Australian Election 2013

Every three years, Australians are forced to vote for members of federal parliament. Most elections are predictable, but the last two have been surprising to say the least. In 2010, no major political party had a majority in the lower house, resulting in a hung parliament. A few independents held the balance of power, the majority of which supported a Labor government. For numerous reasons, the Labor government became unpopular, which is why a few days ago, the Liberal and National coalition were given a decent lower house majority in the 2013 election.

The general consensus among pundits is Labor lost the election due to its infighting, while the Coalition presented a small target and a popular policy campaign. The Coalition’s lower house majority was largely expected, but what was unexpected was the number of primary votes going to the Palmer United Party and the preference deals that resulted in minor parties elected to the Senate. This post will cover why Tony Abbott’s campaign was so effective and how Kevin Rudd employed the same strategy in the 2007 election. It will then analyse the swing to the Palmer United Party and what this means for the future of Australian politics.

I'm Checking In!

When I first heard about the Hotelling model in university, I thought it might explain the vacancy rate of a fancy Westin Hotel. But what it really explains is how two agents maximise their market share. The practical example is two ice cream trucks on a stretch of road parallel to a beach on a summer’s day. Both the beach and the road parallel to it, are exactly 1000m and beach goers are evenly distributed across the beach. Ice Cream Truck X (now known as X) parks itself 250m from the east end of the beach while Ice Cream Truck Y (now known as Y) parks itself 250m from the west end of the beach. There is a 500m gap between the two trucks. Beach goers standing in the middle of the beach (500m from the east and west end) are indifferent to which truck they buy ice cream from because each truck is 250m away. A beach goer at the east most end of the beach, prefers truck X since it is 250m away while truck Y is 750m away. Similarly, for a beach goer at the west most end of the beach will prefer truck Y because it is closer.

X realises that moving to the middle of the beach (500m from either end) results in more customers. Someone standing in the middle of the beach now prefers X to Y since X is right in front of them. Someone standing at the east more end of the beach still prefers X to Y since X is now 500m away but Y is still 750m away. Y also realises that moving towards the middle of beach results in more customers so now Y parks right next to X in the middle of the beach (assume that they are both right in the middle). Now people standing in the middle of the beach are indifferent between the two trucks since they are both right in front of them. A person at the east most part of the beach is indifferent since both trucks are 500m away and the same goes for someone at the west most end of the beach.

A is Ice Cream Truck X and C is Ice Cream Truck Y

What this model demonstrates is that the optimal location of an ice cream truck is right next to each other. IT IS NOT IN THE MIDDLE. The middle is the result because both ice cream trucks rationally play this strategy. For example, if Y was irrational and for some reason stays 250m from the west end. X just parks 251m from the west end and captures 749m of beach while Y is only left with 250m.

Hopefully all of this made sense because this is exactly the same strategy used in a political system that is a two party system. However, in politics it is more commonly referred to as Median Voter Theorem. Essentially, both parties converge towards the median voter’s policy preferences.

To capture the most votes, A and B move towards the median

The Real World

Tony Abbott leads the centre-right coalition which is the standard conservative party that claims to believe in free markets and family values. However, Abbott’s move towards the median voter resulted in a massive welfare scheme (Paid Parental Leave) which is funded by a tax on large businesses. The median voter also cares about cuts to government spending which Labor tried to exploit with their claims the Coalition would “Cut, cut, cut …” where … is public sector jobs, education and health spending, economic growth, small babies, you name it. In the end, the Coalition’s budget was marginally better than Labor’s which neutralised the major cuts to spending scare campaign. Abbott also watered down his commitment to a surplus claiming a return to surplus “within 10 years”. As you can see, the welfare scheme funded by a new tax and the lack of major spending cuts is more to the political centre than to the “political or economic right”.

We saw the same thing in 2007 when Rudd’s policies were similar to Howard’s and because of this he was called “Me Too” Rudd. Ross Gittens, who I disagree with on a lot of things, covered this “Me Too” strategy here. 

The same occurs in the US Republican primaries where potential nominees try to out-Republican each other in the primary campaign. Then the winner becomes the Republican Presidential nominee and has to moderate their policies to appeal to the median voter who is undecided between a Republican or Democrat president. 

Does that mean we are doomed to have two parties that are identical on most issues with a few issues here and there to differentiate them? No, because the further to the centre the two parties go, the further away they are from the ends.  This allows minor parties room to move in and capture some of the electorate. The lack of differentiation between the two parties is the reason Clive Palmer’s Palmer United Party (PUP) received a large primary vote given the party was only registered a few months ago. Even though PUP’s policies were populist (cut taxes and increase spending), a lot of the electorate felt disenchanted with the major parties and voted with their votes!

