Whoever Wins the Australian Election Will Inherit a Ticking Time Bomb

A man's hand putting an envelope in the slot of a box
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Bre-what now?

Stocks, and just about everything else, rallied strongly overnight as markets ignored the biggest event in Europe since the fall of the Berlin Wall, deciding that stimulus will heal all wounds.

It’s like Brexit never really happened

The UK’s FTSE 100 surged 3.6% overnight to close higher than it was just prior to the referendum. But keep in mind that this doesn’t accurately reflect the make-up of the UK economy.

Credit Suisse reckons around 75% of the earnings of companies in the FTSE 100 come from offshore. So Brexit isn’t going to have as big an effect on them. Throw in a large pound devaluation, which increases the value of those offshore earnings, and you get an index in pretty good shape.

The broader FTSE 250 index is a better reflection of the UK economy, as it contains a greater exposure to domestic stocks. As you would expect, even after last night’s rally of 3.2%, it’s not looking so great.

You can see this in the chart below. The index collapsed to new lows following the vote to leave the European Union. Over the past few days, it’s bounced back. It’s now just under the bottom from mid-June, when the market panicked in the lead up to the vote.


Source: BigCharts
[Click to enlarge]

This is an ugly looking chart. My guess is that further weakness is only a matter of time. But here’s a tip: If you want to get an insight into what is really going on in the UK economy, keep your eye on the FTSE 250, not the widely followed FTSE 100.

Whatever the index though, overnight it didn’t matter. In the US, stocks jumped around 1.7%. The Euro Stoxx 50 index was up 2.6%, but the German DAX noticeably underperformed other European markets, rising just 1.75%.

While there were no particular announcements from the global central banking fraternity, I can only assume the expectation of something…anything…and soon…was enough to get markets going.

That’s reflected in the performance of the US dollar — which fell — and the rise in gold, oil and commodities in general.

If there was a genuine expectation that Brexit was no big deal, or that it was off the table, you’d see gold tanking and bond yields soaring.

But it’s not happening. Gold is holding on to its strong gains, despite being ‘overbought’ in the short term. That’s because this whole Brexit thing has turned the Fed’s planned interest rates hikes around to expected cuts. As Bloomberg reports:

Circle Jan. 31, 2018, on the calendar. That’s the soonest the Federal Reserve hikes next. At least if money market derivatives are to be believed. Traders, who have consistently been better at projecting the path of interest rates than the Fed itself, are now pricing in a greater probability that policy makers will cut rates in upcoming meetings than raise them. They don’t assign more than a 50 percent chance of an increase until the beginning of 2018, and don’t price in a full rate hike until the final quarter of the year.

The Fed’s away; who wants to party?

The funny thing is that the market will have less chance of getting some direct stimulus if it prices it in. Over the past few years, the dance between the market and the Fed has gone something like this:

The market sells off, and the Fed adds stimulus or promises to ‘act’ if they need to. The market rallies, and the Fed says it will tighten in the future.

Now the UK is busting in on the dance, treading on feet and complicating matters.

Whatever the case, I see this bounce as being short term. There is way too much uncertainty over how Brexit will play out in the months and years ahead to send stock markets blissfully higher.

A pleasant side effect from Brexit has been a lack of focus on Australia’s election. Which is kind of nice. I’m sick of hearing politicians hocking their wares every time I tune into the radio.

I confess that I’m a cynic when it comes to politics. But it’s hard not be on the evidence. From Rudd, to Gillard, to Abbott and Turnbull, it’s all been the same. Each one tinkers around the edges according to their ideologies but, in the meantime, the underlying structure of the economy continues to deteriorate.

Despite all the rhetoric, there is no long term plan for Australia’s economy. The only plan is for more debt to drive house prices higher and increase demand, which in turn encourages people to take on more debt.

It’s a model that works in the short term because it makes a lot of people believe they are getting wealthy. But in the long term it will fail. And when it does, it will do so spectacularly.

So whoever wins the election on Saturday inherits an economic time bomb. That they don’t know it doesn’t make it less so. And in a post-Brexit world, Australia, with net foreign debt of $1 trillion, is a much riskier proposition.

Why do you think gold in Aussie dollars broke out to new all-time highs this week? It’s not because things are good!

Turnbull is in front in the late polls, so he looks like getting the poisoned chalice. But after what happened with Brexit, who wants to trusts the polls?

Cheers,

Greg Canavan,
For 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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