Why This Iron Bust is Serious…

iron ore resize medium
Reddit

I mentioned last week that Australia had reached a turning point in its realisation that the iron ore bust was serious. Now, the government is finally starting to get it.

The Financial Review reports this morning that Treasurer Joe Hockey is contemplating using an iron ore price of US$35/tonne for future budgets. If he did so, it would mean another $6.25 billion reduction in annual revenue compared to what the government is currently budgeting for.

$35/tonne sounds like a realistic forecast. At the very least it ensures the government has a better starting point for understanding what its longer term revenue stream will be from this crucial export.

As I’ve explained before, the iron ore price feeds into the terms of trade, which in turn has a major effect on Australia’s nominal national income growth. It’s this income growth that determines the governments’ revenue raising abilities.

The sooner the government gets more realistic on the revenue front, the sooner it will understand how important it is to start winding back the boom time largesse.

The only problem is it doesn’t appear to have the will to try and push for changes now. It wants to take major changes to the next election, which won’t be until sometime next year. And then there’s no guarantee Australians will vote for change.

The resources boom did wonders for national income growth. As well as inflating our pay packets, it allowed governments to increase pension and superannuation entitlements and allow poor policy like negative gearing to proliferate and damage the underlying budget.

When you try and take these entitlements away, you meet resistance. So politically, it’s probably necessary to take the time to build a strong narrative around why such a generous welfare and tax system cannot continue.

Importantly, the narrative should be about closing overly generous loopholes as well as reducing spending…not just on increasing taxes.

Like the rest of the world before it, Australia is headed into a ‘new normal’. We’re going back to a world of revenue and spending that existed before the commodity boom.

To show you what I mean, here’s an excerpt of what I wrote to paid-up subscribers of Sound Money. Sound Investments. in last week’s update…

My advice to you is not to go bottom picking in the iron ore market. A structural shift is taking place. After a massive cyclical boom, prices are again returning to their long run averages.

Have a look at this 20-year monthly chart of the iron ore price to see what I mean (it’s yet to reflect the drop into the $40s). The scale isn’t very clear but the price was around US$11-12/tonne up until 2003 when the rise of China lifted it off the floor.

 

Source: indexmundi.com


Click to enlarge

 

At the time, iron ore was subject to annual contract pricing, which is why the chart looks like a step ladder up until late 2008. Thanks to China’s strong demand, the miners negotiated higher contract prices each year.

In late 2008, the iron ore market changed to spot pricing (meaning a price based on daily supply and demand factors), and this coincided with the start of China’s massive credit boom.

As a result, the price exploded, reaching a high of nearly US$190/tonne in 2011. The bull market — combined with optimistic projections of long term Chinese steel production growth — led iron ore miners to invest heavily in expanding their own future production.

But the miners were wrong about future steel demand. It now looks like Chinese steel production peaked in 2014 at around 820 million tonnes. The likes of BHP and RIO thought production would keep rising to over one billion tonnes by 2030.

As I explained last week, there’s more chance of Chinese steel production falling rather than rising over the next 10 years. The iron ore price is simply reverting to it’s long term average.

The majority of analysts think the price will bounce back next year, but I think they’re wrong. There is a structural change taking place…this is not cyclical. So the likes of BHP [ASX:BHP] and Rio Tinto [ASX:RIO] are still quite expensive at these levels because analysts expect earnings to bounce back in 2016 and 2017.

In my view, that won’t happen. As an investor, you should look at your portfolio to ensure you’re not overly exposed to a dependence on this expected price bounce back. Because if it doesn’t happen, then the iron ore majors still have big share price falls in front of them.

This structural shift is why you shouldn’t be too surprised about the demise of Atlas Iron [ASX:AGO], which announced the closure of its mines late on Friday. There will be others to follow. These companies only got off the ground because of a one-off jump in prices. They will all go out of business as prices return to the ‘new normal’.

From Australia’s perspective, the return to a ‘new normal’ means much lower government revenues, which means spending will have to pull back too. And about time! We’ve become too used to handouts and welfare…whatever happened to the Australia that stood for hard work, individual achievement and responsibility?

It’s still there somewhere, but the curse of the resources boom has certainly buried it for a while. If necessity is the mother of all invention, then plenty is the father of idleness. Or something like that…

But are things really that bad?

In the Weekend Australian, Adam Carr argued that the economy is actually picking up, not weakening. Now Mr Carr has always been a glass overflowing type of guy. As the Aussie economy remained tepid despite record low interest rates over the past few years, Mr Carr has long argued the bullish case.

To my mind, the absence of a boom does not indicate disaster — just a more normal growth profile: an economy growing at trend, led by strong export growth, a residential construction upswing and decent consumer spending.’

The economy is actually growing below trend, but Mr Carr says this has something to do with the national accounts understating State and Federal government spending. Maybe, I don’t know. However, budget deficits are probably growing because of weaker revenue rather than greater spending, so I’m not sure he’s got the interpretation right.

But he is right about solid residential construction and decent consumer spending. Thanks to higher house prices and the growth in debt needed to keep up with this house price growth, there is still solid demand and spending in the household sector.

In my view, this solid demand is narrow and fleeting. A neighbour mate of mine who is a financial planner reckons his business clients are doing it tough, while his ‘asset dependent’ clients think it’s all rainbows and unicorns. That sounds about right.

I’d be interested to know what you think. If you run a small or large business, or are in a position to comment on the underlying demand your business is experiencing, I’d love to hear from you.

Please send a brief comment, with subject line ‘Business Conditions’ to letters@dailyreckoning.com.au.

I’ll publish the best responses (bullish or bearish).

Regards,

Greg Canavan+,
for The Daily Reckoning Australia

Join The Daily Reckoning on Google+

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.
Reddit

Leave a Reply

1 Comment on "Why This Iron Bust is Serious…"

Notify of
avatar
Sort by:   newest | oldest | most voted
Ed
Guest
I am not an economist or any business owner, but I have recently started following fundamental analysis articles to gain some insight into what happens. Some of my stocks are the mining iron ore ones. Alas I have to agree with you, Greg that the trend and its underlying explanation is against an iron ore price recovery anytime soon. What frustrates me the most is the confusion in the media such as TV channel 7, where I hear the same “optimistic” upbeat tone in the bad economic news reports. To these people there is always something to smile about, because… Read more »
wpDiscuz
Letters will be edited for clarity, punctuation, spelling and length. Abusive or off-topic comments will not be posted. We will not post all comments.
If you would prefer to email the editor, you can do so by sending an email to letters@dailyreckoning.com.au