Author: Dan Denning

How about some reader mail on housing?

Having lived through the collapse of the Irish property market & returning to Australia after 14 years in Europe I am alarmed that the same blinkered approach to housing and the obsession with home ownership & the use of the asset to purchase consumer items that I saw there is being repeated here – while its highly unlikely that we will see anything like the complete collapse of housing prices that occurred in Ireland since the peak in 2007 the present price regime particularly Sydney is unsustainable – a lot of people are going to be savaged…

–Dear DR,

I’ve returned to Australia recently, and what I see here is exactly what I experienced living in the US and the UK for thirteen years. The key observations are:

(1) Excessive personal debt with loans and credit cards.

(2) Very large mortgages due in part to the cost of housing.

(3) The belief that housing always goes up.

(4) Main stream media and banks hyping the process.

On the housing front I’ve heard that Australia is different and the immigration is driving the housing, and that was the case in the UK until many found jobs hard to get, and the cost of living forced people to vote with their feet. That is another point as it’s not just Australian homes that are expensive it much more and the cost of living is a key factor. I’m not sure how many people coming now return to their countries due to cost, but it may be a factor here eventually.

While Australia seems to have weathered the GFC better I’m not sure it has if you look at the banks foreign debt to support their lending portfolios. The RBA says that banks are safe, but what would an independent audit find? Who pays for the stimulus packages? What economic risk analysis is going on at the RBA, and can someone show it’s valid if a China pullback occurs?

How many current mortgage holders are under stress, and I suspect that is a lot more than we know, but in true Australian tradition families work harder to pay the mortgage rather than loose the family home.

The danger I see is that there is very little manufacturing or science/engineering companies. I’ve written to the Labour party since I’ve returned but the response showed they don’t understand. I’m not sure if they feel a service economy are all we need, but that failed in the UK. Additionally, if the resources boom slows down due to China punning back then what has the country got to fall back on?

I have worked in Australia and overseas developing mobile phone modem software and there are no jobs for me in my profession here, and in the 90’s there were. I’m sure it’s the same for others. Furthermore, with universities producing students for say Industrial Design, how many can get jobs in Australia? I spoke to an under grad a few weeks ago, and I was told that only two of the hundred students in her year got jobs in that profession. What does that say about the health of the economy and country?

Summary:

Housing is just one issue that needs a resolution, however, with the Real Estate agents under quoting, and other vested interests in pushing prices up I’m not sure anything sensible will happen, and we will get a correction at some point.

There needs to be urgent government planning/policies to get a bigger manufacturing base here (look at the carbon footprint given that almost everything is imported). Also, develop science / engineering and offer conditions where technology companies will return to Australia rather than always finding the staff outside this country.

Manufacturing can also help balance the economy, and provide valuable jobs for our citizen’s. The tax base needs people to work. What is the real unemployment? Someone is not employed if they are only able to get two days a week outside their profession, yet the statistics don’t show you that.

There are very severe economic conditions outside Australia (UK/US/Europe and others) that we have no control over, and it’s possible the banks will have to pay higher rates for their foreign debt, and that will be passed on plus some to consumers.

The main stream spin says things are getting better, but are they really, and how long will it be before some countries can pay back the stimulus, the bank bail outs, and other foreign debt let alone any maturing debt obligations that we’ve not aware of?

Regards

Adrian

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Last week – before we set about proving that Australian housing was a bubble waiting to blow up – we began making the case that the resource boom might be facing an unquestioned assumption behind its enduring boom: that China won’t blow up. But what if it does?

There is emerging evidence that China has its own enormous property boom. The fortunes of provincial governments are tied to land sales. So real estate has become a real rice winner in terms of government revenues. But to be honest, that is not a story we’ve investigated much.

It’s Australian resource stocks that are our beat here. And it seems like if China’s demand for raw materials is driven by an unstainable level of fixed asset investment (short-seller Jim Chanos says China is on a “treadmill to hell” with 60% of GDP derived from construction spending) then the rosy assumptions about rebounding exports (and the royalties that heal damaged federal finances) are pretty stupid and short-sighted assumptions.

Luckily while we were over in Perth talking about how to be free in an unfree Australia , our man in Sydney, Greg Canavan, had his thinking cap. Greg’s new venture, Sound Money. Sound Investments, combines a big picture perspective with a kind of a forensic analysis of the balance sheet and some time-tested methods of valuation. He sent us a note on China’s perceived strengths and weaknesses over the weekend.

He writes that, “Most people point to China’s huge foreign exchange reserves as a source of wealth and firepower to deal with any emerging problems. As I’ve stated in previous reports, I don’t agree with such an assessment. Why?”

“China based economist Michael Pettis says that only twice before in history have nations built up foreign exchange reserves similar in size (as a proportion of global GDP) to China’s current hoard. Those two lucky countries were the US in the late 1920s (despite Britain’s attempts to stop the US accumulating gold) and Japan in the late 1980s. Pettis says rapid expansion of domestic money and credit were responsible for these two countries’ subsequent malaise.

“‘It was this money and credit expansion that created the excess capacity that ultimately led to the lost decades for the US and Japan. High reserves in both cases were symptoms of terrible underlying imbalances, and they were consequently useless in protecting those countries from the risks those imbalances posed.’

“This doesn’t mean China will suffer a decade or so of deflation and falling asset prices. But it does mean you should be cautious about the country’s prospects and the expected impact on your investments. At a guess, I would expect China to feel the effects of much slower credit growth and lower government involvement in the economy by the final quarter of the year, if not before.

“None of this expected risk is priced into the Australia equity market at the moment. And that is not surprising. All we hear is how the Chinese are on the hunt for resource projects, and how demand for steel inputs is going through the roof. But that demand is the result of past stimulus.

“Meanwhile, inventories of most base metals are at or near their peaks (and above 2008 peaks) suggesting that basic raw material supply is more than adequate to satisfy demand. After all, the global economy is only just emerging from recession and is not expected to bounce back strongly.

“The biggest concern for Australia is that China has brought forward much of its raw material demand via the 2009 stimulus measures. When the impact wears off, commodity prices may correct and give back some of the very large gains achieved since the 2009 lows.

“For this reason I am avoiding the resource sector until prices move back to more favourable valuations. This may take months, and I may look like an idiot in the meantime, but my view preservation of capital is more important than jumping on momentum trades.

“When the inevitable correction comes and good value appears, I look forward to making some quality recommendations. I’m not predicting China to endure a nasty, drawn out depression like the US and Japan experienced previously. But it will go through a post credit boom hangover. The result will likely be another round of extreme equity market volatility. Be sure you have cash on hand to take advantage.”

Incidentally, Slipstream Trader Murray Dawes would probably be sympathetic to Greg’s view. Murray put out a new trade yesterday in which he said, “I have been banging on for a while about my feelings that the market is entering a sell zone and I think it’s time to start playing the market from the short side. [Deleted] has sent a sell signal on the false break of the January highs of $[deleted].”

Obviously we can’t tell you what trade Murray recommended. But we would like to point out that if you don’t have a macro view in this market, you’re going to get blindsided. And having a bearish macro view doesn’t mean you can’t make money. Murray writes that, “I see this position as a way to get short the market as a whole because I believe the index charts are all pointing to some weakness dead ahead. The ASX200 in particular is today looking close to confirming a false break of the January highs of 4,955 after touching the 50% retracement from the crash.”

Greg has a macro view. And his strategy is to avoid the correction and have enough cash to take advantage of the values when they emerge again. That sounds sensible.

Do I contradict myself?
Very well then I contradict myself,
(I am large, I contain multitudes.)

Walt Whitman, Song of Myself

It’s important to remember that no one knows what the market is going to do. We were asked recently by an interrogator if publishing seemingly contradictory positions on the stock market was..well…contradictory. Shouldn’t we be consistent?

We explained that is was not our primary mission to be consistent. That means sticking dogmatically to a view because you’re too stubborn to change your mind. Or, in the case of investment advice, because your business has a vested interest in promoting a certain outcome or view point.

Our business is to find and publish intelligent and well-researched ideas about how to make money in the stock market. Smart people often disagree. And we see no reason to try to arbitrate their disagreements. We don’t know who’s going to be right.

But we do know that it’s better to have hard-working people beavering away on their best ideas in their chose areas of expertise, and then to let the market decide what works best. This way, you have a portfolio of well-researched views and ideas from real independent analysts who are not serving any other interests.

And when it comes down to it, how and if any of these ideas fit in with your own financial plan is ultimately up to you. A free, thoughtful, and financially independent person wouldn’t have it any other way.

Dan Denning
for The Daily Reckoning Australia

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The Aussie market has opened down. But for the first time since September of 2008, the Dow Jones Industrials have closed over 11,000. All hail the coming of the new bull!

You could surmise that the catalyst for higher share prices – since it isn’t earnings or the economy or insider buying – has to be the Greek deal/bailout announced on Sunday. That plans sounds a lot like the plan to exit an airplane, “in the event of a water landing.” Until Sully Sullenberger landed his plane in the Hudson last year, we’d always assumed “a water landing” meant a smash into the ocean and instant death.

But the Greeks have avoided a flat spin into debt default for now. Europe’s wise old men and women agreed to a US$61 billion rescue plan that makes $43 billion in loans available to Greece at 5% interest if private capital markets do not participate in Greek bond auctions. Call in the Trichet put.

This does not end the sovereign debt crisis. It only takes us to the next stage. And we have quite a bit to say on that stage. But for now, we’re still finishing a bit of research on it so we won’t dive into it in today’s episode.

How about a brief epilogue to yesterday’s discussion of housing? More buyers are needed to send over the wire and into the auctions. But where will they come from? Despite the high clearance rates nationwide, Peter Martin reports in today’s Age that buyers are actually deserting the property market. Maybe they got what they came for. Or maybe it’s too expensive. Or maybe they can’t get credit.

According to data from the Australian Bureau of Statistics, the number of home loans made in New South Wales is down 27% from September of 2009. The decline was 29% in South Australia, 25% in Queensland and Tasmania, 16% in Western Australia, and just 12% in booming Victoria. “This will lead to a slowing of price growth, no question about it,” says David Airey, president of the Real Estate Institute.

Hmm. Do you reckon the Real Estate Institute is trying to bluff the RBA into not raising interest rates any longer? This might allow the banks to keep lending. But the banks are actually lowering their loan-to-value ratios. Requiring a larger deposit shores up the balance sheet. But when UK banks tried to address their overexposure to residential real estate by lowering LVRs, the market “got slammed.”

This is exactly what we were thinking last night over a cheese-drenched veal parma (without the ham), reading Dr. Marc Faber’s latest Gloom, Boom, and Doom Report. “I think it’s fair to say that every asset bubble makes people feel temporarily rich, because on the back of rising asset price the owners of assets can increase their borrowings or trade out of their inflated assets and consume more than is possible of no asset bubble had taken place.”

To wit, this article from last week’s Sydney Morning Herald suggests that Australians are refinancing their homes (at lower rates and higher prices) and withdrawing equity (when they have it) to finance the purchase of big ticket items. Not only is your home your castle, it’s also an ATM.

This is just what Dr. Faber is talking about. “In an asset bubble, people can consume today out of borrowings and capital gains what, in a non-inflationary environment they would have consumed through accumulated savings. Simply put, asset bubbles ‘frontload’ consumption at the expense of consumption when the bubble bursts.”

If they could understand it, this would not be welcome news to government ministers. It means that by “bringing forward” housing demand to prop up prices (via the First Buyer’s Grant, the relaxation of foreign investment in property, and the buying of securitised loans by the AOFM) they have ignited a super spike in Aussie house prices. And not only are house more unaffordable than ever, the paper gains have encouraged people to refinance and borrow against their home to support new consumption.

When you have unsound money and unsound money management, you get a debt-laden disaster. You can’t really blame politicians for suckering Australians into new debt at precisely the point where interest rates were/are making historic lows. Politics is all about “time preferences” too. They’re called elections. And if you haven’t made people feel richer by the time they come around, your time may be up.

This is why H.L. Mencken called elections “an advance auction of stolen goods.”

But the moral hazard of shifting time preferences for savers and investors – which is what you do when you manipulate the price of money and distort markets by throwing money at them – is that you cause otherwise prudent people to make really bad economic decisions. Low interest rates and government handouts shift time preferences forward. Or, in laymen’s terms, they cause people (and a nation) to be short-term focused (or financially short sighted).

