The Aussie is flying… trading at 79.18c at the time of writing.
We told readers a week ago (before the spike) we are likely to see it move higher as the weekly trend was bullish. Therefore, don’t bet against it.
Guess what… it could go much higher.
Granted, the Aussie dollar is overvalued (more on why shortly). However, does that mean you sell it short?
Let’s start with a simple lesson…
A Simple Trading Lesson
As an example, I am going to use the S&P 500 over the past five years or so.
Fundamentalists were saying it was overvalued when it traded at a forward PE of 16x a few years back.
That compares with the historical average of around 15x… where these types argue things are more expensive.
We didn’t agree. Turns out the S&P moved from 16x forward earnings to 17x.
Not surprisingly, the “funnymentalists” (ie those who based their trading on PEs etc) reiterated that stocks were overvalued and to tread carefully. Case in point – I remember Marc Faber telling us only 3 years ago expect stocks to fall 50% that year.
What happened? Stocks did the opposite and went up another 50%.
Surprise surprise the forward PE for S&P 500 went from 17x to 18x.
This left the ‘value’ guys dazed and confused.
“18x is nuts. Don’t buy this market. Upside is limited and the downside potential is huge”... or sentiment to that effect.
Here’s a great chart showing how wrong they were (and are):
Guess what. The S&P 500 went from 18x to 19x.
“A stock market correction imminent” they told us.
“Markets are euphoric. Sell everything now said RBS. You would be mad to buy the market here”
Guess what. Wrong again. The S&P 500 went from 19x to 20x.
Now at their wits end (it doesn’t stop them warning us after seven straight years) — the market continues to dumbfound the funnymentalists.
We are up another 10% since this chart was produced… rubbing more salt into the wound. Today the forward PE for the S&P 500 is ~21x – quite normal in a zero rate environment by my measure.
We have explained how this works in the past; and remained consistently bullish whilst most around us were bearish.
Point of the story is the Australian dollar is also “overvalued” .
But that doesn’t mean it can’t go to 80c… 85c… maybe even 90c?
If it’s overvalued today what does that say about 90c?
You could end up looking like one of the disgruntled (and typically wrong) perma-bears who can only write about why everything is so hopelessly broken (as they continue to miss out on the triple digit gains others have enjoyed).
Don’t let it be you…
Australia’s Dependency Hurts
For what’s it’s worth – unlike the S&P 500 – I do think the Aussie dollar is trading at a ripe premium.
But what do I know… the price action (ie the tape) will be the judge of that.
Not my poor fundamental analysis.
Now the other day – when talking to global rate hikes – we explained why we think Australia is different. And it comes back to the all-important commodity complex.
Despite global growth improving – commodity prices remain very low – evidenced by what we see with things like iron ore, coal, oil and even copper.
As opposed to say our developed economy peers (eg United States, United Kingdom, Japan and Europe) – they do not need higher commodity prices to enjoy stronger economic growth.
That’s something we need.
As such, Australia is in a very different position – as we wrestle with our unfortunate dependency on China.
But let’s explore this commodity complex further…
Westpac-MI Leading Index
Today I read something very interesting to support my case… Westpac’s leading Index:
In a moment I show why it was commodities which ripped this chat low…
But first (and for those not familiar) – this is an indicator that uses eight specific inputs from home and abroad to evaluate how the Australian economy is likely to perform looking three to nine months in the future (ie about the time when the RBA wants to raise rates).
For example, a reading of 0 indicates that it’s likely to perform around trend, seen by many as around 2.75% to 3% GDP
And as we know, 3% is the underlying basis of the RBA’s current “hawkish” tone (and current government budget assumptions).
If we don’t hit it – expect a massive deficit (again).
On the flip side – anything below zero points to slower than usual growth looking ahead.
Guess what… the index fell to -0.76%, a sharp turnaround from the one per cent plus levels seen just a few months ago.
Houston – confirmed – we have a problem!
The table above just shows you how big a “chunk” the commodity complex plays in the mix.
There’s your collapse.
This is the first time the index fell below zero July last year.
