Silver surged to 7-year highs overnight. We have long been fans of precious metals during a period of unprecedented central bank printing. The good thing is many people haven’t cottoned on to the value of silver.
Silver surged to 7-year highs overnight. We have long been fans of precious metals during a period of unprecedented central bank printing. The good thing is many people haven’t cottoned on to the value of silver.
If you haven’t done so already, we strongly encourage people to sign up to Narrow Road Capital’s insights on high yield and distressed credit markets. Even better it is free. Jonathan really puts together his thoughts in a very digestible format.
Jonathan has penned this excellent summary of the state of debt markets and cautions us not to get too excited. We have highlighted the things that stood out for us.
Credit is Normalising, But…
Credit securities, both in Australia and globally are getting back on their feet. The bookbuilds this week of $1 billion of corporate debt by Woolworths, $1.25 billion of RMBS by La Trobe and the $500 million of hybrids by Macquarie are all positive signs. However, secondary trading in many debt sectors is light and a few sectors remain moribund. Whilst the signs are generally encouraging, three dark clouds on the horizon point to the possibility of worsening conditions.
The leverage fuelled, panic driven sell-off started on February 24 and ran until March 23 . The circuit breaker was the Federal Reserve’s announcement of “unlimited quantitative easing”. At that time, there were widespread reports of global investors struggling to sell even the highest quality government bonds. Given how dire it was, it has been a relatively quick journey back from the abyss.
In Australia, major bank senior bonds recovered first and are now trading at similar spreads to three months ago. Corporate and securitisation debt has had a far slower recovery with trading remaining patchy. The large issuance this week by Woolworths and La Trobe, as well as a smaller issue by Liberty showed that buyers were willing to return. But unlike major bank bonds, spreads on corporate and securitisation debt have been reset at much higher levels.
At the same time as credit markets are improving, the economic outlook is also brightening in some ways with the gradual easing of restrictions on business. There is a growing view that the worst of Covid-19 has past and that a vaccine or drug treatment might not be far away. The optimism of the human spirit seems boundless with some investors seeing the pandemic as just another opportunity to buy the dip.
Where many investors are seeing mostly positives, I’m seeing mostly negatives. Australia has gone nearly 30 years without a recession leaving our economy fat and lazy. Asset prices (notably housing) have been propped up by population growth, credit growth and interest rates cuts, all factors unlikely to repeat. We’ve had over a decade of Federal Government deficits, destroying the legacy of Peter Costello’s decade of fiscal discipline. The economic buffers we had before the last crisis have been frittered away, leaving Australia poorly placed to withstand and rebound from the current economic and financial crisis. Given this backdrop, there are three standout risks for investors to factor in.
Remember 2007 – Fundamentals Matter
The bounce back in the last two months reminds me a great deal of 2007. In July 2007 credit markets slammed into a brick wall with credit default swaps and CDOs taking substantial damage. Bank bonds sold off as the riskier European banks started to have their solvency questioned. Yet after an initial shock, some of the markdowns turned around offering a window to get out with limited losses.
At first, equities and property continued on their merry way oblivious to the damage in credit markets. Australian equities peaked in October 2007 but held near record levels until January 2008. In December 2007, the property sector was slammed as Centro disclosed it couldn’t roll over its debt. Both at the time and in hindsight, the second half of 2007 was a bizarre period where fundamentals and market prices were so divergent. Given the medium term outlook for Australia includes significant unemployment and business failures, it is hard not to conclude that most investors are ignoring the fundamentals, just like they did in 2007.
If the global debt markets are likened to plumbing, then quantitative easing is the duct tape used to cover the cracks. Central bank buying of government debt has delivered liquidity to debt markets at a time when governments and corporates are going on record borrowing sprees. If investors weren’t able to sell assets to governments via quantitative easing programs, they wouldn’t have capacity to buy the new issuance and bond yields would soar. Quantitative easing is beating back the bond vigilantes temporarily.
Australia has been a late entrant to this charade but is making up for lost time with the RBA hoovering up 7% of Australian government bonds in two months. At this rate, they will own the entire government bond market by the end of 2022. Whilst the RBA buying government bonds is the main game, there’s also been cheap funding for banks and the securitisation market. It’s no longer a case of merely providing liquidity against super safe assets, the recent purchases of sub-investment grade securitisation tranches come with the meaningful possibility of capital losses.
Whilst quantitative easing has yet to hit its unknown limits in developed economies, emerging markets have shown what happens when citizens and investors lose confidence in a fiat currency. The widespread use of US dollars in Argentina, Ecuador, Lebanon, Venezuela and Zimbabwe is the practical outworking of a country adopting funny money practices. At some point, the duct tape stops working and the value of the currency goes down the drain.
