Hedge Clippings | Friday 28 June, 2019
 

All eyes will be on the G20 Summit being held in Japan over the next couple of days, but in particular on the outcome - if any - of the discussions between Presidents Trump and Xi as they continue their arm wrestle over tariffs. At stake is the potential to ramp up the battle, which could lead to a full-scale trade war, which would not only damage both the US and China, but also the global economy.

Neither leader is going to want to be seen as the one giving ground, and given their domestic politics and economies, neither can probably afford to. However, history is littered with wars that shouldn't have been fought, and wouldn't have been save for the intransigence of at least one of the parties involved. Common sense and "for the greater good" might well be the best solution, were it not for the individual egos of Trump and Xi.

Having said that, based on a combination of the premise that "people behave the way they're allowed to" and "that's what you get if you reward bad behaviour", over the past 30 years the Chinese have been allowed to operate by their own rules almost with impunity. Along the way they have stolen a march (along with a huge amount of IP) on US and Western companies' technology, and the US and the West have happily let them do so as they swarmed around the honeypot of over a billion (previously out of reach) consumers.

China profitably exported deflation to the world, thanks in part to their incredibly low labour costs, and deliberate over production, but also as US and other manufacturers happily lowered production costs by relocating their production. At the same time they turned a tin ear to issues such as social justice, democracy, bribery ("it's the local taxation process"), IP theft* and pollution (if it's not in our back yard, it's not our problem). Meanwhile resource rich Australia, as a major beneficiary, wasn't prepared to spoil the party, and still doesn't really want to.

And now back to interest rates: The RBA meets again next week, with markets expecting a further easing. If that eventuates either the RBA is panicking, or they can see some serious problems ahead. Not that we think there aren't problems ahead, but the cut just gone seems to have stabilised residential property prices, and with (hopefully) tax cuts to come in early July, one would assume they'd pause to review before cutting again.

As we've mentioned previously, setting monetary policy based on an inflation target of 2% doesn't seem to work, particularly when rates are so low that the effect of further cuts is not only limited, but leaves no room or fire power if the above-mentioned trade war escalates and results in a global recession. Meanwhile, ultra-low bond yields have pushed asset prices, and equities in particular, to eye watering levels. We're reliably informed that globally there are $13 trillion of government bonds on issue which carry a negative yield, whilst Austria has just issued a 100 year - yes, one hundred years - bond at a yield of 1.1%, down from 2.1% two years ago.

We've used the boiling frog analogy before - ultra easy money has driven debt fuelled asset prices, and seen a gradual turning up of heat or pressure on the global economy which sooner or later (and possibly sooner rather than later) is going to end in tears.  
  
*Hedge Clippings is not without guilt, happily playing golf (albeit not well) with a Chinese-made $100 knock-off set of "Callaway" clubs. Maybe the stubbornly high handicap is IP karma? Or possibly lack of talent and application.

Hedge Clippings | Friday 21 June, 2019
 

It's difficult preaching the gospel of risk aversion at a time when markets, both in Australia and the US, are at record levels and, given the outlook for interest rates, likely to head higher still. However the fact is that equity markets are being driven by those very interest rate cuts which are signalling that all is not well with the economy, both locally and, despite whatever the Donald might say or tweet, in the US.

As the governor of the RBA points out, there's only so much that monetary policy can do to stimulate the economy, and there's the risk that come the day - and it will come - that the policy cycle turns from easing to tightening, there will be plenty of pain for both individuals and those businesses that have loaded up on super cheap credit.

However, as we've noted above, the "careful of what you wish for" message is not easy to get across - akin to trying to sell umbrellas in the bush during a drought. There may be some bumps ahead for some companies come reporting season, as investors and fund managers react - or possibly overreact - to negative surprises, particularly at current stretched valuations.

