Saturday, October 11, 2008

A comment on Aussie equity markets

Equity markets around the world have fallen dramatically over the past week as fear of the next financial disaster or just fear of the pure unknown has taken hold.  I have no idea what will happen or how long the current crisis will prevail - indeed I am unconvinced anyone does - but I have a few tentative ideas about the current situation at least with respect to equity markets.

The collapse of the Australian dollar and the collapse of Australian export-oriented resource stocks do not make a lot of sense taken together.  The Australian economy seems in much better shape than most other developed economies and, at the present time, our financial system seems sound.  It is difficult to believe that the main sources of demand for our coal, iron ore and food exports will dry up and there has been some relief from the drought.

Consider a stock like BHP-Billion which at $27-74 is now priced at 9.7 times earnings.  Its share price high for the year was just on $50.  It is true that its export prospects have dimmed somewhat with the likely future global recession but the destination of most of its exports remains in the high growth parts of Asia where recession is unlikely.  The price in US dollars of these exports would need to decline by a little less than 1/3 to match the improvement in returns in Aussie dollars that will result from the vastly devalued Australian dollar which has fallen from 98 to about 65 cents US.  And if this reduction in 1/3 did occur that would restore the Australian dollar earnings of this exporter. There would be no further implied need for a fall in the Australian dollar price of the stock of the type that has occurred. I cannot help thinking that (further financial disasters excluded) this stock is massively oversold.

Indeed, looking through the industrial and mining stocks I see a fair bit of apparent value in many places.  Rio Tinto is selling at 8 times earnings and looks even cheaper than BHP-Billiton - an additional bonus is that, if BHP-Billiton's takeover of Rio Tinto does go ahead, it is a cheap way of getting into BHP-Billiton since the target is currently trading at a discount to the takeover offer.

Much the same sorts of observations can be made about the prospects of listed beef and food exporters. They look very cheap at current prices and would seem to have tremendous medium to long-term prospects.

Boring though hopefully safe income yielding stocks like Telstra (13X earnings) at $3-90 and AMP (12X earnings) at $5-89 are yielding around 8% when interest rates look like falling to around 5% over the next few months.  There are plenty of other stocks in similar situations.  Again very cheap.

I am not suggesting anyone hops in and starts buying - I'd definitely at least wait until the market heads out of its current nosedive before doing this.  But I wonder if because I can see real value emerging in the market at present that others might be doing the same. Barring further financial shocks and disasters - OK these do seem reasonably prospective - greed and self-interest should start to drive a recovery in what seem to be very undervalued Australian stocks.


conrad said...

What does a supply and demand graph look like for some of the main commodities?

I ask this because if China is still growing at 8%, then surely there is still going to be a fair bit of demand around for them. Or is the idea that the rest of the world gets so hammered that the increase from China is going to be massively outweighed by the decrease from other nations?

Kevin Rennie said...

Some uncommon common sense. There must be many potential bargains out there. The banks for instance.

Sir Henry Casingbroke said...

Hmm. High growth Asian markets are high growth because the US has relinquished manufacturing, outsourcing the activity to Asia, principally to China and S Korea plus Taiwan. The rest subcontract to those. Drop of demand for manufactured goods in in the US consumer market (i.e. Walmart) means drop of demand for the raw materials and the energy required to make them. Australia supplies the latter, such as steaming coal and iron ore, plus LNG.

The Australian dollar fell because the hedge buyers put the two and two together about the prolonged drop of demand for manufactured goods in the US and shorted the Aussie - talking up the dollar won't work, ask King Canute.

The Chinese, who do not have a floating currency, have to keep their currency at about 10% of its real value if we were operating in truly free international market. Furthermore, the Chinese manipulate the US dollar, keeping it artificially high by buying it to keep their economy stoked up. Having a planned economy they can shift people and manipulate labour markets to their needs. (We do it as well via our immigration policy, as per our previous discussion).

The only way out of this caper for the US is to replace the Chinese support foir the US dollar with its own savings, which it currently does not have. Consequently, it will take time to build it up. I'd say 7-10 years.

Consider the US and its shift from the 1929 crash and the 30s "Brother can you spare a dime" decade which eventually emerged at the end of 1945 with a boom that lasted until 1972.

Current US spending on war and defence is 3.7 per cent of GDP. During WWII, once it wound up to its full-on, 24 hours 7 day a week war production it became exactly 10 times that, 37 percent.

The US was working around the clock fulfilling the orders. The people couldn't spend the money, even if they had the time or had anything to spend it on due to shortages and restrictions and instead bought war bonds and put their excess earnings into savings.