It’s fun while it lasts but it won’t last forever. And at heart, you have to acknowledge that the origin of rising Australian prices is not immigration, tight supply, or some bogus shortage. It’s a credit bubble. As Dr. Faber writes, “Every asset bubble was caused and accompanied by easy money and a rapid expansion of credit. Rising asset prices reinforce credit growth as investors leverage up.”

Nearly everywhere else in the world, investors and households have deleveraged. But as Dr. Steve Keen recently pointed out, Australians – encouraged by their government and the real estate industry – have taken the seemingly benign GFC as a reason to releverage. Private debt to GDP levels have risen.

Or, in his own words, “Australia has avoided the GFC by recreating the conditions that led to it. Needless to say, this is not entirely a good thing. We are potentially avoiding pain now by setting ourselves up for greater pain in the near future.”

But how soon is that future? Is it now? Or now? Or now?

One key is whether the faux resolution of the Greek crisis will lead to rising sovereign bond yields. This might seem counterintuitive. If Greece is less risky and volatile, shouldn’t bond yields fall? Maybe not. If investors think the sovereign debt crisis is over, they may shift out of supposedly risk-averse assets like bonds and into equities. This would argue – in the very short term – for higher highs on the indices.

But rising government bond yields cause a world of hurt, too. First off, it makes it more expensive for governments to borrow. Perhaps this is why Pimco bond chief Bill Gross is selling U.S. Treasuries. He’s not worried about deflation at all. He’s worried about rising rates and inflation.

You should read his full note if you have the time. But the short version is that, “high fiscal deficits and higher outstanding debt lead to higher real interest rates and ultimately higher inflation, both trends which are bond market unfriendly.”

One more note of caution. U.S. and U.K. banks increased their holdings of government bonds during the GFC as a way of improving the asset side of the balance sheet with more, ahem, credit worthy assets. That could be a problem if bond yields spike (and prices fall). In other words, for the Atlantic economies, the next phase of the crisis might come from falling bond prices affecting the solvency of banks.

And Australian banks? They remain uniquely exposed to residential home prices. And they remain uniquely dependent on funding expanded lending through wholesale borrowing overseas. To the extent that rising sovereign bond yields mean higher borrowing costs globally, Aussie banks will face higher funding costs. You’d imagine that would lead to higher home loan rates here, which, needless to say, would not be good for the housing market.

Not that the banks are going to just come out and tell you there’s a problem. According to today’s Wall Street Journal, “Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York.” Hmmn.

A group of 18 banks – which includes Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc. – understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.”

We won’t go into the details of the trick here. But the takeaway is that everyone thought the banks had deleveraged in the last two years. But perhaps that is not the case. And perhaps banks are still using short term lending to boost collateral, which allows for more borrowing and more speculating…on things like higher stock prices, commodity prices, or the collapse of Greek debt. Now wouldn’t that be interesting?

Dan Denning
for The Daily Reckoning Australia

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“She broke wind without breaking stride. And that’s when I knew something funny was going on in Washington, DC.” That’s one of the lines your editor used to describe his disillusionment with public policy solving all the world’s ills. But first, the markets!

In case you missed it late last week, Australian’s are re-leveraging. While most other households in the Western world are dialling back credit-financed personal consumption, the opposite seems to be happening here. This conforms to almost exactly the same pattern we saw in American in 2006. But first the facts.

The Big Four Aussie banks used the financial crisis – during which their non-traditional lending saw their securistisation model fail – to expand their control over the Aussie mortgage market from 65% to 75%, according to JPMorgan analyst Scott Manning, via Richard Gluyas in last Friday’s Australian. The banks actually grew their loan book in residential housing by $75 billion in the last 18 months.

Does this leave the Big Four exposed to just one incredibly important asset class? Well at least two of the Big Four might lose some sleep over it at night. Commonwealth Bank has 65% of its loan book tied up in household mortgages, according to Eric Johnston in the Age. Westpac/St. George comes in second with 62% of its assets in the local housing market.

Because Australian house prices always and only ever go up, this is probably not a problem. But were house prices to go up less fast, or, gasp, even go down, well then it might be a problem. To keep it from becoming a problem, the housing industry must attract a constant stream of buyers and the banks must continue offering them credit. If not, look out below.

But let’s go to the way back machine and recall how it played out in America. The Greenspan Fed panicked in 2001 and lowered the Fed Funds rate 13 times in the next three year until it was just 1% in 2003. These dirt cheap rates triggered the first wave of the U.S. housing bubble: the extension of credit to the most marginal of borrowers in the economy (the subprime and ARM vintage loans that blew up the system in 2007).

However, as you can see from the chart below, the predatory luring of bad borrowing risks into the market (begun by the Fed, blessed by the banks, and bankrolled by the GSEs) was just the first wave of the boom in mortgage originations in 2004-2006. The second wave was refinancing. You can see that low rates attracted a huge boom in refinancing from existing owners to lock in low rates while they lasted.

Now comes double-barrelled perplexing news. Just over 37% of March mortgage lending was for refinancing purposes, according to housing statistics firm AFG. The last time it reached that level in Australia was in December of 2008 – another moment when Aussies feared spiking interest rates. The AFG data also show that the Big Four reduced mortgage lending by 82% in March while non-traditional lenders doubled their lending.

Hmm. What do you reckon is going on here? First the government gooses the market with the first home buyer’s grants. The marginal borrower is “brought forward” into the market to keep it going. Then, refi reinforcements are brought into fill the breach as the first buyer’s grant expires. Finally, the non-traditional lenders use the securistisation scheme at the AOFM to sell even more mortgages and keep the boom rolling.

Does this have all the elements of the conditions that led to the peak in U.S. home prices and their eventual collapse? Yes it does! Of course, the banks would never dial back lending would they? Even if their cost of capital is increasing, they wouldn’t dare pass that on to Aussie variable rate borrowers, would they?

Why bother with housing when the market is threatening to bust out over 5,000? Its double bubble, toil and trouble. We think markets are running out of credit and sentiment to make new highs. And any external shock makes the next few months highly susceptible to a big correction.

The libertarian show in Perth was great. Your editor explained that he first knew something was amiss in Washington when, after giving a speech on the floor of the House of Representatives, a future cabinet member in the Bush administration bustled past him, breaking wind without breaking stride. Right there on the floor of the House chamber.

We knew then even as a 16-year old that something was wrong. You’ll get a full report tomorrow. There are free thinkers in Australia and they understand that ideas matter. More on those ideas soon. Until then!

Dan Denning
for The Daily Reckoning Australia

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Perth looks like it’s booming again. This is the fourth time since 2003 your editor has come out to the frontier of Australia’s resource boom to get the vibe in person. A shiny new glass building is going up just in front of our hotel on Hay Street. On Hay Street itself we can see the signs for Louis Vuiton, Yves St. Laurent, and Tiffany and Co. Who knew the miners were so well appointed? More on Perth in a moment.

But first, how about those yield spreads between 10-year Greek and German debt? They are now at 4.27%, the highest level since Europe’s monetary union began in 1999 according to Bloomberg. Now yield spreads aren’t the stuff of breakfast (or even dinner) conversation. But they do matter. Why?

Theoretically, it should cost the Germans and the Greeks roughly the same to borrow. Both governments use the same money and both economies have their interest rates set in Brussels by the European Central Bank. So why do the Greeks have to pay more to borrow for ten years than the Germans?

It’s the debt and deficits, to be sure. Greece is trying to get its fiscal house in order. And Germany is traditionally (or at least in the post-War era) Europe’s best steward of sound money policies. But for all of Europe (and America) these rising bond yields can be reduced to a much simpler explanation: you can’t get something for nothing.

Europe’s political and economic living arrangement – in which the State provides for an increasingly large share of private needs, wants, and dreams – is running smack into the brick wall of demography. Some people find it off putting to hear that the Social Welfare state – despite its best intentions to improve the human condition – is a Ponzi scheme funded by coercive taxation. But we reckon it’s true anyway.

The good news the State is just one of the institutions in a liberal society. There are other ways people can care, love, and empathise with one another. It doesn’t all have to be mediated by the civil service.

But modern government has grown so grotesquely fat and ubiquitous that an entire generation of Westerners have been trained to think only the government can and should solve problems. It’s like having an Uncle stuck in your living room who’s become too fat to move. You have to feed and clean and care for him and after awhile he becomes a living piece of inconvenient and intrusive furniture right smack in the middle of your life.

But cheer up. This will work itself out. The world is too complicated for a room full of well-meaning (or ambitious) men and women to manage it. Complex societies (or adaptive systems) cannot be managed by a handful of human brains. They can only be mismanaged.

In fact here’s a prediction: what happened to the Catholic Church in Europe in the 17th and 18th centuries will happen to the Nation State in the 21st. That is, the funding model which puts one institution at the centre of public and private life will break down. The institution will get too large, inefficient, slow, and greedy to do all the work it’s taken for itself.

This is a good thing. In economic terms, it up opens up new productive possibilities. Maybe all the world’s capital won’t be consumed by over-borrowing governments who are robbing from the future to win elections today. Or maybe it will. We’ll see soon enough.

Is there an investment story in today’s DR? Maybe. Gold is up 28% in the last year. Oil is up 75%. And silver is up 48%. They might go higher. But are they cheap? Probably not. As we said the other day (quoting our friend Rick Rule), with commodities you’re either a victim or a contrarian. Entering commodity stocks at these levels might be profitable. But it feels more like speculation on higher prices rather than investing based on tangible asset values that are cheap.

Speaking of which, there is a lot of vacant land in Australia. A lot. Flying across to Perth from Melbourne we looked out at the Great Australian Bight and wondered if anyone could ever live there, and what would they do if they did. Can resilient, decentralised communities that generate their own energy (and somehow find water) be a genuine alternative to having 65% of 21 million people living in the same large capital cities?

Who knows? But that’s a long, long way off anyway. The more immediate question is whether there’s anything worth buying on the stock market right now at these valuations and with this economy. Our take on it – published yesterday in the Australian Wealth Gameplan – is that now is a great time to become an 21st century energy baron. And it’s easier than you think.

Granted, the idea may be completely nuts. But if you want to avoid being a victim you have to buy stuff nobody wants now but may be worth something later. Radioactive mineral sands come to mind. They could become a new substitute for uranium in powering nuclear reactors. And with a fleet of cheap nuclear reactors you could build desalination plants and pipe water into Australia’s red centre and make it bloom like an oasis in the desert.

But less romantically, land prices also appreciate during a great inflation. And we think a great inflation is coming with a rising bond yields presaging currency collapses in Europe and America. We know this from some research we did on the birth of the industrial revolution in Britain in the 16th and 17th centuries.

The full story, for now, is only available to AWG subscribers. But the concept is simple: become a land banker. Mind you , you’re still doing this through the stock market and you’re still buying shares. And with shares you can lose everything. But owning a kind of call option that could profit from a long term energy trend AND the financial crisis coming round the bed seems possible to us, elegant even.

It could be rubbish too. But we’ll see. That’s why the stock market is not a savings account. You have to take risks to get rewarded.

What else can we say about Perth? Well there’s a lot more to say but we’ve run out of time and we forgot to bring a tie. It’s time to see what they cost on Hay street before we give our presentation today on why all libertarians should be institutionalised. Until Monday…

Dan Denning
for The Daily Reckoning Australia

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On that subject of the insulation scheme, we have refrained from saying on a word on it out of respect of the many people who have lost their homes due, apparently, to faulty installation of the insulation. And of course, there is the far more serious and tragic fact that four young electricians died installing insulation in the government-generated boom.

Most government programs are laden with fraud and waste and incompetence. But most are not generally lethal, at least not directly. You could argue the Welfare State has been killing hope and real economic change for years.

But it is truly stunning that a $2.5 billion program designed to put insulation in people’s homes (a dubious program to begin with) actually killed four young Australians…and no one has had the courage to link the bad policy with the tragic result.

Think about that again – the death of four young people is directly linked to government policy – and no one has been fired, lost a job, or held accountable for it at all. If, for example, four diggers were killed in Afghanistan after being sent on poorly planned mission, what do you think the coverage in the media would be like?

We’re not having a go at the current government here. We’re having a go at complacency about the costs of an expansive and intrusive and meddling know-it-all Nanny State. Not just this Labour government either but ALL government. The idea that make-work programs to spend money in a Keynesian fashion are cost-free and benign is a fraud. They are not.

