Yielding to tougher economic conditions

The share and commodity markets are trying to tell us all a story about what is going to happen next. Listen to them, because I think they are right.

As I look at the major Australian share indices I see they are well above 5,000, and on the surface all seems well with the world. In other words 5,000 is a comforting figure, indicating the problems are behind us. And yet, this week, I’ve encountered experiences that make me fearful about what is really ahead.

So what is the first market message? Inflation is now low and, as I will describe below, events in China are causing concern and could bring on a serious Australian downturn.

Accordingly, the likelihood of further interest rate reductions multiply and this accelerates demand for bank shares, Telstra and other high-yielding shares. The rise in bank shares and the weakness in the dollar show that the market is telling us to expect lower interest rates. I realise that prediction is widespread. Keep reading.

If only the market’s message was simply lower rates and higher yield driven share prices.

Our biggest and greatest profit industry – mining – has been hammered in the sharemarket. Mining shares may have recovered fractionally but are down to levels we have not seen for decades. It is clear that very few new mining projects are going to go ahead, which means that while this enormous contributor to the Australian GDP - mining investment - is going to stay high for the next year or two, it will completely collapse around 2015. That means a very big rise in unemployment is ahead of us, because the mining investment boom has spawned tens of thousands jobs in a wide variety of sectors which will simply not be there longer term. That’s why mining shares are down. There is nothing on the horizon to replace the investment boom.

At the same time we are about to have an election and almost certainly the coalition will win that election. Next month Wayne Swan will announce a budget with an unsustainable deficit embedded in it. So Tony Abbott and Joe Hockey are going to have to cut back on the public service in a pretty draconian way. They will make all sorts of noises in the election campaign to muffle what is really ahead.

The most severe blows will come in Canberra, which will almost certainly affect residential housing prices in that city. If you are a resident of Canberra and thinking of selling, do it now. If you are a long-term resident in the city obviously you can ride it through. In about two years we are going to see a sizable rise in unemployment - first via the end of the big projects and second by public service cut backs. Abbott will attempt to overcome that unemployment increase by creating jobs in small business via deregulation and stimulating infrastructure projects and he will have some success in both areas.

But the enormity of the current investment in mining projects will make filling the gap very difficult. Therefore, I think in the absence of a rise in global world interest rates (unlikely), Australian interest rates are likely to fall a few notches as the Reserve Bank becomes alarmed at the prospect of higher unemployment.

Higher unemployment will almost certainly shave the top of the current bonanza wages that have been earned in the mining sector. As that problem seeps through the community it will affect bank profits. But bank profits will also be helped by further falls in interest rates, which may hold up the housing market, provided the unemployment doesn’t rise too far in any particular area. I know all this sounds gloomy but we have experienced a very big fall in our mining shares and the fall is not simply an isolated event. If you need further confirmation look at the price of copper, which is a very good barometer of what is happening around the world.

The markets are telling us what is going to happen. So listen. The key reason why mining shares are falling is that the economic statistics out of China are disappointing. The Chinese are generating enormous amounts of credit growth but probably around half of that growth is simply funding the cost uneconomic loans in the banking system. During the week I was yarning to Patrick Chovanec who has just stepped down as professor at Tsinghua University after five years in the post. He says that the demand for minerals over the last four years was a very special event and won’t be repeated for a long time. Moreover China is beginning to struggle, because in its attempts to stimulate the economy to avoid the global financial crisis China made a series of uneconomic investments usually on borrowed money.

Right now vast sums are being borrowed in secondary markets, short term, on very high interest rates and to pay those interest rates it is necessary to raise more and more borrowings. It is akin to a Ponzi scheme and is a very dangerous situation indeed. And it is that situation and its ramifications that are playing a big role in the fall in commodities and our mining shares. I think that the sharemarket in the short term will move in all sorts of directions and looks like it is headed for a further rise.

However, ignore short-term fluctuations, I think it is time to look back at your equity percentages and the levels you decided you were comfortable with last year and make sure you are not above them. And with your interest bearing securities don’t be frightened to lengthen the term a little bit in the next month or two because I think we are going to see some more local interest rate cuts to try and take some of the steam out of the dollar, although the enormity of the money flowing into fund the new projects makes a lower currency rate difficult in the short term.

But in the longer term make sure your portfolio includes companies with overseas income - by about 2015 when these resource projects have been built, the dollar may well fall and create a new interest rate scenario. I am not telling you to sell everything and go hide in a cave, but I think at these levels it is time to be a little more cautious.