The headlines on the first couple of pages of The Australian Business Review say it all:
‘Copper sinks to five-year low’
‘Iron ore in retreat as Citi slashes forecast’
‘Coal price under pressure as China demand weakens’
‘Analysts point to $US40 oil’
‘WA leads confidence fall’
On the back of all this ‘good’ news, the World Bank has cut its growth forecast for 2015 from 3.4% to 3.0%. No surprises here — the World Bank, IMF, Fed, ECB, et al are serial over-promisers and under-deliverers.
The debt-infused economic growth model continues to disappoint those who long for a return to the good old days. Minus the private sector’s pre-GFC embrace of debt, the global economy is destined to shrink in size.
Furiously rubbing the stimulatory sticks together for six years has failed to produce the sparks authorities desire to rekindle credit funded consumption. They should realise it’s difficult to ignite a fire when people are drowning in debt.
In a nutshell, there are far too many factories producing far too many ‘things’ for a world that no longer has the level of desire and/or funds to buy all these ‘things’. Hence the slump in the price of commodities that are required to produce ‘things’. Apparently, this is a bad thing.
The banking system is at the very core of the credit-infused growth model. The US banking system has prospered disproportionately:
‘…the American financial-services industry’s share of total corporate profits, [grew] from 10% in the early 1980s to 40% at its peak last year. Its share of stock market value grew from 6% to 19%. These proportions look all the more striking—even unsustainable—when you note that financial services account for only 15% of corporate America’s gross value added and a mere 5% of private-sector jobs.’
When stress appears in a credit based system, it pays to watch the banking sector. In 2007, the signs of what lay in wait started to show in the US banking sector (KBW Bank Index) about six months prior to the overall share market peak. Between May 2007 and November 2007, the KBW Bank Index fell 20%…while the rest of the market continued to rise. The smart money knew there was credit stress in the system.
The KBW Bank Index is again in decline. All the gains of 2014 have been wiped out with a 12% slump since the start of 2015. The contracting forces in the global economy are again putting credit stress into the system.
JP Morgan Chase (the biggest US bank) reported a 6.6% fall in its latest quarterly profit. Is this a sign of things to come in the US banking sector?
In Australia, our banking sector is heavily exposed to the residential real estate market. A deflationary world would impact real estate values. Yes, I know the Australian property market is bullet proof and unlike any other in the world. Just ask any property spruiker — they too will tell you why our property market is destined to go higher and higher.
But let’s just pretend our property market is not actually immune to the forces of global contraction. Let’s say that, due to globalisation we are drawn into the deflationary vortex. Unemployment rises, wages stagnate and social mood is one of concern — these factors are negative for property values.
How much stress can our banks handle in this type of environment? How safe will your money in the bank be?
With banks shares soaring to record highs, questioning the viability of our banking sector seems to be a preposterous indulgence. I can’t help it; I’m the kind of guy who collects firewood in the summer.
The fact is the world can turn quickly…look at the difference in social mood between 2007 and 2008.
Being aware and prepared is essential to successful investing.
The following (edited) email from a Gowdie Family Wealth reader tells me others are also giving thought as to how best protect themselves in the event our financial system is once again placed under unexpected strain.
‘I too have been 100% cash (and renting for the last 3 years) and yes, I am braced for more interest rate pain in the coming year.
‘But, even though up until now I’ve been in 250k lot, 12 month terms, Australia’s deteriorating terms of trade, end of mining boom and elevated property values have me holding serious concerns for a banking system that could well not be as sound in 12 months time as it is today. If you were to agree with this, would it not be more prudent to go for a lesser term, enabling more flexibility should any problems arise?
‘Was it not David Murray who recently said that Australia may have little choice but to adopt bail in rules?
This was my (edited) response to the reader’s concerns:
‘The entire global financial system is fragile. The system survives on confidence and credit.
The efforts of the central bankers for the past six years has been to maintain both.
‘Banks have been recapitalised, provided with guarantees and additional cash holdings. Customers no longer fear their bank is running out of money. In fact, when you look at the share price of banks, investors are falling over themselves to own a slice of the business.
Confidence is a funny thing. Not enough of it and you have a bank run. A little too much of it and you have a run-up in the share prices. We really are fickle.
‘The media talk about the strength of the Australian banking system; I don’t believe it. Our banks are just as vulnerable to a loss of confidence as any other country’s. Banks hold minimal reserves. If confidence deteriorated to such an extent that everyone turned up at their bank tomorrow and demanded the cash, we would end up with Cyprus-like withdrawal restrictions. No question.
‘Our banking system is only as strong as the confidence that underpins it. Therefore, the severity of the next crisis will determine whether a bail-in is required.
‘The events of September 2008 (the official start of the GFC) bought our banks dangerously close to running out of cash in a matter of months.
‘In early 2009 I had a discussion with high profile investment identity. He told me his government sources said ‘the bank run was so serious the RBA was running out of $100 notes in late 2008’.
‘It was only after Rudd and Swan announced the government guarantee on deposits that calm was restored. Phew, crisis avoided.
‘Will we be so lucky next time? Maybe. Maybe not.
For starters, our government is deeper in debt than it was in 2008. Therefore, it’s unlikely a greater guarantee [more than the current $250,000] will be offered. Also if next time the Fed, ECB, PBOC or BoJ cannot ‘steady the ship’ with their ‘hocus-pocus’ then it’ll be every person for themselves.
‘I share your concerns/fears about the fragility and vulnerability of our banking system.
‘Will those fears manifest themselves in 2015? Honestly, I don’t know. The world is a funny place and the known flash points in the world are possible Russia and Ukrainian defaults; Greece exit from the Euro; European deflation; Japan’s print and be damned policy; one or more South American countries defaulting. Any one of these events could throw a match into all the printed tinder out there.
‘In addition to the known problems there are probably as many unknown ones. These have the potential to really mess with the market’s head — assassinations, terrorist attacks, disruption to commodity supplies, an Arab Spring type event in the West etc.
‘These are probable but unpredictable. The unintended consequences of one or more of these events is way beyond my limited brainpower…other than to say it would not be good.
‘However, we have a few things in our favour compared to our western counterparts that could backstop our system:
- On a debt to GDP level Australia is comparatively in the low range. This means more scope to borrow to prop up the financial system. Not as much as pre-GFC, but we could add another $500 billion to the tab.
- Australia still has (for now) a AAA credit rating.
- Our interest rates are well above other sovereign debt offerings. There’s scope to reduce interest rates (via RBA intervention in the bond market) to ease the interest cost burden in the budget.
- RBA can play follow the leader and print.
- The government could also resort to ‘helicopter money’…more $900 cheques.
‘In summary, I don’t think this year will be the tipping point for a collapse of the system. This year authorities will be dealing with deflation and debt defaults. Expect to see more stimulatory measures to keep the good ship ‘Credit Forever’ afloat.’
Falling US bank shares will be a proxy for the credit stress in the system caused by the contracting forces at play in the global economy.
The KBW Bank Index is the canary in the mine. Watch it closely.
There’s little doubt 2015 will test the patience of investors. Too much volatility will be a call to arms for central bankers to go for broke. And believe me, eventually, they will do just that.
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