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Why is the Australian market underperforming?

Peter Warnes  |  25 Jan 2018Text size  Decrease  Increase  |  
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The underperformance of 2017 has continued into the early weeks of 2018. Most macro indicators are positive and interest rates are at historical lows, but the Australian equity market exhibits little conviction. Consensus forecasts are for another positive year, and while it is early days, the upcoming earnings season had better exceed expectations, otherwise the underperformance is likely to continue.

The Australian economy created 403,000 new jobs in 2017, of which 303,000 were full time. This is a very strong outcome. Due to a higher participation rate of 65.7 per cent in December, which is the highest level since January 2011 and just shy of the all-time high of 65.8 per cent in November 2010, the unemployment rate fell from 5.8 per cent in December 2016 to 5.5 per cent.

Consumer sentiment as measured by the Westpac/Melbourne Institute Index improved in January to 105.1 from 103.3 in December. The uptick reflects a "less threatening outlook for interest rates and improving confidence around the economy and jobs." The mood is "cautiously optimistic" rather than buoyant and the latest reading is the best since late 2013 and the most positive start to a calendar year since 2010.

The National Australia Bank's monthly business survey for November saw business conditions give back the gains of October, but the reading is still elevated and "well above the long-run average and are at solid levels across most of the economy."

While there was a slight deterioration in business confidence the reading remains positive. Respondents were particularly concerned with the outlook for consumer demand, pressure on margins and government policy.

Concerns around energy eased, while greater importance was placed on wages costs than the previous quarter and these are now of much greater concern. This is difficult to understand with wages growth still well below trend, although a return to industrial unrest with a train strike called for Sydney, may alter the landscape.

Why, with all these macros positive, is the stock market struggling? The elevated A$ is taking the shine off exports but prices remain strong, comfortably offsetting any volume declines. After two surprising successive trade deficits in October and November, Australia should be back in surplus in December and into 2018.

Australia's total labour force at 2017 year-end totalled 13.17m--12.44m employed and 730,600 unemployed--for an unemployment rate of 5.5 per cent. Unemployed looking for full-time work stood at 501,800. There is still spare capacity in the labour market working against a meaningful lift in wages. The 403,000 jobs created represented 3.06 per cent of the labour force. This was a better performance than the US, reflecting the higher unemployment rate.

Comparatively, in the US a total of 2.055 million non-farm jobs were created in 2017 with the participation rate a lowly 62.7 per cent. Total labour force was 160.6m--154m employed and 6.6m unemployed--for a 4.1 per cent unemployment rate. Jobs created in 2017 represented 1.28 per cent of the labour force.

According to the National Australia Bank's business survey, one of the main concerns of Australian business is government policy, or the lack of it. The most vigorous debates of the past six months have been around social issues involving same-sex marriage, changing the date of Australia Day, and the Republic chestnut. Hardly a serious attempt at economic reform, draining a bloated Lake Burley Griffin--Australia's Washington-like swamp--or cutting red tape.

Until Canberra gets serious about national economic issues to halt a falling standard of living and create an equitable sharing of the economic output, the country is likely to remain in the global backwater and its financial markets will underperform.

US$ in the hands of central bankers

The slide in the US$ has surprised, particularly against the €. Some suggest the European Central Bank (ECB) will become more aggressive than the US Federal Reserve (the Fed) over the course of 2018, as both move to normalise their respective bloated balance sheets.

In the words of Darryl Kerrigan in The Castle, "Tell 'em they're dreamin'." The ECB is significantly behind the Fed and I can't see the gap narrowing in 2018. The ECB President Mario Draghi is the top dove and has already shown a reticence to tighten meaningfully and European markets, particularly the German DAX, have responded positively to a persistently dovish stance. Only last week did the DAX react to reports the ECB will not be making any significant changes to its wording before March.

The ECB is still purchasing financial assets, albeit at a slower rate, but is still adding to its balance sheet. Rate increases look unlikely until late 2018 at the earliest. The ECB is likely to remain dovish until Mario Draghi steps down in October 2019.

Should chief of the German Bundesbank Jens Weidmann succeed Draghi, the game will change. A hawk will replace the dove. How can one rationalise the robust growth of the German economy with a 10-year bund yield of 0.56 per cent?

The next president of the ECB will have a more difficult job than the retiring Draghi. Weidmann has already criticised Draghi's monetary stimulus, warning in 2012 "central bank financing can become addictive like a drug." Global investors have been injecting bargain-priced liquidity for eight years. The withdrawal could be long and painful.

Should the Fed unexpectedly lift rates on 31 January, the US$ would respond immediately, pricking the € balloon. The short US$ is currently a very crowded trade, helped recently by government shutdown squabbles. The Fed needs to show a firmer hand in the face of signs of irrational exuberance in US equities markets.

While the bond market appears to question the longevity of the current recovery in economic growth rather than inflationary issues, there is some evidence market-based inflation expectations are on the move.

Commodity prices have strengthened and are showing up in the producer price index and US wages are growing faster than the core consumer price index. This, before the effect of tax cuts on investment, economic activity and labour hire.

By waiting until March to lift rates, the Fed will get further behind the curve and could rightly be accused of being asleep at the wheel. The bond market does not meet eight times a year, like the Federal Open Market Committee. It is open 24/7.

The 2-year bond yield is already 69 basis points higher than the mid-point of the federal funds rate range of 1.375 per cent. The 10-year spread at 129 points. The spread on the 2-year yield has widened from 33 basis points six month ago, the 10-year from 113. Perhaps Janet Yellen's last meeting could see a 25-point hike the markets are not expecting. It would be a fitting farewell.

Is the Fed running scared?

Is the behaviour of the Fed in allowing the spread between bond yields and the fed funds rate to widen acknowledgement the bond market might just be right? Is the US economy as robust as it seems or will the recovery vaporise as soon as monetary policy tightens meaningfully?

Remember, this recovery and the associated asset price inflation was conceived during unprecedented monetary easing, born into an accommodative environment of unmatched proportions and is now addicted to and expects no interruption to these nirvana-like conditions.

It is as if the umbilical cord is still attached and the adolescent, driven by animal spirits, is beholden to no one. The parents have outlaid US$15 trillion. With little or no discipline, the behaviour of the spoilt child when the "toys" are withdrawn is unpredictable. But greed is probably alive and well and fear could easily overwhelm.

The Fed is probably aware aggressive tightening could trigger a recession and knows it has little in reserve to fight such an event. This may explain the softly, softly dovish approach to the difficult tightening task.

Jerome Powell, the incoming chair of the Fed, is now faced with the task of unwinding a liquidity-driven, highly leveraged coiled spring without inflicting widespread damage as monetary and fiscal policy clash and equity valuations continue skyward.

Central bank sponsored asset inflation and leverage has had a major impact on US net wealth. Net worth to disposable income is at a record level but the gap between the haves and have nots is also at a record.

As is the case when the wealth effect is in the ascendency, the savings ratio slides. The psychology overtakes reality. The US savings rate is currently 2.9 per cent, down from 6.1 per cent two years ago. Raiding the piggy bank has accounted for at least 1 per cent of GDP growth over the past two years and is not sustainable.

The Fed and Jerome Powell face a challenge of similar dimensions to that of Paul Volcker in the early 1980s and may have to dispense equally unpleasant medicine.

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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

 


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is Morningstar's head of equities research.

© 2021 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

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