US markets hand Australia a warning

BHP’s Jimblebar iron ore mine in the Pilbara. Iron ore could prove to be Australia’s “tech stock equivalent”.

Australian investors were cocooned in the soothing budget words of Treasury that there will be no wage or inflation breakout Down Under in the foreseeable future.

But our markets are linked to the US where both inflation and COVID-19 fears are at a higher level.

And as my readers know I think Treasury has made a wrong call on wages and inflation. My opinions are on The Australian’s website, under the heading “Budget Lights fuse on wages explosion”. I set out below how the Commonwealth Bank has supported some of my fears.

In the US, where the money printing and government borrowing is greater than Australia, there is a deep-seated fear that we are headed into a world of both higher inflation and interest rates.

And while Wall Street is still firmly in bull market territory that deep-seated fear breaks out in sharp corrections from time to time, the process gives us a preview of what is ahead if inflationary fears become a reality.

As Josh Frydenberg was beginning the endless round of interviews that is required of Treasurers after a budget, Wall Street was preparing for one of those nervous mornings.

The most vulnerable shares in the US market are the technology stocks led by Apple, Alphabet (Google), Microsoft. Amazon, eBay and Facebook. They got hammered in the downward thrust, accelerated by the margin calls on those that held the stocks on high leverage.

The selling spilled over to everything from bank stocks to energy and industrials. The tech stocks recovered but the industrial stocks remained lower.

In Australia the top of our market is dominated by banks and miners plus CSL so we don’t have the same tech stock trigger point. But when a US tech stock fall causes US industrials to decline it spills over into Australian shares, although this week the upbeat budget helped our markets. We are not immune from the US tech stocks.

But our domestic “tech stock equivalent” is a fall in the iron ore price. At the moment the iron ore supply demand squeeze is being intensified by the demand created by huge US, China and global spending.

China may undertake measures to curb the iron ore price but the Australian crunch time comes when Brazilian producer Vale is able to restore its production to around 400m tonnes. For the last few years it has been around 300m tonnes as a result of the tailings dam failures and COVID-19 --- a 100m tonne annual fall.

Treasury expects a sharp iron ore price fall in 18 months or so, which is a long-term share market warning. But copper nickel look like remaining strong.

US and Australian markets unite in the fear of higher interest rates. The US 10-year bond rate has been hovering around the 1.5 to 1.6 per cent mark for some weeks. It is now edging higher, which is a danger sign for shares.

One of the great risks of Western societies has been the rise in asset prices caused by low interest rates. It has greatly widened the gap between rich and poor and, in the US, President Biden is trying to reverse some of the gap via social spending and taxes on high wealth individuals. We are taking similar steps without the higher taxes.

In the US that acceleration in asset values has been multiplied by extremely high leverage on shares and crypto currencies. The crypto currency borrowing is so huge that many say it is now in the “too big to fail” category.

Wall Street gave us a preview of what could happen if inflation and rate rise fears become a reality. Picture: AFP

Here in Australia our share markets will be particularly vulnerable because we are affected by rate rises in both local and US markets.

We can expect that if wage rises trigger interest rate increases then there will be an overall fall in share markets.

But later there will be a division between those stocks that are benefiting from the higher economic activity, but can contain the impact of higher wages, and those that are closely linked to interest rates.

Stocks priced on yield rather than growth, like banks, will be among the most vulnerable.

Remember that apart from 10-year bond markets the future interest rate indicator will be salaries and wages growth and their impact on inflation.

I went out on a limb in saying that Treasury’s wages increase forecasts were wrong. That’s why I was so pleased at these remarks from the Commonwealth Bank: “Wages growth, as measured by the wage price index, is forecast (by Treasury) to be 1.25 per cent at mid-2022 and 2.25 per cent at mid-2023. This is broadly in line with government’s forecasts for inflation.

“The upshot is that no real wages growth is expected.

“The risks to the government’s wages forecasts are to the upside given the international borders are closed and growth in labour market supply is low. The sharp drop in net overseas migration (NOM) means that employees in many industries have had a lift in their bargaining power that is independent of the level of slack in the local labour market.

“Essentially talent is scarce because firms can’t hire from abroad like has previously been the case. We expect wages growth to accelerate to 2.5 per cent by mid-2022 ”

CBA’s wage expectation is twice that of Treasury and even that may be too low. It’s an ominous sign for interest rates and markets next year and it could coincide with higher Vale iron ore production.