Author: Dan Denning

Contrary to our prediction, shares of the Commonwealth Bank fell yesterday. A $2 billion profit was not enough to please everyone. But mostly it was the bank’s $1.20 dividend that appeared to disappoint the crowd, even though it was a six percent increase.

Outside Australia, all eyes are on Greece. According to Bloomberg, Germany and France want the Greek government to make concrete budget cuts before organising a bailout. Of course it’s not just the Greeks that have a lot to lose if a deal isn’t found. A lot of bondholders (banks) will lose too.

But the biggest loser of all is Europe’s common currency itself. Monetary union in Europe was always an experiment. It got rid of all the old colourful paper currencies in Europe and replaced them with impressive looking new paper notes. It also made the euro a reserve currency to rival the dollar.

It now looks, though, like Europe’s experiment with paper money may go up flames even faster than the U.S. dollar, which is an impressive achievement. Twelve economies, one interest rate policy, high government deficits as a matter of course….it’s a mess. It makes high-yielding commodity currencies like the Aussie dollar and the Canadian loony look downright sexy.

One perverse irony of the Euros woes is that it might be good for the U.S. dollar. Still, the bond markets are telling us that the world is fed up (or over-fed) with U.S. debts. Dow Jones newswires reports that an auction of $25 billion in 10-year U.S. notes “did not go particularly well.” It doesn’t bode “particularly well” for an auction of $16 billion in thirty year bonds set for later this week.

Even though the 10-year auction was over-subscribed, this kind of action suggests higher yields (borrowing costs) ahead. That’s an ominous sign if you have or plan to have large structural deficits. It’s also a bad sign given that the Fed hasn’t even begun its “exit strategy” from the bond markets. It’s still supporting prices and suppressing yields.

If the mere indication that it’s going to exit the market lessens demand for Treasuries, what will it’s actual exit do? Come to think of it, what will happen when the Fed stops buying and the Chinese start selling? We reckon the Fed will have to a quick about face. More on that in second.

Further to yesterday’s point about debt as a very bad habit, check out the chart below. It shows the large spike in gross and net interest paid to Australia’s overseas creditors. By today’s standards, paying out $30 billion in interest to your creditors (half of whom are in the U.S. and the U.K)seems like a fairly small price to pay for such an extravagant increase in house prices across the nation.

Just one small point, though. According the date, 37% of Australia’s debt is denominated in Aussie dollars and 39% of it matures in 90 days or less. This makes the debt sensitive to exchange rates and extremely interest rate sensitive too. A spike in rates and/or a fall in the Aussie dollar makes paying back and servicing the debt much more expensive.

Perhaps this is one reason CBA is keeping more of its cash.

In any event, the net interest on the debt doesn’t look back-breaking at these levels. But if the debt continues to accumulate or interest rates rise, it does start to get heavier. And at bottom is a simple financial point: interest paid on your borrowings doesn’t increase your capital. It’s just money sucked into a giant black hole.

You had better hope the capital goods or investments you made with your money compensate you for the cost of servicing your debts. In Australia’s case, that means the country needs higher and higher house prices. By the way, the ABS reported yesterday that housing finance approvals fell by 5.5%. The question is begged: when housing finance slows down, will housing prices follow?

Yesterday we claimed that borrowing your way to national prosperity is a sure-fire way to servitude and political instability. Today, we aim to prove it. To do so, we cite this article from Reuters. It suggests that China is using or should use its large holdings of U.S. Treasury bonds as a cudgel with which to bludgeon the United States its strategic adversary/ indispensable economic partner.

Figures in the People’s Liberation Army want the financiers to sell U.S. bonds as a way of punishing Washington for selling arms to Taiwan. Mind you this might not seem like such a good idea if the bond selling triggers a run on the dollar and swift devaluation in China’s forex reserves. But maybe China’s arsenal of U.S. bonds is a like a pile of bullets – they’re no good unless you fire them.

Of course what we’re suggesting is that China accumulated U.S. debt as both a by-product and a weapon. The huge stock of U.S. government securities was by product of China’s trade strategy. That strategy was to keep its currency low and gain global manufacturing market share through low labour and production costs. The result was a blizzard of U.S. dollar trade surpluses that were reinvested into U.S. bonds.

You could say it’s China that’s paid for the wars in Afghanistan and Iraq.

But why is this bundle of bonds now a weapon? We think China’s export-driven growth strategy is on its last legs. Labour unions in Europe and America given today’s political climate and high unemployment – will have the ear of politicians. And they will be saying something like this, “Make the Chinese pay!”

What they’ll mean is that China will be pressured to give up its main economic weapon – currency manipulation. This has kept Chinese exports cheap all over the world and led to the gutting of American manufacturing jobs. It’s made it pretty tough on exporters in Europe too. As a result of China’s dollar peg, European exporters suffered doubly from a weaker U.S. dollar. American goods were cheaper in Europe. But European goods were not cheaper in China.

So the unions and the politicians will probably not tolerate another leg of the global recession in which China gains more market share by keeping the currency peg and exporting its way to more growth (if growth is to be had). It brings us to the end-game of China’s export-driven development.

It also brings us back to one of the great monetary questions of the day: when will China de-peg? The answer has always been simple: when it is in China’s interests to do. To us, that means China will de-peg when the benefits of increased purchasing power in the currency are more important that dwindling export profits.

In other words, we think China is close to a new phase of growth that’s driven by consumer demand, domestic consumption, and more mature Chinese capital markets open to foreign investment. A de-pegging of the currency would see a much stronger Yuan. This would give Chinese savers a lot of spending power on global markets. They would also be able to buy more Chinese goods, which might lead to higher wages in China too (and more stoking of consumer demand).

This is all a theory, of course. And we could be way wrong. But there will come a day when Chinese customers are worth more to Chinese producers than American customers. De-pegging the currency will bring that day forward. And it could be sooner than you think.

This means that the accumulation of forex reserves was never really meant to protect China from external trade shocks, although they would be handy in that event. It means they were a side effect of a trade strategy whose ultimate objective was to gain as much global manufacturing market share as possible.

Now, you might wonder why China would damage its own interests by “punishing” the United States and selling bonds. But it depends on what China’s interests are. If China’s interests are in fundamentally weakening an economic competitor and strategic adversary, then selling U.S. bonds is in China’s interests.

China’s ultimate interests are in regaining Taiwan. And we’d suggest it try and use its bond leverage to weaken U.S. resolve about defending Taiwan. And selling U.S. bonds or crashing the dollar wouldn’t just weaken U.S. resolve. It would expose the loss of strategic influence that occurs when you are a chronic debtor nation.

Mind you the U.S. still has a lot of aircraft carriers, strategic bombers, and nuclear weapons. It’s not like its bereft of tools of persuasion. But the basis of all those tools has always been a strong economy, a strong industrial base, and sound finances.

The question now is, if the base of military strength has been eroded, how long will the U.S. maintain its military advantage? Can America afford it? And when push comes to shove, will American voters demand that an American President defend Taiwan? Hmmn.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• The Chinese and the Fed Both Buying U.S. Treasury Bonds
• David Murray Says You Become Dependent on Global Banks When Importing Capital
• China Performs a Kind of Financial Alchemy
• China Reduces Holdings of Treasury Securities
• A Look at Strategic Oil Reserves – Who’s Buying Oil?

“Are you one of those American finance guys from Lehman Brothers or something?”

Your editor was eating pizza at a café on St. Kilda Road last night with a friend who works in the mainstream financial media. The owner knew our friend, but not us. And once he picked up on our accent, he had a few questions like, “What is wrong with all those people in Greece?”

We’ll get back to that story in a moment. But this week’s markets make for compelling reading – and the week is barely half over! In today’s Daily Reckoning, we confess the things we don’t know, look at the routine rigging of the global financial system, and discuss whether the People’s Liberation Army of China is about to drop the big one on the United States of America.

Let’s quickly dispel a rumour. There was a rumour on the Internet of secret emergency meeting in Sydney of the world’s central bankers. We’ve been assured by sources that it was just a regularly planned retreat by the Bank of International Settlements. Rather than some extraordinary rigging of the world’s financial markets, it was just regularly scheduled, ordinary rigging.

In the not so mundane world of markets, today is looking pleasant, if not totally rigged. The futures were up overnight, so Aussie stocks will probably follow New York’s lead and have a big day out. The big report today is the half-year earnings for the Commonwealth Bank of Australia. And the big question: have bad debts peaked?

“Yes!”, says CBA chief Ralph Norris. Last year the bank reported nearly $2 billion in charges for “bad and doubtful debts.” This year, it’s just $1.39 billion. The bank also reported a 13% increase in first half profit to $2.91 billion. Yep, doing it tough is the old CBA.

There’s no doubt that the reduction in bad debt charges is a good sign for the banks. The “operating environment” (the real economy) appears to be less threatening. We’ll see how it goes, but the rest of the market could take the CBA numbers as a sign the debt problem has well and truly peaked. A re-rating of the bank shares might take place and you’d see a mini rally.

Mind you it’s not a rally we’d care to go to. There was another interesting note in the CBA’s media release about the last six months. It reported a 49% increase in home loans to $1.19 billion. The CBA said the home loan growth was, “mainly as a result of increased market share and significant growth in outstanding home loan balances.”

In other words, CBA had less of a bad debt problem in the last six months. But just you wait. It rode the FHOG to higher loan values and volumes and market share. If those borrowers struggle with higher interest rates or – horror of horrors – Aussie house prices grow less fast (or even fall) – we’d expect to see the bad debt problem again affect earnings growth and, ultimately, the valuations on Australian bank stocks.

But there is a lot about the world we don’t understand. As our old friend Thom Hickling used to say when he visited us in France, “Je sais rien…I know nothing Dan. That’s my motto.” It’s more or less our motto as well. That’s why we ask a lot of questions.

And it’s also why you’ll find apparently contradictory statements and advice in the Daily Reckoning. Your editor thinks you should use any rallies in the market to gradually liquidate your stock portfolios. In other words, retire now before the government seizes your super assets or the market crashes.

Yet we work with experienced traders and analysts who’ve spent years in the markets finding great investments. We publish and sell their research and that contains buy recommendations on all sorts of Australian stocks. We publish that because fundamentally, we have no idea what will happen. It’s what we’re all trying to figure out.

The best strategy in that case is to surround yourself with people who are thinking hard and working hard to figure things out. And ultimately, you get to choose the ideas and editors you agree with or whose thinking you’re interested in and whose track record impresses you. And even if you never take a punt on any of those publications, we’ll keep reckoning every day for free! How good is that?

While we’re still on the subject of debt, three cheers for Senator Barnaby Joyce! The finance spokesman for the opposition is copping it from all sides for suggesting that Australia is in hock “to our eyeballs to people overseas.” He also said, “You have got to ask the question, how far into debt do you want to go? We are getting to a point where we can’t repay it.”

Even members of his own coalition have turned on him for suggesting Australia may not be able to repay its sovereign debts. But we say if Barnaby Joyce is fiscally incompetent, we need more men like him in government. He couldn’t do much worse than the debt-first mentality of the establishment.

