Accounts Receivable

Harley’s horrible huffing contains plenty of puffing

HDQ1US

When companies won’t give guidance, we must find ways to see where we were relative to history to get a picture of the future. Harley-Davidson (HOG) makes a good case study. Coronavirus may be one factor but the company has already produced results that have undercut the worst levels experienced during the GFC. We have long criticised HOG for fuzzy maths under the disastrous leadership of the recently ousted CEO Matt Levatich.

While there are strictly no direct apples for apples comparisons on the timing of coronavirus and the GFC (the latter requiring no lockdown), we note the weakness in Q1 2020 unit sales in the chart above.

This is what the trend of Q2 looks like.

HDUSQ2

If we assumed a similar slowdown for April and May then theoretically the company would comfortably breach the Q2 2009 unit sales level of 58,179 which is only 18.6% below the Q2 2019 level. Q1 2020 global sales fell by 17.7%, even though the company made a very misleading statement which we’ll get to in a moment.

One thing that struck us was the steadily rising value of quarterly inventory as a percentage of quarterly non-finance revenues since Q1 2014. While the former value is a balance sheet item and the latter P&L, Q1 is generally a period where new models are rolled out ahead of the busiest Q2 & Q3 seasons to ensure the distribution network can move metal.

HDQ1Inv

Shipments reflect this. The inventory metric drops off into Q2 although exhibits a similar type of trend to Q1. Given Q2 2009 was the beginning of the tough times post-GFC, will we see the high watermark breached or will the slowdown in production offset it? How badly are revenues affected such even flat inventories lead to a deterioration of this measure?

In Q4 2019, inventories to motorcycle revenues surged to 69.1%.

We note that Q1 2020 shipments equated to an inventory of 12,534 units (+29.0%YoY).

HDq2Inv

Here is where it gets interesting. By HOG’s own admission in the quarterly investor presentation pack (p.7), it noted that Q1 2020 US retail sales were on target to be one of ‘the strongest quarters in the last 6 years through to mid-March‘, until COVID. 6 years ago US Q1 unit sales hit 35,730 units. US sales in Q1 2020 ended up at 23,732.

By deduction,

In Q1 2014, over 90 days HOG shifted on average 397 bikes per day. (35,730/90 = 397)

In Q1 2020, over the 74 days to mid-March, HOG was moving on average 321 bikes per day. (23,732/74 = 320.7027).

If we assumed that HOG was to hit that magic target over the 16 days stolen by COVID19, it would have had to punch out 750 bikes a day. (11,998/16 = 749.875).

We would love to see the order book for these magical beasts that were waiting for a home…it would seem the sales and marketing department cherry-picked one strong day and multiplied it over the quarter to create such a questionable statement.

Here is a chart of motorcycle related revenue for Q1 since 2008. No wonder the shares have underperformed since 2014, even with a small fortune squandered on share buybacks.

HSQ1rev

The Q2 revenue book doesn’t look too flash either if April is wiped out. At present 50% of dealers are shut since late March. Is the market prepared for a sub Q2 2009 print? The share price has rebounded strongly after the Q1 results even though there is no guidance to speak of.

HDq2Rev

But it gets worse. So poor has the Q3 season become for HOG that its unit sales have missed the Q3 2009 post-GFC low for seven out of the last 10 years. Are we to believe if the world is out of lockdown by Q3 that there will be a miraculous surge in new bike sales when unemployment is likely to remain at troubling levels potentially above that of GFC?

HDq3US

HOG is a great example of a divine franchise. It wasted far too much money on share buybacks (now suspended) and sits with a credit rating just two notches above junk.

The annualised Q1 2020 loss experience for the finance business sit at 10-year highs even before it has been thumped by the coming turndown. People buy HOGs as a hobby, not transport. A purely discretionary purchase. We imagine that restoring household balance sheets will take precedence to stumping up serious coin for a Harley cruiser.

