Big things, like cities, dinosaurs, and Jenga towers made of oversized wooden blocks, are doomed to fail. They consume too many resources. They don’t adapt well to change. And they don’t react well to meteors (cosmological Black Swans) or other structural challenges. That was the basic point of yesterday’s Markets and Money, and one I’d like to follow up on tomorrow, where we’ll talk about Italian city states and the modern Police State.
Today’s episode, though, is all about Jenga. It was inspired by something I saw on Fitzroy Street as the sun went down in St Kilda last night. It occurred to me that it’s a great analogy for what’s going on in Australia’s economy and in the share market. The more hollowed out something becomes, the less structurally stable and the more prone to a catastrophic crash. Take a look at the picture below and then let me explain.
Janet Yellen in Action
Janet Yellen in Action
Source: Jenga Tournament
Jenga is a dangerous game. You win by not losing. But that’s easier said than done. Each player must remove one of the wooden blocks from the Jenga Tower. At first, it doesn’t really matter which block you remove. The stability of the whole structure is not affected by the removal of a random block.
But as the game progresses, you have to be more careful. You need a keen eye for which block can be removed without causing the whole tower to topple. And of course, at some point — let’s call it a tipping point — no further blocks can be removed without compromising the structural integrity of the tower. If you’re the one who has to remove a block at that point, you lose.
An economy is like a Jenga tower. The more diverse it is, the greater the division of labour, the stronger the whole of the structure is. The more blocks there are holding the whole thing up. You can lose a whole industry to creative destruction. But because there are so many other pieces in play, the tower won’t fall.
If Australia’s economy were a giant Jenga tower, it would have four big banks, two big miners, a few retailers, a telco, a conglomerate or two, and some insurance companies. That’s about it. And you know what that means.
You can’t remove too many blocks from Jenga Australia without toppling the whole thing; at least that’s the claim I’m making. Right now, the blocks are coming out thick and fast. For example, the iron ore price fell 2.3% again overnight. It’s broken through the $80/tonne level. Not coincidentally, the Australian dollar fell below 90 US cents at the same time. There goes another block!
If confidence were a Jenga block, Li Xinchuang took it out yesterday. Li is the deputy secretary-general of the China Iron and Steel Association. He told a conference here in Melbourne that Chinese steel production would not — in fact, could not — grow beyond 900 million tonnes. It’s 800 million tonnes at present.
The trouble is BHP and Rio Tinto are adding production capacity based on the forecast that China will eventually produce a billion tonnes of steel per year. ‘It cannot, trust me, I have been in the business 30 years,’ Li told The Australian. Who is right? The man from China or the Australians selling him iron ore?
Well, as usual, not everything is as it seems. BHP and Rio don’t mind oversupplying the market now to gain market share later. They are the low cost producers. The lower prices hurt the profitability of their operations, but they hurt high-cost producers more.
BHP and Rio can stand lower iron ore prices, especially if it drives high-cost Chinese producers out of business, giving the pricing power in the market back to producers. The non-Australian shareholders of both companies will see the wisdom of the strategy. The short-term pain, especially to the share price, is the price that must be paid.
You can see there is a strategic game going on between China’s steel producers and Australia’s iron ore companies. Who holds the power over prices? Consumers or producers? For Team Australia, what’s good for BHP and Rio in the long term may not be enough to save the economy from a nasty recession in the short term. And I haven’t even discussed the banks!
The banks, all four Jenga pillars of them, are critical to the growth of the housing bubble. But they’re just as important to the Australian share market, where they pay out rich dividends and are key holdings in main superannuation funds. It hasn’t been a great September for them.
For example, Commonwealth Bank shares are down 7% this month. NAB shares are down 6% Westpac shares are down 8%. And ANZ shares are down 7%.
The S&P/ASX 200 is down only 5% cent in the same time. But that fall wipes out nearly all of this year’s gains by the index. It began the year at 5352. It reached an intra-day high of 5667 in early September. It opened today at 5355.
The ASX 200 has the same problem as the broader US market, a lack of breadth. Yesterday’s blogs focussed on the ‘death cross’ in the US small cap stocks. That’s a technical situation where a short-term moving average (50 days) crosses below a long-term moving average (200-day). It’s a bearish chart pattern. But not nearly as bearish as the chart below.
The chart shows how broad the rally in the NASDAQ composite is. The answer is, ‘not that broad’. The index fell by 1.3% yesterday. Tech stocks always move higher faster and fall further faster than the rest of the market. But this chart shows you that the 45% of the stocks in the index are not even in bullish technical trading patterns.
In simpler terms, the rally in all stocks has been driven by an increasingly smaller group of companies. The concentration of liquidity into a narrower number of positions — mostly big-name tech stocks in America and blue-chips with a high yield in Australia — is enough to move those stocks, and the index, higher.
But the index highs have managed to mask a structurally weak market with little breadth. It’s a Jenga tower near the tipping point. And for the Pollyannas in the Australia financial press who think everything will be fine, there is more uncomfortable news.
China won’t be reacting to a lower iron ore price by pumping money, said its Finance Minister Lou Jiwei over the weekend. It means China is concerned about its own Jenga tower — unstable from an over-reliance on steel-intensive fixed asset investment. How low will the iron ore price go without the promise of more Chinese stimulus? How low the dollar?
The questions are hard. The answers are ugly. And now the global jackals are circling, howling for a lower Australian dollar, a house price crash, and a share market correction. Nouriel Roubini says Aussie GDP growth will stall at 2% in 2015. He’s calling for a 20% correction in the value of the Aussie dollar on weaker Chinese growth. That would put the dollar below 75 US cents.
Maybe it’s all a tempest in a tea cup. After all, we’ve made it through September without the traditional market crash. We’re nearly home free, aren’t we? More on this tomorrow.
For Markets and Money