Global High Yield and Emerging Market Debt
Whilst most credit sectors are recovering well, corporate high yield debt and emerging market debt are on life support. The US high debt market has recovered around half of the losses that occurred since mid-February. However, this has been a quality driven rally with BB rated companies able to issue whilst B- and CCC rated companies are stuck in the doghouse. Several failed transactions have been a clear warning that lenders have little appetite for companies that can’t demonstrate their solvency in the medium term. The weaker airlines, energy companies and tourism associated businesses are looking at their cash positions and making calls about when to enter bankruptcy.
It’s a similar outlook for the weaker sovereign borrowers, particularly in emerging markets. The years leading up to this crisis saw an explosion in lending to the lowest rated sovereigns. Many of these countries are now turning to the IMF for bailouts; at last count roughly half of the world’s countries had put their hands up for help. There’s a global wave of jobs that will be lost as the weakest companies and countries are forced to reign in their spending. Whilst investors are pricing in a solid probability of defaults, they are ignoring the wider economic impacts of defaulting borrowers on the global economy.
Written by Jonathan Rochford for Narrow Road Capital on 16 May 2020. Comments and criticisms are welcomed and can be sent to firstname.lastname@example.org
This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice. It contains information derived and sourced from a broad list of third parties and has been prepared on the basis that this third party information is accurate. This article expresses the views of the author at a point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including securities linked to the performance of various companies and financial institutions.
Over three decades ago, the Japanese introduced a TV programme titled, ‘Za Gaman‘ which stood for ‘endurance‘. It gathered a whole bunch of male university students who were challenged with barbaric events which tested their ability to endure pain because the producer thought these kids were too soft and self-entitled. Games included being chained to a truck and dragged along a gravel road with only one’s bare buttocks. Another was to be suspended upside down in an Egyptian desert where men with magnifying glasses trained the sun’s beam on their nipples while burning hot sand was tossed on them. The winner was the one who could last the longest.
Since the Japanese bubble collapsed in the early 1990s, a plethora of think tanks and central banks have run scenario analyses on how to avoid the pitfalls of a protracted period of deflation and low growth that plagued Japan’s lost decades. They think they could do far better. We disagree.
There is one absolutely fatal flaw with all arguments made by the West. The Japanese are conditioned in shared suffering. Of course, it comes with a large slice of reluctance but when presented with the alternatives the government knew ‘gaman’ would be accepted by the nation. It was right.
We like to think of Japan, not as capitalism with warts but socialism with beauty spots. Having lived there for twenty years we have to commend such commitment to social adhesion. It is a large part of the fabric of Japanese culture which is steeped in mutual respect. If the West had one lesson to learn from Japan it would be this. Unfortunately, greed, individualism and self-entitlement will be our Achilles’ heels.
It is worth noting that even Japan has its limits. At a grassroots level, we are witnessing the accelerated fraying of that social kimono. Here are 10 facts taken from our ‘Crime in Japan‘ series – ‘Geriatric Jailbirds‘, ‘Breakup of the Nuclear Family‘ and the ‘Fraud, Drugs, Murders, Yakuza and the Police‘ which point to that old adage that ‘all is not what it seems!‘
These pressures were occurring well before the introduction of Abenomics – the three arrow strategy of PM Shinzo Abe – 1) aggressive monetary policy, 2) fiscal consolidation and 3) structural reform.
Since 2013, Abenomics seemed to be working. Economic growth picked up nicely and even inflation seemed like it might hit a sustainable trajectory. Luckily, Japan had the benefit of a debt-fueled global economy to tow it along. This is something the West and Japan will not have the luxury of when the coronavirus economic shutdown ends.
However, Japan’s ageing society is having an impact on the social contract, especially in the regional areas. We wrote a piece in February 2017, titled ‘Make Japan Great Again‘ where we analysed the mass exodus from the regions to the big cities in order to escape the rapidly deteriorating economic prospects in the countryside.
Almost 25 years ago, the Japanese government embarked on a program known as
‘shichosongappei’ （市町村合併）which loosely translates as mergers of cities and towns. The total number of towns halved in that period so local governments could consolidate services, schools and local hospitals. Not dissimilar to a business downsizing during a recession.
While the population growth of some Western economies might look promising versus Japan, we are kidding ourselves to think we can copy and paste what Nippon accomplished when we have relatively little social cohesion. What worked for them won’t necessarily apply with our more mercenary approach to economic systems, financial risk and social values.
Sure, we can embark on a path that racks up huge debts. We can buy up distressed debt and repackage it as investment grade but there is a terminal velocity with this approach.
The Bank of Japan is a canary in the coalmine. It has bought 58% of all ETFs outstanding which makes up 25% of the market. This is unsustainable. The BoJ is now a top 10 shareholder of over half of all listed stocks on the index. At what point will investors be able to adequately price risk when the BoJ sits like a lead balloon on the shareholder registry of Mitsui Bussan or Panasonic?
Will Boeing investors start to question their investment when the US Fed (we think it eventually gets approval to buy stocks) becomes the largest shareholder via the back door? Is the cradle of capitalism prepared to accept quasi state-owned enterprises? Are we to blindly sit back and just accept this fate despite this reduction in liquidity?
