Triple storm on horizon

Fallout from the automotive, mining and retail sectors will hit Australia hard from next year.

Summary: The rise in Australia’s unemployment rate is a pointer to more problems ahead, as the demise of our car manufacturing sector, a decline in mining investment, and further retail job losses combine. These triple blows will not hit the economy this year, but they could begin to bite in 2015.
Key take-out: Large-scale retrenchments will hit the middle class, and the businesses that service people in this income bracket. Businesses selling to lower-income areas will benefit from the increase in the number of people in their ranks.
Key beneficiaries: General investors. Category: Economy.

As you move amongst analysts and people in the stockmarkets, there is an underlying sense of optimism. That optimism was really underlined last week by good results from the Commonwealth Bank and Telstra.

But, I must warn you, I have a deep-seated belief that something is set to go wrong in 2015 and 2016. Despite the latest unemployment figures, I don’t expect that the problems will emerge in 2014 – although towards the end of the year markets may start to become apprehensive.

Like everyone else, I saw the Toyota decision to cease motor manufacturing, along with General Motors and Ford, as a major blow to Australia. On their own these decisions will cause great disruption, but they are probably manageable. The problem is that they are going to coincide with the decline in the enormous mining investment boom that has occupied so many people around Australia for the last few years, and there also is a looming sharp in decline retail employment. See Lighten the retail property load.

All three of these blows will land around the same time. Last week I was yarning with the Commonwealth Bank CEO, Ian Narev, and he believes the economy can get through these three blows. I left that conversation really questioning whether I was right. I have a great respect for the talents of Narev, and so I actually wondered whether I should write this commentary. Then, by chance, I ran into a non-executive director of one of our top 10 companies. He had just left a morning meeting with a series of other directors – they apparently get together on a semi-regular basis. In turns out he has exactly the same view as me, and it was the majority view at the meeting.

Nevertheless, I hope Narev is right and that both myself and the non-executive director are wrong. But I think the triple blows in 2015 and 2016 are going to cause a lot more problems than the markets expect.

A wave of retrenchment benefits

Currently the Commonwealth Bank’s bad debt ratios are at a record lows, and the same applies to all of the banks. That is going to change, although in the case of the Commonwealth Bank, to be conservative, it actually makes provisions that are higher than its actual bad debt experience .

I think part of the shock that is going to come to the banking community will be because those businesses that fail as a result of the motor, mining investment and retail declines will have very large retrenchment benefits.

And these retrenchment benefits will take the money out of the businesses and cause a shortage for the banks, and nothing for shareholders.

Very few companies list in their contingent liabilities a provision for massive retrenchments should the business fail. And I think banks are going to come to grips with this, and will be more reluctant to lend.

In addition, employment in the motor area is concentrated in certain suburban areas, and workers and the motor companies are used to working in highly unionised conditions. They will be very hard to employ, so we are going to see a substantial house value problem in those areas. As it is, the residential markets in Sydney and Melbourne are starting to divide between those areas where the Chinese are buyers, and those where the Chinese are absent.

The price differential is substantial, and I think a third area of difference will emerge – those suburbs that have a large amount of motor-related employment. For what it is worth, I simply don’t believe that the analyst community understands the power of these three events coming at once given that officially our unemployment is now at 6%. (It’s actually higher, but is restrained by definitions of unemployment). And, if those blows happen to coincide with a fall in commodity prices and/or the Chinese stop buying our real-estate, then we will encounter something quite serious.

The middle class contraction

Always remember that the people who are losing their jobs during these three upcoming blows are in the middle class, and it is that area where contraction is taking place.

Most of the businesses that are being shut have enterprise agreements that have propped up wage levels, and so the people involved have been well paid. This is why they are currently in the middle class, and so the area that will be most affected by these developments will be businesses that sell to the middle class.

Those that are selling to lower-income areas will actually benefit from the increase in the number of people in their ranks and, of course, those selling to higher income people will ride through this fairly smoothly.

Just to illustrate this point, a couple of weeks ago I was yarning with a locksmith who has done well but not made a lot of money. His friends, who left school at about the same time, worked for Ford and they have received much higher wages. But they are all about to lose their jobs and will find it incredibly difficult to get employment, except at much lower rates of pay. A vast number of these people will move from the middle class to the lower income area. My locksmith may actually improve his business, because there could well be more crime.

Bank challenges ahead

And so, for what it is worth, I think that in the current run in bank shares I would be wary in increasing exposure to banks. They are now at the peak of their cycle. The CBA is incredibly well managed, with expenses rising by only 1.7% in the latest half-year on an underlining basis. But I believe that in 2015 and 2016 it will face greater challenges, as will all the banks, and this will affect the current high level of bank shares. Of course, likely lower interest rates will help bank shares during this time.

These are the logical conclusions from my belief as to what will happen, but remember Ian Narev has a different view. I am certainly not interested in increasing my bank exposure at these current price levels, despite the fine results that are emerging from the banking community.

On a happier note, in my chat with Narev, I pointed out that banks have been able to reduce term deposit rates from plus 5% to plus 4%, to now plus 3%, and the amount of money in bank deposits has kept rising. In other words, the individuals and the superannuation funds overall have not responded to the lower rates by taking the money out of banking system. So, assuming there is no change in the cash rate, will banks press for return deposit rates that are below 3%?

Narev gave no iron-clad guarantee, but he clearly believes that the competition for deposits will be sufficiently lively to stop term deposit rates from going below 3% – assuming there is no cash rate fall.

Of course, if unemployment rises, cash rates will fall despite the inflationary effect. We saw the dollar fall one cent after the latest unemployment figures. Unless there is a very strong commodity market, it has a lot further to fall – if I am right.