GFC

A gem on how to work our way out of the coming economic crisis

Image result for truck nitroglycerin movie

Jonathan Rochford of Narrow Road Capital has written a gem on the role of central banks in spawning this current crisis. An excerpt here:

The rapid and widespread sell-off over the last four weeks is a textbook systemic deleveraging. Whilst the culprits are many; hedge funds, risk parity strategies and investors using margin loans have all been caught out, the underlying cause is excessive leverage across the economy and particularly the financial system. The timing of the unwind and the economic damage from the Coronavirus wasn’t predictable, but such a highly leveraged system was like a truck loaded with nitroglycerin driving down a road dotted with landmines.

Frustratingly, this inevitable deleveraging was clearly predicted. Rather than act to reduce systemic risks central banks encouraged governments, businesses and investors to increase their risk tolerances and debt levels.

Naturally, it fits our own long-held view on central banks.

Jonathan adds some sensible actions which are contained in this link. The question remains whether governments will put principle ahead of expediency in the cleanup?

Coronavirus will end up killing way more jobs than the people in them

GDANSK, POLAND - SEPTEMBER 3, 2018: Norwegian Air Shuttle airlines offers cheap flights. Airplane Boeing 737-800 takes off on from the International Lech Walesa Airport in Gdansk.; Shutterstock ID 1176630295; Purchase Order: -

None of this should be a surprise. 7,300 (out of 11,000) workers at Norwegian Air have been temporarily laid off as 85% of flights are cancelled.

This follows on from Scandinavian Airline Systems (SAS) which has temporarily suspended 10,000 workers and cut 90% of flights to combat coronavirus.

In short, Coronavirus will likely kill way more jobs than the people in them. Sadly, there isn’t a robust economic cycle to be able to weather this storm.

Note that Boeing shares fell 20% overnight as markets finally come to grips with what we mentioned yesterday. Boeing was also put on credit watch negative by Fitch. GE is back at $6.

And Trump’s S&P500 index reading was 2,264 when he took office. It is at 2,474 or 9.3% above that. We always said what he proudly attributed to his leadership on the way up could end up making him hoisted by his own petard on the way down.

Buy Gold, not toilet paper.

Surely lightning can’t strike twice, RBA?

The video posted here is of then Treasury Secretary Hank Paulson who steered the US financial system through the GFC. He is speaking to the Financial Services Committee in 2009. Perhaps the most important quote was the one that world central banks failed to heed –

Our next task is to address the problems in the financial system through a reform program that fixes our outdated financial regulatory structure and that provides strong measures to address other flaws and excesses.

Central banks across the globe honestly believe in fairytales to think they have learnt the lessons of 2008 or 2000 for that matter. Sadly they continue to use the only tool they possess – a hammer – which would be great if every problem they encountered was actually a nail.

When will people realise that had central banks practised prudent monetary policy over the past 20 years, they would possess the ammunition to be able to effectively steer the economy through Coronavirus? Everything the RBA and government are deploying is too little and too late. They never ran proper crisis scenarios and are now scrambling to cobble together an ill-contrived strategy wasting $10s of billions in the process all at our expense.

Central banks only have one role – to support markets with consistently sound monetary policy that creates confidence in the marketplace. Not run around like headless chooks and make knee-jerk responses and follow other central banks off a cliff like lemmings to disguise their own incompetency. The willful negligence displayed by our monetary authorities needs to be recognised. The RBA has got the economy trapped in a housing bubble of their own creation.

So when the RBA talks about, “Australia’s financial system is resilient and it is well placed to deal with the effects of the coronavirus” it couldn’t be further from the truth.

While it is true to say that Australia is relatively more healthy than other economies in terms of the percentage of GDP in national debt, the problem is we rely on the health of our foreign neighbours. 37.5% of our exports go to China. What is the first thing that will happen when our trading partners suffer economic weakness at home? Nations that exercise common sense will look to push domestic production and supply so as to boost their local economies. It is a natural process.

Sadly the RBA, APRA and ASIC have been too busy convincing us that climate change was a priority rather than getting businesses to focus on sensible commercially viable shareholder-friendly strategies. Some groups like the AMA have been encouraged to parade their climate alarmist virtues on breakfast TV.

Unfortunately, instead of focusing on fireproofing our establishments from ruthless cutthroat overseas competitors, our businesses and commerce chambers waste time on chasing equality and diversity targets instead of striving to just be the “best in class”.

Sure, we may have certain raw materials (that the lunatic Greens and Extinction Rebellion protestors will do their best to shut down) that China or other nations will rely on, our service sector weighted economy will be crushed. Almost $250bn, a fifth of our GDP, derives from exports.