One additional relentless driver of the market has been the popularity of index and ETF's. And while the market continues to rise it's easy to see why these products are so easy to sell; the market's on the up with little sign of interest rates changing direction to spoil the party, so jump aboard and relax as you're only paying a few bps in fees. As the market rises so inflows increase, with little to no care taken of stock selection. If it's in the index, the good will be bought along with the bad.

However, when the tide turns the opposite will occur, and falling markets will result in ETF redemptions and sell orders, putting further downward pressure on the market and triggering further sell orders... and so on.

While there's a place for ETF's and index investing, there's also a place for active fund managers, albeit sorting the good ones from the bad is neither easy or simple. But then as Kerry Packer once reportedly advised "if it was easy son, everyone could do it." 

Hedge Clippings | Friday 14 June, 2019
 

Hedge Clippings has been known to be cautious, risk averse, glass half empty, negative even, call it what you will. Indeed, we know this not only as a result of some intense and painful navel gazing (not only painful as a result of the gazing, but also the shape of the navel) but due to some of the feedback we occasionally receive to that end.

However in our own defence - after all if we can't defend ourselves, it is left to others to defend us, and we can't always rely on them - we're firmly in the camp of always making sure that the downside is fully evaluated prior to taking risk. Sometimes this is easier said than done, which is when the rear-view mirror comes in handy, but essentially investing success is as much the result of not losing one's capital as it is making great returns.

That possibly explains our preference for those hedge and absolute return funds, which might not shoot the lights out in bull markets, but aim to protect investors' capital when it matters most. By and large, and taken on the average, this has proven itself over the years as shown in the chart below, where since 2003 equity funds in AFM's database have significantly outperformed the ASX200 Accumulation Index mainly by avoiding the latter's drawdowns:

As highlighted below, this is particularly evident from October 2007 to February 2009, and again from February 2015 to February 2016:

However this logic has been sorely tested over the past 12 to 24 months, particularly in the last quarter of 2018 and the first quarter of this year when the correlation between the ASX200 Accumulation Index and AFM's Average Equity Index became unusually high.

Much of this can be attributed to the vagaries of US Fed policy and 10 year bond yields, which in September last year were expected to reach 3.5% (this making US equities judged by the S&P500 with an average yield of just 2% look expensive) prior to a policy reversal which now sees 10 year bonds at 2.11%, and the 30 year yield at 2.59%. 

Fund managers and investors who had struggled to reset portfolios in the last quarter of last year were then faced with a double whammy as markets reversed in the first quarter of this year. Not easy therefore for "momentum" investors, while the issue for many "value" investors is that it is difficult to find value at historically high PE's, or amongst tech or new economy stocks with great forward estimates but negative earnings.

The investment outlook is being clouded by doubt - doubt about economic issues such as growth, interest rates, inflation, low wages growth and employment, all overlaid by geo-political and trade tensions as a result of the Trump-Xi trade tussle, Brexit, and China (where the latest monthly auto sales fell over 16% y-o-y), be it demonstrations on the streets of Hong Kong, Taiwan, or the control of the South China Sea.

Closer to home, employment rose last month by an unexpectedly high 42,300 in May, of which only 2,400 were full time jobs, and April's number was revised upwards from 28,400 to 43,100. However, unemployment is locked firmly at 5.2% - some of that is possibly election related. Consumer and business confidence are showing little correlation either - again possibly election related. 

The RBA has focussed on employment and inflation, and it seems likely therefore that the market is correct in forecasting further rate cuts in official rates to 1% or even less, but that in itself won't fix the economy - in fact the reduction in deposit rates will curb consumer spending further.

It's not to say there aren't opportunities. In spite of all the above, Hedge Clippings is not pessimistic. However, we think we can - and should - be excused for being cautious.

Hedge Clippings | Friday 07 June, 2019
 

When the RBA's decision to cut the official cash rate came through this week it was somewhat of an anti-climax given it had been well flagged by the RBA themselves. In addition, nearly every economist had factored it into their models, and they have now moved on to when the next cut may be, and how low rates may eventually go.

