The Week That Revealed the System’s Weakness

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What a week.

The RBA kept interest rates on hold. But my guess is we only have a month’s reprieve before Glenn Stevens takes us down another 0.25%. Oh how I wish Glenn’s taxpayer funded retirement pension was tied to interest rate movements. Perhaps he might gain a little more empathy for savers then.

The election outcome means political instability has all but been assured for the next three years…if parliament lasts that long. All bets are off on Scott Morrison’s $1.6 million superannuation cap being passed into legislation. The National Party is blaming this ill-fated budget initiative as a major turn off to loosely aligned Liberal Party voters…I agree. Morrison’s surprise announcement lacked industry consultation on how this would work on a practical, administrative level. It has/had all the promise of being a ‘dog’s breakfast’.

The Brexit recriminations continue to dominate politics in the UK. Blame and counter blame are the order of the day. Who is going to be the person in charge of working through the minutiae of the British exit? The contenders are jockeying for position. At present the UK is rudderless. PM David Cameron has resigned, and the opposition leader is being told to resign by the majority of his party. By comparison, Australia looks like a bastion of stability.

Bank of England Governor Mark Carney has wasted no time in priming the pumps…easing the previously tighter regulations to enable UK banks to lend a further £150 billion ($258 billion). For a little perspective on this number, (new) net lending in the UK last year was £60 billion ($103 billion). Carney is looking at pumping up lending volumes by 150%…an ambitious target, especially if you have a public that’s wary about taking on debt in a world of increasing uncertainty.

Carney’s response is straight from the (increasingly irrelevant) central bank playbook — that a highly indebted economy needs more debt. The alcoholic needs another (even bigger) drink.

Adding to the BoE’s list of woes is the news that three large UK commercial property funds — M&G Investments, Aviva Investors and Standard Life — totalling £9.1 billion ($16 billion) in funds under management, have been hit with a spate of redemptions, resulting in the funds temporarily suspending payments to exiting investors.

According to The Guardian:

Investors have been buying into commercial property funds to try to benefit from the 40% rise in commercial property prices since the 2009 crisis. But concerns that the market may have peaked before the referendum — plus fears on the impact of the Brexit vote on the UK economy — has triggered nervy investors to ask for their cash back.

This statement confirms two points I’ve been repeating ad nauseum for the past few years.

First, chasing returns that have already been made is just plain dumb investing. A fund that has made 40% is unlikely to provide a repeat performance of this magnitude anytime soon. Past performance is exactly that…history.

Second, nervy investors asking for their cash back is confirmation that, when push comes to shove, it is return OF capital, not return ON capital, that’s important.

Then there was this bombshell from the IMF Financial Sector Assessment Programme: ‘Deutsche Bank appears to be the most important net contributor to systemic risks, followed by HSBC and Credit Suisse.

Since January 2014, Deutsche Bank’s share price has fallen a massive 70%. The market is giving you an insight into what it thinks about Europe’s banking system.

But the big German bank is not the most immediate concern for the European banking system. Italy’s banks are in desperate need of a bailout.

Given that Italy is the world’s eighth largest economy, this is a real concern.

Officially, Italian banks have non-performing loans totalling €360 billion ($530 billion) on their books. It’s widely considered the valuations of the assets securing these loans are on the generous side. Unofficially, who knows how much toxic debt is on the books.

The Italian government is in a ‘damned if they do, damned if they don’t’ situation regarding any bank rescue plan.

The EU rules are very clear on government assistance in the troubled banking sector. The first step must be a ‘bail-in’. Shareholders’ capital and depositors’ funds are the first ports of call to cover at least 8% of the failing bank/s liabilities. In Italy’s case, this rule means that any investor with bank shares and/or unsecured loans (think hybrid securities) to the bank can kiss their money goodbye.

This ‘bail-in’ rule was invoked last year, when a few small Italian banks required financial assistance…wiping out the capital of 100,000 small investors. The political backlash was fierce.

With the far-right political movement gaining traction in Italy, Prime Minister Matteo Renzi has little appetite for the bail-in option.

What we have is a situation where government doesn’t want to risk the ire of investors with a bail-in, and the EU won’t release funds to recapitalise the banks unless there is a bail-in. While Nero fiddles, Rome burns.

A third option might be the EU, in its desperation, rewriting the rules. The whole situation in Europe keeps lurching from bad to worse.

The date to watch on this possibility is 29 July. This is when the latest stress test report on European banks is due for publication from the European Banking Authority. If, or most likely when, the Italian banks fail to measure up, the EU may have the trigger it needs to waive its own rules.

This response is also straight from the central banker playbook…when a crisis hits…change the rules to be more accommodating.

As if the problems in Euroland are not enough to worry about, Hayman Capital’s Kyle Bass has shone the light on the Achilles heel of our GFC saviour: China.

In 2005, exports and investment constituted 34% and 42% of China’s GDP respectively. By 2014, exports had fallen to 23% and investment had grown to 46%. This growth in investment was funded by rapid credit expansion in China’s banking system, which grew from US$3 trillion in 2006 to US$34 trillion in 2015.

Bass described this massive expansion in credit as ‘the largest banking system experiment in world history.

It seems like central bankers the world over are experimenting on how much debt the global economy can support before it collapses.

Here’s something to ponder. Much has been made of China’s massive foreign reserves — roughly US$3 trillion — as a buffer to support any hiccup in its economy. What if 10% of the US$34 trillion banking system is written off as unrecoverable debt? There go those reserves… What if the figure reaches 20% (which is closer to the number on the books of Italian banks)?

The instability in the system is building, and we haven’t even mentioned Japan’s inevitable economic train wreck, or US corporate debt defaults, or emerging market debt levels.

The coming ‘greater’ depression is crushing in on all sides.

Not surprisingly, gold has responded positively to all this negativity, rising to around US$1,370 per ounce. The consensus is for the price to go even higher, as bond yields fall further into the negative and Europe lurches from one crisis to another.

My longer term view is for gold to be part of the upcoming once-in-a-lifetime asset sale…with the precious metal being sold off in the rush for US dollars.

However, after a near five-year period in the investment wilderness, gold is enjoying its safe haven status…for now.

Regards,

Vern Gowdie,
Editor, The Daily Reckoning

Vern Gowdie

Vern Gowdie

Vern Gowdie has been involved in financial planning in Australia since 1986. In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners. His previous firm, Gowdie Financial Planning, was recognized in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top 5 financial planning firms in Australia. He is a feature contributing editor to The Daily Reckoning and is Founder and Chairman of the Gowdie Family Wealth advisory service and editor of the Gowdie Letter To follow Vern's financial world view more closely you can you can subscribe to The Daily Reckoning for free here.
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