DR Managing Editor Dan Denning Backs His Recession Call

10 years ago Markets and Money launched in Australia. We had one mission: to give you an alternative analysis of the finance news and to give you alternative strategies to profit and protect your wealth.

The underlying philosophy of Markets and Money has been and always will be this: ideas matter.

Recently, I sat down with DR Managing Editor Dan Denning to discuss on very important idea for Australian investors: that the economy is in deep trouble.

It was a long chat. You can read part 1 here. Comments and feedback are welcome to letters@marketsandmoney.com.au. But please, no birthday cards.

Callum NewmanYesterday Dan, you covered consumption and government spending in Australia. What about investment and the trade deficit/surplus? Are those the basis of your prediction for a recession this year?

Dan Denning: Yes. I’ll try to be brief and keep it simple. But let me make one last point about government spending. I know there’s a lot of debate about whether debt and deficits are bad things or whether there’s a real crisis about government spending or whether it’s manufactured to suit a political agenda.

CN: That’s right. A lot of people compare Australia’s government-deficit and debt-to-GDP ratios to bigger countries like the US, Japan, and smaller ones like Greece and point out we’re nowhere even close.

DD: Well on a relative basis, that’s true. Japan has a government-debt-to-GDP ratio of 227%. Greece is at 175%. The US is at 101%. The UK is at 90%. Australia, by comparison is 20%. But keep in mind that number was zero just six years ago. And more importantly, the number is only good by comparison.

This is not a revenue problem, not yet anyway. It’s a spending problem. The Australian government took in nearly $370 billion in total tax revenues last fiscal year. That’s up 33% since 2007, when it took in $294 billion.

We’re not running a deficit because we’re taxing too little. We’re running a deficit because we’re spending too much. The government is doing what households did, living above its means. The trouble with that is that once you get into the habit, it’s hard to break. There’s always a great debate when you pass critical levels like 50% of GDP or 75% of GDP.

But to me, it’s more of a mindset issue. Once you accept that it’s okay to spend money you don’t have and make other people pay it off, the battle’s lost. I suspect if you asked them, most advocates for larger government spending as a percentage of GDP—for stimulus or for whatever—would say that in theory, the government debt never has to be paid off anyway. You just have to pay interest on it.

To me, this attitude is immoral. It also destroys a culture of wealth building by encouraging more debt. You may as well have a really good debate about the problem now while you can still do something about.

Once you get on the road to debt, Greece and America and Japan are just signposts on the road. You’re all headed in the same direction. Australia is lucky that it’s tackling the problem now while something can still be done about it. This will prevent a full blown economic crisis later.

CN: Maybe. But you said you were going to talk about the investment component of GDP and the trade deficit.

DD: Ah yes! Let’s start with the trade deficit. Like I said earlier, imagine having a once-in-a-century boom in mining and not being able to run a trade surplus. It’s inconceivable. But for the most part, that’s what happened. The value and the volume of Australian exports rose with the commodity boom.

But the value and volume of imports rose further. While Australia was sending record amounts of copper, iron ore, coal, gold, and bauxite to China, it was more or less running a trade deficit the whole time! That trade deficit continually subtracted from GDP growth.

CN: You say ‘more or less’ running a trade deficit. What are the actual figures?

DD: You can get them from the Australian Bureau of Statistics. Or maybe we can put in some charts after the interview. But basically, from the beginning of the resources boom in 2000 until early 2010, there was only one period where you have a nice string of trade surpluses. That happened in 2008, mostly due to high iron ore prices and a big drop off in imports due to the GFC, where consumers got really nervous.

Trade Balance, Seasonally Adjusted, Jun07-Jun11

DD: After March 2010 up until the end of 2011, you had a really good run of trade surpluses. This was the result of relatively high commodity prices and lower imports for capital goods. Capital goods make the trade deficit worse when you spend on them.

But once you import drill rigs and mining equipment and things like that, they then help you increase production. I believe this is why you saw such an extended run of trade surpluses in 2010 and 2011. Exports of commodities ramped –they peaked at around $300 billion in value in 2011 if I recall correctly—while imports stayed flat.

Trade Balance, Mar10-Mar14

CN: So where does that leave us now?

DD: Well that’s the bad news. Some people think Australia might start running a trade surplus in the future because of increased Liquid Natural Gas (LNG) imports. Most of the major projects in Queensland will start to come on line this year and begin exporting gas to Asia. And that’s true. It should deliver a big boost to export values. Just who enjoys the benefit of that boost is another matter, which I’d like to come back to. But the increase in LNG exports may increase the trade surplus without improving GDP.

CN: How is that possible, though? You said that the difference between exports and imports is added to the GDP if it’s a surplus and subtracted from GDP if it’s a deficit. Trade deficits are a drag on GDP. Surely if Australia is going to run bigger trade surpluses thanks to the beginning of LNG exports, it should add to GDP. We’ll avoid recession and you’ll be wrong!

DD: Well, of course I could be wrong. But you’re forgetting about some other factors.

CN: Enlighten me.

