Where Have Our Leaders Gone?

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In this week’s Weekly Insights:

– Where Have Our Leaders Gone?
– A Global Recession On The Horizon?
– More China Pain For Commodities
– Australian Banks: More Questions, No Momentum
– Rudi On TV

Where Have Our Leaders Gone?

By Rudi Filapek-Vandyck, Editor FNArena

We are all learning a few valuable lessons. Never underestimate the odds for a left field surprise is unmistakably one of them.

On Friday morning, Sydney time, Janet Yellen’s Federal Reserve surprised by not lifting interest rates while communicating a dovish message. As one expert put it, out of all discussions with colleagues and clients over the past months, not one conversation had even touched upon such a potential outcome.

Don’t worry. I know you are all being bombarded with reports, commentary and analyses about what exactly happened on Friday and I am sure you’re starting to feel bored, if not nauseous, about it by now (or soon will be). I’ll keep this brief.

Though Yellen & Co continue to express their intent to start “normalising” interest rates, exact date unknown, their updated projections revealed below trend growth for years into the future accompanied by lower than targeted inflation for at least the next two years. This suggests there is seemingly no urgency to act at anytime in the foreseeable future, despite labour market data suggesting some tightness should be expected.

Don’t be surprised if this worn-out story extends into 2016. December is Christmas shopping month. US GDP has now established a habit of starting off the new calendar year on extremely weak footing (often assisted by terrible weather) and what are the chances, really, for a quick turnaround in Chinese data and conditions in Emerging Markets?

Where Are Our Leaders?

Cutting through all the humbug, the repeats, the conflicting views and analyses and the overload of white noise, I believe that what we are experiencing is the remarkable and painful absence of leadership. When I made my first foray into financial journalism, the world adored Alan Greenspan -quite literally- for being the world’s most powerful central bank magician.

Less than half of Greenspan groupies the world around was actually able to decipher what the “Oracle” was saying, and the Federal Reserve under his leadership made a lot of mistakes, as we now know in hindsight, but at least investors felt confident he had their backside covered.

Today there is no such leadership and, as a result, not much confidence. Maybe there are simply too many tectonic plates shifting. Maybe it’s simply a sign o’ the times. The Fed’s ultra-conservatism reeks of indecisiveness, of a circular angst about potential consequences, of handing over the power to act to outsiders.

So who’s in power now? Currency markets? Beijing? Robots and momentum traders in global risk assets?

What the world needs are leaders who can both act and communicate, while giving people enough confidence their affairs remain in safe hands. Janet Yellen and the FOMC did neither on Friday. Their message is one of moderate, below trend growth accompanied by spineless inflation, headed by a central bank who sees threats everywhere and is very much worried not to cause any ructions.

Lack of leadership. You can see it in American politics. You can see it throughout the refugee crisis in Europe. Australia has just witnessed the ascendency of its fifth Federal Government leader in as many years. A simple observation teaches us the local share market too has fallen victim to losing any form of leadership.

I have more uninspiring news about the leaders for the local equity market, further below, so prepare yourself. But first…

Chinese Torture

China is slowing because its economy is transforming from being predominantly centred around investments and exports to one that is increasingly based on domestic spending. Such is the official narrative and most central bankers, economists and China watchers the world around stick by it.

Underneath the surface, however, there is a helluva lot more happening than just that. The giga-stimulus post-2009 has led to grand scale misallocation of resources, with many heavy industries such as cement and steel battling serious over-capacity. The housing sector went through a mini-bubble and still is trying to cope with large inventory, in particular in tier-3 and tier-4 cities. And large, major shifts in global currency markets, while the Chinese authorities have largely behaved like honourable global citizens, and have made Chinese exports less and less attractive.

This was perfectly captured by NAB economists (see chart below).

On CommBank economists’ calculation, the Chinese currency has over the past year appreciated by some 12.5% on a trade-weighted comparison. Does anyone expect anything different than that China’s growth is increasingly facing tougher headwinds for further growth in exports?

This also raises poignant questions about growth in the rest of the world. How much of QE-improvement is linked to a weaker currency? How sustainable is it without a weak currency? Can we ever get rid of QE?

Remember, this is all one big global experiment and we’re as yet only half-way through it. At best.

What has caught the attention of some experts recently is that Emerging Economies’ central banks’ responses to the flight of capital, which undermines asset prices and the value of their currencies, is now effectively in the process of offsetting the central bank balance sheet expansions in Developed Markets. The main culprit on the EM side is, of course, China, but Brazil and Russia are not that far behind.

All it takes is one moment of reflection about how sizeable the balance sheet expansion by the Fed, the ECB and the BoJ has been to date to realise the magnitude of what is happening in Emerging Markets this year. Economists at Deutsche Bank make the point any correlation between global CB balance sheet expansion and the performance of risk assets is not well-established, apart from the obvious question whether all balance sheets expansions are equal (probably not).

At best, observes Deutsche Bank, the tailwinds from global QE will be neutral this year.

Deutsche Bank’s observation highlights the potential dangers and threats from decisions made in Bejing to FX and asset prices across the globe. Is the PBoC going to allow further depletion of its reserves? Probably not, as no central bank can continue to counter-act market movement into eternity. Current reserves are large, but not endless. Hence why further devaluation of the Chinese currency will happen. Some are anticipating the PBoC might abandon the USD-peg. Any adverse movement in the CNY will have a negative impact on currencies throughout the Emerging Markets.

Maybe the FOMC is merely buying more time to assist the PBoC?

