What Lies Underneath Australian Banks is Not a Pretty Sight

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I know that seeing trillions wiped off global stock markets is not in any way funny. But I had to laugh when I saw this Bloomberg story and headline on the front page of the afr.com last night: ‘China must act as ‘circuit-breaker’ to end stock market rout’

The article went on to say that because interest rates in China were higher than in the US or Europe, and because China had ample bank reserves, it was the only central bank with the firepower to halt the global stock market slide.

Then came this comment, which makes me glad I’m not an economist.

“The PBOC is the last major central bank that still has some ammunition left that could help to stimulate global growth,” said Rajiv Biswas, Asia-Pacific chief economist at IHS Global Insight in Singapore. “The Chinese government also has some fiscal headroom for more fiscal policy stimulus measures.”

Umm, haven’t they already done enough? I mean, over the past few years China unleashed the biggest stimulus in global history. And look where it got them!

Most recently, they tried to engineer a stock boom to enhance household wealth. It was a disaster. The market crashed and they had to come in as the buyer of last resort. The Financial Times reports today that they have now given up trying to support prices:

After spending about $200bn buying shares to prop up falling equity prices over the past seven weeks, Beijing capitulated to market forces on Monday by choosing not to intervene as the benchmark Shanghai Composite Index fell 8.5 per cent.

The comment from the ‘Chief Economist’ above points to the psychological shift going on in markets right now, a shift reflected in the obliteration of bullish stock market trends around the world.

A major factor underpinning this hitherto bull market was an unfailing belief in central banks to engineer a desired outcome. That belief is now coming under extreme question.

And as far as anyone can tell, ironically, the catalyst for this loss of faith was an act by a central bank. That is, the decision by the People’s Bank of China to devalue its currency against the US dollar a few weeks ago.

That caused traders to panic over the ongoing use of the ‘carry trade’ as a money making strategy. It has created trillions in global liquidity over the years and been a driving force behind the emerging market and commodities bull markets.

This is how it works…

Traders borrow cheaply in US dollars thanks to the Fed’s zero interest rate policy. They then sell these dollars and invest in a range of non-dollar assets. A favourite trade was to buy the yuan, which provided a much higher interest rate than the short term cost of US dollar borrowing.

The difference was all profit for the trader. And it was a guaranteed profit while ever China maintained the yuan’s peg to the dollar.

But that all changed a few weeks ago. While the actual devaluation wasn’t extreme, it was enough to change the psychology of markets.

But this isn’t a recent development. This sentiment change has been a while in the making.

The US dollar carry trade, which creates so much global liquidity, has been under pressure for around a year now, especially in the commodities space. The yuan devaluation was just the tipping point. It sparked a change from steady selling to outright panic. And as you’ve seen, the panic spread to the broader markets last week.

Commodities are still at the epicentre of this panic sell-off. BHP Billiton [ASX:BHP] crashed nearly 10% in London trade overnight. The Crisis & Opportunity portfolio has a short position in BHP and has had for nearly a year, which means it benefits from a falling stock price.

Rio Tinto [ASX:RIO] also crashed overnight. Technically, there is no support for the shares until around the $30 mark, which was the GFC panic low. If iron ore prices break down to new lows, as I expect they will in the months ahead, then RIO will get there, no problems.

Global markets now firmly see the Aussie dollar as a China proxy. That’s why it plunged to new lows overnight too. It finished the US trading session at 71.56 US cents, down a whopping 2.22%.

That’s good news for gold in Aussie dollars. Thanks to a plunging Aussie, gold priced in Aussie dollars surged to over $1,600 an ounce last night. With the currency under attack, gold is doing its job in preserving wealth.

But gold is now ‘overbought’ and so should correct lower in the coming weeks. That could coincide with a little respite from the selling on the stock market.

You’re seeing a little bit of that respite today. Market futures pointed to a 200 point loss, but in the first hour of trade it’s not too bad.

For the past few weeks I’ve highlighted the 5,100 to 5,000 point level on the ASX 200 as being very important. It’s right at the lower edge of this range now.

A sustained break below here would be an ominous sign and a harbinger of a nasty bear market developing. Foreign capital is beginning to wake up to the risks of investing in Australia. My guess is that the market plunge has much to do with panicked foreign capital getting out at any price. Aussie investors are just standing around with jaws agape.

The market is telling you the crisis is now at the heart of the Aussie economy…the banks. Check out ‘old mate’ the Commonwealth Bank [ASX:CBA], below.

Click to enlarge

Source: BigCharts

The stock is slicing through support levels like a hot knife through butter. So much for the dividend…

Here’s the deal. Banks are highly leveraged and highly risky. Aussie banks rely on foreign capital to fund their loan books. If foreign capital flees, as it’s doing now, funding costs rise, which saps demand for loans. This in turn puts the whole Aussie property Ponzi scheme at risk.

This is why you’re seeing CBA’s share price crash. On the surface profits and dividends look good. But it’s what lies underneath that is the concern. And for the CBA and Australia, what lies underneath is not a pretty sight.

Regards,

Greg Canavan

Editor, The Daily Reckoning

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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