Bank capital, as published by the RBA, peaked in December 2009 at $190 Billion. As of May 2010, that capital has reduced to $176 Billion.

With both the Westpac and NAB publically stating that commercial lending was declining, it will be a surprise if the bank reporting will be all that positive.

Also, separately, the banks report their impaired assets and bad and doubtful debt provisions. (As of 31st March 2010).



Michael Cornips

General Advice Warning

The Reserve Bank of Australia publishes the monthly receipts and expenditures of the Australian Government. The figures for the end of May 2010 were just released. Here are some highlights:



Annual expenditure is running at $342 Billion, in a continued uptrend, with revenues flatlining, maintaining the levels achieved in April 2008.

Revenue is projected to increase to $400 Billion by 2014, up 35% from the current level of $296 Billion.



Company Tax (red line) has declined from its $66 Billion high to $56.7 Billion. Remember that the Government was targeting around $10 Billion in collections for the new resource tax, so it was a sizeable increase in Company tax, let alone what resource companies just pay. Interestingly, Company tax is rebated through the franking credit system as a tax refund to investors such as those with retirement savings. As the new resource tax is not classed as part of the franking credit tax rebate system, investors don't get the benefit of being refunded the additional tax. In effect, it is the old double tax system.

Also you can see that total individual tax (net of refunds) (blue line) has declined from its high of $127.4 Billion to the current level of $123 Billion.



Where is a bull market when you need it?

As previously stated, the Australian Treasury Department forecasts, not the Government, is predicting to breakeven by 2014. This requires a 35% increase in GDP, which bodes well for the economy and sharemarket.

Michael Cornips

General Advice Warning

The recently announced cash for clunkers program by the Government seems more populist than making practical financial sense. I would leave it to others to debate the environmental effect of the program, but the Government receives more back for giving you $2,000 in return for an old car worth less than that. The program encourages people to spend (important word) $20,000 to $40,000 on what is more than likely an imported car. Like the 50% tax allowance for capital purchases (including cars) introduced during 2009, you would question why the Government concentrates spending on encouraging large ticket purchases of imports.

On a $30,000 cost of an imported car, the import tax duty levied is $1,500 (5%). Then we add a 10% GST tax to that total - $3,150. And then we add the 4% State tax on that total - $1,386. So the total tax generated is $6,036. Doesn't sound too generous, and we end up supporting manufacturing jobs and profits of overseas companies. Then of course you will need to insure it, which in turn attracts GST and State stamp duty on the premium. And anybody driving around an old bomb probably hasn't got $36,000 lying around. So you need to get a personal loan that costs between 8% to 12% (and more). A car loan for $36,000 for 5 years with a 40% residual equates to a monthly payment of $624.

So for the very tempting $2,000 gift, you get to make payments of $51,800 over 5 years, pay insurance ($600 pa?), pay a few more running costs, and you get to contribute $6,000 back to Government, Given that the demographic of a family driving the old rust bucket is probably a family of four, with Dad working a part-time job, paying for rising health care, education and costs of living that are only rising 3% per year (sure they are), you can see this is an offer that is well targeted. Targeted at what I don't know.

Concerns over the fiscal position of some European countries have persisted since May. Ratings downgrades on Greece and Spain and fears that Hungary may follow are weighing on the markets.

European authorities announced results of a stress test of the largest European banks. The vast majority of banks passed the test. In order to settle markets, it was critical that the stress tests were credible and that plans are in place to deal with any capital shortfall identified by the stress tests.

For the major economies sovereign-level yields have fallen, with US 10-year yields falling below 3 percent and German yields declining back to historic lows. Australian Government yields have also fallen to 5 percent. There has been some increase in money market spreads, although these remained far lower than mid 2007 to mid 2009.

In Australia, the money market has continued to function well. There has been some upward drift in the Australian bank bills to Overnight Index Swap rate spreads. The Reserve Bank has temporarily supplied extra liquidity at the end of the financial year.

The tensions in European financial markets have seen a further pushing back in the expectations of when central banks in the three largest advanced economies would begin a rate tightening policy. Six other countries have announced monetary tightening: these included Canada, New Zealand and Sweden that took their initial steps in this cycle.

Globally, corporate bond issuance remains low but rising. Issuance by Australian entities has also picked up and some of the large domestic banks issued bonds at spreads moderately higher than earlier in the year.

After recovering in the first part of July, global equity markets turned down sharply again later in the month. The Chinese equity market has continued to record significant declines.

The People's Bank of China announced a change to the exchange rate regime. It reverted to the arrangement in place over 2005 to mid 2008, whereby the value of the Renminbi would be adjusted in small increments on a daily basis relative to a basket of currencies.

