Ah. So that’s what happens when you spend money you expect to have and then the money fails to show up. You get a $7.5 billion federal deficit that will be around $12 billion by the end of the year. If Standard and Poor’s said Australia’s AAA credit rating was under threat without a government commitment to reduce the deficit, then aren’t bigger government deficits a threat to Australia’s credit rating now?
The conventional wisdom is ‘no’. The anti-austerity forces are busy marshalling their arguments for fairness and social justice. Asking the government to live within its means is apparently unacceptable in modern democracy. More must be spent, even if there’s no money to pay for it.
We broach the issue to start another week of reckoning because it has clear consequences for Australian investors. If Australia’s government deficits start to worry investors about the country’s credit rating, a couple of things are likely to happen. Let’s go through them both.
First, the Australian dollar would come under pressure. The credit quality of Australia’s government and corporate bonds has drawn a lot of foreign capital. Relative to other developed economies, Australian interest rates are still high. Lower capital flows would weaken the dollar, which wouldn’t be bad news at all for industrial stocks.
But for investors, what’s good for industrial stocks might turn out quite badly for the leading players in the ‘safety trade’. That would include the banks and the high yield consumer staple companies like Woolworths and Wesfarmers. It would be a major change in the primary trend in the market. We’ll ask our Slipstream trader Murray Dawes what he sees and get back to you.
In the meantime, there is a golden thread running throughout the bad decisions made during a boom. In fact, the government and the gold miners have made the same mistake; forecasting higher revenues on higher commodity prices and spending accordingly. It has cost both dearly.
For the government — and this goes for whatever sorry lot of psychopaths wins the election in 20 weeks — the problem is now ‘structural’. Expenses are growing faster than revenues. It’s not like revenues are not growing, though.
The government’s tax take in the 2012–2013 fiscal year was $340 billion. It was a seven per cent increase on 2011–2012, where the tax take was $316.8 billion. The trouble is, forecasts from the Treasury expected $352 billion in revenues. When that money didn’t show up, and spending had already been increased, you get a deficit that’s about $12 billion more than they thought it would be a few months ago.
Where did the money go? Well, corporate tax revenues are down for a host of reasons. But the big reasons are that neither the mining nor the carbon tax will generate nearly as much revenue as expected. Treasury originally estimated the carbon tax would generate $9.4 billion in 2015–2016.
But that was at a target price of $29 per tonne, linked to the European carbon market. Now that the European carbon market has imploded, Treasury is hoping for a $1 billion from the tax. A couple of years is an eternity in politics. But for investors, the effects of a structural deficit will start impacting interest rates, the dollar, and stock prices today.
Today’s politicians are making the same mistakes people always make in a credit boom. They take the future for granted. They spend as if the cycle will never turn. And cheap money makes them take risks they wouldn’t otherwise take.
You see this in spades in the gold mining sector. The rising gold price of the last ten years did not translate into the kind of gains you’d expect to see in gold stocks. Why? Costs blew out in the gold mining sector. But so did management discipline. The rising price seduced companies into pursuing projects that could only be profitable with a rising gold price.
Again, this is nothing new in the commodity cycle. But it seems like a lesson everyone forgets. Prices correct. The boom ends. The high cost producers with undisciplined management are left high and dry. Or, in the government’s case, the big fall in commodity prices as the credit boom ends wipes out their expected revenue increases.
Either way, the wheel turns. And here we are again. This is good news for contrarians and investors. Investors can begin judging companies on how efficiently they use shareholder capital. Metrics like return on capital and return on equity will come into vogue again.
And the upside of a price crash is that you get to buy something no one else wants, but which still has value. A good example is gold. As a form of monetary savings that is not anyone else’s liability and can’t be printed, gold is no less valuable today than it was three weeks, three months, or three thousand years ago. It’s the price, in paper money terms, that’s different.
‘Price is what you pay but value is what you get,’ to paraphrase Warren Buffett. He probably wouldn’t like us saying that with respect to gold. Buffett and his partner Charlie Munger don’t like gold because it doesn’t pay a yield and, compared to a business, is an unproductive asset. But as a monetary asset, we’d say gold is good value at these prices.
That’s not to say we aren’t looking at capital efficient productive enterprises. In fact, we’re about to put out our April issue of The Denning Report. In that report, we’ve looked at capital efficient global blue chip stocks. You can’t find equivalent companies in Australia. And for the purposes of getting out of Aussie-linked stocks, you have to go outside Australia to find them in any event.
More on this strategy tomorrow. And will it matter? Tomorrow, we’ll show you why the current rally in stocks, driven by the Bank of Japan, has all the makings of a kamikaze ending. Stay tuned.
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From the Archives…
Gold Demand: The Great Disconnect Between Paper and Bullion
26-04-13 – Greg Canavan
Lest We Forget
25-04-13 – Greg Canavan
Praying for Government Incompetence
24-04-13 – Bill Bonner
The Cracks in Solidarity at the Recent G20 Gabfest
23-04-13 – Greg Canavan
How Central Planners are Committed to Ruining the Economy
22-04-13 – Joel Bowman