Come the 50s everyone was cashed up and boom times happened.

The US kept the war economy on the boil with the Cold War rhetoric. There is a direct relationship between consumer confidence and fins on cars.

The lessons?

1. War is good but you can't have a war and cut taxes.
2. Keynes and Galbraith were right all along.
3. Small government is a bad idea.
4. For the last two reasons, the Republicans will pay a huge electoral price come November.

rabee said...

Let's wait at least until after Columbus Day-Monday (our Tuesday), the U.S. Treasury bond market will be closed and equity markets are open (all day). Gold went down Friday because people were hoarding money in bonds for the Monday holiday I guess.

hc said...

Sir Henry, Many of the points you make are right but I don't think China's entry into the industrial revolution will be ended by US bad consumption habits. For one thing many Chinese exports go to other high growth emerging markets.

What I think is true is that the gradual ending of US economic dominance of world affairs will now accelerate. Of course McCain is finished with this debacle.

China's growing trade with the US that involved an accumulation of a currency and government debt whose value will come to look increasingly shaky sounds like a chapter out of a Joseph Heller novel. It is bizarre but it will end with China increasingly owning many of the undervalued real assets in the US economy.

This collapse will eventually be put in proper historical context. It is not only cyclical but also evolutionary.

rabee said...

You know Harry it's becoming apparent that deflation is much more harmful than inflation given the way our financial system is structured. It has to do with how we use certain assets as collateral and the notion of default.

For Australia, I think that we can avoid much of the pain (being a small country) through a level of inflation that's higher than what we would normally want.

I'm so glad to see the Australian dollar falling and hope for a further fall. But I'll be worried when inflation rates start going down.

Frankly, who cares if the Australian dollar hovers under .40USD and inflation is above 8% so long as we maintain near full employment.

sir Henry Casingbroke said...

Washington Times columnist Bruce Bartlett (a free market economist) wrote recently in defence of the ridiculous US trade imbalance that the U.S. can afford high trade deficits with countries like China:

"Economic theory tells us that if we ever reach the point where it becomes a problem, there is an automatic adjustment mechanism, which is that the dollar will fall in value.

"When the dollar falls, then that makes U.S. exports cheaper on the international market in terms of foreign currencies and it makes imports more expensive in terms of dollars."

Oh, oh. If I were marking his term paper, I'd be writing in red on the margin, "Bruce, come and see me in my faculty office."

Here are some figures: The world's biggest exporter is Germany with $1.3 trillion revenue from exports p.a. and this is 10 per cent of ALL world export revenue. On the other hand the US imports $2 trillion worth of goods, p.a.

OK. Big numbers. Add to that what was once America's biggest corporation, General Motors, has tanked, is on Credit Watch, is B--, and will file for bankrupcy in 2009 if not before. Last Thursday its shares dropped 32 per cent, or to what they were in 1952, wqhen the buying power of the buck was 20 times what it is now. That's the real economy.

Then there is the other, fantasy, parallel world economy. The value of derivative instruments that are not paid for but forever owing until onsold to another sucker like some mega pyramid scheme, a sword hanging, by a single horse-hair overhead, is $64 trillion, give or take a German industrial output.

Piiiing! The hair has just snapped.

That is why, sitting at home in front of my Samsung widescreen LCD 105cm screen, sipping on a cold Becks, a plate of Thai tiger prawns in front of me on a Villeroy and Bosch plate, I am laughing myself silly at the reassurances of all those grinning cretin heads telling me how safe our banks are.

rabee said...

Well Henry there is a difference between this peculiar large US economy and a small economy like Australia.

One paradox in macroeocnomics that will emerge from all of this is why the US dollar appreciated and why the normal foreign exchange movements that we expect didn't kick-in.

The disaster in all this is that the US dollar appreciated. But I guess that that's good for us. If I was a cashed-up US investor I'd think about buying Australian assets right now.

hc said...

I think the choice you offer Rabee of a steady 8% inflation is illusion. The best way to secure high employment is to keep inflation low. and that comes from someone who feels very strongly about unemployment.

I still wonder if massive inflation will not be forced on the world by the US as a way of dealing with its indebtedness. Happened before - Vietnam etc.

sir Henry Casingbroke said...

Rabee, there is no textbook or paradox here regarding the US dollar.

Apart from the Chinese and the Japanese who own about 40% of US Treasury bonds between them plus the Gulf oil exporters with about 7%, and all with excellent reasons to keep the US dollar RELATIVELY high, the other investors in the Treasury paper were investors fleeing the debt issued by Fannie and Freddie. See this article in Fortune last month:

With the stock market in the US falling, the securities refugees are also looking to park their dough in Treasuries and cash.