In fact, these ambitious and modest “government initiatives” alike, from healthcare to insulation are always and everywhere prone to just this kind of result. Policy makers might feel smart and morally superior spending other people’s money to produce “outcomes.” But the outcome is never what you expect, and usually worse.

Economically, when the government pours money into a market, it distorts all the incentives and leads precisely to this sort of hazard. In this case, the fact that it offered a rebate to install insulation attracted a lot of new installers. Whatever happened next – who knew what and when – is still unclear. But how it all started couldn’t be clearer – the government decided to blow $2.5 billion because it thought it ought to do something about the economy and this was a casual, victim-less way to do it.

It did something alright. And four people died. That’s a fact. And hundreds of Australian houses may now have electrified roofs. Millions and perhaps billions more will have to be spent to remedy the problem.

If you believe that government spending creates prosperity, then you could rationally argue the faulty program is actually a net economic benefit (despite the death toll) and a huge success. You could argue that it’s making more work for uninstallers and electricians who will have to go back and fix things. And then there are all the extra man hours for inspectors to make sure it’s all proper.

This is perfectly rational under the logic that spending money is good to stimulate aggregate demand. As long as people are busy, no distinction is made in the GDP figures between production and destruction. It’s all work all the same.

And to follow it through to its logical conclusion, we suggest the government hire an army of unemployed Australians, pay them money to bake bricks, and then march through the streets of every CBD in every capital city in Australia breaking as many windows as possible. Think about how much prosperity that would create!

Just remember, the government can never create wealth. It can only take money from one person and give it to another. You can argue, and many on both sides of the political spectrum do, that government ought to redistribute wealth in order to achieve “desired social outcomes”. Elections are held to put these propositions to the people for a vote. But even if the result is democratic, it certainly doesn’t result in wealth creation.

More on Australia’s production possibilities frontiers and how to save the country from a gradual decline into a Statist nightmare in tomorrow’s report. We’re off to Perth to see the boom first hand speak to a room of libertarians about why they should all be institutionalised. Until then!

Dan Denning
for The Daily Reckoning Australia

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One of the scariest things about the American Great Recession is the shift toward long-term unemployment. As bullish as some people thought last week’s U.S. employment numbers (they included nearly 50,000 census takers in the jobs gain..who could presumably be kept busy by going out and more accurately counting the actual unemployed), did you notice that nearly 45% of America’s 15 million unemployed have been out of a job for over six months?

It’s called “long-term unemployment.” And it sounds like a structural shift in the nature of the American economy. An economy based on consumption sheds manufacturing jobs and produces services jobs. We have a pile of data we compiled two years ago from the Bureau of Labor Statistics that shows this. It also shows that the average hourly wage in service industry jobs (retail primarily) is about half the hourly wage in manufacturing jobs.

But hey, in a world where labour is getting cheaper (that’s what happens when you add 1.5 billion former communists and 1 billion people from the sub continent to the global labour pool) the margins on making stuff are going to shrink. You can make it cheaper elsewhere. So you de-industrialise and loose nearly 8,000 million jobs as China gobbles up market share and productive capacity.

And incidentally, maybe Wall Street decided that if the margins on making “stuff” were shrinking to the vanishing point for firms with U.S.-based labour and legacy costs, then the best business of all would be the business that made nothing…and sold it! There you have the key idea of securitization.

But this seismic change in the kind of jobs the economy is producing is also what happens when the Wall Street Washington Axis makes a conscious choice – as it did during Robert Rubin’s time as Treasury Secretary (not as Goldman Sachs man) – to favour the capital account over the current account. That is, to favour finance over industry. As long as foreign investors wanted U.S. bonds and stocks, America could live beyond its means and consume away and finance large government deficits because there was no upward pressure on interest rates.

Sure, the average wage was going down. But Wall Street made a killing. And the everyday low price of the things Americans were buying went down too. It’s a bit like here in Australia at the moment. You could argue that most Australians are actually better off (in the short-term) because of the GFC. True, interest rates have started moving up. But think about it…

When the oil price collapsed from nearly $150 to the low $30s it delivered a kind of tax cut to motorists. The government chipped in with various schemes to pump money into the economy and job market. The first home buyer’s grant…the squandering of the stimulus (which was a huge bonus for alcohol and gambling establishments)…the school building program…and the infamous insulation (pink bats) program.

The net result of the GFC seems to have left Australians better off in the short-term, although the long-term effects (especially on super) are less clear. No wonder everyone is so content. It’s good to be Lucky.

Dan Denning
for The Daily Reckoning Australia

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Damn you Dow Jones index flirting with 11,000!

If Australian stocks follow the overnight U.S. lead, they will fail to break through key psychological resistance levels and decline. In the U.S., the mental block investors have was compounded by U.S. Fed Chairman Ben Bernanke who, in a “dog bites man” kind of story, said that unemployment and rising home foreclosures would “challenge” the U.S. recovery.

Gold was up $15 on the day.

By the way, is that phrase “key psychological levels” just a load of horse pucky used by analysts and commentators to try and explain things they don’t understand? Why is 5,000 a key psychological level? Why not 5,031? Or 5,187? Or 42?

“The charts – especially the volume indicators and the moving averages – are an aggregate expression of people’s psychology and sentiment,” explained our resident trader Murray Dawes last week when we asked him about it. “It doesn’t’ have anything to do with valuations. But it does have to do with expectations. And whether you like it or not, those tend to be self-fulfilling. So if people believe 5,000 matters, then it matters.”

Murray, by the way, is one of the few traders we’ve worked with who DOES understand the fundamental picture. In fact, he’s a bit of an Austrian at heart, or at least considers that perspective in his “big picture view.” That informs all of his trading. And he’s actually a bit in the deflationist camp right now, although when we looked at his update last week for Slipstream Trader he was doing just fine – despite being wary of a big drop in the market.

Rio Tinto isn’t wary at all. Rio’s Andrew Harding, who heads its copper business, said that copper prices looked good based on tight supply. “From a supply point of view, there are just not a lot of new stories out there…It would be hard to imagine what would cause a collapse in the copper price.” Hubris alert.

We could imagine it easily enough. All you have to do is go back a few years. It’s not a feat of imagination at all. Just memory. Copper sold for a shade under US$9,000 a tonne in July of 2008. By December, it had fallen to $2,812 – a previously unimaginable decline.

As our friend Rick Rule says, in the resource markets, you’re either a victim or you’re a contrarian. So what is it right now? Diggers and Drillers editor Alex Cowie probably has the hardest job at our shop at the moment. He has to pick resource winners while being aware that the market may be like a few years ago, when forecasts and expectations became wildly unrealistic.

Alex is doing just fine. In fact he recommended a copper stock a few months ago which is travelling nicely. We remember being skeptical at the time. But the question is whether it’s like 2007 – where you have another year of euphoria in front of you. Or 2008, where you may have another few months.

Dan Denning
for The Daily Reckoning Australia

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We read a morning update from John Robb that we liked so much we thought we’d ask John if we could pass it on in its entirety. Robb’s book, Brave New War: The Next Stage of Terrorism and the End of Globalisation was one of the best books we’ve read in the last few years about the world we’re moving toward. He continues to write about the major changes in the world and today’s letter is a doozy. If you like what you read below, make sure you check out his blog at http://globalguerrillas.typepad.com/globalguerrillas/

Today Robb wrote about “The Three Horsemen of the Global Apocalypse.” He writes that, “There’s some confusion relative to whether the depression (D2 in shorthand) is over or not. It’s not. The process will be uneven, but it will continue. Why? The three horsemen continue to ride:

• A huge, complex, and fast moving global system that isn’t under any meaningful level of control. The computer automated interconnectedness of this system makes very easy to spread contagion. Worse, this system is leveraged to the hilt with debt and riven with imbalanced feedback loops (Chinese/German mercantilism). Any crisis can set off a global crash. NOTE: Rick Bookstabber (via Kedrosky) thinks a collapse in the municipal bond market will be the source of the next crisis.

• A financial oligarchy that has shifted loyalties to the global market (think in terms of the shift to primary loyalties in fourth generation warfare). This group is highly destructive to its host, and in a process similar to cancer have co-opted normal market function via the establishment of the shadow banking system. The huge size and opacity of this system has allowed them to systematically loot the middle class and gut national treasuries (via a process known as control fraud). If municipal bonds are the cause of the next global financial collapse, these oligarchs will be center stage: note JP Morgan’s role in the collapse of a municipality in Alabama.
• A plethora of violent super-empowered guerrilla groups. The legitimacy of nation states will continue to diminish due to a financial insolvency (which means it won’t be able to finance social/stability programs), successive global shocks, and tolerance of looting by a financial oligarchy. As national legitimacy weakens, people will give their loyalty to groups (gang, church, tribe, etc.) that can protect and provide for them. Many of these groups will be violent. As these groups multiply in number, open source warfare and systems disruption will spread. For the US, think in terms of what is going on in Mexico or what went on in the USSR post collapse, but bump it up a couple of orders of magnitude.

There’s a lot to think about there. More on the value of a big picture view tomorrow. Until then…

Dan Denning
for The Daily Reckoning Australia

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Just a reminder that you can sign up for Friday’s Freedom Factory conference in Perth here. Your editor has finally selected a title for his talk on Friday afternoon: Why All Libertarians Should Be Institutionalised. If you’re in Perth, you can stop by during any part of the day, or show up for the dinner. But please make sure you book your spot today or tomorrow.

Ron Manners, the founder of the Freedom Factory, sent a note this morning from Hong Kong in which he poses a valid question: why isn’t anyone worried that Australian miners, with their technical skills and business experience, are choosing to open more and more mines overseas and fewer here in Australia? Is the country exporting its future in the form of its most talented miners and entrepreneurs?

It’s a complicated issue. For example, Diggers and Drillers editor Alex Cowie has recommended a handful of Aussie-listed firms whose main resources and assets are overseas. There are certainly high-quality resources in Australia. But for a variety of resources Alex has outlined, these firms have taken their shop overseas. And from a shareholder perspective (if not a national economy perspective), it’s working out alright.

Speaking of Alex, he’s working from home one day a week now as a new dad. But we asked him via email if the proposed boycott of the Aussie iron ore majors (BHP and Rio) by the China Iron and Steel Association (CISA) was having effect on the smaller iron ore stocks he’s recommended. Incidentally, we wouldn’t expect the move to stick. The CISA famously bungled last year’s ore negotiations and is either too combative, or not able to corral China’s diverse steel producers into concerted action.

In any event, there HAS been some action in the ore juniors. Alex writes that, “Our junior iron ore recommendations are both up very nicely since the news broke. One of them has already started producing iron ore and has felt the full benefit, rising 12%. The other one is a few years from producing so is up 4%. Both are great results in just a few days. Between the two companies, they are now up 28% on average since we recommended them in February.”

He elaborated, “The changing pricing mechanism and the massive jump in the iron ore price recently has been another driving force in all companies involved in iron ore, from BHP to the smallest of the juniors. There have been some takeovers already and more are expected. This new move from China could change the playing field in the sector a bit. A takeover from a major suddenly looks less logical or appealing.”

“It will be interesting to see if China takes the same approach to coking coal, as there have been similar price changes amongst the majors there as well. We recommended a developing coking coal company recently, and subscribers that bought in are 10% up in less than two weeks. This company is more targeted at the Indian market, so should not be affected if China pulls the same stunt with coking coal.”

Dan Denning
for The Daily Reckoning Australia

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Before we launch into this week’s reckoning, a quick note if you’re reading this in Western Australia. Your editor will be speaking Friday night at the second annual Freedom Factory conference, sponsored by Ron Manners and the Mannkal Economic Education Foundation. For more information on how to attend, go here. It should be a great afternoon of discussion and debate with good food and good people.

The theme of this year’s conference is a question: Where to From Here?: Economic Survival post-GFC: The Individual, the State and the Nation. Your editor is going to be speaking on the Nation, which is naturally a perfect topic for an ex-patriot American. And our first point is that we are not “post-GFC.” We are in a more advanced phase of it in which the disease of politics has infected the body economic via nationalisation. This grows the body politic itself (the Welfare/Warfare state) even though the way in which the State feeds/funds itself is clearly leading to cardiac arrest (via a sovereign debt crisis).

But really, isn’t that all so passe? Stock markets are fixing to make their highest highs since September of 2008. The Dow nearly closed at a post-Lehman high of 11,000 overnight in New York trading. And here in Australia, the ASX/200 looks to break out of a long channel of indecisiveness and close above 5,000.

