Signs of the top are everywhere in the business world. All you have to do is look at record iron ore prices and merger and acquisition activity in coal, iron ore, and gold. It all feels very 2007. We’ll explain in detail below what’s got us so nervous.
But you couldn’t close out your week without studying the action in the bond and currency markets. The illusion of U.S. dollar stability has given the market the confidence to believe everything is A-Okay.
In fact the Dow just finished its best first quarter since 1999. The U.S. benchmark was up 4.11% for the quarter and up 5.5% in March alone (things didn’t start so hot, but it ‘recovered.’) The Dow is now up 65% from the lows of last March. Even an unexpected loss of 23,000 U.S. jobs in the month didn’t slow down stocks all that much.
Our view is that the strength of the dollar and dollar-denominated assets is mainly relative. The greenback is not the euro, and lately that’s worth something. But now is probably the right time to examine what happens to Aussie stocks and the Aussie dollar if the U.S. dollar weakens.
One asset to look at is gold. When the greenback falls, look for another move up in the gold price. Gold itself closed higher on a quarterly basis for the sixth time in a row. It was only up a modest 1.7% in the first quarter. But it’s up 27% since September of 2008, according to wire service reports. And more importantly, this sixth-consecutive quarterly rise is gold’s longest such rally since 1979.
Hmm. Take a look at the chart below. We cooked it up this morning over coffee. The red box on the left shows that the U.S. dollar gold price went up by 721% in just 41 months by the time it topped out at $850 in January of 1980. Conversely, the current move in gold is about half as much (379%) over a much longer period of time (125 months). So what’s the difference?
We’d argue that the move in gold over the last ten years is more like the move in gold between 1970 to 1974. During that time, gold was unhitched from the U.S. dollar, which was no longer redeemable at the U.S. Treasury for physical gold. The metal went up 461% in 48 months. Then it corrected. And then – when inflation took hold and U.S. interest rates hit double digits – gold peaked.
It was clear by 1974 that a global fiat dollar standard was going to be inflationary. The markets priced relatively scarce tangible goods appropriately as the supply of dollars grew. This recent move in gold has been more gradual, probably because what’s happening in the world of fiat money is less clear. But things are clearing up now, which is why we’d expect to see a higher gold price.
What’s more clear? That paper money of any vintage is increasingly garbage.
In the first five years of the last decade, it looked like the euro was becoming a serious and respectable contender as a world reserve currency to complement, or even replace, the U.S. dollar. Central banks and investors began diversifying their foreign exchange reserves to reflect the power shift in the fiat money world.
But in the last two years, it’s dawned on more and more institutional investors that the super cycle in paper money itself – kicked off in the early 1970s – may be reaching its final self-destructive peak. This is, of course, an extreme position and many people would argue against it. To accept that paper money backed by nothing is a con game is to accept that much of the prosperity of the last twenty years is phoney and that the policy makers who fix the price of money are con artists.
You don’t say that sort of thing in polite company. But it doesn’t mean you shouldn’t wonder whether or not it’s true, and what it would mean for your net worth if it was. Obviously we believe it is true. And we think the gold price is beginning to show that other investors agree. It is possible, however, that a genuine euro crisis would send the U.S. dollar higher and gold lower in the short-term.
After all, gold made a short-term high and nearly busted through US$200 at the exact time that the the Dow was making a 1974 bear market low at 577. Over the next two years the Dow nearly doubled and gold fell. By the end of 1976 the Dow was at 1,004 and gold had fallen back to just above $100.
It’s interesting to note that the gold price bottomed in 1999 about six months before the Dow made its tech boom high (in January of 2000). And today, the notable difference in the behaviour of the gold price is that it has not made lower lows as the Dow has bounced off its lows last year. Gold looks stronger and more resilient now than it did in the early 1970s when it was harder for retail investors and institutions to buy it through a vehicle like an exchange traded fund.
Fortunately, people know more about gold today and understand its investment benefits. If the Dow makes a new high, it’s of course possible gold could correct below $1,000. But either way, we expect the next down move in U.S. stocks to be bullish for the gold price.
As always, it’s complicated for the Aussie dollar. If the U.S. dollar weakens against the Aussie and the Aussie approaches parity, the Aussie gold price will probably not move up higher. On the other hand, an Aussie dollar decline would imply some strength in the U.S. dollar. And that is not exactly consistent with our view on the greenback, given the horrible fiscal picture in America. So how we make sense of the muddle?
That brings us to the merger and acquisition activity in Australia. You may have seen that gold producer Lihir received a $9.2 billion takeover offer from Newcrest over night. Lihir says the offer undervalues the company’s assets. But whether it does or doesn’t, does the bid remind you at all of the BHP and Rio Tinto shenanigans a few years ago?
That was a case of a major company feeling its oats at the top of the cycle and making a bid too far. Rio’s reaction to the BHP bid was surprisingly destructive for shareholders. The company went out and borrowed billions of dollars to buy Alcan. It did this right before the credit crisis.