Just look at Australian business investment as a % of GDP dwindle at 1994 lows. Mining, engineering, machinery and even building investment are nowhere.

That means our ridiculously high level of personal debt will become a problem. It stands at 180% of GDP as recorded by the RBA on p.7 of its Chart Pack. Most of this debt is linked to housing. Housing prices should crater should coronavirus not be solved in short order. Delinquencies will surge. Families that are funding a mortgage with two incomes may end up being forced to do in with one. Then we cut our gym memberships, Foxtel and stop buying coffee from our local cafe. It is the chain reaction we need to be wary of.

That will work wonders for banks with 60-70% mortgage exposure and precious little equity to offset any ructions in housing prices. If you thought Japan was bad after its bubble collapsed – you ain’t seen nothing yet. By the time this is over we could well see Australian banks begging for bailouts. Note that cutting interest rates further kills interest rate spreads and smacks the dollar which hikes the cost of wholesale funding which these banks heavily rely on.

Yet our RBA knows that it must choose the lesser of two evils. It needs to keep the bubble inflated at all costs because the blood that would come from bank failure is just not worth contemplating. Maybe if they had listened to Hank Paulson they might have been able to hold their heads high rather than showing off, the fool’s version of glory.

Milton Friedman once said,

The power to determine the quantity of money… is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power… Any system which gives so much power and so much discretion to a few men, [so] that mistakes – excusable or not – can have such far-reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic – this is the key political argument against an independent central bank.

How right he was. When the economy tanks, await the RBA and government pointing fingers at each other when both failed to avert the coming crisis which had been so bleeding obvious for so long.

Batten down your hatches.

Trebling down on failed central bank policy. RBA will copy and start QE soon

So the US Fed has slashed rates 1% just now to 0-0.25%. $700bn in asset purchases has been allowed. Jolts like this have far more short term optical impact than mere drip feed cuts. However the two takeaways are:

1) economic impacts are unsurprisingly crippling the economy, hence the need to cut so hard. While the size of the cut is shock and awe, markets can still panic as to why such bold action was necessary. $700bn in asset purchases will try to contain that. Forget Fed tapering, QE is on its way. This is but the beginning of asset purchases. Congress needs to approve the purchase of equities but that may well come. Has worked wonders for the Bank of Japan – not.

2) cutting interest rates don’t necessarily end up doing much because people/companies invest because they see a cycle and the one ahead looks highly uncertain. So refinancing existing debt or easing the monthly burden will not lead to a powered up plan to consume especially if people are being told to self isolate.

There is little option (because of the poor policies to date) left but to double down again like a drunk at a casino table. Gold is one of the few safe havens left. Silver (poor man’s gold) will play catch up. We own both.

And for those that want to lash out at the failures of capitalism for its evils, note this is not anything remotely representing it. When the government and monetary authorities are blatantly interfering and preventing free and open trade to set market clearing prices, that is what creates the distortions and misallocation of capital that leads to economic disasters.

Take advantage of any pops to reduce exposures. We ain’t seen nothing yet. GFC2 will make the crash of 1929 look like a picnic. It won’t be long before the RBA starts to follow suit with zero rates and the journey of QE.

Political expediency will trump Coronavirus market rout. Await market manipulation

MARKETS YTD

Share markets have been decimated in recent weeks across the globe. This year to date (YTD) chart above shows the extent. It shouldn’t really have taken Coronavirus or plunging oil prices to lead to this. We’ve been living high on the sauce for two decades and even though GFC in 2008 was a rude hangover, our authorities thought doubling down on all those free money excesses would work again.

Let’s not get too carried away. On a 5-yr basis, shares haven’t exactly blitzed with the exception of the S&P500. The ASX has put on just under 7% in 5 years. Germany, Japan and Italy have gone down. So if one is 45% higher than 5-yrs ago with an S&P fund, is that a mass hysteria moment?

INDEX 5YR

Automotive stocks have been dud investments over the last 5 years. It didn’t take Coronavirus to expose the underlying trends. BMW is don 52% on 5 yrs ago. Ford down 60%. Volkswagen -40%.

Car stocks

Industrial bellwethers like Caterpillar and GE have also not escaped stagnation. YTD, all of these stocks have bloody noses. Boeing has held up surprisingly well despite the MAX problems.

Industrials

Yet if we look at the FAANGs (Facebook, Apple, Amazon, Netflix & Google), we can see that over 5 years, investors have made a bundle.

FAANGAs these 5 stocks make up 15% of the S&P500 Index by weight, if they fall the impact is greater. With the exception of Netflix, these monsters are down 15~20%.

FAANG 1M

Worried?