Surely those numbers indicate that people feel good about the economy. And if people feel good about the economy, then the economy must be good itself, right? Isn’t this the power of the collective mind over the little matter of recession?

And speaking of matter, it’s not just stock indices that are screaming ahead. Crude oil futures made an 18-month high and closed at $86.82. Palladium cleared $500/oz for the first time since March 2008. Platinum was up to its highest level since August of ’08. Iron ore trades at $140/tonne in the spot market and coking coal at $250/tonne.

Happy days are definitely here again, if the headlines can be believed. And if you’re a resource speculator – it’s hard to be an investor at these valuations and with so much liquidity distorting underlying commodity prices – this is definitely time to make hay. But how much longer will the sun keep shining?

China’s State Council believes the nation is in a “race against time” to secure its natural resource needs, according to John Garnaut in today’s Age. The story quotes from a Chinese reports called How China Should Improve Its Overseas Resource Investments: Reflections on the Chinalco-Rio Tinto Deals. It reportedly concludes that, “With the recovery of the world economy, the opportunities [to cheaply secure overseas resources] are becoming less, so we should race against time.”

The race may already be lost, though. For one, take the example of rising iron ore and coking coal prices. These are great for Aussie exporters, but not so good for steel producers. Steel producers can either eat the higher cost or pass it on to customers. Markets being what they are, we’d expect the increase in raw commodity prices to make their way into higher construction material prices. That’s one self-regulating way of dealing with soaring prices: it reduces demand.

But remember those “red flags” we mentioned last week? In Edward Chancellor’s excellent article on China for GMO clients, his first two red flags were that “great investment debacles generally start out with a compelling growth story,” and that “A blind faith in the competence of the authorities is another typical feature of a classic mania.”

Call us paranoid and delusional, but there is an obstinate faith in the sustainability and inevitability of China’s resource-driven growth. Visible signs to the contrary – empty cities – are inconvenient and thus ignored. And here in Australia at least, everyone has faith that local political leaders “saved” the economy from the worst of the GFC and that China’s communist central planners will be able to keep the Big Red Machine rolling for years on end.

And those are just two of the signs that we are in the midst of an even bigger bubble! But that does not fit the current narrative. In fact, Australians are now so sanguine about their national prospects that one of the front page stories in today’s Australian Financial Review is about how to set aside superannuation money for infrastructure funds.

Rod Eddington, the government’s infrastructure adviser, told the paper that, “Given the infrastructure investment challenges we face and given the many calls on government capital, there is a real need for the private sector to increase investment in infrastructure. Superannuation funding is an obvious source but the construct has to be right if the people who manage superannuation funds are going to put those funds into infrastructure.

Hmm. “The many calls on government capital”? You got that right. The government is busy paying for everything these days with borrowed money and higher taxes. And what “construct” would a fund manager require in order to invest in an infrastructure fund? Granted, the super assets represent an irresistibly giant amount of capital that any number of people would like to get their hands on. But it’s there for a reason.

John Brodgen of the Investment and Financial Services Association is protecting his group’s turf. He says that, “Whilst I understand the pleas for more funding, the primary objective of superannuation trustees is to get the best return for their members. They make decisions based on returns. It’s pretty black and white. I don’t think members would thank super trustees for backing a tunnel that was a lousy investment but a good piece of infrastructure.”

He’s probably right. But that doesn’t mean it won’t happen anyway.

Meanwhile, while this great argument rages about how to fund Australia’s infrastructure needs AND provide for everyone’s comfortable retirement, house prices keep going up. “No ceiling to housing prices in sight yet,” reports Carolyn Cummins in the Age. Is it demand growing faster than supply? Is it foreign buying? Or is it just a classic bubble that begins with too much credit? Some reader mail on the subject below.

–Hi

Why all the concern about the Chinese buying up units and houses?

You frequently write how money spent on Mc Mansions is dead capital but if we start selling to overseas customers, house building becomes an export (productive) industry!

Of course we not only sell the house but also the block of land on which it sits, so to some extent this export industry involves a bit of “selling the farm” too unfortunately. But, hey, we need to import capital and selling land may not be a bad way of doing it. Unlike selling coal or iron ore the sold goods cannot be taken out of the country and we do not lose dividends as we might do if we sell parts of our businesses to foreigners. Of course we may lose capital appreciation but isn’t it better that foreigners buy from us believing property prices will increase for ever than us believing it ourselves?

It sticks in our claw [sic] because it is pricing our young out of the property market. If we believe in free (international) markets we just have to wear this. If we are not prepared to wear it we must wear the alternative of government intervention (first home buyer’s grants, restrictions on imported capital etc).

Kind Regards,

Ian H.

When the government intervenes and sets the price of money, as the Reserve Bank is set to do today, somebody always “wears it.”

–Dear Dan

I have thoroughly enjoyed reading the DR and its sister (paid) publications. Good work. My family and I moved to Perth from Canada in 2002 to take up an employment opportunity.

We fell in love with the climate, the people and the lifestyle but we could never make sense of how people made ends meet with the cost of living being so high, especially the cost of property.

Having owned our house in Canada outright, it was (emotionally) difficult for us to take on a large mortgage for what appeared to us to be a pretty average property.

As we all know, property went up from there and for nearly 8 years we have rented. When the GFC hit, we decided to start looking at buying a property as we expected the prices to relax, even if only just a little. We soon realised that the government was working against us, and for good reason: the whole ‘miracle’ economy is dependent on ever increasing property prices.

To make a long story short, we have decided to ‘vote with our feet’ and move back to Canada. We have already purchased a property there which is far from average and will own it outright at far less than we would have paid here for a basic 4×2.

We love Australia and may even return one day but it seems that, at least for now, the property “crisis” has changed the course of our journey and has cost Australia an Oil & Gas Engineer/Project Manager, a Maths Teacher and three bright young kids with heaps of potential.

To have it attributed to a ‘land shortage’ is an assault on any form of intelligence, but anyone who subscribes to such rubbish will recognise that we have helped alleviate the shortfall in available properties by one!

Cheers,
Steve

Dan Denning
for The Daily Reckoning Australia

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Signs of the top are everywhere in the business world. All you have to do is look at record iron ore prices and merger and acquisition activity in coal, iron ore, and gold. It all feels very 2007. We’ll explain in detail below what’s got us so nervous.

But you couldn’t close out your week without studying the action in the bond and currency markets. The illusion of U.S. dollar stability has given the market the confidence to believe everything is A-Okay.

In fact the Dow just finished its best first quarter since 1999. The U.S. benchmark was up 4.11% for the quarter and up 5.5% in March alone (things didn’t start so hot, but it ‘recovered.’) The Dow is now up 65% from the lows of last March. Even an unexpected loss of 23,000 U.S. jobs in the month didn’t slow down stocks all that much.

Our view is that the strength of the dollar and dollar-denominated assets is mainly relative. The greenback is not the euro, and lately that’s worth something. But now is probably the right time to examine what happens to Aussie stocks and the Aussie dollar if the U.S. dollar weakens.

One asset to look at is gold. When the greenback falls, look for another move up in the gold price. Gold itself closed higher on a quarterly basis for the sixth time in a row. It was only up a modest 1.7% in the first quarter. But it’s up 27% since September of 2008, according to wire service reports. And more importantly, this sixth-consecutive quarterly rise is gold’s longest such rally since 1979.

Hmm. Take a look at the chart below. We cooked it up this morning over coffee. The red box on the left shows that the U.S. dollar gold price went up by 721% in just 41 months by the time it topped out at $850 in January of 1980. Conversely, the current move in gold is about half as much (379%) over a much longer period of time (125 months). So what’s the difference?

We’d argue that the move in gold over the last ten years is more like the move in gold between 1970 to 1974. During that time, gold was unhitched from the U.S. dollar, which was no longer redeemable at the U.S. Treasury for physical gold. The metal went up 461% in 48 months. Then it corrected. And then – when inflation took hold and U.S. interest rates hit double digits – gold peaked.

It was clear by 1974 that a global fiat dollar standard was going to be inflationary. The markets priced relatively scarce tangible goods appropriately as the supply of dollars grew. This recent move in gold has been more gradual, probably because what’s happening in the world of fiat money is less clear. But things are clearing up now, which is why we’d expect to see a higher gold price.

What’s more clear? That paper money of any vintage is increasingly garbage.

In the first five years of the last decade, it looked like the euro was becoming a serious and respectable contender as a world reserve currency to complement, or even replace, the U.S. dollar. Central banks and investors began diversifying their foreign exchange reserves to reflect the power shift in the fiat money world.

But in the last two years, it’s dawned on more and more institutional investors that the super cycle in paper money itself – kicked off in the early 1970s – may be reaching its final self-destructive peak. This is, of course, an extreme position and many people would argue against it. To accept that paper money backed by nothing is a con game is to accept that much of the prosperity of the last twenty years is phoney and that the policy makers who fix the price of money are con artists.

You don’t say that sort of thing in polite company. But it doesn’t mean you shouldn’t wonder whether or not it’s true, and what it would mean for your net worth if it was. Obviously we believe it is true. And we think the gold price is beginning to show that other investors agree. It is possible, however, that a genuine euro crisis would send the U.S. dollar higher and gold lower in the short-term.

After all, gold made a short-term high and nearly busted through US$200 at the exact time that the the Dow was making a 1974 bear market low at 577. Over the next two years the Dow nearly doubled and gold fell. By the end of 1976 the Dow was at 1,004 and gold had fallen back to just above $100.

It’s interesting to note that the gold price bottomed in 1999 about six months before the Dow made its tech boom high (in January of 2000). And today, the notable difference in the behaviour of the gold price is that it has not made lower lows as the Dow has bounced off its lows last year. Gold looks stronger and more resilient now than it did in the early 1970s when it was harder for retail investors and institutions to buy it through a vehicle like an exchange traded fund.

Fortunately, people know more about gold today and understand its investment benefits. If the Dow makes a new high, it’s of course possible gold could correct below $1,000. But either way, we expect the next down move in U.S. stocks to be bullish for the gold price.

As always, it’s complicated for the Aussie dollar. If the U.S. dollar weakens against the Aussie and the Aussie approaches parity, the Aussie gold price will probably not move up higher. On the other hand, an Aussie dollar decline would imply some strength in the U.S. dollar. And that is not exactly consistent with our view on the greenback, given the horrible fiscal picture in America. So how we make sense of the muddle?

That brings us to the merger and acquisition activity in Australia. You may have seen that gold producer Lihir received a $9.2 billion takeover offer from Newcrest over night. Lihir says the offer undervalues the company’s assets. But whether it does or doesn’t, does the bid remind you at all of the BHP and Rio Tinto shenanigans a few years ago?

That was a case of a major company feeling its oats at the top of the cycle and making a bid too far. Rio’s reaction to the BHP bid was surprisingly destructive for shareholders. The company went out and borrowed billions of dollars to buy Alcan. It did this right before the credit crisis.

Then commodity prices fell and Rio was left with a massive amount of debt to refinance. It solved the problem by selling off some assets and making an abortive merger attempt with China’s Chinalco. Shareholders got punished the entire time.

You can assume Rio’s board did not begin with the intention of destroying shareholder value. Neither did BHP. So why do big merger propositions tend to rear their heads at the top of the cycle in the commodity markets? Is it just managerial vanity? Riding high on higher production and higher prices, do CEOs want to take over the whole world?

Or is there a rationale approach that you can only achieve further growth through acquisition, and not organically? We reckon it’s a product of vanity and lack of imagination. What else are you going to do with shareholder cash at the top? You ought to probably keep it and wait to buy undervalued assets when no one wants them. But that takes patience and doesn’t make headlines or always make compensation incentives.

Yet Australia is rife with signs of firms large and small making hay while the commodity sun shines. Mid-West iron ore producer Gindalbie Metals announced yesterday an off-take deal with its joint venture partner in China valued at $71 billion. Gindalbie aims to produce 30 million tonnes of iron ore a year from its mine for thirty years and sell it to Chinese steel producer Ansteel.

A deal like this is only possible if iron ore prices are moving higher. The highest-grade hematite ores are still found in the Pilbara and mostly locked up by BHP, Rio, and Fortescue. But at the big end of the market prices definitely ARE moving higher. This has a kind of “trickle down” effect that makes smaller projects with lower grade ores or higher capital and infrastructure more economic with the higher ore price.

