Gottliebsen's Week: Volkswagen's disaster and CBA risks
Last Night
Dow Jones, up 0.7%
S&P 500, down 0.06%
Nasdaq, down 1%
Aust dollar, US70.3c
Volkswagen's disaster and CBA risks
Don't get too fussed by the exact mathematics but the 30 per cent drop in Volkswagen shares over the past week and the 30 per cent fall in Commonwealth Bank shares since March has delivered a clear message to me.
In a strange way, while the circumstances are totally different, what is happening to both companies is linked to the environment we face in the corporate sector over the next half decade or so.
Volkswagen shares fell 30 per cent when the horror of its technology rigging to beat authorities became known and the Commonwealth Bank shares at one point this week were down around 30 per cent from the aspiration target of $100 we gave them earlier this year.
Let's talk first about Volkswagen. The global motor business has been tough and gaining market share and profits has been extremely difficult. So someone in the technology area of Volkswagen thought up this idea of designing software that would enable Volkswagen and Audi diesel vehicles to pass the test and not perform to anywhere near the same low emissions level out on the roads.
Of course, not being required to deliver low emissions for most driving delivered big production cost savings. Eventually we will find out who thought up the idea and who knew as the amount at stake got bigger and bigger. But what happened at Volkswagen is by no means unique in global and Australian companies.
When an error takes place or a dangerous strategy begins to fail, wider and wider areas in the executive structure realise that their rewards and careers are set to be decimated. They may try and ignore the situation or conceal the disaster. The board rarely knows about it and often the CEO only discovers concealment when the problem is of monumental proportions. Of course it is possible such a situation could involve everybody from the board down from day one but that is not usually the case.
Endless teams of analysts and investors investigated every figure that Volkswagen produced but they had no knowledge of this festering sore so all their work was useless. If you had all your savings in Volkswagen and you lost 30 per cent in a week it is a sickening blow. I might add at this stage that for those looking towards or are in retirement, nothing illustrates better the need for spread of investments than the Volkswagen investor surprise.
But the Volkswagen problem has much wider implications for Australian and global markets. According to CommSec, total Australian corporate revenues were about steady in 2014-15. While there is obviously great variation between individual corporations I suspect we will encounter this sort of environment in many of the coming years. To gain profit rises companies are going to have to reduce costs and they will usually do that by investing in new technology. Sometimes that technology will not work. We will therefore see new versions of the Volkswagen scandal, where technology looks to work but where there are traps that people didn't pick up or mistakes were concealed.
CEOs and boards are going to be required to be much more technology literate than they have ever been before because in a low revenue growth environment, technology and innovation are where profit increases are going to come from. I might add that if you are going to give advice to your children and grandchildren tell them not to skip the computer subjects.
Volkswagen situations are very tough for investors and I have no simple solution. But there is one test that often picks up faulty management. In Australia the Volkswagen-Audi group has sometimes been very bad at replacement parts deliveries. That was a sign that all was not well in this company.
Don't be afraid to use your consumer experiences to help you in your selection of stocks. And there have been a number of ways that you could have applied that consumer knowledge. For example, as soon as Woolworths started on its Masters adventure it was clear to anybody who walked into those empty stores and or saw the early results that it was a disaster born out of top management hubris.
Like the Volkswagen situation it got bigger and bigger and nobody would face it because it wrecked salaries and careers. And at the same time it weakened the jewel in the crown -- supermarkets.
Now Gordon Cairns as chairman has the task of appointing executives to repair the damage and almost certainly you will expect writedowns. And of course the shares have slumped.
The fall in the Commonwealth Bank and other bank shares is not related to a Volkswagen or Woolworths-type situation.
Banks, as our largest companies, are part of the global share market value changes but there is an extra concern in Australia that is particularly worrying overseas investors: We have a series of Australians with very powerful economic levers who are not in any way coordinated.
So we have new Treasurer Scott Morrison saying he is going to slash government expenditure. That is a long overdue good idea on its own because unless we tackle the deficit we will lose our credit rating, causing big rises in the cost of overseas borrowing.
