Month: November 2010

The growth rate of the Westpac-Melbourne Institute Leading Index continues to point to a solid pace of expansion heading into late 2010/ early 2011, but that pace has slowed abruptly over the last six months. The speed of the turnaround is a little disconcerting. At 10.3%, the peak growth rate in the Index back in March was extremely high and although it currently remains comfortably above its long term average a continuation of trends seen over the last few months could easily see the growth rate drop further in the near term to a below average pace. For now though, the signal from both the Leading and Coincident Indexes is still broadly positive. Both point to above trend expansion in the second half of 2010 and the first half of 2011, albeit with some tapering in the new year.

Matthew Hassan, Senior Economist, The Westpac Group, 17/11/ 2010.

The global economy always forms an important backdrop to understanding developments here in Australia. The world economy is quite divided at present. The United States, Europe and Japan are struggling to recover from the effects of the financial crisis, while emerging Asian economies, and to a lesser extent Latin America are growing strongly…….. Overall, the outcome for global economic growth over the past year has been strong. When the figures for 2010 come in, they are likely to show that the world economy grew by about 4.75%, a rate that is noticeably above trend. Most forecasters are expecting that growth of the global economy over the next couple of years will be slower than in 2010, though probably at a pace that is close to trend…….. The US economy clearly lost momentum around the middle of the year, with GDP growth slowing to an annual rate of 2 per cent over the June and September quarters. This is below potential. Our reading of the recent data is that they have been a bit stronger, but nonetheless consumer confidence remains low, the housing and labour markets remain weak, and the repair of household balance sheets still has quite a way to run. Basically, the US household sector is in very poor shape. One of the features of the US economy that has changed over the past 50 years or so is that households are now bearing more of the brunt of recessions than used to be the case, and business is bearing less. After each downturn it has taken progressively longer for employment to regain its peak…….. The US corporate sector is in pretty good shape.

Ric Battellino, Deputy Governor, Reserve Bank of Australia, Perth 18/11/ 2010.

Most people view contemporary economics like the hypothetical jigsaw puzzle – tedious and unrewarding – and economists as eccentrics looking for a solution to an unendurably complex puzzle. But it can be a financially fatal error to shrug off economics as pointless if you want to make money in the financial markets. It is the designs of theoretical economists and the alleged solutions to economic problems instituted by bureaucrats and congressmen that largely determine the long-term course of business activity and the direction of price movements.

Victor Sperandeo, "Trader Vic – Methods of a Wall Street Master", 1991.

 

TRANSITION

The recent speech by Ric Battellino is well worth reading in its entirety as it indicates (to us at least) that the world is still transitioning towards trend growth (less assisted by abnormal stimulus/ bail-out measures), and it cannot get there unless, and until, America and Europe joins the recovery with enhanced momentum from their current positions. Australia is well placed in Asia and our two main exports – coal and iron ore are showing both price and volume growth. A new long-term (say 3-5 years) bull-market begins when the fundamental economic and corporate underpinnings are consonant (in harmony with) a confirmed support level in the major indexes. Ecinya does not believe that we are quite there as yet, and volatility will stay in evidence and confidence will ebb and flow. This means plenty of opportunity for the nimble, but obviously with an increased level of risk.

The nexus between the economy and the stock-market is not linear. Liquidity and confidence are also important drivers, particularly when the economic outlook is uncertain. Best gains are made when things are so-oversold, when the ‘crisis’ word is being shouted from the parliamentary roof tops and featuring in public discourse (buy in gloom), or when markets are reaching a level of euphoria that is unsustainable and/ or being expressed as a new age of prosperity (sell in boom). The Ecinya Market Barometer (clik to link) is a useful reference tool here.