But make no mistake, BHP’s announcement that it secured nearly a 100% rise in ore prices from last year’s contract price AND that it’s convinced Asian steel-makers to move to a quarterly pricing system ends 40 years of doing business one way. It also has several major economic consequences investors must sort out.

First, it’s going to improve the terms of trade. That is Australia is going to get more for what it sells and pay less for what it buys. You’d expect this to result in much narrower current account deficit, which is already chronically wide. But so far, anyway, that’s not the case.

The ABS reported today that February’s current account deficit was nearly $2 billion. Exports were off one percent as coal volumes fell while imports were up 2%. It’s always a shocker that a country in the middle of a commodity boom would regularly run trade deficits.

That might change a bit as the terms of trade improve. Australia’s export volumes should grow. And with higher coal and iron ore prices, export values would grow too. It would be hard, in the absence of a credit expansion (and business credit is NOT expanding according to yesterday’s RBA release) to see domestic consumption and imports outsprint exports. But stranger things have happened.

Incidentally, what’s happening in iron ore is also happening in coal. ASX-listed Macarthur Coal rejected a take-over bid from U.S. listed Peabody Energy earlier in the week. It drove up Macarthur’s shares by double digits. And Diggers and Drillers editor Alex Cowie tells me it drove up his latest coal recommendation too. He also mentioned his two iron-ore recommendations are doing quite nicely as well.

What’s interesting about all three recommendations is that Alex didn’t make them solely on the basis that he expected higher prices for the underlying commodities these firms were out to produce. He did a good old fashioned balance sheet analysis about net cash. He found the companies, in other words, when they were relatively cheap.

It also turned out they had great resource projects that were leveraged to higher resource prices. But the healthy balance sheet is where he started his search. Keep your eyes peeled this weekend for a message from Alex about what he’s up to. If you’re a current Diggers and Drillers reader, you’ll have already read about what he’s talking about. But if not, stay tuned.

Back to the big picture. Do think the RBA may be worried that all that iron ore and coal money is going to lead to inflation in the country? If it is, the improvement in terms of trade and the new iron ore pricing structure may indirectly contribute to the case for higher interest rates. But the whole scenario shows you clearly what a two-speed economy really is.

Australia’s extractive industries are set to generate big surpluses and profits that should fuel wages in the mining sector. This won’t make Perth homes more affordable, mind you. The median Perth home price is $500,000. But the mining boom will fill government coffers and should be good for shareholders as long as it lasts.

Yet if the banks persist in importing capital to finance more housing lending, the country’s resource bounty will effectively be squandered away. The windfall coal and iron ore profits aren’t yet leading to any substantial investment in other productive industries that diversify the economy and lessen its reliance on the booms and busts of the commodity market.

And that’s the last note we’ll leave you with before the long weekend. Australia is more than ever vulnerable to a China bust. The 2007 slump and GFC had its roots in the American sub-prime mortgage crisis. Since that debacle, the Aussie economy has battled through and now, with mergers afoot and ore prices doubling, everyone thinks the good times are here to stay.

But that won’t be the case if, in fact, the world’s biggest bubble is precisely what’s driving demand for Australia’s resources. If China turns out to be a paper dragon, what will happen to Australia’s economy then? And what, if anything, can you do now to hedge against that risk?

Putting the question in the China context suggests that the shift in pricing power in the iron ore industry is temporary. A deep and liquid market for iron ore with more continuous pricing is only possible if the growth in the global steel market continues. And THAT is only possible if Chinese fixed asset investment continues to command a huge share of Chinese GDP.

But as we’ll show next week, that last bit is not possible at all. And it’s end may come sooner than you think. We’ll take up that subject in full next week. Until then…

Dan Denning
for The Daily Reckoning Australia

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Well you have to give RBA governor Glenn Stevens credit (no pun intended). He is no Alan Greenspan. He got on the idiot box yesterday and told anyone who would listen that speculating on house prices is crazy. Specifically he said that, “I think it is a mistake to assume that a riskless, easy guaranteed way to prosperity is just to be leveraged up into property. It isn’t going to be that easy.”

There are two reasons why it’s not going to be easy, although we don’t speak for the governor. The first is that he pretty clearly telegraphed his intention to raise interest rates to what the RBA considers more “normal” levels. “We can’t assume rates will remain low,” he told Seven. “The relationship between the cash rate and what they pay for mortgages or small business loans is what we think is useful.”

Useful for what? For predicting where mortgage rates are headed. And that would be higher if the relationship between the cash rate and mortgage rates persists. “If you look back when the economy was stable and we had low inflation, the cash rate, that is the rate we decide on, the rate has been in the average of 5 per cent.”

So if Stevens thinks the economy is pretty normal now with low inflation, then you’d expect the cash rate to rise from 4% now to at least 5% by the end of the year, beginning as soon as April 6th when the RBA meets again to rig the price of money (we mistakenly said they meet today in yesterday’s edition.) In February, Stevens said there was a good chance rates were headed up in the first half of this year.

When the man who sets interest rates tells you that you’re rising, it would be wise to at least hear him out. Whether you take him at his word is up to you. But if you’re making financial plans – say, like you’re going to buy a house and are trying to figure out if you can stand a few extra points rise in the interest rate – the man has told you what is going to happen.

Of course there is the chance, mentioned last week, that bank interest rates have decoupled from the cash rate. This was the possibility raised by NAB execs when they said Australia’s dependence on wholesale borrowing from overseas meant that the foreign cost of capital would determine the local cost of capital, not the RBA’s price for money. We’ll see about that.

In the meantime, Stevens has also said the RBA is watching whether or not “the role of foreign purchases [in the Australian housing market] is an important one.” We’d submit that it is. This is the second reason it won’t be “easy” for Australians to get risklessly rich in leveraged property investments. They’ll be outbid!

It’s obvious now that the Rudd government has opened the Australian property market wide open to overseas investors in order to keep the housing market bubbling along. The stamp-rich gorging state governments have not objected. The end result is a huge spike in prices that locks out Australians hoping to enter the market at the bottom end of the property ladder.

Some people might call this the government selling-out the interests of its citizens in order to prevent the bubble from popping on their watch. In fact, we just muttered that aloud to ourselves. And we’re not even Australian. But as an American, we’ve seen these desperate attempts to keep the good times rolling before. It always costs the little guy the most.

To be fair, there isn’t much data yet on how much of last year’s national price surge was fuelled by foreign buying. And let’s face it. By “foreign,” most of the media accounts mean Chinese. And you know, from a Chinese perspective, buying real Australian houses with money not subject to Australian interest rates is probably a great investment.

But whether it’s such a good thing for Australians depends on who you ask. If you’re a Baby Boomer with 3.6 investment properties that you’re counting on to fund your comfortable retirement, the influx of cashed-up foreign buyers is just what the doctor ordered. If you’re a first home buyer…well…you’re going to need a bigger grant…or be willing to live in an outer suburb…or rent for the rest of your life.

Can you see now that we have the confluence of two bubbles? The first is Australia’s fevered national pastime of speculating on property. It’s all good as long as it’s making someone – property spruikers or investors – rich. But what if it makes the Chinese rich? And what if the Chinese investment in Australian property is itself a product of China’s massive lending bubble?

As always, all bubbles come back to excessive credit growth. You have to prune away at the flowers these bubbles are decorated with. They make it look pretty, desirable, and natural. But beware!

In a great article we read over the weekend by GMO’s Edward Chancellor we found this quotation from 19th century economist John Mills: “Panics do not destroy capital; they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works.”

Has Australia over-invested in higher house prices at the expense of other national investment and productive possibilities? Let us know what you think at [email protected]

And if you think we’re making up the idea that China has exported its property bubble to Australia, well, that’s alright. Free thinking is encouraged here at the Daily Reckoning. But according to today’s Wall Street Journal, “China’s banking regulator banned new property loans to 78 companies owned by the central government in an effort to control risks in property credit and curb asset bubbles, which pose a threat to the country’s strong economic recovery.”

Urban property prices rose 11% in February compared to the same time last year. In fact, there’s a way of seeing the performance of the entire commodity sector – and by extension Australian resource stocks – as a function of China’s retreat from the U.S. T-bill market and into tangible asset markets like copper, iron ore, coal, and high-rise flats in Melbourne.

We’re taking these concerns and questions to a meeting in an hour with Diggers and Drillers editor Alex Cowie. Alex sent us a note yesterday that one of his gold stock recommendations has nearly doubled. But he hinted that there are some decisions he’s made regarding the rest of his recommendations. He’ll share those with D&D readers when he’s made them. But tomorrow, I’ll let you know what he thinks about the big picture and the China risks highlighted above.

Until then…

Dan Denning
for The Daily Reckoning Australia

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Greece is behind us (apparently) but a interest rate rise from the Reserve Bank of Australia is ahead of us (possibly). So what will Australian stocks do? And is the world still meandering its way to a systemic collapse?

You’ll pardon the sense of inevitability in today’s Daily Reckoning. After all it’s raining. But even so, with over $1 billion in Melbourne property clearing auctions this week (at a clearance rate of 86%) it definitely feels like Australians have found a way to hasten their own financial day of reckoning. Of course not everyone agrees.

“We have never reached a billion-dollar figure in a week, especially coming off a very quiet period,” says Real Estate Institute of Victoria executive Enzo Raimondo in today’s Adelaide Now. “The significance is that if it starts off like this it could be an indication the residential property market in Melbourne probably will be the same as in 2007 when we had some double-digit price growth.”

Ah yes. 2007. The year the global credit bubble began deflating. Maybe Mr. Raimondo is right. If he is, the great reflation from March 2009 could end in one big orgy of housing spending. Followed by?

President of the Real Estate Institute of Australia, David Airey told the same paper that the increases in sale prices and total properties listed reflected the “surging confidence” in the housing sector. He said that after the financial crisis, Australians were more interested in investing in property than on the stock market.

Airey says that, “This latest data shows buyer confidence in the sector, and particularly the auction system, has significantly increased clearance rates under the hammer…In every capital we’ve got strong sales and that says that the buyers – despite the likelihood of higher interest rates – are still wanting to invest in property.”

Is this a good sign? Despite rising – or perhaps because of them – you have people entering the market even when they know interest rates are rising. This is obviously a sign that investors are chasing short term capital gains. Of course, they may also think they will never get another chance to get on the property latter at these prices. But that also is the sign of a mania.

Airey reckons it’s just Australians showing a preference for property after being disappointed by stocks. “Australians have taken the lessons learned through the economic downturn and have decided this time round to put their money in property… it’s encouraging and it’s good news for buyers and sellers alike.”

It’s certainly good news for the real estate industry. Some in the industry, like Tim Fletcher of Fletchers Real Estate said that median home prices in Melbourne will “hit $650,000 in a few months and $1 million within six years….We have too many buyers chasing too few properties, and unless something drastic is done about urban consolidation and freeing up more land on the fringes it’s only going to get worse.”

It’s going to get worse. On that we can agree.

While Australians go barking mad for property, there is relief in financial markets that the can of Greek debt has been kicked down the road. European leaders, along with the IMF, arranged an aid package for Greece should it be unable to sell €15.5 billion at the end of May. Mind you, the Greeks are getting eaten alive by higher interest rates. According to Bloomberg, the yield on a 10-year Green bond is 6.19% compared to 3.04% on German securities of a similar duration.

Borrower beware! And let us not forget, Europe is filled with other sovereign nations that have equally problematic finances. They all have to borrow. And rates are going up. Who’s going to lend? And how long can the euro stay strong?

Perhaps the more important but less urgent question is how long the U.S. dollar rally can last. The Wall Street Journal is reporting that, “A sudden drop-off in investor demand for U.S. Treasury notes is raising questions about whether interest rates will finally begin a march higher – a climb that would jack up the government’s borrowing costs and spell trouble for the fragile housing market.”

“For months, investors have focused their attention on the debt crisis in Europe, but there are signs the spotlight is turning to the ability of the U.S. to finance its own budget deficit. This week, some investors turned up their noses at three big U.S. Treasury offerings. Demand was weak for a $44 billion 2-year-note auction on Tuesday, a $42 billion sale of 5-year debt on Wednesday and a $32 billion 7-year-note sale Thursday.”

If foreign central banks are losing their appetite for U.S. debt, the upward pressure on U.S. rates will be immense. We don’t think this makes the dollar more attractive on a yield basis, when you factor in how much annual deficit is growing (and how fast U.S. tax revenues are falling, and how social security payments now exceed payroll tax takings). The upward pressure on rates is going to make the Fed’s exit from the mortgage market that much more problematic.

