Is the market beginning to top out? We think so.
Last night, the S&P500 fell 1 per cent, although the large cap Dow Jones Industrials index only fell a few points. Nothing too dramatic, and certainly not enough to scare the permanently bullish, but it’s probably a sign of things to come.
As Dan wrote yesterday, QEII is beginning to sink. How do we know? It’s a matter of probabilities. We can’t seem to recall anytime in history where printing money created lasting benefits or wealth. So why should this time be different?
Sure, there are a few major beneficiaries of QEII. Bankers. The world’s central banks create money but private banks disburse it. As the newly created money washes through their computer screens, they take a portion for ‘services rendered’.
By the time those funds spread to the broader economy, it turns into inflation. Those furthest away from the source of money are the ones who pay for it.
That’s why you are seeing commodity prices, especially food prices, skyrocket. Inflation is becoming a problem across the emerging markets. Also, rising fuel prices are hitting consumers everywhere. Every extra dollar spent on fuel is one less dollar to save or spend.
Check out the chart below. It shows the ishares MSCI emerging markets index. For all the bullishness about emerging markets, the index is no higher than it was in November. Following a correction, the index tried to move up through the old highs but has since fallen back again.
With many emerging market economies attempting to fight inflation (if lamely, in some circumstances) it’s hard to see how emerging markets can continue to move higher from here.
What QEII gives with one hand it takes from the other. It’s just that it gives to one segment of society and takes from another, which is what makes markets and capitalism so ‘unfair’.
QEII creates a false illusion of wealth and prosperity. But it’s not sustainable. Most investors realise this, so they instead turn to speculation. They know there is a chance of making some short-term money. They think they will be able to get out before everyone else.
We think the smart speculators are now beginning to get out. A top is forming. Soon, the dumb ones will follow en masse. Then we should see some fireworks.
*** Eric Johnstone reports in today’s SMH that Australia’s big four banks will need to borrow more than $130bn in the next year to fund their loan books. The problem is that the cost of obtaining those funds is rising.
The banks are now competing for capital with bankrupt governments. Markets are demanding a higher rate of interest to lend to these governments so in turn, the banks need to pay more.
After many years of not caring, debt markets are starting to price risk sensibly (although the equity market couldn’t care less at this point).
This has important implications for the Australian banking sector and the economy. A higher cost of credit means we probably won’t see a rebound in lending anytime soon. Banks won’t expand their balance sheets, which means their share prices will stagnate.
Even worse though, the higher cost of credit will hurt the property sector. Over the past decade, cheap and plentiful credit has propelled the property market higher and higher. Based on capital city prices, Australian residential property is one of the world’s most expensive.
But with credit now coming at a higher cost, you will see house prices begin to fall. Residex recently reported that Australian capital city house prices fell an average of 1.1% in December, with year on year gains of 5.1%.
That annual gain is less than the cost of funding, so in real terms property investors are going backwards.
Remember, property is a highly geared investment, so even small falls can have a major impact on investors’ equity.
This will put further pressure on the banks and balance sheets of a highly indebted household sector.
The equity market is not the only asset class topping out. Residential property is joining in. Will there be a crash though? Maybe. But we think that will only happen if unemployment starts to rise.
The two income household is one of the major drivers of property prices. As long as there is employment income to service debt, you probably won’t see major price falls.
But here’s a twist. Australia’s extremely low unemployment rate has come at the expense of declining productivity. We may be near full employment, but as a group we’re becoming less productive.
A big part of the reason for this is that Australia has overinvested in property, an unproductive asset. The balance sheets of the big four banks are overwhelmingly tilted towards residential property. As a percentage of Australian assets, the average is somewhere around 65 per cent.
So the majority of money borrowed by banks (from you, the depositor, and overseas lenders) goes into housing. This does not increase our productive capacity.
Along with the benefits of the China boom, this is why there is fear of a wages breakout in Australia. And this is why Glenn Stevens at the RBA still has his finger on the interest rate button despite numerous signs of a weak domestic economy.
Wealth is many things but it’s not higher asset prices pushed up by cheap credit. Tops are beginning to form. It’s time to be conservative.