 

 

THE CHARTS ABOVE

The first chart compares changes in the SP500 and the All Ordinaries index (XAO) with changes in world gross domestic product (GDP). GDP is the market value of all goods and services produced in an economy including exports and after deducting imports. We have smoothed the data by using a 3 year year moving average to make the correlation work better and to mitigate the wild percentage swings generated by annual movements. Generally the chart shows the following –

• When the world is growing markets are going up at a strong pace as listed companies are such a large part of the business landscape. When the curve flattens be careful, as the downturns tend to be sharp and deep.
• The SP500 series has a better fit than does the XAO. Given that the US is about half of total world market capitalisation this is not surprising.
• Markets tend to lead the economies.
• Markets over-shoot on both the upside and downside.
• Australia lagged until about 2001 and then outperformed as our commodities were eagerly sought by Asia.
• The impact of the 2007-2008 global financial crisis can be clearly seen.
• The tech-telco crash of 1999- 2001 can be clearly seen followed by the Greenspan era of easy money as the Iraq war got into full swing.

When markets are up look for reasons why they might go down. When markets are down look for reasons why they might go up. Be prepared to move as soon as you are convinced that the market has started to agree with your conclusions.

The XAO vs Domestic GDP chart uses annual data and has not been averaged over any period. The fit seems particularly good to us and our market seems to lead the economy fairly well. This conclusion appears to be supported by the Westpac Leading Index conclusions summarised above and which are available on the Westpac web-site in their entirety. Westpac are saying that there are signs of a slow-down. This accords with our own observations and is reflected in our company models where growth forecasts are less than robust without being significantly negative, except perhaps for parts of the retail sector. Australia’s central bankers have raised interest rates somewhat pre-emptively in our view. Our guess is that they are disturbed with current spending levels, particularly by the federal government. In a beautiful world for stockmarket bourses the combination of lower interest rates and lower taxes tends to accelerate corporate earnings and consumer confidence with greater momentum than does fiscal stimulus which often leads to waste and unintended consequences such as inflation.

 

SO WHAT DOES THIS MEAN IN CURRENT LOCAL STOCK-MARKET TERMS ?

• The macro environment is recovering, but there are fragile elements with the USA being the worst of the economic performers on a weighted-for-importance basis.
• Stock-picking is essential.
• Dividend are important and look carefully at companies that are maintaining or increasing dividends to determine that it results from operational confidence, not protection of the share price.
• For the longer-term investor ‘accumulate’ is currently a better strategy than ‘buy and hold’. The banks seem obvious candidates for accumulation but watch entry points.
• Special situations are important, many stocks are in recovery mode having re-capitalised, paid down debt, restructured etc.
• Takeovers are marvellous opportunities.
• Selling into over-bought strength to keep cash on hand is important. We call this active value management.
• If you are speculating make certain you do not believe you are an ‘investor’. Many of the 52 week highs are indicating that ‘penny-dreadfuls’ are in strong demand.
• Watch the economy.
• Watch technicals. Use tools that show direction and trend. Try to identify turning points. Moving average cross-overs are useful tools on both the buy and sell side. The most important thing after price is volume.
• Watch overseas markets – in particular the SP500 and the Shanghai indexes.
• Stay in touch with the China-India story.
• THINK, ACT, REVIEW….. on a regular basis.

 

The myth of excessive bank profitability seems to stay alive in 1995……Banks do not need to be universally loved, but they do need to be universally respected for their financial acumen, strength and vitality. This includes the Big Daddy, the Reserve Bank of Australia…. We cannot run the country on a talk-back radio basis. Given that misinformation flows travel faster than a speeding bullet, bank bashing is becoming hugely counter-productive………Banks are not outrageously profitable in Australia. They also pay enormous fully franked dividends and enormous taxes….. Apart from the employment and other taxes that accrue when about 125,000 people are employed in Australian banking, the banks are the greatest benefactors to fiscal policy among Australian companies. Why any government would want to reduce the profitability of banks is beyond reasonable comprehension. No household should offend such a proven breadwinner……

WE should scold the banks for honest errors, and continue to demand lower charges and insist on competition. but we should concurrently recognise that not much economic good can come from banks that perform below top-sector financial parameters on both a national and international basis. We should not ask that banks become part of the welfare system and have battlers’ rates and charges. Weaken the banks and weaken the nation.

From George Sutton’s weekly column ‘ On Closer Analysis’ , The Australian, 20 January 1995.