One important feature of China that hasn’t been mentioned yet is that it shares one key restraint with so many countries abroad: too much debt. Nobody really knows how much debt has been piled up exactly but forecasters at Bloomberg who try to keep track recently estimated China’s debt-to-GDP ratio has now surged to 207% as at the end of June. Other forecasts are significantly higher. Apart from the fact non-performing loans are rising too, a number of economists (outside mainstream) believes the point has been reached whereby this mountain of debt simply starts weighing upon the country’s pace of growth.

Whatever the cause, economists continue to downgrade their GDP growth numbers for the years ahead. Many with conviction there won’t be anything close to a turnaround in the next six months, at least.

A Global Recession On The Horizon?

The global team of economists at Citi headed by the widely respected Willem Buiter has come to the conclusion that the risk for a global recession over the next two years is “high and rapidly rising”. Slowing China, as described above, is one crucial factor in the team’s assessment that a global recession is not just possible, it is but the most likely outcome (albeit with the caveat “the debate across our broader Economics team remains fervent”).

Note there is continuous misunderstanding and misrepresentation in finance because of different meanings and interpretations of what looks like generally accepted common terminology. In Citi’s report, “global recession” has nothing to do with negative growth for two consecutive quarters, it simply means “a period of global output below potential output”.

Another way of translating Citi’s assessment is that the world is steering towards a period of slow-motion growth. The hare has become turtle. It won’t involve negative growth and there won’t be a financial crisis, but there will be plenty of negatives because of it. And it won’t come fast either, with Citi forecasting this period of sub-par growth is set to start from the second half of 2016, and expected to last until 2018.

Note that on Citi’s projections, China will continue to grow at relatively rapid pace, but nevertheless at considerable slower pace than has been the case in years past, including in 2015. “Because of China’s weight in global production and trade, and because of the high commodity intensity of its production and demand, China’s recession is the one that matters most for the global economy”.

More China Pain For Commodities

With most commodity markets battling over-supply, it should be but a straightforward conclusion that a slowing China (irrespective of its impact on global growth) is not going to help improve the outlook, unless we start witnessing significant supply cuts.

But there’s yet another factor that is also likely to weigh on demand: China’s upcoming five year plan covering 2016-2020. It will be China’s 13th Five Year Plan and they might as well announce it on a Friday, given the expected impact on demand for industrial metals. According to commodity analysts at Citi (separate from Willem Buiter and Co), a first draft is expected to be released in October with the National People’s Congress expected to agree on a Final Draft in March next year.

Citi analysts are expecting a central focus on environmental targets and measures, favouring renewables over fossil fuels, attacking pollution and aiming for further reform, while setting the most aggressive targets to date regarding environmental protection laws and limitations to carbon emissions. Citi is anticipating a carbon trading scheme, an environmental tax and a big push for electric vehicles. The expectation is the strong focus on greener policies and reform will hit demand for industrial commodities.

The Chinese government is also expected to announce the end of its Agricultural Stockpiling System which effectively means it stops providing a floor price to local farmers. The analysts anticipate the phasing out of China’s stockpiling system will likely have a significant impact on the market dynamics of agricultural commodities such as cotton, sugar, soybeans, and corn.

Admittedly, further down the track China’s One Belt, One Road program should benefit demand for commodities in the medium term. But investors with exposure will still be hoping Willem Buiter and his team have got it all wrong about global growth next year and beyond.

Australian Banks: More Questions, No Momentum

It used to be the case that Price-Earnings (PE) ratios for Australia’s Big Four banks fluctuated between 13-15x, unless they got caught in a bear market spiral during which PEs can fall as low as 9. These numbers from the past have acted as a reliable guide throughout the nineties and the noughties, even post-2008. Until this year.

In the past few months PE ratios for ANZ Bank ((ANZ)), National Australia Bank ((NAB)) and Westpac ((WBC)) have all sunk below 12.5, and failed to recover.

So what’s happening? The beginning of a new bear market? Certainly PE ratios for the banks are suggesting this might be the case (see Stock Analysis on the website for more details).

One logical explanation is that many an investor has become gun-shy because of the heightened volatility in markets, while most SMSF and mum-and-dad portfolios already are heavily overweight the sector, while local instos are still digesting three large cap raisings from NAB, ANZ Bank and CommBank over the past four months. In other words: everybody now owns plenty of bank stocks, leaving the buying power to foreign investors who are sharply negative about the prospects for the Australian economy and the Australian share market. A case of not enough buyers left? It would appear so.

But there can be another factor in play too. On Monday, bank analysts at Citi issued a detailed and in-depth report on the sector and their conclusion is that current dividend payout ratios will be proven unsustainable. The combination of more capital requirements and more operational headwinds, including the inevitable turn/deterioration in the credit cycle, is going to push up bank payout ratios to 80% and beyond, predict the analysts. This is simply not sustainable.

Citi analysts expect the major banks will need to recast their “headline” dividend payout ratios back to between 60-70% on top of ongoing DRP take-up. Although the share price retracements since May have made valuations for Australian banks much cheaper, Citi analysts suggest this uncertainty about future dividends is likely to keep a cap on share price performance in the medium term.

To be continued (no doubt).

I wish to point out it is pure coincidence I reported on three separate research reports from Citi this week.

Rudi On TV

– on Wednesday, Sky Business, 5.30-6pm, Market Moves
– on Wednesday, Sky Business, 8-9.30pm, Your Money, Your Call Equities (host)
– on Thursday, Sky Business, midday-12.45pm, Lunch Money
– on Thursday, Sky Business, between 7-8pm, Switzer TV

(This story was written on Monday, 21 September 2015. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena’s – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via Editor Direct on the website).

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena’s bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Odd as it may seem, but today’s share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

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