The key pointers to problems ahead

The downturn in markets signals a deterioration in economic conditions longer term.

Summary: The impacts of currency movements on equity markets, fuelled by the higher-risk activities of US banks and others, and a slowing of demand from China, are among the factors that do not augur well for markets longer term. The falling Australian dollar and falls across the sharemarket also reflect poor perceptions about our government, management and IR laws, and future demand for our key minerals commodities.
Key take-out: An economic slowdown and a rise in unemployment in Australia will likely lead to further falls in interest rates and the dollar, which will see a renewed hunt for higher yields by Australian investors.
Key beneficiaries: General investors. Category: Economics and strategy.

When you return from an overseas holiday – and what a holiday it was (see below) – it gives you a chance to gain an overall view as to what has happened and is happening in global and local markets.

I believe our stockmarkets are giving some clear pointers as to what is ahead longer term. Markets can be wrong, but when big movements are involved they have an uncanny history of being right.

First on the global stage, I returned to find that movements in the dollar-yen exchange rate were having dramatic effects on global equity prices. In practical terms, this is a complete nonsense because shares should be valued on their intrinsic worth. Relatively small variations in the dollar-yen exchange rate in theory should have minor implications.

But what markets are alerting us to is that our gambling institutions on Wall Street are playing high-risk games with the liquidity created by quantitative easings. These gambling games are creating big variations in our markets that show there is a degree of risk in global sharemarkets that should not be there. US commentator, Peter Morici, says that US banks are also now making high-risk loans to American businesses and then packaging them up and selling them to unsuspecting institutions – exactly what they did with housing loans, which triggered the global financial crisis.

President Obama did the world a great disservice when he failed to take action against the gambling US banks and institutions after the home loan debacles. This doesn’t mean that the world is going to come to an end, but the gyrations we are seeing have a danger alert to them.

Meanwhile few global sharemarkets have been hammered more than Australia. The combination of our falling shares and slumping dollar means that unhedged overseas investors have lost in the vicinity of 20% of the worth of their Australian shareholdings in a short time. Overseas investors have become frightened of Australia for understandable reasons. First, they are seeing appalling government, which seems to them as akin to a third world country. For such poor government to happen in what appeared to be a stable country like Australia unsettles overseas investors, and many are saying “I want out”.

The second depressing force is, of course, the fact that not only is China slowing but, more importantly, it is switching its demand from energy intensive industries to service industries.

It is possible that demand from other Asian countries will fill the gap, but I doubt it, especially as there are looming big rises in production capacity of iron ore, coal and gas. In particular, thanks to the techniques developed by the Americans to extract shale gas, we can see a future world that will be awash with gas – a key Australian export. Australia rides on the back of iron ore, gas and coal and the boom is well and truly over.

A third depressing force to overseas institutions is that in the next two or three years we will have an enormous fall in mining construction spending, which will affect the country dramatically.

Of course, for local investors, our miners will be helped by the lower Australian dollar, but a lower Australian dollar depresses returns for overseas investors. Those investors are appalled that the combination of bad management and bad IR laws has caused Australia to be one of the highest-cost mining countries in the world. To fix the high costs of mining and construction in Australia will require a different approach to industrial relations.

Overseas investors are getting a clear message from our political commentators that Tony Abbott is not going to fix the problem in his first term. What he will do is to make it substantially easier for independent contractors, which can lift mining productivity. But that requires a totally new approach to management and very few Australian CEOs are up to it.

Nevertheless, at some point shareholders of our large miners are going to revolt and demand that their managers perform to world cost standards.

Meanwhile banks have been amongst the hardest hit of our stocks and Telstra has not been far behind. Clearly the overseas institutions believe that there are tougher times ahead for Australia.

Abnormally low levels of bad debts are currently boosting bank profits but the overseas institutions clearly do not believe that it can continue. Australian bank shares are amongst the most expensive in the world and so their shares are vulnerable to a pessimistic view about the Australian economy. Telstra is also not cheap and got caught up in the same momentum.

The latest in unemployment statistics indicate that Victoria is driving Australian unemployment down. I live in Victoria and I simply don’t believe those figures. I think the warning from the sharemarket is much closer to the mark.

Of course, if we do get an economic slowdown and a rise in unemployment, then interest rates will fall further as will the Australian dollar. In turn, that will see Australian investors scampering for bank shares and Telstra.

Finally, when Tony Abbott becomes Prime Minister he will place much greater emphasis on smaller enterprise and indeed the Coalition plans to lift the tax rate on the top 3,200 companies by 2.5%. The proceeds will be used for parental leave entitlements. Most of the larger companies already provide these entitlements, so it represents a shift of wealth to smaller enterprises. This is not an encouraging sign for overseas investors, who naturally concentrate on our largest companies.

But this is going to create some wonderful buying opportunities.

Footnote: Barbara and I flew to Glasgow to visit Dumfries House and its Chippendale furniture and then took a Botanica cruise on the Island Sky – a small 100 passenger vessel – from Edinburgh around the UK and Ireland to Portsmouth. It was a wonderful experience.

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