World markets are discounting that something big will happen

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For my latest musings - please visit www.scottreeve.com
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This is my take on the world economy - Preserve your wealth while you still can!

The current talk is that the US and Europe may go back into recession. The reality is that they never left recession that hit in 2008. Bogus diluted statistics, such as inflation, unemployment rates have falsely portrayed the economic reality being felt by individuals in towns and cities around the world. Arguably many cities have been in depression for the last decade (look at Detroit and parts of Europe). The world economy is now on a detox diet and it will take many years, if not decades, to clean it up.

The markets are currently discounting that something very, very big is soon to happen. The markets always do this long before the average man on the street and the media realise it.

It could be a combination of things:
*country default;
* Euro monetary changes (Greece is insolvent, and other countries are close behind);
* central bank quantitative easing (monetising debt);
* major bank failure (particularly in Europe); and
* a significant slowdown in China.

All of these things are very real and we are already seeing the effects of this on world markets.


European contagion

All the major Euro countries are so intertwined lending billions to each other. A contagion will quickly spread when more of the bad debts rise to the surface.

Most of the current Euro-cris discussion is centred around Greece. By many measures its economy looks quite sick. It's sharemarket is now at its lowest level in 18 years (This is debt implosion!).

On other measures it certainly doesn't look as bad as other countries. Greece doesn't have the largest amount of government or private debts in the world, or the highest debt-to-GDP. One big difference is that it owes a much higher per cent of its debt to foreign creditors (foreign banks and countries).

Many argue that its non-sovereign entities which are clamping down on Greece. ie. the Global banking cartel led by the IMF, the World Bank, the Federal Reserve etc working in tune with the credit rating agencies (Moodys, S&P, Fitch). All I ask is what is the interests of the global banking groups? All actions to date show that they put their interests and survival ahead of everyone else. They do not care about the sovereignty of nation states.

So which countries banks' have the most at stake with Greece?

The following interactive chart I put together uses Bank for International Settlements data demonstrating which countries banks are most exposed to sovereign Greek debt as of the first quarter ending March 31 2011.

The most exposured banks are (by country):
French banks US$56.9 bn;
German banks US$23.8 bn;
UK banks US$14.7 bn;

The most exposed individual banks are:
BNP Paribas with US$7.1 bn (France)
Dexia with US$4.8 (Belgium)
Société Généralewith US$3.8 (France)

This is just the banks. When you add Government's holding Greek debt the amount is another US$145 bn.

Chart : There has been a huge widening of bony yield spreads and risk insurance on credit default swaps. Greece has gone parabolic. Portugal and Ireland are where Greece was a year ago.

or as Alan Kohler puts it, when the financial crisis hit last time in 2008, it was about liquidity (banks wouldn't lend to one another). This time around its about insolvency. There is plenty of cash around, but the banks might be broke.

Chart:
source: Alan Kohler, ABC News, Sept 2011

The dominoes are lined up

The next graph shows why the banking system is trying to fix Greece before it sets a precedent. You may have heard that Spain and Italy are "too big to fail, too big to bail". Europe bank exposure to Spain and Italy's are 6 to 7 times worse than Greece.

Chart :

The harsh reality is that no industry should be bailed out, including the banks from country to country. The ongoing debt crisis has come about because banks have lended and taken billion dollar bets to keep this unsound monetary system going (which is based on nothing but paper money generated out of nothing).

Monetary systems do blow up - why is the Euro any different?

One article I came across discuses that country default is more common than we are led to believe. There were a number of large defaults in the 1980s and 1990s in emerging countries across the Americas and eastern Europe. Economist Carmen Reinhart states that the list of deadbeat countries included

"current investor favorites like Brazil, which defaulted in 1983, went through a bout of hyperinflation in 1990 and effectively defaulted again, for the same reason, in 2000"

Reinhart and Professor Rogoff show that, on average, nations add 86% to their debt loads within three years of a credit crisis. At the same time, government revenue falls an average of 2% in the second year after the onset of the troubles. The way things are heading Greece and other Euro countries are heading down this path. Debts need to be rolled over...just like...a few snow flakes can lead to an avalanche.