But then over in the banking regulator corner we are telling our banks to cut back their lending on houses, particularly on investor loans, which is the area of economic activity that is holding the country together at this time. And we are also saying to the banks: ‘Please increase your capital ratios and liquidity at a time of falling share prices.' The banks have already raised capital but the falling share market means increasingly they will be tempted to make any further adjustment to their capital ratios by reduced lending policies, which can give us a credit squeeze.
And then we have Chinese investors, who have dominated our dwelling scene and are concerned about the falling currency.
Each of these actions has their own validity but if all the levers are pulled at the same time we will have a situation that could compound into much lower bank profits. And that is why bank shares are getting an extra hammering.
But remember the banks are among the best placed companies to reduce their costs via technology. What they all have to do is make sure that as they introduce this technology they don't deliver a Volkswagen result. But if you watch your own banking experience and keep in touch with your friends you may discover pending disasters before the market.
Last Week
By Shane Oliver, AMP
Investment markets and key developments over the past week
It's been another volatile week in financial markets with most share markets (except Chinese shares) dragged lower as global growth worries continue highlighted by more weak Chinese data and sharp falls in some emerging market currencies and a miss by Caterpillar and ongoing uncertainty regarding the Fed. Australian shares have retested their late August lows and European shares have slipped below them, not helped by VW, refugees and uncertainty regarding the Catalonian election. Commodities have held up a bit better but this didn't stop the $A from falling back to around $US0.70. Bond yields mostly fell on safe haven demand.
Fed Chair Janet Yellen indicated the Fed still expects to tighten this year – which was the message from last week's Fed meeting anyway - but left plenty of wiggle room in that "surprises" may delay this with ongoing reference to "global economic and financial developments” and talk of gradual tightening. While there has been much criticism lately of the Fed (mostly sour grapes from those who bet wrong I think), they are only responding to the same information and risks everyone else sees. Maybe we should turn down the noise on all the over-analysis of the Fed. Meanwhile, other central banks are still easing – Norway and Taiwan being the most recent.
It's still too early to say that the lows in share markets have been seen. The volatility and consolidation we have seen in share markets since late August could be a sign of base building but it could also just be a pause before another dip to new lows. This is particularly so given that worries about global growth and the Fed remain and worries about a US Government shutdown might start to impact. September is historically the worst month of the year for US shares - and the US share market invariably sets the direction for other markets.
However, beyond near term uncertainties we see the cyclical bull market in shares as likely to resume. Shares are getting even cheaper relative to bonds; monetary conditions are set to remain easy with the latest global growth scare already driving further easing and keeping the Fed cautious; this in turn should help see the global economic recovery continue; and finally investor sentiment is around the levels of pessimism that provides great buying opportunities. October is often seen as a "bear killer" month, ie a month where share market falls finally bottom out giving way to seasonal strength into year-end. It's likely we will see something similar this year. The key for investors is not to be thrown off well thought out long term investment strategies and to recognise the opportunities that share market falls provide, eg shares are now a lot cheaper than they were around April and May and yet are still paying the same (or higher) dividends.
While a potential US Government shutdown and/or debt ceiling standoff may add to global growth worries our base case is that there will be another last minute solution or if there is to be a shutdown it won't go too long. Congress needs to pass either a new Budget or extend budget funding by the new US fiscal year that begins October 1. The risk is that the desire by a group of extreme Republicans to tie budget funding to defunding Planned Parenthood could lead to the usual brinkmanship. The GOP leadership knows that it will end up getting blamed by the American people for any shutdown, and this is something they will likely be keen to avoid given next year's elections. So our base case is a last minute deal but no shutdown. Similarly, expect some argy bargy around increasing the debt ceiling later this year and again another last minute deal. However, budget funding and the debt ceiling could end up getting rolled in together again if budget funding is only extended to say December and the risk of some market impact is certainly there, so it's worth keeping an eye on. It's worth noting though that the two week US Government shutdown/debt ceiling brinkmanship last seen in October 2013 had no discernible negative impact on the US economy at the time. December quarter 2013 GDP growth of 3.8 per cent annualised was the strongest quarter for the whole year.
