Midyear Musings

Midyear Market Musings

Do you feel that? There’s something in the air…an unsettling feeling…like something pretty big is going to happen. It could just be the changing of seasons and the arrival of another long, harsh Australian winter. But it feels like more than that…more global…

I feel like I blinked and nearly half the year vanished. Surveying the financial landscape we find ourselves at an interesting point. There’s some powerful conflicting forces and it’s not clear when and how some things are going to resolve and what the outcomes will be.

I want to explore some of the vast array of things fighting for our attention at the moment. There are just so many – most of which could be a letter on their own (and many I have written about in the past 12 months or so) so I’ll try and keep this relatively succinct.

And the winner is…

An unexpected result that in hindsight was perfectly expected. Our Liberal-National Coalition government has maintained power in a result that surprised a lot and supposedly hurt some bookies.

Most Aussies are at least sensing some pain in their lives from a financial perspective. Living costs are rising and statistics show that the average income has not kept up. There’s growing discontent with things such as immigration policies that are filling cities and stretching infrastructure to the brink.

But the pain isn’t enough just yet – not like in the US and Europe.

This is the reason the Liberal’s campaign succeeded – “more of the same versus a chance on something new and different”. If (when) economic conditions worsen there may be enough pain to drive a move to something different. Maybe then we end up with Clive Palmer as Prime Minister (I just want to be the first to throw that possibility out there!)

The election result realistically can be seen as a positive for the economy and markets. I’ll admit I was a fan of some of Labour’s policies such as abolishing negative gearing on property – I believe it would reduce the amount of speculators in the market and bring some more rationality to decision-making. I’ll also admit however that it did stand to be a negative in terms of pricing pressure. And of course higher is always better, right?

Aussie Housing:

Speaking of housing, according to the good people at Corelogic, Sydney prices are now down 15% since their top in October 2017. The national average is somewhere around a 9% correction. That’s quite some falls – if you owned a couple of places in Sydney totalling $2M in 2017, you’ve lost around $300,000.

That at least has some psychological impact. It impacts people’s financial decision-making. It’s interesting that business and consumer confidence surveys remain relatively intact yet there’s been a wave of retailers reporting declining sales. Conflicting signals. I’m seeing a lot of people coming out now the election is sorted predicting the bottom in housing. It’s interesting that a lot of these industry “experts” never saw the falls coming to begin with (or maybe predicted a “softening”), but I guess their opinion is still valid.

Like all these issues, there’s conflicting forces. There are some genuine positive catalysts around the corner. The election result killed negative gearing and capital gains tax reform. Interest rate cuts are happening, there’s first home buyer stimulus coming and the banking regulator APRA is set to let the banks go easier on scrutinising would-be borrowers.

It’s logical that we see a stabilisation in the market.

But I feel that the biggest hurdle from a longer term perspective continues to be overlooked. I’ve been bashing on about this for some time now: Debt.

This above is Household Debt to GDP, highlighting Australia’s number-2 global position.

Australia accumulated all that debt largely through borrowing more and more to bid up house prices. My thesis is that we must be getting very close to “peak debt” – that point where debt outstrips debt servicing capacity.

There has been a very high correlation between debt accumulation and house prices. If Australia experiences a period of private-sector deleveraging, the impact on house prices will likely be quite significant.

I do believe more of an economic shock might be needed to get deleveraging underway thus we might not be there yet. But it’s why I’m closely scanning the world for possible shocks – and sadly, we’re not in control of our own economic destiny at the moment.

Iron ore:

There’s various exchanges and prices for iron ore – this one is the New York Mercantile Exchange.

Iron ore exceeds 15% of our total exports by dollar value. That’s huge. The meaning of this is whilst volumes shipped are important, the price we get for it really is even more important.

It’s been a good 6 months! What a spike in January! In case you missed it, the January spike corresponded with the Brumadinho mine disaster in Brazil. The one where a tailings dam at the Corrego do Fejao mine owned by Vale burst, flooding the valley and killing at least 237 people.

The immediate fallout was Vale being pressured to close other mines that had similar dams – around 19. This took around 40 million tonnes of production offline. That’s a big number. For some context, Australia’s iron ore darling Fortescue managed 170 million tonnes of production in 2018.

Take that amount of supply out of a relatively balanced market and you will get a price response. And what a boon that’s been for Australia – pushing our terms of trade up, increasing tax revenues and applying upward pressure on the AUD.

But its transitory – a lot of the lost supply will find its way back on-line eventually once engineers shore-up dams. Unless we see more disaster-related supply, we’re likely much closer to the top of this price run than the bottom.

If (when) prices return to where they were just 6 months ago this would strip billions out of the economy with no change at all in volumes sold.

