Cracks in the Foundation

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Step away from watching the markets hour by hour and eventually you’ll notice something. What you’ll notice is that most of the news is garbage. Websites and cable news channels need a constant news flow to justify movements in stock prices. But most of the time there is no connection between the news and the price action.

Your editor makes this observation after being away from his desk for two weeks. During that time, we were only intermittently in touch with hourly news flow. We didn’t miss it a bit. And it turns out we didn’t miss anything important either. The status quo prevails.

And what is the status quo? Well, for one, let’s not make the mistake of calling the market a market. It isn’t. A market is where you have a buyer and seller willing to exchange goods and money at a mutually agreed price. That price is ‘discovered’ by aggregating all the bids which buyers are willing to pay and the asks which sellers require.

Price discovery is ruined — and markets don’t function — when you have a serial intervener in the form of a central bank. That’s what we have today. For example, markets reacted in Pavlovian fashion last week when European Central Bank (ECB) President Mario Draghi said he’d do ‘whatever it takes’ to save the euro.

What does that even mean? Does it mean Draghi will print money to buy Spanish and Italian government bonds? Does it mean he will don Lycra and learn to leap tall buildings in a single bound? Does it mean anything at all when it comes to resolving Europe’s structural economic problems?

It’s a giant pile of nothing, to be frank. You should ignore it. And while you’re at it, ignore the Dow Jones Industrials index too. As we said in our remarks in Vancouver a few weeks ago, the Dow communicates no useful information about the underlying health and direction of the US economy. It’s a narrative device designed to promote stock buying to the investment public.

What is worth paying attention to? Well, the Reserve Bank of Australia (RBA) has a busy week ahead. Tomorrow, the RBA will announce any changes to short-term interest rates in Australia. On Friday, it publishes the latest Statement on Monetary Policy. You won’t want to miss that.

You should especially keep an eye on the latest index of commodity prices and the Aussie terms of trade. As commodity prices come down from all-time highs, a lot of mid-tier and small-cap miners are going to have trouble finding money for projects that only work when commodity prices are high. It’s a ‘funding hole’ that the front-page story in today’s Australian Financial Review talks about.

You can see from the RBA’s two charts below that both the terms of trade and commodity prices are coming off startling highs. If both data sets are mean reverting, then a nasty correction is ahead. For Aussie investors, that means you should be prepared for stocks making new lows. What will be the catalyst for these new lows?

Source: RBA

Well, we could be wrong about the whole thing. But after two weeks abroad, our sense is that investors are still pricing in lots of economic growth. Australia is a proxy for global growth. Finished goods can only be manufactured with raw materials. The whole chain of global value added begins here.

It’s hard to have growth when the whole economic system is burdened by debt. Until that debt is extinguished — through default, repayment, or restructuring — we have a hard time making the case for stocks (at least as an asset class, individual shares may do well as outliers). Everything done in Europe to keep government bond yields down is an exercise in avoiding the reality that debt must be repaid.

The status quo is to avoid pain by avoiding reality. How long can you live in imagination land, if you’re a central banker? Quite a while, apparently. But not forever! Let us tell you why.

Back in Colorado we visited the Flatirons Crossing mall in Broomfield. The mall is struggling as America’s consumer economy deleverages and cuts back on spending. But it’s also struggling because it was built on bad foundation. Literally.

The soil underneath the mall is bentonite clay. It’s a type of soil that expands with water. That means it’s a bit unstable. The mall owners know that now. Numerous structures throughout the 140,000 square metre facility have cracking drywall, buckling concrete, and shifting steel beams. Some of the structures have already been demolished.

This isn’t even a metaphor. If you build on shifting soil, your foundation is rubbish. An economy based on consumption through debt can’t generate wealth. A society based on satisfying all its wants and desires by accumulating debt is not a productive society that looks ahead. It’s about gratification now, the future consequences be damned.

But that attitude of consume now and pay later seems to be changing in America, at least at the household level. These social moods go in cycles. At the grassroots level, Americans are revising their expectations and living within their means. It’s the government that continues to live high on the hog.

That said, boy is America cheap. Your editor went out for a couple of pints with a friend. When the bill came, it was $18. We sent it back, sure there was an error. But there wasn’t! The same four beers in Australia would cost you $40. It’s the sort of inflation in cost of living that you only notice when you leave a place.

Regards,

Dan Denning
for The Daily Reckoning Australia

From the Archives…

As Draghi Drags the European Crisis On
3-08-2012 – Nick Hubble

China’s Economy – How the Devil is in the Detail
2-08-2012 – Greg Canavan

The Greatest Interest Rate Fix featuring… Mario Draghi and Friends
1-08-2012 – Bill Bonner

What the Credit Boom Left Behind
31-07-2012 – Greg Canavan

The Australian Economy: A Case Study in Weirdness
30-07-2012 – Greg Canavan

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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