‘A Debt Crisis Will Derail Markets’

Stock market

Another day, another beating for US dollar denominated commodity prices.

Iron ore is perilously close to making new, multi-year year lows. Copper fell another 1.2% overnight, while nickel plunged 5%.

Gold fell to another low too. It’s now trading around US$1,069 an ounce. The only positive for gold right now is that it is stretched to the downside. Technically, it’s in an oversold position…and has been that way for nearly three weeks.

In the futures market, the speculators have ramped up their bets on further falls in the gold price. The latest data showed a massive 40% weekly increase in ‘short’ positions. This indicates a big increase in traders betting on further falls in the gold price.

Surprisingly, the gold price managed to absorb these bearish bets without falling too much. This suggests a short term rally might not be too far away.

But the big picture trend for gold — in US dollar terms at least — remains unequivocally down. Like it or not, gold is a part of the commodity price complex and tends to rise and fall with the sector in general.

Although its supply and demand dynamics are very different to other commodities, gold will get caught up in any broad commodity sell-off.

With Australia being a major commodity exporter, the gathering bear market is bad news for our economy. Although you wouldn’t know it. The general view out there is that the economy is successfully rebalancing away from the mining downturn.

I think that rosy viewpoint will change before too long. A recent essay by Carmen Reinhart, co-author of This Time It’s Different, explains why. She points out that the effects of commodity price busts are long and painful.

While she doesn’t mention Australia specifically, see if you can spot the similarities with our economy in the following quote:

Commodity-price booms are usually associated with rising incomes, stronger fiscal positions, appreciating currencies, declining borrowing costs, and capital inflows. During downturns, these trends are reversed. Indeed, since the current slump began four years ago, economic activity for many commodity exporters has slowed markedly; their currencies have slid, after nearly a decade of relative stability; interest-rate spreads have widened; and capital inflows have dried up.’

Yes, we had rising incomes, a strong fiscal position, an appreciating currency and capital inflows. And borrowing costs were easy for much of the boom.

But since the boom peaked and began reversing in 2011, you haven’t seen a reversal in all of these factors. Australia’s fiscal position has certainly deteriorated, and the dollar is well off its highs. National income growth has stalled too.

But capital inflows haven’t reversed and borrowing costs remain very accommodative. In short, our foreign lenders haven’t been at all concerned about the commodity boom turned bust.

Reinhart continues:

Just how painful the downturn turns out to be depends largely on how governments and individuals behave during the bonanza. If they perceive improvements in their terms of trade as permanent — a view that gains traction as prices climb — increases in consumption and investment tend to outpace income gains, and public and private leverage grows. The risk is that when the roller coaster careens downward, a debt crisis will derail markets.’

There is no doubt that public and private debt levels increased throughout the boom and in its aftermath. During the boom, the government spent the proceeds on handouts, which is why the budget is under such pressure now. Clawing those handouts back will not be an easy task.

And Aussie households continued to borrow during the boom and after the bust too. In fact, this is exactly the behaviour the RBA encouraged by lowering interest rates so much after the commodity bubble burst in 2011.

You can see this in the chart below. Household debt as a percentage of disposable income is at all-time highs.

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Source: RBA

While this gives the short term impression that the economy can handle the post-boom adjustment, it’s really just a mirage. We’re creating growth by accumulating more debt. That’s just not sustainable during a commodity price bust when you’re a commodity exporter.

But that’s of little concern to those looking at the results of the increase in debt. Those results include booming house prices and services related to this general asset price boom. It’s the only game in town.

Want proof? Here you go…

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Source: RBA

Total housing loan approvals over the past few years are through the roof. If you don’t think this represents a massive risk for the Aussie economy, you’re just not paying attention.

Or maybe you’re too far in…like former Aussie cricket captain Michael Clark. The Australian revealed today that Clarke is thinking of getting into property development as a post-cricket career.

‘I’ve always loved property. I think probably 75 per cent of my finances are in property, I’ve always had an interest.’

Compared to many Aussie’s, Clarke’s exposure to property is abnormally low. It’s un Australian. Even so, 75% (no doubt with a lot of leverage involved) plus a looming role in property development should be a concern his financial planner. Diversification?

This just goes to show how price influences judgement. And then judgement influences price and so on…until the relationship breaks down.

Just remember, the foundation for all this debt accumulation is commodity exports. And that foundation looks increasingly shaky.

By the way, I think Clarke is a good bloke. My wife worked with him in his role as an ambassador for Bonds. On the birth of our first child, Clarke sent a congratulatory text.

Not much, you might think. But he didn’t have to send anything. He’s always come across as decent and down-to-earth. That much of the cricketing public don’t like him says more about them than him.


Greg Canavan

For The Daily Reckoning

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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