Surviving a euro trashing and the mining bust

PORTFOLIO POINT: Investors need to keep a close eye on the events in Europe as well as mineral commodity prices. Don’t panic, but be ready for some dramatic changes.

Two events took place this week, which will change the landscape of investment both in Australia and around the world.

Let me explore with you some of the ramifications that I see from these events, although I emphasise that we are in early days and life may change as we learn more about these latest developments.

The first development was the culmination of a series of situations that have been building up for some time. It is now clear that the mining investment boom will now end around the end of 2014 or in early 2015. We will complete the projects that have been started, but relatively few will go ahead if they haven’t already been committed. The reasons for this are the fall in mineral prices, the high Australian dollar, the difficulties with the Australian workforce, the carbon tax and the general rise in mining capital and operating costs. BHP Billiton surprised the market this morning (August 3) with $3 billion in asset write-downs.

The end of the mining investment boom is going to change the landscape of Australia and the Australian sharemarket.

The second development promises to be even more dramatic. The president of the European Central Bank, Mario Draghi, is promising a whole new world of financing whereby the countries of Europe and the bankers of Europe will be effectively funded by the ECB. Parliaments will be bypassed. This is the ultimate in money printing, and it means that the value of money in Europe will fall gradually each year.

European savers, particularly the middle class in Germany, will see their savings wiped out. Many believe this will spark inflation, which is probably true but not absolutely certain because the money is replacing debts that already exist in the countries and banks. However it will change the investment landscape. At this point I must add that the German middle class are beginning to understand that the Italian Mario Draghi, who worked for Goldman Sachs, plans to take them to the cleaners and wipe out much of their post war savings. They are not happy and Germany there should be no major bond buying without austerity, which would kill the plan.

But Draghi supporters argue that unless you print money then the euro must split and the damage to the German banking system will be far worse than the gradual elimination of German savings. In the next few weeks and months this argument will get played out. The outcome will govern the global investment outlook. Initially markets assumed that Draghi was going to win, but last night they recognised that it could easily go the other way, with continued draconian austerity and the inevitable euro split and damage to the world banking system. Eureka readers must understand this is a world-changing debate, and it is much more important than whether the US has a QE3.

So let’s bring these two developments together and try to make sense of the situation. First, the downscaling of the Australian mining construction boom will have dramatic effects on our economy.

Chart 1 Iron Ore Monthly Price - US Dollars per Metric Tonne

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Source Index Mundi

Clearly the vast number of Australians, who have shares in small mining companies that do not have an existing mine but are looking to fund a future one, will be hit. Very few of these mines will get off the ground, so it’s worth looking at your portfolio and taking a loss on small miners that have limited cash reserves to see this situation through.

A number will be taken over by the major miners if they have a particularly large deposit. There will also be mergers of small miners. But the prices paid above market will be limited. The cutback in production in new mining ventures is actually good long-term news for our big miners. The worst thing that could have happened is that all these new projects in the pipeline actually took place and flooded the supply of minerals. Had that taken place, the big miners would have been held back for years because of the lower prices that would be caused.

We still of course have the Chinese economy to consider, and there is no doubt that China has slowed down much more than was originally thought likely. But the Chinese are stimulating. They can’t afford to have their economy slip back too far.

At the moment Perth is teaming with people planning new mining ventures, which is distorting the real estate economy in the state capital. That is going to change, so beware of paying top prices for Perth real estate. If you have Perth real estate, and if you get the chance to get a really silly price, take it. I emphasise that it doesn’t mean Perth will collapse, because there has been an enormous amount of investment in projects in Western Australia and they will continue to generate revenue and operating income that will underpin Perth. But there is an end game to the crazy situation.

All things being equal we would expect to see a fall in the Australian dollar, because the money flowing into the new projects in Australia will cease on any major scale at the end of 2014. Of course in currency markets you also have to make assumptions about Europe and the US. At the moment we are seeing safe haven money flow into Australia despite lower commodity prices.

Chart 2 Australian dollar vs euro

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But if we assume there is a lower dollar then that is going to boost a whole series of industries that have been suffering from the higher currency.

For example, our tourism industry would be set for a resurgence; our education industry would also be greatly helped, as will a range of manufacturers. So those companies that still have a viable business under the current dollar, but who are suffering, stand to do very well on a lower currency.

However inflation would rise and, of course, repeating the forecast of a lower dollar must carry a European caveat.

The beauty of the Draghi solution is that it does not require European parliaments to pass any acts – it is just simply pure money printing via a central bank.

If he wins it means that the chances of the euro splitting in the short term are much less, although it is possible that Greece and a few marginal countries might be hived off. But that would not apply to Italy and Spain. This means that the wholesale banking market will continue to support our banks and, indeed, given the constant erosion of savings in Europe via money printing, there will be attractions of investing in countries like Australia.

So this would be a good development for our banks, because the worst possible situation that they faced was that on a split in the euro the wholesale market, which supplies about 40% cent of big bank loans, would simply dry up and need to be replaced by local savings. In turn, that would require much higher interest rates.

So Australians will want the Draghi plan, but that does not mean it will happen and we may get yet another period of indecision, which would be a disaster. If the Draghi solution in Europe gathers pace then banks may be more inclined to lower their deposit rates, because the possibility of the freezing of the wholesale market has been greatly reduced.

But any major money printing without austerity is going to create side effects that are not necessarily apparent at first glance. In theory vast amounts of money printing is good for shares and boosts share markets. But this money is not going out to consumers. Rather it is going to simply replace debt and devalue the savings of Europeans, particularly those in Germany. When you undertake such an exercise you actually force people to save more, and so it won’t greatly help overall economic activity, but it does avoid a crisis.

So where will money looking for returns end up under the Draghi plan? My friend Oliver Marc Hartwich is the executive director of the NZ Initiative and is a long-term student of events in Europe.

Hartwich believes that we would see a rush for assets that have scarcity because of the inflation pressures money printing would create. Prime property in Europe would be in great demand. Art works, expensive wines and precious metals will be greatly sought after. The suggestion that precious metals are going to benefit immediately has all antennas being raised.

Is this the time to invest in gold? The answer is that if there is large-scale money printing then, yes, and certainly it should be part of your portfolio spread of risks given what could happen in Europe.

Clearly, it is a big step from an announcement by the president of the central bank as an intention to actually be going full bore on money printing.

And last night’s fall on stockmarkets showed the Draghi bandwagon is in danger of losing a wheel. Always remember that Europe has been amongst the best performing markets, because the European sharemarket has been heavily discounted on the expectation of a crisis. You could see a movement up in European shares if the money printing exercise gathers pace, as European shares are re-rated not on the basis of huge amounts of European growth but simply to bring them up to the level of American shares. Most big European companies operate globally and are often much larger outside of Europe than in their home countries.

So we have a very new environment to begin our early months of 2012-13. My suggestion is that there is no need to rush into protecting yourself against inflation caused by money printing, but be ready to do so.