This is what 7 years of Abenomics has brought us. The BoJ already has in excess of 100% of GDP in assets on its balance sheet, up from c.20% when the first arrow was fired. We shouldn’t forget that there have been discussions to buy all ¥1,000 trillion of outstanding Japanese Government Bonds (JGBs) and convert them into zero-coupon perpetual bonds with a mild administration fee to legitimise the asset. Will global markets take nicely to erasing 2 years worth of GDP with a printing press?
Who will determine the value of those assets when the BoJ or any other central bank for that matter is both the buyer and seller. If the private sector was caught in this scale of market manipulation they’d be fined billions and the perpetrators would end up serving long jail sentences.
Can we honestly accept continual debt financing of our own budget deficit? Japan has a ¥100 trillion national budget. ¥60 trillion is funded by taxes. The remainder of ¥40 trillion (US$400 billion) is debt-financed every single year. Can we accept the RBA printing off whatever we need every year to close the deficit for decade upon decade?
In a nutshell, we can be assured that central banks and treasuries around the world will be dusting off the old reports of how to escape the malaise we are in. Our view is that they will fail.
What will start off as a promising execution of Modern Monetary Theory (MMT), rational economics will dictate that the gap between the haves and the have nots will grow even wider. Someone will miss out. Governments will act like novice plate spinners with all of the expected consequences.
In our opinion, the world will change in ways most are not prepared for. We think the power of populism has only started. National interests will be all that matters. Political correctness will cease. Identity politics will die. All the average punter will care about is whether they can feed their family. Nothing else will matter. Climate change will be a footnote in history as evidenced by the apparition that was Greta Thunberg who had to tell the world she caught COVID19 even though she was never tested.
Moving forward, our political class will no longer be able to duck and weave. Only those that are prepared to tell it like it is will survive going forward. The constituents won’t settle for anything else. Treat them as mugs and face the consequences, just like we saw with Boris Johnson’s landslide to push through Brexit.
The upcoming 2020 presidential election will shake America to its foundations. Do voters want to go back to the safety of a known quantity that didn’t deliver for decades under previous administrations and elect Biden or still chance Project Molotov Cocktail with Trump?
What we know for sure is that Trump would never have seen the light of day had decades of previous administrations competently managed the economy. COVID19 may ultimately work in Trump’s favour because his record, as we fact-checked at the time of SOTU, was making a considerable difference.
Whatever the result, prepare to gaman!
One of the more uniques ways of describing the behaviour of the US Fed. Zerohedge noted that the Fed has gone full Leeroy Jenkins. Who the hell is Leeroy Jenkins?
As you will see in the video clip, the team gamers are discussing a coordinated strategy to defeat the monsters waiting in the next stage of the game. Unfortunately one of the gamers, Leeroy Johnson takes matters into his own hands.
Since 2001, we have continuously said that easy credit would become so addictive. The resulting complacency would turn destructive.
We said that the then-Fed Chairman Alan Greenspan would go down as the most hated central banker in history. Despite being heckled, laughed at and mocked, we never waivered from the key tenet that his actions and those of the subsequent Fed chairs would ultimately end up in tears.
We should have had that cathartic moment to reset back in 2008/09 (and 2000 for that matter). Instead, we merely doubled down on the very same mistakes that got us into trouble in the first place.
If the Fed moves to support the junk bond market, undeserving companies run by irresponsible boards will be kept on life support instead of the free market being able to set clearing prices and potentially terminate them. Why not let market forces determine whether anything of value remains inside their entrails?
The Fed doesn’t have the power to buy equities yet but surely that is a coming attraction. We have seen how dismally it has worked in Japan.
The Head of Japan’s stock exchange admitted that Japan’s central bank now owns around 60% of all Japanese Exchange Traded Funds (ETF) which is almost a quarter of the broader market. By stealth, the Bank of Japan has become a top 10 shareholder in almost 50% of listed stocks. In a sense, we have a trend which threatens to turn Japan’s largest businesses into quasi-state-owned enterprises (SoE) by the back door. At what point does it stop? When is enough?
We must accept a new reality where bankruptcy is openly accepted as a cure to weeding out excesses in the economy. Should there be demand, more efficient players can pick up the spoils.
We need this to make people realise that moral hazard isn’t going to be tolerated and personal responsibility is the order of the day. Anyone who is more than happy to have a winner-take-all mentality on the upside must be prepared to accept that the loser has to take all as well. Why should Main St bailout people who poorly assessed personal risk because our authorities provided a platform that encouraged the behaviour?
Let us not kid ourselves. There are no excuses in the game of greed. Lessons need to be taught to avoid such calamities in the future.
Sadly, our authorities will reject that advice and continue to fool around using the same reckless tools tried making us pay an ultimately higher price.