At 1.25% it took the RBA Governor to point out that there was a limit to how much monetary policy can do to stimulate the economy, employment or inflation, correctly indicating that fiscal policy must play a part as well. There's still an element of doubt about the certainty of the tax cuts due in July once Parliament returns, but along with the reduction in loan repayments for those homeowners with a mortgage, they'll help consumer spending - provided the additional income doesn't go towards debt reduction.

One option is an increase in spending through increased infrastructure projects, but the government will be loath to not deliver a surplus, although with a further three years in power this may be a better - or more politically acceptable - solution. Hedge Clippings has repeatedly called for an allocation of a portion of all superannuation into infrastructure given the alignment of interests and the similarity of the investment requirement and life cycle of each.

Looking further afield, although it will potentially impact the Australian economy to a significant degree, the US/China trade spat - not quite a war, but getting mighty close to becoming one - appears to show no sign of diminishing. We were reminded on the 30th anniversary of the Tiananmen Square massacres that the Chinese government is not fond of losing face - or control.

One economic issue for China is their current account balance as a share of GDP. According to an excellent piece of analysis by the UK's Longview Economics this showed a surplus of just 0.4% in 2018, whereas as recently as 2007 it was just shy of 10%. As Longview's chart below shows the IMF is forecasting a modest continued surplus through to 2021 before moving to a deficit.

However Longview believe that it is more realistic to expect a deficit this year as the underlying dynamics of the Chinese economy continue to deteriorate due to a range of factors, including the US induced trade war, increased credit fuelled consumption and a shrinking of their working age population and employment. The above reference is just a snippet of Longview's in-depth analysis, and if you are not familiar with their work, or their founder and CEO Chris Watling, it is well worth taking a look.

But back to Trump: Last week after we dispatched Hedge Clippings Trump upped the overall threat of a global trade spat by taking a shot at Mexico's tariffs as well, before setting off to the UK and Europe for the D-Day commemorations, where generally he actually seemed to present "presidentially" - but only after giving London's Lord Mayor a verbal serve.

One thing you can say about the Tweeting Donald, he's not short of an opinion.

Hedge Clippings | Friday 31 May, 2019
 

Last week we thought it "more likely than ever" that next Tuesday's RBA meeting would result in a rate cut. According to the markets, and it seems 100% of the economists, that's now not only a certainty, but some are predicting a 50 BP cut, while others (or maybe the same ones) are suggesting official rates will be as low as 0.5% by this time next year.

While Hedge Clippings is not prepared to put money on the chance that every noted (and other) economist is wrong, particularly given the messages coming from the RBA itself, we certainly hope they are not correct, simply because of the implications for the economy, and various sections of it, and the community if they are (correct).

Firstly, it was only 12 months or so ago that all and sundry were lamenting the property boom, and housing affordability. Whilst part of that was caused by overseas buyers, particularly from China, and some by lax lending standards or approval processes from the banks, a significant part of it was historically low interest rates. We may have seen the boom times disappear, but property prices are still way above where they were 5 years ago, and re-kindling the fire under them again will cause further issues down the track when (maybe that should be "if") rates rise again.

Overall debt levels in Australia - and the US and elsewhere if it comes to that - are at record levels, both at a consumer and corporate perspective. In the US in particular the level of sub investment grade corporate debt is a worry - as so-called Zombie companies pile up the debt such that all their cashflow is directed towards paying the interest, leaving nothing for investment or expansion.

Next, anyone relying on bank deposits for their income is struggling as it is. Their income is going to be trimmed further - although this will support equity markets. But supporting equity markets by lowering rates only makes equities look reasonably priced on a relative basis. If an investor's choice is 1% or less keeping their money in the bank, or 3 or 4% or more from putting it into the ASX it's pretty easy to see what's going to happen. However, when (sorry "if") inflation ever kicks in again, and rates rise, the opposite will happen, resulting in a capital loss on equities, and tears before bedtime for some.