Then commodity prices fell and Rio was left with a massive amount of debt to refinance. It solved the problem by selling off some assets and making an abortive merger attempt with China’s Chinalco. Shareholders got punished the entire time.
You can assume Rio’s board did not begin with the intention of destroying shareholder value. Neither did BHP. So why do big merger propositions tend to rear their heads at the top of the cycle in the commodity markets? Is it just managerial vanity? Riding high on higher production and higher prices, do CEOs want to take over the whole world?
Or is there a rationale approach that you can only achieve further growth through acquisition, and not organically? We reckon it’s a product of vanity and lack of imagination. What else are you going to do with shareholder cash at the top? You ought to probably keep it and wait to buy undervalued assets when no one wants them. But that takes patience and doesn’t make headlines or always make compensation incentives.
Yet Australia is rife with signs of firms large and small making hay while the commodity sun shines. Mid-West iron ore producer Gindalbie Metals announced yesterday an off-take deal with its joint venture partner in China valued at $71 billion. Gindalbie aims to produce 30 million tonnes of iron ore a year from its mine for thirty years and sell it to Chinese steel producer Ansteel.
A deal like this is only possible if iron ore prices are moving higher. The highest-grade hematite ores are still found in the Pilbara and mostly locked up by BHP, Rio, and Fortescue. But at the big end of the market prices definitely ARE moving higher. This has a kind of “trickle down” effect that makes smaller projects with lower grade ores or higher capital and infrastructure more economic with the higher ore price.
But make no mistake, BHP’s announcement that it secured nearly a 100% rise in ore prices from last year’s contract price AND that it’s convinced Asian steel-makers to move to a quarterly pricing system ends 40 years of doing business one way. It also has several major economic consequences investors must sort out.
First, it’s going to improve the terms of trade. That is Australia is going to get more for what it sells and pay less for what it buys. You’d expect this to result in much narrower current account deficit, which is already chronically wide. But so far, anyway, that’s not the case.
The ABS reported today that February’s current account deficit was nearly $2 billion. Exports were off one percent as coal volumes fell while imports were up 2%. It’s always a shocker that a country in the middle of a commodity boom would regularly run trade deficits.
That might change a bit as the terms of trade improve. Australia’s export volumes should grow. And with higher coal and iron ore prices, export values would grow too. It would be hard, in the absence of a credit expansion (and business credit is NOT expanding according to yesterday’s RBA release) to see domestic consumption and imports outsprint exports. But stranger things have happened.
Incidentally, what’s happening in iron ore is also happening in coal. ASX-listed Macarthur Coal rejected a take-over bid from U.S. listed Peabody Energy earlier in the week. It drove up Macarthur’s shares by double digits. And Diggers and Drillers editor Alex Cowie tells me it drove up his latest coal recommendation too. He also mentioned his two iron-ore recommendations are doing quite nicely as well.
What’s interesting about all three recommendations is that Alex didn’t make them solely on the basis that he expected higher prices for the underlying commodities these firms were out to produce. He did a good old fashioned balance sheet analysis about net cash. He found the companies, in other words, when they were relatively cheap.
It also turned out they had great resource projects that were leveraged to higher resource prices. But the healthy balance sheet is where he started his search. Keep your eyes peeled this weekend for a message from Alex about what he’s up to. If you’re a current Diggers and Drillers reader, you’ll have already read about what he’s talking about. But if not, stay tuned.
Back to the big picture. Do think the RBA may be worried that all that iron ore and coal money is going to lead to inflation in the country? If it is, the improvement in terms of trade and the new iron ore pricing structure may indirectly contribute to the case for higher interest rates. But the whole scenario shows you clearly what a two-speed economy really is.
Australia’s extractive industries are set to generate big surpluses and profits that should fuel wages in the mining sector. This won’t make Perth homes more affordable, mind you. The median Perth home price is $500,000. But the mining boom will fill government coffers and should be good for shareholders as long as it lasts.
Yet if the banks persist in importing capital to finance more housing lending, the country’s resource bounty will effectively be squandered away. The windfall coal and iron ore profits aren’t yet leading to any substantial investment in other productive industries that diversify the economy and lessen its reliance on the booms and busts of the commodity market.
And that’s the last note we’ll leave you with before the long weekend. Australia is more than ever vulnerable to a China bust. The 2007 slump and GFC had its roots in the American sub-prime mortgage crisis. Since that debacle, the Aussie economy has battled through and now, with mergers afoot and ore prices doubling, everyone thinks the good times are here to stay.
But that won’t be the case if, in fact, the world’s biggest bubble is precisely what’s driving demand for Australia’s resources. If China turns out to be a paper dragon, what will happen to Australia’s economy then? And what, if anything, can you do now to hedge against that risk?
Putting the question in the China context suggests that the shift in pricing power in the iron ore industry is temporary. A deep and liquid market for iron ore with more continuous pricing is only possible if the growth in the global steel market continues. And THAT is only possible if Chinese fixed asset investment continues to command a huge share of Chinese GDP.
But as we’ll show next week, that last bit is not possible at all. And it’s end may come sooner than you think. We’ll take up that subject in full next week. Until then…
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