The Stumble Cycle

Sovereign defaults--when a country stops paying its bills--go in waves, often following global financial crises, wars or the boom-bust cycles of commodities. Some countries, like Spain and Austria, mend their ways; others, like Argentina, are repeat offenders.

Chart :

The combination can be fatal for investors holding bonds issued by financially shaky countries like Argentina or Greece, which sell a lot of their debt outside their own borders (as does the U.S.--45% of all publicly held debt). As a nation's finances deteriorate, foreign investors sell their bonds, putting upward pressure on interest rates. That usually sets off a spiral including a deteriorating currency, which, if the bonds are denominated in foreign currencies, makes it impossible for the country to pay its debt. Greece doesn't have to worry about this last syndrome, because it uses the euro. But that might make things worse since it can't print its way out of its financial difficulties. "It's like entering a prize fight with one hand tied behind your back," Bass says. Argentina takes a different tack. Still struggling in the wake of its 2002 default on foreign-held debt, its president recently tried, and failed, to seize central-bank dollar deposits (and cashier her central banker) in order to repay overseas debt.

France

Following from earlier discussion, the big questions are which of the big European banks will go under first. The largest French banks, Credit Agricole and Societe Generale have billions in exposure to Greece and other Euro countries.

Chart : The share prices of the 3 largest French banks have fallen 73%, 87% and 87% since start the debt crisis started in 2008.



Italy

Until recently UniCredit was the largest bank in Italy by market capitalisation and a major euro-zone bank. It owns other large banks in Germany, Austria, and Poland with around 40 million customers all up. As the following charts shows, the market is dumping the two largest Italian banks. UniCredit is one of the "too big to fail and bail" euro banks and many of its depositors lie outside Italy, making and bail out practically impossible.

An ironic twist to this is that, UniCredit's predecessor was a bank called
Credit-Anstalt. This bank collapsed in 1931 which lead to a contagion which took Europe off the gold standard and pro-longed the Great Depression. Few people remain from the last depression era. Perhaps the money lessons need to be relearn?

Chart :



Australian dollar

The Australian dollar is a proxy for commodity prices and ultimately China. The Australian dollar has recently fallen sharply to 97 cents and has hit a major support level. If this fails there is another major support level at 94 cents.

Chart: The Australian dollar managed to bounce off the firs support level at US$0.97



Commodities

Overall commodity prices are not showing that China is in immediate trouble. Base metals: copper, zinc, nickel, lead etc are not in a major bear market yet. This may mean that the current correction will be short lived. If base metals start free falling and other negative signs come from China (popping of housing bubble?), than the Australian dollar and commodity prices will fall a lot (a huge amount) further.

Gold

Meanwhile, gold and silver have recently experienced a significant correction. Chart wise (USD/gold), gold's correction is not unhealthy. Gold was sitting at 11 year bull-market resistance line and its trending support line is about US$1550.

Chart:


As I posted recently, I believe the gold demand is getting stronger, and will remain strong, despite the recent price volatility. Since that post it has been reported that Mexico, Russia, South Korea and Thailand have all made large purchases in 2011 and globally, central banks are set to buy more gold this year than at any time since the collapse of the Bretton Woods system 40 years ago. The IMF even reported that European Central banks have started accumulating small quantities of gold after selling on average 400 tonnes of gold a year since 1999.

Silver

Silver plummeted last week by 34 per cent within trading days. It went straight through two key support levels and bounced back above them. After hitting a low of US$26.03, silver rebounded 28 per cent in 28 hours.

Chart: Silver fell 34 percent within 4 trading days, then bounced 28 percent within 28 hours


Is this volatility unusual? Silver is a very small market and historically has been prone to major corrections. My research shows that the major corrections in the last few years has lead to an increase in demand for physical silver (from mints and bullion dealers). I believe this will happen again.

Australia

Take away mining and Australia is in recession, and as I stated early, the key to the Australian economy is whether China can keep its economy upright. If it shows signs of weakness, commodity prices will collapse (along with oil, gold and silver) and the Australian Dollar will fall 10 or 20 cents against the USD.

China kept the world economy somewhat afloat during the global financial crisis, and is the sole reason why Australia didn't go and stay into a technical recession. One of the key barometers on the health of China is commodity prices.