Sadly Levatich and his 2027 vision have not been consigned to the dustbin of history which is the only logical filing cabinet for it. Completely unrealistic, devoid of reality and totally in denial of the shifting sands in the global motorbike market.

The new “Rewire Plan” (p.5) while sketchy on detail (as it would with an interim CEO) is a reheat of Levatich’s plan. Sad.

In our view, the entire motorcycle industry needs a strong HOG. New management is a good start but it won’t help if they intend to convince investors that they were on course to shoot Q1 to its best level in 6 years with questionable math. How quickly can inventory be pared? What models will revive its fortunes?

HOG needs to get in touch with its core customer base the way Willie Davidson did after the dark days of AMF ownership. It needs to build products which hark back to its former glory rather answer questions in segments that no one is asking it to fill.

Indian, its rival of 100 years ago is killing it with the FTR1200. Indian’s parent company, Polaris Industries, posted a small single-digit increase for motorcycles in Q1 2020. Enough excuses HOG. You are running out of time and your retained earnings are 1/5th what they were 5 years ago!

Why is the market giving it the benefit of the doubt when the worst is still ahead?

HOG

Harley needs a crisis manager. Will the incoming CEO possess those skills?

QLD gov’t to subsidize the rest of Australia on Virgin bailout?

AA

You have to hand it to the Queensland Government’s absolute lack of awareness. It has intimated that it might fork over $200m in loans to rescue the airline. To call any airline a “family jewel” means one probably thinks Great Wall is the pinnacle of luxury auto brands.

Perhaps what Premier Palazczuk and Treasurer Trad miss is that by using Queensland taxpayer funds they would effectively grant residents in other states the full benefit of Virgin’s recovery for free. Furthermore, if Virgin didn’t manage to pay back the monies, Queensland taxpayers would undoubtedly be caught in a zombie lending scenario. So the other states would still benefit. Federal Treasurer Josh Frydenberg should be more than happy to see the sunshine state take his place.

We are surprised that so much umbrage is being taken at the idea of Chinese money coming in to subsidize the troubled airline. There is a sense of irony to see people cry nationalism when the airline has largely been owned by foreigners, 40% from China for a considerable time.

It is not as though the Chinese would treat Virgin Airlines like cans of baby milk powder and take all their planes home. Any rational investor would want to own a profitable airline based on juicy slot allocations rather than pursue relentless growth by building parallel tracks to already unprofitable destinations.

Sure, having an airline that boosts competition is a wonderful thing. We agreed with distressed debt specialist Jonathan Rochford’s summary which suggested insolvency as the best path forward. That way, hard decisions would be forced on Virgin and the restructuring would leave no stone unturned. Aircraft leasing companies have gone through this dance before and would be only too willing to act sensibly to help in the rebirth, especially given the appalling state of rail or road alternatives.

We understand people want to play hardball with China in a post-COVID19 world for its willful neglect shown during the pandemic. However, we must not let irrational fears turn away investment that benefits us, just because it is from China. Aussie investors haven’t supported Virgin much since the IPO in 2003. So why not let the Chinese do their dough? If we embraced their capitalist streak, were this investment to lower ticket prices, would we really complain? Or would we protest the idea that Qantas’ future might be at risk?

As comedian Dave Allen once said bout airlines, “they would make more money by leaving the planes at the gate and burning piles of cash on the runway!

A gem on how to work our way out of the coming economic crisis

Image result for truck nitroglycerin movie

Jonathan Rochford of Narrow Road Capital has written a gem on the role of central banks in spawning this current crisis. An excerpt here:

The rapid and widespread sell-off over the last four weeks is a textbook systemic deleveraging. Whilst the culprits are many; hedge funds, risk parity strategies and investors using margin loans have all been caught out, the underlying cause is excessive leverage across the economy and particularly the financial system. The timing of the unwind and the economic damage from the Coronavirus wasn’t predictable, but such a highly leveraged system was like a truck loaded with nitroglycerin driving down a road dotted with landmines.

