A Genuine Economic Recovery Requires a Genuine Bust

Australia’s economic growth for the three months to 31 March came in at 0.6%, just below expectations of 0.7% growth. The annual rate of expansion slowed to 2.5%, the slowest growth rate since June 2011.

As we mentioned yesterday, Wayne Swan would be out immediately telling everyone how good the numbers are, or more to the point, were…and he didn’t disappoint. The all-important measure of national income, ‘real net national disposable income’, increased a robust 1.3% in the quarter. But with iron ore prices off significantly in the current quarter, you’ll see that reversed on the release of the next set of accounts.

Not that it will stop Wayne Swan from selling the numbers before the unwinnable election, but the three months to March 31 were a long time ago. Since, we’ve had lower mining investment, weak retail sales, poor consumer sentiment and rising unemployment. So we’d expect that 2.5% annual growth rate to be even lower in three months’ time, and we’d also expect national income to go backwards over the year.

Anyway, the market wasn’t impressed with the numbers — or with Swan — as the Aussie dollar sold off on the news. We think the Aussie dollar is headed back to around 80 cents…the only question is how long it takes to get there.

But we didn’t want to discuss the Australian economy today…or China, or mining. There’s plenty of all that and where things are headed right here. We wanted to look into the plumbing of the financial system and see how many leaks have sprung. It turns out they’re all over the place.

US markets sprang a leak overnight with the main indices falling over 1.3%. Apparently it’s due to concerns about the end of stimulus measures. But maybe the markets are just having a long overdue correction.

And there’s water all over the place in Japan. Or, as one witty headline read following the recent announcement of Prime Minister Abe’s craz-e-nomics policy, ‘It’s Raining Yen’.

Now, the Nikkei is leaking everywhere. After peaking at around 15,300 points on May 21, the index is now around 13,000. That’s nearly a 15% decline in a few weeks. Maybe it’s just a correction after a bubbling run up, but the market is looking very unsettled.

And it’s having an effect on Australia too. The chart below shows Australia’s All Ordinaries index (black line) and the Aussie/Yen exchange rate (red line). As you can see, yen weakness/Aussie strength (rising red line) helped to drive the market higher ever since Abe got himself in the driver’s seat last year.

But he’s driven things a little too hard and now you’re seeing yen strength coincide with weakness in the Australian market. So if it is just a correction in the Nikkei and only momentary weakness in the yen, you could well see our market turn around soon enough and start rallying again.

Kris Sayce reckons you’ll see this happen soon, and he’s identified four stocks that are set to benefit from the yen/Aussie market relationship.

Source: StockCharts
We’re not sure what will happen tomorrow or next week, but we’re pretty sure the whole financial system is screwed. And the latest comedy festival out of Japan is evidence of that. Yesterday, the Nikkei tanked around 4% while Abe spoke at a press conference. Confidence is waning.

A few weeks ago, we nominated the day of Bernanke’s ‘maybe we’ll taper maybe we won’t’ speech as the day the Fed lost control of the market. In case you’re wondering, to ‘taper’ means to buy less government bonds and therefore monetise debt at a slightly less dramatic rate. Sounds innocuous, but it’s become a big deal.

We don’t really believe the Federal Reserve is serious about ending QE anytime soon. But they may have started to realise that QE is not the answer. It’s not that they want to ‘taper’ because the economy is improving. They want to taper because QE makes the economy worse.

Two recent articles got us thinking on this point. A few weeks ago, hedge fund manager Andy Kessler wrote an op-ed in the Wall Street Journal saying that QE — Fed purchases of US Treasuries — was having a major negative impact on the shadow banking system.

We’ve written about this before. The shadow banking system uses Treasuries as money substitutes. That is, if you have a Treasury bond, it can act as collateral for a cash loan. It’s known as a repurchase agreement, or repo. Here’s how Kessler explains it:

‘Repos are pretty simple. A “borrower” puts up securities as collateral and receives cash from a “lender” in exchange for an agreement to repurchase the security at a later date, maybe a day or a week (even years), of course at a slightly higher price. Usually the securities are U.S. Treasuries or something liquid that can be easily disposed of in a default.