Tourism has been in recession for many years now, in part to the high Australian dollar and a tightening of consumer belts.

Manufacturing has largely been in recession for a number of years except for businesses with astute management and niche business models.

Manufacturing insolvencies growing

Despite insolvencies around the world dropping to their lowest levels in nearly four years, Australia is headed in the opposite direction. This year is shaping up to be a record one for business failures on a par with troubled Eurozone countries. The most recent D&B Global Insolvency Index, ranking business failures in more than 30 key economies, found Australia's insolvency rate was on a par with indebted countries such as Italy, Spain and Hungary. Australia recorded a 12.1 per cent increase in business failures in the June quarter compared with falls elsewhere in the world of 5.7 per cent. D&B said its findings tied in with Australian Securities and Investments Commission data which pegged 2011 as a record year for insolvencies.

Business failures in manufacturing have soared 60 per cent in three years. Almost 300 manufacturing firms went broke in the first six months of this year, the business analyst Dun & Bradstreet says, and just 14 new manufacturers started up. By contrast, in 2008, 974 new manufacturers got off the ground, and only 392 folded.

Retail

Retail is finally entering recession. This has long been coming, even though the likes of Westfield (and other groups) have been creating mega-shopping centres around Australia. The whole retail industry relies on ever increasing amounts of debt (more credit cards and increasing consumption). This model is dead, and there is currently too much competition in Australia alone (before you look at internet shopping of overseas products on eBay and the like). Take electronics, there are so many major stores competing on price, and margins are getting thinner. Many of the private equity firms which bought up a lot of the retailers in recent years have failed, as over-inflated sales targets have missed the mark. In the last 12 months several major groups have entered administration: REDGroup (Borders/Angus and Robertson bookstores); Colorado Group (Jag, and shoe shops), Allied Brands (Baskin Robbins, Cookie Man), Krispy Kreme doughnuts, and Starbucks Australia. Most recently sharper falls in consumer spending has forced Harvey Normany to scrap its Clive Peeters and Rick Hart brands (7 stores to close) and David Jones announcing a 10.3% drop in fourth quarter sales and now expects a small profit for the new financial year.

Sizeable retrenchments are coming.


Housing

Chart:


Lastly, this is a very good presentation by Mike Maloney


Cheers
~ Scott

The mother-of-all bounces

Last November I posted on the mother-of-all-crashes Through a couple of graphs I detailed why the Australian and US sharemarkets were falling at a faster rate than the great sharemarket crashes of 1929. After the post, the Aussie market drifted sideways for a few months before falling even lower to below 3100 (March 09), for a total peak to trough fall of 55 per cent.

Now, a year on from that post, we have witnessed, perhaps, the mother-of-all (dead cat?) bounces, in an 8 month period from mid-March 2009 to mid-October 2009, the All Ords has rebounded some 56 per cent from the trough (see chart below).

Chart 1: All Ords - crash and bounce
The rise or fall of the All Ords is largely attributed to the big 4 Australian Banks and BHP. The big four banks account for 21.47% of the All Ords, while BHP accounts for 10.15%. If you compare the chart below (Financials Index) with chart 1, they are a mirror image of each other.

Chart 2: The Big 4 banks led the All Ords crash, and now the recovery. Notice the % fall and % rise similar proportions to Chart 1 (XAO)
No other area in the Australian economy has done as well as the Big 4 Australian Banks. They now have combined market capitalisations which exceed the pre-GFC crash. Through help of the Government, they have increased their monopolistic position in lending. For reasons unknown, the Australian Government and ACCC allowed Westpac to buy St George Bank (no. 5 bank), and Commonwealth Bank to buy BankWest. In early September 2009, the Australian Prudential Regulation Authority figures reported that the big four lenders captured almost 100 percent of the $7 billion in new mortgages written in July 2009, squeezing the small lenders out of the mortgage market. Before last year's funding freeze in global markets, the big four banks' share of new mortgages was running at about 60 per cent. Some day soon, just like in the US, we will be having the “too big to fail” debate in Australia. The Australian banks are sitting on the mother-of-all housing bubbles, which is staying upright for now due to unprecedented net migration and government stimulus intervention (see further below). Give it a couple of years, the Great Australian Housing Ponzi Scheme will eventually run out of buyers.