Democratic Party hopeful Bernie Sanders announced overnight that he is dropping out of the presidential primaries. For the first time ever, his actions actually led to substantial wealth creation, sending the S&P500 up 3.4% on a $21 trillion market cap index.
All jokes aside, we thought markets have found a (short-term) bottom. S&P has reclaimed almost half of the peak since the corona-crash. We question the sustainability of this rally. At the moment the trend is our friend. We pointed out that the kitchen sink would be thrown and provide one last hurrah before the realities of businesses coping with a return to business played out.
As the lockdown continues, it is very hard to determine what the actual prints will be for large-scale macro-economic data and where that fits into expectations. We know that the Fed has already been out hosing the credit markets with promises of unlimited QE.
The housing market is already giving us hints. According to the Mortgage Bankers Association’s (MBA) Forbearance and Call Volume Survey, the total number of loans in forbearance grew from 0.25% to 2.66% from March 2 to April 1, 2020, with mortgages backed by Ginnie Mae seeing the largest growth (from 0.19% to 4.25%).
While not strictly an apples for apples comparison, the Delinquency Rate on Single-Family Residential Mortgages, Booked in Domestic Offices, Top 100 Banks Ranked by Assets peaked at 12.89% in 2010.
Plenty of trouble ahead. The market complacency is quite astonishing.
This chart shows how fast he printing presses have been flying to boost the “asset” line of the Bank of Japan (blue), the US Federal Reserve (red) and the ECB (green).
The BoJ has grown its “assets” from ¥100 trillion in 2008 to ¥585 trillion today. Yes, that is right the Japanese central bank has printed so much money that the assets on the book are the equivalent of 100% of GDP, 5x that of 12 years ago.
Does MMT predicate that it is ok to print another 100%? After all the existing Japanese national debt pile is ¥1000 trillion. So who is counting?
We note that the shares in Japan’s biggest currency printing press maker Komori (6349) quadrupled during the boom and only tapered off as the BoJ slowed the rate in early 2018. Maybe coronavirus will get the BoJ back to its wicked ways as it buys up even more of the stock market??? It already owns 58% of outstanding ETFs and by stealth has become a top 10 shareholder in almost 50% of listed stocks. In a sense, we have a trend which threatens to turn Japan’s largest businesses into quasi-state-owned enterprises (SoE) by the back door.
The US Fed has grown “assets” from just shy of US$1 trillion at the time of GFC when the economy was worth US$15.7 trillion or around 6%. There was a nice breathing period between 2014 and 2018 before tapering started.
However, in October 2019 we noted that the Fed was getting a LOT more active in the repo market. Now with coronavirus upon us and the volatility in capital markets at the start of 2020 we can see that another $1.6 trillion has been added to the asset line to a record $5.8 trillion or around 30% of current GDP.
The European Central Bank (ECB) has powered up its balance sheet too from around Eur 1.4 trillion to Eur 4.7 trillion. or 40% of Europe 19’s Eur 10.7 trillion GDP. At the time of the GFC, Europe 19’s combined GDP was Eur 9.3 trillion meaning ECB assets were only 15% of the total. Note the ECB has discontinued reporting its assets.
The point is with the world economy about to hit a brick wall, will markets just face more central bank distortion? Surely no one honestly believes that central banks have got this under control with such an appalling record.
To be honest, if modern monetary theory (MMT) was truly working to date, there should be no unemployment, no poverty, no taxes and we could have easily funded all that renewable energy without even having a debate. Just print and spend.
Therein lies its fatal flaw of MMT. Eventually, conjuring money out of thin air hits terminal velocity. Truth be told the tales above show that each asset that the central banks have bought has created less and less impact in the real economy. Velocity has been sliding for decades.
It is a bit like taking morphine to kill the pain. Take too much and the side effects are:
Not unlike the symptoms being shown by the global economy today.
Jim Grant of Grant’s Interest Rate Observer has a great article pointing out the irresponsibility of the US Fed. It criticises the very conditions that made the outcomes of coronavirus way worse than had they administered sensible monetary policies decades ago. FNF Media has been saying this for years. Now we are facing long overdue nemesis. It is true of the overwhelming majority of unimaginative MMT ‘me too’ central banks.
“It took a viral invasion to unmask the weakness of American finance. Distortion in the cost of credit is the not-so-remote cause of the raging fires at which the Federal Reserve continues to train its gushing liquidity hoses…But the firemen are also the arsonists. It was the Fed’s suppression of borrowing costs, and its predictable willingness to cut short Wall Street’s occasional selling squalls, that compromised the U.S. economy’s financial integrity.”
FNF Media keeps on hearing tales about the failure of evil capitalism. When the actions of central banks stifle the free market from achieving price discovery, distorted capitalism will inevitably backfire.
From hereon, sharp pain will be the only effective – and quickest – way to resolve this mess. Governments need to ensure bad companies go bankrupt by rejecting bailout money to zombie companies that will just be a drag on the economy.
