Kohler's Week: A tough 1st quarter, What the correction is really about, Is a recession coming? ANZ, Wesfarmers, Greenearth Energy, DWS, Holiday snaps

Last Night

Dow Jones, up 1.23%
S&P 500, up 1.41%
Nasdaq, up 1.75%
Aust dollar, US70.5c

A tough 1st quarter

No, I’m not talking about today’s Grand Final, although if it’s anything like the last time these two teams met it will indeed be a pretty brutal first quarter. I’m talking, of course, about the first quarter of FY16 for investors: the ASX 200 fell 8 per cent on top of the 6.4 per cent fall in the final quarter of FY15, for a total six-month correction, so far, of 15 per cent. The global MSCI fell 8.9 per cent in Q1 of this year and the US S&P 500 fell 7 per cent.

That’s what you got if you invested in exchange traded funds – that is, the market as a whole. But here’s the performance of each component of the Eureka Report Growth First model portfolio for the quarter:

Ridley 3.6%
GWA 8.8%
Empired 10.5%
AMA Group 57.1%
Capitol Health -26%
Brickworks 12.5%
Tox Free -15%
Qube -18%
Vita Group 9.7%
Netcomm 99%
DWS 67%

That’s an unweighted average for the stocks themselves of 19.1 per cent, while the model portfolio, which includes 30 per cent cash at the moment, returned 8.8 per cent. My own portfolio did slightly worse (why, oh why, do I stray?) -- 12.6 per cent for the quarter.

This is not to boast, or to give a shameless plug to the ER Growth Portfolio (although there’s a bit of that I admit), but to point out that there’s a big difference between investing in “equities” and investing in companies.

I don’t agree with treating equities as an asset class, never have. The stock market is a collection of companies that happen to have made their shares available to the public to buy and sell in order to raise capital. There are several advantages of employing this method to save, rather than buying into private businesses: it’s easy to get in and out, there’s regulated disclosure of what they’re up to and you can check the prices, and therefore your wealth, regularly.

That might seem pretty obvious, but there’s also a big disadvantage: you’re part of a very large mob that occasionally stampedes irrationally, and the mob increasingly includes mysterious computer programs and algorithms. There’s also another big disadvantage if you invest by just buying the whole market, either through an ETF or an “index-aware” fund manager: you end up having most of your money in big companies simply because they’re big, not because they’re any good.

This is essentially what Warren Buffett is on about, and has been for 50 years – take no notice of the market, just invest in great businesses. Few investors – professional or private – actually do this because they treat “equities” as an asset class rather than a collection of listed businesses that you can invest in, and they measure themselves against the index not against opportunity cost. If a fund manager loses less than the index, he or she is a winner! Buffett’s first rule, you’ll remember, is: don’t lose any money.

Investing in great businesses is easily the best way to grow your wealth; investing in “equities” is a distant second and is often a good way to lose it.

So my advice about how to deal with share market corrections like the one we’ve just had and might still be having? Ignore them. Focus on the businesses.

What the correction is really about

As noted, the correction is 15 per cent, which is so far larger than any since 2011, when the market dropped 20 per cent. The most common explanation for it is China’s slowdown, with Glencore thrown into the mix this week, but in my opinion these things are furphies. It’s not about China – it’s about the US.

I’m certainly not forecasting an American – or Australian – recession (see below), and nor is the market, but fund managers have been adjusting their settings around the economic risks in the United States. Unless something changes, specifically a recession does develop, I’d say the adjustment is just about done, although last night’s payrolls report in the US puts that view under a bit of pressure.

US employers added 142,000 new jobs in September, well below market expectations for 200,000. It was a poor result, even though unemployment stayed at 5.1 per cent, and economists are now ruling out a 2015 rate hike. The stock market fell sharply at first but has since rebounded.

The weak employment data adds to five other factors about the US that have been weighing on the market and are, I think, the reason for the correction:

First, since the Federal Reserve cancelled the expected September rate hike two weeks ago, the S&P 500 has fallen, not risen. Normally, given the market’s focus on all things Fed, the opposite would have occurred, but investors took the decision negatively – that is, the economy is not strong enough for rate “normalisation”.