As a leading indicator, it accurately predicted the sharp slowdown in growth seen in Q1 2017 — where GDP growth decelerated to just 1.7% YoY – the slowest pace since the GFC.
Will it be on the money again?
The RBA (and government) certainly hope not… but I know which horse I am backing.
Not the one being ridden (poorly) by Mr. Lowe and Morrison. It’s only got three legs.
Commentary from Westpac
Westpac tell us their index is pointing to a slowdown in momentum in Australia’s growth profile with the first below trend reading since July 2016.
The deterioration mainly reflects international factors including a sharp turnaround in Australia’s commodity prices in Australian dollar terms.
Two components account for all of the reversal: commodity prices and the yield spread (both highlighted in red).
First up, Australia’s commodity prices have fallen 17% over the first half of 2017 in AUD terms (iron ore below)
That hurts us where it counts most… in the hip pocket (just don’t tell housing speculators – they couldn’t spell iron ore).
While we have seen a solid recovery in iron ore prices since mid-June in USD terms, the sharp increase in the Australian dollar from USD 0.755 to USD 0.79 will partly offset that adjustment.
Damn you strong Australian dollar… damn you to hell!!
And you think the RBA will raise rates to strengthen the AUD further?
We think not… moving on.
Secondly, the all important yield spread – the difference between the short and long term interest rates (nb: something we watch like a hawk at TradetheTape) – captures financial market assessments of the economic outlook both locally and abroad (long term rates are heavily influenced by benchmark rates abroad).
After widening significantly over the second half of 2016, the yield gap has narrowed sharply in 2017, led by lower 10yr bond rates as markets have pared back expectations for growth stimulus policies in the US and inflation expectations ease. The move has taken 0.64ppts off the Index growth rate since January.
A narrowing yield spread is bad news. Our readers know this… it generally implies recession (or at least slow down) ahead.
Markets have quickly moved to price in rate hikes in Australia in 2018 partly in response to the Reserve Bank’s July Board minutes which set out the Bank’s revised estimate of ‘neutral’.
We think prematurely.
Since the GFC it has become clear that the new neutral rate will be lower than in previous years due to lower inflation; and lower trend growth particularly reflecting lower productivity growth and high risk aversion associated with excessive household debt.
The timing of that decision will come down to the state of the economy
No shit Sherlock!
Westpac expects that growth in 2018 will be a below trend 2.5% with limited prospects of that improving much in 2019. Furthermore that growth rate is unlikely to be associated with much improvement in the labour market with considerable spare capacity likely to remain for some time
Better hike rates I guess?!
We expect that as the Bank is forced to revise down its growth and inflation forecasts through the remainder of this year and 2018 the need to raise rates will dissipate.
You don’t say.
Putting it All Together…
For those who have been reading my blog for the past 12 months or so — none of this is new.
We said the bounce in commodities was temporary.
In other words, as soon as China turned off the tap, watch prices fall.
And as soon as prices fell – we said watch for growth to revert.
This is a hymn sheet which has been in play for a couple of years… not a couple of months. And it doesn’t take a trained economist to see it (nb: I have no background in economics)
I am looking at all this through a layperson’s lens.
But I do have a very basic question:
How do falling property values factor into this “leading indicator” equation?
There is no mention of it in their commentary… perhaps they are assuming they remain stable (or even rise)? They do mention excessive household debt… but that’s about it.
What’s interesting is the “leading index” is plummeting lower with house prices holding up. So what effect could that have?
The RBA won’t be raising rates this year. And they will struggle to raise them in 2018 should growth (and inflation) slow further.
Someone should tell both the central bank (and the government) that a bounce to 3% GDP is wishful thinking.
Sounds good in theory… but can someone please tell me where it’s coming from? More government spend? The national credit card? Guess we’ll find out soon enough.
As always, please let me know what I am missing. Obviously a lot.
… trade the tape
When investing in shares, you can lose you some or all of your money. The potential gains on my blog are based on investing in Australian and US markets and don’t include taxes, brokerage commissions, or other fees. It’s important you seek independent financial advice regarding your particular situation. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you’ve invested. If in doubt – always seek independent financial advice.