What's really spooking our market?

It has not been a good week for the Australian stock market.

In looking at why our market is falling I want to focus on the statements of two people – the new Treasurer Josh Frydenberg and the veteran Australian director Michael Chaney.

First to Frydenberg, where this week the new Treasurer couldn't believe what he was reading, as across his desk came high Australian growth rates and a wonderful set of economic numbers.

He went before the TV cameras with his chest out and smiling as he boasted about how well the economy was going under the Coalition government. It also meant that the Government's deficit would be reduced from the budget numbers.

But behind those numbers were some disturbing facts. Profits have been rising strongly – this is, of course, great news for stock market – but wages have been stagnant and Australians have been using the equity in their home to run down their savings. For most people that means extra borrowing, and it clearly can't continue.

And I will discuss below that while the accounts were correct in confirming the strong profits, which have been reflected in the excellent results during the 2017-18-profit year, the outlook for 2018-19 is not as good.

Chaney's words of caution

Michael Chaney was CEO of Wesfarmers between 1992 and 2005. After he stepped down his successor Richard Goyder took the high-risk path of buying Coles.

Chaney is now back as chairman of Wesfarmers and, perhaps not surprisingly, Wesfarmers is distributing its Coles shares to shareholders and the company will return to the more manageable corporate acquisitions game that it pursued under Chaney.

Chaney was also chairman of the National Australia Bank until 2015 and is current chairman of Woodside.

Whereas Frydenberg is full of optimism, Chaney issued a strong note of caution to the Australian corporate community.

First, he warned that it was not unrealistic to assume that house prices in Sydney and Melbourne could fall as much as 20 per cent.

Sydney prices are already down 5.6 per cent but in areas like inner-city apartments they are already down 20 per cent. Melbourne is down around 3.5 per cent and its inner-city apartment fall matches Sydney.

At this stage, apart from small inner-city apartments, the biggest falls are in the more expensive properties.

Chaney says that if house prices fall 20 per cent then there is great risk of Australia falling into recession, which will have major ramifications for retailers and the wider economy. And that risk is exacerbated by the prospect of a Labor government removing negative gearing from existing properties.

Chaney points out that for the last three years Perth house prices have been stagnant or falling and that housing trend has had a marked impact on Wesfarmers' retail sales in WA.

Chaney's views came in the same week that Westpac increased its interest rates on home loans and was followed by ANZ and CBA. Most of the smaller banks have already increased their rates.

House prices have been drifting for the last 11 months and the market consensus is that, given the restrictions on lending and interest rate fears, the falls will continue.

Chaney is warning us that this will affect business activity. Our share market is priced at levels that assume nothing will go wrong and that the profit rises will continue.

But already a number of brokers and institutions have lowered their profit forecasts for selected Australian companies and those profit downgrades are contributing to the nervousness of our stock market.

The market has taken the Chaney warning to heart. If you have shares in a company that disappoints on the profit front, then the shares will be battered. That is a true sign of a market that has become fearful.

Investor are becoming more nervous

As I move around I get the distinct feeling that there is a greater propensity for people to seek to maintain their capital rather than be adventurous in the share market.

The difficulty is, of course, that maintaining capital usual involves very low returns.

The weakness in Australia is also part of a global nervousness, which started in emerging countries where their banking systems had borrowed in US dollars when their asset base was in the local currency.

President Trump has instituted tax policies that incentivised American companies to bring their money back home. Much of that money was parked in emerging countries and the return to the US has been a factor in hitting the currency in those countries.

So far the emerging country contagion has been contained but, as usually happens, the bad news tentacles seep out.

And in particular they have seeped out into metals like copper, which is usually regarded as a barometer of future world industrial activity.

It is now widely accepted that there is a likelihood that the trade dispute between the US and China is likely to continue for an extended period – and that message that is being delivered by the lower copper price.

And in turn that also tends to suck money into the United States and keeps its currency strong.

Meanwhile the strong American economy is causing the US Federal Reserve to commit to further interest rate rises, which may lift the currency further.

That has led to all sorts of catastrophic predictions for the Australian currency, with some commentators predicting it will fall to US60 cents or even US50 cents.

Be very wary of these sorts of predictions, because when the Australian currency is rising people very often predict much higher currency. Exactly the same thing happens on the decline, except that the direction is different. In other words the tipsters forecast a continuation of whatever trend is in vogue.

Overseas investors in Australia are being hit first with lower share prices and then with a lower Australian dollar.

That makes them interested in selling, particularly as the cracks in the Australian economy take Reserve Bank interest rate rises off the agenda.

All these forces are combining to put pressure on the Australian market.

And we haven't even mentioned political instability and the likelihood of an ALP government next year, which multiplies all the above forces.