Why It All Hinges on the Building and Construction Sector

Stocks were weaker overnight following ‘disappointing’ comments on the likelihood of more stimulus from European Central Bank boss Mario Draghi.

What the…? Hasn’t the ECB been flat out for years now? And still disappointed!

Yes, but the market hoped Draghi would reveal another extension to the QE program overnight. From Bloomberg:

Traders were taken aback by Mario Draghi’s signals that the ECB is in no rush to boost its asset purchases at a time of mounting concern over a euro-zone recovery after the U.K.’s secession.

More mixed signals from central banks?

There was a G20 conference just recently. Perhaps Janet Yellen had a little one-on-one with Mario…and said something like:

‘Mario, we’re trying to convince markets we’re going to raise rates…with you and Kuroda (Bank of Japan boss) pumping money like mad, that’s pressuring the dollar and slowing our economy. If we go down, you go down. Go easy on going easy for a while and let’s see what happens. The financial markets have just about got us pegged. They’re out of (our) control. We need to stick together here and provide confidence that all is well.’

Or maybe not. Who knows what was said.

But there is no doubt central bankers do get together for backroom chats that you and I don’t hear about. They’re all playing the game together…with their own set of rules. They’re trying to rig the outcome, of course, but markets don’t play to anyone’s set of rules. It eventually outsmarts everyone.

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I reckon outgoing RBA boss Glenn Stevens knows this. It’s just that he can’t do anything about it. As much as he has tried to wake Australia up to the challenges it faces with his words, during his tenure his actions had the opposite effect. The irony is extreme, as his statement below, from today’s Financial Review, makes clear:

Reserve Bank of Australia governor Glenn Stevens has delivered a rebuke to the nation and its leaders, warning that 25 years of economic growth have bred complacency over what it takes to fix the budget and prepare for the next crisis.

In his final extensive interview as governor, Mr Stevens said the record run of growth, officially confirmed on Wednesday, threatened to leave voters and politicians with the deluded view that it’s “just the natural state of affairs, that we don’t need to do anything to achieve it”.

“That’s not really so. It’s not a game. It’s not a sporting event that we like to spectate on. It’s real.”

Indeed it is. As I pointed out yesterday, without such heavy government spending in the June quarter, the Aussie economy would have actually contracted. Yet a large portion of the mainstream media was plastered with pompous, self-congratulatory commentary on how well we’re doing.

Unfortunately for Stevens, he’s largely responsible for the nations’ complacency. There’s nothing like a good dose of easy money to anesthetise the mind of any concern about economic performance.

When money is flowing through the economy, it’s natural for the majority of people to think everything is all good. The average person doesn’t realise that the source of the money flow comes from debt creation. Debt that must be serviced…

This is a long term problem that will stay long term…until it suddenly becomes short term. When that shift will occur, no one can tell. The market doesn’t seem too concerned about it right now, but it’s something to keep in mind. Forewarned is forearmed, as the saying goes.

In the meantime, let’s see what the market IS concerned about.

Yesterday, I pointed out that household spending grew at the slowest pace since the June 2013 quarter. But the consumer discretionary stocks index is only just off record highs. Check out the chart below:

Source: Optuma
[Click to enlarge]

Not surprisingly, this index of stocks is very sensitive to interest rates. Note the two recent surges relate to the May and August interest rate cuts. The strong performance of consumer discretionary stocks suggests there is still a fair bit of momentum in the consumer economy…despite what the economic growth data indicated yesterday.

Of course, the chart not only reflects spending growth, it reflects the natural response of asset prices to lower interest rates. That is, lower interest rates naturally lead to what’s called ‘multiple expansion’, irrespective of whether earnings grow or not.

For example, say a stock trades on a price-to-earnings multiple of 10 times. Then, the RBA cuts rates twice and, a few months later, the stock trades at 12 times earnings, despite the expectation that earnings will not grow. That means ‘multiple expansion’ accounts for a 20% share price increase.

But if earnings start to fall, multiple expansion will have the opposite effect, regardless of interest rates.

So I’m keeping an eye on the consumer discretionary index. Right now it looks OK. And if you look at the chart above again, I wouldn’t get overly concerned until it breaks down through the green support line.

If that occurs, it will suggest the consumer is not well.

I think a more important sector to look at near term is building and construction. The big risk to the economy is that housing and apartment construction turns down sharply.

Should that happen, the flow on effect to the household sector would only be a matter of time. More on Monday…


Greg Canavan,
For Markets and Money

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money 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 Markets and Money for free here. If you’re already a Markets and Money 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 Markets and Money emails. For more on Greg go here.

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