China and Trade Wars:

This is the big one at the moment – the issue that’s fixating everyone. And rightly so…

So where are we at? In essence, no deal has been able to be reached as yet…President Trump is looking at levying further tariffs on Chinese imports and the Chinese are threatening retaliation.

To digress a moment, a little historical perspective is always valuable. There’s a little thing that became know as the “American System”. It originated around 1791 – soon after the USA came into existence. It was suggested by key leaders that in order to grow a strong economy the US needed a strong manufacturing base that provided good jobs with income security and developed skills that in time would enhance productivity and innovation. It was posited that in order to achieve this, government intervention by way of subsidies and the like would be needed to help the US compete successfully with Europe.

The strategy was refined and adopted on a broader scale beginning with the Tariff of 1816. Protectionist policies were a feature of the US through to the 1960’s – enjoying much success in the 19th and 20th centuries. The ‘60’s saw the start of the global movement towards “free trade”.

The introduction of tariffs isn’t some radical, unprecedented event. It’s merely reversion back to where things were – when the USA was booming. What’s that slogan? “Make America Great Again”. I’m not saying I’m in support of tariffs, but I’m respectful of the US’s right to retaliate.

Retaliate? Retaliate against what? Well…

China’s evolution into a manufacturing powerhouse capitalised firstly on one main competitive advantage – a large, cheap labour pool. But make no mistake, it’s been accompanied by all sorts of protectionist policies designed to enhance competitiveness of local firms with the goal of stealing the manufacturing base from other nations.

During this time the Chinese have continuously sent the message that things are changing. That they are evolving… working to reform their poor human rights record… becoming more open… a better “global citizen”… maybe even more democratic…

The last couple of years have proven that China has no plans to change. It’s a communist dictatorship nation that is more intent than ever to push its values on the world. Have you heard about their “Social Credit Score” system? If not, it’s worth looking it up.

As a reminder, there’s basically two demands being made of China by the US – “take steps to reduce your trade surplus with us” and “stop stealing our intellectual property!”

This seems to have been largely ignored by a lot of commentators. Trump is being painted by many as the villain in this war – recklessly risking economic damage on the US and the world.

By all reliable accounts, the key reason no deal has been reached is that China has not been willing to make any real, enforceable commitments to the protection of intellectual property.

This trade war is about fighting back. Fighting back against a nation which has cheated and stolen its way to economic significance and is now more and more seeking to impart political influence on the world. I’ve gotta say I support Trump on this issue.

Economically, the trade war is hurting. But remember one key thing:

Surplus nations don’t win trade wars.

China has by far the most to lose in this war. There will certainly be victims on the US side, but far less than what China risks – a massive blow to its manufacturing sector.

A lot of damage has already been done. We’re repeatedly hearing US companies talk about shifting their supply chains – maybe not back home to the US but certainly to other nations such as Vietnam and the like.

The inflationary impact of tariffs is getting a lot of attention. Sure, there will be some impact. But it’s a one-off – its not going to manifest into runaway inflation. And some will be transitory – reversing in time as new supply chains are established.

This trade spat is lowering economic activity – I see analysts throwing out numbers like $600 billion impact to the global economy through to 2021. Sounds very plausible. This comes at a time when global economic activity is sluggish to say the least. And, guess who Australia’s largest trade partner is: That’s right, it’s China (by a long way)

Economic Data:

I’ll spare you today from three pages of economic data commentary – maybe next time. For now, let’s say that global economic data is “mixed with risks of downside” – the trade war fallout being one of the big downside risks.

Here’s a fun anecdote regarding the European/German economy

This is the share price of Deutsche Bank. One of Europe’s biggest banks. Hitting new lows. This doesn’t scream thriving economy

Debt:

There’s always a bunch of people howling about debt bubbles. We know however that some debt matters a lot more than others. Private sector debt matters. Government debt? Not so much, provided it’s denominated in your own floating fiat currency.

There’s one area that has caught my attention. It’s not new, but it’s getting interesting. We know that the main side-effect resulting from 10 years of low interest rates has been the search for yield. Any asset offering any kind of yield has been in high demand. Corporate debt has been one such asset.

Companies have found it very easy to sell corporate bonds. Wall Street no doubt has helped, raking in millions in fees for facilitating bond sales. We’ve known for some time that many corporates have taken full advantage by issuing mountains of debt. And in many cases using the proceeds to buy back their own shares.

This chart highlights the phenomenon in all its staggering glory (courtesy of David Rosenberg via John Mauldin)

The actions of some companies certainly will be prudent management of its capital structure – replacing higher-cost equity for lower cost debt. Others however have surely pushed their debt servicing capacity to breaking point and during the next downturn there will be a price to pay.

