Who to Believe — Bonds or Stocks When it Comes to the Economy?

Waving United States of America and Australian flags on the background of the political map of the world
Reddit

The looming Federal election on 2 July could prove to be tricky timing for any number of companies.

Yesterday, the Senate failed to pass bills introduced by the government that aimed to increase the regulation of unions. This failure triggered a double dissolution election, a term which refers to both houses of parliament facing a vote at the same time.

Given that some opinion polls currently put the two major parties neck and neck, there is likely to be a reasonable amount of uncertainly over the next few months, which could weigh on economic activity. 

It’s already having an effect, according to Qantas. The Financial Review reports:

Qantas shares have plunged after the airline and its low-cost spin-off, Jetstar, said it was cutting back planned flights on domestic routes in response to reduced demand from Australians worried about the economy and the upcoming election.

At first, this seems like a copout. Blaming an election that is still 10 weeks away for a drop off in demand looks like Qantas is searching for an excuse. But there could be something to it.

Australian politics is in disarray. People know that, at some level, the country is heading down the wrong path. And they know that we don’t have the leadership qualities to reverse course or manage the situation.

We need a period of tough reforms, but neither politicians nor the electorate have the appetite for it. In these circumstances you need a strong leader to drive the narrative.

Malcolm Turnbull has been a clear disappointment on this front. Instead of pushing a reform agenda, his main contribution has been to push the concept of an ‘ideas boom’ through an Orwellian advertising campaign.

Ideas need nurturing and development to evolve into globally-competitive, productive contributions to our economy. That starts with a competitive tax regime. But, instead of actually doing something to promote ideas, the government satisfies itself with an advertising campaign.

That will do nothing for the Australian economy, apart from making people think that someone, somewhere, is actually doing something useful.

Getting back to Qantas, I can see how businesses might want to pull back on making any major decisions while a potential change of government looms. That means less activity.

There are questions over how many other companies might feel the effects of this shift in sentiment. We’re coming up to confession season (whereby companies warn on profits ahead of the end of financial year), so we’ll begin to see whether there is a general election effect on profits over the next few months.

Turning to the US, I read a recent investment report that contained some disturbing information, and perhaps gives some insight into what Australia can expect to confront in the future as our overall debt levels grow higher.

The report, by Hoisington Investment Management, analysed debt trends for the US economy throughout 2015. It found that, while nominal economic growth expanded by US$549 billion during the year, non-financial debt surged US$1.912 trillion.

In other words, non-financial debt (which includes household, business and government debt) rose at 3.5 times the rate of economic growth in the US last year.

The report states:

During the four and a half decades prior to 2000, it took about $1.70 of debt to generate $1.00 of GDP. Since 2000, however, when the nonfinancial debt-to-GDP ratio reached [harmful] levels, it has taken on average, $3.30 of debt to generate $1.00 of GDP. This suggests that the type and efficiency of the new debt is increasingly non-productive.

And the US economy is the pin up economy for the developed world?

That’s a worry.

The Hoisington report also revealed concerning trends in the business sector. This is important because business performance and profits ultimately drive the stock market. That being the case, you’d have to wonder whether US stocks, hovering near record highs, are justified given the economic environment.

In the past eight quarters profits fell 6.6%, the steepest drop since the 2008-09 recession. On only one occasion since 1948 did a significant eight quarter profit contraction not precede a recession.

The question is: did the market price this profit contraction earlier in the year? And is it now looking ahead and seeing improved profits in 2016? Not so fast, say the folks at Hoisington:

The jump in corporate debt, combined with falling profits and rising difficulties in meeting existing debt obligations, indicates that capital budgets, hiring plans and inventory investment will be scaled back in 2016 and possibly even longer.

All of these things are necessary for healthy economic growth. If the Hoisington analysis is correct, then you’re going to see US stock markets roll over soon. There just isn’t enough profit momentum to push the indices to new highs.

The bond market doesn’t appear too confident about the economy either. US 10-year treasury bonds currently yield around 1.77%. That compares to June 2015, when yields peaked around 2.5%…or late 2013/early 2014, when yields hit 3%.

Rising bond yields signify a strengthening economy and inflationary pressures. Right now, the US bond market isn’t concerned about either of these things. At the current yield, it’s only about 40 basis points from the all-time low reached in 2012, when it looked like the Eurozone was about to break up.

Are bonds right in continuing to signal deflation? Or is the stock market correct in seeing inflation on the horizon? The message from these two markets tells you there are massively diverging opinions about the path ahead for the US economy.

Or maybe it just shows you the results of central bank mismanagement…and a deliberate policy of financial repression. 

Cheers,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
Reddit

Leave a Reply

Be the First to Comment!

Notify of
avatar
wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au