Instead of doling out tax dollars, the government should take equity in any business that receives money. Taxpayers deserve a return and by this methodology, it will enforce a mindset that always rejects propping up companies with failed business models. Instead of the government calling the shots, the expertise of commercial lenders should be tapped, a valid point made by Jonathan Rochford.
Unfortunately, this will cause huge short-term disruption and impact large swathes of the community but it will allow markets to clear and provide a platform for risk to be priced appropriately. It is like yanking off a Band-Aid. It stings at first but the recovery becomes far more sound, based on rational economics. Failure to do so will just lead to a protracted Frankenstein economy which will frustrate the majority.
The sad reality will be that Western governments will try to emulate Japan’s lost two decades by crawling on our belly making marginal inches forward. This is somehow seen as superior to hitting the giant “reset” button.
The only major difference being that the Japanese monoculture is experienced and better suited than any other nation to share grief. Western cultures are not remotely close to being able to tolerate such conformity. Japan is not capitalism with warts. It is socialism with beauty spots. It will pay to remember this. In the West, we will demand that others atone for our mistakes. Moral hazard will be the order of the day. This mentality must be stopped dead in its tracks.
Grant reinforced our long-held view on distorting capital markets with this,
“The Fed commandeered investment values into the government’s service. It seeded bull markets in the public interest…But investment valuations don’t exist to serve a public-policy agenda. Their purpose is to allocate capital. Distort those values and you waste not only money but also time…Like a shark, credit must keep moving. Loans fall due and must be repaid or rolled over (or, in extremis, defaulted on). When the economy stops, as the world has effectively done, lenders are likely to demand the cash that not every borrower can produce.”
We must not forget that post-GFC authorities have been asleep at the wheel even after the introduction of poorly thought out red tape designed to protect us.
Right before the regulators’ eyes, so many blue-chip corporations (e.g. Boeing, GE) binged on ultra-cheap debt to buy back their own shares just to chase short term performance incentives. In recent years, companies like Boeing and GE spent around $45 billion each aggressively buying back their own stock despite being in the midst of severe balance sheet deterioration. Both are trading in a state of negative equity today.
Ford Motor has a junk credit rating. GE & Boeing won’t be far behind them. Over 50% of US corporates are trading one-two notches above junk.
The financial community has merely taken advantage of all of this short-termism. Where were the financial analysts doing forensic work on companies? All of this balance sheet deterioration was plain to see. Why couldn’t they see the obvious long term deterioration in cash conversion cycles? How could they miss that aggregate corporate after-tax profitability has been trending sideways since 2012? Where were the biopsies? We will be witness to plenty of autopsies that were preventable.
For Australia’s part, 28 years of unfettered economic growth has bred untold complacency. Only now will we realise the conceited arrogance of government and industry alike. One day we will realise that all of the onerous regulations dripping in ideology (e.g. climate/environment) to confound foreign investment will blow up in our faces. They will not have forgotten that Australia is an unfriendly place to conduct business.
Australia has behaved like a bloated drunk bishop looking down upon his destitute disciples climbing the stairs on hands and knees putting what is left of their pitiful savings into the collection tin. From now, the roles will be reversed at prices that will be highly unfavourable such will be our desperation. Not to mention our currency could well depreciate to a degree which makes us even more vulnerable to foreign predators. Setting our FIRB at $0 will be irrelevant if we fold to the whims of the first suitor that shows interest. The show will be on the other foot.
In press conference after press conference, we continue to be told that hibernating companies will spring back to life and it will all be a case of ‘keep calm and carry on!’We hate to sound negative here.
However, we believe that we are merely being realistic about what is to unfold. The coming depression will force us to become truly appreciative about just how well we have had it while governments have distorted our markets. Had we truly reflected on decades of prosperity instead of wailing about how life has never been worse, things might have turned out differently. We are about to get a true taste of the latter.
On reflection, some positives will come out of this tragedy because we will focus on things that matter rather than getting enmeshed in the theatre of the absurd – identity politics and the cancel culture.
Coronavirus might be a black swan event to the global economy but we have been complicit by allowing our lawmakers and regulators to play slalom with the icebergs. We all knew our overloaded ship was in danger of listing before we left the safe harbour but it was simpler to be suckered into the weather forecasts that predicted endless sunshine and eternal millponds. The engines have now stalled because the tanks are empty. We find ourselves in the middle of a pitch-black, stormy night with howling gale-force winds and a 40-foot swell. Some continue to cling on to the blind hope that the incumbent crew can bail fast enough to avoid the economy capsizing.
It will be all in vain because the ship’s crew left a tape recorder playing on a loop over the tannoy promising passengers to stay in their cabins while they secretly slipped away in the early hours on the only lifeboats available.
Central banks had one mission – create confidence. They have been complicit in the failure. They doubled down on all of the same policies that got them in trouble in the lead up to GFC. They had a simple task of telling governments to embark on structural and tax reform. Instead, they appeased their masters by endlessly cutting rates.
