Steward Wealth monthly review October 2015

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Written by James Weir

James specialises in the theory and best practice of portfolio construction and management. His success within national and international investment banks led him to become a Co-Founder of Steward Wealth and he is a regular columnist for the Australian Financial Review.
November 1, 2015

Monthly Roundup

October table


It’s amazing how different markets are when they’re not fixating about something. Over October there were no blow ups in Europe, the Chinese market actually went up and central banks made noises about more easing rather than tightening. All those dramas of the last couple of months seemed to fade into the background and voila! the markets went up.


Australian banks and growth

The big four Australian banks are finding themselves in uncomfortable headlines again as they sell assets or issue new shares in order to comply with the regulator’s demand to increase their capital position (that’s the money they have stashed away to act as a buffer against loan defaults in case the markets get volatile), but at the same time strive to meet their shareholders’ demands to maintain their profitability by increasing variable home loan rates.

As we’ve written in the past, the Australian Prudential Regulation Authority (APRA) used to require the big four banks to keep only a tiny amount of capital against their property loans. In fact, Westpac revealed last year that for every $100 it held in property loans it kept only $1.32 of capital in reserve. That’s why those banks have been so insanely profitable: you give them a deposit of $10 and get paid 2% p.a. (i.e. 20c a year) and they turn that into over $1,000 of housing loans and charge 4% p.a. (i.e. $40 a year). By international standards, that level of capital reserves is very, very low, meaning our banking system is a whole lot riskier than what we’d thought.

On top of that the big banks got preferential treatment from the regulator insofar as the smaller, regional banks had to keep a lot more capital in reserves, so they couldn’t possibly compete. Consequently our oligopolistic banking market just got more and more concentrated as the majors steadily increased their market share to the point where they write about 80% of Australian home loans.

However, the system has its downsides. The big banks are incentivised to lend to home buyers, who put their house up as security, because of the breaks they get on capital requirements. By contrast, if a bank makes a personal loan or a business loan that is not secured by property, it gets counted dollar for dollar against capital and sometimes the risk weighting is even higher. So the incentive structure is all towards home lending, which means the banks’ traditional role of facilitating commerce through funding business growth and capital expansion has been dwindling.

Consequently in a world that’s supposed to be awash with liquidity and boasting historically low interest rates, commercial lending has gone sharply backwards over the past couple of years (see the chart below) as banks have piled more money into the housing market to the point where Australian households are the most indebted in the world at 134% of GDP.


Value of Commercial Lending (Ex. refinancing, cancellations & reductions)

Value of commercial lending

Source: ABS


At the same time there’s been a big drop in capital spending plans by Australian businesses. We got advanced warning of the likely cut in non-mining investment and it appears to have arrived, with a further 8.4% fall over FY2016 in the offing. This isn’t all the banks’ fault: a recent survey showed Australian businesses use an average 10% hurdle rate for return on equity before going ahead with a project. In an environment where the 10 year bond rate is 2.7% that’s a remarkably high rate of return they’re demanding, but if those businesses were more confident of securing funding, would they be more inclined to undertake those projects?

Hopefully the change in capital requirements the big four banks have been grappling with will see a shift in the lending environment. The average amount of mortgages counted against the banks’ capital is set to rise from 16% to 25%. That means the banks have to have more money sitting around as a buffer against market volatility, money that isn’t being lent out at big, fat margins. Plus the banks’ cost of raising funding in the bond markets has gone up by about 0.3% since the beginning of the year simply due to changes in global markets. That means they’re copping a double whammy: they have to sit on more cash so they make less profit and a lower return on equity, plus their costs have gone up, all of which means the dividends might have to go down. Unless of course, they simply raise the price of loans – thus the increase in the variable home loan rates. We know that’s the case since the Bank of Melbourne and St George, both subsidiaries of Westpac, have also increased their home loan rates even though APRA hasn’t required them to increase their capital ratios. It’s all so they can keep reporting those record profits.