Like the Aussie market, most world markets have bounced, including the Dow Jones (US). As the following chart demonstrates the length and magnitude of this bear market bounce is unprecedented when compared to the Great Depression bear market rallies.

Chart 3: Depression-era bear market rallies (Dow Jones)
source: Chart of the Day

The three charts above give us a clue about the state of the world economy (and I would argue, the state of the US-centric monetary system). Extreme volatility is in full swing.

USD-AUD Exchange Rate

No better example of extreme volatility in the system is the USD-AUD exchange rate.

Chart 4: In 16 months the AUD has gone from almost parity with the USD, crashing 39%, and now rebounding 56% from the lows at 60 cents
So what has changed?

Nothing, nothing has changed. The fundamentals are still broken. The US is still trading insolvent and an aging population will ensure most Western Countries will pursue a path of monetisation (going into more debt) to pay for the welfare state. What has changed is two things:

Inflation and Timing

During the GFC we were constantly told of deflation (decreasing prices). However, during this time I argued that inflation was and will remain our greatest concern. In the middle of the GFC (June 08), Australia's money supply growth was at 23 percent (annualised), the highest rate since the mid 1970s. I ask.. is it any wonder that it appears Australia is such a buoyant economy right now? We inflated our way through the GFC. Another angle is that we populated our way through the GFC (see chart below). If you add more citizens to the economy, there is greater demand on food, housing and general consumption. Add Government "free" handouts, and the warm fuzzy experience we feel aobut our "resilient" economy was all-but inevitable. To the contrary, I believe this is making a bad situation worse, at least for the long run. The artificial wealth effect continues.

Chart 5: Inflate and populate out of financial crisis! Australia net migration since 1860. You would think there was a gold rush on...source: ABC News, Alan Kohler, 23 Sept 2009

The other difference at play here is timing. During the GFC, the All Ords, Dow Jones and even world trade (click to see charts) were declining at a faster rate than what they did during the 1929 crash. The rate of fall was just unsustainable. It's the law of the markets... or like bouncing a tennis ball. If you bounce it hard on the ground, its going to bounce back to some extend. In market terms, this is called a dead cat bounce (however some stocks fall and just don't bounce...). Timing is everything. For instance BHP was almost $50 per share prior to the GFC crash, than fell to $21 seven months later. Same company, and arguably the fundamentals of BHP were stronger than ever. The difference is market mood. Perceptions of value change over time.

Dow-Gold Ratio still falling

One of the key indicators I keep an eye on is the gold-dow ratio. When we price the world sharemarkets against gold, the downward trend is still well intact. Historically the Dow-Gold Ratio goes to below 1 when gold becomes very expensive relative to the sharemarket (Dow). There is still a long way to go... Gold is very cheap at US$1,100 oz!

Chart 6: What bounce?
source: Chart of the Day

Money can be made in all market conditions. Volatility in the markets in the last two years is telling us something is happening. Short-term it may appear that everything is back to normal. This couldn't be further from the truth. Measuring the share market and housing markets (and other debt-based markets) in terms of a tangible good (ie. gold) tells a very clear non-volatile storey. The long-term fundamentals have not changed, but arguably getting worse year by year, as Government and banks continue to fuel the fire with more fuel (inflation).

Cheers
Scott

(feel free to comment!)

The Houdini Economy

I believe there are many, many parallels in the world economy today, to that of previous economic depressions. We need only to look at past history. However, historian's all have different accounts and points of view. Is historical information based on objective analysis, primary evidence or a biased second hand account?

Is the economic events of today so different to that of the past? We are constantly told we are living through the worst economic downturn since the Great Depression; then we are told Australia has a resilient economy and that we are weathering the storm. Surely it can't happen to us?

"But we live in a modern, innovative, high-tech society today!"

In the 1920s America - the "Roaring Twenties", the sharemarket was booming, the humble car was built for the masses (T-Model Fords), and the population was extremely opportunistic. The population had never felt so wealthy, the horse and buggy were essentially gone from urban areas and the economy had never been more innovative. It seemed the good times would always last.

And today? We live in the so-called "new economy". A modern, innovative, high tech economy. We have never felt wealthier. We expect the good times to always get better. The next 20 years will be better then the last 20 years.