Never again must central banks be allowed to use QE to rescue the economy in a downturn. Central bank balance sheets should be forced to unwind all QE assets. Interest rates must be allowed to set at normalised rates which allow positive returns but avoid reckless borrowing.
While a lot of this piece might sound pessimistic we simply view it as being a realist with experience.
What will it take to wake the media up to the fact that the way our government is spending it won’t be long before we are a $1 trillion net debt baby?.
Our current federal liabilities (p.121) stand at $1.002 trillion (which is pre COVID19). Have the media bothered to look at the state of the budget accounts? Or are they too busy lavishing praise on rescue packages which have a finite lifespan.
We pointed out yesterday that the “revenue” line could be decimated by the disruption – huge cuts should be anticipated in the collection of GST, income, company and excise taxes. Not to mention huge rebates to be paid to now unemployed workers. On an annualized basis the revenue line could get thumped 30-40% if this continues for 6 months.
So on the back of an envelope, it is not very hard to work out that with a current $511 billion revenue line looking to fall towards the early to mid $300 billion mark against a projected expense bill of $503 billion a deficit of $150bn will open up. Throw on c$150bn of COVID19 stimuli arriving by June 30th and we get a $300 billion budget deficit. Our net financial worth would grow from minus $518 billion to negative $818 billion.
Rolling into next year, it is ludicrous to think that hibernated businesses will have resumed as normal. This means that the following year’s tax revenue line will look as sick as the previous period. The government will be torn shredding the expense line as unemployment shoots higher so assuming minimal budget cuts, it could face another $200 billion deficit taking it north of $1 trillion net liabilities in a jiffy.
Let’s not forget what the states may face. Severely lower handouts from the federal government via GST receipts which will balloon deficits, a trend we’re already seeing.
The states currently rely on around 37-62% of their revenue from the federal government by way of grants. The balance comes through land/property taxes, motor vehicle registration, gambling and betting fees as well as insurance and environmental levies.
All of those revenues lines can dry up pretty quickly. 40% of state budgets are usually spent on staff. Take a look at these eye watering numbers.
NSW spends $34 billion on salaries across 327,000 employees.
Victoria spends $27 billion across 239,000 public servants.
Queensland uses 224,000 staff which costs $25 billion per annum.
WA’s state workforce is 143,000, costing $12.6 billion.
SA has 90,000 FT employees costing $8.5 billion.
Tasmania 27,000 setting taxpayers back $2.7 billion.
Just the states alone employ over 1.05 million people at a cost of $110 billion pa!! The territories will be relative rounding errors.
A lot of the states have healthy asset lines which are usually full of schools, hospitals, roads and land). These are highly illiquid.
Unfortunately, one of the golden rules often forgotten in accounting is that liabilities often remain immovable objects when asset values get crucified in economic downturns. When markets become illiquid, the value of government assets won’t come at prices marked in the books.
How well will flogging a few public hospitals go down politically to financially stressed constituents?? This is why gross debt is important.
The states have a combined $202 billion outstanding gross debt including leases.
Throw on another $150 billion for unfunded superannuation liabilities. Good luck hitting the “zero by 2035” targets some state have amidst imploding asset markets. It simply won’t happen. If only these liabilities were marked to market rather than suppressed by actuarial accounting. The WA budget paper (p.42) notes the 0.4% bump to the discount rate to lower the pension deficit figure. To be fair, they are far less outrageous than US state pension deficits.
How must the State Gov’t of Queensland be praying that Adani keeps plowing ahead? How Greyhound must regret terminating a contract to ferry construction workers to the mine? We doubt the incumbent government will have a climate change bent in the upcoming Oct 31 state election. See ya.
The trillion dollar federal debt ceiling seems like a formality especially as the chain reaction created by the states puts on more pressure for the federal government to inject rescue packages to prop up their reversal of fortune budgets. It is that trillion with a T headline that will get people’s attention.
In short, we ain’t seen nothing yet.
COVID19 will be defeated but the cure is turning out to be way worse than the disease.
Unfortunately, the sad reality is that at the rate governments are tightening legislation to keep us in shut down mode, we are day-by-day staring at a great depression.
While some will praise governments for throwing the kitchen sink at the economy with all manner of stimulus packages, the relief will be temporary because all of the ammunition for a sustainable recovery had been depleted years earlier. It is like supplying an alcoholic on rehab with an all-you-can-drink open bar.
Our feckless RBA has just embarked on QE, a mission that has failed every other central bank that has tried it. The velocity of money has been falling for decades. Who will be given access to borrowing at zero interest rates when the economy is in freefall? Which banks will lend against properties that will likely implode in value? 50% down? To think of all the reckless “first home buyer” schemes that loaded young people at the top of the property market. The RBA has been complicit. Not wanting to put pressure on the government to reform, it just kept cutting rates to keep housing afloat. It was totally negligent in its duty even though it will signal its role as a rescuer of last resort.
