In November 2010, Intelligent Investor Share Advisor explained why iron ore prices couldn't stay high forever, listing six companies you should avoid. Since then, their share prices have collapsed along with the iron ore price.
Unfortunately, this trend may well have further to go, which has huge implications for Australia’s terms of trade and the possibility of escaping a recession. For investors in Australian stocks, there is no bigger issue than this.
The oversupply in the iron ore market is already substantial but will increase. Over the next 18 months between 200 and 300 million tonnes per annum in spare capacity will emerge.
A lot of Australian production is going to close, taking a few listed local and assorted international high cost producers with it. Locally, Fortescue Metals Group is most exposed.
There’s a serious possibility that the price falls could trigger a recession and at the very least, future economic growth will be weakened.
With iron ore constituting almost a third of Australia’s terms of trade, the total hit over the next year will be about 9%. That may not sound like much but it would take the measure through its GFC trend low.
That’s why national income is likely to fall over the next year and nominal growth will probably be weak. As a consequence, corporate profits are likely to fall, dividends and costs could be cut and government budgets will be stretched, possibly leading to more cost cutting and/or tax rises at a time of rising unemployment.
BHP estimates that for every $1 fall in the iron ore price it loses $135 million in profit. Rio estimates it loses $122 million. Any fall in the Australian dollar may offer some relief but it won’t fully offset the huge margin squeeze that is now underway. The profits of the big three are likely to take an $8 billion haircut.
That means shareholders can forget about buy backs and growing dividends. Households will also feel the pinch. As mining income stalls, households could struggle to overcome the mining capex contraction and income downdraft. Per capita disposable income is already falling and has been since the terms of trade peaked in 2011.
As the decline in incomes accelerates, companies in the discretionary services and retail sectors will find sales growth difficult. High immigration, which helps grow the pie, will help but the per capita headwinds will be difficult to overcome for businesses dependent on domestic demand for growth.
Now, remember how the mining boom delivered us personal and corporate tax relief and a wave of middle class welfare? These measures drove down the percentage of household income taxed to a 35- year low, a process that’s already reversing.
By the mid-year economic update (MYEFO) in December, the Government may still not have passed all of its May budget measures yet will be staring at an even bigger budget black hole. Both the income and confidence impacts for households will be significant.
We’re already on the threshold of a labour market shock as the mining boom unwinds. In the next year or so major LNG and iron ore projects could shed some 35-40,000 jobs. With appropriate multipliers, many more may be lost.
The housing boom will help keep the rate down but unemployment is likely to continue to grind higher as strong immigration outpaces jobs growth.
Australia may not enter a recession but for investors and consumers it may very well feel like one. A recession is a very real risk if house prices begin to fall, as there would be nothing to support domestic demand.
For that reason you can expect interest rates to remain low. Either way, the economic and investment challenge presented by the iron ore crash is formidable.
For the past few years I’ve been urging Share Advisor members to manage this risk by investing overseas and, if that’s not possible, allocate more of their portfolio to local stocks with international earnings.
There are plenty of attractively priced growth stocks with international earnings and international funds management and ETF options abound.
Diversifying overseas is still smart and investors should remain careful about exposure to businesses highly leveraged to a strong Australian economy, especially the banks.
Of course, this disaster scenario may never happen but that’s no reason not to prepare for the possibility of it.