Fear not, our heavily indebted incompetent political class and complicit central bankers will concoct a new potion of even lower rates, more QE and further fiscal spending on wind farms, solar panels and roads to nowhere to keep the ship afloat. It may be a hapless task in the long run but just watch the printing presses move to full speed. The ride is about to get interesting.

We’ve been bearish for years based on the underlying tenet that financial market manipulation by authorities has merely distorted the most efficient clearing mechanism -free markets. The invisible hand will eventually win. Just not quite yet.

Italian Senator and former Deputy PM Matteo Salvini has called for a ban on short selling. Why? All he’ll do is exacerbate the sell-off by diverting capital from Milan to London. The politicians just don’t get it. That is why Milan FTSE All-Share index fell by 10.75% overnight. That market is down 23% YTD.

When the pandemic hit the economy, we should have known from last month that it would spread and impact global travel, trade and oil prices. Why did it take so long?

We wrote last week that the explosion in market chasing (especially levered) ETFs would exacerbate distortions on the downside. The main reason being is that options markets that hedge levered products see heavy delta bleed (pricing blowing out) during routs. The reason is in bull markets human nature is more comfortable taking risk. In bear markets, people panic hence needing larger insurance premiums to protect against the madness of crowds.

Essentially what that means is that when ETFs were a far smaller chunk of the market, today’s 7.8% drubbing may only have been -4% in equivalent terms. That is because the ETFs chase, not lead markets because their product design is to replicate the immediate past. Yet our first instincts are to compare these apples with oranges and equate them to 2008. Wrong. Furthermore, a larger part of the market is dominated by a smaller

So the question is, do we liquidate all of our shares into the falling knife or take the view that some wonderful opportunities will present themselves to get exposure to what we hopefully viewed as sensible long term investments.

We take the latter view. We need to separate Coronavirus (the disease) and the hysteria (eg hand sanitizer and toilet paper panic buying).

While the disease is problematic and will hit the economy hard in the coming quarters, the question is market hope pinned to government response will come back. The measures should continue to grow and grow until they have cauterized the wound. After all, we live in a market where financial TV programs are summoning the opinions of NY Mets baseball pitchers for their ideas on stocks.

Of course, it will be all academic, but confidence is the only thing that matters from here. As soon as we get on top of Coronavirus, markets will swing back into action and many will simply fall for the same tricks like Pavlov’s dog and the short squeeze will send stocks powering back.

Governments now have a legitimate excuse to blow out deficits and borrow to save us. In that sense, this pandemic is a blessing in disguise. That isn’t to trivialize Coronavirus but to note that politicians will do almost anything to stay in power, even if the long term consequences will linger long after they’re out of office.

Where will they spend? The automotive sector has been in the doldrums for ages. Expect to see EV related subsidies which will be a boon for the EV battery plays – we’ve bought Jervois Mining (JRV.AX) which is about to start a cobalt mine in Idaho.

Think of support to the aviation industry when the crisis is under control. Boeing and Airbus. Don’t forget that American Airlines renewed 900 aircraft soon after it announced Chapter 11 bankruptcy back in 2011.

Think construction – cement companies and construction machinery companies tend to benefit from public works programs. We continue to hold gold (have done since 2001) as the ultimate insurance policy when the whole system can no longer heal with band-aids.

So get ready to buy some bargain-basement names with cash flow survivability, especially if you have a self-managed super fund.

Yes the underlying economic backdrop is dreadful but there will be one last hurrah!

Nothing to be proud about

Biz Ivest

Flipping through the latest RBA Chart Pack, it is no surprise that business investment keeps sliding off a cliff. As a % of GDP, it has slid from a peak of 18% off the short-term trough of 14% (GFC) to 11%, which now puts it at 1994 levels. It proves the old adage that businesses don’t invest because interest rates are low, they invest because they have confidence in the cycle.

Our government should be looking at this with alarm bells. It doesn’t take too much imagination to work out that political instability has played its part.

Australia was once regarded as the vanguard of political stability in the region which made it a sensible investment choice for domestic and international investors as a place to do business. There was a comfort in knowing that there wouldn’t be revolving door prime ministers and flip flops on policy positions. After all, much business investment takes years to get to the production stage.

The Howard years saw our business investment surge. Sensible fiscal policy was a feature too. While Rudd can be forgiven for GFC causing a slump in business investment it resumed until political instability put the mocker on business confidence.

We have been running deficits ever since and cranking up the national debt (we wrote about it here) because it is clear we don’t have sensible free-market conditions to self sustain direct investment at anywhere the levels we need.

Instead, we kowtow to radical activists who try to stop investment in projects like Adani and conduct illegal secondary boycotts on businesses like Greyhound Australia and Siemens without repercussions.