When will banks be forced to mark to book the value of mortgages on their balance sheet? Equity is thin as it is. 15-20% equity buffer to mortgages is pretty wafer-thin. They need to do this immediately so we can properly assess risk. Forget stress tests by APRA. They’re meaningless. Our housing market will collapse with higher unemployment. 50% falls from here are possible. Remember there will be hardly any buyers. Prices fell up to 90% in Japan after its property bubble popped.
Worse our regulators have been asleep at the wheel chasing financial institutions on their commitment to climate change, the absolute least relevant metric to save them from here. It shows how complacent they became.
Australia has made some interesting crisis policy choices. For instance, PM Scott Morrison is trying to pass rent moratoriums where landlords suspend payments from tenants until things return to normalcy. It is not enshrined in law yet. In principle that is a nice gesture even if the government is subsidizing the banks for forgone interest due to short term loan repayment moratoriums. Let’s assume this continues for 6 months. Apart from the astronomical size of the subsidy, who will ultimately end up sacrificing the 6 months? Landlords? It won’t be the tenants.
Shouldn’t landlords be free to choose whether they are prepared to forgo rent or not as a purely rational business proposition? Shouldn’t a landlord be free to enforce a rental agreement? Will contracts matter anymore?
At some stage, the free market must be allowed to function and the government will hit a tipping point of weighing stopping economic armageddon by allowing businesses to function and the marginal risk of infections. The people will be crying for this if shutdowns remain.
Landlords may be labelled un-Australian or worse but in 6 months time, if unemployment has surged to nose bleed levels well above the 6% we saw during GFC at what point will disposable income be able to support a daily coffee at a cafe?
A cafe might soldier on for a further 3 months on skeleton staff before realising that they can’t cover costs. A landlord would be well within reason to demand that early cancellation clauses and fees are enforced.
Then what of all the invoices to coffee suppliers, bakeries who provide muffins and croissants and utilities? Who misses out? What about the invoices of the coffee supplier? Will the bakery get called on by its flour supplier to pay upfront for future deliveries when it has no operating cash flow, instead of the long-standing 60-90 day terms? That happens overnight. It isn’t a managed outcome. Cash is king.
The question is why hasn’t the government taken advice from the banks on business lending so it can better assess the risks involved from those that deal every day with small companies?
We can’t just shut an economy down for 6 months and expect a return to normal when it is all over. Unemployment rates are likely to surge well above 10%.
As we wrote in an earlier piece, there are 13.1 million Australians employed as of February 2020. Full-time employment amounted to 8,885,600 persons and part-time employment to 4,124,500 persons. Retail trade jobs come in at a shade over 1.2 million jobs. Construction at 1.15 million. Education 1.1 million. Accommodation/restaurants /bars etc at 900,000. Manufacturing another 900,000. Noticing a trend in our employment gearing?
We can fudge the unemployment figures however we like. We can pay $1,500 a fortnight for 6,000,000 workers to pretend they still have a job. That is $18bn a month. The PM can talk about how this will help us bounce on the other side. If it continues for just over 6-months can the budgeted $130 billion will be spent. This is separate to NewStart payments too.
Yet, will people lavishly spend or pay down debt and economise as best they can? We think the latter unless moral hazard has truly sunk in.
What people need to understand is that our Treasury expects to raise $472.8 billion in taxes for FY2019-20. Throw in sales of services, interest and dividend income and that climbs to a total of $511 billion. Expenses are forecast at $503 billion. In the following three years Treasury anticipates $490.0 billion, $514.4 billion and $528.9 billion in taxes. Expect those totals to be cut significantly.
So if ScoMo’s JobKeeper rescue package for workers goes beyond 6 months, that is equivalent to 27% of annual tax revenues. That doesn’t take into account the slug to tax collections of lower GST and vastly lower income tax for individuals and corporates. That is just at the federal level.
Note, states such as NSW have recently waived payroll taxes for small businesses in a $2.3bn stimulus package. We shouldn’t forget that the NSW Government is the largest employer in the Southern Hemisphere at 327,000 staff.
We remind readers that according to the RBA small businesses employ 47% of the workforce. Medium enterprises employ 23%. That is 70% of the entire workforce who are most at risk from a slowdown.
In 2019-20 income tax collections will make up $220 billion. Company tax was forecast to generate $99.8 billion. GST $67.2 billion. Excise taxes (petrol, diesel, tobacco etc) $44.7 billion. This data can be found on page 21 here.
Local cafes are reporting a 60~80% fall in revenue. Pretty much all casuals have been let go. It is a bit hard to survive on coffee when a lot of stores aren’t stocking pastries for fear of spoilage.
It is not hard to assume a scenario where government income taxes fall to $160 billion (-28%) due to mass layoffs. One assumes many people will be able to get a tax rebate come June 30th. So this number may end up being conservative on an annualised basis.
