Hope from China

I want to tell you why, in midst of this chaos, I am becoming more confident that we won't face a banking meltdown but we will see a serious and extended US and European downturn or recession.

The late fall on Wall Street after an attempted rally tells us the market believes that the world must really be in a serious economic state for central banks to take such action as coordinated rate cuts, and as a result profits will be hit hard.

Many leveraged investors are being forced out of the market. Mining shares had a very bad time but I have a special message of hope for BHP and Rio Tinto shareholders from last night's measures. Plus at the end of this commentary I have a short message to address the increasing alarm being felt by superannuation holders.

At the moment the world is very risk averse because the banking plumbing is freezing up which is causing huge global problems, including in derivatives markets.

Last night's truly amazing coordinated central bank interest rate reduction, UK purchase of bank equity and other measures, actually signalled to risk takers like hedge funds that it's time to quit shares, commodities and high risk currencies such as the Australian dollar. Of course many were forced to quit because their financiers were withdrawing money – it was like the world's biggest margin call. What we're seeing is a massive deleveraging of the global share and commodity markets.

We saw further huge share falls in Europe. In early trade on Wall Street, once the forced and panicked hedge funds sellers had quit, a few real buyers started to appear, but they were very nervous because they know that there is profit carnage ahead for the US and global markets. Then they were hit with a wall of sellers and Wall Street fell 2 per cent, which is not a good signal for Australia and a sign that the world stock market fall is not over.

Readers of Business Spectator understand why fear is gripping the banking system and that there will be a big fall in profits and asset values across the board. At the end of this commentary I will give you links to three past Business Spectator commentaries that explain those issues. However, there are many more.

Given it was an historic day, before writing this commentary I decided to first remind myself of the lessons we can derive from our past.

Seven of the eight lessons have now been fully embraced by the market and that contributed to the recent round of falls. We are going to have a severe downturn/recession in most areas of the globe.

But the market has not heeded the problem I outlined in my 'first lesson' of the past – that we are not likely to experience a repeat of 1929 and a meltdown of the banking system because governments and central bankers understand the problem. We are now seeing a remarkable demonstration of this 'first lesson'. Last night's actions were a demonstration of what the global banking system should have done in 1929. Our central bankers have all read their history books. At some point share markets will react favourably.

Meanwhile as I saw oil, copper nickel and other minerals hit hard last night, ringing in my ears was the DVD interview with BHP chairman Don Argus and CEO Marius Kloppers, which was posted to shareholders at the weekend.

Argus and Kloppers were certain that whatever happened to the world (barring a banking meltdown) China's demand for commodities would remain strong. And just last week, Rio chief executive Tom Albanese was saying exactly the same thing.

But the commodity and share markets currently believe that Albanese and Kloppers are simply talking their book and are wrong. BHP and Rio Tinto shares were hammered in London last night.

Yet for BHP and Rio Tinto shareholders, and indeed all of Australia, the best possible news was that China cut interest rates at the same time as the rest of the world.

China, our biggest trading partner, is becoming part of the solution. For Australians looking to the longer term it's time to look more closely at where our biggest trading partner stands instead of being constantly being spooked by the looming recessions in US and Europe. And as I looked again at what was happening in China I could understand the longer term optimism of Albanese, Kloppers and Argus who are seeing current events as a correction and not a trend reversal.

I have found that some of the best contacts in China come from the Morgan Stanley group and I am indebted to the firm's Qing Wang, Denise Yam, and Steven Zhang for providing a remarkable insight on what is happening in China.

It's easy to forget that China has been a net exporter of savings and is substantially under-leveraged compared to the rest of the world; its domestic banking system is still awash with liquidity; and thanks to capital account controls it has avoided investing in the US toxic assets with most Chinese overseas investments are in high-grade, highly liquid instruments that are suitable for official foreign exchange reserves. But they are dependent on the US dollar so China does not want a meltdown.

So thankfully, the biggest buyer of our commodities is not a part of the global inter-bank mess and their households have low debt. But China has been hit by of series of clamps that the government imposed to cut inflation and by the big fall in its exports to the US and Europe.

Those exports are not going to recover in the short to medium term so China is going to respond by boosting domestic demand via last night's interest rate cut and later further reductions; by lowering taxes; reversing the clamps imposed earlier and a series of other measures. Inflation is no longer a problem in China. It is likely to substantially lift infrastructure expenditure and promote housing. China's growth rate in 2009 is likely to drop to 8 per cent but this is no disaster. However, there is a danger that the Chinese property bubble will burst although given the liquidity of the Chinese banks the Morgan Stanley researchers give this only a 25 per cent chance.

This underlying strength plus the amazing industrialisation and urbanisation in China is what Kloppers and Albanese are seeing on their visits to their customers.

Mineral prices have been driven very low by the combination of the western world downturn, the China clamps and by the liquidation of hedge fund holdings. A big chuck of the hedge fund selling has passed but there could be more to come.

Western world demand will stay low although down the track governments will try and stimulate their economies by infrastructure spending. Demand in China will take time to build up but it will build up. There is not going to be a sudden jump in demand rather a more gradual rise once the run of selling is over.

Meanwhile, many of the mining projects that were designed to fill the long term supply gap maybe delayed because the world no longer has the money to develop them and current prices make them uneconomic. Long term this is good news for established miners.

Back home it's important to remind all superannuation holders that global fear and risk aversion is driving all stocks down. Later, well before Christmas, it is likely there will be the normal major rally, which will be driven by a lower interest rate rally. But in 2009, as the bad results come in there will be a divide between those companies that get through this slump well and those that face big profit falls and dividend cuts.

The articles I think all Business Spectator readers should pay particular attention to are: A global asset revaluation, October 8; Mayhem on Wall Street, October 7; and Best case scenario October 8.