Watch Out For When Australia’s Terms of Trade Goes Back to ‘Normal’

Another day, another marginal new high in the S&P500. After all, central bank debt monetisation has to go somewhere, right? Dan Denning, editor of The Denning Report, reckons global blue chip ‘citadel’ stocks are the place for it to go. He’s working on the idea that there are no safe places for your wealth in the financial system anymore, but the least risky place in a risky world is in global blue chips – equity investments with bond-like characteristics.

And because government bonds no longer display bond-like characteristics (they don’t pay you a decent income) you’re seeing private capital shift into equities to ‘buy’ that income.

But the interesting thing is that you’re not seeing a shift OUT of government bonds. Central bank debt monetisation means there is a constant (non-market) bid for low-yielding government paper. Despite a constant supply of new debt from governments, the central banks snap it up eagerly, providing plenty of demand.

The liquidity created from these central bank purchases then goes into equities, or corporate debt, or junk bonds, or derivatives of any of the above, or whatever. (But not gold.)

With the caveat that nothing is safe anymore, Dan reckons this is a tradable event…that you can front run the Fed and every other central bank by buying quality private companies, no matter the price.

Kris Sayce over at Australian Small Cap Investigator has been saying the same thing for months now. He reckons small-caps will eventually benefit big time from this enforced risk taking. He’s calling for the Dow at 20,000 and the ASX200 at 7,000 by 2015.

Meanwhile, another day, another budget bollocking for the government. The front page of today’s Financial Review states that the shortfall in forecast budget revenue will be $60 billion – $80 billion from now to 2016. Rosy projections made at the height of the mining boom are proving woefully inaccurate.

The mining tax will only raise $800 million this year, well short of the $2 billion forecast. As a result, the government will not go ahead with a plan to increase the Family Tax Benefit Part A scheme. They’re not cutting anything, mind you….just not increasing like they planned to. When it comes to politicians, a spending freeze is as good as a cut.

But it’s not just idiotic tax grabs, done at the height of a historic boom and predicated on that boom enduring, that is behind the red ink. It’s the whole management of the country’s finances.

Government revenue depends on nominal economic growth. So all the forecasts for future revenue (and therefore spending) projections rely on nominal growth, not the ‘real’ GDP growth you generally hear about.

A major factor in Australia’s nominal rate of economic growth is the terms of trade. It’s a measure of the value of exports relative to the value of imports. A rising terms of trade basically says we are getting more import bang for our export buck. It boosts national income, nominal growth and the government’s tax take.

As you can see in the chart below, over the past decade, the terms of trade have generally been of great benefit to Australia’s nominal economic growth. The rising trend has also obviously benefitted the government’s coffers. Greatly.


Australian’s were lucky enough to benefit from the rise of China’s economy. The government was lucky too. China’s rise maintained the illusion of Australia’s fiscal probity when the rest of the developed world lurched towards larger and larger deficits. But as we’ve been saying for a while, Australia was simply a few years behind. Now it’s time to play catch-up.

But the government, in all its wisdom, couldn’t see that the historic peak in the terms of trade would be just that; a peak. Around the time the terms of trade pushed above the 100 mark on the chart above for the first time EVER, the government brought in the mining tax and a whole bunch of spending initiatives to ‘spread the benefits of the boom’…just as the boom was ending.

Instead of preparing for the inevitable bust, they thought the boom would go on forever. That’s why there is such a large hole in the government’s future revenue projections. A declining terms of trade means nominal economic growth is very weak, much weaker than previous forecasts allowed for. The forecasts are now simply realistic…or, more accurately, not as idiotic.

There’s a fair chance the new forecasts still assume China will grow at the jolly old rate of 7-8% per annum. We would argue that within a year or two China’s growth rate will be under 5% (assuming China’s leadership is serious about rebalancing). That will cause more red ink spillage for the next budget.

So the emperor has no clothes, and within a few years Australia’s vaunted fiscal position will look markedly different. That’s especially so if the terms of trade fall back to anywhere near ‘normal’ levels. It might even mean we should expect real cuts to spending, not just cuts to spending growth plans.

But that’s being optimistic. Australia will mostly likely walk the path of other major developed economies. That is, keep spending, increase deficits, and let the central bank buy up surplus debt issuance if it comes to that.

That would be an interesting experiment. It’s easy enough for large developed debtor economies like the US and Britain to play that game. But it might be harder for a minnow like Australia.

Think about it. Our largest trading partner is changing its growth strategy to one less reliant on red dirt from Western Australia. Our second-largest trading partner just fired a monetary bazooka in the ongoing currency wars (which may lead to an actual war with our largest trading partner). With the mining boom ending, we still run a current account deficit, which means we still need to import capital to maintain our standard of living. Our household sector remains highly indebted by global standards and our government debt growth is in catch up mode.

Who will continue to finance Australia’s deficits should the situation deteriorate? Foreign capital will flee if they even get a hint that the RBA will monetise Australia’s deficits. Which is why it probably won’t happen.

The answer is that someone will finance the deficit…but not at the current dollar/interest rate structure. Rumours of George Soros shorting the dollar may have much more to do with the above than any short term bet about which way interest rates will go today.

Common sense tells you the Australian dollar is vastly overvalued. At some point it will crack…and the fall will be a sharp one.


Greg Canavan
for Markets and Money

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From the Archives…

The US Federal Reserve: What a Humiliating Failure!
3-05-13 – Bill Bonner

The End of the Road
2-05-13 – Bill Bonner

Why Apple’s Advantage is Gone
1-05-13 – Dan Denning

The Kamikaze Rally That Could Drive Stocks Higher
30-04-13 – Dan Denning

Australian Deficit: Where Did the Money Go?
29-04-13 – Dan Denning

Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:


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