The ‘Wave of Money’ Flooding Australia

The ‘Wave of Money’ Flooding Australia

The S&P/ASX200 took its biggest fall since 30 June yesterday.

That puts the market at a three week low.

Investors in Wattle Health Australia couldn’t give a rats about any of that though.

And why would they? The stock was up 30% at one point yesterday. The company released some exciting news for the future.

Wattle Health is only worth around $70 million. It’s a baby. Small caps like this can make big moves, and fast. I said the same thing on Monday. Now you’re seeing it in action.

Take it from me, there’s always moves like this happening. That’s even if the headline numbers don’t get your pulse racing. Don’t take your lead from what the index does.

There’s also a good chance this kind of thing could really heat up soon too.

Stay with me here. It’s important.

When money booms and the economy doesn’t

In The Australian yesterday there was a story about economists warning Australia’s money supply is racing ahead of GDP.

They’re getting worried that inflation is going to break out. This money has to show up somewhere. It could cause the RBA to lift interest rates.

This line of thought resurrects what’s called the Quantity Theory of Money. This goes back to Irving Fisher in 1911.

Basically, the idea here is, as the money stock goes up or down, so goes the economy.

That’s what should happen…except the link doesn’t always hold.

That’s a problem if you’re running a government budget…or getting your portfolio set for the way the markets are going.

Either the theory is useless or something inexplicable is going on.

We’ve been here before. In the 1980s, central banks tried to control the money supply and found that they couldn’t do it.

Economists had two problems. They didn’t have a rock solid definition of money in the first place.

Was it cash? Was it cash and bank deposits? Was it these two plus a few other metrics thrown in?

The second problem is that the money supply stopped trending in the same way as GDP. This became known as the ‘velocity decline’.

Mainstream economists never solved this problem. Instead they gave up and switched to obsessing about interest rates and ‘inflation targeting’.

That’s a shame. It kept the world on its ongoing rollercoaster of boom and bust.

The link between the money supply and the economy is valid.

But there’s a flaw in the Quantity Theory of Money. It assumes that all transactions are part of GDP.

But financial transactions don’t show up here.

That’s why we can have a booming property market while economists sit around wondering why the economy isn’t doing much.

It’s also why rising interest rates are a feature of big busts throughout history.

They stress overleveraged borrowers who eventually can’t hold on, and then asset values start to collapse.

The inflation is on NOW

Now, I haven’t read the actual research paper. It’s not available as of now. So I’m doing a bit of guesswork here off the news report to tease things out.

The money supply increased 7.5% over the year to May. Now we know Australia’s GDP growth rate is nowhere near that.

So where did the money go?

The property market.

We know bank credit growth is strongest for the property sector. Instead of CPI inflation, we’ve got asset inflation.

That’s why I don’t share the view that inflation will break out from this. It’s already here in Sydney and Melbourne land values.

This is why people who rattle on about property being divorced from fundamental cash flow analysis miss the point.

The more banks lend to the real estate sector, the higher the prices will go. This can run for a long time. Far longer than most people think.

The same is true of the share market if margin loans increase.

The banks inject new purchasing power into the market when this happens. Stocks rise on buying power. In fact, this is exactly what happened in the 1920’s in the USA, and it sent Irving Fisher bankrupt.

He thought shares had reached a ‘permanently’ high plateau. Actually, the whole thing was a giant credit bubble built on margin loans.

But Aussie shares aren’t hot like the east coast property market. Investors look too wary to borrow big and buy up shares.

The RBA’s statistics on this show margin lending is down over 40% since the peak in 2007.

There’s a couple of caveats to this, of course…

CFD’s may have replaced margin loans for the most aggressive traders. I don’t think that shows up in these figures. And you can borrow against your house to invest in the share market.

But in general I’d say there’s too much fear for the average punter to go heavy into the share market with leverage. That’s one reason why I don’t think there’s any great collapse coming.

In fact, I think it will go the other way.

Eventually punters are going to move into the share market and they’ll borrow to do it.

The market will be hot then – and more dangerous by the day.

Right now is the time to buy up what you can before we get to this type of market.

Best wishes,

Callum Newman
Editor, The Daily Reckoning Australia