So what’s Plan B? Can the Fed really exit the market just when rates are headed up? Is the U.S. headed for a de-facto devaluation? Do the U.S monetary and fiscal authorities – Fed Chairman Bernanke, Treasury Secretary Geithner, and President Obama – even have a plan? Or do they think things are all better? And do they think the world will keep lending to America?

Perhaps we’re over-caffeinated, but our sense is that trouble is coming. Big trouble. And soon. Party while you can. But you might think about preparing too.

Dan Denning
for The Daily Reckoning Australia

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There we were under a London Plane tree watching the sun set into a smoky sky while having a Mexican beer with some mates. Coming up Fitzroy Street on the footpath to left was a rag-tag band of people banging drums and wearing orange robes. On the right, stuck in traffic and puffing on cigarettes was a van full of tired looking men wearing Ferrari shirts and staring at the scene. See below for what happened next…

What happened overnight in the market was just as interesting as the goings on in St. Kilda on the eve of Melbourne’s Formula One race. For one, bond yields are moving on up in the United States. The ten-year bond yield jumped again after putting on 17 basis points the day before.

Equity strategist Peter Boockvar at Millar Tabak told Bloomberg that “The U.S. Treasury market has gotten slammed over the past two days. This is the last thing a fragile economy needs because yields aren’t spiking because all of a sudden the U.S. economy is great again.”

Good point. So why are they spiking? Bonds have been a 30-year bull market. Is that topping out? We thought it was a few years ago. But when the Fed slashed interest rates beginning in 2003 to reflate the dot.com bubble (and unintentionally cause a housing bubble) bonds went on a tear again. Now, though, it may all be ending.

For one, as we pointed out earlier in the week, some corporate bonds are yielding more than sovereign government bonds of the same duration. Maybe that’s anomalous. As David Goldman of Bank of America pointed out in a Barron’s article, if the government needs more money to pay higher interest rates, it can just raise taxes. Corporations, on the other hand, do not collect their revenue at gun point.

We think Mr. Goldman may have a bit too much faith in the ability of governments to keep raising taxes without seriously undermining business investment. What’s more, people are getting tired of paying higher taxes to bail out financial companies and/or to pay for public pensions. And that’s before a huge increase in government spending on the boomers as they get older. You’ll have fewer and fewer workers supporting more and more retirees.

That leaves already damaged public sector finances in an even bigger lurch. They’d face rising interest payments on debt outstanding as well as rising payments to the elderly and the retired. It doesn’t leave room for much else in the way of spending, does it?

“The sharp uptick in Treasury yields may indicate something more fundamental – that the bond market cannot absorb an infinite amount of even U.S. debt without a price concession,” writes Randall Forsyth. Rising U.S. bond yields will trigger a lot of global consequences, including right here in Australia.

Keep in mind that governments in the U.S., U.K. and Japan will have to refinance trillions in debt in the coming years. And that’s not including new borrowing. In other words, they’re going to gobble up a lot of capital. Australia’s banks (and its government) have to compete in that global capital market.

This prospect makes the rosy conclusions of yesterday’s Financial Stability Report from the Reserve Bank of Australia a bit premature, in our opinion. In its summary, the RBA wrote that, “The Australian financial system remained resilient through the crisis period and, in aggregate, banks experienced only a relatively shallow downturn in underlying profits. ” This all sounds positive, so far. But what about the loan portfolios?

“The quality of banks’ housing loan portfolios has proven to be very high by international standards, notwithstanding a modest increase in loan arrears. There has been a more significant deterioration in the quality of banks’ business loan portfolios, particularly for commercial property, and this remains an area to watch closely in the period ahead. Nonetheless, recent indications are that banks’ overall loan losses may have peaked and that profits have again begun to increase.”

Yes, banks profits are just fine, thank you very much. But we’re not entirely convinced that the banks are out of the woods on their commercial property loans OR their housing loans. The fact that Australia’s residential housing market is the only one in the Western world not to see a major decline tells us that it’s overdue, not that it’s impossible.

But that’s an old debate and we won’t rehash it here. One interesting note was the RBA breakdown on bank assets held overseas, especially in Europe. You can see from the table below that Aussie banks have $56.4 billion in assets held in various European investments.

We’re not saying a euro crisis would render all those assets worthless, or that $56.4 billion is a balance sheet killer (especially since that amount is spread out across all the banks). But between Europe, New Zealand, and the U.S., Aussie banks have an awful lot of foreign assets. How are those going to hold up in a global currency/credit crisis?

And speaking of Europe, is it reaching a tipping point? The Continent is at war with itself (verbally for now) over how to bail out Greece. Should the IMF be involved? Overnight, European Central Bank President Jean Claude Richet came out against it. It’s now clear that nothing is clear.

On CNBC, via Zero Hedge, we learn that Phillip Mancuda, head of investment at the ECU Group, puts the Greek situation even more directly: the only thing that can save the euro now is a dollar crisis. “Trichet said the Greeks are crooks, and they’ve been lying about the numbers. There is a deeply embedded corruption within the Eurozone,” he said.

“Combined with the endemic European socialism and there is just no way you are going to get spending cuts and tax raises and maintain a GDP that makes any sense of the percentage aspect of debt to GDP. So the whole show is wrong. This is an intractable situation. This is going to continue on and on. The only hope for the Eurozone, and the Euro as a currency, is that someone takes the spotlight soon, and that may be the United States.”

Hmm. So which will go first? The dollar or the euro? The financial markets are telling us the Euro. But really, the question is not entirely financial. The question is this: will bad fiscal and monetary policy lead to a social crisis and civil instability in the US or Europe first? In Europe, the Greeks in the streets could be joined by others.

In the States, we’ve been saying privately for the last year that this year’s mid-term elections in the United States could see the first non-peaceful transfer of Federal power in a long, long time. The healthcare debate has gone beyond the ins and outs of good policy to ignite a kind of anti-Federal distrust that we think has always been part of the American political character.

And of course, the United States was formally a union of separate States, rather than a large homogeneous Federalised entity. It’s entirely possible that this voluntary union is coming under the kind of strain that won’t leave it unchanged. After all, if other large institutions (made possible by cheap money, cheap energy, and cheap labour) are having trouble adapting to this new world, why would America be left unchanged?

None of this was probably on the minds of the Hare Krishnas chanting their way up Fitzroy Street at sunset. They looked pretty happy singing their song. And most people smiled as they passed.

Hare Krishna Hare Krishna

Krishna Krishna Hare Hare

Hare Rama Hare Rama

Rama Rama Hare Hare

“Hey what does that mean anyway?” our friend asked. “What are those guys all about?”

“I don’t know. Krishna is a Hindu god right? Or is it Vishnu. Or Ganesh? I don’t know much about it.”

“You’d probably better learn.”

But just then, on the right, a car full of Italians pulled up and stared sullenly at the Hare Krishnas. They had a Ferrari logo on their van and were wearing the red shirts of the Ferrari F1 team. They looked exhausted and expressionless watching the world pass by.

“They know the Red Bull car is faster,” our friend said. “But they don’t look very happy do they? Maybe they should hook up with the Hare Krishnas. That’s it! It would be a great team. Ferrari Krishna!”

Silence.

“What are you talking about? Those Italians probably know the euro’s made a ten-month low against the dollar. They’re probably wondering what their country is going to be like when they get home, and if their money will still be good…and maybe if they should buy some gold while they’re here in Australia.”

“Not that again! I’m going for another beer. And so are you.”

“Okay.”

By the way, after some study this morning, we learn that the Hare Krishnas pursue “a higher consciousness taking the form of pure love.” And their god Vishnu is, “He who removes illusion.”

The world could use a little more Vishnu right now. And more cowbell.

Dan Denning
for The Daily Reckoning Australia

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Rumble rumble rumble. Do you hear that? It’s the sound of over-leveraged financial organisations beginning to crumble. Of course, by crumble, we actually mean “forcibly confront fiscal reality.” It is not the end of the world. But it is, as Bill says in his article, the end of the world as we know it.

Ratings agency Fitch began the rumbling when it downgraded Portugal’s sovereign credit rating to AA and changes its outlook on the Iberian nation to negative. Analyst Douglas Renwick wrote, “A sizeable fiscal shock against a backdrop of relative macro-economic and structural weaknesses has reduced Portugal’s creditworthiness… Although Portugal has not been disproportionately affected by the global downturn, prospects for economic recovery are weaker than 15 European Union peers, which will put pressure on its public finances over the medium term.”

Europe’s monetary failure is bringing about a fiscal crisis, and probably a social crisis too. The Euro not only made 10-month lows against the dollar. But the viability of the common currency (one interest rate, many fiscal policies) is now being openly questioned. And in Greece, rising interest rates are already consuming the savings made by emergency budget cuts.

It’s a real pickle. Actual monetary contraction may be politically impossible. What elected official is going to slash and burn the public budget? But continued fiscal expansion is equally impossible if you can print the money you borrow in. No one in the European Monetary union can print money to effectively inflate their way out of the crisis. So the crisis persists.

By the way, one quick point. We get lots of letters telling us we’re an idiot. And many of them point out that a country that prints the money it also borrows in (like the United States for example) cannot default on its bonds. It can always pay back bond holders with new money.

Yes. That’s true. But money-printing is a de-facto devaluation of the currency against real goods. It’s inflationary. And ultimately, rampant money-printing destroys purchasing power. An outright default is also the end of the fiscal road. But in terms of outcomes, there is not much difference between default and inflation.

Or is there? Perhaps a default would be a quick and painful realignment…whereas an inflation would be far more weatlh destructive. We’ll find out soon enough. Greece isn’t going away. And Portugal won’t be the last to be re-rated by the agencies.

“Isn’t it great that 30 million people in America now have health insurance?” we were asked by a mate at the pub last night. “Yeah. But who’s going to pay for it?” we asked (it was a genuine question).

“I don’t know,” he conceded. “But it’s nice to see America joining the civilised family of nations. You should be proud of your government. It finally did something nice for the little guy.”

“That it did. The whole progressive project is finally capped off. But I still have no idea who’s going to pay for it. You can have an idealistic vision of what kind of country you want to live in. And you can make people pay for it with higher taxes. But it doesn’t mean it’s going to stand up to economic reality. Just seems like weird timing to me…the whole welfare state system is proving that its financial model is defunct…and America’s politicians expand it. Only in America!”

By the way, new home sales in the U.S. hit their lowest monthly level since the figures began being kept in 1963, according to the Commerce Department. New home sales fell 2.2% last month and the inventory climbed again. It’s yet proved more that America’s over-investment in housing is going to take years to recover from – both at the household level and the bank level.

But what about Australia’s over-investment in housing? Did you hear Don Argus in today’s Age say that Australia’s banks are becoming “giant building societies?” He was making – but far more succinctly – the same point we made yesterday: the banks have over-invested in residential housing. Commonwealth Bank has 60% of its loan-book tied up in housing and Westpac’s is over 50%.

The additional trouble with that is that it deprives the rest of Australia’s capital-intensive resource businesses of the capital they need to increase production and exploration. Hence, smaller Australian companies like Moly Mines selling off equity to Chinese funding partners. Molybdenum is not, apparently, as safe as houses.

And that’s fair enough. Banks are in business to make money loaning money. They are not compelled to loan money to the mining industry because it’s in the national interest that the benefits of the resource industry go to Australian shareholders. The banks have their own shareholders to look out for.

But those shareholders should ask around and start thinking about whether the banks are over-exposed to Aussie houses. It seems obvious to us that they are. But as many readers tell us, we’re an idiot. So maybe it’s not so obvious…

Speaking of Chinese investment in resource projects, a previously announced $60 billion LNG deal in Queensland was confirmed yesterday. China National Offshore Oil Corporation signed a 20-year contract to buy LNG from Britain’s BG Group. Technically, it’s coal-seam-gas from Queensland’s Surat Basin.

These are the kind of deals you can probably make money on. But as we’ve said before, you have to be early. Once the projects are “de risked” and final investment decisions are made, the smaller stocks tend to be fully valued. At that point, you’re essentially buying producers. And producers are valued differently than explorers, developers, or prospect generators.

Finally, have a look at this if you get a chance. It shows that the average annual return on a super fund was 3.6% in the five years ended in June of 2009. Over the past three years – and this excludes most of the big recovery since March of last year – the return is 2.3%. And can you guess what the best performing in house corporate super fund was over the last five years? Go on….have a guess.