Frustratingly, this inevitable deleveraging was clearly predicted. Rather than act to reduce systemic risks central banks encouraged governments, businesses and investors to increase their risk tolerances and debt levels.

Naturally, it fits our own long-held view on central banks.

Jonathan adds some sensible actions which are contained in this link. The question remains whether governments will put principle ahead of expediency in the cleanup?

MSM relishes trade of economic depression via pandemic over Trump as POTUS w/ no virus

Trump Derangement Syndrome (TDS) knows no bounds. Yes, the mainstream media (MSM) is celebrating the milestone that the Dow is below the level when Donald Trump was inaugurated.

We have always said that if Trump continued to boast about market gains he would have to wear it on the downside too. Alas, he is being hoisted by his own petard.

Sadly, as much as CNN and others relish the though of Trump out of office, we sincerely doubt the vast majority of Americans would trade a pandemic with catastrophic unemployment over business as usual before the WuFlu with a Trump at the helm.

Markets are forward looking. They anticipate where corporate earnings are likely to be. This market rout has little to do with Trump’s policies in isolation.

We’ve said repeatedly that global central banks have created a debt bomb through reckless monetary policies over the last two decades. They have proved just how little impact cutting rates to zero or throwing $850bn in handouts has on markets. They’re out of ammunition. Confidence is shot. We’re in uncharted territory.

Boeing is the perfect canary in the coal mine. The 737MAX debacle which is imminently due to be on sale again to a market that has effectively vanished. Airlines are cutting routes and it will be up to the zombie lending cycles of aircraft leasing companies to renegotiate rates so they can keep the patient alive. Airlines will push out deliveries.

However before Boeing’s core business troubles, the management embarked on short term incentive chasing buybacks to the tune of $43bn since 2013. The company is trading negative equity and has drawn down ALL of its credit lines ($13.8bn) and now wants a handout.

All of this is the product of two decades of mindless expediency. Governments are just as culpable for allowing greed to override common sense. No lessons have been learnt since 2000 and especially 2008. Blue chips like Boeing and GE are now heading to record lows because of it. Ford Motor is rated junk. How long before Boeing and GE fall foul of the same problem?

We are particularly interested in the next set of results from Parker Hannifin. It is like the global industrial hardware store. All of the major manufacturers use Parker for parts – pumps, hydraulics, pneumatics, valves, hoses etc. When we see Parker’s upcoming report on order flows we can gauge how bad it is at the manufacturing coal face.

This time we are staring at a “global depression” and it would be nice to think the MSM would try to put some context around the ramifications of this virus and the raft of economy killing policies governments around the world are introducing instead of just blaming Trump. Yes, he’s been his normal self during this but is he responsible for the actions of other countries going into shutdowns? Seriously? Do the US Coronavirus stats stack up poorly vs countries like Italy on a relative or absolute basis? No. Moreover COVID-19 cases in the US are a mere fraction of H1N1 swine flu cases which the media made nowhere near the level of hysteria as now. It’s a disgrace how far the media will go for clickbait.

Had the world’s central banks behaved sensibly to stop excessive debt and allowed markets to function freely, this pandemic would have had far less effect than it is now because we would have had the ammunition to fight this war of attrition. Now all our governments and regulators are doing is moving phantom armies across maps trying to stop economic Armageddon.

Macron invites moral hazard

President Macron of France wants to suspend all utility and rent payments for 30 days. So what if Coronavirus lasts 6-9 months? Will landlords get special treatment from the banks to suspend loan payments on those properties forced into providing free rent?What about banks who have to pay for staff with reduced income because loan payments are frozen? Who pays? The very people the government is trying to help.

How long can a country subsidize employers and employees? What will happen when those French citizens who end up 6mths in arrears on rent? Should we expect that they have prudently set aside those payments to hand over as a lump sum to their generous landlords? Will the tenants claim that they had to spend it on other things and ask for the government to pay on their behalf? Of course they will.

These are the first steps to guaranteeing moral hazard. This misguided altruism will backfire big time. The vicious circle will mean the people he tried to help will end up in a worse place after it. Higher taxes, fewer jobs and more handouts with money that has been borrowed or printed.