International Economic Conditions
The global economy continued to grow in the July quarter, although uncertainty about the future strength of the recovery have risen and downside risks are apparent, largely reflecting ongoing concerns about the fiscal situation in Europe and the health of the European banking system. In contrast, economies in Asia remain robust, although there are signs that growth in the region is moderating to a more sustainable pace after the strong V-shaped recovery of the previous year.

Several of the smaller European economies have announced fiscal tightening. Some of the larger European economies also announced some tightening of fiscal policy, although the cuts were smaller and would be implemented more gradually.

Confidence and business conditions are surprisingly strong. The economic data for a number of countries, most notably Germany, was more positive than had been the case a few months earlier, and it was likely that euro area GDP would record a solid rise in the July quarter after little growth over the previous half year.

In China, retail sales, fixed asset investment, exports and credit have all grown strongly. Growth in industrial production has moderated over the past few months, but this was inevitable after the 20% plus growth in previous months. Conditions in the property market are also cooling, particularly in the major cities.

Wage growth in China has picked up noticeably. This is good in the long term, but in the short term it will lead to inflation.

Elsewhere in Asia, there were also early signs that growth was returning to a more sustainable pace after the very strong bounce-back from the contraction in late 2008 and early 2009. The Japanese economy is continuing to recover, although there remained considerable excess capacity.

In the United States, economic recovery is continuing at a moderate pace. This is most apparent in the business sector, especially in manufacturing. Indicators of business equipment investment are improving, business surveys were positive and industrial production has grown solidly. Labour market conditions remain soft and the payrolls data are disappointing. Unlike in Europe, no new steps have yet been taken to tighten fiscal policy, although there would be some unwinding of temporary measures through this year.

The large output gaps in the United States and the Euro area has resulted in ongoing decline in inflation, with core inflation running at annualised rates of 0.5 0.75% over the past half-year.

Australian Economic Conditions
The domestic economy continues to expand at a solid pace, with public-sector spending providing support to activity. Growth in private demand will pick up as investment strengthens, supported by high commodity prices.

Consumer sentiment remains a little above its long-term average, although it has fallen recently. Sales of motor vehicles to households has been strong in recent months, but retail spending which has recorded growth over recent months is now slowing as discounting has slowed.

Business surveys have also indicated some easing in confidence over recent months, although trading conditions remain a little above average. Some measures of company investment intentions have increased quite strongly, and capital goods imports increased in May. The amount of work yet to be done in mining is very high, particularly for the LNG sector. Private non-residential approvals remained weak; if this persists a tightening in some commercial property markets could emerge in the medium term. The slowing in growth in Chinese steel production has been reflected in falls in iron ore and steel prices. Spot prices for iron ore are now below the estimated contract price for the September quarter. Spot prices for coking coal have also eased. These prices remain very high from a longer-term perspective, and the terms of trade are approaching the peak level seen in 2008.

There are some signs that conditions in the established housing market have eased. Auction clearance rates in Sydney and Melbourne have declined from their earlier elevated levels. Housing credit growth remains at around the average pace of the preceding year.

In the labour market, hiring has remained strong with employment now 2.5% higher over the year. The increase was entirely driven by full-time jobs. Business surveys and data on job advertisements have been firm, suggesting further solid gains in employment in coming months. The unemployment rate has fallen to 5.2% and is significantly better than had been expected a year earlier.

Consumer price inflation data for the July quarter will be published on 28 July, and is expected to show the underlying rate of inflation continuing to moderate in year-ended terms, to be below 3 percent for the first time in three years. CPI inflation is, however, expected to rise to a little above 3 percent, partly due to the effects of some higher taxes.

The share market has fallen by 30 points or 0.6% in the past month. This is quite disappointing as the remnants of the Resources Super Tax concerns should have washed out of the markets by now. The better than expected positions of most European banks should have stimulated our market more.

Many Business Surveys have been showing a growing level of confidence up to June. The results from the June surveys are pointing to poorer conditions and confidence and may result in a slow down in activity.

The somewhat weak policy statements and strategic direction of both major parties involved in the next Federal Election are certainly not giving the business sector much confidence.

ASX Sector Weightings

Consumer Discretionary XDJ
Reduce to underweight position. Reduction in consumer and business confidence and fears of inflation and interest rate increases are weighing on the sector. The strong Australian dollar will help sustain this sector until interest rates in the US and Europe start rising. The sector really needs another stimulus boost.

Consumer Staple - XSJ
Maintain market weighting. The sector has recovered slightly in the past month, in line with the overall market. Given the stable nature of the underlying businesses, the high quality of stocks within the sector and the ongoing challenges the global economy faces, some exposure is warranted as a defensive measure. The building fears of a potential global slowdown will see more funds flow into this sector.

