Annnnd we’re back. This week begins with very different levels of manufacturing activity in China and Australia. One is bullish. The other not so much. One confirms the basic idea that the world is slowing down, growing less fast, writing down bad credits, and saving for a rainy day. The other doesn’t exactly contradict that idea.
But we’d like to begin this week of reckoning with a simple observation: the rigging of short-term interest rates can prompt ordinary people to take extraordinary risks.
We hesitate to say bad risks because each act of risk taking is an individual thing. But what they have in common is that access to cheap money effectively lowers personal inhibitions to risk in the same way that a shot of tequila increases your chance of doing something stupid in a bar.
Take the Mrs. Watanabes of Japan. Its term that refers to retail investors in Japan who play the foreign currency markets with lots of leverage seeking lots of yield. The hunt for yield is prompted by an anti-deflationary monetary policy in Japan that has left short-term and bank interest rates appalling low, and often negative in real terms (below the rate of inflation).
That’s right. If your cash is getting hammered in a savings around and if it’s relatively inexpensive to borrow, why not gear up and speculate on something like, say, Australia’s commodity currency? The Financial Times is reporting that Japan’s regulators are cracking down on the amount of leverage forex speculators can use. The aim is to reduce “excessive speculation” by “inexperienced traders.”
The new rules limits borrowing by traders to fifty times whatever collateral they can post. Next year, it will be dialed back to twenty-five times collateral. The new rules, the FT claims, have accounted for a move up in the Yen as retail investors close out positions to comply. Just what they will do with their underperforming cash instead (buy stocks) is unclear.
What’s perfectly clear is that an inflationist monetary policy of cheap rates turns ordinary people into speculators. It’s a practical response. As cheap money distorts asset values and punishes those on a fixed income, you have to take greater risks just to find a decent yield for your money. By preventing retail investors from doing something to earn a return on their money, the regulator are just compounding the original mistake of forcing people to speculate in the first place.
But since we’re talking about speculating, and since we’re assuming that most people in Australia are not going to do so in the forex markets, what about stocks? Is that a reasonable way to speculate? Well, it certainly could be, if you’re able to find a stock tied to an asset that’s being revalued/de-risked/or in demand.
Diggers and Drillers editor Dr. Alex Cowie will be looking for a lot of those shares this week at the Diggers and Dealers conference in Kalgoorlie. At first we were concerned about the tremendous confusion that might result on Alex’s name badge. But the stock Doc has been jet setting his way from one mining project to another in the last three months. So we agreed that the possibility of confusion was worth whatever new stories he might come across in Kalgoorlie. He’ll be filing reports with DR all week. And D&D readers, as usual, will be treated to a comprehensive round up of the week’s events in Alex’s subscriber-only e-mail update on Friday.
But really if you read about India’s purchase of nearly $1 billion worth of coal tenements in Queensland, you’ll know what we’re talking about. Speculating on resource stocks can pay. It can also drive you nuts and lose you a fortune. But it can pay.
The deal in question is between Indian coal giant Adani and Linc Energy (ASX:LNC). Linc will be a familiar name to long-time Australian Small Cap Investigator readers. Your truly tipped it several years ago as a play on the unconventional gas-to-liquids industry that might develop from Queensland’s stranded coal fields (coal deposits too small or low in quality to qualify as a mine, but too rich in energy to be ignored altogether).
Linc’s business plan was always complicated, gasifying the coal underground in a barely commercial process, and then turning the gas into a liquid fuel in a proven process that’s been around for a long time and has been used by the Germany in World War Two and South Africa during apartheid.
But the basic value proposition hinged on the coal in Linc’s tenements being valuable. And despite the changing regulatory and political environment, the coal in the ground was coal in the ground. The deal still requires approval by Australia’s Foreign Investment Review Board. If it goes through, it will be India’s largest deal in Australia yet, and probably not its last.
For the record, ASI editor Kris Sayce sold out of the Linc position in February of this year. When he sold, the stock was up 122% from the original share price. Kris managed to bank gains on the stock, even though the business itself has yet to generate cash-flow in the way your editor described in the original story. That’s the world of speculation, where you take your gains when you have them.
Will there be more on offer this year, though? Kris and Alex think so, obviously. And they are paid to do nothing but look for such opportunities every day. So we hope the find some. Of concern, though, is the report today from China’s Federation of Logistics and Planning that manufacturing activity fell in July.
Mind you the survey showed that China’s manufacturing is still expanding, but barely so. The big question is whether this slowdown is evidence that the government’s crackdown on housing and real estate speculation is slowing the whole economy down and leading to slower demand for Aussie resources. And if it’s working, has it just started or is it already over?
We won’t bore you by reciting our theory again about how a bursting Chinese property bubble could do serious damage to Aussie resource investors. But it IS our story and we’re sticking to it. And the relatively encouraging Aussie manufacturing data released today (which also show expansion) doesn’t change our mind.
Finally, how about that Alan Greenspan? He is the gift that just keeps on giving. No longer speaking in any official capacity as the leader of banking cartel, the former Fed chairman now says things in public which seem contradictory to his policy objectives as Fed chief. It’s as if Greenspan is now saying all the things he secretly thought, or simply thinking thoughts that were unthinkable when he worked as the lead shill for the Fed.
The Maestro did point out that while the Fed can control short-term interest rates (as the Bank of Japan and the RBA can generally do as well), it can’t control long-term interest rates. Speaking to Bloomberg, Greenspan said, “There is no doubt that the federal funds rate can be fixed at what the Fed wants it to be but which the government has no control over is long-term interest rates and long-term interest rates are what make the economy move.”
This is relevant for Australians, too. As we’ve said, we reckon that what banks charge for mortgage loans here in Australia will be less and less a function of the cash-rate (the RBA’s price of money) and more and more a function of the global cost of capital (where Aussie banks borrow in the wholesale funds market in Europe and America.)
To the extent that Aussie banks can attract more deposits through higher bank interest on savings accounts, it’s possible that more funding needs can be sourced by a growing deposit base. But without crunching the raw data, we’d suggest the rate of expansion in the Aussie economy would be a lot lower if it has to be sourced from available savings. Slower, but a lot healthier.
It might not be all peaches and cream for America, though. Greenspan says that, “If this budget problem eventually merges to the point where it begins to become very toxic, it will be reflected in rising long-term interest rates, rising mortgage rates, lower housing. At the moment there is no sign of that because the financial system is broke and you cannot have inflation if the financial system is not working.”
Come again? Do what now?
We think the Maestro means that as long as investors keep dumping savings into the U.S. bond market, rates will stay low and the massive expansion of the Fed’s balance sheet will not result in any runaway inflation in the U.S. We will have “deflation” (lower credit growth and bank lending and falling asset prices) as long as banks remain undercapitalised and continue to carry hundreds of billions of dollars (if not trillions) of bad loans and dodgy collateral.
What happens when the financial system starts working again? We’ll tackle that one tomorrow. Until then…
for The Daily Reckoning Australia