In 1984, I think it was a pity bank deregulation took place when it did and/or to the extent it did. Mainstream Australian banks reacted stupidly to the threat of foreign competition. Prudential controls were sacrificed in pursuit of market share, facilitating borrowings and buy-outs by the gaggle of paper entrepreneurs then emerging. Normally conservative bankers lent billions of dollars to corporate cowboys without tangible security, on no more than a negative pledge and without bothering to determine the extent of pre-existing unsecured debt. The takeover merchants bore no relationship to the capitalist entrepreneur of textbook economics or the real world entrepreneurs like Henry Ford – who touched off economic growth by developing new products and better ways of producing products.

Neither I nor, as far as I can remember, anyone else, anticipated that the banks would behave in the reckless manner they did. The Labor left vehemently opposed deregulation, but not for that reason. It wanted to direct lending to favoured borrowers, and also saw deregulation as an obstacle to its ambition to extend public ownership of banks.

Peter Walsh, ‘Confessions of a Failed Finance Minister’, 1995.

 

Lest we Forget

We should all remember that the Global Financial Crisis was not born out of the Real Economy – the production of goods and services. Rather it was spawned out of the Symbol Economy (that of money and credit) and the Political Economy where increased access to American housing finance offset opposition to the war in Iraq. If households could be beguiled into buying houses that might subsequently prove to be unaffordable and liable to foreclosure then the resulting economic growth at the outset would divert attention away from the difficulties of fighting a war of choice, rather than one of necessity. Also the increase in GDP from the housing boom made it look as though the war and the rapidly escalating oil price were easily affordable. The politics overrode the economics as Fannie, Freddie and Mr Greenspan were there to assist the madness of crowds, both bankers and borrowers. Also we were paying the bankers as though they were commission salesmen who were engaged in financial engineering to enable the ticket to be clipped more than once, and on the way down as well as up.

The ‘Made in America’ global recession came directly from the bankers to whom easy profits were irresistible..

The beginnings and the ends of the bankers’ madness is neatly summarised by Robert Murphy’s article of October, 2010 "Putting Austrian Business-Cycle theory to the Test" : "…the government seized Fannie and Freddie, thereby effectively nationalizing a large portion of the entire US housing market; the Fed nationalized AIG; the treasury secretary told everybody that he needed $700 billion pronto to patch up the financial sector or the world would end; the treasury secretary then proceeded to partially nationalize the US financial sector; the federal government took over two of the Big Three car companies and threw traditional creditor rights out the window; the Fed more than doubled the monetary base in six months’ time; the new Obama administration borrowed almost $800 billion to spend on "stimulus"; the federal government has taken a giant leap forward to socialized medicine; and just for kicks, the federal government also banned offshore drilling (though the rules are yet again undergoing revision)."

We should remember that big banks earn big profits because they have large asset bases and large shareholders’ funds. But ‘large’ must be measured accurately and ‘outrageous’ should have some perspective beyond populist pap. Joseph Hockey’s Nine-Point Plan does not seem to contain anything too extreme, but when coupled with his television and radio appearances carry with it the presumption of guilt, and certainly a certain imbalance and lack of attention to relative and relevant facts.

This Insight article focuses on the 4 Pillars – ANZ Bank Group, Commonwealth Bank, National Australia Bank, and Westpac Banking Corporation.

 

What do banks do? What role do they play? Why is sound banking important?

Banks are primarily intermediaries between depositors and borrowers. Their product is money, a loan, and their price is the rate of interest. Peripheral activities such as transactions processing and wealth management are also carried out.

The primary functions of banks are –

• To protect depositors’ funds.
• To make and administer prudent loans.
• To use their experience to know when and how to lend to an innovative borrower.
• To know when and how to foreclose.
• To price risk at appropriate levels and thus distinguish between different classes of borrowers.
• To report transparently and honestly to authorities and shareholders.
• To use leverage prudently by borrowing themselves as principal.
• To employ lots of people.
• To pay large amounts of federal and state taxes.
• To pay large quantums of dividends.
• To be a vibrant part of the community.

 

Do banks earn ‘outrageous’ profits?

 

We think not. Statistics can be manipulated but the following tables prepared from Morningstar and Ecinya data suggest that banks earn appropriate levels of profits.

