The turn in the market I discussed yesterday looks like it’s started right on cue. US stock markets fell between 1–1.5% overnight. Gold had a good session, jumping around 1.5%.
Momentum in stocks, for now at least, looks to have stalled. It’s time for a correction.
The trick in this market is not to be either too bullish or bearish. Financial markets seem to be in a phase of experiencing broad multi-month swings in either direction. As soon as sentiment levels get too lopsided, things swing back the other way.
But, as I pointed out yesterday, the overall trend is down. That’s especially the case for Aussie stocks, which are set to lose another 40 points or so today. It certainly looks like the ASX 200 will head back to test the lows reached in February.
After rallying for most of March, the Aussie dollar might have run out of puff too. It fell around 1.3% overnight. Could it be all that debt weighing on the currency?
This week I’ve talked about Australia’s private sector debt levels quite a bit. Given the absolute size of the debt (around $2.5 trillion), it’s a crucial issue for the Australian economy.
You wouldn’t really know it though, would you? Australia’s private sector debt levels don’t often get a mention in the mainstream media. The media focuses on concerns and hand-wringing related to rising levels of government debt; or they share the grave concerns that everyone seems to have about ‘balancing the budget’.
While fiscal discipline is important, it’s more so because of the private sector credit binge of the past few years. I’ll explain more about that in a moment.
For now, keep in mind that private sector debt dwarfs government debt. Funnily enough, I found the following chart in an article on news.com.au, owned by News Corp. But a News Corp journalist didn’t write the article; economics blogger Jason Murphy wrote it.
Here’s the chart, originally sourced from Bank for International Settlements:
Source: Bank of International Settlements
[click to open in new window]
As you can see, total private sector debt is huge compared to total government debt. Thanks to the borrowing binge of the past few years, Australia has leveraged itself to record highs.
By the way, this chart is a little different to the one you saw yesterday. I’m not sure what the source data is, but it appears to measure debt against real GDP, which is adjusted for inflation. Yesterday’s chart used nominal GDP. That’s why the ratio is higher in the chart above.
Either way, it is clear that, in the aftermath of the ‘crisis’ of 2008 (which wasn’t much of a crisis for Australia), the private sector has ‘re-leveraged’ rather than paid down debts, as has occurred in the US, for example.
A nasty by-product of this rise in debt is an increase in our trade deficit. The deficit for February came in much worse than expected, at $3.4 billion when seasonally adjusted. Again, this wasn’t really news in the mainstream media.
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Over the past three months, the trade deficit came in at around $10.6 billion. And this is occurring at a time when exports should be benefiting from the multi-billion dollar mining investment boom that occurred over the past few years.
But it’s not happening. Instead, we’re still borrowing to fund our lifestyle. A trade deficit is another way of saying we consume more than we produce. The mining boom was meant to translate into a production boom. That’s not happening.
So we keep on borrowing. Despite record low interest rates, Australia forks out around $40 billion a year in net interest payments.
No wonder we’re selling off our prime property to foreigners hand over fist. It’s just a law of economics. Deficits need financing, and we don’t really have a choice about how those deficits are financed.
We don’t seem to care if its funny money or not. As long as its money!
But what’s the cart and horse here? Do consumption preferences (which drive the deficit) produce the need for foreign capital? Or is foreign capital the driving force, pushing up the Australian dollar and encouraging consumers to go into deficit?
I’m guessing it’s both. There is no horse or cart. It’s too complex for that.
But the big risk here is that foreign capital will look at Australia’s debt ratios and start to see the Aussie dollar in a different light. Right now, it’s a place to hide out to escape the currency wars. But that could change quickly. If it does, Australia’s economic fortunes will change abruptly.
This is where Australian government debt comes into it. While debt levels are currently low, they are also misleading. That’s because the government implicitly backs the banks. If the banks get into trouble, the government will bail them out.
In this scenario, government debt would balloon to dangerous levels in the blink of an eye.
Because of this implicit backing by the government, the banks enjoy a strong credit rating…stronger than it should be, given the highly leveraged state of the banking sector. Consider this article from the Sydney Morning Herald back in February:
‘Global ratings agency Standard & Poor’s has warned it could cut major bank credit ratings if the federal government indicates it is any less willing to provide financial support to banks in a crisis.
‘Lower bank credit ratings could put upward pressure on bank funding costs and interest rates paid by borrowers.
‘Ratings agencies factor high levels of federal government support for banks in any crisis into their credit ratings. But moves are afoot globally to put bank bondholders on the hook in financial crises, rather than taxpayers, part of regulatory efforts since the global financial crisis to prevent banks becoming “too big to fail”.’
Australia’s banks are definitely too big to fail. They operate with the implicit backing of the government’s AAA credit rating. Our foreign creditors know this. It’s why they are happy to buy Aussie bank debt…for now.
But it wouldn’t take much for sentiment towards Australia’s credit rating to change. For a highly leveraged economy, a fall in the credit rating would be serious indeed.
On top of this, there is a huge fallacy in the Aussie housing market. The team at Cycles, Trends and Forecasts revealed this fallacy in their latest issue.
That is, a lot of foreign capital flows directly into the property market…specifically the apartment market. But the CTF report points out that the apartment market is much more fragile than the mainstream statistics would have you believe.
I won’t reveal the contents of the report here. It wouldn’t be fair for paid-up subscribers. But if you’re an investor in the capital city apartment market, it’s a must read. If you’re interested, keep an eye out for a special CTF offer this weekend.
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