What next? Bail out restaurants, bars and cafes that are affected by shutdowns?

We are staring at a Great Depression. No one likes to talk about it but we can’t just expect economies to shutdown for 2 months or more and then go back to business as usual once the whole pandemic has been defeated like nothing ever happened.

Take the example of a cafe. Most coffee shops buy in muffins and pastries. So if the coffee shop must cease trading for a while, it will tell its bakery to halt deliveries. Same for the coffee bean makers. And the coffee cup suppliers. They’ll tell their raw materials providers to stop until further notice. And so on and so on. The cafe will temporarily lay off staff. As will the baker, bean supplier and others.

Some staff or owners may have mortgages. Many won’t be able to meet monthly payments. They could default. Their homes could be repossessed by the banks which will then be faced with marking to market the value of the property on their loan books which could technically wipe out all their thin equity. Then the banks will be forced to ask for a bail out. Housing prices implode. Australia, are you listening?

Then home owners struggling to make payments cut back on non essentials. Out go gym memberships and cable TV subscriptions. Buying a latte becomes a luxury.

We are all going to have to realize we will have little choice but to click the big fat RESET button if the economy is to recover properly and soundly. It will be painful and bring out the worst in people but experience is a hard teacher. We’ll get the test first and the lesson afterwards.

And for Australia, which has experienced 28 years of non stop growth, the shock will be exacerbated because of so much complacency.

In a nutshell we all need to relearn the word “personal responsibility“. Governments are only doing everything in their power to remove us having to be accountable for anything.

Coronavirus will end up killing way more jobs than the people in them

GDANSK, POLAND - SEPTEMBER 3, 2018: Norwegian Air Shuttle airlines offers cheap flights. Airplane Boeing 737-800 takes off on from the International Lech Walesa Airport in Gdansk.; Shutterstock ID 1176630295; Purchase Order: -

None of this should be a surprise. 7,300 (out of 11,000) workers at Norwegian Air have been temporarily laid off as 85% of flights are cancelled.

This follows on from Scandinavian Airline Systems (SAS) which has temporarily suspended 10,000 workers and cut 90% of flights to combat coronavirus.

In short, Coronavirus will likely kill way more jobs than the people in them. Sadly, there isn’t a robust economic cycle to be able to weather this storm.

Note that Boeing shares fell 20% overnight as markets finally come to grips with what we mentioned yesterday. Boeing was also put on credit watch negative by Fitch. GE is back at $6.

And Trump’s S&P500 index reading was 2,264 when he took office. It is at 2,474 or 9.3% above that. We always said what he proudly attributed to his leadership on the way up could end up making him hoisted by his own petard on the way down.

Buy Gold, not toilet paper.

Boeing’s negative equity & prospect of zombie lending

We should have seen this earlier. One sign of trouble in industrial businesses can be seen through the lens of the cash conversion cycle (CCC). A CCC that is positive essentially means that payables are being executed way before receivables are being banked. Rising CCC is never a good thing. Amazon is at the other end of the spectrum with negative CCC which means they receive payment before delivery.

Note Boeing has seen its CCC blow out from around 124 days in Dec-2010 quarter to 344 days in Dec-2019. Effectively Boeing is sucking up a year of net receivables before collecting them. What escaped us is that the company is trading in negative equity at present and it will be a hard balancing act to let such CCC get much larger to a group that is so under the fiscal pump.

We recall the difficulties the supply chain had under the delayed 787 program in the early 2000s. Parts suppliers were bleeding because they’d invested and prepared for an expected ramp-up that ended up arriving 3.5yrs later than anticipated. All that high fixed capital formation and inventory that needed to be paid for by a client that couldn’t take delivery. Boeing tried to muddle through but was ultimately forced to rescue suppliers to keep them alive after some faced the brink. Boeing bought some suppliers in house.

