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.”

The Keynesian Endgame

I absolutely despise the Keynesian school of economic thought. The Keynesians worship three gods: demand, jobs and inflation. All of which have given us the world that we live in today. A world mired in debt due to government policies designed to stimulate demand and “create” jobs. The parabolic rise in debt across the economy since the 1970s cannot go on forever. It should be obvious to anyone that anything rising at an exponential rate will eventually hit a constraint that will reverse the trend.

The constraint to hit parabolic debt is deflation. Deflation is a contraction in the money supply. Most people will say deflation is falling prices but changes in the price level are a consequence of the supply of money relative to the goods and services produced in an economy.

During the boom times, economic activity is rising and money is being borrowed. Fractional reserve banking creates a vicious cycle of rising asset prices, followed by rising levels of equity relative to debt, further leading to more money borrowed which is then used to bid asset prices higher. Eventually, this cycle is reversed as central banks increase interest rates to a point where asset prices stop rising and debts are repaid or defaulted upon. What follows is a cycle of falling asset prices and as debt is repaid, a contraction of the money supply (deflation). Central banks (CB) see this as a major problem which is solved by slashing interest rates to get people borrowing and see rising asset prices. Before you say this is crazy talk, Bernanke has explicitly said the Federal Reserve has propped up not only the housing market but the stock market in what he calls “the wealth effect”. Every major central bank has this secret third mandate of propping up both housing and the stock market (the first two are inflation and employment). It was only a few years ago that no central banker would admit to having this secret third mandate.

This model of monetary policy has worked “fine” until the demand for new borrowing evaporates and despite interest rates being cut, the economy does not return to the debt fuelled inflation boom. This is my theory of the economic cycle, which closely resembles Austrian Business Cycle Theory and it may even be the same. Eventually debt becomes too high and no matter what the CB does the deleveraging process continues.

Either the government slowly tries to reflate the economy (Japan last 20 years) or they go nuclear with continuous debt monetisation (US Federal Reserve) or threats to go all in (Bank of Japan in recent months) with seemingly outlandish policy options such as negative interest rates, nominal GDP targeting and monetising private sector assets (corporate bonds, equities etc.).

With central banks increasing underestimating the risk of rampant inflation as a consequence of their unconventional monetary policy (debt and asset monetisation), the inevitable conclusion is hyperinflation. CBs have made it clear they will not tolerate deflation. Nothing is stopping them from expanding the money supply by trillions as long as they fear the threat of deflation. This is exactly why asset prices will skyrocket and the only thing likely to destroy confidence and asset prices are an exogenous shock (natural disasters, political risks, terrorist attacks, wars, social unrest etc.).

The consequence is rising interest rates as investors realise the CBs have poured gasoline on the fire through their reckless monetary inflation. Bond markets will collapse and anyone holding long duration debt will be burned (insurance companies, banks and pension/superannuation funds). Government borrowing costs will rocket higher as rising interest rates will mean any debt that is rolled over will rollover at higher interest rates. This is very similar to the sub-prime mortgages crisis when low teaser interest rates made the mortgage affordable until the interest rate reset to a much higher rate a few years later. This will result in the government slashing government expenditure in an attempt to service the debt and appease the bond vigilantes. The current European debt crisis is a glimpse of what we can expect when governments have to make tough decisions that are very politically unpopular.

The penultimate result of the chaos will be a deep recession as unemployment rises, causing social unrest (riots and protests) as governments struggle to deal with the problem (see Greece and Spain).

Central banks will be forced to increase interest rates but I guarantee they will be too slow to act or worse remain in denial and downplay the inflation risk as “transitory”. The UK has already experienced the effects of monetisation on consumer prices.

What’s worse is there are now calls in the UK to drop inflation targeting in favour of nominal GDP targeting. This essentially means if the nominal GDP target is 4%, inflation can be 3% which means real GDP is only 1%. Another combination is a target of 3%, real GDP of -2% and inflation of 5%. There are numerous permutations but it just shows how ridiculous nominal GDP targeting is.

What is the solution? Over the years I’ve realised it’s usually the politically unpopular decision that is the correct decision. The only way we can address the debt issues not only on the public balance sheet but also the private balance sheet is to embrace sound money and back currency with gold or at the very least some other commodity. This stops the limitless expansions of the money supply and links it to a steady growth rate. There will be pain initially as people realise of the features of a gold backed currency is an end to the continual debasement and the end of rising prices economy wide.  

This solution is unlikely to happen because firstly, the mainstream pundits support the current monetary system and secondly, moving to a gold backed currency will be politically unpopular as vested interests scream and shout in protest (banks will probably the most vocal opponents given their mortgages denominated in the old currency and because the new system limits their ability to lend).

It will usually take a crisis to change people’s perceptions but even then, there’s no guarantee that perceptions will change for the better. I will strongly support the minority that adopts the new system first because it will take the minority view becoming the majority view before we see real change for the better.