You can also judge a man by his enemies. In an article titled “Credit experts line up to rebuff Joyce” published by the ABC, we learn that experts from Fitch, Standard and Poor’s, and Citigroup assure us that Australia is in no danger of defaulting on its sovereign debt obligations. Yes, the same people that nearly brought the global financial system to its knees and didn’t see it coming are telling us there is nothing to worry about.

Irony aside, it’s true that Australia’s fiscal position at the sovereign level is better than a lot of other countries. As Michelle Grattan points out in today’s Age, “Australian net debt is expected to peak at 9.6 per cent of GDP, or $153 billion, in 2013-14. In contrast, debt in 2014 in the US is estimated to be nearly 85 per cent of GDP. It will be nearly 92 per cent in the United Kingdom, 143.5 per cent in Japan and 93 per cent for the major advanced economies collectively.”

Based on these numbers, it’s looking pretty grim for the Senator isn’t it? He does look a bit alarmist for warning of an imminent crisis in servicing Australia’s sovereign debt. What’s interesting is how vigorous the attacks on him are. What’s going on there?

Well, there are certain interests in government and finance who want the debt to go higher. It’s the business they’re in and it supports their livelihoods and lifestyles. Some of the people criticising the Senator benefit tremendously from larger and larger government borrowing in Australia – whether it’s the politicians who spend it or the bankers who arrange it or the ratings agencies who get paid to slap a triple A on it.

And in case these folks haven’t noticed, the funding model for the welfare state is breaking down all over the world. It will catch up to Australia eventually. Indeed the very premise of the welfare state – that society can enjoy less risk higher standards of living through progressive taxation on a tax base that’s getting smaller and less productive by the day and faces global wage deflation – is being exposed as bogus and fraudulent. That’s why you should expect more measures that punish you for withdrawing your money from super or the banks – or restrict it outright.

But on this issue of debt, if only the Senator had spoken about Australia’s net foreign debt as a nation, he would have made a better point. The net foreign debt is the sum total of how much Australians have borrowed from the rest of the world, minus what Australians have lent or own in equity. According to the ABS, “Net foreign debt is equal to gross foreign debt less non-equity assets such as foreign reserves held by the Reserve Bank and lending by residents of Australia to non-residents.”

A simpler way of thinking about it is “how much of the world do we own and how much do we owe to the rest of the world.” The facts on this matter clearly support the Senator’s position. According to research published last year by the Statistics and Mapping section of the Parliament of Australia’s Parliament, Australia’s foreign debt was just $3 billion in 1976. According to the ABS, it’s now $637.5 billion – or about 63% of GDP. That’s a lot higher than the sovereign debt-to-GDP level of 9%.

Even without knowing how this compares to other countries, it’s safe to say that number is alarming. Australia has $1.1 trillion in foreign assets. Half are in equities and half in debt securities. As always, there’s the risk that asset values, especially equities, can fall.

On the debt side, Australia has $1.8 trillion in foreign liabilities. Nearly $700 billion of that is foreign equity ownership of Aussie stocks. The other $1.2 trillion is debt owed to foreigners by Australians. The odds are that if there’s a double dip global recession this figure will increase. Domestic consumption of imports will rise with more stimulus while exports would presumably fall in a global slowdown.

But so what? Who cares if Australians firms and households borrow abroad to finance their consumption and investment? Isn’t that a private or market-driven decision? Well, yes. But we think it exposes the country to several big risks.

First, the lenders might not always be so forthcoming. With massive borrowing needs in places like Japan, the US, and the UK, it’s probably not safe to assume a ready supply of foreign capital. Even with a great credit rating, in a credit depression capital is going to be scarcer and the cost of it will inevitably go up.

The big risk, of course, is that you build an economy based on debt which isn’t sustainable when the creditors turn you down. You have long-term liabilities you racked up when the currency was strong. But if they’re denominated in foreign currencies and the Aussie crashes again (as it might in a global W shaped depression) paying back your debts gets more expensive.

Ultimately, it comes down to what you’ve down with your borrowed money. Have you invested in wisely? An increase in debt – or even net foreign debt as a permanent feature of Australia’s economic landscape – wouldn’t be so bad if it translated into an increase in productive assets. You’d be a capital importer. But you’d use it to build your asset base.

Those assets – especially capital equipment in the resource sector – would lead to higher exports, lower current account deficits (also as a % of GDP) and generally more investment led growth instead of consumption led growth. It would be a responsible use of debt.

But if the debt – as we believe the numbers show – has been taken on to finance a housing boom, or worse, to finance speculation by Aussie banks and financial firms in asset markets abroad, then it’s not going to be what we call productive debt. So we’ll see, won’t we?

Tomorrow, we’ll show you why borrowing your way to prosperity is not only a sure fire bet to national servitude, but also a recipe for political instability. Our case in point will be the United States of America and its main creditor, the People’s Republic of China.

Finally, our waiter last night asked us, “What’s wrong with those Greeks? Is there some sort of crisis or something? Is it like that Lehman thing you guys caused?”

“What’s wrong with Greece? They can’t pay their bills. Nobody wants to admit it. But they’re living beyond their means. All of Europe is.”

“So what will happen?”

“Probably some fake bail out. The bigger countries in Northern Europe will guarantee emergency borrowing by the Greeks. No one wants to admit that standards of living have to fall and government spending has to fall too. They’re going to fight it…but it’s like fighting the orbits of the planets.”

“Hmm. Imagine that. Even in antiquity the Greeks were bad with money. But the Romans figured it out didn’t they? They were good at collecting taxes. Not the Greeks. They had all the good ideas though.”

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Corporate Debt is Just One Aspect of the National Debt Problem
• Australia to Borrow as Much as $300 billion
• Central Bankers Encourage Debt Booms That Become Debt Bombs
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• RBA Buys $780 Million in Residential Mortgage-Backed Securities

The last successful invasion of England took place at the Battle of Hasting in 1066. William the Conqueror, a Norman, brought his French language and toppled the natives and their King. We only mention it because both the S&P 500 and gold closed at the same level after Monday trading in New York: 1066.

It probably means nothing. But then again, there is a nice historical resonance, isn’t there? Financial markets are making a lot of history with their volatility and excess. And the world’s currency landscape is changing fundamentally as gold is remonetised and debt backs the break of vulnerable nation states.

It’s quickly becoming a market where you’re worried more about the preservation of your capital rather than capital appreciation or even dividends. Late last night we read the latest monthly report from Australian Wealth Gameplan, edited by Kris Sayce. Kris has come up with a way to hedge against the falling Aussie dollar and listed all the collateral damage that would occur if the currency falls more.

Kris normally chases beaten down blue chips that pay dividends. If the market keeps going this way, there may be quite a few more beaten down stocks. But until recently, valuations were pretty rich. What’s more, companies are hoarding more cash and paying out less.

“Lean times for investors on dividends,” reports George Leonidis in today’s Australian Financial Review. Australian investors will lose $4 billion in dividend income this year, according to research from Macquarie Securities. Macquarie analyst Neale Morris says, “Company management are being very cautious. They have just come through a very cathartic event. They are trying to retain as much cash as possible just in case bank lending disappears again.”

Just in case.

Now one medical definition of ‘cathartic’, according to dictionary.com is “An agent for purging the bowels, especially a laxative.” This raises an interesting question. Have the bowels of the banking system been purged of bad debt or not? Or does the financial sector merely feel better without any fundamental improvement…in its bowels?

We’d say there is still a large debt overhang in the banking sector. Granted, according to official Aussie sources, residential and commercial real estate loan portfolios are performing well. But globally – and Australia was certainly not immune from global trouble last time around – there are plenty of private and public balance sheets that are pretty stuffed up.

Speaking of which, how about some news which should terrify anyone who owns a significant amount of U.S. dollar-denominated assets. The American Treasury Secretary Tim Geithner has said the U.S. government “will never” lose its triple A credit rating. As one of our friends back in the States wrote, “Never is a very long time.”

One thing we know for certain is that all paper currencies eventually reach their intrinsic worth. It’s also true that the more vocal monetary officials are about not devaluing or preserving the purchasing power of a currency, the closer they are to doing exactly the opposite.

The greenback is enjoying a nice flight-to-liquidity rally. Investors prefer liquidity now over return. But that doesn’t mean the buck is strong or safe. It’s neither. It’s notable that gold was up $13.20 in trading today and that North American listed-gold stocks are moving too.

Last week Slipstream Trader analyst Murray Dawes went “long” a couple of Aussie blue-chip gold stocks. He was worried he might be a bit early. But his signals fired and he pulled the trigger on the trades. This morning he sends this chart over of the Australian Gold Composite Index. It looks fairly bullish, although we’ll l leave the analysis to the traders.

Still, it’s hard for us to shake our concern that other commodities, especially base metals, have gone too far too fast on the easy money express. The rally since last March has been a huge boon for base metal prices and some base metal stocks. We expressed this worry to Diggers and Drillers editor Alex Cowie. He’d just recommended a copper stock in his latest report.

Alex replied that, “My view is that the resource sector is oversold after a very rough month. The key issue driving mining stocks down is risk aversion driven by fears of a European sovereign debt crisis. The anxiety in markets is that the Greek tragedy may lead to what I like to think of as ‘the Ouzo effect’.”

“This is where we see contagion pass across to the other European countries with bad balance sheets like Portugal, Italy and Spain, the so-called ‘PIGS’. If this situation plays out slowly, and investors get little reassurance from the ‘PIGS’, then high risk assets such as mining equities may offer even better buying opportunities in coming weeks. It all hangs off the European story at the moment.

“Mining stocks are doing well in the market today despite a flat Friday session in the US markets, so investors may be seeing opportunities in front of them already. Although the commodity markets are still getting a hiding with risk aversion driving the US dollar up, I believe that the supply and demand story should keep prices trucking higher over the year and take resource stocks along with them. This week or two looks like a crossroads in the market to me. Either the debt story passes like Dubai did, or it festers.”

Tomorrow? More on the festering and the reaction of resource stocks.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Latest Energy Bull Market Won’t Be Confined to Crude Oil
• Aussie Banks Addicted to Foreign Borrowing
• Gold, the Aussie Dollar, the Greenback and You
• Stocks Better than Bonds When Inflation is a Big Threat
• Banks or BHP?

Sometime around last Thursday afternoon the mood in the market went from concerned to “totally freaked out”. It is a trifecta of concerns that have investors on the edge. Chinese growth is slowing. The American employment picture is not good. And Europe is in the middle of a dangerous debt crisis.

The result for Aussie stocks was a $25 billion wipe-out on Friday. Stocks made a three month low and fell by 2.3%. Aussie stocks are now 45% above their March lows. But the direction from here is anything but clear.

As cautious (and bearish) as we generally are, this could actually be a very good buying opportunity if you’re a fearless trader. It felt this way in markets in December of 2008. There was a real sense of despair at the time. And at the time, we talked with Kris Sayce about whether or not to recommend any stocks that month in his newsletter.