What the PUP?

The Palmer United Party has stunned the political establishment by commanding 5.5% of the primary vote, which was more than the Nationals 4.4% primary vote. They fielded candidates in all 150 lower house electorates and senators in every state. Running on a highly populist campaign of lower taxes and more spending, PUP was the perfect protest vote for voters apathetic to the major parties. There was also millions poured into the campaign by its alleged billionaire leader, Clive Palmer. Despite PUP’s electoral success, cracks have already emerged within the party after the surprising result. Funnily enough, when candidates are recruited a few months before the election, party loyalty is probably lacking. Enter Jacqui Lambie who has already shown insubordination to the party by contradicting her party’s policy of abolishing the carbon tax. 

Earlier in the vote count it looked like Jacqui Lambi would be elected but that now looks unlikely.

Election Junkie 

The election had me captivated and probably too captivated. The best result to come from this election is that Liberal Democratic Party was elected in NSW to the senate. The LDP is a libertarian party I strongly endorse since I hold libertarian views. That means 6 years of a libertarian senator!

This election has really been about the rise of the minor parties and the backlash against Labor and the Greens. Hopefully this election marks the downfall of the big three parties, with Labor receiving its lowest primary vote in 100 years, the Greens vote down 3.4% since last election, the Liberals only picking up a 1.8% swing and minor parties holding the balance of power in the senate. Who said Australian politics is boring?

Lower house votes

Apocalypse Now

This blog update will focus on the main risks I see on the horizon for the Australian economy.

I warn you that I haven’t really bothered to format and edit it, so I apologise in advance if it’s difficult to read.

I will start off with the simple premise: All booms come to an end. The Japanese boom of 80s and 90s, the 1994 Tequila crisis, 1997 Asian financial crisis, the 2001 tech boom, the 2007 US housing boom and in 2013 the China boom. All of these eras culminated in major increases in asset and commodity prices, usually accompanied by debt, until central banks removed the punchbowl through contractionary monetary policy.

A Bear in a China Shop

Australia is a major beneficiary of the Chinese boom by supplying the energy and minerals needed to fuel China’s economic activity. China’s rapid industrialisation has resulted in many malinvestments, which will be liquidated as capital flows dry up. The excess capacity and debt accumulated during the boom will haunt the economy for years to come. It is generally accepted that the bigger the boom, the bigger the bust.

The Chinese banking system has also been dysfunctional in recent weeks with SHIBOR spiking as banks face liquidity problems. This is a microcosm of the systemic imbalances and instability plaguing China. It’s only a matter of time before a tiny bump in the road crashes the economy.

Falling iron ore, copper and coal prices will be the harbinger heralding the beginning of the end for the Australian mining sector. The government will stimulate as usual but just like in 2009, it was the currency devaluation and the stimulus from China that did most of the heavy lifting.

Big in Japan

Japan is rolling the dice with its audacious monetary policy. The volatility seen in JGBs will have consequences for institutions that are sensitive to high volatility investments. I know this from experience that banks look for positive carry and low volatility assets. JGBs are likely to sell-off given higher future prices from today’s QE. (Funny how a few years ago if you said QE causes inflation, you were ridiculed). Like all government actions, the unintended consequences will be largely unknown. However, it is certain to cause massive market disruption as long-held beliefs are shattered.

If JGB yields rise significantly then the consequence for the Japanese government’s budget is dire. This is what Kyle Bass refers to as the Keynesian Endgame which is when the interest cost of servicing the debt rises in a non-linear way which means simply increasing taxes will be ineffective. Then it will be Japan’s turn to experience its own Greek moment, however there’s no Troika to bailout Japan. Inevitably, the social fabric of Japan will be torn and the historical outcome of mass social unrest is the rise of extreme politics (See Greece and Golden Dawn, see Weimar Germany and the Nazi Party) followed by conflict and war.

Everybody was Kung Fu Fighting

Chinese and Japanese economic risks are not the only factors but also geopolitical risk stemming from conflict over the Senkaku Islands. Both sides are irrationally attached to these islands and are willing to go to war to seize control. If there were a conflict, it would first result in economic sanctions between the warring nations followed by armed conflict unless the UN intervenes to negotiate a cease fire. The impact on financial markets would be huge with the yen likely to rally substantially in risk-off flows bringing an abrupt end to Abenomics. Equities are guaranteed to sell-off. It would be hard to imagine any rallying (maybe domestic producers) but with so much of the global supply chain located in Asia, most multinational companies will face major disruptions.

