dividend. And that’s just one of the transformations to take place. Similar transformations are taking place at BHP.

Housing risks

In this context I was yarning yesterday to Lazard’s Phil Hofflin. Hofflin says that the history of investing is to make sure you are not caught in booms and to buy when no one else wants a particular industry and so the smart investors sold out of the technology boom, the China boom, the resources boom and so on.

Of course it is incredibly easy to be wise after the event, but Hofflin says there is another boom taking place in Australia that is just as dangerous as the booms that cracked: the boom in housing and bank shares. 

My ears pricked up when he began discussing this because one of the very big debates we are going to have between now and the next election is negative gearing and houses.

Phil says that houses in Melbourne and Sydney yield in the vicinity of 3 per cent and their costs are about 1 per cent, so on average the net yield is just over 2 per cent.

Apartments yield more but their costs are higher so while the overall yield is above that of houses, the net yield is in the same ballpark.

Yields outside Melbourne and Sydney are higher, but if we use the major capital city yields and then deduct 30 per cent corporate tax (most investors are negatively geared but to equate the property yield to the sharemarket we need to deduct a 30 per cent theoretical corporate tax rate), the net yield is in the vicinity of 1.5 per cent. This translates into an ungeared residential home price-earning ratio of around 65 times. Add the gearing and it tops 80 times.

That is way above any leading stock, even in the boom times. Australian house prices have risen faster than almost any other country and alongside the housing boom have been bank share prices, which have reaped a fortune from the boom. This has enabled all four Australian banks to be among the largest 14 banks in the world.

Hofflin does not know when the housing market will crack (it could be years away) but says that it is very vulnerable. In his view Australians are particularly vulnerable because if you combine housing equity and equity in the finance sector shares, Australian investment portfolios are dominated by the housing sector. Property accounts for 70 per cent of the average Australian’s wealth. Add bank shares and around three-quarters of Australian wealth is exposed to property and is at risk of a housing correction.

While Hofflin has no idea when or what will cause the market to crack, he raises six areas that could see it turn nasty for Australia. In no particular order, they are:

  • Substantial changes in negative gearing;
  • A disruption of offshore cash flows, perhaps through Chinese clampdowns;
  • Any withdrawal of offshore investors, who dominate apartment buying in Melbourne and Sydney;
  • An Australian recession with higher unemployment;
  • A frustration from dwelling investors: The statistics indicate that two million Australian landlords lose money on their property investments; and
  • A rise in US inflation, which would send US and global interest rates higher. (I would add to this that in the theoretical event of Donald Trump winning the US presidential election, a combination of lower migration and a curbing of cheap imports would send US wage rates, inflation and interest rates substantially higher.)

Hofflin says that rather than being so exposed to housing and banks, Australians should be switching their long-term exposure to the mining sector, where values are at distressed levels. And of course that coincides with the ‘green shoots’ we saw in this week’s rally.

Given those high housing PE ratios it is very clear that Bill Shorten is playing a dangerous game with negative gearing, albeit in an attempt to give the up-and-coming generation a chance to buy inner-city houses.

And here is a strange conundrum: Roy Morgan Research analyses employment far better than the ABS and they use very different methods, which show the real unemployment rate is much higher than the ABS claims.

But Roy Morgan says this week that unemployment in Australia has been falling regularly for the last four months. Moreover, in February Australia’s real employment is up 710,000 from a year ago. That is an impressive rise and has taken place despite the mining investment boom collapse. 

Roy Morgan believes that the rebalancing has been achieved by creating jobs in industries such as property and real estate. In other words, the housing boom has replaced the mining boom, which underlines the dangers of changing negative gearing, even though it is desirable from a social point of view. It doesn’t look as though the Coalition is going to make changes to negative gearing but we can’t be sure. We will need to follow that debate with more than usual interest.