Thirdly, depending on what happens to rates in the US, where the Donald is doing everything that he can to talk or Tweet the FED into lowering rates, lower rates here are likely to see further weakness in the Aussie dollar. This of course is a double-edged sword, making imports more expansive, and exports more competitive. But at 0.5% (if we get there) the A$ will lower significantly, unless the US$ weakens in line.

Had Bill "it wasn't my fault" Shorten been elected PM then it might have been necessary to cut rates as business confidence, and thus consumer confidence, would have taken a hit. The market, and business, has spoken about the benefits of Sco-Mo's re-election, as unlikely as it might have seemed a fortnight ago. We'd like to see the newly elected government - having been given a clear mandate - give the economy a clear kick through their tax cuts, business investment and infrastructure. 

And while they're at it, simplify superannuation and redefine its original purpose of encouraging workers to save for their own retirement, thereby taking them off the public payroll when they get there.

Hedge Clippings | Friday 24 May, 2019
 

The excitement's over, now back to work!
 

After all the expectations and then, depending on one's political leanings, the excitement or disappointment of the final result, it's now back to normal. Or as near normal as life ever seems to be.

There wouldn't seem to be much that Hedge Clippings could add to the reams that have been written, spoken or broadcast over the past five and a half days, except everything is always much easier to understand when looking in the rear-view mirror. Firstly, Shorten and Bowen underestimated the effect of their franking grab, and Sco-Mo made the most of it, aided and abetted by the financial services sector in general, and Geoff Wilson in particular. For those who missed it first time around, or our reminder on Monday, here's a link to our own effort in the form of the Ballad of Wee Willie Short One.

Secondly, it'll likely be a while before a convoy of environmentalists (probably the kindest thing they were called on their trip once north of the Tweed) travel to Queensland to tell a bunch of prospective coal miners what they should be doing with their employment chances. Amazing how dumb some otherwise intelligent people can be.

And finally, let's not forget Sco-Mo ran a good, direct and clear campaign. Probably the most important outcome was there's presumably now stability in and around the PM's office, and hopefully a clear policy agenda.

Meanwhile the RBA seems more likely than ever to be on the way to easing in June - at least if you listen to financial markets and the bookies - but let's not forget bookies (in spite of Hedge Clipping's previous incorrect prediction) can get it wrong as well. We're still not convinced that a 25 or even 50 bp easing will have any great effect on inflation, as the RBA's firepower looks severely limited. Tax cuts due in July might help stimulate consumer spending to a degree, and the banks' easing of lending restrictions might help the property market, but the view ahead is "caution" in spite of the events of last weekend.

The macro issue - or risk - that we see is an ongoing escalation of the trade war between Presidents Trump and Xi. One would think there's too much to lose to see the situation deteriorate further, but there's too much face to lose for either of them to be seen to be the loser. Having said that, Trump's probably correct in saying enough is enough, but that should have been said by his predecessor - or his predecessor's predecessor.

Hedge Clippings | Friday 20 May, 2019

Monday Hedge Clippings - Better late than never!

Hedge Clippings was missing in action for last Friday's edition; maybe we had a premonition that any predictions might put the kybosh on the Sco-Mo Miracle. However, we did feel some-what vindicated when reminded of the poem included in Hedge Clippings on 23rd March, 2018 - almost 14 months ago. While there were other factors in the Liberal's success over the weekend, there's no doubt that Shorten's plan of taxing franking credits, and Bowen's encouragement to those who didn't like the plan to vote against it, cost the labour party dearly.

So, as requested by one eagle eyed recipient, we have reproduced our now prescient poem below:

Wee Willie Short-One was looking for a plan,
to soak the rich and famous and so help the common man;
With an election 'round the corner, it's a chance he couldn't miss,
He tried it with his Mediscare, it might just work with this:

"I know!" he says to Albo, (who's breathing down his neck),
"What about the pensioners, they're fair game - what the heck!
Best of all I'm sure they're Libs, so wouldn't vote for us,
We'll call it taxing millionaires, that'll not cause so much fuss."