Up the Creek

In addition to foreign risks, domestic risks are a slow grind lower in property prices as the boom over the last few decades ends, and the factoid of property prices rising forever is rejected.

There are also known unknowns (as Donald Rumsfeld likes to say), which include terrorism, global health pandemic (watch the movie Contagion), natural disasters, wars, government policies (QE, protectionist trade and capital policies). Individually they are unlikely to occur but collectively one of these happens every 3 years (Swine/Bird flu, Fukushima, QE, Boston bombings).

Of course it’s not all doom and gloom. There are a few unlikely upside risks which include: New technological development that makes Australia a world leader, major resource discovery, massive Chinese economic stimulus. This is the Bon Jovi equivalent of living on a prayer. 

The fundamental problem with the Australian economy, along with most advanced economies, is the heavy debt burden which must be alleviated through deleveraging or defaults. Just think about it like this: It’s 2009 and interest rates are at record lows. John decides to buy a $500k house to take advantage of the low interest rates. This means upwards of $400k in new money (expanding the money supply) has entered the economy courtesy of fractional reserve banking when the mortgage is originated. It’s now 2013 and interest rates are coming down. Joe can now repay his loan faster (contracting the money supply) or use the money saved in interest payments for other consumption purposes. The key point is unless new loans are being originated, falling interest rates have a diminishing effect on monetary expansion given it was only 4 years ago that people took out massive loans which they are still repaying.

This causes the economy to deleverage which means businesses go bust, unemployment rises and prices fall. All of these outcomes force the RBA to cut interest rates to ignite another cycle of inflationary monetary expansion and the illusion of economic growth. Keep in mind we haven’t had a technical recession (two consecutive quarters of negative economic growth) in over two decades. We are due for a recession because markets and economies NEVER move up in a straight line. There are dips along the way and the longer we postpone the recession, the deeper it will be.

Breaking Windows Will Boost GDP

Already we have seen the fallacy of stimulus spending. The moment we try to pay back the debt, jobs are destroyed through contractionary fiscal policy (less spending or higher taxes). This means when the next recession comes, the government will go deeper into debt. On average, recessions occur every 7-10 years which means we should expect an Australian recession between 2015-2018 using historical data. However, given the inability of the RBA to raise rates substantially before the economy begins to deleverage (as seen post 2009), the business cycle is contracting in duration. So much so that I am sure a recession will come before 2016. Obviously the government will try to stimulate and rates will be cut closer and closer to zero.

As a personal anecdote, I know financially unsophisticated boomers who bought their homes a few decades ago that are now cashing out their investment properties and living off term-deposits. This is exactly why interest rates continue to fall. The economy is trying to delevereage which means property prices and other assets will decline while the RBA tries to push prices back up to avert pessimism overcoming the property market.

There is a theory that claims the closer rates go to zero, the more risk averse investors become and the more they invest in government bonds and other relatively low risk investments. This theory is only true for advanced economies with an ageing population such as Australia.

Forecast: Cloudy With a Chance of Thunder Storms

My predictions: base case rates go lower in Australia to 2% and in combination with the lower AUD (70c-80c) causes the economy to re-leverage. Worst case scenario is an implosion in Asia due to any of the factors mentioned above, will cause rates to go to zero in Australia and the AUD to go sub 50c as commodity prices collapse and the high unemployment prevents credit growth from occurring.  It’s difficult to see any bullish scenario simply because “we’ve been there and done that” for a few years now.

The obvious plays for a long-term investor in a falling interest rate environment are defensive stocks and high dividend yield stocks. But a safer option would be corporate bonds that would still offer a decent yield while central bank rates approach zero. If you want to trade it then the obvious trade is shorting AUD against a reserve currency like the USD or EUR. Or a safer currency trade would be short AUD against another commodity currency less affected by China such as the NOK (Norway). Other trades include shorting high cost iron ore miners which will see their businesses go under overnight as commodity prices plunge.

Anyway I hate predicting anything financial or economic more than one year out because there are so many variables that could throw a spanner in the works. It will be amusing to see how it plays out compared to the aforementioned predictions.

Summary of Predictions

• Australian recession before 2016
• Interest rates to go to 2% and AUD/USD 0.80-0.70 base case with rates going to zero and AUD/USD below 0.50 worst case (financial/political crisis in Asia or global macro risk mentioned above)
• Corporate bonds to outperform, short AUD and iron ore miners trades to also outperform

“I don’t get paid to be an optimist or a pessimist. I get paid to be a realist.”