Energy XEJ
Maintain overweight. Oil prices are hovering between US$70 - $80 a barrel. The Energy sector has underperformed this quarter with coal and gas outperforming oil. The sector is expected to be supported by the recovery in global economic conditions, causing energy demand to grow in coming years, with the IEA and OPEC recently upgrading their global oil demand forecasts for 2010 and 2011. A longer-term investment perspective is required for this sector, given significant LNG growth opportunities for many major participants with earnings expected to rise significantly over a five-year horizon.

Financials -XFJ
Hold at market weight position. As in past quarters, sector exposure continues to be recommended via the larger retail banks. The sector had performed very strongly until the March quarter, but has now taken a substantial fall. Some M&A activity has now appeared in the insurance sector and we can expect that to spill into the property sector as availability of credit increases with a stronger economy and a construction boom. A stronger focus on AREITS may be due.

Healthcare XHJ
Remain at overweight. The sector performance has been steady. Nevertheless, as a defensive exposure to provide portfolio stability, we believe the sector plays an important role in risk managed portfolio construction. We believe sound growth opportunities exist within the sector while maintaining an element of defensiveness to portfolio construction to manage periods of market volatility. World demographics and continuing Government support within some sub-sectors makes this a defensive sector in current times.

Industrials - XNJ
Maintain overweight overall. The sector has exhibited its highly cyclical nature. It was unable to continue its strong July and September quarters and traded sideways since October until it fell in line with the rest of the market in May. As a wide range of stocks is captured in this sector, selective and careful stock picking is essential with a medium-term view required. The Transport sub sector has good prospects with a great potential for upgrades from a low base. Growth of revenue from international sources has been disappointing, suggesting that economic growth in areas outside Asia may be delayed for longer than expected. Tax issues in Australia are also weighing on many engineering companies.

Information Technology XIJ
Maintain overweight position. The sector capitalization held up during difficult times, reflecting relatively immune earnings growth potential from the broader macro-economic challenges. Careful attention to the growth patterns of these companies will reap great rewards in time. This has been a solid sector for the first part of the year and it is expected that this will continue. Significant share price rises have been achieved in a very short space of time which could lead to a period of consolidation.

Materials - XMJ
Maintain overweight. The outlook for global economic conditions continues to improve, assisting the outlook for demand for raw materials. Commodity prices have taken a small fall in $US terms. With an upgraded outlook for global recovery in 2010 by the IMF, the outlook for this sector is good. The PE for the sector are not overly demanding, however demand drivers from the US and China need to continue to strengthen.

Telecommunication Services - XTJ
Maintain market weight. Some uncertainty has been removed with the agreement reached with Government and Telstra. It is not clear who the winner will be as Telstra has sold its annuity income, but has eliminated much of the risk associated with a legacy copper infrastructure. We expect the best opportunities will come from the smaller more nimble end of the market. Telstra will maintain its position as a strong income investment.

Utilities - XUJ
Maintain market weight. Because of the essential services that are provided the companies in this sector are generally well supported and provide consistent, if not spectacular returns. The way the sector is now structured; most balance sheets are heavily geared to take advantage of the cash flows available. Companies with low gearing and strong cash flows can be seen as takeover targets. Costs are rising while capacity is not growing. A good sector for income investors.

In doing research on how common it was that Countries defaulted on its debt, I found an excellent book titled: "This Time is Different" by Reinhart & Rogoff. As you can see from the table, defaults, rescheduling and banking crises are quite a common occurrence. The years between 1300 and 1799 also saw numerous defaults: Austria (1), England (2), France (8), Spain (6), Germany (Prussia) (1), Portugal (1).

Literature suggests that the main driver of whether a country defaults is the level of external borrowings a country has, ie How much foreign currency has a country borrowed. As pointed out here previously, Domestic debt is not as of a great concern since any demands on the Government to repay its domestic debts simply allows them to print the money as needed. The US Government has no external debt. Reinhart and Rogoff go to some lengths to explain that Governments allowing inflation into the economy is actually an indirect form of defaulting by a Government. So an official default may not occur, but inflation may be pervasive. As assets prices inflate, and tax revenues increase, the Government effectively reduces the value of its fixed term outstanding debt.

With US domestic outstanding debt above $13 Trillion, nearly 100% of GDP, the last thing the US need is a sustained bout of deflation. Unlike the UK and the EuroZone, the US will possibly favour another round of Quantitative easing. The Federal Reserve also have large deposits from Commercial Banks sitting on deposit, earning .25% interest, rather than lend into the economy. If the Reserve dropped its rates for deposits, it would be more attractive for the Banks to starting lending more. Congress has extended further unemployment benefits until later in the year, as a continuance of adding income to the household sector. If the US can create some inflation, as the economy splutters along, it will create some upside impetus for the market. The next pullback would be when the Government tries to tame inflation, and extract the excess liquidity from the economy.