The conclusion then was what we try do every month: give you our best idea. Kris’ best idea at the time was to take a punt on some LNG stocks. As it turned out, it worked really well. The stocks were cheap and the point of maximum despair was a great entry point.

Does today present you with the same kind of entry point? Well that depends on if you think we’ve reached a bottom in bearish sentiment. A few weeks ago the Investor’s Intelligence survey had the fewest number of bears in twenty years and the most bulls since the market top in 2007.

Then, within the space of a few weeks, the percentage of self-identified bulls slipped from 53% of those surveyed to 38.9%. The bull-to-bear ratio also declined from 3.36 to 1.75. Not that we have much skill at reading charts, but you can see from the chart below that the bull-to-bear ratio has had trouble getting and staying above 3.3 over the last three years.

If you were using investor sentiment as your timing mechanism to enter a long trade now, you might want to wait until a further decline in the bull-to-bear ratio. We’ll duck into the research office later today and ask Murray what that might correspond to on the ASX/200. That said, he’s just sent through a new “buy” alert via the Slipstream Trader on a stock he thinks is already over sold, so the timing of the trades may vary based on the business and the industry.

By that we mean the news in the banking and resource sectors may also be as big a driver of stock prices as sentiment. On the resource front, a stronger U.S. dollar means falling commodity prices. More importantly, there is the argument than China will dial back growth to restrain inflation.

Charles Dumas from Lombard Street Research writes that, “With China overheating and soon to repress its domestic demand, India ditto in the the throes of major inflation, and the commodity countries about to be caught in a collapse of their metal and energy export revenues, the second leg down of the ‘W’ could start by 2010 Q3.”

That’s obviously not a very bullish forecast for resource shares. He’s arguing that this move in the share markets presages a bigger fall in the global economy. If that argument is correct, you’d expect bigger falls in commodity prices and commodity stocks and a weaker Aussie dollar.

Mind you, none of these seems to have bothered the markets much at today’s opening. Stocks are up. And over the weekend Clive Palmer announced that his private firm Resourcehouse had signed a $70 billion deal to export coal for twenty years from Queensland to China. That’s going to be a lot of coal.

It’s estimated to be about 30 million tonnes a year, to be precise. China Power International Development will contribute US$5.6 billion in debt financing to build four underground and two surface coal mines in Queensland. Hmmn.

This not-so-little development suggests that even with tighter monetary policy, Chinese per-capita energy use is rising from a very low base. That means there could be much more growth ahead in Chinese energy imports, even if industrial production slows down.

That argument seems riddled with internal contradictions, of course. China will use less energy if China makes less stuff to send to consumers in the West. But if Chinese wage growth appreciates – which could also be accomplished without inflation by allowing the currency to strengthen – there might be more internal demand. Or, China might buy more of the stuff that it makes, which would hold up demand for resources.

None of that might matter much in the next few months if financial markets have another nervous breakdown. And what about the other major driver of Aussie indexes, the banks? A lot depends on how the market takes the news that the Federal government is withdrawing its guarantee on large deposits and wholesale funding for the banks.

The guarantee won’t go away until March 31st. The government is convinced that the economy is strong enough now that banks can raise wholesale funds without its backing. Whether the banks choose to raise that money, or raise interest rates on consumers too, remains to be seen.

One big issue to watch: credit growth. If the banks feel adequately capitalised, are confident about the performance of their loan portfolios, and not worried about raising money from abroad, credit growth should resume and the economy would hum along. If banks tighten up, watch out.

Watch out is probably good advice in general at the moment. In 2008, the business model for investment banks broke. Leveraged players imploded in the credit crisis. Since then, the risks taken on by the financial system have been transferred to national governments. The result is higher annual deficits and larger debt-to-GDP ratios and a general concern that the deficits may never be paid back.

Last week, Moody’s said as much. Specifically, it said U.S. economic growth would have to be much higher than projected for the country to grow its way out of its debts, which are themselves growing pretty fast. If America can’t get its fiscal act together, Moody’s said the triple A credit rating enjoyed by Uncle Sam is at risk.

“Unless further measures are taken to reduce the budget deficit further or the economy rebounds more vigorously than expected, the federal financial picture as presented in the projections for the next decade will at some point put pressure on the triple A government bond rating.” This year’s $1.56 trillion budget deficit is 10.6% of GDP. And overall, when you include household debt, corporate debt, and state and local government debt, the ratio is well on its way to 100%.”

Strange that despite all that the greenback is rallying. But as we said last week, we’ve seen it before. In a risk averse world, liquidity matters more than yield. That said, this year’s permutation of the Global Financial Crisis is different. The problem with national governments in fiscal crisis is that there is no one to bail them out. This is what makes debt default for at least one of the struggling European nations so likely.

For America? Technically, a nation that can print the money in which its debts are denominated cannot default. It can always print more money (inflate) to pay off creditors. Practically, creditors know this too and plan ahead of time. First, they shift to shorter durations in their security purchases (which they have done). And they diversify into other currencies or hard assets, which they also have done.

Where does that leave us on a Monday? We’re at the pointy edge of what feels like another financial panic. The trader with a pocketful of courage might double down on the negative sentiment and buy some oversold stocks for a rebound. And the investor?

At best, we reckon the markets will remain range bound with so much uncertainty coming from fiscal and monetary policy. The world’s major economies are not exactly transmitting clear intentions either. And Australia, whose economic success derives from the economy in China and global capital flows, is caught in the middle of all of this. More tomorrow on what to expect.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Rio Scraps Deal to Sell to Aluminium Corporation of China
• Good Month for Aussie Stocks, While U.S. Stocks Fell to Close the Quarter
• Chinese Steel Price to Rise in Wake of Coal and Iron Price Hike
• Stocks for the Lifeboat
• Wage Pressure in China to Drive Up Cost of Goods in Australia

Last time the world’s financial markets panicked, something strange happened: the U.S. dollar and U.S. bonds rallied while stocks, commodities, and emerging markets sold off. The same thing could be happening now. It’s not so much a flight to quality as it is a flight to liquidity and a massive case of global risk aversion.

The S&P 500 fell by over three percent and the Dow Jones by 268 points and two percent (nearly closing below 10,000). Gold was off $45, or just over four percent. And oil was off by nearly $4, or over five percent. We’ll get to what you should do about all that in a moment.

But first, take a look at that chart below if you believe the past is prologue. The chart shows how impressive and fast the rally was in the U.S. dollar from a level of 72 on the dollar index to a high just below 90 in late 2008 and early 2009.

During the dollar’s rally, stocks and commodities fell. Yet once low interest rates and government stimuli found their way into stock markets, leveraged traders again bet on equities and higher-yielding risk assets around the global. The dollar fell and the stock market rally got pretty carried away with itself (mostly on the flimsy idea that the global economy had been rebalanced and was recovering, which was palpably not true).

The chart can’t tell us what will happen next. This time around, we wouldn’t expect the dollar rally to go as high or last as long. We don’t think the monetary authorities would be inclined to let a deleveraging positive feedback loop set in again (which indirectly explained the dollar’s ferocious rally last time). That is, the powers that be don’t want to see falling asset values trigger forced liquidations by leveraged players, leading to more asset sales and further liquidations in property, commodities, and equities.

Now just because Ben Bernanke and the global cabal of counterfeiters don’t want something to happen doesn’t mean it won’t happen anyway. The deflating of the reflated asset bubble is going to happen sooner or later. The world’s massive inverse pyramid of debt is supported by a very small asset base. When the underlying assets (often commercial and residential real estate fall) the whole structure becomes unstable (this is what happened in 2008).

That means that this time around, you wouldn’t expect the monetary authorities to let liquidity to dry up again. Granted, the fundamental issue is the soundness of bank collateral (and that has not improved much). But if central bankers and policy makers have been publicly worried about inflation in the last few months, you can forget about that now.

A ten percent fall in stock prices (though probably overdue) is just the thing to get policy makers in an accommodative mood again. The U.S. employment figures still suck. And markets are increasingly confused and worried about whether certain sovereign nation states (like Greece and Portugal) can finance their deficits and/or reduce public spending without increasing civil unrest.

Mind you, we don’t think more money, credit, or liquidity is the answer. It is, in fact, the problem. The modern world economy is built on a foundation of unsound money. We may all be surprised at how just abnormal everyday economic life gets when the artificial life support of easy money is either withdrawn or simply ceases to be effective.

The young man above, who’s keeping vigil outside the RBA in Sydney, would probably agree with us. His brother sent us the picture and this note, “My younger brother has been protesting outside the RBA every second Friday morning for the last three months. After discovering Austrian economics about three years ago Seb and I have been compelled to speak out against central planning through central banking. I have attached a couple of photos above of his mornings outside the RBA. As you can see it’s a lonely battle and would appreciate all the help we can get.”

Keep hope alive brother!

If you’re not familiar with Austrian economics, don’t worry. There’s actually a small introduction to the subject we wrote last year that we’re happy to send you if you’re interested. Just send us a note to [email protected] with “Austrian Economics” in the subject line.

The basic idea, when you strip away all the big words, is that the entire free market system is distorted/perverted/corrupted by the fact there’s no free market for money. The interest rate is essentially the price of money (or the cost of capital). This rate is set by unelected bankers. The result, since central banking got its start with John Law and the Banque Royale in France, is a series of massive misallocations of capital and destroyed wealth.

When you change the cost of capital willy nilly, you change all sorts of incentives in the real economy. And you alter the economics of tens of thousands of investment decisions. Make money too cheap (always the preference of governments) and you create asset bubbles (in stocks, real estate, and commodities).

In fact there’s a pretty persuasive argument that the commodity super cycle is itself a symptom of the de-facto dollar devaluation engineered by Richard Nixon in 1971. Once the world moved to free floating exchange rates and fiat currencies not backed by any metal, a tsunami of paper, credit, and debt has lifted (inflated) prices for everything (houses, stocks, commodities, and bonds).

Some people call this wealth.

But if the super cycle of paper money is ending (a big claim for sure), wouldn’t it mean a dramatic contraction in global economic activity? Not just a severe recession like in 2008 but really, a long depression in which debts are worked off and paid down, or in which debtors simply default and their creditors must take capital-destroying losses?

Well, yes. All that would happen if the super cycle in paper money is ending.

We’ve argued that it IS ending and that one symptom is a series of escalating sovereign debt crises. The funding model for the welfare state is broken because it’s base on unsound money. It’s time to pay the reaper. Don’t fear the piper.

The argument we hear most often against our position is that all of that would be terribly inconvenient and people would prefer to not believe it. People would prefer to believe that debt is wealth, that you can spend your way out of recession, that we all can live at each other’s expense, and that the misallocation of real resources (capital, labour, land and commodities) doesn’t have real long-term consequences.

But paper money has always been a con game based on belief. The emperors of Rome, the Kings of France and England, the chairmen of the Federal reserve cannot resist debasing the currency. It makes both warfare and welfare possible. Guns and butter are the health of the state and the death of sound money.

The counterfeiters always get first use of the bogus money before its purchasing power is diminished by the increased supply. And after all, the modern banking system IS debt-based money. The banker’s product is debt…and the more you have, the better for them.