‘But here’s where it gets interesting. Since the repo lender owns a highly liquid security, the lender can do another repo with it, raising more cash to play with. This is known as rehypothecation, a fancy term for what basically creates a money multiplier similar to fractional reserve banking. Today, this means credit creation of 2½ or three times for every piece of highly liquid security used in repos (down from four times in 2007).

‘Just as the monetary base is commercial banking’s gold, Treasury bonds are shadow banking’s gold. Credit created by repos funds financial instruments (such as credit-card debt and mortgages) but also inventories, drilling projects, even fiber-optic buildouts. Hedge funds use repos for over half their funding and live for these riskier projects.’

Kessler argues that the Fed is taking precious collateral out of the system, which is actually deflationary.

A recent Bloomberg article, titled ‘U.S. 10-Year Note Repo Shortage Drives Lending Rates Negative’ supports this point of view.

On the other hand, QE does take assets out of the market, which pushes yields down across the board, which in turn should encourage borrowing and the creation of normal bank credit. So what the Fed takes out of the system in the form of Treasury securities, it hopes to more than replace via private credit creation.

But a recent ‘investment outlook’ by PIMCO’s Bill Gross argues that this is distorting the economy too. He argues that just as the notion of profit is crucial for the capitalist system to evolve, the notion of return or ‘carry’ is ‘critical to our financial markets’. Put simply, ‘carry’ is the return you can expect to achieve over and above a risk free rate.

With rates across the board now so low, Gross argues that the potential for ‘carry’ is as low as it’s ever been. Hence, there is very little incentive to take risk. He then brings this financial aspect back to the real economy:

‘In addition, there are several other important coagulants that seem to block the financial system’s arteries at zero-bound interest rates and unacceptably narrow “carry” spreads:

‘1. Zero-bound yields deprive savers of their ability to generate income which in turn limits consumption and economic growth.

‘2. Reduced carry via duration extension or spread actually destroys business models and real economic growth. If banks, insurance and investment management companies can no longer generate sufficient “carry” to support employment infrastructures, then personnel layoffs quickly follow. With banks, net interest margins (NIM) are lowered because of “carry” compression, and then nationwide retail branches previously serving as depository magnets are closed one by one. In the U.K. for instance, Britain’s four biggest banks will have eliminated 189,000 jobs by the end of this year compared to peak staffing levels, reports Bloomberg News. Investment banking, insurance, indeed the entire financial industry is now similarly threatened, which is leading to layoffs and the obsolescence of real estate office structures as well which housed a surfeit of employees.

‘3. Zombie corporations are allowed to survive. Reminiscent of the zero-bound carry-less Japanese economy over the past few decades, low interest rates, compressed risk spreads, historically low volatility and ultra-liquidity allow marginal corporations to keep on living. Schumpeter would be shocked at this perversion of capitalism, which is allowing profits to be more than “temporary” at zombie institutions. Real growth is stunted in the process.

‘4. When ROIs (return on investment – ed) or carry in the real economy are too low, corporations resort to financial engineering as opposed to R&D and productive investment. This idea is far too complicated for an Investment Outlook footnote – it deserves expansion in future editions – but in the meantime, look at it this way: Apple has hundreds of billions of cash that is not being invested in future production, but returned via dividends and stock buybacks. Apple is not unique…Western corporations seem focused more on returning capital as opposed to investing it. Low ROIs fostered by central bank policies in financial markets seem to have increasingly negative influences on investment and real growth.’

We don’t know if this has all of a sudden dawned on Bernanke, and he’s trying to ‘taper’ to help the economy or whether he genuinely believes in an improving economy.

But the fact is, in order to have a genuine economic recovery you need to have a genuine bust.

Could this be the start?

Greg Canavan
for Markets and Money

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From the Archives…

Why You Should Keep Your Portfolio Grounded in Cash
31-05-13 – Vern Gowdie

China’s City in the Sky
30-05-13 – Dan Denning

House Prices First, Stocks Second.
29-05-13 ­– Dan Denning

Why Natural Gas Could be the Next Crucial Industry for Australia
28-05-13 – Dan Denning

The Japan’s Nikkei is Starting to Crack
27-05-13 – Dan Denning

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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