The European refugee crisis is unlikely to have major negative economic implications, but will generate lots of noise (just like refugee boats coming to Australia). The past week saw the European Union vote to distribute 120,000 refugees across its membership but with some fearing that the vote against such a move by four countries reflected dangerous disunity and that this and the imposition of border restrictions threatens the EU. This is all a bit too negative as a big majority of EU countries supported the refugee plan and temporary border restrictions have always been allowed (and don't appear to prevent the free movement of labour that helps underpin the EU). The migrant crisis is a big one but needs to be put in perspective against the EU's 500 million population. In the short term it may provide a boost to anti-establishment parties but I suspect it will result in Europe becoming a lot more motivated to put an end to the war in Syria (which will probably involve siding with Russia in supporting a solution involving President Bashar al-Assad) as this is where the bulk of the refugees are coming from. It is also likely to involve more government spending (less austerity) and ultimately "more Europe, not less" (as it comes together to help secure its external borders).
While Eurozone shares have been hit hard by worries about global growth, the VW scandal, refugees, the Catalonian election, etc - down 19 per cent from their April high making new lows in the last week, they look very attractive for when the dust settles. Our valuation indicators shows to be very cheap, the ECB remains very supportive and economic indicators like PMIs and business surveys remain solid.
Major global economic events and implications
US economic data was again mixed. Existing home sales fell and new home sales surged. While regional manufacturing conditions indexes point to weakness, the national Markit manufacturing PMI was unchanged in September at a solid level of 53. While durable goods orders fell in August, core capital goods orders are reasonable. The US growth story remains one of solid but unspectacular growth leaving plenty of scope for the Fed to take its time.
Eurozone business conditions PMIs slipped in September, but given the concerns about global growth the fall was modest and leaves them well up last on year's lows and still solid. Meanwhile, ECB President Draghi remains dovish indicating that more time is needed to assess the emerging market slowdown and in particular that the ECB "would not hesitate to act if downside risks to inflation materialise".
Japan's manufacturing PMI softened to a still ok 50.9 in September and Japanese inflation rose to 0.8 per cent yoy on a core basis in August, but is still well below the Bank of Japan's 2 per cent target. The case for more BoJ easing remains strong.
The flash Chinese manufacturing PMI fell further in September. While it could be distorted by the early September Beijing area factory shutdowns it nevertheless highlights that small and medium sized manufacturers are still struggling.
Australian economic events and implications
In Australia, the main development was a strong 9 per cent bounce in consumer sentiment according to ANZ-Roy Morgan index, with the elevation of Malcolm Turnbull to PM having the predictable favourable impact. This is good news but we have seen several bounces before. For it to be sustained, the Government needs to avoid a return to the accidents that seem to have characterised Australian governments since 2010 and put in place a positive economic reform agenda. Meanwhile, ABS data confirmed that home price growth remained very strong in the June quarter but this was mainly driven by Sydney and Melbourne and is likely to slow as APRA measures bite. Slowing population growth to 1.4 per cent over the year to the March quarter from 1.8 per cent yoy 3 years ago, mainly due to lower immigration, will also take pressure off house price growth. It's also one reason along with lower productivity growth why potential growth in the economy has slipped from around 3-3.25 per cent pa to around 2.75 per cent pa. The RBA is still likely to have to cut interest rates again.
Next Week
By Craig James, CommSec
Data dump
The “top shelf” indicators return in Australia in the coming week. In China the purchasing managers' indexes are released. And in the US, arguably the most important monthly indicator – the employment or non-farm payrolls data – is issued.
In Australia, the week kicks off on Tuesday when ANZ and Roy Morgan releases the weekly consumer confidence rating. Last week the weekly consumer confidence readng rose by 8.7 per cent last week – the biggest weekly gain in the 7-year history of the survey. Whether the initial positivity is sustained will depend on the future performance and direction of the new administration. But increased confidence is certainly a positive for the Australian economy – hopefully translating into increased spending, investment and employment.
On Wednesday the Australian Bureau of Statistics release data on building approvals while the Reserve Bank releases the Financial Aggregates publication – a report that includes private sector credit or loans outstanding together with money supply indicators.