One imagines the 737MAX delays will exacerbate the CCC again although Boeing contends it is in cash conservation mode. Coronavirus can only add to the misery of airlines reluctant to add to fleets where capacity is being slashed aggressively. Just look at the self-isolation bans being put in place in recent days. Who wants to holiday abroad if told they’ll spend two weeks in their hotel room feasting on room service? Airlines get the efficiency of new aircraft helping operating performance but at the same time running any planes at 20% capacity won’t help.

This is only going to get worse. For all of the pain of a much higher unit volume plane yet to be approved for flight, Boeing cash flows are being tortured. It is incredible that the shares had held on so well during the MAX crisis.

It is interesting to note that Boeing is trading in a state of negative equity. Liabilities are greater than assets. Where is the press on reporting this? It is hardly trivial for a business that hasn’t even faced the worst of its struggles.

Just like we wrote two years ago about GE, Boeing went straight down the line of monster share buybacks. $43bn to be exact since 2013. Over half of the buyback has been conducted at share prices above the current level. The goodwill and intangibles on Boeing’s balance sheet total $11.398bn. Equity at minus $8.3bn. So negative $20bn.

bA

We did the following infographic some 3 years ago but the trend has deteriorated further. As we can see AAA-rated (top) stocks in the US have dwindled while BBB+ and below has surged. It is estimated that over 50% of US corporates have a rating below BBB. That is the result of artificially low-interest rates which have lured companies to borrow big and splurge on buybacks. Our biggest worry is if the market starts to reprice corporate debt accordingly, such as what happened to Ford when it was dropped to junk.

IMG_0523.PNG

So the question remains how does Boeing manage to get out of this pickle? Even if MAX gets certified, airline cash flow is being crippled. How big will discounts need to be in order for airlines to take on new planes? At the moment one imagines many airlines are deferring deliveries (787, 777 etc) until they get a clearer picture.

Boeing has delivered 30 aircraft in the first two months of 2020. At the same time last year, Boeing had delivered 95 planes. A lot of MAX impact but we imagine March will be even worse.

Airbus delivered 86 aircraft so far in 2020. At the same time last year, Airbus delivered 88 planes.

Think of the major gateway that is Hong Kong International Airport. It’s passenger flow for February 2020 – minus 68%! 6 months of this type of crippling volume would be catastrophic for airlines. 9-11 was a watershed moment for the aviation industry where the confidence to get back on a plane turned quickly after the terror attacks. Now we have a situation where passengers would be more than willing to fly again but governments simply aren’t letting them. The problem is whether they will be in the same financial position to fly if the virus isn’t contained rapidly

One sweet spot for Boeing is that it is a major defence contractor which means that government bailouts are a given. Sadly, shareholders shouldn’t think this current share price collapse has finished. Boeing feels a lot like mimicking GE when it sunk to $6 from over $30.

It is probably worth referencing AerCap Holdings which owns International Lease Finance Corporation (ILFC) one of the big two commercial aircraft leasing companies. Its share price has cratered from a high of $64.79 to $24.50. Moody’s affirmed the “Baa3” ILFC this month.


AerCap

The company has 3.1x leverage. $36bn of property (mostly planes) on its books. The shares are trading at 0.35x tangible book value presumably because the market is forecasting the value of the tin is going to fall through the floor if leased planes return from airlines that have been forced to cut costs or go bankrupt.

The only crux is the future appetite of investors to support AerCap in the debt markets. It has $17.5bn in unsecured notes and $9.8bn in secured debt with a further $2.3bn in subordinated, mostly via a 2079 maturity bond issue. The maturity profile is still comfortably beyond 2028. No problems just yet but times are only just starting to get challenging.

Of note, AerCap is paying $1.295bn in interest charges on $29.5bn of debt. Leasing rents from its airline customers total $4.281bn. It all comes down to the assumption that its multiple airline customers can keep honouring those payments or whether the leasing companies are forced to renegotiate their deals in order to keep the customer alive. The last thing a leasing company needs is a flood of aircraft to return because customers go belly up. Fingers crossed there is no zombie lending to avoid having to mark-to-market the value of the fleet (assets) which would flip the ratings and refinancing prospects considerably. The balance sheet would be slammed.