Donald Trump

Finally I want to return to the US and Donald Trump. You may have missed an excellent article in Business Spectator by US-based journalist Luke McKenna (The economics of America’s bitter politics, March 9). McKenna quotes Nobel prize-winning economist Joseph Stiglitz as pointing out that ordinary American citizens are finally waking up to the fact that they are not doing as well as their parents, or even their grandparents.

Moreover, they have seen a lot of injustices as people were thrown out of their houses where they didn’t owe money and none of the bankers were held accountable for their roles in the financial crisis. 

Stiglitz believes this has really motivated anger across the US spectrum, especially since in the first three years of the US recovery most of the income gains went to the nation’s wealthiest 1 per cent. This anger is being reflected in opinion poll after opinion poll.

And Republican frontrunner Donald Trump has harnessed this anger into support for draconian crackdowns on immigration and foreign imports.

On the Democratic side Bernie Sanders wants to redistribute wealth from the rich to the poor and will break up the big banks. 

These are incredibly dangerous policies for the US and the world, but they are gaining taction because of community anger. Australians need to stop laughing at Donald Trump and realise that he is a threat to our wellbeing because we export iron ore and commodities to China and China exports to the US. If Trump turns off the tap we will suffer. Similarly, Sanders’ recipes will cause a huge fall on Wall Street, which will have an impact on us.

And so if Donald Trump or Bernie Sanders gets the nomination (and Trump is a hot favourite) we need to be on the edge of our seats in Australia, remembering that it is a two-horse race.

Readings & Viewings

ECB’s Mario Draghi plays his last card to stave off deflation.

Barrie Cassidy: Abbott, Credlin and the abuse of power.

From Assistant Treasurer Kelly O’Dwyer: “No one has a right to a taxation concession. This is a gift from the Australian people that we provide. No one has a right to it.” 

Mohamed A. El-Erian: Is the perfect storm over for markets?

How global investors turn negative Japan yields into big returns. 

The return of the 1930s: Donald Trump’s demagoguery may be a foretaste of what’s to come.

The end of globalisation?

The whole of Europe risks spinning into crisis if leaders mishandle Brexit.

Very interesting video from the FT on the end of the Chinese miracle.

Watch Google's self-driving car get into an accident with a bus.

…And then read about how a Google computer program walloped one of the world’s top players at Go, the most complex board game ever created.

Australia is the best place on earth to be a millennial, apparently.

The restoration of a castle in Spain hasn’t been well received by the locals…

Fans have been waiting a long time for this one: Game of Thrones season 6 trailer. Looks like it’s going to be a cracker.

Last Week

By Shane Oliver, AMP Capital

The past week saw most share markets pull back partly due to a perverse reaction to the ECB and partly (or most likely) because after a strong bounce markets had become overbought and due for a bout of “profit taking”. Australian shares were an exception though getting a boost from a further rise in the iron ore price. Oil and gold prices also rose but metal prices fell. Meanwhile, bond yields mostly rose as expectations for negative interest rates globally were wound back a bit, US interest rate expectations rose a bit and the US dollar fell which enabled the Australian dollar to briefly push above US75c.

The ECB more than delivered, but inadvertently shot itself in the foot (hopefully temporarily). Whichever way you look at it the ECB delivered much more than generally expected: its monthly quantitative easing program was increased from €60bn to €80bn; it will now include buying corporate debt; new cheap financing programs for banks (what the ECB calls TLTRO) will start in June with an interest rate as low as -0.4 per cent; and the rate of interest on bank deposits at the ECB will be cut to -0.4 per cent (from -0.3 per cent).

The problem was that President Draghi indicated he doesn’t anticipate more rate cuts which caused bond yields to rise, the Euro to rise and shares to sell off.

While Draghi’s comments were perhaps too heavy handed and unhelpful its likely markets will ultimately settle down and see the ECB’s move as very positive.

First, Draghi’s comments were likely aimed at limiting expectations for any squeeze on bank margins.

Second, given concerns about banks his real message is that “the emphasis will shift from [negative] rates...to other non-conventional instruments [like QE and TLTRO]” and it’s likely that ECB officials will stress this in the period ahead.

