Geopolitical Tensions Escalate as Federal Reserve Stimulus Ends

October, so far at least, has managed to live up to its reputation as a wild month for the stock market. You’ve seen a big sell-off followed by a slightly smaller recovery.

That recovery looks to continue into this week, with the Australian stock market up again so far today. News of China’s ongoing house price slide doesn’t seem too much of a concern.

Central bankers managed to stem the decline a few weeks ago with a few soothing words…showing that they are still in control. But for how long is the crucial question.

The US Federal Reserve meets this week and will release a statement on Wednesday US time, in which it is expected to end its quantitative easing (QE) program. Although the actions are well known, it will be interesting to see how the mood of the market changes (or not) post the end of QE.

I finished last week writing about the biggest threat to Australia being the need to finance our current account deficit. It turns out former Treasurer Ken Henry thinks the same thing, although he didn’t say so as blatantly.

Last week, he told the Financial Review that the biggest risk to Australia was that the Eurozone would fall apart. In classic bureaucrat fashion, he clarified his remarks by saying of course he didn’t think that would really happen and that no one should be unduly concerned about anything.

But…if he were forced at gunpoint to nominate a risk, it would be the Eurozone. The risk being that if troubles emerge there, the disruption to the market might stop European capital flowing to Australia.

You see, the Eurozone generates a current account surplus of around US$400 billion a year. Australian banks enjoy some of those surplus funds.

In his comments, Henry related an anecdote from before the last crisis in 2008. As tensions grew in US asset markets, Kevin Rudd asked him what the greatest threat to Australia was. Henry responded by saying, more or less, that it was a threat to funding.

Henry’s advice to Rudd six years ago, pinpointed accurately and presciently the threat to our banks from a freeze in international funding markets.

That threat remains even though it has been lessened by the significant increase in domestic funding of the banks using deposits. David Murray’s financial system inquiry has observed that ongoing access to foreign funding has enabled Australia to sustain higher growth than otherwise would have been the case. “The risks associated with Australia’s use of foreign funding can be mitigated by having a prudent supervisory and regulatory regime and sound public sector finances.”

It’s a good thing then that we have a prudent supervisory and regulatory regime and sound public sector finances…right?

Hmmm. Well, Tony Abbott signaled on the weekend that he’s thinking about giving more power to the states to raise revenue from GST. Which of course means the Federal government will not have to give as much funding to the states…which in turn means a possible shift in federal deficits to state deficits.

You gotta love politicians. There are so many other things they could propose on the tax front to increase Australia’s productivity and improve their finances but no…let’s go down the most difficult path, by shifting budget problems onto the states.

But am I fighting the last war with my concern about Australia’s access to foreign funding? Or is a new one brewing?

It really doesn’t matter what the economic or financial market issue is…if it’s bad or comes with a loss of economic confidence, it will threaten the flow of international finance, and Australia risks being cut off.

But as I said last week, no one takes these warnings seriously when times are good. So carry on…as you were!

What about Vladimir Putin though? Is anyone taking him seriously? They should be, because he’s reasserting Russia’s traditional role as cold war opponent to the US.

In a speech on Friday he accused the US of damaging the existing world order. From Reuters:

Russian President Vladimir Putin accused the United States on Friday of endangering global security by imposing a “unilateral diktat” on the rest of the world and shifted blame for the Ukraine crisis onto the West.

In a 40-minute diatribe against the West that was reminiscent of the Cold War and underlined the depth of the rift between Moscow and the West, Putin also denied trying to rebuild the Soviet empire at the expense of Russia’s neighbors.

“We did not start this,” Putin told an informal group of experts on Russia that includes many Western specialists critical of him, warning that Washington was trying to “remake the whole world” based on its own interests.

Putin made a special mention of Ukraine, the latest flashpoint between the US and Russia.

“Instead of a difficult but, I underline, civilized dialogue they brought about a state coup. They pushed the country into chaos, economic and social collapse, and civil war with huge losses,” he said.

Them’s fighting words…

Tensions between the two countries won’t go away anytime soon. The US is trying to crush Russia economically by imposing sanctions and having its ally Saudi Arabia help push oil prices lower.

In fact, the falling global oil price could have huge ramifications. Many oil producers require a price of at least US$100/tonne. They have built their welfare state and low tax regime around the surplus dollars that perpetually high oil prices bring in.

But that’s all fallen apart in the past few months with prices plunging.

Ironically, these former surplus producing nations (including Saudi Arabia) might start to sell down foreign reserves to maintain the rate of spending they have become used to.

‘Foreign reserves’ of course refers to US treasuries. You can bet the US didn’t think about that when trying to weaken Russia. Talk about unintended consequences!

This is where the end of QE will get interesting for the bond market. With no Federal Reserve buying and foreign central banks taking in the least amount of Treasuries in years, it’s something to look out for.

It’s not an issue yet. Not with the threat of global deflation and the market’s belief in treasuries as a ‘safe haven’ intact. But the bond bubble is closer to the end than the beginning. When it goes down, it will be the biggest ‘pop’ the world has ever heard.

Greg Canavan+
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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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