The Trade Deficit is Back


NB: Your regular weekend edition editor Callum Newman is off to Spain with his missus for a siesta. What you’ll find below is a sample of the research I produced this week for both Port Phillip Insider and The Denning Report. The ‘Insider’ by the way, is a thrice-weekly collaboration between myself and Kris Sayce that goes to anyone who subscribes to a Port Phillip publication. Apologies to Denning Report and Insider readers who normally have exclusive access to this material. But we hadn’t planned for Callum’s absence, so I put the following together as a substitute. Enjoy!

From Dan Denning in Albert Park:

Indonesia’s presidential elections take place on Wednesday, July 9th. You may know that Indonesia is the world’s largest Muslim country. The nation’s overall population is 252 million, making it the fourth most populous country in the world, behind China, India, and the US. That also makes Indonesia the world’s third largest democracy, behind India and the US.

I’ll confess I don’t know a lot about Indonesian politics. The two main candidates are Prabowo Subianto and Joko Widodo. Some Australian think tanks have produced articles on the election and both candidates, which I’ll share with you in the Markets and Money next week. There is a lot at stake for Australia with this large nation immediately north of us.

For 1,000 days in a row, the S&P 500 has traded without a 10% correction, according to Bespoke Investment Group. That’s the fifth-longest streak for the index since 1928. To the extent that Aussie stocks follow the US lead, it’s a good sign.

But you can’t take more profit out of a business than it generates in earnings. Businesses operate in the real economy. And in the real economy, Australia ran a $1.9 billion trade deficit in May. That is most definitely not a good sign.

Analysts expected a ‘small’ deficit of around $200 million. What they got was a 6% drop in the value of ‘non rural’ goods like coal, iron ore and gold, and a 5% drop in total exports. The real culprit was iron ore, which hit a 20-month low during the June quarter. Keep an eye on those mean-reverting commodities prices!

Now, maybe everything will be fine in the September quarter. Maybe commodity prices will stabilise at a higher equilibrium. And maybe the increase in export volumes from the production phase of the commodity boom will lead to a resumption of trade surpluses and good times. Yes, good times.

Buy maybe not. Consider the following: exports accounted for 80% of GDP growth in the March quarter. If exports fell in the June quarter, what’s going to make up for their contribution to GDP growth? Government spending? Business investment? Consumer spending?

I’ve said before that nothing is going to replace the jobs-producing, income-increasing, national-wealth-boosting effects of the resources boom. The first quarter GDP data gave everyone a false sense of security because of the huge increase in export volumes.

But now the economic truth is being laid bare: Australia’s boom was dependent on a huge price rise in few key commodities to a single customer. That’s why the first quarter numbers were ‘as good as it gets,’ according to Ben Jarman from JP Morgan. And that’s why this a ‘precarious prosperity,’ according to Andrew Charlton in an article published in Quarterly Essay.

Sorry to rain on the parade, especially when stock markets are making new highs. But there are some serious economic, military, and even psychological weaknesses in Australia that are going to make the next recession a doozy. The time to prepare for that is now.

Australia’s economy and stock market are more vulnerable than widely believed. Two quick notes on that today, both of which are about Australia’s largest shares being ‘repriced’ for less growth and higher debt costs. In both cases, it’s negative for share prices. And since we’re talking about six of the biggest stocks on the market, by capitalisation, it’s also negative for benchmark indices and any investments linked to them (like STW, the S&P ETF linked to the ASX/200).

First, Standard and Poor’s warned this week that the credit ratings of Rio Tinto and BHP Billiton could be negatively impacted by falling iron ore prices. If earnings are negatively impacted by lower ore prices, the outstanding debt at both companies could be negative for share prices. S&P analyst May Zhong wrote that:

‘Mining companies with large iron ore exposures, but which are unable to cut costs and are saddled with debt, will face a severe deterioration in earnings and credit metrics if iron ore stagnates at this price threshold through 2015… As such, they will have less flexibility at the current ratings to undertake debt-funded growth or capital-management initiatives.’