The building approvals data is arguably more important than the private sector credit data, serving as a leading indicator for home and commercial building. The problem is that the data is ‘lumpy' with approvals down 5.2 per cent over April, up 2 per cent in May, down 5.2 per cent in June, and again up 4.2 per cent in July
Housing continues to be the main lending driver but the gains in business borrowings over the past couple of months have also been encouraging. Business conditions are healthy and it seems to be translating to a lift in business borrowings, with annual growth at 4.8 per cent. Credit probably lifted 0.5 per cent in August or around 6.2 per cent over the year – which would mark the strongest growth in 6½ years.
On Thursday the Performance of Manufacturing index is issued alongside the CoreLogic RP Data Home Value index for September. The falling Australian dollar should help boost manufacturing activity in coming months (at least for domestic fabrication rather than for the export market). But the home price data is likely to garner the most interest. Based on daily observations, home prices probably rose by a sedate 0.3-0.4 per cent in September. Sydney property prices may have actually dipped by around 0.3 per cent - a much needed reprieve after the 7.2 per cent gain in the prior three months.
Also on Thursday, the ABS releases data on job vacancies. If vacancies rose in the past three months, it will be a further sign that the job market is gradually strengthening.
On Friday, retail trade data is released. Sales figures have been more mixed in recent months, having fallen by 0.1 per cent in July after a 0.6 per cent increase in June. Annual spending growth is holding at 4.2 per cent – slightly below the decade average of 4.4 per cent. Disappointingly, last month non-food spending fell by 0.1 per cent, the first fall in seven months. The hope would be that the more upbeat confidence readings, warm weather and early mid-season sales should have encouraged some early lift in Spring-related spending.
Overseas: US jobs data back in the spotlight
In the US, the week kicks off on Monday with the release of personal income and spending figures together with the pending home sales index and Dallas Federal Reserve business index. Economists tip a 0.3 per cent lift in spending, funded by a 0.4 per cent lift in income. Pending home sales are expected to lift by 0.4 per cent following the 0.5 per cent lift in July.
On Tuesday, the Case Shiller home price index is released in the US together with consumer confidence. Home prices were likely flat in July while consumer confidence is tipped to have eased from 101.5 to 97.0.
On Wednesday the ADP national employment index is released together with the Chicago purchasing managers' survey and the weekly report on mortgage transactions – purchases and refinancing. Economists tip an 185,000 lift in private jobs – a precursor to Friday's official job report.
On Thursday the ISM manufacturing survey is issued alongside auto sales, construction spending and the weekly data on claims for unemployment insurance.
On Friday in the US the spotlight shines brightly on the September job report. Economists tip a 200,000 lift in jobs, up from 173,000 in August, while the jobless rate is seen unchanged at 5.1 per cent. This is a potential market-mover in every way. A strong job report would raise the prospect of US rate hikes, boost the US dollar further, and, in turn, put downward pressure on commodity prices.
Also on Friday factory orders for August are released alongside the regional New York ISM survey.
In China, the official purchasing managers' index for manufacturing is released on Thursday alongside the services variant. The Caixin purchasing managers' index is also slated for release on the same day.
Sharemarkets, interest rates, commodities & currencies
Each month, there is much speculation about the cash rate, and therefore the implication for variable interest rates. But this ignores the fact that many businesses are more focussed on the swap market and thus longer-term fixed rate loans. And the yield curve shows that rates are arguably the lowest businesses have ever seen.
Longer-term bond yields are a useful guide on economic conditions, especially inflation. Clearly a main concern for an investor looking to squirrel money away for a long period is the potential for value to be eroded by inflation.
On February 3, 10-year bond yields hit a generational low of 2.27 per cent, before lifting to highs near 3.15 per cent on June 11 and yields are now around 2.66 per cent. Similarly 3-year bond yields are holding at 1.90 per cent, not far off their recent lows of 1.73 on August 24. But whichever way you cut it, financial markets believe low inflation is here to stay.
For the record, financial market pricing suggests that there is a 22 per cent chance that the Reserve Bank will cut rates in October.