The Big Red Plan

–“A surprise dive in company profits has all but confirmed Australia will record negative economic growth when March quarter figures are published tomorrow, with quite possibly a worse result than during the global financial crisis,” reports today’s Age. This is not the contraction we warned of at the end of yesterday’s Markets and Money. But it’s a start.

–Corporate profits were down 2% in the first quarter, according to figures published by the Australian Bureau of Statistics. Mining profits were down 6%. The ABS cited floods, cyclones, tsunamis, and earthquakes (the one in Japan, obviously) as the main reasons for lower mining profits. A rebound is, ahem, expected.

–The contraction we had in mind is the kind you get after a multi-decade global binge on credit. The contraction we had in mind is more like a convulsion, the sort of thing you get when the global economy goes through credit withdrawal. That’s not a one-quarter contraction. It’s a contraction that demonstrates corporate profits are mean-reverting too.

–But for THAT contraction to happen, China’s economy will have to stop expanding by around 10% a year. China’s economy could very well cease expanding by double digits if you get currency destroying crises in Europe and North America. But for today, at least, you’ll read that Chinese steel production will grow by 25% over the next five years.

–The China Iron and Steel Association, which is run by the government, reckons China will produce about 750 million tonnes of steel by 2015. That would be according to plan, literally. China’s latest official five-year plan calls for annual GDP growth of about 8% per year. Given China’s high rates of fixed-asset investment—bridges, roads, buildings, etc.—that’s a lot of steel.

–China already produces (and consumes) a lot of steel, come to think of it. According to the World Steel Association, Chinese mills produced about 626 million metric tonnes of steel in 2010. That was more than the next 15 countries combined. In fact, China has more excess steel production capacity than the production capacity of industrial nations Japan and Korea.

–Hmm. If everything goes according to the Big Red Plan, then all Australia has to do is tuck itself in China’s slipstream and enjoy a free ride to prosperity. A lot of coal and iron ore will have to be dug. But that should keep everyone busy and cashed up for the next 20 or 30 years.

–Of course it’s also possible that China’s steel production is based on consumption trends that are utterly unsustainable and also a function of the global credit boom. If that were true, it would be impossible to decouple China’s growth story from America’s deleveraging story and Europe’s sovereign-debt story. And it would be impossible for China, and by extension Australia, to escape the consequences of the downturn Marc Mobius says is coming.

–Mobius runs Templeton Asset Management’s emerging markets group. He told Bloomberg yesterday that, “There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis.” Mobius reckons that the global derivatives market is where a new crisis is brewing. The notional value of the over-the-counter (OTC) global derivatives market is more than $600 trillion, according to the International Swaps and Derivatives Association (ISDA). That’s more than 10 times global GDP of $50 trillion.

–It is not always easy to understand how something like a derivative, which is a kind of financial abstraction, can destroy real asset values. But oh can it ever. Derivatives are just financial instruments whose value is linked to some other asset. The biggest derivatives markets, by size, are in interest rates, bonds, and currencies. The ISDA reckons that 77% of OTC derivatives are interest rate derivatives.

–So what’s the problem? If investors are using interest rate derivatives to hedge their risks, that’s kind of what derivatives are for. Put and call options, which are also derivatives, are kind of like insurance policies against movement in an underlying security. If the stock goes down, your put option (in theory) goes up.

–But with most insurance policies, you hope you never use them. You’re happy to pay the premiums for a policy because the small regular cost means you’ll never be poleaxed by a giant, catastrophic cost. The premium buys you peace of mind.

–There are surely some financial operators out there today who use interest rate derivatives as insurance. But the size of the market reveals an obvious fact: derivatives have become a playground for over-leveraged speculators to make profits on interest rate bets. It’s a big casino.

–There’s nothing wrong with casinos, of course, unless you have a gambling problem. But the problem for investors is that what happens to the value of the derivatives in the OTC casino affects that value of assets and capital on the very real world balance sheet. Big losses in the derivatives markets can trigger asset price falls and defaults. This is what happened in 2008, only then the derivatives in question were securities linked to the value of sub-prime backed U.S. mortgage bonds.

–Come to think of it, we’re kind of back where we were in 2007. The financial industry has somehow hijacked monetary and fiscal policy in major countries in order to serve its own interests. And its own interest are to leverage up again via cheap global interest rates, make a lot of speculative bets, and leave the losses to the public.

–Excess leverage distorts investment values (all sorts of non-investment values too, really). It turns all of us into speculators because asset values are divorced from fundamentals (a business’s ability to grow cash flow and profits) and become subject to financial money flows. When it’s that dangerous to invest, it’s better to identify assets you want to buy…and then wait for prices to correct.

–“Why are you such a depressing person?” a friend asked last night.

–“I’m not depressed at all. Life is good. Why would you ask that?”

–“I didn’t say you’re depressed. I said you’re depressing. You only ever write about bad things that have happened or might happen. It’s almost like you want them to happen. Like they make you happy, in a depressing sort of way.”

–“Well, that’s not the case at all. I just think a lot of bad things are probably going to happen. That’s why I write about them. But it doesn’t make me happy. It doesn’t make me sad, either. When I think good things are going to happen, I write about those too.”

–“I don’t remember reading about any good things in the Markets and Money. I look around me and see that for most people, life is getting better. They have jobs and money and credit cards and smart phones. I mean for most people, things have never been better. ”

–“Well, if you mean that most people, on average, have never enjoyed so much material affluence in human history, yeah, that’s right. That’s not the same as being richer, or enjoying a better quality of life. But it’s true…a lot of people live like kings today compared to…people who used to be kings. But my point is that if things tend to get better and better over time, people pretty much stay the same. People don’t improve like new versions of an iPod or an iPhone. People today aren’t any better, qualitatively, than people a hundred or a thousand years ago.”

