Memo to Glenn Stevens — You Can’t Fight the Trend

He’s been quiet for a while, but former Greek Finance Minister Yanis Varoufakis is back. Not in Greece, but with some (presumably unsolicited) comments on the Aussie economy.

In an interview with Fairfax Media, the former University of Sydney academic said:

“There will be a recession in Australia, because of the collapse of investment and because of the collapse of animal spirits – and this is because of what’s happening in China.”

This is hardly a revolutionary statement. I’ve been predicting an Aussie recession on the back of a China slowdown for years. And I’ve been wrong.

The Aussie economy is truly one of the wonders of the economic world. It just keeps defying the ‘doomsayers’, or realists, as I would prefer to call them.

It sailed through the crisis of 2008. It did so via massive fiscal and monetary stimulus. China’s record breaking credit boom provided another shot of economic adrenaline. It kicked the economy along from 2009 to late 2011.

I can’t remember the stat off the top of my head, but the Chinese banking system expanded credit at something like five times the size of the whole US banking system in the space of a few years.

Much of the credit went into property construction and speculation. This is what pushed the price of iron ore up to a nose bleed level of US$180 per tonne in early 2011.

But what’s going on now? The iron ore price fell yesterday to fresh 10-year lows. The Tianjin benchmark price is now trading at US$42.80. This is a nasty trend and will keep going. I don’t see a bottom in sight for some time.

The fall to new lows comes just in time for Gina Rhinhart’s $10 billion Roy Hill mine to deliver its first shipment of red dirt to China this week.

And that’s the problem for the market. The demand and supply metrics remain awful. The juniors — and I’ll add Fortescue [ASX:FMG] to that list — keep cutting costs to remain competitive. But that doesn’t remove supply, which is the whole point of lower prices.

As a result, prices will keep falling until meaningful supply exits the market. That won’t come from BHP [ASX:BHP] or Rio [ASX:RIO] or Brazilian miner Vale. It will come from the juniors and probably Fortescue.

So spare a thought for all those who tipped in millions to keep Altas Iron [ASX:AGO] afloat back in August. The way things are headed, that money will be gone by the end of the year.

In case you needed any more evidence of the woes facing the iron ore industry, look no further than Rio. Yesterday, its share price broke down to new lows. It’s now trading at the lowest point since its existential crisis of 2008.

Here’s the one year chart…

Source: BigCharts

[click to open in new window]

Don’t try to bottom fish here people. This is a stock with massive exposure to iron ore and the price will continue heading down until something happens with supply.

Demand won’t save it. China is long past pumping up the iron ore price with its infrastructure stimulus packages. It’s desperately trying to transition to a consumer led economy, and away from the old growth, commodity intensive model.

I wonder how the Reserve Bank will view the ongoing deterioration of Australia’s most valuable export? They’re meeting today to decide on interest rates. It’s a pretty safe bet that they will leave them where they are. When you’re this low on interest rate ammunition, you want to make sure you save it until it’s really necessary.

In recent weeks, the Reserve Bank has sounded quite sanguine on the local economy. It goes back to Varoufakis’ comment above on ‘animal spirits’. RBA boss Glenn Stevens is a big fan of animal spirits.

In previous speeches, he’s talked about the mysterious absence of animal spirits when it comes to business lending. At the same time, he ignored the frothing-at-the-mouth-spirits of the property speculators.

One way of keeping the punters hyped up, in Stevens’ world, is to remain ‘confident’. If he starts getting all worked up about the iron ore price, and cutting rates in response, it will have a negative effect on ‘animal spirits’.

So better off to pretend that everything is fine and encourage as much debt accumulation as possible, right? Sounds crazy to me, but that’s how our economic managers see things right now.

To be fair, some of the data out lately on the Aussie economy hasn’t been too bad. Employment remains decent and the services sector is humming along. Consumers keep spending too, although not at Dick Smith [ASX:DSH] stores by the look of things.

But the way I see it, most mainstream economists and the RBA look at each pick-up in activity as the start of a ‘recovery’. This is like looking at each momentary rally in BHP’s share price and thinking it’s the start of a new uptrend.

My point is this: the bigger picture trend for the Aussie economy is weakness. The overriding driver of that is the collapse in the iron ore price. This drags down our terms of trade and reduces growth in national income.

Falling national income growth is basically a recession. So far, falling interest rates have masked the effect of this stagnating national income growth. The question is, for how much longer can interest rates subvert the overriding trend?

We’ll get more clues on the trend of the economy tomorrow with the release of the September quarter national accounts. The signs are that the growth number will be better than the June quarter. But as always, the devil is in the details.


Greg Canavan

For Markets and Money

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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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