What is the market's biggest danger?
This week I am going to address the question – which event poses the most danger to markets: the US interest rate rise, the possible China trade war or, for Australia, the banking Royal Commission?
But first I want to raise the matter of James Packer and some of the lessons from his experiences and the importance to Crown shareholders of my former journalist colleague John Alexander.
It's not easy being the son and heir apparent of a dominant entrepreneur like Kerry Packer. James Packer had no easy childhood. And it was not made any easier when he broke out on his own, partnered with Rupert Murdoch's son Lachlan to start the One. Tel telephone operation.
Then he had the ignominy of failure and the blast he received from his father still rings in his ears. But Kerry made one very sound call about his son. He would not be able to tough it out in the hurly burly of the media world.
When Kerry died, James knew he needed help and bought alongside him John Alexander. Alexander enabled Packer to exit the media world in a superb fashion and well ahead of the now very apparent problems. But Alexander did not go onto run Crown.
James was a brilliant mathematician and loved the world of casinos. But just as he didn't handle well the pressures of the media world, when he began mixing with tough, hardened casino entrepreneurs in Las Vegas and Macao he again was not in his element and the people around him didn't pick the dangers of the Chinese clampdown on money laundering casinos.
Add that to personal problems including divorces. So, Packer is now in the state of mind where he must take an enormous step back from the business world. Normally that would create chaos for a company like Crown, but to his great credit James Packer has now given John Alexander the job of running The Crown Empire.
I am biased, but my guess is that Alexander will do it well – although I suspect that the Barangaroo high-roller development was conceived in a different era of operations. The Crown entertainment complexes in Melbourne and Perth are much better placed to handle Chinese tourists given that high rolling is now a dangerous occupation.
The Packer example is an illustration to us all that when you are in a large or small business it is important to have someone who can take your place should you become incapacitated. And for those who hope to hand the business on to their children you need to be careful that the children are actually suited to run the business.
An excellent rich family example in Australia of the baton passing to the next generation is the Pratt family. For all their family problems the Pratts split the business between the various members of the family and the son Anthony Pratt has proved to be an excellent executive chairman of the base operation at Visy.
A looming credit squeeze
Now to those crisis ratings starting with the Royal Commission.
During the week I found myself in the company of a group of former banking executives. And they were all shaking their heads. Most of them had been very proud of the way they set up strict credit controls to monitor the credit quality of their banks' loans.
It is now clear that, at least in some of the banks, those very careful controls have been cast aside so that banks could participate in the boom. As we discussed last week, the share market now has a real concern about who borrowed from the Australian banks, because it is very clear that the statements that have been made about the income levels of bank borrowers are in most cases simply wrong. That is being confirmed at the Royal Commission.
UBS has led the research in this matter and covered this in an early report. The great danger for the nation and bank shares is that this will lead to a credit squeeze as the banks clamp their lending policies in reaction to the Royal Commission.
For what it is worth, I regard this as the greatest long-term (not short-term) danger for the local market. I hope I am wrong.
To underline this, during the week I was also yarning with James Kinghorn of Nikko Asset Management, who runs a large global portfolio. He stays away from Australian banks because he fears a whole raft of new regulations will result from the Royal Commission and other areas.
He finds that US regional banks with their sound balance sheets and better customer relations are much better value.
US rates and uncharted territory
Next interest rates. Kinghorn selects companies with good balance sheets and limited borrowing. And the reason he is concerned about levels of borrowing is that the world is in a strange interest rate place at the moment. We saw during the week the new Federal Reserve chairman Jerome Powell lift official US interest rates and indicate that the pace of future increases might be at the higher end of expectations.
For that to be right the US boom must gather momentum and cause inflation to break out. And a great many commentators believe that is exactly what will happen. Indeed, we are looking at a global economic resurgence which will include both China and Europe.
Given the level of world debt, much higher interest rates (say 2 per cent) are very dangerous. Yet, in places like the US when we look at the bond market, investors have a totally different view of the world and the threat of a trade war has seen investors rush into US bonds, pushing rates lower not higher.
Investors are buying US bonds because they are frightened of an economic calamity. But there is another scenario. While big segments of the market think we will have inflation, others believe that is wrong and that before 2018 is over there will be a US slowdown because its economy will reach maximum employment capacity, which is now very close.
While employment capacity normally means wage rises, technology including artificial intelligence will stop wage breakouts and inflation. That's the reverse of the scenario where a highly indebted world raises interest rates as part of an economic recovery and, as often happens, over-corrects, which creates a downturn of some magnitude.
Either way, the interest rates increases take us to uncharted territory, but unlike the local Royal Commission pressures we have a Federal Reserve with the levers to adapt to whichever scenario emerges. There will be big fluctuations, but it's controllable.
The trade war with China
Now to the threat of a trade war. I don't claim to have expertise in this, but the Chinese are pragmatic and know that in Donald Trump they have a dealmaker. He is looking for a deal, and the Chinese made such great strides in technology that they no longer need to steal intellectual property from the US. Trump is too late—-the horse bolted under Presidents Obama and Bush.
If I am right, there will be lots of filibuster, but a deal will be done. Trump also wants deals with NAFTA and Europe and is using the threat of tariffs to get those deals. He knows that if in the process he wrecks Wall Street, his domestic agenda will be trashed.
Accordingly, this is the least of my long-term concerns, although it might be the greatest of them all in the short term.
But we are in the most uncharted of waters and the whole trade war matter is linked to North Korea and the South China Sea. It's an area we will need to watch closely.