With so many financial excesses built into the global economy, a prolonged spell of coronavirus containment will come at the expense of a crippling economic armageddon which will undo so much of the disastrous can-kicking we’ve become accustomed to. You can’t quarantine the world for 6 months and expect a tiny ripple.

CLies IT

It is not the disease we need to worry about per se. It is government and central bank incompetence over the last 20 years which has created a situation where we are out of ammunition to rescue the situation because expediency is so much easier for voters – comforting lies are easier to take than inconvenient truths.

Be sure to reference our thoughts on

Aussie banks,

Aussie government debt,

central banks and the

pension crisis ahead.

Political expediency will trump Coronavirus market rout. Await market manipulation

MARKETS YTD

Share markets have been decimated in recent weeks across the globe. This year to date (YTD) chart above shows the extent. It shouldn’t really have taken Coronavirus or plunging oil prices to lead to this. We’ve been living high on the sauce for two decades and even though GFC in 2008 was a rude hangover, our authorities thought doubling down on all those free money excesses would work again.

Let’s not get too carried away. On a 5-yr basis, shares haven’t exactly blitzed with the exception of the S&P500. The ASX has put on just under 7% in 5 years. Germany, Japan and Italy have gone down. So if one is 45% higher than 5-yrs ago with an S&P fund, is that a mass hysteria moment?

INDEX 5YR

Automotive stocks have been dud investments over the last 5 years. It didn’t take Coronavirus to expose the underlying trends. BMW is don 52% on 5 yrs ago. Ford down 60%. Volkswagen -40%.

Car stocks

Industrial bellwethers like Caterpillar and GE have also not escaped stagnation. YTD, all of these stocks have bloody noses. Boeing has held up surprisingly well despite the MAX problems.

Industrials

Yet if we look at the FAANGs (Facebook, Apple, Amazon, Netflix & Google), we can see that over 5 years, investors have made a bundle.

FAANGAs these 5 stocks make up 15% of the S&P500 Index by weight, if they fall the impact is greater. With the exception of Netflix, these monsters are down 15~20%.

FAANG 1M

Worried?

Fear not, our heavily indebted incompetent political class and complicit central bankers will concoct a new potion of even lower rates, more QE and further fiscal spending on wind farms, solar panels and roads to nowhere to keep the ship afloat. It may be a hapless task in the long run but just watch the printing presses move to full speed. The ride is about to get interesting.

We’ve been bearish for years based on the underlying tenet that financial market manipulation by authorities has merely distorted the most efficient clearing mechanism -free markets. The invisible hand will eventually win. Just not quite yet.

Italian Senator and former Deputy PM Matteo Salvini has called for a ban on short selling. Why? All he’ll do is exacerbate the sell-off by diverting capital from Milan to London. The politicians just don’t get it. That is why Milan FTSE All-Share index fell by 10.75% overnight. That market is down 23% YTD.

When the pandemic hit the economy, we should have known from last month that it would spread and impact global travel, trade and oil prices. Why did it take so long?

We wrote last week that the explosion in market chasing (especially levered) ETFs would exacerbate distortions on the downside. The main reason being is that options markets that hedge levered products see heavy delta bleed (pricing blowing out) during routs. The reason is in bull markets human nature is more comfortable taking risk. In bear markets, people panic hence needing larger insurance premiums to protect against the madness of crowds.

Essentially what that means is that when ETFs were a far smaller chunk of the market, today’s 7.8% drubbing may only have been -4% in equivalent terms. That is because the ETFs chase, not lead markets because their product design is to replicate the immediate past. Yet our first instincts are to compare these apples with oranges and equate them to 2008. Wrong. Furthermore, a larger part of the market is dominated by a smaller

So the question is, do we liquidate all of our shares into the falling knife or take the view that some wonderful opportunities will present themselves to get exposure to what we hopefully viewed as sensible long term investments.