No matter that they worked for years to put some funds away,
or started up a super fund just for that rainy day.
"Look at all the franking credits they're getting back in cash -
They'll whinge a bit, poor old folk, but few teeth left to gnash."

"But best of all OUR super's safe, indexed and inflation free,
Fifteen percent and guaranteed, it won't hurt you and me.
If it works I'll get a pension, gold pass, driver and a car,
But only if I make PM - if I can only get that far…"

But Willie's got his facts wrong, as pollies often do,
Didn't understand the people his franking tax will screw,
There's lots of labour voters who he forgot to note,
Have also put some shares away - and bloody hell! they'll vote!

Hedge Clippings | Friday 03 May, 2019

This week saw the ongoing debate continuing between various economists over the likelihood of the RBA delivering a rate cut following their meeting next Tuesday, with about 50% of them thinking they will (or should) and the other 50% thinking they won't (or shouldn't). Those in the first group (the "will'ers" or the "should'ers") including Shayne Elliott, ANZ's head teller, want the RBA to cut rates to save the property market (which it won't - or shouldn't) even though it was only 12 to 18 months ago that the RBA was concerned about the property bubble!

What was interesting was that Elliott's opposite number at NAB was in the opposite camp, espousing the view that at these ultra-low levels a rate cut of .25%, plus another one later in the year of a further .25%, will not only not help to resurrect the property market, but is also unlikely to reverse the low inflation levels which triggered the whole debate in the first place.

To be fair, Elliott's concerns were also directed at APRA's responsible lending guidelines which require the banks to ensure a borrower's actual rate, say around 4.25% to 4.75%, has a sufficient buffer between 4.25% and 7.25% - the rate the regulator considers prudent for future serviceability. The ANZ bank can carry on about "Responsible Lending" and APRA's margin of error, but until they were outed by the Hayne Royal Commission, all the big four were more interested in lending volumes, not lending responsibility.

And if ANZ really think 0.25% off the current 1.5% is going to help the property market, that assumes they're committed to passing any cut on to borrowers in FULL? Pigs might fly! Canstar produced figures showing that, assuming only half of a .25% cut is passed on by the banks, the monthly saving would be just $26 on the average mortgage of $400,000.

And if the ANZ (and others) were really committed to lower rates, or passing them on, why haven't they dropped credit card interest rates one iota since cash rates were 5 or 6% higher than they are now?

For the record, credit card rates are still in the 18 to 22% band for most bank customers. ANZ currently offer (or promote) 0% for 15 months on balance transfers, and once you're up to your eyeballs in debt the rate reverts to a somewhat less generous 21.47%. (oh! And with a $58 annual account fee).

And lowering interest rates to push inflation up? Monetary policy used to be used to stimulate or dampen demand in the economy, which right now is traveling ok, even if it's not going gangbusters (depending on which politician you listen to). And if you want to see how much low interest rates have done to stimulate economic activity elsewhere, take a look at Japan or Europe, where negative rates have had little to no effect on growth, consumer demand, or inflation.

The RBA's inflation target of 2-3% was set at a time when no one in their right minds considered the lower level would be breached, let alone halved. Those wanting to see rates fall further also seem to ignore the effect it will have on deposit rates - already pitifully low, but at least supporting equity prices thanks to dividends, including, for some, franking credits - for the time being.

Hedge Clippings | Friday 26 April, 2019

Reading the press - or more accurately the media as a whole - it seems many economists are predicting a rate cut from the RBA following their meeting on Tuesday week, May 7th.  However, we're not so sure - or at least not sure that it is either the right thing to do or will have the desired effect.

This of course begs the question, "what is the desired effect?". From what we can understand from the media, and even noted non-economist Bill Shorten, it seems low inflation is what is now the economy's major issue! Not so long ago it was high inflation.

