The Aussie Economy Heads off the Capex Cliff

Assuming you haven’t self-excommunicated from Markets and Money community of gadflies after yesterday’s rambunctious effort, I’d like to follow up yesterday’s letter on LNG with a few more charts and provocations. The charts, as you’ll see in a moment, are provocative enough. It shows you the Australian economy didn’t really have a resources boom. It had an LNG boom, with iron ore and coal doing their bit. And now the boom has driven itself straight off a cliff. Let the hysteria begin.

First, though, is there anything noteworthy happening in financial markets? Not really. But keep your eye out for today’s first quarter national accounts from the Australian Bureau of Statistics. They’ll tell you where the growth in the Australian economy is (or is not) coming from. Export values will be up, but that doesn’t tell the full story of what to expect for the rest of the year.

By the way, the first quarter GDP ought to have a big influence on the share market. But don’t forget about the money printers in Europe. The annualised rate of inflation for the Eurozone was just 0.5% in May. This is the ‘deflation’ that Ben Bernanke feared and European Central Bank president Mario Draghi has sworn to fight. How?

Negative interest rates. That’s how. Large banks can park excess cash at the central bank and earn a modicum of interest on it while they wait for some enterprise worth lending to. But instead of paying interest on those excess reserves, the ECB could in effect charge rent. The banks can either pay the ECB the fee for keeping reserves safe, or they can go out and do something unsafe.

It’s a little strange, isn’t it? The core of the problem that led to the system meltdown in 2008 was that banks had taken too much risk. They were undercapitalised, so that a fall in asset values not expected by the bank’s risk model put the thin base of bank equity at risk. What’s more, they were so intricately connected with one another that the failure of one allegedly put all of them at risk. None of that was good.

And everything the regulators have tried to do since then has been aimed at making the financial system more robust. Why would the ECB and the Fed push banks to take risks just for the sake of getting credit in the system? Because they have small minds and a mechanistic view of the economy. That’s why. They’re making it up as they go along, hoping their heads don’t end up rolling from the guillotine.

But back to markets! There WAS one important non-event yesterday that bears examination. For the tenth month in a row, the Reserve Bank of Australia kept the cash rate at 2.5%. Like the patient and forlorn housewife of a sailor lost at sea, the Bank is waiting on the shore for its ship to come in.

That ship would be some sector — any sector! — in the Australian economy to pick up the slack of the flagging resources sector. The Reserve Bank of Australia wants an investment boom without a housing bubble. Yesterday, it straightened its apron, unwrung its hands, and composed itself enough to release a boring (but revealing) statement which included the following (emphasis added is mine):

Monetary policy remains accommodative. Interest rates are very low and for some borrowers have edged lower over recent months. Savers continue to look for higher returns in response to low rates on safe instruments. Credit growth has picked up a little.

‘Dwelling prices have increased significantly over the past year, though there have been some signs of a moderation in the pace of increase recently. The earlier decline in the exchange rate is assisting in achieving balanced growth in the economy, but less so than previously as a result of the higher levels over the past few months. The exchange rate remains high by historical standards, particularly given the further decline in commodity prices.’

The Bank acknowledges that by attempting to create a non-mining boom to drive GDP growth, it’s punishing savers. But tough luck! I do find it ironic it uses the term ‘safe instruments’, presumably in relation to government bonds. Is any security tied to the full faith and credit of a sovereign government really safe anymore?

In any case, the RBA also acknowledges that all it’s managed to do by keeping rates low for ten months is boost house prices. It admits that it can’t figure out why falling commodity prices haven’t led to a correction in the dollar. It maintains that a weaker Aussie dollar would balance GDP growth with cheaper exports and more expensive imports. It was a busy little statement.

The RBA ought to admit that it’s doing what all other central banks are doing now: making it up as it goes along and hoping nothing blows up in the financial system. But analysis from UBS shows that nearly 95% of the credit extended by Australian banks since mid-2012 has gone into commercial and residential property. Australia’s banking on another land boom.

Clancy Yeates had the story on page 19 of yesterday’s Australian Financial Review. Despite its best intentions — or because central banks have no control of where new credit will flow in the economy — UBS banking analyst Jonathan Mott reckons that over $116 billion in new credit flowed into owner-occupied housing, residential investment properties, and commercial property. By contrast, non-property business lending accounted for 2.6% of credit growth in the last two years, or $3.2 billion.

Do you see what’s happened? The Bank knew commodity prices were topping and that the Terms of Trade had hit a cyclical peak. It lowered rates in the hopes it would finance a non-mining lending boom to drive GDP growth, create jobs, and deliver another decade without a recession. Mission incomplete!

Figure 16: Outlook for committed project investment Australia

Value of projects at the Committed stage by commodity
click to enlarge

You can be sure that behind closed doors, the Bank’s researchers are well aware of the two charts above. The first is the ‘capex cliff’ I mentioned at the top. It shows that the investment phase of the resource boom peaked last year with $268 billion in committed project spending last year. That’s actual money invested by mining and energy companies to bring new production on line. By 2017, that number will be less than $5 billion.

Between now and then, there are bound to be other projects which go through the feasibility stage, get approved, and become ‘committed.’ But that will depend on commodity prices, supply and demand. In cyclical terms, investment spending’s contribution to GDP growth is over for Australia’s economy. We’re over the cliff because there was no bridge to another boom.

The second chart shows that of the $198 billion in committed spending as of the first quarter of this year, the vast majority of it was LNG related. It’s not even close, really. On the resource side, Australia’s ‘all in’ on LNG to be the big driver of export income (with iron ore and coal). The only other sector that could conceivably boost GDP is housing. And I’ll have more to say about that tomorrow.

By the way, I neglected to mention an important detail yesterday about Metgasco [ASX:MEL]. In the process of suspending Metgasco’s already-approved licence to drill in Rosella, the New South Wales energy minister also referred the company to the Independent Commission against Corruption (ICAC). He publicly aired that referral to ICAC, which was unusual. Combined with the suspension of the exploration licence, the referral saw the company’s share price fall from eight cents to three cents.

ICAC wrote to Metgasco on Monday and revealed it had no reason to investigate the shareholder arrangements the energy minister raised in mid-May. Now, it’s not the job of the New South Wales energy minister to look out for the best interests of Metgasco shareholders. But don’t you wonder why he went out of his way to couple the suspension of the drilling license with the ICAC referral?

It’s not hard to figure out, really. There are a handful of dedicated protesters who have the ear of the government. They have certain outspoken talk-back radio hosts on their side. And they have the government on the run. It’s a textbook guerrilla political campaign. It’s also what I referred to yesterday as faith-based energy policy driven by the religious-like zeal of true believers. More tomorrow on the psychology of belief and its application to the stock market (or why we always do the wrong thing).


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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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