Michael Cornips

Questions from reader Ben:

1. Has there ever been a paper currency that has withstood the test of time?

To my knowledge, never. Interestingly, the current length of the fiat money system seems to be a current phenomenon. The world's money system has predominantly been based on Gold for the past few hundred years, but again the gold in the hands of the powerful has always been open to manipulation.

2, I can't see an alternative world currency, but it hardly seems fair for the US to flood the world with their green back. It may be impossible now, but in hind sight should Nixon not have abolished the gold standards?

No, Nixon should not have abolished the Gold standard, since it breached the 1944 Bretton Woods agreement, where the world agreed to use US dollars, but the US agreed to back the dollars with gold. It was the same as Bank capital rules, it created discipline. Until 1971, the US diluted the gold backing of their currency, The world worked it out and started to do what it always does, attack the dollar. The US's great coup was to get OPEC to agree to only sell oil in US dollars. And we all remember what happened to oil prices and gold prices in the 1970?s. The result was/is that the world needs US dollars.

3. How can the hyperinfaltion not be a problem, if the US continues to print money out of thin air?

My view is that hyperinflation only (?) occurs if a countries debt is based in a foreign currency. The US government only borrows in US dollars. Nobody can make the US government do anything. The dollars are locked in the US. Like a question the other day, the Chinese $2 Trillion in US debt has already been created. Selling the debt only turns it into a bank deposit. China needs to find another willing buyer to buy it.

4. Are they not spending their grand kids inheritance?

All debt is future Government taxation. I cannot recall many instances in history where Governments consistently were not concerned about anything other than remaining in power.

5. What makes Australia any differant? We create money out of thin air too don't we via government bonds?

Technically, Government creates money by just spending it. When they spend $1 Billion on handouts, it is just an accounting entry, where it appears as a deposit in your bank account. You do what you like after that, but whoever you give it to (Woolworths, Harvey Norman etc.) it forever remains a bank deposit in whoever's hands. The next step is that the Bank must deposit that back with the Reserve Bank to balance the system out. So it is only an accounting entry. The Government has the choice then of whether to convert the RBA deposit into Government Bonds, or just leave it as cash in the system.
All banking is created out of thin air. If ANZ lends you $100,000, it again is just a book entry. You get a liability, but you have to deposit the funds as a bank deposit in someone else's bank account. Debits and credits in the system have just increased by $100,000. Magic.
In 1984 M3 Money Supply was $100 Billion, today it is $1,210 Billion.
So every fiat currency system is the same. They are all based on fiscal discipline and trust. There is no limiting factor though. Banks had 8% capital rules, but securitization required 0% capital, hence the GFC. It happened because it could.
Government debt is the canary in the coal mine. Voters tend not to complain as long as the handouts and promises continue (Spain, Greece).

Is the World's economy sustainable?

Economic cycles will always exist, and eventually excesses are washed out of the system (1930?s), but the cycle just starts again. Like Great Britain losing it dominant power to the US, the US now is clearly in decline. Dollars can't be replaced by Gold, since there is not enough supply. It probably needs to be based on a combination of dominant exporters currencies and base metals.

I was talking with Ted Szkuta about what was affecting the ComputerShare share price, and why the price was trending down. Even though the share registry business is not CPU's entire business, we thought it may be affected by volumes being traded in the sharemarket. We tested the theory by extracting the ASX weekly dollar turnover volume since 4th December 2009 and charting it against the CPU shareprice. Allowing for the seasonally low turnover figures over the Christmas period, the CPU share price is showing good correlation to the ASX turnover. It suggests that we certainly need to see a pickup in ASX activity before we see a recovery in the CPU price.

Looking at the aggregate balance sheets of Australian Banks over the past 5 years highlights where growth has occurred, and highlights the challenges facing our economy. Since 2005, total bank assets have nearly doubled, suggesting that to be equally successful in the future, the pace of growth needs to be maintained. The compound growth has been 14% per annum.

Three lagging sectors have been Credit Card lending, Personal lending and loans to financial corporations. Loans to financial corporations peaked at $70 Billion in 2008, but has actually declined to $55 Billion in 2010. Credit Cards and Personal lending both have been dramatically beneath overall growth, with Personal lending also declining in absolute terms between 2008 and 2010.

For the economy to grow, lending must flow into Residential lending, Personal lending and Commercial lending. Between 2009 and 2010, total lending has actually stalled, with May 2009 assets totalling $2,618 Billion and May 2010 barely higher at $2,626 Billion.

The bottom line, total equity, reflective of the equity value being carried by the banks, has grown 15.1% compound over 5 years, but the last 12 months the growth has only been about 6%. The breakdown over the last 6 months shows that bank equity has declined from its peak in December 2009. Bank equity rose from $166 Billion in May 2009, peaking at $191 Billion in December 2009, but has since declined to the current $176 Billion. This of course reflects the decline in the share prices of the banks.

Bank Balance sheets are published monthly, and we will continue to monitor trends.

Michael Cornips