Whether coal is evil or not is irrelevant. The problem is such activism, which is further supported by ideologically corrupted government environmental departments – that push their own agenda on granting approvals – doesn’t endear domestic industries or foreigners to invest in us. These are dangerous precedents. All of this tokenism when we only need look at the realities of what will happen down the line.

Don’t take our word for it. Even our domestic businesses are leaving.

Thanks to Australia’s ridiculous energy prices, Aussie company Bluescope confirmed the expansion of capacity in Ohio. In Feb 2019, the company CEO said, “much cheaper energy in the United States is a major driver of the company’s preparedness to invest in a $1 billion expansion in Ohio.”

In 2017, Tomago Aluminium reported, “We have to grow to be competitive and to be ahead of the curve, but when the spot price went to $14,000 [per megawatt hour] we had to take that load off. It’s just not sustainable. You can’t smelt at that price. We have had to curtail or modulate the load [on occasions] or we get hammered by the price…We cannot continue to keep paying those prices. We have to find a solution. The prices are crippling”

Aust Manuf.png

Unfortunately, 28 years of unfettered economic expansion has made us complacent. We think this economical miracle has no off-ramp.

None of this is remotely surprising.

Can we honestly say that the impact of higher electricity prices hasn’t been a factor in pushing away investment in engineering and manufacturing? So this mad push for renewables will not alleviate this pressure. Germany is the perfect beta-test crash dummy. It predicted flat prices. They doubled from those forecasts.

GEP.png

Yet our political class is playing with fire.

We never thought Australia was realistically going to have a surplus when it was announced. Secretly there must be a sigh of relief in Treasury that the impacts of the bushfires and coronavirus will provide a convenient scapegoat to miss those targets under the premise of ‘doing the right thing.’  And no that does not mean the government is glad those two catastrophes have happened from a humanistic approach.

We need proper reforms. We need to ditch these notions of political correctness in public policy. We are as unimaginative as many other governments around the world. Living on a low-interest rate fuelled debt bomb. Kicking the can down the road simply does not work. Why aren’t politicians convicting their cases with evidence rather than folding to ideological positions held by fringe dwellers on Twitter?

When we visited Israel on a business delegation in 2018, Israeli PM Benjamin Netanyahu uttered the only 4 words that mattered for investors – “we want your business.” The innovation nation knows what it is good at and is prepared to back it to the hilt.

It would be so nice if our government spent some time in Israel to discover that we have it all wrong. Because we are only storing up a rude awakening. When our economy does suffer from the eventual ramifications of all of that lack of investment, the public will be howling that they can’t pay their mortgages, that they can’t get decent jobs and they can’t keep the lights on. None of that would have been necessary if they had been more open to business.

The ultimate result will be that we’ll put ourselves deeper into debt to fund some monster infrastructure projects that will provide short term relief, not long term solutions.

The foreign investors that could have helped had we treated them in a more dignified fashion will just buy our assets at fire-sale prices instead. Then we’ll have another moment to howl at the moon.

That will be the true price of our complacency. Experience is a hard teacher. You get the test first and the lesson afterwards.

You want Aussie Banks in your retirement fund far less than their advisory services

This is while things are still supposedly good for our banks. CM has written on the pickle Aussie banks find themselves for a year or so. Their relative value compared to banks such as Deutsche, Commerz or RBS is astonishing. So many global banks are worth 90% less than in 2007 while ours keep whistling Dixie. Mean reversion will hit hard and the complacency still baked into these supertankers is immense. Aussie banks could well be worth 90% less by the time this is all over. Forget the stress tests – meaningless – as they need pretty much all stars to align to be remotely accurate and markets in times of panic seldom play to script. Don’t be surprised if these banks require a taxpayer bailout in time.

With more interest rate cuts planned and inevitable QE down the line from the RBA, think of it more as a time banks must make considerable efforts to deleverage. Should banks consider a benign central bank as a virtue, they should seriously think again. People and businesses invest because they see a cycle, not because interest rates are low. Further cuts won’t make a difference.

In short, sell the Aussie banks. The impacts from the Hayne RC will only have adverse outcomes for the banks at a time they need maximum flexibility in order to be able to right the ship. Sadly, such outcomes are highly unlikely. Governments tend to be the most accurate contrarian indicators when it comes to introducing business stifling policy measures at a time, the industry can least afford it.

Maybe former President Reagan had it right when he said, “If it moves tax it. If it keeps moving regulate it. If it stops moving, subsidize it.” The government has already completed the first phase and in the midst of finishing up on the second…

Sell your Aussie banks. Headlines, like the above, will be regarded as extremely positive in the next 12 months.