Summary: Many have blamed this week's stock market falls on the Brexit vote, but I think we are seeing the results of slowing US employment data having an effect on company profits, with some suggesting the US correction is maturing.
Key take-out: Locally, our banks are being hit by this low interest rate environment, and you can guarantee regulatory scrutiny no matter who is elected in July.
Key beneficiaries: General investors. Category: Australian economy.
Brexit and a correction?
Most market commentators blamed this week’s big fall on stock markets on the opinion poll which showed that the UK could well exit the European Union after its referendum vote on June 23. But in fact we are seeing a series of forces, in combination, which are causing the market correction. And I think it is a correction. Yes, it is true that if Britain leaves the common market it will cause disruption in European markets and given the close relationships between Europe and other global money markets there will be a share market reversal, which investors are now bracing for. In such a period of uncertainty what we are seeing is a swing of money to US bonds with the 10-year bond rate plummeting to almost 1.6 per cent. But I think there are even more important forces at play. The first is that we are starting to see a number of cracks in the US employment market and that is leading to the rather astounding comment that the US recovery is starting to mature. Given the enormity of the stimulation we have seen in the US, to have that recovery now maturing is a disturbing thought.
On the surface, it’s no wonder that money is fleeing into bonds because the US interest rate increase will be delayed. And then to make matters worse it is clear from figures coming out of China that the instruction from authorities to provinces to curb their stimulation of building is starting to have an effect. You will remember this stimulation sparked a rally in commodities early this year and if you combine the bumps in Europe, the reduction in stimulation in China and the so called maturing of the American recovery, we see a world where the level of economic activity is not going to drive share prices.
But to help us step back, during the week I was in touch with veteran US economist Al Wojnilower, who has seen it all before – and many times.
He tells me that as the US economy nears full employment, the growth in employment necessarily has to slow. So as full employment is reached, the monthly payroll gains of 200,000, that the US had become accustomed to expect, must give way to much smaller increases of 100,000 or less. This process has now begun. The May plunge to only 38,000, although probably a statistical outlier, has reminded the media of this cyclical process.
In the past, wage, inflation, and interest rates usually rose faster with full employment, and, importantly for share markets, profits fell. Fewer new jobholders meant slower growth in consumption, and ultimately less business investment, including reductions in inventories that had become overstocked as sales disappointed. This often culminated in in mild recessions, unless intensified by a financial crisis.
Although today’s pattern is similar in some respects to the traditional pattern, it is quite different in others. As in the past, core inflation and wage rates have been speeding up a bit, and profits have edged down from high peaks. In contrast to the past, however, energy prices remain far below where they stood not long ago and, with many home mortgages refinanced at lower interest rates and stock prices near all-time highs, household finances are much sounder than at previous cyclical turning points.
Wojnilower believes that longer term, the US Federal Reserve is likely to react more quickly whenever core inflation exceeds its two per cent target than to a corresponding shortfall in employment. But in the near term, during an election campaign in which Federal Reserve’s independence is being questioned by both right and left, there is likely to be enough domestic or international bad news to justify postponing high-publicity rate increases.
As for long-term interest rates, the bifurcation between the US and the global outlook seems more pronounced than ever. From a purely US domestic standpoint, Wojnilower says that 10-year Treasury yields, currently near 1.6 per cent, should eventually approach three per cent. That should lift the US dollar.
And then there is an extra wild card. Let me be politically incorrect and call it militant Islam, because that is what the market talks about albeit in hushed terms. Only a small minority of Muslims are militant but that small minority is starting to influence the political scene. From what I can tell two factors are causing many people in the UK to swing towards exiting Europe. The first is the enormous waste of money in the Brussels bureaucracy. It really is a complete disgrace. But on its own, that might not swing the UK the vote. Those opposing continuation of membership in the common market are scared Britain will be forced to take a lot more refugees, most of whom are Muslims and many have not been checked. The British clearly fear that a portion of those people, albeit small, will be terrorists. It might be a totally unjustifiable belief but is clearly affecting the vote. Having said that there is clearly no certainty as to which way the vote is going to go and we are relying on opinion polls, which in the UK have been notoriously wrong.
In The US Donald Trump to date has worked out that extreme Islam is a real burning issue in the US and with the Orlando terror attack he is now beginning to play that card with much more vigour. Like everyone else I expect Hillary Clinton to be the next US President, but if Trump is right about the Muslim issue he will take a lot of beating. Trump policies mean a return to greater isolation in the US. The enormous global force that has given the world stability and has greatly assisted world trade is therefore in danger of changing course. Again I emphasise there is no certainty that this will happen and I believe Hilary Clinton will make a great President, but it is one of the factors spooking markets.
Banks hungry for higher rates
The other factor that is not greatly discussed is that ultra-low interest rates interest rates affect global bank profits. Banks make their money by the difference of deposit and lending rates but the extreme low rates overseas are reducing banking profits and causing overseas bank shares to be hammered, particularly as there are fears that some banks have increased their risk exposure to cover the profit shortfall.
Some of anti-bank sentiment is extending to Australia where there is either going to be a Royal Commission or an ASIC investigation into the banks, depending on who wins the July 2 election. The fact that both parties are promising an inquiry shows the unpopularity of banks in Australia – and that unpopularity is even greater in the US.
In Australia, the Turnbull government is making a determined push to try and expand small and medium business by tax cuts and investment allowances. Assuming the coalition is re-elected this is going to be growth area in the economy and Australian banks no longer dominate this area. They tend to want a house as security, while the APRA capital rules mean that small business loans require much more capital than housing loans. And so what we are seeing is a large number of enterprises starting up that lend directly to small and medium sized enterprises without the capital regulation and in due course we are going to see a lot of debt raised by these enterprises which are looking to compete with banks. I have taken out debt in one such enterprise but those looking to take up that sort of debt to relieve the pressure of very low interest rates need to be sure the group they are lending to is not making big loans to property, but rather has a wide spread of loans.
There is a lot of second mortgage money backing the apartment boom, which carries considerable risk. I like a wide spread of loans and those groups that insure their exposure with reputable insurance companies provide an extra level of security albeit that they offer a lower return. But one-way or another, that means more competition for banks. In this time of low growth and very low interest rates, the great risk that faces investors is that in their desperation to get higher rates, they will take risks that blow up on them. Be constantly on the alert for this. I will feel a lot more comfortable if we have a coalition win with its associated small business stimulus and Hillary Clinton becomes president in the US, but as is always the case with elections you can never be sure – they are two horse races.