ANZ reported results this morning. Cash earnings and dividends were up an impressive 11% and 13%. It seems like it’s always earnings season for Australia’s banks.
An interesting tidbit about banks generally is that interest drives their profit. In other words, repaying your loan is not a good thing for them because it reduces the amount of debt in circulation and thereby the amount of interest they receive.
In fact, interest only loans are a bankers’ dream: A stream of profits without having to find a new victim…err customer as the loan balance falls. Even better are rising house prices, because customers top up their loans.
Not that the average Aussie has done badly out of the credit boom. At least on paper. According to Credit Suisse, the median Australian is by far the wealthiest in the world. Almost five times richer than the median American. But only about four times richer than the median Greek.
You guessed it; house prices were the source of the wild disparity. Of course, borrowers had to create all that home equity, which means cash sent to the bank as well as any capital gains. Leveraging rising asset prices also gives you a leveraged downside though. All that wealth can evaporate darn fast.
Investment manager Perpetual points out that, going by price to book, our big four banks have hit valuations above the tech bubble and the financial crisis. Anyone game to buy?
We discussed how monetary policy creates an imbalance in an economy’s capital structure yesterday. Low interest rates encourage parts of the economy that rely on debt over those that don’t. ANZ’s $6.5 billion cash profit and remarkable share price highlights the imbalance, not to mention house prices. Not that the Reserve Bank of Australia governor Glenn Stevens is worried about what this means for the future.
Instead, he pondered the strong Australian dollar at an investment conference. He’s most definitely not invited to our conference if he sticks his neck out with risky statements like this: ‘It seems quite likely that at some point in the future the Australian dollar will be materially lower than it is today.’ The Aussie dollar promptly fell on the comment, quickly proving him to be right.
But why will the Aussie dollar fall in the long term? Stevens discussed the terms of trade, costs and productivity. Never mind the interest rates he rigs and the money printing going on overseas.
Monetary policy in the developed world has thrown up an interesting question we’d like to pose to you. But first, some background. Here’s the abstract of some ground breaking research done by the American National Bureau of Economic Research (possibly in collaboration with the Bureau for Stating the Blindingly Obvious):
‘We show that “loose” monetary policy – that is having an interest rate below the target rate or having a growth rate of money above the target growth rate – does positively impact asset prices and this correspondence is heightened during periods when asset prices grew quickly and then subsequently suffered a significant correction. This result was robust across multiple asset prices and different specifications and was present even when we controlled for other alternative explanations such as low inflation or “easy” credit.’
Now that we know loose money bids up prices, what does that mean for stock markets around the world?
Well, the real question is whether the Fed can engineer a proper rally this time. The first one gave us the tech wreck in 2000. The rally between 2003 and 2007 barely got above the tech wreck’s 2000 peak before there was another plunge. And this third rally has barely outdone the last one in terms of time and distance, especially adjusted for inflation.
The S&P500’s Three Rallies
click to enlarge
Source: Yahoo Finance
Will it be third time lucky? Is this the rally you’ve been looking for? A new bull market?
On the ‘yea’ side we have a compelling argument. Slowly but surely, the tapering of QE is being abandoned. More QE means higher stock prices.
Recently, the Federal Reserve announced that it plans to never sell its mortgage backed securities. Because of rising interest rates, the central bank faced ‘unprecedented losses and may be unable to remit a profit to the Treasury for as long as six years‘ if it does sell out. Instead, it will hold the securities to maturity. (We just revealed a similar strategy of abolishing price risk in The Money for Life Letter.) That means the central bank’s balance sheet will stay bloated. Of course, by the time the mortgage backed securities mature, all sorts of new money printing programs could be in place.
Here’s a wild prediction for you. A drug dealer will never restrict the supply of drugs. And a central bank will not reduce QE. At least not for long. Each time there’s a pause in QE, or discussion of a pause in QE, stock markets tank. The occasional reminder of just how addicted Wall Street is to loose money probably improves relations with the Federal Reserve.
Also in favour of a continued rally is the change at the helm of the American central bank. A loose monetary policy Fed Chairman is being replaced by an even looser one in Janet Yellen. As a more Keynesian Keynesian than Bernanke, her focus is on the wage level instead of unemployment. In other words, she doesn’t like market prices in the employment market. And she’s quite happy to get some inflation to get wages to pick up, which she thinks will spur on the economy.
The thing is, wages drive consumer price inflation (not just asset price inflation). So this change in leadership could be the link to the inflation so many have been warning about since the start of QE.
Arguing that this is not the rally you’ve been looking for is Vern Gowdie. In fact, he’s predicting a heck of a crash.
Third time unlucky it will be.
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