All of this is absurd and, as Murray Rothbard said about fractional reserve banking, deeply immoral. It’s a pretty dodgy way to run a world economy. But the assumption – encouraged by the powers that be – is that the economy is a complex machine which can be controlled with the right tweaks to the right dials by the right people wearing the right suits in the right government offices with the right university degrees.

This is also absurd.

But enough of the theory. What now? If the correction becomes a rout, expect more quantitative easing or policy measures designed to mask the pain (more stimuli). That won’t solve the basic problems either. But it might arrest the dollar rally and the commodities sell off. At some point, much more aggressive measures might be needed, at which point we’d expect to see a huge increase in inflation and interest rates (as deficits spiral out of control).

But in the short term, we’d say this is a chance to lower your average purchase price on gold and other precious metals. We hope you used the rally as a chance to liquidate some of your stocks and increase your allocation to cash. Our preference right now is for liquidity over capital gains or yield. Cash doesn’t yield much. But you can keep it in your hot little hands.

Of course no one can see too far into the future. We’re pretty sure that at some point down the road, the sovereign debt crisis will again become a U.S. dollar crisis. But it could be that the sovereign debt crisis is going to take out the smaller welfare states in Europe first and that this will actually lead to dollar strength as global investors concentrate their remaining capital in a few very liquid markets (like short-term U.S. Treasuries). Under this scenario, emerging markets (including Australia) would probably sell off more than developed markets.

One final note today. The South Australian Attorney-General, Michael Atkinson, has changed his tune on the new law requiring internet commenters to reveal their identity when commenting on the upcoming election. That seems like good news.

Atkinson wrote in a statement, “From the feedback we’ve received through AdelaideNow, the blogging generation believes that the law supported by all MPs and all political parties is unduly restrictive. I have listened. I will immediately after the election move to repeal the law retrospectively.”

Hmm. “It may be humiliating for me, but that’s politics in a democracy and I’ll take my lumps…This way, no one need fear now that they are being censored on the net or in blogs, whether they blog under their own name or anonymously. I call upon all the other political parties who supported this review to also review their position.”

Maybe Mr. Atkinson should review his analysis as well. From his comments, he seems to be unrepentant about the spirit of the law. But he says that because all the young whipper snapper bloggers don’t like it, well that’s democracy so we’ll respect that, even if all the youngsters are a bunch of dunderheads.

The danger here is still clear. You have an elected official exercising his own discretion about what speech ought to be free, and then exercising even more discretion about whether to apply the law or not. How capricious. The law is the law. How can the Attorney-General not exercise it?

But really this shows why you need a constitutional protection for free speech in Australia. Take it out of the hands of legislators and put it above statutory law entirely. In some sense, this IS un-democratic in that you’re telling the legislature there are some individual rights they can’t tamper with just because it seems like a good idea at the time. In that case, we’re happily un-democratic.

Protecting individual liberties is the fundamental reason (we think) for consenting to be governed in the first place. If the legislature becomes a tool for systematically stripping you of your economic and political liberties (as well as grabbing, without your consent, a larger and larger percentage of your productivity via the income tax), you’d have a serious think about withdrawing your consent.

Hmmn.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Commodities Tell Us the World Won’t Stop Turning in a Financial Crisis
• Teach Your Children Chinese Because China is the Next Great Country
• U.S. Dollar Rallies as Economic Foundation Crumbles
• Millions of Zimbabweans Face Starvation due to Nationalisation caused by Hyperinflation
• The More Money in a Financial System the Less Each Unit is Worth

And one last note on politics. Please welcome your new Internet overlords, Australia. They are hiding in some parliamentary office somewhere at the moment. Since this is a free e-letter, and since there is a clear connection between political freedom and economic freedom, a story from South Australia caught our attention and demands a comment.

A new law has come into effect in South Australia. The law, according to the Adelaide Advertiser, “requires internet bloggers, and anyone making a comment on next month’s state election, to publish their real name and postcode when commenting on the poll.” It effectively prevents anonymous comments on politics on the Internet.

The law “also requires media organisations to keep a person’s real name and full address on file for six months, and they face fines of $5000 if they do not hand over this information to the Electoral Commissioner.” So there you go.

The law’s proponents – not surprisingly incumbents from both parties – say it will prevent defamatory and libellous comments from sullying a high minded public debate about the poll. But last we heard, laws generally punish transgressions of behaviour rather than trying to prevent the behaviour itself by making it illegal (you get fined for speeding when you speed, not for thinking about it).

The law is obviously going to have a chilling effect on political speech. True, there is an argument to be made that if you want to have a healthy democracy, people ought to put a name on the ideas they espouse and be willing to articulate and defend them openly. But there is a long tradition of anonymous political commentary, and for equally democratic reasons.

For example the writers of the Federalist Papers (which were essays and pamphlets on why the separate States should ratify the U.S. Constitution) wrote under the pseudonym “Publius.” Obviously John Jay, Alexander Hamilton, and James Madison weren’t afraid of the rough and tumble of public life. So why write under a pen name?

The State, or its agents, can exercise all kinds of retribution on those who challenge it. It could be political. It could be economic. Or it could be using the tax collectors to chase down your favourite political enemies. In the hands of the vindictive or the malicious, the tools of State power can be brought to bear on vocal critics.

That’s also why whistleblowers are protected. But really, it shouldn’t matter why someone chooses to remain private when making a public comment. If their argument is about an idea, then the person making the argument doesn’t matter. It’s not an argument made “from authority,” where the force of the person making it carries the day. It’s an argument about an idea.

The fact that South Australia is stifling political speech ought to be embarrassing for Australians. Of course we say that as an American. As a colleague tut-tutted last night, “You Americans get so wound up about freedom of speech. This is just a sensible law that improves the quality of the political discourse in Australia.”

He’s right about one thing. Freedom of speech is not a protected right anywhere in Australia’s constitution. We read up on the matter here. So you don’t have freedom of speech guaranteed anywhere, but you do have an “implied freedom of political communication.”

The problem with an “implied freedom of political communication” is that it is not a positive right above the tampering of the legislature or judiciary. Statutory protections for free speech can be changed by statute (once you get a bunch of legislators riled up). If, however, freedom of speech were part of an Australian Bill of Rights, it would be constitutionally protected and above the tinkering of morons in all branches of government.

We know from experience that many Aussies oppose a bill of rights because they believe it gives the courts and judges more power to determine what “rights” actually are. But the whole point of a bill of rights is that it’s mostly based on “negative” rights, or those things which the government cannot or must not do to you (in most circumstances).

To the extent that rights are positive in a bill of rights, they are things the government MUST do to protect you, like offer you a trial by jury of your peers, or not hold you in jail for too long without charging you for a crime. To be fair, having a bill of rights doesn’t insure the government won’t violate these rights. But at least you can take it to court and win.

And yes, taking the government to court to protect your rights probably does promote a more litigious society. But so what? That’s not the sort of objection that invalidates the idea of bill of rights. Liberty is worth defending, isn’t it? C’mon Australia. Stand up for yourself!

It’s better to have the rule of law operating to protect speech and to have way to hold the government accountable for its infringements on your liberties than to have your speech shut down by politicians who want to bully their opposition into silence through coercion.

Intellectual coercion is a second cousin of physical coercion. Once you concede the principle that the government can censor what you say…well…you’ve conceded an awful lot. What do we know though? We’re neither a lawyer nor a climatologist. Just a “carpetbagger with a modem,” as one reader wrote. Until tomorrow.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Whiskey & Gunpowder
• CBA Sees More Bad Loans
• The Banks Should Hold More Capital
• Europe and Japan are in recession
• George Bush Speech Sounded Like an Edition of the Daily Reckoning

Paul Volcker is fronting the U.S. Congress to push for restrictions on the proprietary trading desks of U.S. banks. The RBA stunned economists yesterday who had unanimously predicted the central bank would raise the cash rate to 4%. It did no such thing. Stock indexes in the U.S. rallied over one percent, but jobless figures come out later this week. And that makes everyone nervous that despite the nice recovery narrative, the economy still sucks for real people.

So we’ll see how it goes in Australia today. Our general survival strategy at the moment is to gradually reduce exposure to all but a select portfolio of stocks that are leveraged for big returns. As to the first issue – reducing exposure to stocks – now might be a good time, according to Morgan Stanley economist Gerard Minack.

Minack reckons we’re in for a correction after this 9-month “relief rally.” In a note to clients Minack wrote, “We see the rise from March 2009 as a typical relief rally that follows major bear markets. Those relief rallies can occur regardless of underlying macro conditions, regardless of liquidity conditions and – most importantly – regardless of what happens next….The fundamentals did improve this time – systemic financial crisis ended – but we think risk assets have swung to pricing a better outlook than is likely.”

Minack says that while the rally could take developed market equities up to 75% or so from their March lows last year, a 25% correction is now in order. To be fair though, he doesn’t think the market will make new lows after that – only that it’s gotten way ahead of itself at these levels.

The Grand Old Man of Dow Theory, Richard Russell, is even more direct. He’s predicting a “second round of pain” for stock markets. He wrote, “I note that most analysts are now bullish, and that they are recommending stocks for the ‘continuing advance.’ At the same time, most economists are optimistic, arguing that the ‘longest recession since World War II has ended.’”

“Typical, last March everyone was bearish and the market was establishing a temporary bottom. Now that everyone is optimistic, the stock market is topping out and the public (the amateurs) are about to receive their second round of pain,” he wrote. Ouch.

To protect investors from this pain, the editors of our three financial newsletters have been using trailing stops and stop-losses on open positions (as rough guides). They are not always popular with readers. But they do save you from having your capital destroyed in bear market moves. If you’re not using them, now would be a good time to seriously reconsider it.

With the Boomers now heading slowly for the exits of the share market (converting their portfolios into income they can consume) the ‘weight of money’ argument for owning a basket of blue chip Australian stocks has never looked so light.

We could be utterly wrong, of course. But why not own a handful of smaller miners and small caps where business growth leads to real earnings growth and higher share prices? Surely this is a better bet that buying and holding for the next ten years, isn’t it?

The best financial survival strategy of the coming years begins with not expecting the share market to be a retirement machine. True, the compulsory super tribute will probably be raised and this should bring more liquidity to stocks (and government bonds). But what you’re looking for are good businesses, not just a good stock market.

Did you know that Australia has the highest household debt to disposable income ratio in the world? It’s even higher than America’s. Bigger homes. Bigger waistlines. Bigger debts. Australia is in the middle of its own credit boom, complete with all the social consequences. And the financial consequences.

The chart above doesn’t have the most recent data. It appears to show a gentle decline in the household debt-to-disposable income ratio. Since then, though, due to higher debts and income growth that’s not quite kept up, the ratio has turned up again. It’s around 156% today, largely thanks to the mini-boom in mortgage lending spawned by the diabolical first home owner’s grants.

Speaking of which, Fitch Ratings chimed in with a gloomy forecast for Australians overnight. It said that rising interest rates in 2010 would trigger more home loan and commercial mortgage defaults. It said this would cause some “deterioration” in the quality of assets that underpin mortgage-backed bonds. Hmm. That sounds soooo familiar.

