What the Iron Ore Surplus Means for the Australian Economy

How about a nice piece of symbolism to start the week? The Financial Review reports today that a couple of dodgy kids conspired to use inside information to make millions trading the Australian dollar. After a substantial surveillance operation, the Feds busted them and froze their ill-begotten assets.

One of those assets was a $2.4 million apartment in Albert Park…designed by one of the pseudo celebrities from The Block!

What? We have to explain it? Well, put simply, the fact that a kid who stole millions ended up the owner of one of the most over-hyped properties in Australia speaks volumes for how our society is travelling right now.

But we’ll move on…

This week is Budget week. It’s pretty much all you’ll hear about for the next few days, before it disappears from the headlines all together and we move on with our lives. We’ve written previously how we think the government is blowing the opportunity to enact genuine tax reform, as outlined in the Henry Tax Review a couple of years ago. So we won’t go on about it again.

Not directly, anyway.  But it is a hugely important consideration for all Australians and worth banging on about. We’ll do so from a slightly different angle today.

There is a big elephant (is there any other type?) wandering around the budget room right now…the iron ore price. It’s fallen around 20% in the past month, just as the world’s major producers ramp up production and push the market into oversupply, a situation that will only get worse in 2015.

Why is the iron ore price so important? We’ll, it’s Australia’s largest export by far, meaning it brings in a huge amount of dollars (and tax revenue) into the country. The following chart from MacroBusiness shows this clearly:

Monthly Iron Ore, Gold and Natural Gas exports
click to enlarge

The red line on the chart shows the value of our iron ore exports. Since 2012, the value of monthly exports has jumped from less than $4 billion to around $7.5 billion. (A nearly 90% increase!) It’s a function of a rising price (the iron ore price fell below US$90/tonne back in 2012, before soaring to over US$150/tonne on the back of the final, frenetic stages of China’s property boom) and a big increase in export volumes.

In fact, the increase in export volumes has been more than enough to offset the most recent decline in the iron ore price (it’s now back down to around US$100/tonne) so it’s not affecting Australia’s revenue base just yet.

But this benign situation is unlikely to persist. According to Goldman Sachs, iron ore stocks are piling up at Chinese ports. Inventories are at a record 109 million tonnes. The investment bank says there will be a seaborne surplus of 145 million tonnes in 2015.

There’s only one way you can move such a surplus…increase demand or lower the price. With the Chinese property construction market accounting for nearly half of China’s steel demand, it would seem an unlikely candidate to absorb the iron ore surplus. Especially considering that China’s epic construction boom is now ending:

(Reuters) – China’s efforts to cool its property sector look to have been more effective than intended, as a sharp drop in construction activity and falling prices threaten what had been one of few firing engines of the world’s second-largest economy.

Developers know the market is struggling their inventory is rising and prices are falling but expect that authorities will relax their tight grip on the sector in coming months.

The government has long made it clear that economic growth would moderate as it tries to reform the economy. But by keeping the pressure on property too long, analysts fear the fallout will be more severe than anyone had expected.

Analysts at Nomura estimate that new housing starts fell by 25% in the first quarter of the year, compared with the same period in 2013. That’s a decent fall, and possibly explains why port inventories are at record highs.

Why then is China’s economy continuing to suck in iron ore, despite the drop off in construction and steel demand? Because the government will make sure nothing bad happens. That is the overriding consensus view about China…the government has it all under control and will unleash a new round of stimulus when things slow down too much.

Really?

(Reuters) – China will not use any large-scale stimulus to boost its economy, Central Bank Chief Zhou Xiaochuan was reported as saying on Saturday, in response to speculation that authorities might lower reserve requirements for banks to spur growth.

Zhou, who was speaking at a closed-door session at the Tsinghua University, was also reported by Phoenix New Media Ltd as saying the central bank would only “fine-tune” its policy to counter economic cycles.

The deputy chief of the People’s Bank of China is also wary of repeating past stimulus mistakes, which simply led to financial speculation and created economic distortions. As Bloomberg reports, Liu Shiyu now belatedly realises that the rise of shadow banking in China is not good for the country’s economic development. He told a forum in Beijing on Friday that:

If everyone in society is trying to get into the financing business, we may have entered a phase where a fever has started to affect our ability to think. We must make up our minds to rectify interbank operations and all kinds of wealth management products.

That doesn’t sound like a government about to throw another log on the fire.

Even President Xi Jinping is getting in on the act. Touring the central province of Henan last week, he said China must adapt to its ‘new normal’ condition and stay ‘cool-minded’ amidst China’s biggest economic slowdown in decades.

The bureaucrats are trying to condition the people for slower growth and an end to the property boom. Whether they can control the slowdown without resorting to old and dangerous stimulus programs remains to be seen.

But what is almost certain is that Australia’s old growth model, the one where we relied on China to boost our national income, which we then levered up to speculate on property, is nearly over.

Which brings us back to tomorrow’s budget. The projections you will see are almost certainly wrong. The iron ore price will be lower than what Treasury forecasts over the next few years, which means government revenue will be much worse than expected.

The golden goose has stopped laying eggs, but the government is still feeling around, expecting it to deliver. As Professor Quentin Grafton from the Australian National University is quoted as saying in today’s Financial Review, ‘The only growth in town will be from productivity reforms.

Exactly. But what does the government come up with instead? A deficit levy which tries to tell us that this is just a temporary problem. It’s not, it’s structural. And it’s going to get a lot worse.

Regards,

Greg Canavan+
for The Markets and Money Australia

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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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