The Big Red Plan

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–“A surprise dive in company profits has all but confirmed Australia will record negative economic growth when March quarter figures are published tomorrow, with quite possibly a worse result than during the global financial crisis,” reports today’s Age. This is not the contraction we warned of at the end of yesterday’s Daily Reckoning. But it’s a start.

–Corporate profits were down 2% in the first quarter, according to figures published by the Australian Bureau of Statistics. Mining profits were down 6%. The ABS cited floods, cyclones, tsunamis, and earthquakes (the one in Japan, obviously) as the main reasons for lower mining profits. A rebound is, ahem, expected.

–The contraction we had in mind is the kind you get after a multi-decade global binge on credit. The contraction we had in mind is more like a convulsion, the sort of thing you get when the global economy goes through credit withdrawal. That’s not a one-quarter contraction. It’s a contraction that demonstrates corporate profits are mean-reverting too.

–But for THAT contraction to happen, China’s economy will have to stop expanding by around 10% a year. China’s economy could very well cease expanding by double digits if you get currency destroying crises in Europe and North America. But for today, at least, you’ll read that Chinese steel production will grow by 25% over the next five years.

–The China Iron and Steel Association, which is run by the government, reckons China will produce about 750 million tonnes of steel by 2015. That would be according to plan, literally. China’s latest official five-year plan calls for annual GDP growth of about 8% per year. Given China’s high rates of fixed-asset investment—bridges, roads, buildings, etc.—that’s a lot of steel.

–China already produces (and consumes) a lot of steel, come to think of it. According to the World Steel Association, Chinese mills produced about 626 million metric tonnes of steel in 2010. That was more than the next 15 countries combined. In fact, China has more excess steel production capacity than the production capacity of industrial nations Japan and Korea.

–Hmm. If everything goes according to the Big Red Plan, then all Australia has to do is tuck itself in China’s slipstream and enjoy a free ride to prosperity. A lot of coal and iron ore will have to be dug. But that should keep everyone busy and cashed up for the next 20 or 30 years.

–Of course it’s also possible that China’s steel production is based on consumption trends that are utterly unsustainable and also a function of the global credit boom. If that were true, it would be impossible to decouple China’s growth story from America’s deleveraging story and Europe’s sovereign-debt story. And it would be impossible for China, and by extension Australia, to escape the consequences of the downturn Marc Mobius says is coming.

–Mobius runs Templeton Asset Management’s emerging markets group. He told Bloomberg yesterday that, “There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis.” Mobius reckons that the global derivatives market is where a new crisis is brewing. The notional value of the over-the-counter (OTC) global derivatives market is more than $600 trillion, according to the International Swaps and Derivatives Association (ISDA). That’s more than 10 times global GDP of $50 trillion.

–It is not always easy to understand how something like a derivative, which is a kind of financial abstraction, can destroy real asset values. But oh can it ever. Derivatives are just financial instruments whose value is linked to some other asset. The biggest derivatives markets, by size, are in interest rates, bonds, and currencies. The ISDA reckons that 77% of OTC derivatives are interest rate derivatives.

–So what’s the problem? If investors are using interest rate derivatives to hedge their risks, that’s kind of what derivatives are for. Put and call options, which are also derivatives, are kind of like insurance policies against movement in an underlying security. If the stock goes down, your put option (in theory) goes up.

–But with most insurance policies, you hope you never use them. You’re happy to pay the premiums for a policy because the small regular cost means you’ll never be poleaxed by a giant, catastrophic cost. The premium buys you peace of mind.

–There are surely some financial operators out there today who use interest rate derivatives as insurance. But the size of the market reveals an obvious fact: derivatives have become a playground for over-leveraged speculators to make profits on interest rate bets. It’s a big casino.

–There’s nothing wrong with casinos, of course, unless you have a gambling problem. But the problem for investors is that what happens to the value of the derivatives in the OTC casino affects that value of assets and capital on the very real world balance sheet. Big losses in the derivatives markets can trigger asset price falls and defaults. This is what happened in 2008, only then the derivatives in question were securities linked to the value of sub-prime backed U.S. mortgage bonds.

–Come to think of it, we’re kind of back where we were in 2007. The financial industry has somehow hijacked monetary and fiscal policy in major countries in order to serve its own interests. And its own interest are to leverage up again via cheap global interest rates, make a lot of speculative bets, and leave the losses to the public.

