Australia's iron ore cliffhanger

It's almost impossible to underestimate the share market and national income implications of the unexpected rise in the iron ore price. We have seen a minor prelude in the latest Rio Tinto profit, but that is absolutely nothing to what will happen if the price stays near current levels. 

Meanwhile, a short word about the Commonwealth Bank results. Banking is becoming all about cost management in the light of limited income growth. The CBA achieves small profit rises because its costs are not rising. Longer term, CBA will need to do better.

But did you notice that total customer deposits increased by 4.4 per cent to $541 billion in just six months? Investors are scared. Give them a safe alternative to bank deposits (like government-backed infrastructure bonds) and they will leave. Meanwhile, a lot of Australians are suffering low investment income.

Ore-inspiring

Back to iron ore. It is worth looking at how we got to where we are. I recall about 18 months ago yarning to BHP Billiton executives who were nervous about the long-term implications of the then slightly improving iron ore price. Indeed, the entire mining industry was very nervous and when Scott Morrison estimated his tax revenue for 2016-17 on the basis of an iron ore price of around $US55 a tonne, many thought he was being over optimistic.

The view at the time was that enormous quantities of iron ore were set to hit the market and would depress prices. The additions included Roy Hill's 55 million tonnes, Vale's new iron ore complex (which opened just before Christmas) and higher volumes from both Rio Tinto and BHP.

Indeed Rio Tinto is currently forecasting that the top six producers will add about 100 million tonnes to the market over the next 18 months. Yet the price keeps rising and is now around $US91.

In simple terms, China has reduced its iron ore production from around 400 million tonnes to 260mt a year. So it has absorbed much of the recent extra tonnage, although a large amount of extra ore has not yet hit the market. 

The Chinese have closed old inefficient mines and they are also swinging more of their steel output from high energy, high pollution scrap-based plants to modern furnaces which base their steel production on iron ore and high quality coking coal. 

And if we want to move down the track a little, if Donald Trump really sets American infrastructure alight he will need a lot more steel and American iron ore producers are inefficient. So companies like BHP, Rio Tinto, Fortescue, Vale and Roy Hill might get an extra boost. The impact of higher iron ore prices on profitability is huge. 

For example, Rio Tinto struck an underlining profit of $US5.1bn in 2016 based on an average of $US53.60 per net dry metric tonne. In all it shipped 327.6mt. If the iron ore price was to rise 10 per cent it would add $US880m to Rio's earnings, but currently the price is more than 60 per cent higher than that 2016 level. In addition the full benefit of lower Rio Tinto costs will be felt in 2017. 

A lot can happen in the next 10 or so months, but right now Rio Tinto could double its profit. BHP has a wider variety of mineral profit contributors but its 2017 results will also be staggering, although it may struggle in copper depending on how long the bitter strike in Chile continues (Rio Tinto has minority equity in BHP's Escondido mine in Chile). 

Scott Morrison's projections in the last budget are going to be realised because of the iron ore price rise. Once upon a time the Australian dollar was linked to the gold price, but now it is partly linked to a combination of iron ore and LNG, which explains why it has performed much better than most people in the market had forecast. 

So when you are looking at the Australian outlook start with iron ore and know that if, for whatever reason, it starts to fall – perhaps because China feels the need to increase ore production, or because it is being blocked from exporting to the US – then understand that the outlook for Australia will be less prosperous. 

Teflon apartments?

To our local housing market, and as I have described before, the sharp reduction in Chinese buying of apartments and other residential properties would normally have lowered prices. But Australians are going for negative gearing. 

However, this week the Commonwealth Bank's BankWest put the brakes on the rush to borrow funds for negative gearing by refusing to take into account the tax benefits of negative gearing when assessing how much to lend. At the moment other banks are happy to fill the void but clearly the Commonwealth Bank is nervous. Property on the west coast of Canada in British Columbia has been booming on the back of Chinese investment. As we are seeing in Australia, the volume of Chinese money coming into the main city on Canada's west coast, Vancouver, is falling rapidly and that is having a big effect on the real estate market. Traditionally one might have forecast that the biggest impact would be in apartments but in Vancouver that is not the case. 

The big fall was in detached properties where sales fell an incredible 57.6 per cent from the level of January last year. The benchmark price for detached properties was $1,474,800, which represents a 6.6 per cent decline over the last six months.

Sales of apartment properties fell 24.7 per cent but the benchmark price of an apartment property at $512,300 actually rose, fractionally.

It is strange that our banks are really nervous about lending on apartments but ‘go for the doctor' in lending on houses, yet in Canada it has been the houses that have been more affected by Chinese withdrawal.  

We are watching a trend in major cities towards apartment living and, particularly, apartment living not far from where the jobs are – near the centre of the large cities. This is a community change that is not often recognised. Of course in Melbourne – and to a lesser extent Sydney – there is also a lot of activity in outer suburbia, but once you buy there you usually must allocate large amounts of time commuting, if you work in the city. 

And another thing

Two news items really caught my attention in the last few days. The first was the announcement from Ansell that it was feeling the pressure from the Trump camp to increase its production in the US and it was highly likely that, if it doesn't do that, the company will cop a tariff on its goods. Ansell has not made a decision but has been alerting shareholders that the board was watching very closely what trade protection is to be imposed on groups importing into the US. And, of course, going the other way America's Amazon is planning to ship a wide range of retail goods into Australia, including – eventually – food. And China's Alibaba is also coming here. 

That is going to put a lot of pressure on our retailers, and the first to publically recognise that they must gird themselves for a fight to the death is JB Hi-Fi, which is particularly vulnerable to a big global electronic thrust from groups like Amazon with its large international buying power. To hold its own against Amazon, JB Hi Fi will need to adopt a set of strategies which very few established companies have mastered.

It needs to set up an electronic retail operation that inevitably attacks its own bricks and mortar retailing. If it doesn't do it, others will. And, as we have seen in so many industries when the online damages the base bricks and mortar business, the major retailer often goes soft on electronic retailing because it destroys the bottom line.

If that is what happens at JB Hi Fi it will be a tough time. And, of course, Bunnings is also vulnerable. Bunnings believes that its style of products will not take off via Amazon. I hope it is right, but a much safer strategy would be to launch a strong electronic presence.