Can we just agree to pretend that the last fiscal year did not happen? Australian shares got a nice boost from the latest European flim-flam on Friday (more on that in a moment). But for the last 12 months – the financial year that is – the Australian share market was down 11.1%. ‘Auld lang syne’ to that and move on, right?
It would be nice if you could resolve not to lose money in the coming financial year, but China and Europe will have something to do with the performance of Australian shares. The Australian resources sector takes its cues from China. The Australian banks take their cues from the European credit markets. Six stocks from these two sectors combined make up over 50% of the market cap of the Aussie market (Rio, BHP, Commonwealth Bank, NAB, ANZ, and Westpac).
That’s a brutal one-two punch to the average portfolio. The average portfolio can’t help but be exposed to resources and banks. It was a great combination when credit expanded worldwide and resource prices rose. But now, commodity profits are driven by expanding volumes on declining prices. And bank profits, while fat and juicy, are not driven by double digit rates of expansion in credit.
All of this adds up to a share market that’s still down 36% from the 2008 highs. But wait! Wasn’t Friday’s European summit deal the turning point? Well, as far as we can tell, the big take-away from the summit is this: it’s easier for the ECB to loan money directly to besieged banks, but the ECB’s liabilities still belong to member states and, except for Germany’s economy, none of them has any money.
What exactly did the Europeans agree to? They agreed to let their bailout funds – the European Financial Stability Facility (EFSF) and its successor the European Stability Mechanism (ESM) – lend directly to Spanish banks. Both funds were unable to do this under the previous rules.
This rule change takes the Spanish government out of the loop. It fact, it takes all national governments out of the loop when it comes to recapitalising their banks. In that sense, it may also be a way to decouple national balance sheets from bank balance sheets and still inject capital into banks that need it.
A decoupling of the banking sector from national governments would lower government borrowing costs in Spain, Italy, Ireland and more. That’s important because all those governments will have a lot of borrowing to do. If they must also worry about injecting money they don’t have into banks, well then the market will do what it’s been doing, namely driving bond yields up and stock prices down.
But as you can tell, the problem here is that we’re three years down the track and still talking about where to shuffle bad debts and how to finance new ones. These so-called solutions move the problem further out in time and reduce the risk of an immediate crisis, but they fail to deal with the basic fact that the debt must be extinguished somehow.
Is it better to have a slow-motion crisis than one that’s swift and vicious? Probably not, especially since the delaying tactics nourish belief that the solution is just a matter of finding the correct monetary policy. The time, attention, and capital spent on maintaining the belief that these debts will be paid off delays the recovery. It delays the day when the share market can break out of its trading range.
The European ‘solution’ avoids the path of Lehman by going down the route of Japan’s economy. A giant mass of unproductive, non-performing capital gets cemented at the centre of an increasingly rigid financial system. This prevents a sudden deleveraging – which would slam shares – but it virtually guarantees months of listless, directionless, insipid performance from the share market.
Time is the only upside to all of this. The more the debt-deleveraging is prolonged, the more time you have to make a decision about what to do with your money. It’s better to make that decision in a calm market than in panicked market. You’ll get better prices when you sell.
Don’t be surprised if the world’s attention now turns to China. Europe, Japan, and America have all doubled down on a monetary and currency policy to deal with massive debt problems. This means those three economies may barely avoid recession, but it’s not likely they’ll contribute much to ‘growth’. For that, we’re going to need more credit expansion from China.
And on cue we get this from today’s Financial Times:
‘China is expected to step up efforts to stimulate its flagging economy after an official survey showed the manufacturing sector expanded in June at its slowest pace in seven months. The official purchasing managers’ index (PMI) fell to 50.2 last month, down from 50.4 in May, the government announced on Sunday, with falling orders and weak exports leading a continuing slowdown in the world’s second-largest economy.’
It’s popular among the brainless class of Aussie economists and analysts to assume China has the ‘policy flexibility’ to ensure more growth (and commodity demand). Add a little credit here; cut bank reserve requirements a little there. Boom! You get roaring GDP and rev the growth engine.
Our mate Greg Canavan has been working on a detailed China report that exposes the flaw in this thinking. Stay tuned for more on it later this week. We won’t give Greg’s secret away, but as you might guess, Greg reckons China is not at all in the position to do what everyone expects.
Finally, last week we promised we’d take a look at the government’s new reviews of media regulation. We did so in the weekend edition of the Markets and Money. If you missed it, you can find the whole article on our website. A warning: it has virtually nothing to do with investing and contains the radical view that free speech should trump social benefits. If you’re easily offended, don’t read it.
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