Third, the overall easing announced by the ECB is much bigger than expected and buying corporate debt should help bring the recent blow out in corporate bond yields back down with a flow on to bank borrowing costs. The focus on corporate debt and cheap bank financing is all about making sure that the recent turmoil around Eurozone bank shares is not allowed to mess with the monetary transmission mechanism in Europe.

Finally, the ECB and Draghi signalled even more determination to get inflation back up to its mandate “without undue delay” and Draghi even flagged a willingness to let inflation run above the 2 per cent target for some time if it spends a long time below it. This is all about boosting inflation expectations. But it also alludes to making its quantitative easing program open ended as the US QE3 program was. So overall we give the ECB a big tick.

Closer to home the Reserve Bank of NZ also eased over the last week cutting its official cash rate to 2.25 per cent from 2.5 per cent. While New Zealand is in a different position to Australia having come from a brief tightening cycle, it does have similar concerns regarding its currency being too strong.

In Australia, consumer sentiment data highlighted a renewed degree of caution when it comes to investing. When asked what is the wisest place for savings, the March survey showed a dip in those nominating shares (from an already low 9.9 per cent in the December survey to 7.6 per cent), a sharp fall in those nominating real estate (from 23.4 per cent to 14.7 per cent) and an increase in those nominating either bank deposits or paying down debt (from 44 per cent to 51.8 per cent). Quite clearly share market volatility has weighed on sentiment towards shares but it also looks like all the latest talk about a property crash has weighed on sentiment towards property.

Major global economic events and implications

It was a quiet week on the US data front with a slight fall in small business optimism and a continuing rise in inventories highlighting the more difficult environment for US manufacturers, but a sharp fall in US jobless claims to a five month low telling us the jobs market remains strong. Meanwhile the message from Fed officials was mixed with Vice Chair Fischer pointing to what may be “the first stirrings of an increase in inflation”, but Governor Brainard sounding much more cautious and arguing for patience until the outlook becomes clearer.

Japanese data was soft with falls in economic sentiment, consumer confidence, machine tool orders and slower growth than expected in money supply and bank lending.

German industrial production rose much more than expected in January and factory orders fell by less than expected.

Chinese exports and imports for February fell much than expected warning that Chinese demand for imports and global demand for Chinese goods is soft. That said there is a danger in reading too much into Chinese economic data at the start of the year given the distortions that the floating Lunar New Year holiday can cause. Meanwhile, Chinese CPI inflation rose more than expected in February but this was driven by higher food prices with non-food inflation falling to just 1 per cent year on year. Producer price deflation continued to show signs of waning though.

Australian economic events and implications

Australia saw softness in housing finance and confidence measures continue to bounce around long term average levels. The message from January housing finance commitments is that investor finance is continuing to slow and owner occupier finance, which was filling the gap, may be too. That said it's premature to read too much into one month's worth of data. Meanwhile, consumer confidence fell slightly in March - perhaps not surprising given all the talk about cuts to tax concessions - and business confidence was unchanged in February. Hard to get excited though with both around long term average levels. But business conditions actually improved in February (consistent with various PMIs) with employment and capex intentions running around solid levels.

Next Week

By Savanth Sebastian, CommSec

Unemployment in focus

A bevy of economic indicators is scheduled for release in the coming week. Arguably the employment figures on Thursday are the standout. In addition the minutes of the last Reserve Bank Board meeting alongside two speeches by Reserve Bank officials and the Reserve Bank Bulletin will garner interest. In the US, a Federal Reserve meeting and inflation data are the highlights.

In Australia, the week kicks off on Monday, with the Reserve Bank release of January data on credit and debit card lending. Consumers are using credit cards more often but paying off outstanding balances by the due date.

On Tuesday the Reserve Bank releases minutes of the Board meeting held on March 1. Given that the decision to keep rates on hold was widely expected, and the accompanying statement was virtually a carbon copy of the prior month, investors will certainly be hoping to get a better sense of central bank thinking. We expect the minutes to focus on the lift in activity levels across the economy.

