In yesterday’s Daily Reckoning we made reference to a chart that wasn’t there. Whoops. But it’s important, so we’ll pop it in today and make our point again – that is, the Australian economy isn’t as rosy as recent economic data might suggest. We’re addicted to cheap money…and iron ore.
Yes, let’s talk about iron ore first. It was a public holiday here in Victoria yesterday so we weren’t around to comment on the Chinese data that landed a very strong punch to the guts of Australia’s primary export.
On the surface, a big fall in China’s February trade data was the culprit for the 8.2% plunge in the iron ore spot price yesterday. But January data showed an equally large surge in trade, so February probably wasn’t as bad as the numbers suggest. If you average the two months’ data out though, it looks like China’s economy is weakening noticeably.
People also pointed to China’s first corporate bond default since Mao was a boy (or something like that) as another reason for the poor sentiment towards iron ore and other industrial metals like copper (which has also fallen hard recently). We’re sceptical on that front.
The default of the rather inconsequential Shanghai Chaori Solar Energy Science & Technology Co was classic China stage management. After bailing out a few larger coal company bonds earlier this year, the authorities deemed Shanghai Chaori ‘too small to bail’. In letting it default on a US$14 million interest payment, the central planners in China wanted to let everyone know they understand risk and reward, and that they will tolerate losses…some of the time.
Most analysts and commentators played up to this charade by saying this was a ‘good thing’…that it showed China was willing to let the market work. Indeed it was a good thing, if you have efficient allocation of capital and liquidation of malinvestments in mind. But letting the market work now in China certainly wouldn’t be a ‘good thing’ for most investors around the world.
Why? Because credit growth is now slowing sharply in China. The tide is going out. After January’s credit data looked like the boom would never end, February’s total credit numbers, released late yesterday, were ugly.
Given the start of the year is all over the shop for China’s statistics, its best to average them out and see where things stand. In 2013, total credit growth averaged US$300 billion a month in the Jan/Feb period. This year, the average is just US$285 billion, a year-on-year decline of 5%.
That might not seem like much. But when a historic credit bubble stops growing and starts deflating, even at a slow rate, you’re going to get big problems. That’s why iron ore and steel prices are under so much pressure.
All the inefficient and uneconomic credit growth that supported iron ore consumption and steel production over the past few years is going to evaporate unless China panics and goes for another round of infrastructure stimulus. That’s a possibility, but they probably want to see a bit more pain first. It’s the speculative, shadow banking sector they want to see deflate, and that includes some of the more innovative commodity-based financing.
This is where things get interesting for iron ore. For some time now, China has been trying to rebalance its economy and slow down credit growth. The attempts have been successful, but as always happens at the back-end of a bubble, people try to get around the credit curbs by doing something ‘innovative’.
In the past few months, the latest ‘innovation’ involved iron ore. Traders and steel mills would raise short term cash using iron ore inventories as collateral, speculating with the proceeds. This created an artificial demand for iron ore, because at the same time the steel mills were using less of it.
Inexplicably, investors in Australia’s iron ore miners were oblivious to this. Rio Tinto jumped from $65 to $70 per share during February, while Fortescue surged from $5 to over $6. After yesterday’s wake up call, Rio is trading under $61 while Fortescue is around $4.80.
We recommended our Sound Money. Sound Investments subscribers short sell Fortescue (that is, bet on a share price fall) back in January, on the belief that the iron ore price would fall below US$100/tonne and put profits under pressure. Then the share price rallied, reminding us that markets can do crazy things in the face of seemingly straight forward analysis.
But in the past few days Fortescue’s share price has caught up with reality. In the months to come we think it will only get worse (and cement Fortescue’s reputation as the most volatile large company on the ASX).
One reason to think that is because the Aussie dollar has barely blinked at the latest from the commodity markets. Given that iron ore is such an important income stream for Australia, the lack of concern shown by the dollar is baffling.
Perhaps the currency market just sees this as an attempt to rid the iron ore price of its speculative froth, and it’s not taking the prospect of a genuine China slowdown (and sub US$80 iron ore prices) seriously. After all, China says it will grow by 7.5% this year, so a sharp slowdown couldn’t possibly happen.
Well, anything can happen when a credit bubble bursts, and we’ve yet to see any authorities who can remain in control of the credit deflation process. So 2014’s certainly going to be an interesting year. If equity markets DO fall sharply, investors can’t say they weren’t warned. There are sirens going off all over the place.
It will still take months to unfold, but our guess is that this is just the start of the iron ore price unwind. While most are probably thinking this is just speculators selling, and it will be back to normal soon, we would argue this is just the formative stages of the price correction. A big increase in supply plus falling or stagnant demand always leads to lower prices.
Which brings me to Australia and yesterday’s missing chart. Here it is below. The important line to focus on is the blue one – the real cash rate. The real cash rate is what savers get after allowing for inflation. As you can see it’s trended lower from the early 1990s. In other words, there are increasing disincentives to save. This is why you’ve seen increasing speculation and rapid house price gains over the past few decades. When real interest rates approach zero, speculation takes off.
There are a couple of areas of the chart to focus on. During the early to mid-2000s, real interest rates rose as Australia received its first dividend from the ‘China boom’ (rising commodity prices) which forced interest rates higher to contain inflation.
Then the GFC hit and real interest rates plummeted. Soon after, Australia received the second China dividend, which was essentially the iron ore and coal price boom. Again, interest rates rose to ward off inflationary pressures.
But over the past few years the second China dividend has worn off. Australia’s economy, addicted to cheap money when forced to operate without the benefit of rising commodity prices, began to slow sharply. Worryingly, the slowdown occurred while iron ore prices were still at or around historic highs.
As a result, the addict needed more cheap money to ward off the chills, and the RBA responded. As you can see, over the past few years the RBA helped get the real rate back down to zero.
This kicked off another round of house price speculation, and we are seeing the ‘benefits’ of that flow through the data now. Those who judge each data point in isolation are apt to proclaim that our economy is improving. But we would argue that it’s deteriorating.
Australia needs zero interest rates in a non-emergency environment. As we said yesterday, that’s not a sign of strength. It’s a sign of an economy with major structural deficiencies.
for The Daily Reckoning Australia