The cash flows are coming! The cash flows are coming!
Big Aussie blue chips like Commonwealth Bank, Telstra, and BHP Billiton report their annual results this week. It is a contention of this version of the Markets and Money that corporate cash flows have been unusually high for the last fifty years – a combination of an explosion in credit and debt markets and the real economic activity the credit boom kicked off in the industrialised world and, lately, emerging nations like Brazil, China, and India.
The emergence of those economies as producers of capital goods and consumer goods puts pressure on prices for Western manufacturers. Meanwhile, legacy costs for Western firms (taxes, pension, healthcare etc) rise. All of this eats into cash flows, forcing them to revert to the mean (lower).
And let’s not forget the credit boom has ended. Sure, global capital markets are not as broken down and frozen as they were last year. But trillions of dollars in capital has been wasted in speculation or sunk into bad investments (residential American real estate).
National governments are demanding a larger portion of global savings. Government welfare transfer schemes and bailouts have to be funded from borrowing (unless from money printing), which also makes capital harder for private companies to get. Corporate cash flows will revert to the mean in the absence of huge infusions of credit to finance the growth of the balance sheet.
So yes, the cash flows are coming, and in some cases, going. They will reveal which companies emerged from the last eighteen months of chaos with sound capital structures…and which are still vulnerable (not enough equity, too many dodgy assets not valued correctly). It may sound kind of boring. But for investors, taking a microscope to the balance sheet and income statement has never been more important.
Housing finance data for June is out tomorrow. That will be worth a look. Remember that the Reserve Bank has cut the cash rate by 425 basis points since last October. They remain at a 49-year low. By the way, what do you get when you cut rates by that much that fast? You get yourself a bit of a bubble in the housing market.
“Are we agreed that the proposal is crack-brained, absurd, could prove incalculably expensive, and violates every dictate of financial prudence?” writes Robertson Davies in “The Lyre of Orpheus.” We picked up a copy in Fitzroy Street and ran into that line. It could apply to a great many things.
Speaking of crack-brained schemes, the Australian is reporting that credit unions are looking to the superannuation industry has a source of liquidity for making home loans. “If the fund gets the green light, it will give credit unions an important alternative source of funding to expand their market share in home lending, now at 7per cent,” reports Adele Ferguson.
It’s another example of forced speculation. The Big Four banks source their home loan funding from capital raisings (guaranteed by the government) both domestically and overseas. The borrowed money goes into commercial and residential property. Banks make a mint, and the liquidity drives prices up which drives more people into property, keeping up demand for more bank loans (and keeping stamp duty coffers full for state governments).
The credit unions want a piece of that action. And why wouldn’t they? If the government, the banks, and the regulators rig the housing market so that it’s the preferred destination for foreign capital, smaller competitors can’t be blamed for wanting to get in the game. It’s where the easy money is made.
Of course this could be the mother of all bad capital allocation decisions for Australia. You’ll have a larger share of superannuation money going into the housing market. An increasingly large share of the nation’s income will be tied up in residential housing. This confirms what Dr. Steve Keen said recently at our Debt Summit. “Americans traditionally speculate on stock prices. Australians speculate on houses,” he said. (By the way, the transcript of the Summit should be available this week).
What made the housing boom so unusual in America, he pointed out, is that it was one of the first time’s Americans speculated so wildly on houses. Prior to the last twenty years, house prices never went up much faster than the rate of inflation. They were consumption assets. Not financial assets.
The lowering of interest rates by the Fed and the explosion of non-traditional mortgage lenders changed the financial incentives just enough for Americans to abandon prudence and start gambling with houses. It ended – is still ending in fact – in what we once called the total destruction of the U.S. housing market.
As we told a Diggers and Drillers reader last week, “A report from Deutsche Bank reckons that by 2011, nearly half of all U.S. mortgages could be underwater with negative equity. Further price falls, the Bank reckons, will wipe out the little equity that large swathes of the market currently have. Once the equity in the house is gone, there’s no reason for the borrower to hang on. In the States mortgages are non-recourse loans, which means the lender cannot chase up the borrower if the borrower decides to walk away.”
“Why does this matter to junior resource stocks? It was the original fall in U.S. house prices that kicked of the credit crisis. The fall in home values wiped out bank collateral and rendered into junk a lot of the securities that were made up of subprime U.S. home loans. That episode brought the global financial system to the brink of ruin.”
“The market is telling us that the system has recovered from its near-death experience. In fact the market is obviously pricing – in a robust recovery in earnings, which itself implies a return to normal economic life. No one, apparently, is considering the possibility that further losses in U.S. real estate could again trigger a capital collapse in global financial institutions. But it’s a real threat!
“Australia’s banks appear to have minimized their exposure to losses from U.S. real estate. But what did happen in the last year is that the capital crunch led Aussie banks to be a lot more conservative in their lending to the mining sector. The mining sector responded by tapping the equity markets directly and bypassing the banks. But some companies were left exposed an unable to fund their projects or roll over loans.”
“That’s exactly the situation that could happen again. At least it’s something you have to consider. The supply of capital to the mining sector looks stronger. But Australia is a net importer of capital. Its strategic weakness has been exposed and not fully repaired.”
for Markets and Money