–Excess leverage distorts investment values (all sorts of non-investment values too, really). It turns all of us into speculators because asset values are divorced from fundamentals (a business’s ability to grow cash flow and profits) and become subject to financial money flows. When it’s that dangerous to invest, it’s better to identify assets you want to buy…and then wait for prices to correct.

–“Why are you such a depressing person?” a friend asked last night.

–“I’m not depressed at all. Life is good. Why would you ask that?”

–“I didn’t say you’re depressed. I said you’re depressing. You only ever write about bad things that have happened or might happen. It’s almost like you want them to happen. Like they make you happy, in a depressing sort of way.”

–“Well, that’s not the case at all. I just think a lot of bad things are probably going to happen. That’s why I write about them. But it doesn’t make me happy. It doesn’t make me sad, either. When I think good things are going to happen, I write about those too.”

–“I don’t remember reading about any good things in the Daily Reckoning. I look around me and see that for most people, life is getting better. They have jobs and money and credit cards and smart phones. I mean for most people, things have never been better. ”

–“Well, if you mean that most people, on average, have never enjoyed so much material affluence in human history, yeah, that’s right. That’s not the same as being richer, or enjoying a better quality of life. But it’s true…a lot of people live like kings today compared to…people who used to be kings. But my point is that if things tend to get better and better over time, people pretty much stay the same. People don’t improve like new versions of an iPod or an iPhone. People today aren’t any better, qualitatively, than people a hundred or a thousand years ago.”

–“But people know a lot more. We know the world isn’t flat. We know the laws of physics. We know how to split the atom. Heck, we know there IS an atom.”

–“Well that’s true. But knowing more about the world you live in doesn’t automatically make one a better person, ethically, morally or spiritually. I guess what I’m saying is that you can have progress in a material sense—better medicine, more innovation, higher standards of living—but it doesn’t equate to us being better people.”

–“Speak for yourself.”

–“Okay. In some ways, financially especially, and in the way we let ourselves be governed, we just keep getting dumber…putting people in debt for life with mortgages…putting all our financial eggs in a few baskets with too-big-to-fail institutions that have government guarantees…and tolerating the garbage money produced by our garbage financial overlords. Today’s financial oligarchy isn’t that much different than feudal oligarchies. It’s just that peasants can drive Priuses.”

–“See. That’s progress. More Priuses means less carbon dioxide and no more global warming. See, that’s progress.”

–“I think we better have that discussion another time.”

Dan Denning
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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Comments

  1. Dan’s Friend: “”I didn’t say you’re depressed. I said you’re depressing. You only ever write about bad things that have happened or might happen. It’s almost like you want them to happen. Like they make you happy, in a depressing sort of way.”

    As I read down through The Big Red Plan, I found myself thinking Yankee Dan really gets a charge out of any minor crisis in Australia, doesn’t he?
    Then I read your friend’s comment.

    What you should have explained is that:

    1.) It’s your job to ferret out anything financially negative, here and abroad;

    2.) Where a foreign crisis occurs, it’s your mission* to either correlate that with Oz… or predict dire fallout for us;

    3.) Given that your actions align with your Mission Statement, your glee is both defensible and morally just!~ :D

    * At times you remind us of a Yankee missionary, sent here to enlighten us to the error of our ways. A glowing halo above your crown, in your avatar, might help your friend better understand… . ;)

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  2. Dan

    “record negative economic growth” This is not possiable you can’t have negative growth the pharse doesn’t sense. If something is growing negatively for a long time for instance what would it then become? Ecomamic contraction a much better pharse.

    mark

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  3. Actually the pharse does make sense from time-to-time. ;)

    “I don’t remember reading about any good things in the Daily Reckoning.”

    Shame on you, Friend-of-Dan! What about the incredible rise of Silver after Kris counseled us all to buy? And how about the incredible fall in property interest rates, from 9.45%? I recall that as a Yksnim Moment in DRA reports! Enough of the happy stuff… .

    Good news? Not your job, Dan. We _need_ these distant early warnings of possible crises _daily._ Where would we be if we didn’t search daily for that paragraph, two-thirds through an article, where the prophet cleverly correlates some far-off drama, preparing us for Imminent Ozdoom?!~ :D

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  4. Crumbs BP
    So many vote on your post
    A gun on your hip
    drew attention from most

    You have fought them on the beaches
    And on the the landing grounds
    In word perfect speeches
    We shan’t spell as peaches

    Alas you won’t sleep now
    Without gun at your reach.

