Memo to Glenn Stevens — You Can’t Fight the Trend

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He’s been quiet for a while, but former Greek Finance Minister Yanis Varoufakis is back. Not in Greece, but with some (presumably unsolicited) comments on the Aussie economy.

In an interview with Fairfax Media, the former University of Sydney academic said:

“There will be a recession in Australia, because of the collapse of investment and because of the collapse of animal spirits – and this is because of what’s happening in China.”

This is hardly a revolutionary statement. I’ve been predicting an Aussie recession on the back of a China slowdown for years. And I’ve been wrong.

The Aussie economy is truly one of the wonders of the economic world. It just keeps defying the ‘doomsayers’, or realists, as I would prefer to call them.

It sailed through the crisis of 2008. It did so via massive fiscal and monetary stimulus. China’s record breaking credit boom provided another shot of economic adrenaline. It kicked the economy along from 2009 to late 2011.

I can’t remember the stat off the top of my head, but the Chinese banking system expanded credit at something like five times the size of the whole US banking system in the space of a few years.

Much of the credit went into property construction and speculation. This is what pushed the price of iron ore up to a nose bleed level of US$180 per tonne in early 2011.

But what’s going on now? The iron ore price fell yesterday to fresh 10-year lows. The Tianjin benchmark price is now trading at US$42.80. This is a nasty trend and will keep going. I don’t see a bottom in sight for some time.

The fall to new lows comes just in time for Gina Rhinhart’s $10 billion Roy Hill mine to deliver its first shipment of red dirt to China this week.

And that’s the problem for the market. The demand and supply metrics remain awful. The juniors — and I’ll add Fortescue [ASX:FMG] to that list — keep cutting costs to remain competitive. But that doesn’t remove supply, which is the whole point of lower prices.

As a result, prices will keep falling until meaningful supply exits the market. That won’t come from BHP [ASX:BHP] or Rio [ASX:RIO] or Brazilian miner Vale. It will come from the juniors and probably Fortescue.

So spare a thought for all those who tipped in millions to keep Altas Iron [ASX:AGO] afloat back in August. The way things are headed, that money will be gone by the end of the year.

In case you needed any more evidence of the woes facing the iron ore industry, look no further than Rio. Yesterday, its share price broke down to new lows. It’s now trading at the lowest point since its existential crisis of 2008.

Here’s the one year chart…

Source: BigCharts

[click to open in new window]

Don’t try to bottom fish here people. This is a stock with massive exposure to iron ore and the price will continue heading down until something happens with supply.

Demand won’t save it. China is long past pumping up the iron ore price with its infrastructure stimulus packages. It’s desperately trying to transition to a consumer led economy, and away from the old growth, commodity intensive model.

I wonder how the Reserve Bank will view the ongoing deterioration of Australia’s most valuable export? They’re meeting today to decide on interest rates. It’s a pretty safe bet that they will leave them where they are. When you’re this low on interest rate ammunition, you want to make sure you save it until it’s really necessary.

In recent weeks, the Reserve Bank has sounded quite sanguine on the local economy. It goes back to Varoufakis’ comment above on ‘animal spirits’. RBA boss Glenn Stevens is a big fan of animal spirits.

In previous speeches, he’s talked about the mysterious absence of animal spirits when it comes to business lending. At the same time, he ignored the frothing-at-the-mouth-spirits of the property speculators.

One way of keeping the punters hyped up, in Stevens’ world, is to remain ‘confident’. If he starts getting all worked up about the iron ore price, and cutting rates in response, it will have a negative effect on ‘animal spirits’.

So better off to pretend that everything is fine and encourage as much debt accumulation as possible, right? Sounds crazy to me, but that’s how our economic managers see things right now.

To be fair, some of the data out lately on the Aussie economy hasn’t been too bad. Employment remains decent and the services sector is humming along. Consumers keep spending too, although not at Dick Smith [ASX:DSH] stores by the look of things.

But the way I see it, most mainstream economists and the RBA look at each pick-up in activity as the start of a ‘recovery’. This is like looking at each momentary rally in BHP’s share price and thinking it’s the start of a new uptrend.

My point is this: the bigger picture trend for the Aussie economy is weakness. The overriding driver of that is the collapse in the iron ore price. This drags down our terms of trade and reduces growth in national income.

Falling national income growth is basically a recession. So far, falling interest rates have masked the effect of this stagnating national income growth. The question is, for how much longer can interest rates subvert the overriding trend?

We’ll get more clues on the trend of the economy tomorrow with the release of the September quarter national accounts. The signs are that the growth number will be better than the June quarter. But as always, the devil is in the details.

Regards,

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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