In the Shadow of the Volcano

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It will be a thoughtful reckoning today. Put on your thinking cap. There is a lot to think about. What exactly is going on in the world and what, if anything, can you do about it?

Let’s start with China, where Shanghai stocks fell 5.1% yesterday and are 26% off the index’s 52-week high. If Chinese stocks are leading the economy, one crash is in and another could be just beginning.

About the only bright side of predicting a crash in Chinese construction and real estate spending is that it’s a run-of-the-mill kind of crash and not a systemic failure. That might not sound positive. But it is. It means that while the pain of China crash would be sharp and probably not short, it wouldn’t be the end of the world. Just the end of the world as we know it.

And that would be fine too. Because over the next few decades, you get the sense that the balance of economic power in the world will have decisively shifted. It’s shifting away from the over-indebted industrialised Western Welfare States and toward the higher-saving nations of the developed world. Back a few years ago, we called this The Money Migration. And our view then was that this shift favoured Australia, despite Australia’s own massive private debt levels.

But who knew that so much paper money would be destroyed in transit between points A and B? Markets in Europe and the Americas were again indifferent yesterday. It’s like investors can’t quite believe that you’re actually watching a junior reserve currency (the euro) slowly take off its shoes and socks and lower its dishevelled self into its deathbed.

Can this really be it for the Euro? Well, there is always the possibility that reports of the euro’s demise are simply being exaggerated. That’s the 24/7 news media cycle works these days. Everything is a crisis all the time, especially right now. A lot of what passes for urgency is just manufactured panic.

Despite the theatrics, though, there’s something rotten at heart of the currency. The real problem for the Euro is that it is the unbacked liability of a political union that is slowly unravelling. It must be unthinkable for the planners and bureaucrats of Europe to imagine the economic landscape without a common currency. But they better start thinking fast and printing D-marks.

This must be what it’s like to live in the shadow of a dormant volcano. You plant a colourful green garden in the fertile soil and live on the gentle slopes and pass your days quietly. And then one fine day you are erased from existence in the time it takes to scratch your nose by a searing hot pyroclastic flow. Game over.

Except, switching metaphorical gears, we have always known a global financial system built on debt was an active volcano capable of blowing at any time. Throwing virgins into the crater to appease the gods – like throwing Fed money onto bank balance sheets – is not a realistic survival strategy. Virgins don’t prevent volcanic eruptions and more money doesn’t improve bad debts.

So what IS a realistic survival strategy?

Well, the conventional wisdom – and we say this not really knowing what conventional people think – is probably to not try and time the market, to have a diversified portfolio with an asset allocation strategy designed to suit your risk and your financial goals, and to let time do your work for you, with annual rebalancing to make sure you are not over-exposed or under exposed to any particular asset class. That’s how they write it up in the textbooks.

For most of the last twenty years, that strategy has worked. But will it keep working in a world where you may see de facto default by sovereign governments or, if they manage to avoid that, massive inflation? What do you reckon?

Meanwhile it is beginning to dawn on more people that the Rudd government has introduced its resource rent tax at almost the worst time imaginable for the Aussie share market. China’s banks are being instructed to tighten lending. This ought to reduce the demand for base metals used in China’s infrastructure and housing industries. Base metals prices are falling.

Yet in this environment the government has submitted a budget which assumes perpetual boom times in the resource patch and projects a surplus based on a big tax it hasn’t yet passed. If you have some time today, make sure to read this article by Business Spectator’s Robert Gottliebsen in which he warns of a looming ‘capital strike’ by the mining industry.

A ‘capital strike’ sounds like something out of Atlas Shrugged doesn’t it? Wealth producers of Australia unite! And do nothing! You have nothing to lose but the profits the government was going to take from you anyway.

The government seems to believe that the miners will still develop project in Australia under the new regime. Why the miners would do this when there are other projects in other countries, well, we don’t know. But the bottom line is that nearly $100 billion in mining projects may get shelved as a result of the tax.

You might be of the opinion that this is a good thing; that accidentally the government has done the right thing by slowing down the development of Australia’s resources so they can be managed more deliberately and for the greater good. That would make you a communist. And besides, it’s a pretty risky and presumptuous gamble to say that you can handle an entire industry like a finely tuned automobile, or that you know how to run it better than the people who actually run it for a living.

In any event, it looks like a bigger battle is brewing between the industry and the government. From an investment perspective this is a massive negative for Australian stocks. It introduces a huge amount of uncertainty. And in that environment, no one wants to take many risks.

However, as our mate Kris Sayce pointed out in the note we sent you yesterday, the only good news is that when the playing field is deserted, you have it all to yourself. And if you preserve your capital in the big corrections, you can pick and choose the projects you want to invest in, usually at a cheaper price. At least that’s how it worked for Kris in2008.

Frankly, we’re not sure how anything’s going to work the rest of the year. The sun will come up. It will go down. But in the hours between, what happens next is anyone’s guess. Stay tuned.

Dan Denning
for The Daily Reckoning Australia

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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