We’re not in a recession, so why does it feel tough?

Australia is experiencing one of the longest periods of uninterrupted economic growth in history: 95 quarters and counting. It’s something we can feel justifiably proud of. Yet for many people things don’t feel as strong as what that remarkable statistic would suggest. Why is that?

The answer lies partly in how changes in real GDP are calculated, because for arcane statistical reasons, they’re based on the volume of production, rather than the value. Now the volume of Australian production has been terrific because exports have risen strongly, especially minerals (see the charts below).


Export Volumes

Export Volumes

Source: ABS, RBA


Unfortunately though, the value has been going down because commodity prices have crashed (see the chart below).


RBA index of commodity prices

RBA Index

Source:  RBA


The upshot is that real national income per capita has fallen for 12 consecutive quarters, which is unprecedented. So the “income recession” contributes to things feeling not quite as buoyant as what the GDP numbers would suggest.


Productivity and income

Productivity and income

Source: ABS, RBA


How do we keep the magic going?

Up until 2008 the Australian economy was a non-stop success story because our income increased faster than our GDP. How can that happen? The resources boom saw a huge increase in our Terms of Trade (TOT), which is the amount of imports we could bring in per unit of exports, so the purchasing power of our export earnings went through the roof, plus there was growing employment. Whilst there was a stall with the GFC, the second leg of the resources boom, on the back of China going nuts on fixed asset investment, saw another peak until the commodities boom started to go into reverse in 2011, taking our TOT with it (see the chart below). Since then our national income has been going backwards.


Terms of trade

Terms of trade

Source: ABS


What is required to navigate the next phase of Australia’s economic growth? We can safely say it is extremely unlikely we’ll see another China-type resources boom for a long, long time, so it’s unlikely the TOT will drive an improvement in our standard of living. And we’ve pointed out before that dwindling population growth is going to put downward pressure on GDP. The only lever left to pull is productivity: we need to produce more with the same level of inputs.

Deputy Reserve Bank Governor Dr Philip Lowe spoke about this recently and made the point that economic flexibility is critical. There are a few factors that contribute to that flexibility, like the exchange rate which has weakened a lot and done a great job of cushioning the blow from a declining resources sector by making our other exports more competitive. Another is labour market flexibility. A lot of Australia’s economic weakness due to the bursting of the commodities price bubble has been absorbed by declining real wages rather than rising unemployment (see the chart below), without that flexibility things could have been a lot worse.


Employment and wage growth

Employment and wage growth

Source: ABS


So overall productivity is key to Australia’s future prosperity. This means things like improving education and business competitiveness, which often comes from cutting costs. It also underlines the importance of a political environment that facilitates change.

Australia used to be admired for its effective political system, but now we’re on our fifth Prime Minister in four years and in the past eight years we’ve had four foreign ministers (before that we had two in 19), six defence ministers, and seven finance ministers. We’ve had five Speakers of Parliament in four years. State politics is similar: New South Wales has had six premiers in 10 years, Victoria is on its fourth in five and Queensland’s had three in four. How can we hope to have meaningful reform when political leaders barely have time to familiarise themselves with their portfolio before being moved on?


In the central bank three-legged race, China wins

Announcements by three of the world’s most important central banks over October have put into perspective how concerned they are about the low global growth environment and how worried they remain about deflation.

The US economy continues to look healthy with low unemployment and reasonably steady growth, and the Federal Reserve is still threatening to raise interest rates this year, though quite obviously they’re running out of time. For this month’s meeting the board voted 9-1 to keep rates where they are, implicitly acknowledging that US economic growth is not as strong as they had hoped it would be, yet they still talked about a December rate rises. The bond markets are putting the chance of a December rate hike at about 20%, and instead are forecasting the first move upwards won’t be until May next year. Markets are still in that strange place where they may welcome a rate hike because it would indicate the Fed, which has made it clear all year it wants to raise rates, is more worried about growth being too high than too low.

