Lethal Economy Weakness Exposed

Let’s return to the premise of yesterday’s episode, that merger and acquisition activity is a sign of a market top. Why? Because when there is no real earnings growth to gain in a stagnant economy, company directors have to manufacture that growth by clever use of the balance sheet. There is also an element of ego involved — the need to ‘leave your mark’ and ‘create a legacy’ by spending billions of dollars on acquisitions that do not create shareholder value.

The latest deal to fall off the truck is the proposed merger between telecoms Sprint and T-Mobile. That $32 billion deal fell apart on Wednesday over concerns that it wouldn’t be able to get over regulatory hurdles in the US. Add that to 21st Century Fox’s failed bid for Time Warner, and $100 billion in mergers have gone begging in the last 24 hours.

Still, it’s been an epic year for deal making. Over $2 trillion worth of mergers and takeovers have happened in 2014, according to Dealogic. That’s a 50% increase over last year’s pace. It’s also the fastest pace for M&A activity since 2007.

Hey! 2007? Anyone remember what happened then?

But just as not all debt is bad debt, not all deals are bad deals. Really, it’s about responsible capital management. Directors have to put the long-term interests of the business first. That might mean retaining a dividend and reinvesting it in the business, not paying it out to investors. It might also mean buying a business that puts you in a better competitive position and doesn’t saddle you with too much debt.

This just in! The seasonally adjusted unemployment rate in Australia climbed to 6.4%. That’s a 14-year high. It also means Australia’s unemployment rate is now higher than the US rate, although I conceded the US rate is largely bogus. Still, the Reserve Bank now has another piece of data to put in its policy pipe and smoke.

Did anyone see this coming? Why yes, yes I did. You can’t fall off a capex cliff, over-invest in housing, run a chronic trade deficit, blow a government surplus, create a government deficit, and expect good things to happen in the economy. But boy, it’s now going to be pretty awkward for the RBA, which is due to release its Statement on Monetary Policy tomorrow at 11:30am.

Using my psychic abilities, I will give you a preview of that Statement now: It’s not working! Slower growth, higher unemployment, and bigger trade deficits would call for lower interest rates and a weaker dollar. But interest rates are already low. Sending them lower will only send house prices higher. The Bank will have to begin contemplating lower rates coupled with New Zealand-style loan-to-value limits in the housing market.

Also, as my mate Greg Canavan points out, higher unemployment is the Achilles’ heel of the housing market. New and first home buyers on the margin can least afford either a rapid rise in interest rates or a rapid fall in income. When you lose your job, you get a rapid fall in income. Unless the market goes fully Chinese — the marginal Australian house buyer replaced by the cashed up Chinese buyer — higher unemployment is bearish for house prices.

And while I’m cleaning out a closet full of bad economic news, did you see that Goldman Sachs is calling for lower iron ore prices? The US investment bank says the average price per tonne will hit $80 in 2015. It’s at $95 right now. This is in contrast to analysts at Westpac who reckon the price could rise 30% from here.

Which crystal ball is right? Well, if you look at from a rational perspective, lower prices make more sense. The production phase of the resource boom has begun. Seaborne supply is growing. Demand, on the other hand, is not growing as fast.

A first-year economics student can suss out what happens when supply grows faster than demand. Prices fall. That would be share prices too, at least for the junior ore companies with lower grade ores and higher transportation costs to get the ore to port.

Meanwhile, over in Europe, there IS a case to be made for buying blue chip stocks ahead of European Central Bank money printing. The Italian economy shrank in the second quarter. Industrial orders in Europe’s powerhouse, Germany, fell by 3.2% in June (month over month), according to data released Thursday. Cracks in the European banking system are beginning to form again.

Tomorrow, I’ll take a look at gold’s role in all of this. And by necessity, I’ll also talk about the relationship between sound money, free speech, and political liberty. If you’re easily offended, give it a miss. You’ve been warned.


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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