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When the Euro Disintegrates

Last week’s right hook to markets with the Rudd Resource Rent Tax (RRRT) was followed up yesterday with a stiff left lawsuit jab to the jaw of Australian banks. “Shares in major banks including Commonwealth Bank and ANZ fell by about 1 per cent after BusinessDay reported they faced one of Australia’s biggest class actions for overcharging on penalty and late fees,” reports Eric Johnston in the Age.

Thus, in a matter of ten days, seven of the ASX/200′s ten largest companies by weighting has had a huge cloud of uncertainty descend on their future earnings prospects. For the materials company (BHP Billiton), it’s the RRRT. For the banks, the $400 million claim against them amounts to 1% of profits, according to Goldman Sachs analyst Ben Koo.

Top Ten ASX/200 Stocks Weighed Down

But as important as those two stories are to local stock values – and they ARE important – the biggest story going in the financial world is the possibility that Europe’s common currency could literally disintegerate. Noted economist Nouriel Roubini said Europe’s laggard economies need a weaker currency to spur growth and may have to abandon the project.

“I would not even rule out in the next few years one or more of these laggards of the euro zone might be forced to exit the monetary union,” Roubini told Bloomberg. Jim Rogers got on the television in Singapore and said the ECB’s decision to put together a $1 trillion bail out is a “nail in the coffin for the euro.”

Rogers said, “This means that they’ve given up on the euro, they don’t particularly care if they have a sound currency, you have all these countries spending money they don’t have and it’s now going to continue.” Meanwhile the gold price nearly made U.S. $1,250 in the spot market and A$1,400 here in Australia.

The move by the ECB to essentially devalue the euro came after the huge disruption to Aussie share prices from the RRRT. You essentially had to two separate unpredictable events, one of which was bearish for precious metals stocks, the other of which was extremely bullish. How to deal with both forces?

Our view, and the view of Diggers and Drillers editor Alex Cowie, is that the ECB action is a monetary game changer. It makes inflation the single largest threat for the rest of the year. And it means the desire to hedge portfolios against depreciating paper currencies will be the single biggest driver of precious metals prices for the rest of this year.

You don’t get official confirmation of the intention to devalue a major reserve currency every day. So after careful consultation with Alex, we took the unusual step of re-recommending several of his previous precious metals stocks in an intra-day alert to Diggers and Drillers readers.

By the way, this is normally something we’d avoid doing because we know not everyone gets their emails at work and can act on them in a timely matter. But we – and here I lapse into first person and say I – made the judgement that our first obligation was to tell paying readers that we concluded something very important had changed in the precious metals market and that it required action. We’ll keep you posted on how things develop.

Meanwhile…here are two important questions that came in from readers recently;

Many people anticipating the inflation in fiat currencies around the world believe precious metals are an excellent hedge against this inflation. Many of those same people believe that gold mining equities are an investment class leveraged to provide greater return than holding the PMs themselves. What impact does the KRudd Tax have on this anticipated leveraged position in equities? Is this the Swan song for gold mining equities?

What happens when two uncertainties collide? It makes valuation very difficult, for one thing. And it makes it unclear what is exactly the best way to profit from an underlying trend, especially when you’re not sure which trend is dominant. The underperformance of Australian gold equities relative to the gold price is perplexing. But Alex has taken a specific approach which he believes will reward Aussie investors. It involves having production assets outside the country.

Next question, and it’s a long one. In fact, we won’t answer it. It’s another viewpoint on China. In today’s essay section, we publish an essay from Greg Canavan from his Sound Money. Sound Investment report of several weeks ago.

–Hi,

I thought you might find this interesting – Dan Denning might anyway. Having been worried about the current state of affairs I’ve taken my $$ off the table in Aust stocks, particularly resources. I asked a professional friend who’s been based in Shanghai for the last 10 yrs his thoughts on the bubble:

Response below:

Hi Mate,

Here’s my take on the China market.

1. The population is still growing. It will probably peak at around 1.5 billion in the next twenty years. Up from 1.35 billion now, so that’s an extra 150 million people who will need a house and a job.

2. The economy continues to grow at around 10% a year, and a lot of that is infrastructure led – like all the new interstate highways, inter-city ‘very fast’ rail links, subway systems and airports. All in all, that’s a lot of steel rebar …

3. Cities here are growing, too with massive building and re-building programs that will need to house and provide work space for the people who are migrating from the country to the towns … around 200 million in the past 10-15 years, and forecasts of another 150-200 million to follow in the next 15-20 years. That’s bigger than the population of the US. That’s a lot of rebar, too …

4. On top of that, all these people are earning enough money to buy stuff: home appliances to start with, but they’re dreaming of a car as well. Car sales have gone from under 100,000 in the late 90′s to around 14 million this year (bigger than the US). And car ownership is still under 5% of households. That’s a lot of rolled steel on top of all the rebar …

All in all, the China boom has at least another twenty years to run before it starts to run out of steam and slows down to be a rather poorer version of Japan (static and ageing). If I were you, I’d stop worrying about a ‘credit bubble’ and look at the underlying dynamics and demographics. Then I’d think about buying back in to BHP, Rio Tinto, and Woodside, pronto

Heard the Australian Ambassador at lunch last week talking about the 40% Tax. He seemed to think it was fair enough, given that you can only dig the stuff up once. The country needs to get better value for its resources. Like Norway did with their North Sea Oil.