Even though Aussie rates did not rise yesterday, they are at the low end of their historical cycle. You’d expect them to go up more this year. And Fitch says that’s bad. “The improvement in Australia’s structured finance asset performance, which was experienced during 2009 thanks to historically low interest rates and a resilient economy, is unlikely to continue during 2010,” said David Carroll, the director of Fitch’s Australian structured finance team.

Fitch is talking about bonds and structured products made up of mortgages and commercial real estate leases. That’s an interesting story and will affect the quality of bank assets (and perhaps mortgage funds and listed property investments). But the real story, politically, is whether all those first home buyers who encounter mortgage stress will want to vote for Kevin Rudd again.

By the way, we copped it big time from dozens of readers for dipping our toe into the climate change debate a few weeks ago. We were told – sometimes not so politely – to stick to our knitting (even though the topic has clear implications for the economy and financial markets). By bar the most often repeated objection to our “infantile” thinking was that the science behind climate change is not disputed and that it’s all peer reviewed in a process that’s non-political, objective, and thorough.

Harrumph. The bigger the lie is, the harder it falls.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Debt to GDP Ratio Will Return to Normal
• Dr. Woody Bock’s Essay: The Future Evolution of the Debt-to-GDP Ratio
• A Funds Industry Built on Turning Debt into an Income Paying Asset
• Bailout Deal Will Expand China’s Influence in U.S. Economy
• People Without Jobs Can’t Make Mortgage Payments

Australians all let us become more productive, for we are getting older!

It doesn’t quite have the same ring as the first line of the Aussie national anthem, does it? But even though the country is younger (and perhaps freer) than many other countries, it might not quite feel the same way about itself after reading parts of the government’s latest Intergenerational Report, released yesterday. You can find it here.

The burden of today’s Daily Reckoning is to figure out what’s going to happen when Australia’s millions of baby boomers retire. From the looks of it, the stock market will crash, government finances will be stressed, and the economy is going to slow. None of that sounds very promising. But let’s take a quick look to see what the best financial survival strategy is.

First though, a short look at the markets. The RBA comes out with its new interest rate decision. It’s going to be spun as a positive no matter what it decides. Higher rates mean the economy is growing and it’s bullish for the dollar! No change means the housing market will recover and new buyers could step in again. The market is up strongly today – mostly because it got ganked in January, falling 6.23% for the month.

One more side note. We’ve said all along that thousands of young Australians would come to resent the government for encouraging them, via grants, to get into the house market when prices were high and interest rates were low. It was in invitation to years of debt slavery to the big banks, sweetened with some “free” money the government borrowed in the bond market (which will also have to be repaid.

Young buyers are always at more risk of encountering mortgage stress. They are more likely to lose a job in this economy. And they tend to have less discretionary income. And today we read from Nick Gardner in the Sunday Telegraph that, “Almost half the first-home buyers lured into the market by the Rudd government’s $14,000 grant are struggling to meet their mortgage repayments and many are already in arrears on their loans.

“Thousands of young homebuyers are using credit cards or other loans to meet obligations, while those in ‘severe stress’ are missing payments. Just weeks after the grant was officially withdrawn, a survey of more than 26,000 borrowers conducted by Fujitsu Consulting revealed that 45 per cent of first-home owners who entered the market during the past 18 months are now experiencing ‘mortgage stress’ or ‘severe mortgage stress’”.

Perhaps this is why the Prime Minister is telling everyone that re-election is not a lock. Young voters favoured Labour over issues like Climate Change, an apology, and non-pocketbook issues. Now that their pocket books have been cleanly picked, they may vote a bit differently. We’ll see.

But today’s episode of the DR deals with the “weight of money” argument. That argument is that the share market will make higher highs as long as compulsory super directs baby boomer funds into Australian equities. The question is, what happens to the market and the economy when the boomers shift their weight from saving and investing to consuming their retirement incomes?

Yesterday we mentioned the long-expected move to increase compulsory super from 9% of wages to 13%. But there’s no guarantee this money would go to support equities. Instead, we expect a back-door transfer to pay for Australia’s increasing old age and health care liabilities. It’s a point made yesterday in the Intergenerational report.

The problem for Australia, like in all the Western world is that the population is ageing. You have fewer and fewer workers supporting more and more retirees. Those retirees are also drawing down their stock-market based savings vehicles. Their demand for benefits and income is increasing but their liquidating their asset portfolios to meet that demand.

This transfers the burden of national retirement from the stock market to the government. But as the government itself showed yesterday, the numbers don’t add up. The ageing of the boomers leads to increased national spending on healthcare as percentage of Australian GDP. As you case see from the chart below, health, aged pensions, and aged care all expected to up as a percentage of government spending and GDP

To pay those bills, you need more tax payers and higher taxes. Or you need more productivity. That’s what the government is counting on. It hopes that increases it output per hour by Aussie workers will deliver higher GDP growth and thus higher government tax receipts. But even so, the government itself projects a growing “fiscal gap”, shown below as the annual Federal deficit as a percentage of GDP.

Granted, this fiscal gap isn’t as bad as it is in other places like Japan and the United States. Japan’s government deficits are even more pronounced, and its demographic math even more dismal. The U.S. is also in its own kind of “reality gap” in which expectations of government by the population far exceed what America can afford. The new Obama budget projects $3.8 trillion in spending a $1.4 trillion deficit. There isn’t much in the way of spending cuts to programs what are considered “non-discretionary (defence, social security, Medicaid, Medicare).

You could say America itself has a kind of national “mortgage stress.” The future has been mortgage for a higher standard of living today. But it was a national prosperity built on debt. It’s all falling down. About the only good news is that Obama’s dollar-busting budget may drive higher asset prices for gold, energy, and other commodities.

But Australia and Australian investors face a slow motion fiscal trap. The country receives a big boost from trade income with China and the rest of the commodity consuming world. The government can fund its deficits at reasonable interest rates for now. But what yesterday’s report set up was a fight between two generations.

The Boomers will slowly liquidate share portfolios to meet rising health care expenses. And what they cannot pay out of pocket, you’d expect them to vote themselves. It’s an effective strategy for shifting the retirement burden from the private sector to the public. We have no doubt that Super Funds will be compelled to own government bonds. And the government will sell bonds in order to finance its spending obligations to the Boomers.

But where does this leave the share market and the economy? Can the country really increase output per person and grow its way out of the fiscal gap? The highest paid and largest employing industries are financial services and resources. Are the Boomers going to migrate to those jobs?

Will you have 70-year old coal miners working in Queensland? What kind of work can an ageing population reasonably be expected to do? There are more questions to answer. But we’re up against our daily deadline so we’ll have to leave them until tomorrow.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Baby Boomers Are Ill-Prepared for Retirement
• Baby Boomers Face Early Retirement With No Money Saved
• Bond Scam Perpetrated by Money-grubbing Government
• Baby Boomers Figure They Will Have to Work Longer than Expected
• Boomers Made a Mess of the United States of America

La La Land. According to answers.com, La La Land is “a place renowned for its frivolous activity,” and “a state of mind characterised by unrealistic expectations and a lack of seriousness.” Welcome, then, to Australian financial markets.

The real economy is not La La Land, mind you. By that mean we mean extractive industries that dig and drill the earth for real assets. That is not frivolous. It’s pretty serious. But the stock and housing markets…

The stock market has opened lower today. Wall Street was only down mildly on Friday. But Aussie stocks are on tenterhooks this morning. The RBA meets tomorrow to decide whether to increase interest rates a third time in a row. The economist money is on a cash rate hike of 25 basis points. That would bring short-term rates to 4%.

Meanwhile, conflicting data is coming out of the housing market. Imagine that. Data from the Australian Finance Group shows that borrowing fell to a five-year low in December. AFG reported a 19% fall in mortgage activity. It was the lowest figure in any one month since 2005. And according to AFG’s data, first home buyers as a percentage of new mortgages fell by half from the same time last year. They were just 13% of the market in the AFG survey.

Part of the falling mortgage demand is explained by rising rates. Part is explained by the expiration of the first home buyer’s grant. And part is the expectation of rising rates. All three conspired for a huge surge in prices in the December quarter which ran out of steam in the last month.

The result was that median December prices were quite high. The Real Estate Institute of Victoria reports that Victoria’s quarterly median price was $540,500. It was just over $405,000 in the March quarter. The Institute said the difference is explained by more sales to first home buyers in March (at lower prices) compared to more sales to more established buyers at higher prices in December.

That’s the property ladder, isn’t it? Investors sell starter homes to the newbies and turn around move on up. The question now is, with credit getting tighter and all that first home buyer demand having been brought forward, where is the new demand going to come from? Oh that’s right…immigration!

We have our doubts about how long all this can last, even with government support. But no point in beating a dead drum here.

We’re still about six weeks away from last year’s March 9th bear market lows. The big issue for investors at the moment is whether this is a buyable correction or a path to new lows. The bulls are hoping this dip below 5,000 on the All Ordinaries and the ASX/200 is just a pause on the way to bigger and bullier things to come.

The bears, your editor included, think the March lows will be retested and taken out. We just don’t know when. For the record, we did say on January 15th we thought it was the best time in a long time to reduce your allocation to stocks and liquidate some positions. The All Ords is down 6.75% since that.

Our old friend Marc Faber thinks there is more pain ahead for stocks. He told Bloomberg that he thinks the S&P 500 could drop 20% from its 15-month highs. He says profit and growth expectations are overdone in the U.S. and stocks are expensive.

The picture here in Australia is a bit murkier. Stocks are definitely expensive. But the press is again referring to Australia as a “miracle economy.” And with inflation up and GDP positive, the mood is pretty good. Whether that will translate into higher stock prices is another matter.

One way to guarantee that stock prices go higher – and that profits at financial firms are high – is to increase the mandatory contribution to super annuation. That’s just what the government should do, says the Investment and Financial Services Association!

IFSA says compulsory super contributions should be increased from nine percent of your earnings to twelve percent. This will prevent a “disaster for retirement savings” says IFSA director John Brogden. He says Australians face a collective $700 billion “shortfall” between what they’ll have to retire and what they need.

Last we checked, retirement was something you did privately, not collectively. Thus, whether you have a shortfall or not depends on your own wealth game plan. Nonetheless, you could see this coming a mile away.

It’s being done for your own good, of course. But day by day and step by step, your money is less your own and more the government’s and the financial industry’s. No doubt some of this new super money will buy Aussie stocks. But you can bet some of it’s going to buy government bonds too, to fund Australia’s deficits. Yep, definitely time for a survival strategy.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Are Aussie House Prices in a Bubble?
• Good Month for Aussie Stocks, While U.S. Stocks Fell to Close the Quarter
• U.S. Stocks Concentrate on Present Bond Market Data
• Why I Would Have Raised the Interest Rates
• Farming Cattle is Out; Farming Soybeans is In

Last year’s stock market rally was impressive. But what if it was merely a case of investors taking on more risk, having been encouraged by low interest rates and all the liquidity sloshing around in the stock market, taking it higher? How would that be substantially different from banks taking advantage of low rates and liquidity to make epically bad lending decisions? We’ll get back that in a second. First…to the newswires!