Australia is a banana republic, both by comparison, and by analogy. If nobody wants out bananas, or there is a perception of a future loss of demand for what we can gouge out of the ground, then our dollar is ratshit.

Canadian dollar too copped a hiding in comparison to the US greenback and their "fundamentals" are even sounder than ours.

rabee said...

We're a small country with a floating exchange rate. How's the US going to force inflation on us?

I'm still trying to figure out why the US dollar has appreciated so much. The only sensible thing I can think of is that the implicit cost of borrowing has gone up with the credit crunch and capital is flowing from Australian assets attracted by the high returns they are getting in the US. Who knows!!!

As for inflation, if the choice between between falling asset prices (e.g., house prices) and inflation, I think that it is prudent to want inflation at this point in time.

conrad said...

"As for inflation, if the choice between between falling asset prices (e.g., house prices) and inflation, I think that it is prudent to want inflation at this point in time."

Rabee, there was deflation in HK for about 6 years, and whilst it wasn't happy city, it certainly wasn't the end of the world. As long as you have a really liberal labor market and people get into the habit of taking pay cuts, it's not the end of the world. It's not clear to me that high inflation which never comes down is better than that.

Sir Henry Casingbroke said...


1. The US dollar has not so much appreciated as the Aussie has depreciated against it. That's because our dollar is tied to the ores and energy we sell to China, Japan and Korea. We are an agrarian subsistence economy relying on commodities as a driver of liquidity; as such we are at the mercy of volatile commodity markets, and therefore, hedge jockeys.

2. Australia has had, and will have, higher inflation than the US (until that is the US suddenly starts to print money to pay for its brobdignian unfunded liabilities for medicaid, social security and pensions for baby boomers, or China and Japan.

3. In times of crisis, the Fisher Effect is more pronounced. According to the Fisher Effect, countries with higher inflation rates have higher interest rates. The law of Purchasing Power Parity says the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation. Even though capital markets are more or less integrated, nevertheless, real interest rate differences happen due to currency risk and country risk. If the world economy tanks then demand for manufactured goods slows down, and China's growth is curtailed leading to again less demand for steel (thus our iron ore and coal) used in construction of more factories and housing for its workers. In this way we are perceived as a risky investment by futures currency traders who sell down our dollar.

4. Any pretence of equilibrium in international markets goes out the window with unilateral interventions - as is happening now.

5. The $700 billion intervention by the US Treasury is also a US dollar driver. How? The theory was that the money would go to the banks so they could clear the toxic mortgage debt from their books and hence resume lending to each other, freeing up liquidity and get the real (retail and construction) economy going. But what would you do if you were a bank strategist? Would you lend to another bank? I know i wouldn't. i would do what most sensible punters are doing: protect my balance sheet by not risking capital, instead using the funds by buying Treasury bonds and cash. This further supports the US dollar.

6. Monetary policy is a very flawed instrument. It's like trying to jerk off in boxing gloves standing on a tightrope. Reserve dropping interest rates does very little in getting banks to lend to each other.

7. The gloves are off! Consequently, to effect monetary policy, the logical thing to is to buy a controlling interest in the banks - the real reason why you have partial re-nationalisation of big banks and lending institutions in Europe.

8. Politically in the US there will be a rout of Republicans and their moronic ideological mindset as the people vote in and then demand a New Deal style government.

9. As its $100 trillion unfunded liability bubble pops from the 2020s on, the US will become a command economy on the Chinese model but without the dictatorship of the proletariat rubbish.

10. Eventually everyone will live happily ever after - except you and me Harry, as we will be dead by then.

Gaz said...

People are SERIOUSLY and contageously over-estimating China. The ONLY reason China has been growing at such a fast rate is because it went BACKWARDS from 1949-1978. If it DOESN'T grow at at LEAST 8% there will be serious and catastrophic consequences. Inflation has skyrocketed here too, my PERSONAL, on the ground observation is that the cost of food and clothing has tripled since this time last year, and increased ~12x since I came here 5 years ago.

If China grows at 10-12% then there will continue to be demand for iron ore and coal from Australia, if it only grows at 8% the only demand will be for food, water, and clothing.

jc said...

let's ll take a deep breath. Since the socialization of the banking system (which happened this weekend) you have to buy stocks or hard assets.

Monetary policy is going to be the most expansive we have ever seen and inflation will come back with a raw.

I can't see how anyone can stay in cash from now on.

jc said...

oops roar