It was the in-house staff superfund of GoldmanSachs JB Were. That fund delivered annualised returns of 9.6% in the survey period. Not bad huh?

Dan Denning
for The Daily Reckoning Australia

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In today’s episode of the Daily Reckoning, some important questions about banking – especially the loan books of Australia’s big banks – are asked. You’ll also read why small Australian resource explorers are headed to Africa instead of WA. And more evidence that Chinese real estate speculation has lost its blob.

But first, we’re going to take the 18-month highs on U.S. indexes as a sign that everything is stuffed. The reflation strategy of the Fed has pumped up stocks. But we’re going to take the opposite side of the trade and proceed under the impression that the rally is bogus and rigged. If want the official line, pick up a newspaper.

The first big issue today is property. Residential housing is still doing its best impression of a slow-motion implosion in the U.S. Existing home sales fell for the third straight month, according to government data. Median prices fell to a tidy US$165,000. The sales level was at its lowest since last July, with 8.6 months of supply (3.59 million units) overhanging at current sales rates.

It’s hard to see how that’s going to get any better with high unemployment, tougher lending standards, and higher 10-year Treasury rates and 30-year mortgage rates as the Fed exits from its Quantitative Easing Program. But maybe Congress can pass a new law.

Of course none of this matters to Aussie property bulls, right? There is no inventory overhang here. There is, so it’s claimed, a structural shortage of supply. And in psychological terms, it’s possible the national infatuation with housing (exhibiting all the signs of a mania) is just no reaching its ridiculous phase.

You can tell by the amount of property and credit porn that is beginning to show up on television. Last night we say an advertisement for a new show that promised to show investors how to turn beaten-down properties into rivers of gold. A new coat of paint, some feng shui, and a well manicured hedge were all featured suggestions.

This is exactly the sort of garbage we saw on air in the UK and the US at the height of the boom. But they’re really just tricks and gimmicks to convince people that cosmetic changes to a property would translate into tens of thousands of dollars of pure, low-taxed, capital gains. You’d be an idiot not to tune in.

While the mood of the property market turns deeply bubbly, the guts of finances are increasingly mushy and constipated. Just two lenders – Westpac and Commonwealth Bank – hold 50% of all outstanding mortgages in Australia, according to CoreData’s Q1 Australian Mortgage Report. Like in the rest of the world’s financial system, risk is being concentrated in fewer and fewer large institutions.

CBA owns 25.9% of the national market. And as we mentioned in February, it took advantage of the GFC to grow its property loan book massively. Westpac – with 24% of the market in 2009 – did the same thing.

But the banks have a problem now. And Westpac’s leadership knows it. Yesterday’s Australian Financial Review has a front page story with the headline “Westpac tips five years of rate rises.” In that article, Westpac’s Ted Evans says that the main drive of interest rates in Australia my no longer be the RBA cash rate but the cost of borrowing money on the wholesale international markets.

Uh oh.

Why would it be true that the domestic price of money has less influence on bank interest rates than the cost of wholesale funding? Well, because Australia is a capital importer. The banks borrow internationally to lend locally. That’s what’s powered the housing boom here in Australia.

The loan books of Australian banks are growing faster than deposits. Bank loans outstanding total $1.6 trillion and are growing at 8% per year while deposits of $960 billion are growing at 5% a year, according to John Durie and Martin Collins in the Australian. If Aussie banks want to keep lending, they’ll have to keep borrowing abroad.

The trouble with that is that foreign borrowing costs are on the rise. Between 2011 and 2014, Durie reckons over $650 billion in leveraged loans will have to be refinance by Aussie banks. With so many governments borrowing money right now, Aussie banks are surely going to have to pay more to borrow from abroad. They’ll be able to refinance, but probably a higher price.

That higher price of refinancing old loans and getting new ones is why Westpac reckons it’s going to have to raise interest rates independent of what the RBA does. If the banks can’t loan from deposits (since loans are growing faster than deposits) they’ll have to squeeze existing borrowers with higher rates. And you know who we’re talking about.

Homeowners. Or, to be precise, mortgage owners. Because of the reliance on foreign funding at a time when the global cost of capital is headed up, Aussie banks are going to put the screws to all those newbies who got into the market with the First Home Buyer’s Grant.

The yoke of debt may have felt light until now. But the lash of higher rates on the back will definitely be noticeable. Let’s just hope it doesn’t break the financial back of a whole generation of home buyers, although this is what we fear “bringing forward demand” will do. It brought premature buyers into the market that will not be able to survive in a world of higher interest rates.

A quick note about yesterday’s conversation of converting debt into equity. It’s not new, as we mentioned. But what is really going on both structurally and conceptually?

Well, structurally, converting debt into equity turns a secured or unsecured creditor into a shareholder. Instead of having a claim on the company’s actual assets in the event of liquidation – what secured creditors are entitled to – equity investors get nothing. So why would you agree to restructure your ownership claim if it disadvantages you?

The answer, we think, is that it’s better to get a little of something than all of nothing. A loss is not a loss if you turn debt into equity. In other words, the alchemy of converting debt to equity is acknowledgement that the value of the asset is bogus. Instead of taking a total loss on your capital, you instead restructure your claim so that you get a piece of any future cash-flows or earnings the company or asset may generate. You also get to vote as a shareholder.

So, in a way, accepting equity rather than demanding repayment of a debt is a fundamental restructuring of your investment expectations. You are partially admitting you didn’t get what you paid for and that you may not be made whole on your original capital investment. In other words, it’s a nod to reality and a beginning of the liquidation of mal-investments made in the boom.

The sham, though, is taking debt and forcing the taxpayer to become an equity investor through some government designed Franken-corporation. This is what we expect to happen in the U.S. It’s not impossible that it could happen in Australia too, someday. The AOFM is buying billions of mortgages originated by second-tier lenders. If those debts go bad, they could someday become public equity too.

And while we’re on the subject of red ink and red tape, did you see Monday’s AFR piece on Aussie firms who are moving to Africa to do their exploration? “The difficulty of getting projects up and running in Australia now is immense compared with Africa, where they have more the attitude that Australia had in the 1960’s and 1970’s,” says Paladin Energy managing director John Borshoff.

Nicole Hollows, the CEO of Macarthur Coal, says “For equity markets, why would you want to invest in Australia? Queensland has already increased its royalties and so has NSW, and now [with the Henry review] no one knows what the royalty structure will be…We developed Copabella [coal mine] in 15 months in 1998. You couldn’t do the same project in less than five years now.”

Incidentally, the long-lead time in getting new mines up and running is one reason why sudden spikes in demand can lead to a supply shortage in key commodities, despite big projects in the works. This is something Alex Cowie has been looking at in Diggers and Drillers. With some commodities (like uranium) you only get a share that’s sensitive to price movements in the underlying commodity if the company is actually going to be producing in five years.

But back to the development time and the “green tape” of environmental regulations. Maybe it’s progress (confusion at a higher level, according to aviation genius John Boyd). That is, it is probably easier to take less heed of the environment by doing business in Africa, where governments might not protect it as much.

Even so, Australia’s growing jungle of policy requirements and hazy transparency on royalty taxation are making it a less desirable and easy place to do business. That’s despite some world class ore bodies and abundant supplies of key commodities the developing world needs, like coal and iron ore.

So are the policy wonks at the State and Federal level going to blow it? Are they going to take Australia’s resource endowment for granted because they believe that no matter how difficult and costly it is to extract out of the earth, foreign investors will keep on queuing up because they have no other choice?

As Bill has pointed out, Great Empires and large institutions invariably find a way to seek their own destruction. From Rome to Tiger Woods, nature seems to abhor a hyper-power. So a word to the wise wonks of Australia: don’t squander the boom!

In the meantime, Alex has stocked up the list of recommended stocks in D&D with Aussie-listed companies who have found great resources in Africa. It doesn’t hurt that their capital and operating costs are usually done in U.S. dollars. His latest research came across my desk last night and should be published to D&D readers tomorrow.

Finally, imagine a quaint British village with little replica steam engines, statues of Winston Churchill, Marry Poppins, and Harry Potter…faithfully reconstructed on the other side of the world in China. That’s what this article about Thames Town in Shanghai describes. The only detailed touch missing? People!

If there was ever proof that China’s productive boom is the largest off-shoot of the global credit bubble, it’s this. Of course that makes the demand for Australian resources itself – this great commodity boom since 1999 – derivative of the credit bubble too. Hmmn.

Dan Denning
for The Daily Reckoning Australia

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How about that? A day after land-mark healthcare legislation passed the U.S. Congress, stocks in New York made a 17-month high. The market likes it when uncertainty is lifted from the horizon. It’s now clearly all down-hill from here.

We jest. Back in Baltimore earlier this month, at dinner, it was argued by one and all that stocks might be a good bet to beat inflation. Or, put another way, if you’re going to beat inflation, you’re more likely to beat it in stocks than cash.

This is not a value-based argument. But it IS an argument for why nominal gains in stock markets are not inconsistent with rampant or even hyper inflation. We’re not saying that’s what’s going on right now. And of course, in our one-two Big Crash dance card, asset deflation precedes the Melt Up.

But it’s hard to call the rally since last March’s lows anything else but a melt-up. Stocks aren’t cheap now. And they are pricing in a lot of future earnings growth. In a world where the private sector and businesses are deleveraging and where credit growth – excepting the public sector – is shrinking, the fuel that generates earnings and income growth is running out.

Not that sovereign bonds are any safer. Another point that came up at our dinner earlier this month is that certain high-quality corporate bonds would be better bets than certain faltering sovereign bonds. Or as Bloomberg reports, “The bond market is saying that it’s safer to lend to Warren Buffett than to Barack Obama.”

If you judge executives by their ability to deliver regular and outstanding returns on equity and capital, the above point is self evident. Buffett has a long track record of delivering high returns on net tangible assets. This partly explains why the yield on two-year notes sold by Berkshire is 3.5 basis points lower than the yield on a two-year U.S. Treasury note.

Buffett generates cash from his assets and borrows sparingly for sensible acquisitions of good businesses which he has meticulously valued (most of the time). The Federal Government is not a corporation. But its chief asset is probably its tax slaves, whom it is currently in the process of flogging for more money to pay for more new programs which the country can’t afford.

The trouble is, as Moody’s points out, when you flog your tax slaves in order to simply pay interest on money you’ve already borrowed, you move “substantially closer” to losing your AAA credit rating. Moody’s predicts that, “the U.S. will spend more on debt service as a percentage of revenue this year than any other top-rated country except the U.K. America will use about 7 percent of taxes for debt payments in 2010 and almost 11 percent in 2013.”

Does this mean short-term capital flows – as Greece plays out in slow motion – will favour dollar-denominated assets that are a) not long-term government bonds, b) are stocks ? We’ll see.

Yesterday we promised to look at how Australia fits into all this. The easy answer is that Australian capital markets remain a yield and risk play. When risk appetite is high, capital flows to Australia’s relatively higher-yield currency and its commodity related stocks. Australia’s stock market has all the upside of an emerging market but without the political risk.

But when investors get nervous and flee home to the U.S. dollar, what happens then? And when U.S. and U.K. banks get into capital self-preservation mode, doesn’t that leave Australia in the vulnerable position of being a capital importer in a world where the cost of capital is going up? Will the Big Four be able to borrow? And in a second credit crunch, will China still want Australia’s resources?

Frankly we don’t have the answers to all those questions, although you know our views on all of them. For now, the whole thing makes us nervous. And if the bulls are happy to rush in where nervous angels fear to tread, more power to them.

And let’s not forget the elephant in the room: property. We’re somewhat shocked with the ferocity of the housing bulls. They have a lot invested – emotionally and literally – in the idea that everyone in Australia is going to be a property millionaire because of immigration and the “supply shortage.”

For a different take on the matter, do yourself a favour and read Tim Colebatch’s article in today’s Age. He makes the simple point that negative gearing encourages investors to take on debt and buy new properties in order to make capital gains which are taxed at a lower rate than income. The net effect of the law has led to a debt boom and the misguided assumption that prices always rise.

“But it won’t happen,” Colebatch writes. “Melbourne house prices have trebled since 1997, not because our incomes trebled, but because we paid those prices by a massive increase in debt. In the 20 years to January 2010, household debt to the banks grew 10 times over, from $118 billion to $1224 billion. As a share of our disposable income, they more than trebled, from 45 per cent of what we earn to 156 per cent.”

