Leaderless, directionless, and clueless. That’s how we’d describe the state of the local and global market. The problem is the “known unknowns” (US$43 billion of them) and those pesky “unknown unknowns” (credit derivatives). More on that below.
First, did you see the current account deficit widened to nearly AU$16 billion in the second quarter? The Australian Bureau of Statistics was busy yesterday. Did you wonder what, if anything, that means? Does it matter? We wondered too. What do all these numbers really mean? What we’re really after is whether Australia is getting richer or poorer during the great resource boom.
The current account has two main parts, the balance of trade and investment income. A current account surplus would indicate a growth in a country’s assets. A deficit, on the other hand, indicates a country owes more than it owns.
Australia has a trade deficit, which is a bit surprising for a country in the middle of an export boom. The country’s trade deficit (in goods and services) grew by AU$264 million in the second quarter to AU$3.7 billion. As we said, it’s a bit shocking that a country in the middle of an export boom is still importing more than it’s exporting. What is the country importing? And are people and corporations using debt to buy imports? Hold that thought.
The trade deficit is just 25% of the total current account deficit, $3.7 being about 23% of $16. As surprising as the trade deficit is, the big contributor to the current account deficit is the net income deficit. THAT deficit grew by AU$180 million in the last quarter, for a total of AU$12 billion. But what on earth is a net income deficit and why does it matter?
If we’ve lost you already, we apologise. We’ll try keeping it simple. The net income deficit shows that what Australia owes (or must pay) to foreigners exceeds the amount it owns (or receives in income) from its foreign investments. There are many components to the equation. But to keep it simple we’ll say Australia’s liabilities to foreigners are increasing faster than its income from foreign assets. But why does that matter, you may still be wondering?
After all, Australia’s current account has been in deficit for 16 years. The economy hasn’t had a recession for 16 years. What’s so bad about the whole thing?
What’s bad is that Australia is accumulating a large debt to foreigners. In the stock market, foreigners own an increasingly large share of the income of Australian companies. Those booming profits don’t stay on-shore. And what about debt?
Capital spending was up 6.3% to AU$21 billion, according to more statistics from the ABS. Businesses are increasing spending on equipment to keep the boom going. But this is where the debt issue arises again. Businesses are borrowing to import equipment from abroad. The benefit is that the business has a new piece of capital equipment. The drawback is that the profit on the sale of the equipment goes to the foreign producer and the debt that was used to finance the purchase must be serviced.
Australia owes an ever-increasing amount of debt to foreigners. That’s the key fact of yesterday’s current account deficit. That fact seems trivial during a boom. But that rise in debt can become even more costly when interest rates rise, as they are in the current global credit crunch. It means Australia will be paying a steadily larger amount of interest to the foreign holders of its debt. The deficit will widen.
Who knows, maybe it’s all academic? We doubt it, though. A nation doesn’t get rich by consuming more than it produces any more than an individual can get rich that way. You want to own more than owe. Australia should be racking up huge trade surpluses and exporting capital to the rest of the world. Instead, it’s racking up a trade deficit and importing capital. That doesn’t seem too healthy to us.
The stock market doesn’t care about any of this right now. That’s why this market reminds us of the top of the tech boom. Even after actual stock prices topped out, the psychology of the bull market lived on. You could see all around you signs that the game was up. But those signs were contrary to the overwhelming sentiment in the market, so they were ignored.
All happy bull markets are alike. Markets move up on primary trends, broad themes investors can use to justify buying stocks at current valuations. The tech boom was one such theme. “Technology is making people more productive and changing the way the world does business.”
The resource boom is the latest theme. “China and India are undergoing the third great industrial revolution of the last 150 years, and this one is more resource-intensive than the last two combined.” Of the two, the resource boom has proven to be the more durable because it’s more tangible.
But it is not a new theme anymore. Four years into the resource bull market a new theme comes. It threatens to drown out the pleasant melody of rising commodity prices. Credit deflation. A world pumped up with trillions of dollars in financial assets is suddenly on the verge of becoming unpumped. Stocks have lost the plot.
So what is the plot? Well, the worst case scenario is that the August turmoil was just a preview of distressed selling and forced liquidation in the stock market. The stuff up at Bear Stearns, Basis Capital, and other firms exposed the most unprepared money managers. These firms weren’t just “exposed” to subprime debt, many of them were gorging on the stuff like a fat man in front of a bucket of greasy fried chicken.
Junk collateral is forcing a lot of money managers to reduce the number of bets they’ve made with borrowed money. “Deleveraging” is the term you’ll read. In a bull market, you can afford to borrow a lot of money – even with a small base of capital – to increase you’re overall return. Why? Because the return on your investments is greater than the cost of borrowing money.
Now that the price of money has gone up, investments made with borrowed money are not as profitable. Some are even – get this – losing money. It’s called negative carry. To avoid the consequences of negative carry, levered investors will close out their trades. This means selling, and in a hurry.
A new report from the Royal Bank of Scotland warns that a liquidity crisis in the commercial paper debt market could force “firesales” of as much as US$43 billion in assets. The commercial paper market is where corporations engage in short-term financing. “By our estimates, somewhere around $43bn is the [face] value of the assets that those vehicles, which have publicly disclosed issues, might have to sell-off,” said Tom Jenkins, banking and financials analyst at RBS.
The whole thing seems pretty complex. But the important point is this: there could be a lot more selling ahead in September and October. The Fed meets in the third week of September. But before then, many market participants will try and unload risky, difficult-to-value assets. Then there are the “unknown unknowns,” things that we don’t even know we don’t know.
According to a report by international law firm Morrison and Foerster, nearly 2,000 of the world’s 9,000 hedge funds may face a surge in redemption orders because of their exposure to assets based on credit derivatives. It’s just a more complicated version of the scenario at Australian Capital Reserve, where investors try to get their money out of an outfit before it closes down or goes bankrupt.
The report identified about 2,000 funds with an estimated $1.5 trillion in “at risk” assets that are the “most vulnerable to redemptions.” The report states, “Some foresee an increased risk of both margin calls on hedge funds’ highly leveraged positions, and consequent distressed sales of such hard-to-value assets, all forcing prices and values even lower.”
The key phrase in all of that is values may go “even lower.” This applies to hard-to-value assets like CDOs packed with subprime toxicity. But could it also mean stocks? That’s what we’re worried about. We’re worried that the belief the Fed and other central banks have averted a massive crisis in confidence and liquidity in financial markets is just wishful thinking…and that the smart money will be unloading while stocks are choppy. And then…whoosh. No more buyers come in September and October.
The Daily Reckoning Australia