Second, the OECD leading indicator for the US has gone negative year on year and is now below average.

In this graph from the OECD website, the US is the purple line, China is red (what else?) OECD average is black and Europe is blue. Note how weak China is, by the way, and the relative strength of Europe.

US economic indicators all look pretty good at the moment, but this one looks forward, and it’s not so good.

Third, the GaveKal “US recession indicator” has deteriorated sharply in recent months and has also gone negative.

GaveKal is a research house that I subscribe to, run by various Gaves – Charles, Pierre, Louis – as well as Anatole Kaletsky (Kal). Their recession indicator is an index of 16 components ranging from lumber prices and high-yield bond yields to the financing gap of the US corporate sector. In explaining the above graph, Charles Gave says: “Each time the indicator has gone negative and stayed that way for a few months, a recession has followed in quick order.”

“The indicator has fallen sharply in recent months, mostly because of a decline in the “activity” components. By contrast the financial components have barely budged, which may or not be a sign of complacency among investors. The factor keeping the indicator in positive territory is that most financial spreads are still recording positive readings, while interest rates remain very low. The likely factor that will push the indicator towards zero is a further rise in bond spreads or alternatively a decline in spreads that is accompanied by a fall in US inflation.

“In this event I would expect the stock market to decline sharply and long-dated Treasuries to rally. The US dollar would probably resume its uptrend since a decline in the US velocity of money in effect amounts to a money supply tightening, but I do not get the impression that most investors consider this scenario likely. If it were to happen, then most portfolio managers would need to adjust their positions rather brutally resulting in significantly higher volatility for most asset classes.”

Fourth, the Fed has already been tightening, even though interest rates have stayed the same at 0-0.25 per cent. That’s because there is more to monetary policy than interest rates, especially these days with quantitative easing.

The Federal Reserve Bank of Atlanta regularly publishes what it calls the “shadow fed funds rate”, which takes into account other things than simply the fed funds rate – specifically it measures the effect of QE on market interest rates as well as the even less tangible “mindset” of investors, who now regard “cash as trash” and go hunting for yield. It’s named after researchers Jing Cynthia Wu and Fan Dora Xia, who published a paper on the subject in June last year.

Here’s a chart of the shadow fed funds rate I got from Trilogy Global Advisors. As you can see, there has already been an effective tightening equivalent to a 3.4 per cent increase in interest rates:

And fifth, US housing needs to keep strengthening at the current rate to prevent a slowdown.

In a recent note, Gerard Minack pointed out that the US economy “has never fired on all cylinders through the current expansion, but just as one cylinder seemed about to conk out another has spluttered to life”.

First there was shale oil, then exports, now housing is the most important area of strength. Residential investment has been rising as a share of GDP for more than two years, but is still well below long-term averages.

"If housing does not lift its GDP contribution then US growth could fall significantly short of forecasts next year. Put another way, acceleration in housing is not something that points to stronger US growth next year; it is required to prevent a slowdown. Ironically, the US will depend more heavily on an interest-rate sensitive sector to maintain growth just as the Fed seems set to start a tightening cycle.”


The question of whether Australia is heading into a recession is relevant to us all, whether we invest in companies or equities.

Reserve Bank Governor Glenn Stevens recently said there is “more or less” a 100 per cent probability of a recession … only the timing is uncertain. Ha ha, but what will the timing of the next one be?

To cut to the conclusion: there probably won’t be one in the next year or two, but the risk of it is rising. Here’s a graph of the Bloomberg survey of what economists think is the chance of a recession in the next 12 months:

The consensus GDP growth expectation for 2016 is, in fact, 2.7 per cent. The forecasts range from 2 to 3.2 per cent, so a pretty wide range, but no economist is predicting a recession.

Personally, I’d be towards the top of the Bloomberg survey – around the 30 per cent mark – not my “base case” as the boffins say, but a risk.

To some extent it’s all about what you measure. Real national income per capita has fallen for 12 consecutive quarters. The “income recession” is real, and entirely unprecedented in its length and depth. Just as there had never been a mining and terms of trade boom like the one between 2005 and 2011, there has never been a contraction in national income like the one we are experiencing now, and what’s more it almost certainly has further to go.