We take the latter view. We need to separate Coronavirus (the disease) and the hysteria (eg hand sanitizer and toilet paper panic buying).

While the disease is problematic and will hit the economy hard in the coming quarters, the question is market hope pinned to government response will come back. The measures should continue to grow and grow until they have cauterized the wound. After all, we live in a market where financial TV programs are summoning the opinions of NY Mets baseball pitchers for their ideas on stocks.

Of course, it will be all academic, but confidence is the only thing that matters from here. As soon as we get on top of Coronavirus, markets will swing back into action and many will simply fall for the same tricks like Pavlov’s dog and the short squeeze will send stocks powering back.

Governments now have a legitimate excuse to blow out deficits and borrow to save us. In that sense, this pandemic is a blessing in disguise. That isn’t to trivialize Coronavirus but to note that politicians will do almost anything to stay in power, even if the long term consequences will linger long after they’re out of office.

Where will they spend? The automotive sector has been in the doldrums for ages. Expect to see EV related subsidies which will be a boon for the EV battery plays – we’ve bought Jervois Mining (JRV.AX) which is about to start a cobalt mine in Idaho.

Think of support to the aviation industry when the crisis is under control. Boeing and Airbus. Don’t forget that American Airlines renewed 900 aircraft soon after it announced Chapter 11 bankruptcy back in 2011.

Think construction – cement companies and construction machinery companies tend to benefit from public works programs. We continue to hold gold (have done since 2001) as the ultimate insurance policy when the whole system can no longer heal with band-aids.

So get ready to buy some bargain-basement names with cash flow survivability, especially if you have a self-managed super fund.

Yes the underlying economic backdrop is dreadful but there will be one last hurrah!

Westpac reported a 40% increase in home repossessions

Mortgages Westpac

Don’t get CM wrong – this is still the law of small numbers.  Westpac reported this week that it repossessed another 162 properties in the latest fiscal year.  That is a 40% increase. While it is but a dribble compared to the 100,000s of total loans outstanding it is none-the-less a harbinger of things to come. Westpac made clear, “the main driver of the increase has been the softening economic conditions and low wages growth.”

The current status of 90-day+ delinquencies has been rising over time. As have 30-day +. While nothing alarming, the current economic backdrop should give absolutely no confidence that an improvement in conditions is around the corner. We are not at the beginning of the end, but at the end of the beginning.

Former President Ronald Reagan once said of the three phases of government, “if it moves, tax it. If it keeps moving regulate it. If it stops moving, subsidize it.” How is that relevant to the banks?

We have already had the government fold and attach a special bank tax on the Big 4. Phase 1 done. Now we are in the middle of phase 2 which is where knee-jerk responses to the Hayne Banking Royal Commission (HBRC) where banks will be on the hook for the loans they make. That is a recipe for disaster that could bring on phase 3 – bailouts.

Sound extreme? How is a bank supposed to make a proper risk assessment of a customer’s employability in years to come? Can they predict with any degree of accuracy on the stability of candidates who come for loans? The only outcome is to cut the loan amount to such conservative levels that the underlying purpose gets diluted in the process and prospective home buyers have to lower expectations. Not many banks will look positively at taking several loans on the same property with different institutions. That won’t work. SO loan growth will shrink, putting pressure on the property market.

What is the flip side? Given property prices in Sydney hover at 13x income (by the way, Tokyo Metro was 15x income at the peak of its property bubble), restrictions on further lending against loan books that are on average 63% stuffed with mortgages (Japan was 41.2% at the peak) won’t be helpful. A property slowdown is the last thing mortgage holders and banks need.

While equity continues to rise at Aussie banks, the equity to outstanding mortgages has gone down since 2007 i.e. leverage is up. If banks saw their average property portfolios drop by more than 20% many would be staring at a negative equity scenario. Yet, it won’t be just mortgage owners that we need to worry about. Business loans could well go pear-shaped as the onset of higher unemployment could see a sharp increase in delinquencies through a business slowdown. A concertina effect occurs. More people lose their job and a vicious circle ensues. It isn’t rocket science.

