The Australian Dollar, Iron Ore and the Property Ponzi

Good luck, Mike.

While there’s plenty to choose from, this faux well-wishing of Socceroos captain Mile ‘Mike’ Jedinak by Aussie Prime Minister, Tony Abbott, will go down as one of the best stuff-ups of his short (and looking increasingly shorter) career at the top.

It is beyond belief that the PM and his spinners could get this one wrong. But they did. Not the sort of people you want in charge with Australia facing its biggest economic challenge in years. But that’s who we’ve got so strap yourself in…

Probably the biggest challenge right now for Australia is the persistently strong Australian dollar. Over the past few months, the price of iron ore (our largest export earner) has collapsed yet the dollar remains stubbornly high.

The dollar usually acts as a shock absorber. When we’re hit with an external price shock (either positive or negative) the dollar usually rises or falls to absorb the impact. The role of the fluctuating dollar is to ensure price stability and control demand for our exports and imports.

But now the Aussie battler is a victim of out of control global monetary policy. Before I get into the why…have a look at the dollars’ performance against the US dollar over the past year. After peaking at just over 97 cents in October last year, the Aussie dollar fell 10 cents in around three months, a significant decline in such a short space of time.

At the low point in late January, the iron ore price was trading at just over US$120/tonne. Since then, the dollar has rallied by around seven cents (about 8%) while the iron ore price has collapsed by 25%.

Australian dollar — battling higher

Australian dollar

Source: Stockcharts

What’s going on? Why isn’t the dollar following the script and heading lower?

There are two main reasons that I can think of, both related to ultra-loose global monetary policy.

First, there was the post 2008 China credit boom. This created a huge demand for iron ore and sent the price soaring. It created a signal (which is what prices are meant to do) that iron ore production was highly profitable and that if you had a deposit, you had better dig it out of the ground and get it to China as quick as possible.

Predictably, such a strong price signal generates a supply response, and you’re starting to see that in the Pilbara and Brazil now. Tens of millions of tonnes of new supply is now coming on line from the likes of BHP, Rio and Vale. And the supply surplus will only get worse in 2015.

Despite falling prices, iron ore companies around the world are ramping up production based on a past price signal. They have already made the investment. It’s a sunk cost. The only option now is to go ahead with the increased production to generate a return from the investment.

Australia’s three biggest iron ore producers — Rio, BHP, and Fortescue — have all increased production significantly in 2014, and there’s much more to go. So while the iron ore price might be down by 30% in 2014, export volumes are up strongly which means the damage to export revenues isn’t too bad.

That gives foreigners a reason to buy the dollar. And if they can ignore the fact that the falling iron ore price is going to wipe out a lot of the new supply in the years ahead, then buy they will.

The other reason for the strong dollar is simple. Our central bank is not quite as idiotically irresponsible as its foreign counterparts. We still have above zero interest rates. In the world of fiat money managers, everything is relative. If foreign investors view the manager of the Australian dollar (the Reserve Bank of Australia) as more responsible than, say, the Fed, then they will buy the Aussie dollar.

I think this view will come under closer scrutiny as the year unfolds. The Aussie economy is basically propped up by a property Ponzi, the final stages of which have been made possible by an iron ore price and, now, volume boom.

But the events that underpinned that boom are now unwinding. China’s economy is slowing. That’s why the iron ore price is about to break down through the US$90/tonne level. So far, China is doing a good job of managing its bursting credit bubble, but it’s still early days and the stakes are very high.

It will take some time for the lower iron ore price to do its job…that is, reduce the supply response. First, the juniors will go out of business. Even Fortescue will struggle to survive the new price reality. My guess is that it’s only just producing above breakeven at current prices (Fortescue receives a big discount on the headline iron ore price because it produces a lower quality ore).

But that’s only part of the problem. Fortescue has a huge amount of debt. In 2013, it paid out nearly $900 million in interest expense. Such an expense is no problem when iron ore is at US$130/tonne. But at US$90/tonne? Big problem.

If China continues to successfully rebalance its economy away from iron ore intensive growth, then there’s a good chance that the increased supply planned from BHP and Rio in 2015 won’t find a home. They may have to scale back their output.

At that point, the volume boom will have caught up with the price boom. In other words, it will be over.

What will the Reserve Bank of Australia do then? It will probably be in rate cutting mode again… trying to keep the housing boom alive as the export boom fades. At that point, foreigners will turn on the dollar and it will resume its downward trend, acting as the historical shock absorber it’s meant to be.

Which will be good for a while, but the Achilles heel of a weaker dollar is import inflation. Inflationary pressures and a borderline recession — the worst possible outcome for Australia. On top of that we have a moronic political class and a spoilt electorate who thinks hard times is a Charles Dickens novel.

Good luck dealing with that, Toby…

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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