But we don’t measure that when we talk about recession, we measure the volume of output, not the price. In a way, this is really dumb. Can you imagine a company reporting only the volume of its sales, rather the dollars it got for them? It would be drummed out of the ASX in a flash.

But when looking at the national accounts, and writing headlines about economic performance, we look only at volume. And the fact is that export volumes are still running at record highs, even though the prices of them have collapsed. Here’s a graph of resources export volumes:

… And other exports:

Volumes have fallen in the latest quarter, but as you can see they have been growing strongly, even as prices have collapsed:

Essentially the income recession makes the economy feel worse than it is, as measured by GDP. It compresses household income, corporate profits and tax revenue and gets transmitted through the economy via lower consumption and investment, but while output volumes stay up, the economy stays out of technical recession.

So to some extent, the fact that we haven’t had a recession and no economist is predicting one is simply a statistical anomaly, a function of what we measure. If Australia was a company, it would be reporting losses from a decline in the value of sales and rising costs.

The thing about a GDP recession, as opposed to a GNI (gross national income) one is that it gets reported as such: RECESSION! scream the headlines, which has its own effect on confidence.

And the next one, if it happens in the next few years, will have a couple of new characteristics: household debt is at a world-record high of 134 per cent of GDP (higher than any other country) and there is very little ammunition left for either the RBA or the Government to do anything about it. It’s true that the cash rate is 2 per cent, which is better than zero, and can therefore be cut some more, but the fiscal budget is in poor shape and couldn’t provide much more stimulus, if any.

Most recessions occur because of an official mistake – either monetary policy that’s too tight or a budget clampdown, and by definition that means there is plenty of room to cut rates or boost government spending to compensate. Not this time.


ANZ became the fourth of the big four to appoint an internal candidate as CEO this week – CFO Shayne Elliott will replace Mike Smith at the end of December after an eight-year reign by the externally recruited Smith.

It is a great sign of management and governance quality at Australia’s banks that they have all been able to go inside for succession, and should give shareholders a lot of confidence. Obviously there are some uncertainties in the outlook given the pressure on their capital and the fact that the credit cycle may be bottoming, but internally at least the banks have all got their acts together.

The only sign that Shayne Elliott’s approach might be a bit different to Smith’s was the emphasis he placed at the press conference on capital: “The mark of any great company is its ability to reallocate its capital, part of its intellectual capital, if you like,” he said. Not that Mike Smith misallocated capital, but it seems Elliott might be more focused on capital returns, especially in Asia. Nothing wrong with that.


The main interactive interview this week was with Richard Goyder of Wesfarmers, who was in town partly for the Grand Final (he’s an AFL commissioner). As always Richard was frank and expansive and well worth paying attention to.

Number two this week was a catch up with Sam Marks of Greenearth Energy (one of the stocks in my portfolio). It used to a be geothermal energy play, but now is focused on smart lighting through a business called Vivid Industrial (which is, in fact, what the whole company is probably going to be called soon) and a third share of an Israeli start up called NewCO2 Fuels, which is able to convert carbon dioxide into synthetic gas and oxygen, and the gas can be used for energy and can even be turned into diesel. I am extremely excited about both of Sam’s businesses, but especially NewCO2 Fuels in light of the global pressure to reduce CO2 emissions. Here’s an article about it in The Times of Israel.

The third interview is with Danny Wallis of DWS Ltd, a stock that’s in both our growth and income portfolios. It’s currently on a PE of less than 10 and a yield of 8 per cent, fully franked. The reason it’s cheap is that Danny, the founder, stepped down last year and the business quickly lost its way, profit fell and the share price fell from above $1 to 60c. He’s still a 44 per cent shareholder so he quickly stepped in and resumed control, and is turning the business around again, although the results have yet to come through. Definitely a “buy”.

Readings & Viewings

(or some of things I’ve been reading on holidays)

Magnificent – the Welsh national anthem, sung by the entire crowd at the rugby world cup.

All of the AFL club songs ranked according to boastfulness.

China is ruled by thieves.

Europe’s refugee crisis – the terrible flight from the killing.