The problem is that at 1.5% rates are already historically low, albeit higher than in many other developed countries, as is inflation. Negative rates across Europe haven't resulted in either an uptick in their levels of inflation or, more to the point, an improvement in their economic activity.

Dropping rates to 1.25% won't fix the problem, and Bill Shorten should be called out for advocating higher inflation as a solution to the Australian economy. Today's low inflation is not merely a result of low wages growth (although it helps); it's also a sign of a combination of falling power and energy prices; and increased productivity due to technology and increased competition, in part as a result of improved price discovery thanks to the internet.

In turn, the housing market is in a dive due to a combination of factors: 5 years of unconstrained price rises which created a bubble and an affordability crisis amongst new borrowers and low income earners, driven partly by offshore (particularly Chinese) demand; easy lending practices of the banks, and low interest rates. Dropping rates another 0.25% won't address the other causes, such as tightening of China's capital and exchange controls and the banks' new found reluctance to lend, and now the subsequent decline.

Two leading economists have suggested increasing infrastructure spending; i.e. fiscal, rather than monetary, stimulus as an alternative solution. That would be preferable to a blunt cut by the RBA who have less and less room to move, particularly just before an election where handouts - or at least promises* - seem to be falling from the sky. Tie that in with smart changes to super to ensure a portion of all super is directed towards long term investment in infrastructure, and maybe we'd be getting somewhere.

*P.S. Unless you have a short memory, beware politicians promising pre-election hand-outs. One lot won't need to keep theirs as they'll be in opposition post May 18th, and the others might have a short memory - or a well-practised bag of excuses - when it comes to keeping theirs.

Hedge Clippings | Friday 12 April, 2019

All eyes on the Federal Election. It's the economy, stupid!

I think we said at the start of the year, and maybe well back into last year as well, that in 2019 markets would be significantly dominated by geo-political issues. That's certainly been the case globally (Trump/China Trade Wars, and now Trump/EU, plus the extension of Brexit - all of which are going to dominate the global outlook for a good while yet), but now the Federal election has finally been called it is going to focus - or obscure - the local outlook.

Why this should suddenly focus investors' minds and attention is somewhat baffling. It has always been known roughly when it would be held, even if the exact date was not declared until this week. However, from the perspective of investors and fund managers it will require a decision: Will the outcome have any real impact on the local market and how fund managers manage their investors' money post May 18?

We would suggest it will, to varying degrees;
 

1. Business confidence is one, partly due to the potential for a wages push on a change of government. Consumer confidence is another, especially where it matters with those consumers with discretionary spending ability, along with taxation policy.

2. A change in government will hardly improve the current property slump given potential changes to negative gearing, perceived or otherwise, and remembering that property prices affect consumer confidence to a significant degree. Further falls will certainly improve housing affordability, but that only affects the relatively small proportion of buyers trying to enter the market, not the majority who are already in it.

3. Meanwhile, for those who have only recently purchased homes and/or are mortgaged to the hilt, they'll potentially see their equity evaporate. In addition, as they switch from honeymoon rates, or from interest-only to P&I, they'll be faced with increased repayments leading to further pressure on discretionary spending - and subsequently on both business and consumer confidence.

4. Ditto self-funded retirees, potentially hit by changes to the treatment of franking credits. Whilst they're not all the highest of discretionary spenders, the overall effect of the removal of franking credits will take its toll on the economy.

The only way to increase consumer spending will be increased wages, but refer back a few paragraphs to item #1 - business confidence - and we start to get into a circular argument…

We've previously said there's unlikely to be a further rate cut in Australia this year, but the RBA may have no alternative - and as we've also previously said, if the RBA needs to cut rates further from here, it will indicate there's a real problem with the economy.

For those who want to follow what the RBA's current thinking, today's release of their Financial Stability Review should provide a good place to start. You can find a link to the whole document here if you have the time and inclination, or use the following links to focus on Household and Business Finances and Housing Price Falls and Negative Equity.