    Have a good day BP ;)

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  5. To be sure, the DRA has always published good news; the Gold Price remains good news – and ought remain so, while the world’s real wholesale interest rates remain negative.

    —————————–oOo——————————-

    If that is true – gold and real whole interest rates are negatively correlated – or trades from opposite ends of the table – it would point perhaps to the wisdom of Dan’s statement, above:-

    “There’s nothing wrong with casinos, of course, unless you have a gambling problem. But the problem for investors is that what happens to the value of the derivatives in the OTC casino affects that value of assets and capital on the very real world balance sheet.”

    Well perhaps there is something or worse, a lot wrong with casino policy ? I’d suggest that the answer lies in the later part in the above quote “… the OTC casino affects that value of assets and capital on the very real world balance sheet.”

    That is a subtle mechanism, Dan and it would be great if you could expand on this “transition mechanism” from the OTC market, which clears at predetermined intervals, against the value of the underlying assets. How does the play out into the real markets?

    The answer between ‘nothing wrong’ and ‘a lot wrong’ certainly has to be in the arena of the distinction betwixt laudable(?) insurance contracts and the somewhat not so nice casino betting contracts.

    Certainly both markets trade risk, yet insurance must have, at law, an insurable interest, whereas casino’s are ‘naked’ risk trades? The greater part of the OTC trade is naked too, I’d guess?

    Is this correct? Could you fill us in, on the tinier steps, please Dan?

    ——————————-oOo——————————

    AND

    If casinos and insurers can be distinguished by their insurable interest, or lack thereof, and thus perhaps, the affect mechanisms to a real effect, through a somewhat vague transmission mechanism, then this would point perhaps too the wisdom of Dan’s statement -above:-

    “This is what happened in 2008, only then the derivatives in question were ‘securities’ linked to the value of sub-prime backed U.S. mortgage bonds.”

    Huh?

    Derivatives are NEVER ‘securities’, surely? Securities are strictly of one of two types namely debt securities or equity securities? Derivatives are written on the value of securities, but cannot in some paradox, become securities as well? I believe that sentence only makes sense if you completely erase ‘securities’ – “only then the derivatives in question were […ellipsis…] linked to the value of sub-prime backed U.S. mortgage bonds.”

    ————————————–oOo——————————-

    Finally, also from the article above “The notional value of the over-the-counter (OTC) global derivatives market is more than $600 trillion, according to the International Swaps and Derivatives Association (ISDA).”

    What do you think they mean here?

    The ‘nominal’ value rather than the ‘notional’ value, perhaps? If that is actually “notional” does this mean half the trades would be long – half short of any actual position? That reduces the $600 trillion by a half! Yet that still involves a staggering six times ‘churn’ over the ‘nominal’ value of the underlying assets.

    Yet the individual OTC instrument’s trade ‘notional’ value is usually a fraction of the ‘nominal’ value of the underlying instrument – which balloons the multiple, and makes six times, or even ten times a meaningless statistic, I’d guess?

    It’s akin to trying to associate the total bets laid on the evening’s casino roulette wheel, to the value of the …err, what?

    The non-existent or zero summed value of the underlying value of the positions – punter against the house – when the wheel is at rest – a moment before the first spin of the night!!

    It’s simply a rubbish statistic, surely!

    As always

    Thanks Dan

    Cheers

    PS China’s steel production is certainly a scary statistic! Oh boy!

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  6. bugger! A few grammar/edits needed!

    So sorry…

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  7. Quite a few good things are happening in the first world, just not on TV. More and more veggie patches in more and more backyards, more bartering, more saving, more exposure of mainstream media garbage. It’s all pretty good, as long as you’re not one of the low hanging fruit countries with juicy gold reserves that Wall Street is hoping to milk, such as Greece, Portugal, Spain and Italy. But then again, if you’re in Iceland, you might well have crossed to the other side of the world’s crisis and needn’t worry any further.

    Oh and Biker, Silver is still a good buy ;)

    For objective measures of human experience though, you can look at death rates, life expectancy, smoking rates (as a predictor of pain, disease and poverty), and so on and see that for Australia at least we are doing better than 100 years ago. You could ask some old people and they will tell you better than any study can.

