THE DISTILLERY: Buy the dip?

So, it's a new week and you're thinking about buying the dip. John Durie of The Australian reckons you should jump in because "The Australian market is now down 15 per cent from its near-term high, which marks the fall officially as a correction, and while the reasons behind it are easy to explain, they are also overdone. This opens the chance to buy selected stocks which have been trashed in the stampede, and with the overall market trading on a prospective price-earnings ratio of 11.4 times against the long-term average of 14 times, the equity market is cheap.”

Fair enough this column supposes, but if you buy, understand what it is you're betting on. As last week clearly showed, Australia is in a basket of global risk assets that all get thrown out together when Wall Street gets nervous. As Durie puts it: "Large bundles of Australian stocks are held by US investors, who are dumping so-called commodity countries like Australia as shown by the 21 per cent fall in the market value of the Blackrock-controlled exchange-traded fund MSCI Australia over the past month.”

In other words, global risk assets are now heavily correlated. The technical drivers of why this is so were explored in an excellent analysis by John Authors in the Financial Times over the weekend. What matters for the Australian investor, however, is that while this circumstance persists, buying into the sharemarket means buying into the confidence of New York's managed funds and London's hedge funds. That confidence is now being sorely challenged by the fall of the euro, which has the knock-on effect of destabilising the grand narrative of recovery: that internal Chinese demand and a falling $US will help boost US exports, whilst zero US interest rates boost commodity prices and the yuan ultimately appreciates (which is now cancelled).

This is where this column also parts ways with Adam Carr of Business Spectator who continues to argue that the sell-off is irrational, based on the data: "Once more I find it my duty to put the smack-down on these [bearish] views: No-one is talking recession in Australia and domestic demand is running at an annualised pace of 8 per cent; Asia and even the US are experiencing a V-shaped recovery with GDP rising at 4.4 per cent for the last couple of quarters; Chinese growth is at 12 per cent; The IMF is forecasting world growth at 4.2 per cent in 2010; The unemployment rate is 5.3 per cent and most expect it to drop below 5 per cent this year.”

These statistics are all fair enough, but Carr doesn't connect them. So long the euro falls, there'll be a bull market in the $US, a rising yuan and falling relative value for commodities, with all three trends exacerbated by the flight to safety. Buying this dip, you are therefore betting on one of two outcomes: that either the falls in the euro are finished, or, that the US consumer is ready to step back in as the global consumer of last resort. Neither look at all convincing to this column. Not to mention that you must also ignore the increased trade tensions between the US and China that these new dynamics represent, as outlined by Karen Maley of Business Spectator.

Which brings us to David Uren of The Australian and his ongoing attack on the growth-assumptions behind the resource super profits tax (RSPT): "The most worrying aspect of Treasury's push for a resource rent tax is that it is based on a conviction that the boom will last for decades. The rise of China and India is seen as a kind of manifest destiny that will lift Australia's terms of trade permanently higher. And the resource tax is supposedly needed to ensure that Australia obtains lasting benefit from the surge in commodity demand. But if, as is possible, the boom is deflating before our eyes, the government will have been very poorly advised. If the terms of trade were to revert to their long-term trend over the next year, the investment deferred during the current uncertainty would be lost forever, while the government would be saddled with heavy liabilities in the form of tax credits to unprofitable mining operations.”

This column has deep sympathies with the notion that Australia should not bet the house on Asia. However, it does so for reasons other than those outlined by Uren. Even at its most bearish, this column remains a China bull. Uren quotes Ken Henry who puts the bullish case well: "'Their share of global GDP had dropped through the 19th century and, in India's case, the 18th century, as they lagged western Europe and the US in industrialisation. Both have the potential to revert to something close to pre-18th century GDP shares in coming decades,' Henry said. Until such time as their per capita incomes reached levels of $US15,000 to $US20,000, their growth would be metals-intensive. With China's per capita income at $US8000 and India's at $US3000, the potential for catch-up is large.”

This column agrees, but with lousy Western growth and the supply-shock of the last cycle waning, it can see good terms of trade ahead, not great ones.

Which is why it supports a resource rent tax (RRT) and sovereign wealth fund to boost national savings. Not only is it an inter-generational obligation, it will help prevent the kind of wanton waste and risk-accumulation that is still apparent in the national housing bubble. Thankfully, this column finally finds support for this position amongst business leaders in today's Australian Financial Review cover story.

A similar rationale is also put by the Treasurer in an op-ed in The Australian: "By allowing us to cut the company tax rate and deliver tax relief for small business, the RSPT will broaden and strengthen the economy, ensuring all sectors grow in a sustainable way. It will allow us to invest in the vital infrastructure and tackle capacity constraints particularly in the resource states, as well as fund major incentives for mining exploration. And it will also allow us to build our pool of national savings, which will strengthen our whole financial system and help Australians live in dignity in their retirement.”

However, this column can see some problems here. A $700 million per annum infrastructure fund is – being kind – paltry. The tax breaks for business are welcome but seem unlikely to boost the competitive advantage of Australian exports. It's better to take the pressure off tradeable sectors by shifting the money outside the economy into a sovereign wealth fund. Lastly, Swan's greater savings are welcome but do too-little to wean the country from its foreign debt addiction.

On the tax itself, Swan offers a neat description: "The government guarantees that losses on one project will be paid by allowing those losses to be transferred to another project. If a miner has no other projects, they will be refunded their losses. This will also encourage investment, as a miner will be able to offset losses on a project still under construction against super-profits from another project which is in full production, rather than carry those losses forward. To ensure the value of these deductions refundability and transferability does not erode over time, the RSPT put in place an uplift factor set at the long-term government bond rate. Some critics of the RSPT have misconstrued the bond rate as some kind of hurdle rate of investment return which ignores the risks inherent in mining. But in reality it is not related to a project's financing needs. Instead, rather than paying out deductions as they occur, the government is guaranteeing that they will be either used or refunded, with interest paid in the meantime set at the government bond rate. Refundability means that this commitment is as safe as a bond, so the appropriate interest rate is the government bond rate.”

But as the most reasoned critics of the tax – Athol Fitzgibbons and Michael Stutchbury of The Australian – have argued, the 40 per cent guarantee can be interpreted by miners and their financiers as the excuse for a levy on capital. Better and simpler therefore to drop the 40 per cent guarantee and raise the kick-in rate for the tax in line with the (Petroleum Resource Rent Tax (PRRT).

Which is, according to Andrew Main of The Australian, where we are headed: "All that roaring on both sides about the looming resource super-profits tax has chased both sides up their respective trees, despite the fact that there could be a lot of common ground between the mining lobby and Treasurer Wayne Swan, backed by Treasury Secretary Ken Henry. It's even possible that if the government cancelled the planned tax's give-away element, which has hardly been discussed, we might get a simpler tax with a higher threshold and a fair return that satisfies almost everyone.” Sounds reasonable, but Main does not canvass the possibility of introducing some greater complexity to the tax. The PRRT, although 'simpler' at face value, has eight different uplift rates, for instance.

Also on the RSPT today, Ross Gittins of The Sydney Morning Herald and Max Walsh in The Australian open our eyes with the argument that its release was ill-timed for the election. Alan Mitchell of the AFR argues that three-years out, Australia's number one challenge will be high inflation.

Finally, Adele Ferguson of The Age has an important piece on what NAB's foreclosure of retailer Clive Peeters means for leveraged investments: "The hundreds of small to mid-sized companies that weren't able to raise equity but are getting close to tripping loan covenants will struggle to find a solution. One investment banker said for those companies with share registers dominated by retail investors, the banks will play hardball.”