Practically speaking, shareholders might receive less cash back from the companies in the form of dividends. If you’re generating less free cash flow, and your cost of debt is going up, you’re not in a position to buy back as many shares (which boosts shareholder value) or return ‘excess cash’ to shareholders. It also makes future growth more expensive to finance if the companies have to sell more equity (which also results in dilution for shareholders).

The capital structure of the big miners hasn’t been an issue for the last five years. They’ve been generating tonnes of cash. And interest rates have kept borrowing costs low. But even though interest expenses are tax deductible, a lower credit rating and/or higher rates could mean the miners will no longer be valued as stable, blue chip stocks with safe, predictable growth. If they’re valued more like cyclical mining stocks, expect a lot more volatility and much lower price/earnings multiples.

The banks face a similar issue but for a different reason. The Commonwealth Bank has already paid out $54 million in compensation to customers who lost money thanks to bad or fraudulent financial planning advice from its representatives. The chairman of the Senate committee that looked into the issue, Senator Mark Bishop, reckons it could rise to $250 million once all 400,000 financial planning customers during the period in question (seven years ago) have their cases reviewed.

This week, CBA CEO Ian Narev said the amount of compensation was not ‘material’ in the sense that it would negatively impact the bank’s operations or profits. But Credit Suisse analysts said it does indeed highlight ‘operational risk’ at Australian banks, namely that they may have to hold higher capital on the balance sheet in reserve against further compensation claims.

Now the big four banks made a combined profit of over $27 billion in the last fiscal year. They’re probably not too worried yet, even if they end up paying several hundred million dollars out in compensation for bad financial planning advice. But if the net result of the Senate inquiry is that banks have to hold more capital in reserve, that too affects their ability to grow. And if they can’t grow as fast, their shares could be re-rated to reflect lower growth and higher ‘operational risk’.

We’ll see how both events play out. But just remember, access to cheap finance has boosted company profits and share market returns since 2009. Six of Australia’s biggest stocks are priced for high growth and low interest rates. If we get lower growth and higher interest rates, those stocks will be ‘re-rated’ lower and the index will decline. That might seem like a remote possibility when the All Ordinaries have climbed back over 5,500. But don’t discount it too much.

And finally, yesterday we celebrated the Fourth of July at the office. I know it’s not an Australian holiday. But having lived here for almost nine years now, I think Australians are fairly independent minded (even though you haven’t thrown off the monarch yet). America declared its independence from the old country mostly because of taxes.

But there aren’t many more eloquently written expressions of limited self-government than the opening paragraphs of the Declaration of Independence, signed in Philadelphia’s Independence Hall on July 4th, 1776. Today’s America, sadly, doesn’t resemble any of the lofty ideals expressed in the Declaration. But you won’t find any clearer thinking about the proper relationship between Man and the State expressed anywhere else.

So while I enjoy a bottle of Budweiser and some hot-chili buffalo wings from the Railway Hotel, let me leave you with the words of Thomas Jefferson and his merry band of revolutionaries. You’ve probably seen this many times before. But if this is the first time you’ve read it, relish it:

When in the Course of human events, it becomes necessary for one people to dissolve the political bands which have connected them with another, and to assume among the powers of the earth, the separate and equal station to which the Laws of Nature and of Nature’s God entitle them, a decent respect to the opinions of mankind requires that they should declare the causes which impel them to the separation.

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. That to secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed. That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their Safety and Happiness.

Prudence, indeed, will dictate that Governments long established should not be changed for light and transient causes; and accordingly all experience hath shewn, that mankind are more disposed to suffer, while evils are sufferable, than to right themselves by abolishing the forms to which they are accustomed. But when a long train of abuses and usurpations, pursuing invariably the same Object evinces a design to reduce them under absolute Despotism, it is their right, it is their duty, to throw off such Government, and to provide new Guards for their future security.

There’s more after that. But I’ll leave it at that for the week. Here’s wishing you financial independence…and here’s to life, liberty, and the pursuit of happiness. And baseball.


Dan Denning
for Markets and Money

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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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