Why All Eyes are on the Reserve Bank of Australia

One of the biggest frauds perpetuated by mainstream economists is that spending money makes you richer. The Keynesians of the world — like New York Times columnist Paul Krugman and former Prime Minister Kevin Rudd — believe that spending money stimulates economic activity. It creates demand, which leads to new production, new jobs, higher incomes…and more spending!

All of this is wrong. Does eating make you thinner? Of course not! You can only spend money you’ve earned and saved. To earn and save money, you have to produce something.

Production is the real source of all wealth. The inherent virtuousness of free markets is that they encourage producers to give consumers what they want at lower prices. By focusing on productivity, you make the world richer, with more choice and lower prices.

By the way, if the above is true, it’s worrying news for the Australian economy. Productivity has stagnated. Whether it’s red tape, labour laws, or structural, productivity growth has plateaued in the Lucky Country. The problem? If you’re not producing wealth, you’re consuming it. Or worse, you’re importing real capital from elsewhere to pay for your own consumption and investment.

What does this little diversion have to do with financial markets today? Everything. You may have seen yesterday’s consumer spending numbers from the Australian Bureau of Statistics. They showed that retail sales were up 0.6% in June. The cold weather in Melbourne and Sydney forced a lot of people to buy boots, gloves, and beanies, apparently.

Beanies are important. You don’t want to lose body heat through an uncovered head. But beanie purchases will not save Australia from the negative effects of the end of the mining boom. It would take a lot of beanie making and beanie buying to replace the jobs that will be lost as Australia rolls right off the ‘capex cliff’. More on this subject after Thursday’s unemployment numbers come out.

For today, all eyes (sadly) will be on the interest rate machinations of the Reserve Bank of Australia (RBA). Since cutting the cash rate to 2.5% in August of 2013, the Bank has left it there for 11 straight meetings. In that time, lower interest rates have created no real growth in the non-mining part of the economy, except in housing, where prices continue to be out-of-this-world ridiculous.

Allan Greenspan would be proud.

The Bank could cut rates again. I wouldn’t put it past them. But the trouble is, there’s no guarantee the benefits of the rate cut will go to the parts of the economy that need it most. Lower rates could weaken the Australian dollar. That would be good for exporters, industrials, and tourism. But it could also just lead to higher house prices — which is pretty much what happens every time.

The other risk of lower rates is that Australia can’t afford them. By that, I mean that a country that regularly runs a current account deficit must import capital to make up the difference. Australia might need higher interest rates to remain attractive as a destination for foreign capital, especially with China in a different growth mode and commodity prices in decline.

Reserve Bank of Australia Index of Commodity Prices
You can see from the chart above that commodity prices are mean-reverting too. Where will they settle, though? Thermal coal, coking coal, iron ore, and LNG are the main components of the Reserve Bank of Australia’s index of commodity prices. LNG prices look fairly bullish in the short-term, based mostly on long-term contracts. But the rest? It all depends on China.

Former Bank of England Governor Mervyn King had a few things to say about China yesterday. King was in Kalgoorlie giving a keynote address at the annual Diggers and Dealers conference. He addressed one of the issues I’ve been warning about in The Denning Report recently: The decline of American financial power makes the contest for economic power and control of natural resources in the Asia-Pacific more likely to be violent in the future.

Yes, I know that’s unimaginable to most people, especially the unimaginative. But think about it! In today’s Australian, Paul Garvey quotes King on China’s situation (emphasis added is mine):

If you were sitting in China you would be very unnerved to see that you used to be self-sufficient in food and many natural resources, and … you’re now dependent on imports through seas that are controlled by a foreign country’s navy for all your imports of food and other natural resources.

That ought to make you nervous, particularly when that power [the US} is not obviously a friendly power…It’s perfectly understandable that China itself feels nervous and therefore wants to do something to make itself feel less nervous. The problem is, when it does that, it’s going to make other countries feel nervous.

It’s not a question of blaming a country, it’s not a question of people being goodies or baddies, it’s a question of the logic of the position people find themselves in, which means in this multi-polar world countries will do things to try to give themselves security.

Once you get into a position where each country in order to defend itself takes steps which result in the system as a whole being less secure, the system is less secure and accidents are more likely to happen. That’s why we should be more nervous about it — not because people are good or bad or doing aggressive things, but because the framework we end up with is less resilient than the American dominance that everyone moaned about but which turned out to be very robust.

King’s description of China’s vulnerability to food and fuel imports through narrow sea lanes describes Australia’s position as well. At the moment, Australia finds itself on the positive side of this situation. But the moment is changing. And perhaps not to Australia’s advantage.

But enough about Australia. What about your money? Yesterday, I took up the question of whether Listed Investment Companies (LICs) can help you diversify your portfolio. The diversification would come in the form of less exposure to one country and one sector and one commodity (China, resources, iron ore) and MORE exposure to other sectors, countries, and businesses.

LICs are run by investment managers with specific philosophies and strategies. For example, Investors Mutual, run by Anton Tagliaferro, reckons that most Australians own already own the major blue chip stocks. It looks at mid-cap stocks outside the top 20 largest companies on the ASX — companies like Ansell, Orica, Amcor and Sonic Healthcare.

That’s a kind of diversification, away from big caps. But how about diversification that gets you into businesses that generate their cash flow outside Australia? That was the challenge Albert Park Investors Guild Investment Director Meagan Evans took up. She’s put together the Guild’s model portfolios with diversification as one of the main objectives.

Meagan actually has three sub-portfolios set up for new Guild members — Wealth Havens, All Australians, and World Dominators. She currently has two recommendations in the World Dominators portfolio.

As I said earlier this week, the Guild’s approach to investment problems is a lot more pragmatic than mine. I look at the world and see an empire in decline, an empire in ascendancy — both bursting at the seams with debt — and a global financial system caught between its past and its future. I’m selling stocks and buying bullion.

But Meagan and Bernd Struben, the Guild’s Chairmen, have taken a much less geopolitical view of markets. It’s designed for the investor who is just beginning to plan for retirement. It’s also designed for investors who want their investment ideas without the bigger picture.


Dan Denning
For Markets and Money

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Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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