Meanwhile the other central banks are going the other way. Mario Draghi, the President of the European Central Bank, got markets quite excited when he said the ECB will investigate fresh stimulus measures, possibly before the end of the year. Nine months after the bank confirmed it will undertake €1.1tn worth of quantitative easing (QE), European inflation has once again gone negative. Whilst Mr Draghi argued that a lot of the deflationary pressures were coming from the weaker oil price which he described as transitory, the risk is it takes hold and a dangerous deflationary mindset becomes entrenched.

Similarly, the announcement by the Swedish central bank, one of the minnows in the central bank pond, of further QE measures to stimulate its economy was very telling. With interest rates at minus 0.35%, it is going to increase its sovereign bond buying by US$7.6bn to a total of US$23.5bn by June 2016. What does that mean? Essentially conventional monetary policy is supposed to make money easier to get by lowering its price (the interest rate), and so people borrow and the spending stimulates the economy. But when nobody wants to borrow no matter how cheap the price of money, the only thing left to do is stimulate the economy by increasing the quantity of it in the system: thus the term quantitative easing. More money normally means asset prices go up and they hope activity goes with it.

China too announced its own stimulatory measures, but the package shows how different the approach can be when a government doesn’t have to worry about pesky things like allowing a market to operate unhindered. October saw the Peoples’ Bank of China (PBOC) cut interest rates for the sixth time in the past year and lower the banks’ Risk Reserve Ratio for the fifth time. Significantly, in a big step toward interest rate liberalisation, it also removed the limit banks are allowed to pay on deposits. Something else that’s very important but is not broadly covered in the media is that China has also undertaken something it’s calling a “Pledged Supplementary Lending” (PSL) scheme, which targets particular parts of the economy that are judged to be in need of funds. This is interesting for a number of reasons.

First, last year China produced 823 million tonnes of steel, which is about half of the world’s total output. To put that into some historical perspective, only the US, Japan and the former Soviet Union have ever managed to produce more than 100 million tonnes of steel a year at the peak of their production – but none of them ever exceeded 200 million tonnes a year. The government is acutely aware it needs to reduce the excess capacity but it faces lobbying from local government agencies fearing the loss of jobs. Instead, the PSL allows the government to pick specific industries it wants to support. In the west, there is no way a government or central bank could be seen interfering in markets like that.

Secondly, this equivalent of Chinese QE is a good demonstration of the greater variety of levers available to the PBOC than its western counterparts. Thirdly, the measures undertaken so far have effectively reduced the interest rate that local governments are paying on their debt from about 8% to around 3.5%, which Macquarie estimates has injected some RMB3.9tn (US$350bn) into the economy.

Nobody believes China’s third quarter GDP report of 6.9% because it’s just too close to the government’s 7% target, but the economy is definitely changing. Financial markets love to have something to worry about and China is one of them: those countries dependent on commodities are desperately hoping China’s growth doesn’t collapse and curiously the more markets hope for something the more they worry about it not happening. Consumption is now 58% of China’s economy and the services sector is growing quickly, just like we were told it would. It’s true that manufacturing has been slowing, but its importance is slowly declining having gone from being 48% of the economy to 43%. It’s also true the manufacturing PMI, which measures changes in the rate of growth of manufacturing, has shown growth has slowed in 19 out of the 36 months it’s been released. But it’s only slowing, it’s not actually going backwards, so growth has still averaged 7.5% p.a. over that period.

The PBOC is trying to manage an enormous economic transition and it has levers it can pull that their western counterparts can only dream about. As one observer noted, what the PBOC does worst is its own PR.


This information is of a general nature only and nothing on this site should be taken as personal financial or investment advice, or a recommendation to buy or sell a particular product. You should also obtain a copy of and consider the Product Disclosure Statement before making any decision on a financial product. You should seek advice from Steward Wealth who can consider if the general advice is right for you.

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