–“But people know a lot more. We know the world isn’t flat. We know the laws of physics. We know how to split the atom. Heck, we know there IS an atom.”

–“Well that’s true. But knowing more about the world you live in doesn’t automatically make one a better person, ethically, morally or spiritually. I guess what I’m saying is that you can have progress in a material sense—better medicine, more innovation, higher standards of living—but it doesn’t equate to us being better people.”

–“Speak for yourself.”

–“Okay. In some ways, financially especially, and in the way we let ourselves be governed, we just keep getting dumber…putting people in debt for life with mortgages…putting all our financial eggs in a few baskets with too-big-to-fail institutions that have government guarantees…and tolerating the garbage money produced by our garbage financial overlords. Today’s financial oligarchy isn’t that much different than feudal oligarchies. It’s just that peasants can drive Priuses.”

–“See. That’s progress. More Priuses means less carbon dioxide and no more global warming. See, that’s progress.”

–“I think we better have that discussion another time.”

Dan Denning
Markets and Money Australia

Dan Denning
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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16 Comments on "The Big Red Plan"

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Dan’s Friend: “”I didn’t say you’re depressed. I said you’re depressing. You only ever write about bad things that have happened or might happen. It’s almost like you want them to happen. Like they make you happy, in a depressing sort of way.” As I read down through The Big Red Plan, I found myself thinking Yankee Dan really gets a charge out of any minor crisis in Australia, doesn’t he? Then I read your friend’s comment. What you should have explained is that: 1.) It’s your job to ferret out anything financially negative, here and abroad; 2.) Where a… Read more »


“record negative economic growth” This is not possiable you can’t have negative growth the pharse doesn’t sense. If something is growing negatively for a long time for instance what would it then become? Ecomamic contraction a much better pharse.


Actually the pharse does make sense from time-to-time. ;) “I don’t remember reading about any good things in the Daily Reckoning.” Shame on you, Friend-of-Dan! What about the incredible rise of Silver after Kris counseled us all to buy? And how about the incredible fall in property interest rates, from 9.45%? I recall that as a Yksnim Moment in DRA reports! Enough of the happy stuff… . Good news? Not your job, Dan. We _need_ these distant early warnings of possible crises _daily._ Where would we be if we didn’t search daily for that paragraph, two-thirds through an article, where… Read more »

Crumbs BP
So many vote on your post
A gun on your hip
drew attention from most

You have fought them on the beaches
And on the the landing grounds
In word perfect speeches
We shan’t spell as peaches

Alas you won’t sleep now
Without gun at your reach.

Have a good day BP ;)

To be sure, the DRA has always published good news; the Gold Price remains good news – and ought remain so, while the world’s real wholesale interest rates remain negative. —————————–oOo——————————- If that is true – gold and real whole interest rates are negatively correlated – or trades from opposite ends of the table – it would point perhaps to the wisdom of Dan’s statement, above:- “There’s nothing wrong with casinos, of course, unless you have a gambling problem. But the problem for investors is that what happens to the value of the derivatives in the OTC casino affects that… Read more »

bugger! A few grammar/edits needed!

So sorry…

Quite a few good things are happening in the first world, just not on TV. More and more veggie patches in more and more backyards, more bartering, more saving, more exposure of mainstream media garbage. It’s all pretty good, as long as you’re not one of the low hanging fruit countries with juicy gold reserves that Wall Street is hoping to milk, such as Greece, Portugal, Spain and Italy. But then again, if you’re in Iceland, you might well have crossed to the other side of the world’s crisis and needn’t worry any further. Oh and Biker, Silver is still… Read more »
” More and more veggie patches in more and more backyards, more bartering, more saving, more exposure of mainstream media garbage.” Yes yes yes Dan and it warms my heart. People are starting to think differently esp I detect in the last 6 months. There has been a large shift in thinking about taking status quo for granted. I’m guessing though it’s not the dawn of a completely new world. Personally I feel a need to observe the whole truth and our vulnerabilities but I have to think status quo and work inside the status quo to make material progress.… Read more »

Yeah I bought the silver dip too ;)

Wow ! First time writer, long time reader. I don’t know what to say other than i am very impressed and glad to hear such inspirational words from you Dan. I too were a little sceptical about your “negative” comments over time, but what you just wrote could not be more positive – the fact that our measure of wealth should be more about our humanity and kindness to others and the planet instead of the size of our plasma ( oops sorry LED TV – I forgot we recently became better people ) and the version of our iphone.… Read more »

Institutional inertia is the wrecker and said institutions not regularly dissolved and reconstructed are easy prey to capture and subjugation by the most virulent organised few of the day.


Gave ya the big five for your poetic thoughts, Lachlan!~ :D

Yes, there’s lots of good news amidst the gloom: more saving, family food production, etc. And, of course, China hasn’t fallen over, no-one refuses our plastic money (silly Yanks using combustible paper!) and silver is still a hold if you bought low!~

Those minus votes are a real concern, though. Don’t know what to do!!!~
Am I a contrarian to a contrarian mindset? It’s a worry… . ;)


I’ll wipe those Thumbs Down off for you Biker


Why, thank you, Steven!~ :D

negative? hell no, Ive just spent large parts of the last month looking up Fukushima. arrrggghhh don’t start me (c’mon, c’mon). yep, that derivative death star still hangs in the balance like a hot potato. insurance is fine as long as the insurance is not for 6 times the value of the properties insured and as long as everybody doesnt claim at once in the panic to ensue. as long as there are not moral hazards that involve corporate cowboy kids who don’t know what they are ultimately doing playing with matches in a volatile atmosphere. as long as the… Read more »

Jeez! Look at that… . He did it!
Howdy do dat?

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