Ahhh…there’s nothing like a good rumour to fire your share price up when things aren’t looking so good. After receiving a pummelling yesterday, Rio Tinto’s share price is up strongly today on rumours that international mining house Glencore is keen to make a bid.
But the reality is that a successful bid faces more hurdles than a horse running the Grand National. Not the least of which is a matter of price. Reports suggest Glencore view the tie-up as a merger of equals. But a quick glance at the financials suggest otherwise.
First of all, Glencore is much less profitable than Rio Tinto. Based on estimates for 2015, Glencore should generate a return on equity (ROE) of around 10% while Rio’s ROE will be around 18%. Meanwhile Glencore trades on a 2015 price-to-earnings ratio of around 11 times while Rio is on about 9.8 times earnings.
In other words, Rio is the cheaper stock and Glencore is simply trying to take advantage of it.
This pricing disparity is all about iron ore. The fall in the iron ore price has taken all the players by surprise. The massive investment in additional capacity over the past few years occurred on the basis of a US$120/tonne ‘price floor’ and ongoing Chinese demand.
But neither assumption has played out. Now you’re seeing a huge supply response into a weakening demand environment. This is the reason behind the price collapse this year. And Glencore is simply trying to take advantage of it by making a move on Rio.
Does this mean Rio is cheap? Not if the iron ore price remains weak. Rio is an iron ore miner, as it derives more than 90% of its earnings from digging up the red dirt. It’s not the diversified miner it claims to be. But if you’re making a takeover offer with relatively overvalued shares (as Glencore would be) then it doesn’t really matter. What matters is the relative valuation between the two companies.
Anyway, it’s all conjecture. Even if Rio’s board were willing to entertain an offer, you’ve got major Chinese shareholder Chinalco to consider. Does it want to allow even more industry consolidation and pricing power? After all, it’s in China’s interests to promote diversity of supply and ensure commodity producers remain price takers as much as possible.
So unless Rio’s board and shareholders capitulate in an iron ore induced panic, don’t expect this tie up to go past the talking stage.
Speaking of iron ore, China remains closed for holidays so there’s been no new price update since last week. But the fall so far this year has been dramatic enough. It’s already causing pain for the government, whose budget forecast for the year is looking wrong already.
The sharp drop in the price of iron ore and coal will impact company tax receipts and increase the budget deficit this year and next…and possibly for years to come. Of course, it’s not Joe Hockey’s fault. The renewed pressure on the budget is due to ‘forces outside of his control’, according to an article in today’s Australian.
But is anything ‘in his control’? The illusion of control is just a convenient lie that nanny state politicians peddle to a gullible electorate. They want us to believe that we’re all being looked after and they’ll make things OK…as long as we vote for them.
It’s a lie that global forces will expose in the years ahead. To show you what I mean, take a look at the chart below. It’s an index of commodity prices put together by the Reserve Bank, tailored especially for Australia based on a particular commodity’s export importance. So in the chart below, iron ore and coal have the highest weighting.
As you can see, up until 2011, Australia enjoyed a huge commodity boom, in two distinct stages. The first was from 2003 until 2008. The credit crisis of that year brought on a sharp correction but then China stepped in and prices boomed again…roughly from 2009 to 2011.
Ever since, it’s been all downhill. The boom is over…the bust is here. While the economy has been weak, it doesn’t really feel like a bust though, does it? There are two main reasons for this — low interest rates here and around the world.
The Reserve Bank cut interest rates in Australia from 2011-13. In other words, as the commodity boom began to bust, the RBA offset the damage by lowering rates. Added to this, zero rates in the world’s major economies saw a flood a foreign capital enter Australia in a ‘search for yield’.
This injection of cheap money boosted asset values, specifically in the property market. That’s why I wrote, ‘at least we have property’ in yesterday’s edition. But the boost gives us a false sense of security.
Why? Because asset values driven by low interest rates and leverage (borrowing) are not sustainable. Look at the chart above again. Think of the rise in commodity prices as a huge income boost. Australia borrowed against that increase in income and sent property prices to record levels. That’s why prices here are among the most expensive in the world.
In the lexicon of Cycles, Trends and Forecasts’ guru Phil Anderson, land captured the ‘economic rent’ produced by Australia’s commodity boom. The fruits of the boom went straight into land values. In reality, Australia has a land bubble, not a housing bubble.
But the commodity boom is over and the effects of past interest rate cuts are now waning. In addition, foreign capital isn’t as content as it once was to sit in Aussie assets. Yet Australia’s mortgage debt sits at record levels.
To service that debt, we need to generate adequate economic growth. But that’s not happening. Thanks to sinking commodity prices, national incomes are barely positive, and could well go backwards in the September quarter. Meanwhile, the average interest rate on outstanding mortgage debt is probably around 5%.
With mortgage debt-to GDP of around 80–90% (i.e. nearly the same size as the economy), it’s questionable whether the economy is generating enough income growth to service its debts. No wonder you’re seeing an increase in interest only loans. My guess is that such a change is as much about household cashflow management as it is about speculative investment loans.
Keep this in mind when the Reserve Bank hands down its interest rate decision later today. While rates will stay on hold, the RBA would probably like to cut interest rates further in the future, but won’t want to encourage more mortgage debt.
That’s why you’re hearing rumours about a potential change in the wording of the RBA’s interest rate statement to include something about property. This will pave the way for the financial regulator, APRA, to bring in so-called ‘macroprudential’ controls on property by the end of the year.
It’s too late though. The housing boom, largely confined to Sydney and Melbourne, has already produced a destabilising effect, pushing households further into financial stress at a time when the economy looks most vulnerable.
But hey! At least you can say you never saw this coming. After all, the forces driving it were outside of your control.
Before I sign off for today, a quick message. I’ll be back with you on Thursday, writing from the Gold Symposium in Sydney. Given recent gold price weakness, it will be interesting to gauge the attendance and mood of the room. There could be some important contrarian signs to report!
Tomorrow, you’ll hear from fellow editor Callum Newman, who’ll regularly take up the mid-week slot from now on.
For The Daily Reckoning Australia