The Great Unfolding Economic Debacle

— At the beginning of each month we see the release of manufacturing indexes around the world. The data from China and the US usually grab the headlines and in the month of August, these two manufacturing giants were barely keeping their heads above water.

— In China, the HSBC Manufacturing index moved to 49.9 (from 49.3) in July. The country’s official index was 50.9. (Note: A reading below 50 indicates contraction.) So China’s manufacturing sector is basically stagnant.

— Apparently this is good news because it indicates China is headed for a soft landing. Maybe. But the sharp slowdown in other parts of the world – which has really only become evident in the August data, but has been on the cards for a while – could spell future trouble for China’s export machine.

— Over in the US, the headline manufacturing number was ‘better than expected’ at 50.6. Digging beneath the surface though, an increase in inventories boosted the result. Rising inventories indicated a slowing of final demand. And actual production fell to 48.5. That indicates that US manufacturing output is shrinking.

— On a global basis, manufacturing output shrank in August too. So the global economy is slowing down – again. Keynesians will blame this on insufficient stimulus. But those who use common sense to read the economic tealeaves know there is something fundamentally wrong with the way the global economy ‘works’.

— That is, it is over-managed. If you put a bunch of motivated and intelligent people together to sort out a problem or achieve a goal, the chances are they will work it out. But if you put a bungling manager in charge of the group, one who constantly leads them in the wrong direction, then you’ll get an unfolding debacle.

— We have an unfolding debacle.

— Many years ago… Before rampant credit growth and misallocated resources retarded the global economy… A bloke by the name of Jean-Baptise Say said, ‘products are paid for with products’. You might know it in its more popular phrase, ‘supply creates its own demand.’

— ‘Say’s Law’ spoke a basic economic truth. You can only spend (demand) what your own output (supply) allows you to. Supply creates the income, which in turns leads to demand.

— But back in the boom years, debt augmented income. Income plus debt created a big increase in demand. Because individual economic actors weren’t good at discerning whether demand for their product was the result of debt (phony demand) or income (real demand) they increased output regardless.

— That was then. Now, with the effects of global stimulus fading, manufacturing is close to contracting again. And debt growth is no longer augmenting income. So if Say’s Law holds – and supply does create its own demand – then a global recession is not far away.

— But we’ve always got the emerging markets, right? The West might be mired in an economic slump but the ’emerging’ economies will provide the growth. Well, see for yourself what the equity market is saying…

— China’s Shanghai Composite index is in a noticeable downtrend. Notice how talk of QE3 hasn’t fired up Chinese investors? That’s because QE3 means more inflationary pressures (or a higher yuan). Neither of which is good for the Chinese economy.

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— What about India? It looks much like China’s one-year performance.

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— Is Brazil any better? Yes, it’s recouped all of August’s losses. No doubt helping things along is the decision by the central bank to cut interest rates half-a-percent to a still hefty 12 per cent. It’s a luxury inflation-prone China and India don’t have

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— Brazil cut rates on concern over looming recession in the US and Europe. It’s worried about weaker supply (to its main customers) leading to weaker demand at home. Not really cause for a sustained market rally.

— Speaking of home, the monthly manufacturing data released in Australia wasn’t at all good. The manufacturing sector continues to contract, with the index at 43.3. But get this. All the sub-components – production, new orders, inventories and selling prices – all contracted in August except for input costs and wages.

— In other words, Australia’s manufacturers are facing a perfect storm of falling demand and overcapacity combined with rising costs of doing business.

— Can we afford to contract the ‘Dutch Disease’, where the booming mining sector sucks resources out of the rest of the economy and guts our manufacturing sector?

— What if mining boom part two is really just an echo of part one, caused by the thunderclap of China’s unprecedented stimulus program? Could it lead to overinvestment in resources and a brief surge in the dollar, which will send hundreds of manufacturing and other non-mining businesses to the wall?

— We don’t know the answers. But we do know you need to ask these questions in a world pursuing unsound monetary policy. Such policy throws off all the wrong price signals and leads to unwise investment decisions. Only hindsight can tell you for sure where the misallocated resources lie.

— We’re now moving into the interesting part of the year. Perhaps the action in September and October will tell you where capital has been misplaced.

Greg Canavan
for Markets and Money

Publisher’s note: Murray Dawes’ latest market update video is now available to watch on YouTube. If you haven’t seen it yet, go here now. It’s rare that an experienced trader will give his insight away for free. So while he’s happy to do it, you should lap it up! For Murray’s latest overview of the market… and an idea of where he thinks it could be headed next… click here.

Greg Canavan
Greg Canavan is a contributing Editor of Markets and Money and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to Markets and Money for free here. If you’re already a Markets and Money subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Markets and Money emails. For more on Greg go here.

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Jim Ellis
Apt description of Neo-Classical adherents in the light of the GFC. From Gold Daily and Silver Weekly Charts – Smacked By the Invisible Hand ” “People who hold strong opinions on complex social issues are likely to examine relevant empirical evidence in a biased manner. They are apt to accept confirming evidence at face value while subjecting disconfirming evidence to critical evaluation, and as a result to draw undue support for their initial positions from mixed or random empirical findings. Thus, the result of exposing contending factions in a social dispute to an identical body of relevant empirical evidence… Read more »
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