Company tax could plunge to $40 billion annualised due to the drastic fall in revenues as customers change the manner of contracts and reign in their own spending. Anyone that thinks that business will resume as normal is crazy. The ripple effects will be huge.
Excise taxes may drift to $35 billion as people cut back on drink (currently $7bn in tax revenue), are limited in places to drive negating the need to fill up (currently $18bn in total tax take). The $17 billion in tobacco excise may weather the storm better than most.
GST could fall to $50 billion. People just aren’t spending much outside of food. Massive retail discounts will not make much difference. GST will be the best indicator of how much the economy has slowed. Even if we start to see a massaging of the GDP numbers, GST won’t lie. It will be the safest indicator.
If our assumed tax revenue sums to $285 billion annualised from the budgeted $472 billion that equates to a 40% haircut.
Trim the ‘other revenue’ column to $30 billion from $39 billion and we have $315bn. Will the government then chop away at the $503 billion in expenses? All of the stimuli doesn’t arrive at once but a lot of it in relatively short order. Surely a $300~400 billion deficit is a fait accompli?
We should also anticipate forward year tax revenues be cut c.30% for several years after. The question is when does the government realise that it must cut the public service and scrap wasteful projects like French submarines and other nice-to-have quangos? We won’t see a budget surplus for decades.
We must careful not to fall into the trap Japan finds itself in. It has a US$1 trillion budget funded by US$600bn in taxes and US$400bn in JGB issuance. Every. Single. Year.
Nothing short of drastic tax and structural reform will do. Instead of behaving more prudently by cutting budgets when we had the chance, instant gratification created by governments desperate to stay in power has only weakened our relative position. Since 2013, the Coalition has been responsible for 46% of the total amount of all debt issued since 1854.
States should quickly realise that the $118 billion in federal grants going forward will also be curtailed. NSW will likely fare the worst because its financial position is by far the best.
If the government had a proper plan, it would be looking to what essential industries have been given up to the likes of China that we need to onshore. Medical equipment, masks or sanitiser. For cricketer Shane Warne to be converting his Seven Zero Eight gin factory to produce hand sanitiser shows how much of a joke our local manufacturing has become.
We must never forget that a Chinese government-owned company displayed the Communist Party’s mercenary credentials by (legally) buying 3,000,000 surgical masks, 500,000 pairs of gloves and bulk supplies of sanitiser and wipes. So not only was it responsible for covering up the truth surrounding the virus in the early stages of the pandemic, we openly let it compromise our ability to combat the virus when it hit our shores.
China has shown it doesn’t give a hoot for ordinary Australians. So why should we continue to fold to its whims and cowardly surrender our industries for fear it’ll stop dealing with us? It is nonsense. We have some of the highest quality mineral resources which it depends on. We can bargain. We have chosen to appease a bully.
Our Foreign Investment Review Board (FIRB) needs to be far more vigilant to prevent takeovers by Chinese businesses. We should openly accept the way China conducts business practices and recognise that it is often incompatible with ours when national security is at stake. Surely this crisis has highlighted the true colours of the political system in Beijing.
That leads us to Japanese companies. Many are seriously cashed up, have a favourable exchange rate and have a long-standing history of partnering with local businesses. We should be prioritising our relationship with Japan and look to have them invest in our inevitable capital works programs – specifically high-speed rail. It is the type of project that has meaning for the future and a long enough timeline to turn an economy around.
People need to be prepared for the reckoning. There is no point softening the blow. The brutal truth will eventually arrive and we will have only put ourselves in an even weaker position with the policy suite enacted so far. Time to be rational about risk/reward. Whether we like it or not, the minimum wage will need to be cut substantially in order to get the jobs market alive again. Don’t worry, unemployment will be so high that people will demand minimum wages are cut because it is far superior to the alternative!
(Time to ditch your industry super and start shovelling your superannuation into gold)
Just when you thought it couldn’t get crazier, the Fed has announced that it will buy unlimited sizes of treasuries, mortgage-backed securities and corporate bonds. Recall our comments in 2018 when the Fed discontinued its reporting of assets. We noted that the Fed discontinued M3 money stock in 2006, two years before the GFC. Coincidence?
We were always struck by former Fed Chair Janet Yellen’s comments in 2016:
“Monetary and fiscal policy is far better prepared for large positive shocks than negative ones”
“Don’t expect another financial crisis in our lifetime”
The only thing left is to buy equities outright which would require an act of Congress. Such moves once again only highlight just how bad the situation has become. The Bank of Japan can hardly be credited with success over its ETF based equity purchases. It has now lost $30bn in this recent market rout. We should mention that the BoJ is a top 10 shareholder in almost 50% of listed stocks, creating an overhang of epic proportions should it ever announce it wants to reduce holdings. It now owns $300bn and due to be $400bn by year-end.