First to Europe! They’ve done it. Well, sort of. The European Central Bank (ECB) lowered its refinancing rate from 0.15 to 0.05. It also raised the rate it charges on deposits held overnight to 0.20. As far as bombshell measures to fight off deflation, both are duds.
ECB President Mario Draghi said quantitative easing — the nuclear option — is still on the table. In other words, when lowering the price of credit fails to spur borrowing, we’ll print money to buy bonds and asset backed securities. Liquidity at all costs!
If you’re a gambling man, you might bet that extra liquidity will find its way into European stocks. You wouldn’t be breaking new theoretical ground with that bet, either. When the Bank of Japan vowed to double the monetary base, the Nikkei rose by over 83% in less than a year. And the S&P 500 is at record highs thanks to QE from the US Federal Reserve.
Hold on. I know what you’re thinking. IF QE is a response to a low-inflation, low-growth economic situation, why pay more for stocks? Surely stocks won’t have better earnings when the economy is a drag. Is there something you’re missing?
No, you’re not missing anything. But don’t you worry your pretty little investing head over things like profits and earnings and reality. Leave that kind of thinking to the academics that run central banks. These people have minds untroubled by real world experience. They are in control.
What’s more, if you haven’t figured it out yet, today’s stock market is not about the efficient allocation of capital to productive enterprises. And it’s not about valuing a business or finding the right price to pay for a stock. Stocks have a much bigger role to play in the economy.
Asset price inflation is the key to consumer confidence. Keep house and stock prices up and worries about debt or falling real incomes can be held at bay. And in the Western world, where more than two-thirds of GDP growth is driven by consumption, you need high asset prices. Without them, what collateral can consumers borrow against to finance their lifestyles?
On the subject of declining incomes and standards of living, let’s return to the subject of declining national income. How important is iron ore? We’re about to find out. The benchmark price declined again over night to under $85. The pain fest for the juniors continues.
It’s a veritable perfect storm for the sector right now. On the demand side, China’s regulators are cracking down on the shadow banking system. China’s property market had a horrible July, according to National Bureau of Statistics data. New home prices fell in 64 out of 70 cities surveyed. That’s all negative for construction and steel demand.
But the supply side isn’t helping either. Australia exported 466 million tonnes of iron ore in 2011. The average price for a tonne of iron ore in 2011 was $173. It fell to $129 in 2012, rose to $135 in 2013. Various investment bank estimates have it at between $75 and $80 this year. Next year, the Aussie iron ore industry will export nearly 800 million tonnes of ore.
You can’t always make up for declining prices with increasing volumes. Even for low-cost miners with high-grade deposits (BHP and Rio Tinto), underlying profitability declines when prices fall. The gross profit figure, in nominal terms, might be larger. But the heady days of heaps of free cash flow thanks to booming prices…those days are over. Do you think the share market has that priced in yet? No, me neither.
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