DD: With pleasure. And in all seriousness, this is probably the most important statistic an Australian investor needs to keep an eye on in 2014. It’s going to have the single biggest impact on GDP of any single statistic. It’s much more important than government spending and consumer spending.  It’s what some of us are calling the ‘cap ex’ cliff.

CN: Can you explain?

DD: The ‘capex cliff’ refers to capital spending. It’s the investment stage of the resources boom. When it’s over, I think you’ll see a big spike in unemployment. And the important thing is that there is very little new investment in the pipeline after this year and next.

The ‘cliff’ is the huge drop-off in resources and energy investment that official agencies are predicting, based on the investing decisions of major companies. Once Australia goes off the cliff, we’re going to find out that there are no other industries in the economy coming along to create new jobs and offer new products. It’s about as serious as it gets.

CN: Back up a second, though. You said it was investment stage of the resources boom. What are the other stages and does this mean we’re at the end?

DD: Good question. The Reserve Bank of Australia has said in its research that there were three phases to the investment boom. The first phase began in 2002 and 2003. You saw an increase in resource prices. This was mainly China bursting on to the world scene. Demand was suddenly a lot greater than supply. And like in any market, when that happens, prices rise.

CN: What happened next?

DD: Phase one of the boom delivered a huge boost in profits to the miners when demand outgrew supply. It was also great for shareholders of companies like BHP Billiton and Rio Tinto and anyone who had those companies in their superannuation fund. Their share prices took off as their earnings boomed. I even recommended BHP to my American readers in 2004. The government didn’t hate phase one either. It led to a big increase in the royalties paid to state governments and taxes owed to the federal government.

CN: So that was phase one. What was phase two?

DD: Anyone who’s ever run a business will understand this. When prices rise for what you’re selling, what do you do? You try to produce more of it. Only in the resources industry, that takes a lot of time and money.  You have to plan years ahead and you only do it if you’re confident that prices—in this case commodity prices—are going to justify the investment.

CN: Then came an investment boom.

DD: Australia’s never seen anything like it. From 2003-2012 there were 390 resource and energy projects that went from concept to construction. Those projects had a total dollar value of $394 billion. In GDP terms, that’s a huge investment boom. And that’s just the investment part of the boom. Keep in mind that the investment led to rising wages. It was an employment boom. That’s why you saw so many people moving to Western Australia and Queensland.

Number and nominal value projects at the committed stage

CN: Is that over now in your opinion?

DD: Well the interesting thing is that it wasn’t really a broad-based mining boom. Almost 60% of the total spending on cap ex in that period came from just 13 projects which the government called ‘mega projects’.

Those are projects where the total capital spending is over $5 billion. For example, last year, the ‘mega projects’ made up more than 82% of the ‘committed investment’ for the whole year. They dominated. Of $262 billion in committed investment last year—or investment that’s gone through planned, ticked all the government and regulatory boxes, and received approval form the board with construction starting—nearly $220 billion of that was on ‘mega projects.’

CN: Is that a bad thing?

DD: Not bad in a moral sense. But here’s what’s interesting, once you break down the numbers, you see that it was an LNG boom more than anything else. Over those ten years, LNG projects accounted for almost $200 billion of the total capex. Much of that money was spent last year. It was the peak of capex spending on the mining boom.

Value of projects at the committed stage by commodity

CN: Are you saying iron ore, coal, and copper didn’t have anything to do with it?

DD: Oh they did. There was money spent on new iron ore projects. But the big boon to the iron ore sector was in phase one, with the price raise, and in phase three, which we’ll get to later. That’s the increase in production. But for the investment boom, there’s no doubt it was LNG driving the whole thing.  And here’s the key point: capex on LNG peaked in 2013!

That means the big benefits to the economy from the LNG investment boom, at least in terms of employment, have already been delivered. If you look out over the next five years, the value of committed projects drops to less than $5 billion. Unless ‘likely’ and ‘possible’ projects materialise, investment in new capex will fall off a cliff.

Outlook for committed project investment - likely scenario

CN: If that were true, wouldn’t the RBA be more worried?

DD: You’d think so! But the RBA is convinced that the third phase of the boom will make the capex cliff more of a bump. They think that the production phase of the boom will mean that LNG and iron ore exports can deliver ‘rivers of gold’ to the economy.

CN: Are they wrong?

DD: Yes. I’m sure of it. Forget the value of exports for a moment. Focus on the decline in investment. The ‘worst case’ scenario is actually the most likely. The first is that commodity prices are already on the downside of the cycle. They may not crash. But they are not going to reach the 2008-2009 peaks again anytime soon.

That makes a company a lot less likely to spend billions of dollars producing more of a commodity whose price is in a decline. Second, though, is that a lot of the investment that took place in iron ore is now coming on-line.

This means supply is increasing at exactly the same time prices are falling and demand from China is iffy. You have a second reason NOT to invest in more production. Existing production is already putting pressure on prices!

The third factor is a huge one. It’s that labour costs and the Australian dollar make starting new projects a lot more expensive now than ten years ago. In the LNG sector alone, there are 14 projects in development that are already $144 billion over budget. That is just not competitive. Resource companies know this. Last year alone over $150 billion worth of projects at the feasibility stage were either cancelled or postponed.

