Monthly Roundup
One of the oldest market truisms is “sell in May and go away”. During the northern summer markets tend to go very quiet as those who make the news and those who pay attention to it go on holidays. However, the media has to report on something every day to give the impression it has an explanation for exactly why markets do what they do on a day to day basis. In June there were really only two stories: the ongoing Greek debt crisis and U.S. interest rates. It devolved to the point where if markets went down it was because negotiations were closer to resolving the Greek debt crisis and vice versa. That is a ridiculously one dimensional view.
Turning a drachma into a crisis
As the chart to the right shows, five years ago European institutions owned some €300bn of Greek debt and if Greece had defaulted it would have wiped a lot of banks out. Now most of the money is owed to the IMF and ECB, with banks holding somewhere around €30bn and there’s so much liquidity in Europe it could be readily absorbed.
The European Central Bank has had five years to prepare for the worst: that Greece will not be able to pay its debts and will be forced out of the Euro zone. Clearly markets got jumpy toward the end of the month, and whilst a default will hardly go by without a ripple, particularly for the poor Greeks, contingency plans will have been made. Although at the end of June there was no resolution to the stand off and Greece had even closed its banks, imposed capital controls and called a referendum, it was always likely that negotiations would go down to the wire, just like the U.S. credit ceiling debacle a few years ago, with a compromise solution being reached. It’s worth bearing in mind, since its independence 200 years ago Greece has been in debt default for 90 of them. As one commentator said, for anyone with a sense of history, being told Greece is on the verge of a default is like being told Dean Martin is on the verge of a martini.
As for how Greece failing would affect the rest of the world, it is 0.25% of global GDP. It would be barely a rounding error. Even among the ‘peripherals’ of the EU there is no longer any correlation between capital movements in and out of their economies and Greece’s. Not that the media would have you believe it, but you need to keep in mind, the media knows very well their audience is far more likely to read a headline screaming “DRAMA!” than one that says “relax, there’s nothing to worry about”. The investment banks are not much different: if they can convince their clients they should do all kinds of trades to ‘protect’ themselves the better off they are too.
Elsewhere in the EU inflation was reported as rising 0.9% from the year before. A big part of the recent increase has been the rise in the oil price, which of course had the opposite effect last year when it was falling. The ECB has raised its inflation forecast and retained its growth forecast – Goldilocks is alive and well.
U.S.: it doesn’t matter when, it matters by how much
Even Janet Yellen sounded a little exasperated with the incessant speculation among market commentators as to when the Fed will finally ‘lift off’ zero rates. She said the timing is not what’s important, it’s by how much rates go up over the following year or two that really matters …we couldn’t agree more. As we’ve been saying, rates are going to rise in the U.S., the Fed has told us that many times. We don’t know when it will start and it’s pointless worrying about it. We also have no idea what the short-term market reaction will be so there’s no point trying to second guess it, rather we continue to base our asset allocation on valuations.
Overall the US economy remains strong, which is well illustrated by a bunch of data like the now very low unemployment levels (see the left chart below) and home sales and building applications at the strongest levels since 2007. Plus the equities markets continue to hover around record levels which reflects the confidence in the market (see right chart) being at an eleven year high.
U.S. unemployment rate
Source: BLS, Haver Analytics, Deutsche Bank
U.S. consumer sentiment and retail sales
Source: BLS, Haver Analytics, Deutsche Bank
There are, however, two dark clouds casting questioning shadows. The first is the debt that fuelled the shale oil boom now threatens to be its undoing, which could in turn reverberate through the economy. Total debt across the 62 listed oil drilling companies in the Bloomberg Independent Exploration and Production Index rose 16% in the year to the end of the March quarter to $235bn, even as revenue shrank following the 43% fall in the oil price. Over that quarter the companies in the index spent $4.15 for every $1 earned selling oil and gas – something that can’t go on for very long. Most companies in the sector have had their credit rating downgraded by Standard & Poors and many are now junk status.
Just like Australia’s economy benefited from the mining boom through increased capital expenditure and we’re now feeling the effects of the slowdown, so U.S. industrial production is feeling the effects of the shale boom slowing down. Drilling and services expenditure dropped 8% in one month and has fallen nine consecutive months to be less than half of what it was a year ago.
Industrial Production: Mining: Drilling oil and gas wells
Source: U.S. Federal Reserve
Whenever a business or sector grows rapidly and there’s a lot of debt behind it, it’s a great recipe for bad things to happen. That doesn’t mean the U.S. is going to fall in a big hole because of it, the economy is big enough to withstand the hit, but watch this space.
The second cloud reflects a lack of investment in productive capacity and innovation amongst American companies. The chart on the left shows the decline in U.S. Government R&D spending as a proportion of the government budget and in dollar terms, which funded breakthroughs in shale oil drilling as well as various cancer drugs. The chart on the right shows the massive jump in on market buybacks by U.S. companies.
U.S. Government R&D spending
Source: Bloomberg Finance, FactSet, Deutsche Bank
Weekly announced buybacks SP500
Source: Bloomberg Finance, FactSet, Deutsche Bank
Buybacks have gone up as interest rates have gone down, with companies borrowing money to buy their own shares. Whilst buybacks are good for shareholders insofar as the price gets supported, it means the companies are not investing in productive capacity. The impact of this won’t be apparent immediately, but it will be felt over time.
Australia: an unbroken record
Twenty-four years of unbroken economic growth – a pretty impressive achievement. Australia’s March quarter GDP growth was a little better than expected coming in at an annualised pace of 2.3%. The problem though is that real GDP per capita has been falling for the past thirteen years (see the chart below). In other words, that wonderful record of economic growth hasn’t reflected innovation or creativity, but simply population growth.
Real Gross Domestic Product
Over June Glen Stevens, the Governor of the Reserve Bank, once again hinted at how frustrated he is that the government is expecting monetary policy to do too much of the heavy economic lifting. Perhaps he read our previous blogs: not only did he describe some parts of the Sydney housing market as ‘crazy’ (as did the head of Treasury) he also urged the government to borrow money through the bond market to spend on infrastructure projects. Much like the U.S., Australia needs to invest in its future.
The Australian share market has had a pretty torrid quarter, falling about 6%, and it’s not particularly clear why. What seems to be the most logical reason is that markets are anticipating a rise in U.S. interest rates and possibly global bond yields, so the high yielding stocks are no longer as appealing. Given the strong rally sectors like the banks have seen in the past couple of years, it always left our market vulnerable to the time when investors changed their preferences. The chart below shows the extraordinary increase in how much the banks represent as a proportion of the overall market.
Bank sector and % of Market
Source: Martin Currie Australia
In the past quarter the financials sector and the consumer staples sector (read Wesfarmers, which owns Coles, and Woolworths) have both fallen 7.7% – ouch.
