Gerard Minack of Morgan Stanley did some straight talking to clients recently hitting on many key issues that have been discussed on this blog for months. Firstly, earnings expectations are far too high and some type of mean reversion is in order. Secondly much of the boom in recent years has been funded by cheap credit pushing households deeper into debt. That era is now coming to a close. Third China will not save the day. From the Australian:
Australia faces recession: analyst
THE economy is headed for recession next year, with a 50 per cent plunge in share values and a double-digit drop in house prices. Do I have your attention?
While the Reserve Bank takes a largely benign view of the unfolding credit crisis, believing China’s growth will insulate us from its worst consequences, others are less sanguine.
Morgan Stanley’s chief market strategist Gerard Minack introduced a brief to clients last week saying, “I’m bearish - really bearish.”
He argues that Australia will be dragged into recession by a slowing world economy, the tightening grip of the credit crisis, and the effects of the Reserve Bank’s succession of interest rate hikes.
Economists are often trapped by the inertia of the moment, failing to see the magnitude of both booms and busts and being forced into constant revisions of their forecasts.
This makes Minack, who takes a long view, worth listening to.
He argues that the market is coming to the end of its fifth bull run since the beginning of the 20th century.
As the chart (which adjusts the all-ordinaries index for inflation) shows, the bear markets that followed, produced falls in the region of 50 per cent and lasted for two to three years.
The problem is not that the market is overvalued, relative to earnings, but rather that earnings are themselves inflated and headed for a fall.
Based on profit figures back to 1970, earnings are 44 per cent above their long-term trend.
In the three recessions since then, real earnings per share fell by between 36 and 65 per cent from peak to trough.
“You’ve got to argue that earnings do revert to their mean. On almost every measure we’ve got for earnings, be it profit share of GDP, return on assets or margins, it looks unsustainable,” he says.
Earnings have been inflated by spendthrift households running down their savings. While the Reserve Bank has argued that fears about housing debt are without foundation because household balance sheets are strong, Minack says the picture looks a lot worse when you look instead at household cash flow.
The latest annual national accounts show the household sector remains cashflow negative, with the deficit of 3.75 per cent of GDP accounting for half the current- account deficit.
Besides, he says, household balance sheets also looked fantastic in Japan in 1990, before its lost a decade of economic growth.
Minack is not persuaded by the proposition that Australia’s housing market is somehow immune from the excesses of the US.
Australians have more leverage, are as reliant upon equity extraction and base their household balance sheet on a housing stock that is far more expensive than their American equivalents.
The household sector is booming at present, but is vulnerable to any reversal in fortune. The moment unemployment starts to rise, people will start defaulting on their housing loans.
The view that Australia will be saved by China and the resources boom underestimates the magnitude of the forces ranged against us.
China’s growth may continue to require large flows of commodities, but commodity markets at present are being driven by speculative money that can flee as quickly as it came.
Base metals prices could fall by 40 per cent and bulk commodities by 15 per cent without heralding the end of the Chinese driven “super-cycle”.
Commodity markets are facing not only the prospect of a recession in the US, but also the possibility of recessions in Japan and Britain, with a slowdown in Europe.
The long-awaited rise in the volume of mining exports will not save us, with Minack calculating it will raise GDP by, at most, 0.1 or 0.2 percentage points. The terms of trade, by contrast, has lifted GDP by about 9 per cent, while the increase in business investment caused by the resources boom has added about 3.5 percentage points.
“People react as though there is some injustice. Here we are with the market down 20 per cent, when our economy looks strong and China keeps growing,” he says. “People miss the point that we’re hugely wrapped up in the global credit crunch because we are one of the world’s largest issuers of capital, with the most over-priced finance sector in the developed world and a rickety housing sector.
“People think we’re Teflon coated because of links to China. I don’t think that’s true.”
The point of listening to bears is that they have taken hold of the markets. Minack says if you took the spreads on credit-default swaps literally, you would be forecasting financial Armageddon. Based on the latest benchmarks for default spreads, 7.8 per cent of investment grade corporate debt in the US is expected to default, more than double the worst actual default rate in the last 40 years.
Credit markets do not expect Australia to remain immune, with default spreads on corporations here rising in line with those in Europe and the US.
Markets overshoot - and Minack believes they have - but he is not convinced they have yet reached their bottom.
It reverses the overshoot when margins were so unrealistically low that investors took on huge leverage so that they could make a return. The point about the panic in credit markets is that it affects the real economy.
“That’s why there’s no point in asking whether the credit markets or the equity markets have it right,” he says. “Dislocation in credit markets puts a cloud over the economy and over equity.”
It is an unfriendly environment for one of the world’s largest debtor economies.