The futures were down overnight by 72 points. Like it or not, the Aussie share market still takes its marching orders from the U.S. action. It hasn’t decoupled yet – even though what drives the respective economies of Australia and America is somewhat different. Australia has resource demand for its raw materials from emerging markets. America does not. But both countries have debt (especially household debt), and plenty of it.

Here in Australia, what will investors think of the new powers being sought by the Federal government on behalf the corporate regulator, ASIC? ASIC would have the power to tap phone lines, impose fines of $500,000 on insider traders, and double jail terms for insider traders from five to ten years. Hmmn.

Better yet, what will corporate insiders think? We’ve seen some strange share price activity since moving to Australia four years ago. Shares move on no news and volume spikes. Then a few days or weeks later some important announcement comes out. And frankly, the disclosure rules for insider buying (or selling), or at least the enforcement of those rules, seem fairly voluntary.

Not that it’s any better in America or anywhere else. But perhaps because of the smaller financial community and the under powered regulator, the insiders have a better time of it here than they might other places. Ahem.

But the power to tap telephones? Yikes. That sounds draconian. But it’s fully in line with the encroachment of government power into private life, so it’s no big surprise.

Outside Australia, more trouble is piling up for the world’s most debt-addled nations. “We no longer classify the United Kingdom (AAA/Negative/A-1+) among the most stable and low-risk banking systems globally,” said ratings agency Standard and Poor’s. The FTSE finished lower on that cheery note.

This is the big back story to today’s financial markets. The debt problem has not gone away. Banks have recapitalised, making up for some of their losses from 2008 and 2009. But you still have a financial system addicted to debt and leverage. Investors have bought into the recovery story, though, and taken a punt on shares at just the time they ought to be reducing their allocation to shares (in our estimate). Why?

The deleveraging that kicked off in 2008 still had a long way to run. The banks know this, which is why they’ve decreased risk by being stingier with lending. Shareholders, on the other hand, have done the opposite. And that could cost them.

“Any discussion about the response to the crisis,” reports Peter Larsen at Reuters “must acknowledge the need to reduce the levels of debt that have been built up. A study by McKinsey, the consultancy, found that previous deleveraging episodes have generally taken four forms: a period of belt-tightening, in which credit growth lags behind economic growth for many years; massive defaults; high inflation; or a period of rapid GDP growth as a result of a war effort or an oil boom.”

So which will it be? The RBA releases its report today on financial aggregates. We’ll see if credit growth is lagging the economy. Not likely, we reckon. Massive defaults? High inflation (higher than the RBA is comfortable with)? Or war and an oil boom?

None of them are particularly attractive. But none have really happened yet either. That’s why we think 2010 will have more fireworks. Perhaps a debt default by a sovereign government or two. And then you have fewer and fewer surviving financial firms all deemed too-big-to-fail by the government. Not good.

This just in…the U.S. Senate has voted to raise America’s statutory debt ceiling to $14.3 trillion. This will allow the Treasury to borrow more money to both service existing debt and pay for this year’s $1.3 trillion annual deficit. Ben Bernanke was also confirmed for another for another four-year term as destroyer in chief of the U.S. dollar by a 70-30 vote.

Prediction: at some point the American people are going to turn on the clowns ruining their money and their financial future, piling up debt that will take decades to pay off, if it’s ever paid off at all. The Congressional Budget Office reckons that interest on that debt will more than double as a percentage of GDP. It nominal terms, it will triple from $202 billion to $723 billion.

That’s just interest. That is the price of living above your means as a nation. That is the price (really just part of the price) for making promises you can’t keep. It’s a big price. And in the meantime, we’d take U.S. dollar rallies with a lick of salt. And though we read this morning that George Soros thinks everything is in a bubble – including gold – we’d keep an eye on old yeller and look to buy more on dollar strength.

Finally, we got a fair bit of mail in response to Murray Dawes’ short-selling primer. We can’t reprint all the questions. But we asked Murray to have a look and answer the most common ones. That he did.

He writes, that “One question that came up a few times in response to the shorting article was how long a short could last for. The simple answer to this question is that it is indefinite. There is no time limit on how long you can be short for, but in saying that you have to be aware that the lender can call back their stock at any time.”

“In practice this rarely happens, but the lender may want their stock back so that they can vote with their shares at a meeting of the shareholders. In such a case the investor who was short the stock would be required to buy their stock back and return it to the lender. This could really throw a spanner into the trading plan of an investor who is short and is one of those unforseen risks that we are exposed to in trading the markets.

“Another issue that is constantly in the press is whether or not trading short is ethical. I think it is ridiculous that people turn to scapegoats and start pointing fingers whenever things don’t go their way. I didn’t hear anyone screaming for the heads of people who short while the market was in a huge bull market for years.

“But the situation was exactly as it is now in regards to shorting. People took on risk to go short a stock and in fact take on more risk than someone who is long because markets do rise over time. When the shorts were getting killed, people were happy for them to be short. Now that they are making money everyone is crying in their beer.”

“It would be lovely if markets only ever went up, but as we learnt during the tulip frenzy hundreds of years ago, a bubble will always pop in the end. It’s not the fault of the ‘evil’ people who dared to realise that the market was overvalued. If there is any finger pointing to be done it should be at the people who allowed the bubble to form in the first place. And we all know who that was (see also Greenspan and Bernanke).”

For the record, Murray has a few short trades open in Slipstream Trader. A few weeks ago, in a forecast to Slipstream readers, he called for a decline to 4,600 on the ASX/200. The index trades at 4,619 as we write. Stay tuned next week for a fuller introduction to what Murray’s been up to. We admit we’ve kept his trading method under wraps. We’ll explain why next week. Until then.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• The Problem With a Well-Diversified Portfolio
• Trading Airline Stocks in an Energy Bull Market
• What is Short Selling?
• A Sovereign Debt Crisis Bullish for U.S. Dollar and Bearish for Gold
• Note to Australia: Buy Resources, Not Banks

Hey how about that new iPad? Now everyone can spend more time than ever talking to people through Facebook instead of actually talking to people face to face. What is technology doing to us? We have more ways to communciate than ever but seeming to be saying less and less of substance. Oh well. It is pretty cool looking.

But on to financial markets. The not-so-big news from Wall Street is that the Fed will not be raising the price of money anytime soon. The kingpin of the banker’s cartel told the market it would keep short-term interest rates “exceptionally low” for “an extended period of time.”

Stocks gave a muted “woo hoo” and rallied about 40 points on the Dow. The rally was weak because low rates for most of this year mean several things, most of which are bad. For one, the Fed isn’t sold on the recovery story. It thinks the economy needs cheaper credit to build more momentum.

Secondly, higher short-term U.S. rates would push up ten-year rates. That, in turn would push up mortgage rates. And that, in turn (coupled with falling home prices) would be a death blow to the millions of Americans hanging on to their homes by the skin of their teeth.

That’s not what the Fed said, of course. It actually reiterated its intention to stop purchasing mortgage backed securities in March. So far, the Fed has pumped nearly $1.25 trillion into the market to keep lenders to lending to all those first home buyers taking advantage of the tax credit from Congress.

In any event, today’s news was mostly a non-event. There was finally some dissent on the rate policy from Kansas City Fed President Thomas Hoenig. He reckons the Fed has been too lax already and the economy doesn’t need low rates. But for the most part, the Fed is still intent on financing America’s debt recovery program with more debt.

Should we talk housing for a moment? How can we not? In the U.S., new home sales fell 7.6% in December after falling 11.3% the month before. All that government tax tinkering is increasing volatility in home sales. But that’s what happens when you alter incentives willy nilly.

The U.S. Commerce Department said 374,000 new homes were sold in December. That was the lowest monthly total since the Department began keeping figures in 1963. What’s more, new home prices fell 3.6% to a miserly $221,300. Granted, that’s more expensive than the median price for an existing home. But heck…it’s starting to look affordable to buy a house in America again…if you can get a mortgage.

In Australia, we can’t say the same thing. Prices are soaring in Australia’s capital cities, according to data realised by the Australian Bureau of Statistics. Melbourne led the pack with an 18.5% increase in 2009. Hobart clocked in with a 14.4% increase, while Darwin was next at 13.5%, Sydney at 12.1%, Canberra at 10.6%, Perth at 8.7%, Brisbane at 7.7%, and Adelaide at 2.4%.

As a contrarian, Adelaide interests us the most. We were just down there over the weekend. There are some lovely old homes. Sure, it’s a bit quiet. And the median price of $427,109 is not cheap. But it’s not cheap anywhere in Australia at the moment. The national median price for the December quarter is $525,524 – up 12.1% for the year.

That’s insane.

While Australians march down the path of a national house price obsession/mania, the world’s bond traders are firing warning shots. Bloomberg reports that, “Credit default swap (CDS) protection buying against sovereign debt default has spiked to five times the level of similar protection bought for corporate bonds, as the potential for a wave of sovereign debt defaults intensifies.”

A credit default swap is way of buying insurance against a default in your bonds. AIG, for example, got into big trouble (along with Tim Geithner) for selling insurance on sub-prime backed bonds purchased by Goldman Sachs and other investment banks. When the underlying collateral (U.S. homes) went bad, the bonds fell and the insurance kicked in, taking AIG (and nearly the U.S. financial sector) with it.

Bloomberg’s story shows that credit default swaps have jumped for 54 sovereign governments since October by an average of 14.2%. In Europe its worth, with Portugal’s CDS rates rising 23%, Spain’s by 16%, and Greece’s by 5%. But what does it mean?

Well it means traders think we’re right. Well, that is, it means 2010 is the year the GFC becomes a sovereign debt crisis. National governments were able to backstop their respective financial systems by greatly expending debt-to-GDP levels. But in some cases, those levels are so high that bond traders rightly wonder if those governments can make good on their debts and still function.

The fact that CDS spread are rising means traders reckon government finances in some nations (especially those in Europe that have no independent fiscal policy, i.e. the means of printing money to pay the bills) are in for a tough year. But then, it’s going to be a tough decade for the nation state.

The nation state itself is a relatively modern organisation. It’s a way of allocating power (the monopoly on violence). And, when it’s consensual, it’s way for free people to guarantee that certain rights and liberties (that existed prior to government) are protected in an organised fashion.

But at some point – and we reckon it was the evolution in British finance in the 17th century – the funding model of the nation state turned a way of securing property and individual liberties into a way of making perpetual war. The nation state became the Warfare/Welfare state through the invention of perpetual debt financed by customs, excise, and income taxes.

And here we are in the globalised, iPadded world of today, where the funding model of the nation state is breaking down. It’s not able to deliver prosperity. And in some cases it can’t even deliver security. So what can it do? It can project power and coerce tribute from its citizens through taxation.