Also on Tuesday, the weekly consumer sentiment reading is released alongside a report from the Bureau of Statistics (ABS) on new car sales. The ABS recasts the industry data on new car sales, converting the original data into seasonally adjusted and trend estimates. The Federal Chamber of Automotive Industries has already reported that 96,443 new cars were sold in February, up 6.7 per cent on a year ago. Interestingly while we have been seeing a recent lift in consumer spending, the results are more amplified when it comes to sales of sports utility vehicles (or four-wheel drive vehicles). Despite the slide in passenger vehicle sales in February, it was clear that demand for SUVs was the main driver, scaling new heights. In fact just over one in three new vehicles sold in Australia is a SUV.

In terms of the weekly consumer sentiment reading it is pretty clear that the reduction in volatility and improvement in global markets is having the desired impact, with confidence levels rising in the past week.

On Thursday the Bureau of Statistics (ABS) releases the February job market data. The ABS data now seems to be released a week later than was the norm in 2015. The additional week should provide the ABS with more time to ensure the quality of the data and give investors more confidence in the figures. The job advertisement data has shown signs of consolidating in the past three months and investors would be looking to see how it plays out in terms of unemployment. We expect that jobs lifted by 20,000 in February after falling by 7,900 in January. And the jobless rate may is expected to remain steady at 6 per cent courtesy of no change in the participation rate.

Also on Thursday, Reserve Bank Assistant Governor Debelle gives a morning address at the FX Week Australia conference at 9.05am in Sydney. And the Reserve Bank will release its quarterly Bulletin, a publication that contains topical articles on the economy

On Friday the Reserve Bank Head of Financial Stability Department, Luci Ellis, provides an address to the Financial Risk Day 2016 conference in Sydney at 9.30am.

US Federal Reserve meeting to dominate headlines

Turning attention to the US, a barrage of economic data is set for release, however the key focus for investors will be the interest rate decision midweek by the Federal Open Market Committee (FOMC).

The week kicks off on Monday with the release of the influential New York Empire State manufacturing survey. Also on the same day the National Association of Home Builders index for March is to be released along with retail sales, capital flows and the monthly producer prices index. Economists expect that core business inflation remains contained, while retail sales may have risen by 0.1 per cent in February after a 0.2 per cent lift in January. Excluding autos, sales may have lifted by 0.1 per cent. A modest 0.1 per cent fall in business inventories is expected while the NAHB index is tipped to lift from 58 to 59.

On Tuesday, data on housing starts will be issued alongside building permits for February. In addition the Federal Reserve also commences a two-day meeting (announcement on Thursday morning Sydney time 6.00am AEDT). The number of home starts unexpectedly fell by 3.8 per cent in January dampened by the bad weather. And given the improvement in weather conditions, economists tip a rebound in starts of around 4 per cent in February. Building starts are expected to be flat after a 0.2 per cent fall in January.

Also on Tuesday data on consumer prices is issued alongside figures on industrial production. The core rate of consumer price inflation (excludes food and energy) is tipped to have lifted by 0.2 per cent in February to be up 2.2 per cent over the year. For many, this indicates that the Federal Reserve doesn’t need to be in any rush in lifting interest rates.

The Federal Reserve meeting will be important because new forecasts will be released and the Fed chair, Janet Yellen, will hold a news conference. She will have the opportunity to address the broad array of views among Fed members about the timing of future rate hikes. We expect the Fed to discuss the need for higher commodity prices to justify a further lift in interest rates by around midyear.

On Thursday, the current account deficit for the December quarter, together with the regular US weekly data on new claims for unemployment insurance (jobless claims), the influential Philadelphia Federal Reserve (Philly Fed) survey and the leading index. Economists expect a mixed result across all the indicators.

On Friday is the “preliminary” reading of consumer sentiment for March, and similar to Australia, a modest improvement is expected.