Europe needs more, not less, economic migrants.

There is much in common between the refugee crisis and the euro crisis.

No matter how bad your day is, at least you’re not stuck in a fence being laughed at by a cow.

Sweden introduces a six-hour work day.

How the Liberal Party machine swallowed the real Tony Abbott alive – terrific piece on why Abbott failed.

Jeff Kennett’s vitriolic spray against Malcolm Turnbull.

The delusion of Tony Abbott.

The victims and casualties of Peta Credlin.

A profile of Malcolm Turnbull published in 1991.

And in case you missed it, the NT News’ magnificent front page after the spill:

A fascinating interview with Yanis Varoufakis.

Interesting piece on the Volkswagen scandal – it came out of Europe’s climate politics.

30 charts and maps that explain China today.

The “sharing economy” is now a playground for Wall Street.

The full text of Pope Francis’s speech to US Congress – well worth a read.

Israel is an insignificant country.

All human activity is prompted by desire – Bertrand Russell’s great Nobel Prize speech.

34 funny tweets about life. e.g.: JUDGE: You unplugged your grandmother’s life support! ME: [lips right on the mic] My phone had 1%, your honour.

The Japanese Government has told Japan’s universities to their humanities and social sciences faculties!!

Paul Krugman – the rage of the bankers.

Richard Dawkins explains the evolution of the human eye (on video).

For years the financial economy has trumped the real economy. Now it’s payback time.

Remarkable video of landing an Airbus A340 with engine failure.

Mark Steyn on why the Queen is a unifying presence.

This may be the most important story you’ll read all week – tuna and mackerel populations have declined 74 per cent.

There are 1.4 billion Android devices around the world now – Google is unstoppable.

Let Skynet become self-aware!

The fall of the meritocracy.

And here are a few happy snaps from my holiday:

A dreadful croque monsieur in France the size of a small paddock

The screen on the fast train in France – 299kph!

Dancing in a square in Barcelona

The Sagrada Familia cathedral, designed by Antoni Gaudi, in Barcelona. Awesome

Last Week

By Shane Oliver, AMP

Investment markets and key developments over the past week

The past week has been particularly rough in share markets – which is par for the course as I had a few days annual leave and markets invariably turn sour when I am away! Worries about Chinese/global growth and the Fed helped push the US share market back down to near its August low and several markets to new lows, including Australian shares. While shares rebounded from mid-week from oversold levels, enabling Australian shares to rise over the week, most share markets still ended down. Bond yields mostly fell reflecting safe haven demand and low inflation readings, but commodity prices were mixed and the $A managed a modest gain after recovering from a fall back below $US0.70.

From their highs earlier this year to recent lows US shares have had a fall of -12 per cent, Australian shares -18 per cent, Eurozone and Japanese shares -19 per cent, Emerging market shares -22 per cent, Asian shares -23 per cent and Chinese shares -43 per cent. Interestingly the weakness over the last week has seen emerging market, Asian and Chinese shares hold above their August lows.

September and the September quarter have clearly lived up to their reputations as poor months for shares with worries about global growth and the Fed driving the worst September quarter for global shares (-8.1 per cent) and Australian shares (-8 per cent) since the September quarter 2011. We are still at risk of more weakness in the next few weeks as global growth and Fed concerns remain. This is particularly so for the US share market that has had the smallest decline but is the most vulnerable in terms of valuations on some measures and the only major market with a central bank getting close to tightening.

However, with the seasonally weak September quarter behind us and October known as a “bear killer” month ahead of seasonal strength into year end and our broad view that the cyclical bull market in shares will resume thanks to attractive valuations, very easy global monetary conditions and extremely bearish investor sentiment that is normally associated with market bottoms it makes sense to start averaging into shares over the next month or so for those looking to allocate cash. The failure of commodity prices and emerging market shares to go to new lows through the September pull back in shares is a positive sign in this regard. So far share markets seem to be following a very similar pattern to that seen in both 1998 and 2011, that saw initial sharp falls into August, followed by a bounce and then a retest or new lows around late September/October, followed by gains into year end. History may not repeat but it does rhyme.