“If we want house prices to keep growing at that pace, we’ll have to keep going deeper into debt at that pace – to more than $4 trillion by 2020, or more than three times our income. Any volunteers?” Even with more grant gimmicks and subsidisation of the mortgage backed security market, you’d have trouble expanding debt by that much.

Landlords might not mind taking a net loss on rents if they’re going to clean up on capital gains. But if that’s the case, then it’s clear the Australian housing market is dominated by the idea that buying and selling houses is the best way to get rich quickly in Australia. That leads to speculation, reckless lending and borrowing, and an inevitable bursting of the bubble. You can’t pay infinitely higher prices for what is essentially a consumption asset.

But what would trigger the whole thing? We reckon it’s when the capital dried up – which is largely an external problem. That’s why we spend so much of our time here trying to suss out what’s going in global capital markets.

Locally, the government is still supporting the mortgage market. And maybe it always will, and will go to even greater measures if it has to. But it’s worth noting that the securitisation market – where lenders sell low-doc or higher-risk loans to investors – is still on life support.

True, Lucey Battersby at the Age reports that Macquarie Securitisation managed to sell $500 million worth of low-doc loans via its Prime Masterfund S-8 vehicle. That doesn’t sound dangerous at all, does it? To be fair, according to the article, only 46% of the loans making up the fund have lower approval standards. That means S&P was happy to give the whole bond issue a AAA rating, except for one particular $180 million tranche “for which the rating was not revealed.”

“Right. It’s excellent for the most part, except for the stuff we’d rather not tell you about. Shall I wrap that up for you?”

The buyers were “undisclosed private institutions.” Let’s hope it’s the Future Fund. Or Super funds. With an average loan-to-value ratio of 72%, it’s not quite as worrisome as the LTVs of 90% + that you saw in the States at the height of the boom.

But financial firms are back in the business of selling mortgage debt to investors. All is right with the world again. What could possibly go wrong from here?

Dan Denning
for The Daily Reckoning Australia

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Gold, oil, stocks…you name it. Pretty much everything was down on Friday in the States and the Dow broke its eight-day winning streak (still on light volume). Do you wonder how the market will react if the U.S. House of Representatives passes the Senate health care bill? Hmmn.

Say what you’d like about the proper role of government in your life. But no matter which way your politics lean, it’s clear that making expansive social promises is an expensive business. Someone has to pay for these things. Whether it’s business, rich people, or the unborn children of the next three generations (debt), someone has to pay.

It does seem a little odd that America is expanding the Social Welfare State at just the moment the whole experiment seems to be collapsing in Europe. It’s amazing no one is taking Greece more seriously. It’s as if investors and pundits are convinced this is just a run of the mill deficit problem and not an indication that the finances of the Welfare State are hopelessly compromised and failing.

Perhaps fiscal collapse lies in the eye of the beholder. But we reckon it’s a more tangible phenomenon. Either your finances are sound or they are not. Either your money is sound or it is not. Come to think of it, either your civilisation is sound, or it is not.

That might sound like hyperbole. But according to America’s self-described “#1 political prisoner” Martin Armstrong, the Western world’s fiscal malfeasance has left it trapped between two equally undesirable but unavoidable outcomes: default of civil unrest. We are at the pointy end of the crisis (Phase two as he describes it). Yet very few people seem to appreciate what’s actually happening.

In his latest missive, Armstrong points out that the structure of the European Monetary Union – twelve economies, twelve difference fiscal policies, one interest rate – made this day inevitable. “The EC is in dire position and a debt crisis at [the] sovereign level and the CFTC move to limit currency trading by the public from 100:1 to 10:1 can cause a liquidity crisis that backfires, magnifying everything.”

You have to unpack Armstrong’s analysis a bit to see what he’s getting at. This is just our interpretation. But we think he’s suggesting that the sovereign debt crisis in Europe will lead to rising interest rates (borrowing costs) in the debtor countries. He says the interest rate rises will “cause only an outflow of national wealth.”

That is, faced with a sovereign fiscal crisis, investors in Europe will head for the exits and take their money with them. This would explain (and predict) a short-term U.S. dollar strength. But this reaction is also just the sort of thing government’s want to avoid. And they can begin to do so with capital controls and restrictions on cross-border currency transactions.

Hence the move by the Commodities Futures Trading Commission above, mooted in January, that would reduce retail leverage from 100:1 to 10:1. The target here is currency speculation, although one wonders why the retail investors are the target and not institutions. Besides, is excessive leverage in currency trading really the cause of the Greek crisis?

Armstrong fears capital controls and reduced leverage could create a liquidity crisis. “I have burned my brain raw trying to come up with a solution. But there is only one! A complete restructure that is a debt for equity swap. Debts will never be paid and interest expenditures are the greatest transfer of wealth in history. This is causing rising rising taxes in all areas from Europe to the US, suppressing economic activity, fuelling higher unemployment and civil unrest. Western society is falling apart.”

It may not look or feel that way if you’re dialled in to American Idol or getting your Dream Team ready for the footy season. But Armstrong has many points worth considering. For starters, he makes the deflationists point that in a world with too much debt, the only instruments that can cancel that debt are worth buying.

As we understand them, this is the main reason the deflationists are bullish on the U.S. dollar and near-cash U.S. Treasury notes. On the other hand, Professor Antal Fekete, whom we had the pleasure of meeting at last year’s Gold Standard Institute annual conference in Canberra, reckons that “gold is the only ultimate extinguisher of debt.” This is presumably why central banks have been net accumulators of gold recently.

Whether the dollar rallies or gold rallies, or the dollar crashes and gold rallies, or everything falls..it’s clear that something has to be done with the debt. There are no more rugs large enough to sweep it under. Europe needs a bigger rug.

The rug that just might conceal the debt problem is the debt-for-equity swap Armstrong refers to. This is a bit like the “bad bank” we mentioned recently for the U.S. mortgage market. But building a new institution of the transmogrified debt of an institutions or a government is not exactly cutting edge financial alchemy. It’s old school hokus pokus.

The South Sea Company was capitalised with nearly £10 million in British government debt which was then resold as interest-bearing units to investors. Voila! Debt becomes equity becomes capital. The government got its debt financing in exchange for trading concessions in South America granted to the company. This is what investors expected to produce huge returns, and what generated a premium (bubble) in the company’s shares.

How would a scheme to convert sovereign debt or mortgage debt into equity work today? Who knows? Only the government would be stupid enough to buy shares in a company capitalised by bad debts. But we live in such times. So it’s not a huge leap to predict it will happen.

The shareholders will be the “public.” And the securities will be backed by the underlying assets (houses, or the government’s promise to pay.) The interest will be paid in some new scrip, or in America, perhaps by a new GST or VAT. If the Fed or Europe can pull out a debt-equity swap that cleans up bank/national balance sheets without undermining currency confidence or leading to spiralling interest rates, it will be the greatest magic trick ever.

But if not?

“If we do not act, civil unrest will explode,” Armstrong finishes. “The current choice is default or higher taxes and civil unrest…As Europe weakens, the dollar, Dow, and Gold would rise. When the debt concerns then turns to the US, the dollar will get hit only then.”

So there is no dollar crisis yet. But if you care to acknowledge it, there IS a EURO crisis. And if you think we’re just wearing our tin-foil hat today, keep in mind that IMF Deputy Managing Director John Lipsky has also warned that the finances of the fiscal welfare state are not exactly healthy.

In remarks delivered in Beijing and reported by the Wall Street Journal, Lipsky said the advanced economies need to begin reigning in deficits now, even if economic recovery remains in doubt. He said that, “Merely winding down the stimulus won’t come close to bringing deficits and debt ratios back to prudent levels, considering the projected increases in health care and other entitlement spending.”

What does this mean for Australia? Stay tuned to tomorrow’s Daily Reckoning for the exciting details. Until then…

Dan Denning
for The Daily Reckoning Australia

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“Happy families are all alike,” wrote Leo Tolstoy in Anna Karenina, “every unhappy family is unhappy in its own way.” Today’s Daily Reckoning looks at the unhappy family of nations in Europe and their coming family feud. Each is definitely unhappy in its way.

Yet there is a common thread to the current state of economic melancholy. It’s money. Most failed marriages, we’ve heard, end up breaking up over money. Why would Europe or America or Australia be any different?

But before we get into family counselling, let’s have a look at markets. Over in America the Dow Jones Industrials Index has closed at its highest level since October of 2008. The Dow sits at 10, 979 and has risen eight days in a row. Woop woop.

The volume figures on the Dow, however, show a disturbing lack of faith, or conviction if you prefer. The chart below shows the Dow since the March 9th low of 2009. It’s been a pretty steady rise since then. But you can see that average daily volumes are less than half of what they were when the low was made a year ago. What does it mean?

“It’s bearish. That’s what it means,” said Murray when we ambled over to his desk to show him the chart above. “It means there’s a general lack of conviction by buyers. You’d want to look out below.”

Where are all the buyers? Is the market just drifting higher based on programmed money flows by institutions? Granted this is an index of just thirty U.S. stocks. But it shows you that once you go below the surface of the index levels, the waters in the market are eerily calm and not frothy at all.

The other point about this is that in market-cap weighted index, a few key constituents can account for big day-to-day moves. For example, the table below from Standard and Poor’s shows the top ten weightings in the ASX/200. The financials and the miners dominate, with property, telecom, and consumer staples all making cameos.

In other words an up or down move in BHP or Commonwealth Bank has a bigger effect on the direction of the index based on the size of their respective market capitalisations. That sounds like gobbeldy gook. But the takeaway is you should beware light volumes and indexes whose higher movements are driven by just a few stocks. It shows a lack of breadth which can turn quickly and result in big sell off.

Now, you probably don’t want to talk about this. But we need to talk about Greece. Its on-again, off-again bailout flirtation with the European Union is driving the market nuts. Its reality sovereign debt finance theatre at its most dramatic. But what, really, is at stake?

The European monetary family is in crisis. It meets on March 25th and 26th to discuss whether to kick Greece off the island (survivor style) or to intervene and save the prodigal son. The problem, from a German perspective, is that Europe is full of prodigal children. To save Greece means to save the rest of the economies troubled by rising public debt-to-GDP ratios. Where will it stop? With the trashing of the euro.

But is doing nothing an option? The Greeks have already said they will meet with the IMF on April 2nd if Europe resolves nothing by the end of March. And in the meantime, bond yields on Greek debt are left twisting in the wind. Rising bond yields wipe out the benefits of austerity measures and deficit reduction.

According to Bloomberg, “The yield on Greece’s 10-year government bond rose 12 basis points to 6.21 percent. The euro fell for a second day against the dollar, slipping as much as 0.7 percent to $1.3648. Credit-default swaps on Greek sovereign debt rose 7 basis points to 295, the highest in a week, according to CMA DataVision prices.”

It’s hard to imagine the Northern European powers hanging Greece out to dry. Families are supposed to look out for each other. You do more for your family when the chips are down than you do for most people in the world. But maybe Greece will spare Germany the hand-wringing and default on its own….just throw up its hands and shrug.

The willing default on sovereign debt is what Societe Generale analyst Albert Edwards expects. In a note to clients earlier this week Edwards wrote, “Ultimately, as my colleague Dylan Grice writes, I think we head back to double-digit inflation rates as governments opt to default. I certainly again expect to see CPI inflation above 25% in the UK and indeed in most developed nations in my lifetime.”

This is the old “asset-deflation-first-then-hyperinflation-later” two-step. It’s the Big Crash dance, with the Bernanke/CNBC orchestra providing mellow tunes as your promenade your way to the lifeboats. Edwards writes that, “In the near term, however, the deflationary quicksand will suck us ever lower until we suffocate. A key driver for underlying inflation remains unit labour costs. While unit labour costs decline at an unprecedented rate, they are sucking us inevitably into a Fisherian, debt-deflation spiral. Only then will we see how far policymakers are willing to go to debauch the currency. Last year saw them cross the Rubicon. Monetisation is now the policy lever of first resort.”

Some readers think we’re trying to have it both ways on the inflation/deflation debate. But it is one of the issues you have to be flexible about and be willing to go both ways on in order to keep your money safe. Prepare for falling asset prices and a sovereign debt crisis. And then watch out as central banks reach out and take us to strange new monetary places and boldly go where Weimar Germany and Argentina have gone before.

Buckle up buttercup.

Dan Denning
for The Daily Reckoning Australia

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