Pavlovian Dog Iron Ore Bounce

If ever there was a Pavlovian response by markets, it came with a 4% surge in the iron ore price overnight. After threating to breach US$80, the spot price is now around US$85/tonne.

The bounce came in response to very weak Chinese data over the weekend, which indicated China’s economic growth target of 7.5% will be hard to reach. Most worryingly, power generation fell for the first time in four years, falling in August by 2.2% year-on-year.

So why the iron ore price surge? It means more stimulus, of course!

It’s a response the Chinese authorities have for years now conditioned the markets for. But this is not 2008, 2012, or 2013. In 2014, the art of can-kicking is very different to what it once was.

The old form of can-kicking was to just fire up growth via fixed asset investment, which is basically property construction. But that growth path resulted in a huge misallocation of resources, and going down the same path again would work against Premier Xi Jinping’s attempts to rebalance the Chinese economy more towards consumer spending.

How to do this though?

Well, the standard response from most analysts is to ease monetary policy. Like it’s been tight lately?! From Bloomberg:

China’s one-year interest-rate swaps dropped by the most in almost three weeks as a slowdown in industrial growth spurred speculation the central bank will loosen policy.

“A sharp slowdown in economic activities last month will force the central bank to roll out more loosening policies,” said Deng Haiqing, Beijing-based head of fixed-income research at Citic Securities Co., the nation’s largest brokerage. “Without sustained stimulus, it’s likely that both economic and financial data will continue to worsen.”

But hang on. China is only just coming out of the other side of the greatest credit boom in history. Lower rates don’t tend to work their magic on the way down. More to the point, much of the credit created went to property development, a sector that now suffers from excess capacity.

Will lower interest rates encourage Chinese households to borrow more…to go out and furnish their homes and ‘consume’ like the West does?

I don’t really know…but keep in mind that China is a nation of savers, not borrowers. Lowering interest rates actually takes purchasing power away from the household sector by lowering their interest payments.

Sure, a reduction in rates might help at the margin…and it might help struggling companies to keep their head above water. But if China really wants to rebalance their economy, a standard interest rate cut probably isn’t going to work.

So enjoy the iron ore bounce, but don’t expect it to last for longer than a few weeks, or months at the most. Iron ore is in a bear market. It will likely be that way for years. Sell the rally.

This has major ramifications for the Aussie economy too. As the iron ore price bust washes over the nation during the second half of 2014 and into 2015, the effects will spread far and wide. The iron ore companies are right at the coalface, and the marginal producers are already struggling.

Yesterday, Arrium [ASX:ARI] (formerly Onesteel) put its hand out for $754 million. With the iron ore price below its total cost of production, it wants to pay down debt and get through a protracted period of low prices. It will keep on producing at a loss, but I’m not sure how long it can do so before it goes bust.

Mining services stocks are obvious casualties from the iron ore price bust. But soon, consumer discretionary and banking stocks will begin to feel the pinch as lower incomes work through the economy.

So how do you make money in this environment? Well, if you’re like me, you wait until good value presents itself. The market hasn’t been kind to value investors for years, but that will change.

If you don’t want to wait, you need to take some risks. But it doesn’t have to be mindless. You just need to look where others aren’t. The tech sector is a good place to start because of its vast size and scope.

I just watched a presentation by my mate Sam Volkering, Editor of Tech Insider and Revolutionary Tech Investor. If you can ignore Sam’s hilarious impression of a robot, it’s a quality presentation.

In it, he talks about the importance of getting onto technology trends just before they reach mass market adoption. He profiles five companies that he calls ‘feeder stocks’ — basically suppliers to the soon to be burgeoning robotics industry.

Getting back to the iron ore bounce, it didn’t have a great impact on the Australian dollar overnight. Yesterday, the little battler dropped below US$0.90 but recovered only slightly during the US trading session.

Below is a chart of the recent price action. In the space of a week, the dollar plunged 4 US cents. In foreign exchange land, that’s massive. The currency is now oversold (compared to an ‘overbought’ US dollar as I showed yesterday), so it should settle around 90 cents or rebound a little bit over the next few days.


Aussie dollar plunges



Or maybe not. Much depends on the outcome of the Fed’s interest rate meeting, which gets underway tonight, Australian time.

Usually, in the lead up to Fed meetings, the market rallies on the expectation of ‘lower for longer’ interest rates and generally dovish commentary from Yellen (formally Bernanke). But now, there is more nervousness around. The punters are bracing themselves for an all-important change to the language contained in the interest rate decision.

Rates may no longer stay low for a ‘considerable’ period. This may not seem like a big deal, but in the modern world of central banking where language is an important policy tool, it is.

If the change in language does indeed signal a faster than expected increase in US rates, then expect more market volatility in the weeks ahead.

That means the Aussie will probably resume its fall, after a brief respite. Many think that a weaker Aussie dollar is a good thing and just what our economy needs. Tomorrow, I’ll dispel that myth. I’ll also have a few words to say about gold.

Regards,

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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