More stimulus from China and potential signs of growth bottoming. News early in the week that Chinese industrial profits fell nearly 9 per cent over the year to August didn't help share markets but thereafter the news out of China improved a bit. Firstly, China is continuing to announce more stimulus measures with in particular a sales tax cut on small cars and another reduction in the required deposit ratio for first home buyers. Second, economic data took on a slightly better tone with consumer confidence rising to its highest since May last year, the official manufacturing PMI rising slightly in September, the Caixin flash PMI being revised up and average home prices continuing to rise in September. While it’s hard to see a big rise in Chinese economic growth, the downside risks may be starting to recede a bit.

US Government shutdown averted for now. US Congress - once again at the last minute - passed a bill extending US Government financing out to December 11, averting the threatened October 1 shutdown. Of course this just means that the issue will now come up again in December when it will get rolled into the need to raise the debt ceiling again. This could see more brinkmanship as 30 or so ultra-conservative Republicans seek to defund Planned Parenthood, the GOP leadership is likely to remain more focussed on next year's elections and so a shutdown/debt ceiling crisis is likely to be avoided.

Australian mini-summit on the economy a positive sign. The combination of slowing population and productivity growth and the end of the commodity boom has clearly cut into Australia’s growth potential. Our own assessment is that potential growth has fallen to around 2.75 per cent pa and the IMF appears to have come to a similar view. The best way to turn this around is with a reinvigorated economic reform agenda – focussing on the tax system, labour and product markets, government spending and infrastructure. Explaining the need for reform and building community support for it is essential so having the mini-summit in the last week between the Government and various community groups is a good move.

Major global economic events and implications

US economic data continued to point to an economy with growth averaging around 2-2.5 per cent. No boom, but no bust either. On the solid side consumer confidence surprisingly rose in September (despite share market noise), vehicle sales rose to their strongest in 10 years, construction spending rose more than expected and jobs data remained good. Against this, pending home sales fell in August and a worsening goods trade balance points to a trade detraction from September quarter GDP growth. National manufacturing conditions PMIs painted a mixed picture with the ISM index falling to 50.2 but the broader Markit manufacturing PMI remaining solid at 53.1. Meanwhile, the Fed's preferred inflation measure, the core private consumption deflator, remained low at 1.3 per cent year on year in August. Fed officials continued to speak but simply lined with up with the dot plot from their last meeting that indicated 13 of 17 Fed committee members see a rate hike this year.

Eurozone economic data remained pretty good with overall economic sentiment in September rising to its highest in more than four years and at a level consistent with a pick-up in growth. While CPI inflation went negative again in September at -0.1 per cent year on year, core inflation was unchanged at 0.9 per cent and on its own this is not enough to move the ECB to step up its quantitative easing program. While Catalan pro-independence parties won a majority of the seats in the Catalonian regional election in Spain, they failed to receive a majority of the vote indicating that the case for independence has not been advanced. Spanish bonds and equities outperformed over the last week as a result.

Japanese economic data was mixed with weak industrial production and the Tankan business survey showing softer conditions for manufacturers but against this stronger housing starts, continuing solid jobs data, stronger household spending and the Tankan survey showing stronger conditions for non-manufacturing businesses.

Australian economic events and implications

In Australia, building approvals fell more than expected in August and while they are still strong they do look to have peaked along with new home sales suggesting that the contribution to growth from housing construction will slow next year. Retail sales bounced back in August after a July fall but still look to have lost a bit of momentum relative to last year. Against this, ongoing growth in job vacancies (up 10 per cent over the year to August) and the manufacturing PMI rising further to 52.1 in September are positive signs. National average home price growth remained strong in September, but annual price growth out of Sydney and Melbourne remains poor with four cities seeing falls. Expect to see a slowing in Sydney and Melbourne home price growth in the months ahead as APRA measures impact, with credit data for August already showing a significant slowing in investor lending in the last two months. The latter will be easing RBA concerns on the housing front and providing more flexibility on the interest rate front.

Next Week

By Savanth Sebastian, CommSec

RBA meeting dominates focus

An interesting week is in prospect, dominated by the Reserve Bank of Australia board meeting.

