I started profiling it in my weekly updates a few months back. The reason? It’s simply one of the best measures of ‘risk appetite’ in the market. That is, the corporate bonds that make up this index are of low quality. For that reason, issuers must offer a high yield to entice initial investors to hand over their cash.
But in a raging bull market, where appetite for yield seems insatiable, these investments do very well. Investors forget about risk and only look at yield. They ‘buy’ that yield which in turn pushes up the price.
Then momentum players get involved and the concept of risk goes out the window as prices keep rising and yields decline. (Remember, in a fixed income or bond-like investment, as prices rise yields fall.)
As you can see in the chart below, this is pretty much what happened up until July this year. In fact, since the low in 2011, the index has appreciated nearly 45%. Add the interest (yield) component on top of that and you get a pretty decent return.
You can put that down to the Fed’s policy of Quantitative Easing (QE), which created abundant liquidity for the market to ‘chase yield’ with. But these sorts of instruments are the canary in the coal mine when it comes to potential removal of that liquidity.
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Junk bonds – canaries in the coal mine
That’s why I started showing the chart to subscribers a few months ago. It offered important clues as to what lay ahead for the broader equity markets. For example, it peaked in late June/early July and then started to fall. Meanwhile, the S&P500 (see chart below) continued higher, only falling in late July.
The junk bond index then rallied throughout August and peaked late in the month. Sure enough, the S&P500 rallied too. But unlike the junk bond index, which starting selling off in early September, the S&P500 went on to make a new high.
This was an important divergence. It was telling you not to trust the new highs on the S&P500. It was right. The world’s largest stock index soon began to correct lower.
So what is this junk bond index telling you now? Well, it recently made a new, lower low after the previous rally stopped at the 50-day moving average. This is an early warning sign that the trend is in the process of changing.
The S&P500 is yet to make a new low (see chart below) so it’s too early to say that its long term upward trend is over. But if the junk bond index is any guide, it’s something to be wary of.
The end of QE removes a lot of excess liquidity from the market. It’s clearly impacting high risk vehicles like the junk bond ETF. They’re the canary in the QE coalmine. It’s now starting to have an impact on the major indices like the S&P500 and the Dow Jones too.
Is the S&P500 following junk bonds lower?
Commodity price falls to hit the Aussie economy
It’s hard to argue that the end of QE is responsible for falling commodity prices though. Since peaking in early 2011, the broader commodity complex has spent three years in a downward trend. Recent falls have all but given up the healthy gains commodities achieved in the first half of 2014. The sector is again under pressure.
For Australia, though, the commodity bear market has been much more severe. Yesterday, the Reserve Bank released its index of commodity prices updated for September. As you can see in the chart below, prices are falling sharply. They’re now down to 2010 levels.
The RBA’s commodity index weights the components based on their importance to Australia in terms of export income. Iron ore has the largest weighting at 32.4% followed by metallurgical coal at 14.4%, thermal coal at 9% and gold at 8.4%. Base metals represent just 5.2% of the index while rural commodities make up 12.2%.
Bulk commodities (iron ore and coal) make up more than 50% of the index. You can put the bubble-like spike (and subsequent…and ongoing crash) largely down to iron ore price movements. Given the very sharp moves you’ve seen in recent years, you could probably expect the index to eventually find a bottom around the 60 level, which is where the real volatility started from back in 2007/08.
So what does this price collapse mean for the Australian economy? Is it a big deal or nothing to worry about?
To answer that question, you have to understand how commodity prices impact our economy. During the upswing, Australia enjoyed a big boost to its national income. That translated into a higher dollar, higher wages and employment (and rising prices for many things), and higher interest rates as the RBA tried to contain the boom.
In other words, it underpinned our economic expansion throughout most of the last decade.
But not only that. Rising incomes gave us more borrowing capacity. So we leveraged those rising incomes to buy more ‘stuff’ or acquire new services…new cars, furniture, bigger and better houses, a private education, overseas holidays, etc.
As a result Australia now has record high mortgage debt as a percentage of household disposable income. According to the RBA’s figures, it hit a record high of 137% in the June quarter.
But now commodity prices are detracting from national incomes. In recent years, sharply lower interest rates have cushioned the blow. But interest rates have been on hold for a year now and boss Stevens thinks there’s only so much monetary policy can do. That is, don’t expect another cut anytime soon.
Also, despite Australia’s commodity prices falling for a few years now, employment remains pretty good. But that is set to change as the labour intensive work begins to finish on many of the large gas infrastructure projects currently underway. And iron ore miners are under immense pressure to cut costs as the price falls below US$80. This will have an impact on mining employment as 2014 draws to a close.
So if Australia’s commodity price index continues to fall back to the 60 level, what can you expect in 2015? Here’s my list:
- A falling dollar (towards the low US$0.80s, high US$0.70s)
- Stagnant interest rates (you might see more cuts, but they could be constrained by inflationary pressures from the weaker dollar)
- Rising unemployment
- Budget pressures as revenue comes in weaker than forecast
- Weaker consumption growth
- Declining house prices as the frenzy in Sydney and Melbourne come to an end
I know that sounds pretty grim. But it need not be. A rebalancing must take place in the Aussie economy and if it’s managed reasonably well (a big ask, I know) then any downturn should be relatively short lived.
It may even come with the added bonus of bringing stock prices back down to levels that ensure buyers can achieve good long term returns.
No one knows how the future will play out. But the history of booms says that busts, or prolonged downturns, usually follow. Australia is in its ‘bust’ moment now. So far, it’s been relatively painless. But you should probably expect it to intensify a little next year.
Make sure you’re prepared for times to get a little bit harder.
And make sure you have a plan to deal with unforeseeable shocks.
Greg Canavan+
Editor, Sound Money. Sound Investments.
The post Is This Australia’s Bust Moment? appeared first on Stock Market News, Finance and Investments | Money Morning Australia.
