The task of today’s Markets and Money is simple: ignore the largely irrelevant earnings news driving short-term stock prices and try to determine is the entire market is about to get smashed by another round of deleveraging in the financial system. This would result in another collapse in bank collateral, tighter Australian credit, slower economic growth, and falling equity and house prices (plus rising interest rates).
But before we make the conclusion, we should make the case. There is an Australian grouping of evidence. And there is an American grouping of evidence. Let’s deal with American evidence first. And let us call to the stand Reserve Bank of Australia assistant Governor Guy Debelle.
“While most of the recent jitters have been associated with sovereign concerns,” Mr. Debelle said in a recent speech, “I think the risks stemming from the financial sector are still there. A significant risk is that that we are still yet to see the full impact of the weakness in the North Atlantic economies on the loans on the books of financial institutions.
It might seem strange to begin the case for a further write down in bank collateral with an Australian central banker. But the good Mr. Debelle has done our work for us. He told a crowd in Sydney that, “We are now into the phase where weakness in the global macro-economy is feeding back into the financial sector…We are not all that far advanced in the adverse cycle that normally accompanies recessions.”
In other words, if we understand those comments correctly, there are more losses to come. It’s not just sovereign nations that are feeling the weight of bad debts. It’s the banks themselves – even after a year of recapitalisation and profit growth thanks to low interest rates – that could face serious trouble from a second of losses on residential and commercial real estate.
“For the North Atlantic economies,” Debelle concludes, “this was a big recession which, combined with large falls in both commercial and housing property prices, should result in large losses.” He goes on to point out that the government-guaranteed larger lenders might survive these larger losses. But smaller regional banks might not.
If those regional American banks fail you can expect two results. First, a larger burden the Federal Deposit Insurance Corporation (FDIC), the U.S. (underfunded) entity that insures bank depositors against just this sort of thing (up to US$100,000 per account). The other result would be a second-cousin of what happened when the Fed raised interest rates in the Great Depression: a contraction in credit.
Banks are the engine of money creation in the modern economy. If you have fewer banks, you have fewer engines of credit creation. Meanwhile, national assets and liabilities get concentrated on fewer and fewer but larger and larger balance sheets. It’s the collectivisation of finance, which in corporatist style, greatly benefits Wall Street money centre banks.
And this is all at the private and corporate level. In the world of public finances, American deficits are already spiralling out of control. The Federal Reserve, through its System Open Market Account, is taking an increasingly active role in supporting U.S. bond auctions. This is a fancy way of saying that as foreign investors refuse to finance U.S. deficits, the Fed must print money to paper over the gap itself. More details on this operation tomorrow.
Today, let’s ask the direct question: so what?
Why should Australians care if the United States has begun to monetises its debts? Well, it’s not certain, but you we’re pretty sure that U.S. monetary and fiscal policy is going to give rise to inflation, and higher interest rates. It will make credit harder to come by globally, just as it did in 2008 when the investment banks blew up.
This is bad news for Australia on two fronts. At the banking level, something terrible has happened since 2008. Bank collateral has not, in our opinion, materially improved. On the one hand, it still consists of huge chunks of U.S. commercial and residential real estate. Collateral damage!
On the other hand, those same U.S. banks have loaded up on another kind of equally toxic collateral. They replaced something bad with something equally bad, but perhaps less putrid (sovereign debt). U.S. banks, then, face a double collateral whammy this year from falling house prices and falling U.S. government debt prices.
Even if Australian banks don’t own U.S. backed real estate (and some do, mind you) and even if Australian financial institutions are not direct holders of U.S. sovereign debt (and some no doubt are), they’re still directly exposed to a world of tighter credit. And that world would be an accomplished fact if U.S. banks either ceased to exist or, as a result of more credit write downs, stopped lending globally.
The prosecution for another massive financial deleveraging in America rests. But what about our promised Australian evidence? Won’t things just be fine here, especially since China’s savers are set to become Australia’s creditors?
Well, maybe not. A speech today by RBA Assistant Governor Phil Lowe shows that Australia faces a similar collapse in private demand as in America. In turn, business investment is falling. Government is trying to fill the breach with a larger fiscal deficit. The end result may be economic stagnation and higher public debts and interest rates.
This all goes against the grain of the positive, earnings-driven news about the economy. But remember, the modern economy runs on huge supplies of credit to consumers and businesses. Take away that credit and you take away the fuel of GDP growth. Not even government intervention can offset the massive write downs in asset values required to put the economy on a sounder footing.
But how about the visual evidence. Mr Lowe provides the first chart below which shows falling private demand in the U.S., Europe, and Japan. This doesn’t include Australia. But we’d expect Australia to follow these trends if global credit becomes scarcer and asset values fall. Households and businesses will retreat into a more conservative cocoon.
Speaking of cocoons, Lowe’s next chart shows’s a figure specific to Australia: business credit growth. It’s fallen over 7% in the last year. Whether it’s because demand for credit is down or because supply is down (the willingness of bank’s to lend) is a relevant question. But the chart itself suggests another credit contraction, leading to more shockwaves in financial markets.
This slump in business credit growth has not yet affected access to capital for Aussie companies. Well, it has for companies on the margin of the mining business. But many other companies have turned away from the debt market (only the big banks got government guarantees to borrow). Instead, Aussie firms have tapped the equity markets. The chart below shows that listed companies raised over $85 billion in new share sales last year alone.
With a steady flow of compulsory super annuation money into the system, you could argue that Australian firms are going to have access to equity capital no matter how tight credit gets globally. And that might be true to a certain extent. But even assuming capital is available to listed companies, how will Austrlian firms grow profits in a world smothered by another credit crunch?
Quite clearly, they won’t. That, anyway, is the case for how a second round of deleveraging – driving by credit writedowns at American banks – will crush the Aussie market rally. There is, though, one saving grace. Maybe.
That saving grace is that if the sovereign debt risk in America supersedes the banking story, you will see an outright U.S. dollar crisis this year. That ought to benefit higher-yielding currencies like the Aussie dollar, although truth be told no one really knows how other paper currencies would fare in a full-blown dollar crisis.
What we do suspect is that the dollar crisis will be inflationary in nature. The monetisation of U.S. debts (public or private) will lead to a weaker dollar. And all things being equal, that ought to lead to much higher precious metals and oil prices.
Whether than translates into higher prices for precious metals and energy shares is also an open question. Do you want to be in the equity markets during another round of deleveraging? Last time around, resource stocks proved no refuge at all. And commodities themselves were as inflated as anything else. This time around, what is the best refuge?
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