Over the past 14 years the 4 pillars have earned aggregate profits of $164.7 billion on total assets of $18 trillion and from aggregate shareholders’ funds of $1.1 trillion. The return on assets has been less than 1% and the return on shareholders’ funds has been 14.9%. These ratios, though robust over such a long period, do not appear to us to be excessive if one thinks of nominal economic growth over the period and the necessity for depositors’ funds to be protected from a strong sector performance.

The reason that the 4 pillars had such a strong 2010 fiscal year was because they had charged large provisions against profits in 2009 when the GFC was in full bloom. Also Westpac had an extraordinary $600 million gain on a tax write-back. But even then when compared with the top 20 companies by market capitalisation their returns on shareholders’ funds do not appear to be excessive.

Using annual averages, profits have grown over 13 years at 12.2% while assets have grown at 12.1%. This seems harmonic though it also reflects the fact that the sector could probably do with more viable competition BUT in full awareness of the 1995 experience of Peter Walsh as quoted above where he says competition under poor management can lead to reckless quests for market share. Over 5 years, profits have fallen behind asset growth as loan losses were charged against profits. In 2009 profits actually fell due to the GFC while assets continued to rise. In 2010 coming off a lower base the percentage increases were abnormally high. In Earnings-per-Share terms banks do not appear to be a good bet over the long term and this probably means they are more cyclical than growth stocks. So there is a time to buy the banks and a time not to hold them.

 

INTEREST RATES

When interest rates are going up it is never the fault of fiscal policy .Waste and extravagance at federal and state government levels is not a problem because the waste and extravagance saved us from the GFC ! If only economics were that simple and a false construction of Maynard Keynes theories solved all economic problems.

When interest rates are rising look at where government largesse and profligacy is positioned. Do not look at commercial bankers and the Reserve Bank of Australia for they are mostly right in their interest rate settings. If governments are not truly cognisant of the fact that they generally spend money unwisely and do not know the value of lower taxes and lower interest rates and their impact on the small business sector, then the inescapable conclusion is that shifting the blame is their aim.

There are many emminent and not-so emminent economists, including ourselves in the latter category, that believe in the Austrian school of economics dictum that says sub-optimal outcomes in all areas of an economy are primarily caused by mis-allocation of resources. Over the past few days we came across an article by John P Hussman of HussmanFunds supporting this propostion by saying –

"One of the most fascinating aspects of the current debate about monetary policy is the belief that changes in the money stock are tightly related either to GDP growth or inflation at all. Look at the historical data and you will find no evidence of it. Over the years, I’ve repeatedly emphasized that inflation is primarily a reflection of fiscal policy – specifically, growth in the outstanding quantity of government liabilities, regardless of their form, in order to finance unproductive spending. Look at the experience of the 1970s (which followed large expansions in transfer payments), as well as every historical hyperinflation, and you’ll find massive increases in government spending that were made without regard to productivity (Germany’s hyperinflation, for instance, was provoked by continuous wage payments to striking workers)."

When populist pap takes over from a reasoned analysis of the facts we run the risk of damaging our banking system, threatening the safety of depositors’ funds, and preventing banks going about their useful business. Just as Jesus flogged the money-lenders in The Temple, politicians leading frrom a presumption of guilt, are flogging the money lenders in today’s market-place, and once again, without consultation.

Ecinya does not believe that banks should not be routinely examined. They do benefit in significant measure from their quasi-monopoly position though we should not forget that many foreign banks operate in Australia and competition is not as absent as some would have you believe. The main problem is that we trust our bankers and many have been burned from easy loans from foreign bankers who foreclose as quickly as they lend. Exit fees are generally wrong. Some of the small business charges on Eftpos and merchants fees generally seem excessive and close to ‘outrageous’.