    Spirituality and all that is not objective and can’t be measured in the same way, because any measurement tool for that will be hopelessly biased. People say it’s in a bad way, which it probably is, but here is something to think about: http://www.dailymail.co.uk/sciencetech/article-565207/Modern-technology-changing-way-brains-work-says-neuroscientist.html

    People’s brains have changed with emerging technology, which is providing endless distraction and filling literally every spare moment in peoples’ lives. What need is there for spirituality in this setting? None is perceived. Smart people are becoming dependent on instantaneous intellectual reward, like pokie addicts, and so are becoming mental slaves. That’s poor quality. The pokie addict is lost in a sea of useless thoughts and knows no way out.

    “Cigarettes and whisky and wild, wild women… and iphones”

    Reply
  8. ” More and more veggie patches in more and more backyards, more bartering, more saving, more exposure of mainstream media garbage.”

    Yes yes yes Dan and it warms my heart. People are starting to think differently esp I detect in the last 6 months. There has been a large shift in thinking about taking status quo for granted. I’m guessing though it’s not the dawn of a completely new world.
    Personally I feel a need to observe the whole truth and our vulnerabilities but I have to think status quo and work inside the status quo to make material progress. So I want to believe China will keep going forward. Then mines will keep buying my products. However I am making small plans for a failure, even getting ready emotionally….which is difficult no matter who you are I guess. If one plans too heavily for such they impede their progress in the current paradigm. And it’s anybodies guess how long systems can keep rolling along. And yet they are faulty no? And yet they always were. The US has had many critical problems before now.
    And yes I wonder how the modern brain copes with so much. However mine seems incapable of retaining much information over time (poor memory). So I guess there is an answer….it doesn’t.
    I detect though that more people want to discuss spirituality now than just a few years ago. Due to uncertainty then? Maybe. But then nothing ever was certain.
    One high probability in my view… the sovereign debt crisis must be resolved somehow and probably not too far from now. The exact when and how we cannot know.

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  9. Yeah I bought the silver dip too ;)

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  10. Wow ! First time writer, long time reader.
    I don’t know what to say other than i am very impressed and glad to hear such inspirational words from you Dan.
    I too were a little sceptical about your “negative” comments over time, but what you just wrote could not be more positive – the fact that our measure of wealth should be more about our humanity and kindness to others and the planet instead of the size of our plasma ( oops sorry LED TV – I forgot we recently became better people ) and the version of our iphone.

    Regards
    Jye Miller

    please continue to inspire to youth of today with comments like these – it really makes a difference.

    Reply
  11. Institutional inertia is the wrecker and said institutions not regularly dissolved and reconstructed are easy prey to capture and subjugation by the most virulent organised few of the day.

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  12. Gave ya the big five for your poetic thoughts, Lachlan!~ :D

    Yes, there’s lots of good news amidst the gloom: more saving, family food production, etc. And, of course, China hasn’t fallen over, no-one refuses our plastic money (silly Yanks using combustible paper!) and silver is still a hold if you bought low!~

    Those minus votes are a real concern, though. Don’t know what to do!!!~
    Am I a contrarian to a contrarian mindset? It’s a worry… . ;)

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  13. I’ll wipe those Thumbs Down off for you Biker

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  14. Why, thank you, Steven!~ :D

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  15. negative? hell no, Ive just spent large parts of the last month looking up Fukushima. arrrggghhh don’t start me (c’mon, c’mon).

    yep, that derivative death star still hangs in the balance like a hot potato. insurance is fine as long as the insurance is not for 6 times the value of the properties insured and as long as everybody doesnt claim at once in the panic to ensue. as long as there are not moral hazards that involve corporate cowboy kids who don’t know what they are ultimately doing playing with matches in a volatile atmosphere. as long as the lunatics are not still running the asylum. as long as the parties are primary interests in the insured events, and not third party *gamblers*. as long as there is a one to one relationship of deed to asset.

    still waiting for the big one(s)….

    positively, one cure for internet ADHD. this or similar should be taught at school, call it quiet time. ssssshhhhhh
    http://www.youtube.com/results?search_query=adyashanti&aq=f

    Reply
  16. Jeez! Look at that… . He did it!
    Howdy do dat?

    Reply

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