The Brains of Barbarians

The deflationists continue to run rampant with glee as stocks, gold, and commodities in general get hammered. Is this the market giving a big ‘thumbs down’ to quantitative easing (QE)? Have central banks started to lose the final battle in their war to reflate asset prices? Or is this just the big dump before the insiders buy at the bottom and start the next pump?

We’ll leave conspiracy theories aside for the day. Markets are markets. They’re volatile. QE has effectively anesthetised investors for the last few years, numbing the pain of low growth with higher stock prices. But to not feel pain is to not feel. And pain is a kind of sensory feedback that provides useful information: don’t do this!

The ‘this’, in this case, is buying stocks purely on the expectation that the authorities are in control and have it all figured out. If you believe that, you ignore other important signals, like prices, market cycles, earnings, and the economy. All of those indicators point to weak or slow earnings growth. Which force is stronger then, the power of Fed money or the grinding gravity of credit deflation?

The answer may lay with Japan. Our colleague Murray Dawes is working on a special report for his readers that looks at the key indicators coming out of Japan. Murray’s working theory is that the Yen could get a lot weaker much more quickly than markets expect. What happens next is the big question.

One scenario is that the flight from the Yen leads to a surging US dollar, a surging Australian dollar, and surging Australian stocks. This is a continuation of the ‘yield trend’ in Australia since November. Capital flows (including all that LNG investment) support a higher index as the high yield stocks lead the way. In this scenario, a Yen fall makes the second quarter strong, despite the mixed economic signals.

The other scenario is that instead of finding a home, liquidity evaporates. This is the wealth destruction scenario where deflation destroys everything in its path. In particular, a Yen crisis would be coupled with falling commodity prices. Precious and base metals would fall, along with energy prices, as investors took in the landscape and fled in horror, taking their losses.

Both scenarios would suggest tradable moves. But there could be other scenarios, too. We’ll find out soon enough. In the meantime, keep your eye on the exchange rate between the Australian dollar and the Yen. It could provide some useful information.


Past weakness in the Australian dollar has corresponded with lower stock prices. The Aussie is coming off record strength against the Yen. But you can see it’s come off those highs this week. It may very well consolidate and power higher still – which is probably what the Japanese monetary police are hoping for, but don’t rule out the possibility of a sudden sharp correction in the Australian dollar.

Indeed, it’s astonishing the Australian dollar has remained strong despite falling bulk materials prices and a fall in the terms of trade. Prices for Australia’s big exports to China are falling. Increased volumes can make up for the price falls a little. But from the top-down, you could make a strong argument that the national income derived from high commodity prices and the China trade should, properly priced in, result in a lower Australian dollar.

Something like the above has been the argument of our colleague Greg Canavan for over a year. He’s updating his argument as we speak and you’ll see it soon. For now, check out the two charts below from the Reserve Bank of Australia. If Greg is right, the terms of trade is way above trend and due for a major correction. The first sign of that would arguably be another fall in the iron ore price similar to what you saw in August of 2012.


Of course if any of us knew the future we wouldn’t bother with a reckoning every day. The best we can do is pick up the crumbs of data that are out there and reconcile them with what we know about money, credit, markets, and history. Those crumbs appear to add up to a more crumbly China.

The slower-than-expected GDP number in the first quarter – 7.7% year-over-year vs 7.9% year-over-year in the fourth quarter-was just one data point. Retail sales growth slowed down, from 15.2% at the end of 2012 to 12.6% in the first quarter of 2013. Industrial production was down as well.

Greg is right to wonder just how much of Chinese growth is related to the uncontrolled expansion of credit. That process – credit booms and busts – knows no boundaries. It works the same in China as it does everywhere else. And there’s no doubt there was a credit boom at the local government level.

‘It is already out of control,’ says Zhang Ke, the Vice-Chairman of China’s accounting association. He told the Financial Times ‘We audited some local government bond issues and found them very dangerous, so we pulled out. Most don’t have strong debt servicing abilities. Things could become very serious…A crisis is possible. But since the debt is being rolled over and is long-term, the timing of the explosion is uncertain.’

It always is. But the inevitably of the explosion is not. When any institution borrows more money than it can productively put to use, the piper must eventually be paid. Performance-enhancing credit can only mask so much malinvestment.

But as we said, who knows? Two people can look at the same set of objective facts and perceive them differently. This was one of the other observations we took away from David Walsh’s fabulous museum in Hobart. The objects you use to perceive the world – your senses – may be mostly the same for all people.

But here’s the wacky part. The object that constructs those perceptions into meaning is the brain. And every single one of those is different. Brains are plastic and genetic and can be injured. Our experiences literally change our brains, which is another interesting idea from the MONA in Hobart. We are each of us always evolving, although that doesn’t always mean progress.

Different brains can take the same objective perceptions and mix them into entirely different meanings. That’s what makes markets and ass-clowns. Our perception is that the objective facts of the world’s economy make holding paper assets – especially paper money – a long term losing survival strategy. But maybe we’ve simply stopped evolving and have become a backward looking barbarian.

Dan Denning
for Markets and Money

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From the Archives…

China’s Credit Boom Krakatoa
12-04-13 – Greg Canavan

The Market Is High
11-04-13 – Greg Canavan

Gold vs Bitcoin
10-04-13 – Greg Guenther

Is Cyprus More Important Than You Think?
9-04-13 – Satyajit Das

Our Largest Asian Trading Partners Are in Trouble: China and Japan
8-04-13 – Greg Canavan

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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