 

 

 

 

 

 

China Perspectives: Part Two

_{by Nicole Loewensohn}

China’s famous philosopher and political theorist, Confucius, stated ‘when it is obvious that the goals cannot be reached, don’t adjust the goals, adjust the action steps’. Whilst China has pursued economic growth, there has been consistent acknowledgement that the current route to prosperity may not be viable. With this in mind, the latest five-year plan for China’s development has been released, outlining clear and sustainable goals; however the implementation of new policy may prove difficult. Recently Mr. Xi Jinping was appointed vice-chairman of China’s Central Military Commission, confirming his selection as successor to Mr. Hu, the country’s party chief and President. The change of leadership is expected to occur in 2012, yet the track-record for smooth political transition has not always been positive. Whilst political and economic reforms are currently on the agenda, political paranoia lurks at many corners.

Nevertheless, the key objectives of the five-year plan suggest that China is well and truly on its way to a sustainable future, primarily through a change in the growth pattern. Firstly, as expected, there is going to be a stronger focus on domestic consumption and the services sector, as opposed to industry and investment. This is where policymakers face a tough decision. The rising trade surplus suggests that China’s artificially low currency is preventing structural rebalancing of the economy, yet raising the value of the Yuan would cause a fall in exports, which may create unemployment and squash any rise in domestic consumption. A significant revaluation of the currency looks unlikely, but without removing price distortions and influencing wages it may be difficult to achieve growth in domestic demand and the relatively small services sector.

The other key objectives of the five-year plan are increasing the role of the private sector, urbanisation and regional development. Progress in these areas would undoubtedly help in boosting domestic consumption, but there is a long way to go. The government must be willing to allow private firms to compete with state-owned enterprises (SOEs), especially in areas such as financial services and infrastructure. This could be achieved through a reduction in red tape, giving easier access to finance for small business and reducing regulatory barriers to entry. If this eventuates, Australia could benefit significantly from strategic partnerships, considering Australia’s strong services sector and the respect China has demonstrated for Australia’s success post-GFC.

Furthermore, China’s push towards cleaner energy is also a key opportunity for Australia. China has become a world leader in renewable energy, given that it must significantly reduce carbon-intensive energy production to reverse the severe environmental degradation that has damaged quality of life and may constrain future economic growth. China is keen to expand research and development into new energy technologies, and Australia should seize the chance to develop its own alternative energy sector. Australia has had key breakthroughs in areas such as ceramic fuel cell and photovoltaic technology, yet there has been a lack of government support for their implementation. Thus China, with its seemingly endless demand for energy, could help Australia realise the full potential of such an industry. Australian natural gas reserves are also of strong interest to China. Woodside Petroleum is amongst the Australian companies who are already exporting large quantities of liquefied natural gas, whilst expanding exploration projects to keep up with rising Asian demand.

In order for progress, China must commence economic reform and early signs suggest policymakers are ready and willing to do so. Nevertheless the appointment of Mr. Xi as party successor demonstrates that open competition for government and political reform are not on the near horizon. This could have implications for, or potentially stall, economic reform, particularly if social tensions continue to rise. Censorship remains a contentious issue and even Prime Minister Wen Jiabao’s support for political reform is repressed by Chinese media sources. There has also been a significant increase in large-scale protests and outright criticism of the government via the blogosphere. Other social problems are also cause for concern. The one-child policy has created what is known as the ‘4-2-1’ problem. The law-enforced only child must now support his, or her, two parents and four grandparents, increasing reliance on pensions and other state welfare.

Ecinya has long advocated that ‘The Chinese Communist Party’ should change its name to ‘The China Central Peoples’ Party’ to reflect the obvious fact that China is a free-enterprise economy. This change would also assist to mitigate cheap shots from the West. One party rule is not a bother, and human rights reform can wait, or evolve over time. But China needs to integrate further its philosophical and geo-political actions to become a fully paid-up member of the international community. A change of name removes the ‘communist’ bogey-man from current prominence.

Whilst in the past the government has used economic growth to encourage social stability, structural economic reforms may dampen growth in the short-term. Thus in the context of a transitioning government, it is unsure how much short-term pain China will be willing to bear. In conclusion China has the potential to make significant gains despite a sluggish global economy, with a projected growth rate of around 8.7% in 2011. Australia is uniquely positioned to share in these gains and therefore it is up to us to promote a mutually beneficial relationship and ensure we take full advantage of all resulting opportunities.