Trade slump? Get ready to jump

PORTFOLIO POINT: The economic signals are still building as to whether Australia’s terms of trade will slump. But if it does, as in 2009, be prepared to make some major portfolio changes.

Speculation is rife about what exactly a decline in the terms of trade would mean for Australia. Slumping iron ore prices over the last few weeks have been the catalyst obviously, and have sparked renewed concern that Australian economic growth will weaken and, in the most extreme case, lead to another recession.

To put things into some perspective, commodity prices (shown in chart 1) have fallen by around 8% since a peak this year, and 18% since the 2011 peak. You can see from the chart they are still elevated though.

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The terms of trade (which is the ratio of export price to import prices) for its part is down 7% so far over the year, although by the September quarter it could be down some 18%. Again, as chart 2 shows, the terms of trade is still very high relative to history.

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The question is what we do about it. We’re at a point of inflection clearly, and when I look at the portfolio recommendations I have made to Eureka Report subscribers – the outcome is critical.

Certainly most recommendations have been extremely successful to date and the key portfolio points have so far outperformed the All Ords (and it goes without saying, cash). Since recommending them, oil is up 18%, consumer staples 15% (accumulation index) and financials are up 8.8%. Even my European stocks call has yielded quick results and some of those stocks I mentioned (though they weren’t recommendations) are up 20% on an exchange-adjusted basis. The average increase is over 8%. BHP and Rio have been volatile, but BHP is up 6% and Rio little changed. I would have missed that surge in health care stocks though. But as a switch trade you would not have lost money or underperformed the broader index.

As crucial as this moment is though, there are three significant analytical problems the way I see it.

1. It’s not clear that the decline in iron ore or the terms of trade will be sustained. This is an assumption that may be proven wrong.
2. If it is sustained, there are no indications how steep the fall will end up being.
3. The outcome of any large decline is not unanimously agreed upon.

Questions over sustainability come down to four key facts:

a). The velocity of the decline

So take the price of iron ore. It’s down about 40% since the beginning of the year, with 30% of that over the last month or so. This is the fastest and biggest decline in percentage terms since the boom began – significantly larger than during the GFC and subsequent global downturn when indeed prices kept rising. Indeed, prices are back to where they were in November 2009, which is odd given point (b).

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b). Iron ore demand remains strong throughout Asia – it hasn’t declined materially. Indeed it didn’t even decline during the GFC and subsequent global recession.

I made this point in my piece of July 16, Mining for a Price Recovery, which I would recommend reading if you haven’t as the analysis contained in it is more relevant than ever. More importantly though, neither shipping companies nor producers themselves have reported a significant drop-off in demand in iron ore from Asia relative to last year.

Consequently there are reports of inventories building on Chinese ports. Hard data is hard to come by though – what is rumour what is fact? How can an investor be sure which is which? So I look to point (c).

c). The fall in iron ore or bulk prices is not being replicated elsewhere where China, or Asia more broadly, is a key player.

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If there was some underlying macro problem, such as a sustained slump in Chinese demand, we’d expect that to be replicated in other commodity prices. Instead what we find is that copper has risen modestly since the slump in iron ore prices – about 6%. And indeed crude is up 14%. China might be slowing to 7% or what have you but this, as I highlighted in my July 16 note, is irrelevant. 

d). In any case, and as we found out over the weekend, China’s industrial production remains very strong, rising 10% annually. It’s weaker, sure, the weakest in three years - but 10% is undeniably strong growth.

So what is driving the slump in iron ore and consequently the terms of trade? I don’t know. It’s not a broad-based macro problem though – this much we know as fact. Which is probably why most analysts expect a rebound in the short term. I’m more inclined to think of it as a temporary inventory correction exacerbated by speculative over the counter derivative flows.

Let’s, for arguments sake, say it is sustained and take a look at point 2. How far will it go? The answer is we simply do not know. I haven’t read anything sensible on this matter and analysis is confused by the points mentioned above: China’s still-strong industrial output, the influence of OTC derivatives and the extent of the inventory correction.

This of course leads me to point 3. There is no agreement on what outcome a sustained hit to commodity prices and the terms of trade more broadly would yield. 

At current levels the impact would be negligible. Take another look at Chart 2. The terms of trade is still very high and it’s hard to argue there is too much damage.  Certainly the 10% decline in the terms of trade into the June quarter didn’t hurt economic growth any as the recent, and very strong, GDP figures showed. 

But it begs the question, what would a sustained large fall in the terms of trade do for the economy? Are terms of trade falls even bad? It’s only a price ratio after all.

Well let’s think about the dynamics of a slump. In practice a fall means that our exports are cheaper relative to our imports. Harmless enough, so it would seem.

It is, however, argued that this in turn will:

1. Lead to business investment being shelved, because most investment is mining related.
2. Reduce national income, and so GDP growth, because export values will fall.
3. Smash the federal budget’s bottom line, because tax revenue will be lower.
4. Lead to an increase in unemployment.

It sounds serious, but again these points are all easily rebutted.

1. Business investment is largely concentrated in the LNG sector, the output of which is already locked in for the next 20 years. It’s not going to be shelved or deferred.
2. Exports are cheaper but the income earned from exports is made up of price and volume – volumes will be stronger.
3. At worst the budget will be in modest deficit, but the increase in volumes may actually lift revenue.
4. Points a, b and c suggest unemployment won’t rise.

Past episodes of terms of trade slumps have been bad, that is true, and there have been five such occasions according to Deutsche Bank research. Three of these ended in recession: 1961, 1971-72 and 1975. Nevertheless we can’t just look at those periods, note that there was recession and terms of trade slump and assume causality. Looking at the global economic backdrop it’s abundantly clear the terms of trade wasn’t the cause of the recession – it was merely a symptom of a broader global economic malaise. So, for instance, the recession of 1975 was in fact caused by the energy crisis of the 1973-75 period and tight policy. In the other two cases, recessions were induced by economic policy – that is a tightening of policy. These were consumer led recessions, and not caused by a slump in the terms of trade. 

What we can say then is there have been five significant declines in the terms of trade – and none caused a recession. The bottom line then is that I don’t think the real economy will suffer too much.

So what do we do if the terms of trade slumps? Think back to 2009, as I suspect that’ll be our best guide as to what we can expect.

1. The impact on the real economy will be negligible.
2. The RBA will slash rates, fearful that the terms of trade will have significant effects.
3. The AUD will decline sharply.
4. Government spending will increase to stave of a recession that will never occur – the budget deficit will rise.

This is exactly what happened in 2009 and my investment recommendations, if this occurs, are the same as then.

1. Take profits on European stock trades recommended in my August 6 note Make a Europe splash with Aussie cash.
2. Cut losses on other stock trades and make an immediate and temporary switch into cash.
3. Wait for the trough in rates to be reached as signalled by the RBA board – it could be 0%.
4. Go to you bank manager and borrow as much money as they will lend you. Fix in for at least five years. Buy property, stocks (financials and resource stocks). Switch out of cash. Check the table below to see the returns this strategy would have given back in 2009.

The trick will be in determining whether a terms of trade slump is upon us. For me, the sign posts are the prices of other commodities and equities. If they slump, then maybe there is something in it.