Of course some States are better than others. And we reckon that question – where is the most secure place for myself and my assets – is the most important investment question this year. Not whether house prices and interest rates are going to keep rising.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• U.S. Home Sales Up Because of Congress Tax Credit
• It All Comes Down to Debt Again for NAB
• U.S. Government May Default On Its Debt
• Aussie Stocks on Tenterhooks and RBA to Decide on Interest Rates Increase
• The Trouble With a Sovereign Debt Crisis

And the world got wackier. The rest of the world did not take Australia day off. Instead, strange divergences in normal trading patterns continued to pop up around the globe. For example, bonds finally moved up as stocks went nowhere.

Bonds had been going down with stocks too, lately. The dollar was up against nearly everything except gold, which also closed higher. Uncertainty makes for strange bedfellows. We’ll try to sort out if it actually means anything in today’s Daily Reckoning.

For starters, stocks are looking pretty timid. Our own technician Murray Dawes is expecting a correction. And for the record, Wall Street has closed down four out of the last five days. It did not improve today, although the close on the Dow was negligibly negative.

Financial markets in the States have been pretty gloomy ever since President Barack Obama told the banks he was taking away their favourite profit toys, their proprietary trading desks. If earnings don’t come from the finance sector in the American economy, they will have to come from somewhere else. And just where will that be?

It will not be real estate, mortgage lending, and home building. That’s for sure. At least not any time soon. U.S. existing home sales by the largest monthly amount in forty years, according to the National Association of Realtors.

December existing home sales fell by over a million units and 16.7%, according to the NAR. The positive news, if you’re looking for some, is that sales per year were up 21% compared to 2008. And if you can believe it, the median sales price for an existing U.S. home is a rather humble (by Australian standards) US$178,300.

What a bargain!

Actually, what’s happening is pretty simple. Sales are up because the ass-clowns in the U.S. Congress introduced an $8,000 tax credit for first time home buyers. Sound familiar? It’s not a grant. It’s a tax deduction. But the effect is the same: to bring forward demand and support current prices.

In November, first home buyers taking advantage of the tax credit made up 50% of demand for existing homes. In December, it fell to 43%. Those two months were supposed to be the final months of the credit. The December decline shows that most people who intended to take advantage of the credit had already locked it in.

But what now? The credit supported prices and sent sales soaring. The Congress extended the credit through April 30th of this year. But we doubt it will lead to a huge recovery in home prices. Why?

There is 7.2 months supply of homes at the current sales rate. That’s a huge surplus inventory. It puts massive downward pressure on prices – and that’s before another likely wave of foreclosures hits the U.S. market. Hmmn.

Yes, we know what you’re thinking. In Australia there is not a surplus of homes. There’s a shortage! Yes, median prices are higher in nominal terms and as a percentage of median incomes. But it’s different here. There are immigrants. And there are other things which guarantee house prices in Australia cannot fall. Surely.

We shall see. The principle here is roughly the same. You can bring forward demand through lower interest rates or grants and tax credits. But this does not make housing more affordable. It DOES get the marginal buyer into the market, though, and that supports prices for a while.

Eventually, house prices have to be realistic relative to incomes. In the U.S., that means prices are finding a clearing level that reflects tighter credit, the surplus inventory, and a lower median-price-to-median-wage level. In Australia?

Well, you’d think immigration was a slender reed to lean on. Besides, according to a recent poll, 66% of Australians want the Federal government to cap immigration. Not that the government usually listens to “the people”. But the point is: immigration can be capped.

In fact, the best reason to cap it is generally that a high-tide of immigration lowers average wages by expanding the work force. That might not be the case in Australia, of course. A growing economy creates jobs at all wage levels. And to the extent that Australia is imported skilled workers (to work the mines in WA and Queensland) the wages there are much higher than the wages in the rest of the economy (this pushes WA house prices into the stratosphere).

Our point, though, is that all of these are peripheral factors. Houses can’t be so expensive that people are unable to afford them on the average wage. You can try to bridge the gap with tax credits, grants, and lending schemes. But eventually, prices are going to fall.

This brings us to a quote we saw in Bloomberg this morning. “There’s a looming risk of governments making decisions that adversely affect the economy,” said Tim Brunne, a credit strategist at UniCredit SpA in Munich. He referred to the policy changes proposed for the U.S. banking sector. But really, doesn’t that pretty much say it all these days?

If you want, proof, look to Japan. For twenty years, the government there has tried to cushion the effect of a real estate and share price crash by increasing public spending. The economy has chugged along at tiny growth rates. But at a price: an enormous public-debt-to-GDP ratio.

Yesterday, ratings agency Standard and Poor’s affirmed Japan’s sovereign credit rating of double ‘A’. But it changed its outlook from ‘stable’ to ‘negative’. S&P wrote that, “The outlook change reflects our view that the Japanese government’s diminishing economic policy flexibility may lead to a downgrade unless measures can be taken to stem fiscal and deflationary pressures.”

This is the S&P’s way of saying it forgives Japan for its fiscal excesses…but frankly, it’s just not sure it can trust Japan anymore. Has it really changed? Or is it just saying it wants to change?

You know how relationships like this end. Outlooks go from ‘negative’ to ‘don’t ever call me again…I hate you…I don’t see what we ever had in common.’ Still, Japanese stocks look cheap. Our guess is they will stay that for awhile. The world’s love affair with equity as a way to get rich is getting strained too.

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Credit Default Swap: Buying Insurance Against Default in Your Bonds
• House Prices in California and Las Vegas Hit Hard by Wave of Foreclosed Properties
• Australian House Prices Are Severely and Seriously Unaffordable
• Recovery for the Real Estate Market
• Are Aussie House Prices in a Bubble?

Fresh back from a whirlwind trip to Adelaide to see Victoria smash South Australia in cricket and watch the Tour Down Under up close, your editor finds the financial markets in a state of acute anxiety, while investors, according to a survey, are keeping on the sunny side of life. Reality is keeping a low profile these days. But let’s see if we can find some clues about where he’s hiding out.

He (Mr. Reality) left a calling card in New York on Friday, that’s for sure. Stocks in New York fell 2.09% on the Dow. Wall Street has realised that it’s become the political whipping boy for a President who needs a popular enemy. It’s all probably a bunch of bluster to get the President some political momentum.

But if anything has momentum, it’s the volatility index. It’s up 55% in the last three days (see chart) The VIX measures implied volatility on the S&P 500. It’s nominally a measure of the cost of options on the U.S. exchange. It goes up when uncertainty increases. It does that because options are a way of hedging against future outcomes (positive and negative). When the future becomes more uncertain, the cost of insuring against it (at least in the stock market) goes up.

It’s all basic supply and demand really. But in this case, demand for uncertainty insurance is rising because the supply of uncertainty is soaring. The U.S. economy, the Japanese economy, the European currency, the Chinese bubble, the Australia resource super cycle…these are all part of the complex adaptive system that is the global economy. Hmm.

84% of Australians think house prices will rise in the next twelve months, according to the January Westpac-Melbourne Institute Consumer Sentiment Survey. Mr. Reality is clearly giving these Australians a wide berth. Twenty one percent of those surveyed believe house prices will rise by 10% or more in the next twelve months.

Doing a little back of the envelope math, and if our calculations are correct, a $450k property compounding at 10% a year for 10 years would turn into a $1.16 million dollar property. It would be a gain of 160%. And one million dollars would be the new median house price in Australia.

Now you have to assume a lot of income growth from here for affordability to remain the same with house prices at those levels. Or you’d have to assume much lower interest rates. That would be a stupid assumption, though, given that interest rates are headed up at the moment, and that we are likely at the low end of the interest rate cycle.

Perhaps the 21% of people believe house prices will go up by 10% a year are all real estate agents and bankers. Or perhaps they are functionally illiterate in the financial sense. Either way, it’s a large percentage of people surveyed to believe such clap trap. It’s this kind of belief that is the rocket fuel for the blow off stage of a bubble.

But we’re not going to win that debate this week. We’d just like to point out that this is whole point of the Daily Reckoning really, to scrutinise received thinking and conventional wisdom. Whether it’s the housing bubble, the economy, or global warming, your best defence against a world full of bogus thinking is to question it.

Of course that doesn’t mean you’ll always be right. For example, we’re obviously not a climatologist. The mail bag was full of some choice words for the comments we published last week (Burn More Coal). The polite synopsis is that we were told to stick to our knitting.

But calling out mainstream thought IS our knitting. And climate change is fair game because the financial stakes are extremely high. Indeed, all the stakes are high (political too). We’re not going to rehash the argument here. However, if you don’t like uncomfortable ideas, don’t read them!

Don’t worry though. We will say, yes, most of the time our beat here is investing. And there is plenty to think and write about on that score. So we’ll get back to the main game this week. Until tomorrow!

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Reserve Bank of Australia Will Meet to Determine the Price of Money
• Australian Credit Card Debt Grew by 9% in February
• U.S. Trying to Auction Off $162 Billion in Debt
• Copenhagen Climate Talks Possibly Sent the Market Higher
• Rule Thumb for Modern Times

The Washington-Beijing Axis again hammered New York and London overnight. U.S. stocks fell two percent after suffering a surprise attack from the regulatory flank by President Obama. The Obama proposals are designed to prevent any one bank from becoming “too big to fail.” They aim to achieve this – in ways not pleasing to the investment banking industry – by cracking down on proprietary trading and bank sponsorship of hedge funds.

Not that we are going to defend the investment banks. But Washington should make up its mind. The Rubin Treasury had a clear economic philosophy. It thought up the academic jargon of the day, it “privileged” Wall Street over Main Street and Detroit (manufacturing).

The U.S. ran a capital account surplus and a massive current account deficit. Wall Street thrived and booked record profits (as a percentage of S&P 500 earnings) and stocks soared. The wealth effect even trickled down into 401(k)s during the dot com boom. And it was all good.

But now, it’s not all good. Banks are bad. And fresh from a third-straight trip to the electoral woodshed, the American president is prepared to go populist. We don’t know if the President’s proposals will pass, or if they will fix a banking sector that’s still saddled with debt. But we doubt it.

Regulatory reforms deal with the future. In the “now”, banks still have massive exposure to falls in residential and commercial real estate. Accounting tricks have forestalled the realization of losses. But not even Moses could hold back the tide forever, we reckon.

Speaking of rising tides…another 482,000 Americans filed for unemployment benefits for the first time. That was a 36,000 increase over the previous month. Economists expected a decline.

Stock prices, under siege as Washington attacks the only profit engine in America’s economy still firing away, were also hammered by growing concern over tighter Chinese bank lending. That concern, ironically, was even stronger when China reported that fourth quarter GDP came in above expected at 10.7%. If inflation gets loose in China, the central bank will have to be even tighter.

Thus gold’s fall and the zombie-like rally of the U.S. dollar. We’ve seen this before in the last two years. When bad news gains momentum in the investment press, the dollar rallies and gold and stocks fall. The dollar gets a strange “flight to familiarity” bid. What does this say about gold?

It says that dollar rallies are great chances to enter or add to your positions in precious metals or precious metals stocks. Even base metals like copper might be worth a look on the dips, says Diggers and Drillers editor Alex Cowie. Alex sent us the first draft of his January letter late last night.