I’m still connecting the dots on this one. How systemic is US corporate debt? How far reaching will a wave of defaults be? GFC-1 was largely about US mortgage debt. Could US corporate debt spark GFC-2?

There’s one outcome that’s certain… During the next downturn those Wall St banks that are making a fortune in fees assisting corporates sell debt will make another fortune arranging new equity issuance to shore up corporate balance sheets. Rinse and repeat…

The Australian Dollar:

Okay AUD, medium-term from a macro perspective…

As touched on earlier, a declining terms of trade resulting in declining resources prices should be a negative. Resources demand is all about China, although as noted earlier we need not see a decline in demand to see the price start to fall – increasing supply is a risk.

Aside from resources, capital flows into Australia from other “exports” are a factor. We all know that billions has flooded in to Australia for the purpose of property purchases in recent years. This has stalled to say the least. Will it re-accelerate? The Chinese are doing their best to clamp down on capital outflows.

There’s also been an incredible inflow related to education. As an ABC 4 Corners report highlighted the other week, this is having clear impacts on education standards in our universities. The pushback is on – will it be strong enough to see a marked decrease in student numbers (capital inflows).

Seems that our reserve bank is readying some interest rate cuts: Finally! This will hopefully have some positive economic impact (currency-positive) yet the cut itself is currencynegative. So how much are cuts really priced into the currency already?

US bond markets are now suggesting that official rates are 50 basis points too high – i.e. the magnitude of the increases the Fed made in 2018 in response to strong GDP numbers. Will they reverse these increases?

A reduction in US rates would be currency-negative for them (flipside being currencypositive for AUD). Conversely, just like cuts here at home, if US cuts are accompanied by economic improvement, that’s currency-positive for USD.

On this, relative economic growth in general is a factor. When the next global recession arrives, how will Australia fare? Better or worse that others like the US and China?

A reduction in household debt (if that is indeed what we see at some point) results in a destruction of dollars. Whilst the economic impact would likely prove overwhelmingly deflationary and AUD-negative, it’s worth noting that the destruction of dollars should apply upwards pressure.

Versus the USD, is it okay for me that in the short-term I have little idea? Medium-term lower prices are most likely coming.

Whilst AUD/USD is a favourite trading instrument, AUD versus the Japanese Yen interests me more at the moment. I perceive this to be a better risk proxy and a little more predictable. Medium-term, lower prices can be expected here also.

Valuations:

A quick note…

I tend not to follow valuations in the Australian market very closely. I’ve learned over the years that it really doesn’t matter greatly – we’re the pawn in the global money game.

The ASX 200 is sitting at around 16.2 x forward earnings. Not too bad on a historical basis. But there’s quite a bit of risk in those forward projections. The USA is of more interest. One of my favourite sources for valuation data is US funds manager Dr John Hussman – whilst his positioning has not brought him outsized returns in recent years, his research is excellent.

Here’s one of his valuation models:

To quote John:
“The Hussman Margin-Adjusted P/E (MAPE)… is among the most reliable valuation measures we’ve tested in market cycles across history, based on its correlation with fullcycle and 10-12 year market returns. The MAPE is second in reliability only to MarketCap/GVA – the ratio of nonfinancial market capitalization to nonfinancial corporate gross value-added (including estimated foreign revenues). Both measures essentially act as broad, apples-to-apples market price/revenue ratios, and significantly outperform popular earnings-based measures like price/forward operating earnings, the Fed Model, and the Shiller P/E.”

The model shows that valuations have never been higher. A decline of around 60% from current levels would be needed to return valuations to “normal”. That’s not a prediction – it’s merely an observation.

As Hussman fully acknowledges, models like this are effectively useless as a tool for short-term speculation. Indeed, as the chart above shows valuations have been stretched for some considerable time now. But it’s worth understanding where we sit from a historical perspective.

It’s very improbable that any gains we witness in the US markets from this point will be permanent.

Conclusions

Okay let’s try and draw some conclusions from this jumble of thoughts…

Iron ore has been jolted higher by external supply shocks that will reverse. Chinese stimulus efforts might keep demand strong but maybe not strong enough. We’ve had some success over the years on the short side of resources and this is an area I watch with great interest.

Pressures on the AUD are mixed with a downward bias – sell rallies and focus on AUDJPY as a cleaner risk proxy.

Economic data around the world is indicative of “stall-speed”. Trade tensions are going to have an impact. The risks are to the downside.

Overlay that with a very overvalued US stock market.

On the positive side, there’s the scope for a resolution to trade tensions – this is at least worth a relief rally and might be enough to restore the “muddle through” economic conditions we’ve experienced for the past several years.