Of course, Australia possesses the ‘boy who cried wolf‘ mentality over the housing market. Yet it is exactly this type of complacency that paves a dangerous path to poor policy prescriptions.

In Japan’s property bubble aftermath, 40% of the value of loans went bang. 17% of GDP. $1.1 trillion went up in smoke. It took more than 10 years to clean up the mess and the aftershocks remain. Accounting trickery around the real value of loans on the balance sheet can hide the problems for a period but revenue tends to unravel such tales. 181 banks and building societies went bust. The rest were forced into mergers, received bailouts or were nationalised. Now the Japanese government is a perpetual debt slave, having to raise $400bn per annum in debt just to fill the portion of the $1 trillion budget that tax collections can’t fill.

The problem  Japan’s banks faced was simple.  If a neighbour’s $2m home was repossessed through mortgage stress and the bank fire sold it for $1.4m, the bank needed to mark to market the value of the loan portfolio for that area by similar amounts. In doing so, a once healthy balance sheet started to look anything but. Extrapolate that across multiple suburbs and things look nauseating quickly.

This is where Aussie banks are headed. This time there is no China to save us like in 2009. Unemployment rates in Australia never went above 6% after the GFC in 2008/9, unlike the US which went to 10%. We weathered that storm thanks to a monster surplus left by the Howard government, which we no longer have.

Sadly China has had 18 months of consecutive double-digit car sales decline. Two regional Chinese banks have folded in the last 3-4 months. China isn’t a saviour.

Nor is the US. While the S&P500 might celebrate new highs, aggregate corporate profitability hasn’t risen since 2012. The market has been fuelled by debt-driven buybacks. We now have 50% of US corporates rated BBB because of the distortions created by crazed central bank monetary policy, up from 30%. Parker Hannifin’s latest order book shows that customer activity is falling at a faster pace.

Nor is Europe. German industrial production is at 10-year lows. The prospects for any EU recovery is looking glib. Risk mispricing is insane with Greek bond spreads only 1.8% higher than German bunds.

What this means is that 28 years of unfettered economic growth in Australia is coming to an end and the excesses built in an economy that believes its own BS is going to leave a lot of people naked when the tide goes out.

The Australian government needs to focus on more deregulation, tax and structural reforms. Our record-high energy prices, ridiculous labour costs and overbearing red-tape are absolutely none of the ingredients that will help us in a downturn. We need to be competitive and we simply aren’t. Virtue signalling won’t help voters when the whole edifice crumbles.

All a low-interest rate environment has done is pull forward consumption. It seems the RBA only possesses a hammer in the tool kit which is why it treats everything as a nail. It is time to come to terms with the fact that further cuts to the official cash rate and the prospect of QE will do nothing to ward off the inevitable.

Pain is coming, but the prospects of an orderly exit are so far off the mark they are in another postcode. Roll your eyes at the stress tests. Stress tests are put together on the presumption that all of the stars align. Sadly, in times of panic, human nature causes knee-jerk responses which put even more pressure.

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The Aussie banks have passed their best period. While short term news flow, such as a China trade deal, might give a short term boost, the structural time bomb sits on the balance sheet and while we may not get a carbon copy of the Japanese crisis, our Big 4 should start to look far more like the rest of the global banks – truly sick. The HBRC will see that it becomes way worse than it ever needed to be.

Complacency kills.

Who needs meat in their (portfolio) diet?

Beyond Meat

After 20 years in finance, CM thought he’d seen most anomalies in markets. This one from Charlie Bilello shows the lunacy of markets that can stay irrational longer than we can stay solvent. Beyond Meat shares are up over 9x since the IPO of two months ago and trading at 100x sales. Bigger than Campbells Soup. If only Andy Warhol knew of Beyond Meat…

Thanks SMcK for the flag.

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