If they’re cancelled, they’re not coming back. If they’re postponed, the only thing that can put them back on track is higher commodity prices or lower costs. But that’s not going to happen either.

With higher costs and lower price forecasts for the underlying commodities, the RBA shouldn’t be so sure that the production phase of the boom is going to be enough to compensate for the huge drop off in investment. Once you go over that cliff, you have to run a big trade surplus to make up for the fall in investment. It’s just how GDP works. It’s measuring quantity, not quality.

CN: Readers might be inclined to think the RBA is unlikely to get this wrong.

DD: Well, maybe I’m wrong. I’ll concede that. But if I’m honest, I think the RBA has put all its chips on China. It hopes Chinese steel production remains at about a billion tonnes a year. It hopes iron ore prices stay above $80 so Fortescue doesn’t go bankrupt. It hopes the production phase of the mining boom will deliver billions of dollars to the economy. But I’m not sure it’s thought much past that. Or of it has, it’s not saying what it’s thinking.

CN: What do you think they are thinking at the RBA?

DD: I think they’re scared to death that there’s nothing to replace the investment boom now that the peak has been reached. It’s over the cliff for everyone. That’s why the Bank has left interest rates low even with a strong dollar. Everyone knows the strong dollar is killing Australian manufacturing and tourism.

The only reason the Bank stopped talking down the dollar and stopped talking about rising interest rates is that it knows nothing is coming along to replace the investment boom. It has to leave interest rates low for a long, long, time and hope that business investment from somewhere picks up. Or that a new housing boom saves us all.

CN: I take it you don’t think that’s likely?

DD: Of course not. Australia is already completely over-invested in housing. It’s ruining the economy and destroying the quality of life for millions of people.  It’s creating a ‘rentier’ economy where the only way to get ahead is collect the rent on a property. Nobody produces anything. But more importantly, a whole country can’t get rich and stay rich by selling houses to each other.

CN: Can you expand on that a bit more?

DD: I’m not sure people fully appreciate how extraordinary the mining boom really was, at least in terms of national income. But the best way to show people is to look at the Terms of Trade. That’s a statistic the RBA and other government agencies track over time.

It’s the difference between the value of exports and the value of imports. I like to think of it as the difference between what you get for what you sell the world and what you pay for the things the world sells you. But either way, Australia had it incredibly good for the last twenty years for two reasons.

First, the value of what we sell went way up. Iron ore went from under $40 per tonne to almost $150. Coking well went to over $150 per tonne. And thermal coal went to almost $300 tonne. These price increases delivered a huge windfall in earnings and cash to Australia, which includes the customers who bought the actual coal and iron ore. But in the meantime, the price we paid for imports mostly went down.

I’m talking about electronic goods and white goods and clothes. Don’t get me wrong, Australians actually pay quite a lot for imported goods. But my point is, we were getting a lot more for what we sold and paying a lot less for what we bought. If you put that on a chart, you get a record spike in the Terms of Trade. I mean, nothing else even comes close.

Terms of trade 1873-2013

CN: So you’re saying that’s going to change now. But why? And what are the consequences of falling national income?
DD: Well, most things in life are what statisticians call ‘mean reverting.’  Most things move along in a trend or a range. But you get certain times where something does really well, or does really poorly.

Eventually, it reverts back to its long-term trend. The same thing is true of the Terms of Trade. For about 100 years, its long-term average was 100. During the last boom it went up  to over 175. It’s not going to stay there.

It will fall because iron ore, coal, and LNG prices will eventually fall. And when it does, all that money that flowed into the country through high prices, then investment, and then increased production and sales, will fall. Things will get back to normal. But it won’t seem like normal to people because they’re so used to having all this money flow in.

CN: So what do you think will happen?

DD: Life as we know it won’t end. But it’s going to be a difficult adjustment. For one, you’re going to see a lot weaker income growth. With less money coming into the country, wages won’t grow as fast. And in mining and mining services, they may not fall, but a lot jobs will disappear.

That will mean weak employment growth or much higher unemployment. The economy won’t create as many jobs. There just isn’t any other industry that’s creating a lot of new, high-wage jobs. The jobs that ARE being created are in the service industry. Those are still jobs. But because they’re much lower-wage, lower skill jobs, there is lots of competition for them and you may have to work two of them just to make what one job used to deliver. And that’s if you’re lucky.

This is the Americanisation of the Aussie job market. It’s terrible. But to the extent that it’s driven the globalisation of labour (which means lower wages for the Western world) and to the extent that Australia has crazy laws that keep favouring the real estate industry, I can’t see one single industry capable of employing tens of thousands of Australians. Maybe it’ll come. But I just don’t see it.

Stay tuned tomorrow for Dan’s strategy to beat the recession 


Callum Newman+
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Originally graduating with a degree in Communications, Callum decided financial markets were far more fascinating than anything Marshall McLuhan (the ‘medium is the message’) ever came up with. Today Callum spends his day reading and researching why currencies, commodities and stocks move like they do. So far he’s discovered it’s often in a way you least expect.

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