He was also talking about China and Oz getting together in joint ventures to do some of the processing in Australia before it gets sent to China. Makes sense, really: why ship iron ore and coal separately when you can ship pig iron to China. Good for the environment too, when you’re only shifting half the quantity of ‘dirt’.

Dan Denning
Dan Denning is the Editor-in-Chief of The Daily Reckoning Australia and the author of 2005’s best-selling The Bull Hunter (John Wiley & Sons). He began his financial publishing career in 1997 as a small-cap analyst. From 2000 to 2005 he was the managing editor of Strategic Investment, where he recommended gold and warned of the US housing bubble. Dan has covered financial markets from Baltimore, Paris, London and, beginning in 2005, Melbourne Australia, where he is the Publisher of Port Phillip Publishing. To follow Dan'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.

9 Comments

  1. Ross says:

    I agree with Hi mate in part except that he hasn’t got a measure of the export boom that ran the Chinese economy, the heights that it scaled or the retraction. I saw it in containers and port figures and it was awesome. Reminded me of some early Hollywood block buster starring Charlton Heston. He hasn’t also got a measure of state planning that overbuilt a lot of core infrastructure that means capacity growth can be marginal against spend in comparison to the past. And I don’t think that infrastructure spending can be maintained to replace that export led economy. I don’t think savings or spending habits can be unlocked anywhere in the world easily against habits of a lifetime despite any change that they make by providing a safety net to generate a felling of personal security. And there are still a lot of communists, in rural areas especially that never did work too hard, you give them a safety net and they may just take it.

  2. GB says:

    I disagree with Hi Mate,
    He make a simple observation that 200 mill people moved to the cities in the last 15 years and projects that into the future. Those people moved to cities to work in factories that are now closed. Not only that but the US is talking about exporting more which will decrease chinese manufacturing further and chinese products are becoming more expensive due to inflation (and possible a stronger currency)

    That suggests a marked slowdown in employment growth unless the chinese (who are culturally a saving nation) become US style consumers which will take 15 years anyway so it still wont work.

    China survived on US consumption just like Australia survived on Chinese demand for resources. Without the US there is no booming chinese growth and without china there is no booming australian growth

  3. Don says:

    I can think of one kind of joint venture that becomes more favourable. The one where they pick up a mine, give it the crappiest concentrate payment terms they can find and thus transfer the profit to China where the same company smelts the concentrate and sells the metals. So the mine’s profitability is seriously reduced but the cashflow from the smetler is quite handsome.

  4. Ross says:

    Don, they open themselves up to transfer pricing when they go hard over to ad valorem on resource taxes. There has to be a balance so going the big 40% was another stupid move at the top of the cycle. It has no prospect of sticking beyond the election in any but the most IQ challenged of the labor politicians heads and of coarse Henry who has never had any grey matter. And ad valorem vs per tonne taxes are all upended at the other end of the resource cycle (less so with Henry’s amazing grab but who knows what inputs will cost in the next cycle). Vertical integration is an issue industry as well as govt has to deal with. Industry looks at the market price of its equity short term propped up by user buyers and doesn’t prioritise structural issues sufficiently.

  5. Don says:

    Ross further to the discussion I put up the example of Indian companies buying Australian copper mines. One of the big reasons is the 35% tarrif on copper metal and scrap into the India. This 35% is not levied on copper concentrate however and so it offers a big incentive for them to buy up copper mines that may not be so attractive to other miners. Thus you get companies such as Adityabirla buying and operating the Nifty and Mt Gordon mines (the latter is shut down at the moment with good reason…..) and other examples around the place.

  6. Ross says:

    Don, that is practical trade intel that the old Dept of Trade as a stand alone could get its head around but that gets lost in today’s pussy speak. I have a feeling the same thing led to India buying up the whole Kembla Coal and Coke plant and exporting it (I mean the differential in Indian import tariff). The same reason the ETS was to be a disaster (although the VIC power subsidy on aluminium is plain stupid on the other side).

  7. Bertie says:

    China or not Rudd is making a mess of Australia and that is that.

  8. brc says:

    Norway doesn’t tax the bejesus out of the oil industry. Statoil co-invests with other companies to develop oil/gas fields. It’s been floated now but is still majority government owned.

    There’s a big difference to being involved in the industry as an equal partner to share the losses and profits than just sitting at the sideline nicking the profits after the hard work is done.

    The governments share of Statoil profits are then invested in the Sovereign wealth fund which the politicians can’t get their sticky fingers on easily.

    That’s a world away from a mining tax on declared australian profits, which is just a case of industry raiding.

    If the government was serious about participating in the mining industry for the betterment of all Australians, it would purchase large shares of BHP/Rio/Fortescue, or setup it’s own government owned but independently operated mining companies and put in the capital to generate the results.

  9. Ross says:

    I agree with you BRC. My 1960′s title “Oil companies and governments” had it styled the same way. Sovereign equity, but not state control, as the way forward.

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