Commodities will retrench on dollar strength but these dollar rallies on uncertainty and gloom shouldn’t be confused with any kind of real dollar strength. On an interest rate basis, the dollar is still getting clobbered by the Aussie and other commodity currencies.

Or, if you prefer to view your currencies as proxies for an entire economy and its growth prospects, you could do worse than look at Brazil. Granted, there aren’t a lot of highly liquid options to the USD that don’t also suck (the yen, the Euro). But we read in the wee hours of the morning that the Russians are loading up on some of Canada’s money and lightening their load of USD.

The main point? The United States is a worsening fiscal trap. Washington confusing the markets about policy and being alternatively negligent and belligerent won’t help anything. But then, this is government we’re talking about.

Nope…we have not forgotten our promise to investigate the structure of the Financial Claims Scheme that’s been proposed by APRA. It’s a subject we’ve been circling around for a few months…trying to figure out if it really does transfer responsibility for guaranteeing the banks to the public balance sheet. But it’s a big subject. So be patient, we’ll get back to it. Until then…

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• 4 Ways to Protect Against a Falling Dollar
• Transfer of Wealth
• Trickle of Chinese Money into Australian Housing and Equities Small Compared to Growth in Bank Lending
• DMCC and their Precious Metals Vault
• Gold and Silver!

Well the whole world was pretty much down overnight. Blame China, if you must. Today’s Financial Review reports that Chinese regulators are leaning on Chinese banks to quit lending for the rest of the month. It is probably not a request.

“The move to restrict lending is a sign the government is increasingly concerned about asset bubbles and worsening credit quality.” The concern is welcome, but probably a little too late. Chinese stocks and real estate have soared in the last year on the $1.5 trillion lending boom. Check out the chart below.

You can see that Shanghai’s composite index was up nearly 78% from the March low to the August high. Since then, it looks fairly range bound. And below it, the red line shows you the rough correlation between the All Ordinaries and China. The main difference now is that Aussie stocks are just off a new high made early in the New Year.

We freely admit to knowing very little about China, other than what we read and what we think about in our own head. But the numbers – those published by the government – show a huge fixed asset investment book over the last ten years. Whether that boom has become an unsustainable bubble is a good question. But the answer may not actually matter that much.

The point of contention is whether China’s resource-intensive phase of growth – the massive support of Australian resource prices and resource stocks – is fully mature, or has years to go. If it’s fully mature, resource demand is going to be lower and probably stock prices too. We’ll see about that.

The other global downer on the newswires comes from the U.S. housing market. New housing starts fell by 4% in December and index of homebuilder confidence fell too. But by far the more alarming news was that the Federal Housing Administration is increasing mortgage insurance premiums, demanding higher credit scores, and requiring larger down payments from new borrowers.

Don’t worry. It’s not like the FHA is getting too tight with taxpayer money. Mortgage insurance premiums are rising from 1.75% to 2.25% and the down payment required for a new loan is just 3.5%. It’s hard to imagine these moves significantly improving the FHA’s balance sheet.

According to the agency’s own figures, its share of the mortgage market has gone from 3.7% four years ago to 30% in 2009. It was a key agent – along with Fannie and Freddie – in the nationalisation of the American mortgage market. Yes, the U.S. government is keeping the mortgage market afloat…but the FHA’s cash reserves are down to 0.5% of loans outstanding (instead of the robust 2% required by an inept Congress).

All up, it could be another very bad year for American housing. That would be bad for banks, who still own a lot of housing collateral (and have carried it at what can only be described as “hopeful” valuations. And if banks are worried about further collateral destruction, they aren’t going to be in any hurry to lend money into the economy.

Instead, look for them to borrow short-term from Uncle Sam and loan the money right back to him at a higher rate. This is the dynamic that fuelled bank and brokerage trading earnings last year. Falling house prices and a stagnant mortgage market set up 2010 for more of the same.

Some people say they’re contrarian and some people really are contrarian. We just got off an hour long phone call with our friend and Strategic Investment editor Jim Davidson. Our pen literally ran out of ink during the call. We’ll let you know more about Jim’s new project later. But here are some excerpts from today’s chat.

“The earth is not getting warmer. It’s getting colder. The climate Nazis at the UN admitted this week that their claim that the Himalayan glaciers are melting away was false. I may as well have said the Great Salt Lake is going to turn to sugar.”

Jim’s put together a “Little Ice Age Portfolio” as a response to the climate change hysteria. But the investment response is secondary to the seriousness of the issue, he says. “There’s very little evidence that rising carbon dioxide levels lead to rising temperatures. It’s more likely – as temperature records show – that changes in climate are correlated to solar activity and sun cycles. Imagine that.”

“If it were true that reducing carbon dioxide emissions into the earth’s atmosphere reduced the earth’s temperature, it would be a bad idea to do it. In the Dark Ages, another period of lower solar activity, the Nile River froze. On the other hand, Rome prospered because agriculture thrived and you could grow grain in Carthage.”

“In a colder world, Canada would be an iceberg and one of the great grain growing regions of the world would disappear. People believe that because farmers plant a crop, it will be harvested and the modern world can live on a diet of high-fructose corn syrup that malnourishes people and makes them fat. But in another Little Ice age, hundreds of thousands of people would die if the world’s grain growing regions marginally declined. Billions would die if the impact was more severe.”

“The Black Death hit Europe in the Little Ice Age, too. Lower crop yields reduced the quality and quantity of nutrition available. This weakened immune systems and made people more exposed to infectious diseases. Why, if you’re a humanitarian, would you pursue a public policy that pushes a billion people who are already on the edge of starvation into outright famine?

“If winter comes early or stays late, whole crops will be wiped out. Reducing the output of food – something that would result from a colder Earth – is evil. It’s based on non-existent science in which people forecast things that may happen centuries from now based on their ideological resistance to prosperity. They are trying to force down living standards in the Western world based on their own guilt about prosperity and income inequality.”

“Global warming just another phrase for good weather. If it’s true carbon dioxide emissions warm the planet, we should burn more coal. You can tell the science is dubious because you now have a bizarre feedback loop in which warming makes the world cooler. It’s rubbish.”

“The big risk in the discrediting of the global warming crowd is that it could discredit other, more legitimate concerns about the climate, like the huge amount of harmful chemicals in our water supply. The persistence of dangerous chemicals in our recycled water is something to be really worried about. You don’t want the environment to turn into a sink for man-made chemicals.”

There was much more to report. But we’ll have to leave the rest for another day. Jim is hard at work on the January issue of Strategic. He’s analysing the possibility of a fiscal collapse in the United States, and where investors can seek refuge before it happens. Until then…

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Cattle Prices Have Risen Only 1% This Year
• Americans Are Hoarding Food
• An Old Friend With a New Idea on Global Warming
• Equity Premium Will Be Replaced With a Tangible Asset Premium
• Posco’s Production Cuts May Be Bad for Australian Iron Ore

Yesterday’s market action was a big fat nothing burger. There was at least one item of black humour. Today’s Age reports, that, “Debt recovery specialist Collection House was at its best share price levels since 2007 after managing director Tony Aveling produced unaudited profit guidance figures suggesting its after-tax performance will be about 55 per cent better.”

“Mr Aveling said Collection House, which sources most of its business by recovering customer debts for banks and service providers like phone and energy companies, opted to use its money to pay off debt, rather than borrow more to buy the debts of others and try to chase defaulters. He also said shareholders could expect an increase in interim dividend, contributing to Collection House shares rising beyond 90¢, before settling to a 12¢ gain at 84¢.”

How about that? A debt collection company growing earnings, paying off its debt, and paying a dividend? What does that tell you about the world when the debt collection business is booming?

To be fair, earnings were up at a few companies like Flight Centre and Computershare. But the banks sold off and the market closed down about 1%. So which is it? Are Australian earnings going to be stronger than expected? Or are stocks already priced for earnings perfection?

We’ll ponder that on the tram on the way into the CBD today. A group of investors touring Australia is in town and we’re on our way to speak to them about our forecasts and strategies for 2010. Mostly this involves more cash, fewer shares targeted to industries where there is scarcity, and a handful of energy, precious metals, and small cap shares.

That may seem like a bit of contradiction: bearish on the stock market but bullish on the riskiest sectors of it. But we’d make that case that it’s owning the banks and other so-called blue chips that’s the bigger risk – given the rewards on offer. It’s better to have at least some shares where when one good thing happens, the share can go up 3-1, 5-1, or 10-1.

But true to form, 2010 is going to be the year the solvency of the welfare state dominates the front pages. People are slowly beginning to understand that huge social welfare states have to be paid for by someone. And if your economy isn’t growing, it’s hard to “spread the wealth around.” You have to “borrow it around.” And that puts you in debt.

For example, Greece has a fiscal deficit that’s nearly 12%, or four times what the suits at the European Union in Brussels say you’re allowed to have and still be a member in good standing. What’s worse for Greece, its total debt-to-GDP ratio is working way to 120% – which is pretty bad, even by American and British standards (although modest by Japanese standards).

It may be satisfying for the EU’s finance chiefs to scold Greece. But they all live in the same very large monetary glass house. This is the proverbial Achilles heel of Europe’s monetary union. Twelve economies, one interest rate, zero flexibility. It’s hard to imagine a better recipe for a fiscal crisis.

Our old friend Marc Faber says to beware the PIIGS – Portugal, Ireland, Italy, Greece, and Spain. These are the Euro nations that borrowed up in the boom and now have to pay it back. If these nations ran their own monetary policy, they could set interest rates low or print money. That would inflate away some of the accumulated debts.

But Europe’s central bankers are not as willing as their Fed counterparts to throw their currency to the dogs. Thus the PIIGS don’t have the any monetary or fiscal stability left. They must live within their means, cut spending, or get some kind of bail out from their neighbours.

The whole situation makes you realise how much of modern “wealth” is just debt dressed up in fancy clothes with a flashy car. And that’s just at the household level. We think some European nation’s will realise this year that you can’t infinitely redistribute wealth to achieve the goals of social justice and equality…if the economy itself isn’t producing that wealth in the first place.

Faber reckons one of the PIIGs will default in the next few years. Whether this provokes a currency crisis in Europe is the open question. What the euro has going for it right now is that it is not the U.S. dollar nor is it the yen. That’s not saying much.

Australia doesn’t yet face the kind of fiscal reckoning that the PIIGs, the U.S., Britain, and Japan face. We meant to show today how that could change quickly in the future. It’s a new scheme to put ultimate responsibility for bank solvency on the Aussie tax payer. But we have a tram to catch, so the story will have to wait until tomorrow. Until then!

Dan Denning
for The Daily Reckoning Australia

Similar Posts:

• Central Bankers Encourage Debt Booms That Become Debt Bombs
• Commonwealth Bank (ASX: CBA) Nearly Doubles Bad Debts Over Last Year
• U.S. Government Must Roll Over $3.4 Trillion in Debt Over Next Four Years
• Note to Australia: Buy Resources, Not Banks
• Banks or BHP?