In Australia, the week kicks off on Monday on a somewhat disjointed note. In NSW, Queensland, the ACT and South Australia there are public holidays. But the sharemarket is open while car sales, the monthly inflation gauge and job advertisement figures are released. Inflation is well contained and the job market is picking up.

On Tuesday the RBA board meets and it is a safe bet that interest rates will be left unchanged for a fifth month (six months of rates at 2 per cent). However the accompanying statement is likely to be somewhat different from the September decision. Over the past month some domestic and global economic conditions have shifted – particularly when it comes to commodity prices and the Aussie dollar. But we don’t believe that the RBA will change its interest rate stability rhetoric – at least not this year.

The Australian Bureau of Statistics releases statistics on tourist arrivals and departures on Tuesday together with longer-run migration data and international trade data. In addition ANZ and Roy Morgan releases the weekly consumer confidence rating.

The trade data – while important – has lost relevance for investors. So the main focus will be on consumer sentiment survey. In the past fortnight consumer confidence has surged by 8.7 per cent (the biggest weekly gain in the history of the survey) before falling by 3.4 per cent. last week. The next few weeks will be more telling on whether the recent positivity is sustained. No doubt the future performance and direction of the new administration will be key. The hope would be that the increased confidence is certainly a positive for the Australian economy – hopefully translating into increased spending, investment and employment

On Wednesday, the Housing Industry Association releases figures on new home sales – a useful indicator on the state of home building.

And on Friday, housing finance data is released. Data from the Bankers Association suggests that the number of owner-occupier loans rose by 5 per cent in August while the value of all loans rose 6 per cent. Clearly the focus will remain on the strength of investor loans compared with owner-occupiers (that is, those buying homes to live in rather than as an investment). Overall the demand for homes is strong, but with dwelling approvals at record highs, supply is lifting to meet the higher demand.

Overseas: A quiet week in prospect

It is one of those rare weeks: few ‘top shelf’ indicators for release in the US; and holidays dominating in China. But it is a big week for the US Federal Reserve with the minutes of the last policymaking committee and no fewer than five speeches planned by Federal Reserve governors and presidents.

The week kicks off on Monday with the release of the ISM non-manufacturing survey. The services sector has been expanding at a healthy rate and the trend should continue with a reading of 58.0 tipped for September On Tuesday, the usual weekly chain store sales data is released in the US together with monthly trade data and IBD Economic Optimism index.

On Wednesday the weekly report on mortgage transactions – purchases and refinancing – is released alongside consumer credit data for the month of August. Economists tip consumer credit to have lifted by $US18 billion.

On Thursday, weekly data on claims for unemployment insurance is issued together with minutes of the last Federal Reserve policymaking committee meeting (FOMC). Investors hope that the minutes can provide some broad hints on the likelihood of a rate hike later this year.

On Friday wholesale sales/inventories figures and data on import and export prices is released.

Sharemarkets, interest rates, commodities & currencies

In light of recent developments, CommSec is revising down its forecasts for the ASX200 and All Ordinaries indexes. We now expect the key share indexes to be between 5450-5600 points by end year and 5600-5800 points by mid-2016.

Certainly the broader Australian sharemarket is well supported by solid fundamentals –strong company balance sheets and “OK” earnings. And valuations suggest fair value with the one-year forward price-earnings ratio falling from a high of 17.6 in late April to currently hold at 14.8 (in line with the decade average).

But a weaker Australian dollar has recently prompted some overseas investors to book profits. An easing in Chinese growth and weaker commodity prices have also weighed on investor sentiment more generally. It is probably fair to say that domestic and foreign investors have also been more attracted to the local housing market rather than the sharemarket over the past year.

Looking ahead, the Australian economy is expected to lift over the coming year, underpinned by low interest rates and record home construction. The lower Aussie dollar will also provide a boost for local businesses. Further, the Chinese economy should continue to expand by 6-7 per cent, with solid volume growth expected for commodities. And the US economy continues to heal, with the Federal Reserve inching closer to lifting interest rates.

Investors should also remain attracted to yields on offer across the sharemarket especially in relation to low domestic interest rates and prospects of slower home prices and a softening of rental yields.

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