These are two different points in history - but the same human traits of economic complacency are well and truly alive today. There is usually a large economic depression every 75 years - the average life span of a human. Is it a coincidence economic lessons repeat? Is it a coincidence that each generation since the 'silent' generation (of the 1920s and 30s) has progressively had worse money habits than their parents generation? Everything used to be bought within our means, today its on credit, and we have little incentive to save for a raining day.

Houdini economy

** The big difference between 1929 and today, I believe, is the acceptance of mis-information by the general public and an acceptance to think the monetary system will always work. We live in the so called "Information Age", yet our diluted statistics mean we live in a Houdini economy. It's all smoke and mirrors. Government's have an interest to keeping the public unaware about what is really happening in the economy - to maintain political and social stability (in the short run).

However, comparing today to the past has become distorted because economists, Governments, and the media think they are comparing apples to apples. Today, statistics are treated as gospel. We believe that the stats on the nightly news are accurate, objective and unbiased. Why are we not learning from recent events? Many of the economists and bankers who got it wrong, are still in positions of power and influence. Central banks are being given expanded powers (particularly the Fed Reserve), rather than face increased accountability.

More often than not, an economic number today will be grossly diluted to that of 75 years ago. For example, the unemployment rate, or level of inflation are grossly misunderstated today.

For instance why is unemployment so low at the moment? In the 1930s it got to 32 per cent in Australia! Yet it is still around 5 per cent today, despite a recession and economic turmoil worldwide.

Answer: The ABS counts people as been employed if they are working just 1 hour per week.

But as the following chart shows, the number of hours worked has been falling gradually in the last 15 years. For starters there are a lot more part time jobs. It's good for people who want to work less, but its bad for recording what the real unemployment rate should be.

Chart 1:
Source: Kohler, ABC News

Getting back on topic - lets compare further to the last Great Depression:

1929 to 1932- the greatest sharemarket crash in history put the world into a Great Depression. In 3 years the market fell 89 per cent.

Current sharemarket crash? Depends on your measuring stick, namely, the monetary system has changed. 1929 money was backed by gold. Today it is backed by an exponential curve of debt.

If we use the Dow/Gold Ratio (which is what the 1929 sharemarket crash was recorded against), then the current bear market we have today really started in 1999 (not 2007). So far from top to bottom of the bear market the Dow Jones has fallen 84 percent measured against gold (the old monetary unit).

Perhaps we are already in economic depression but we just aren't awake to it?

As the following chart shows, the inflated US Dollars of today have diluted the impact of what is really happening. From 1999 to 2007 the Dow Jones rose in nominal terms, while the old monetary system was showing the economy was sick (and crashing), now both these measuring sticks are showing the US and world economy is continuing to tank.

Chart 2: Dow Jones over last 100 years
Wow - look at the 1929 crash! It's huge. What this chart fails to show is that important change of the monetary rule book in 1971 (when the gold link was removed).

The following chart puts the 1929 crash, and today's sharemarket crash into a better perspective (apples vs apples).

Chart 3: 100 yeas Dow/Gold Ratio.
Source: Steve Hickel, gold-eagle.com

The last dip in Dow/Gold Ratio:

Notice has taken at least 32 years to reach a new peak in the Dow/Gold Ratio in the last two downturns. In the last downturn there was stagflation in the 1970s, a change of the monetary rulebook in 1971, a commodity price peak in 1982, and an increase in social security outlays of Governments among other things. There was no great depression, but inflation was accepted and new bubbles came along to occupy everyone's money. The key last time is that there remained confidence in the new fiat monetary system. I believe this time round will be different.

Clearly there is a huge difference between Chart 2 and Chart 3. Chart 2 is an inflation drive chart. Chart 2 characters a true free market which goes from undervalued to overvalued and back over time. (Change the monetary system (methodology), and you will change the shapes of the charts!)

Steel industry today vs 1920s

Lets compare 1920s and today even further...

In the 1920s, there was a huge boom in the United States steel industry. 15 per cent of steel was used in automotive manufacturing. By 1928 there was over 21 million cars, enough for 1 in every 6 Americans. When the Great Depression hit however, by the mid 1930s over 50 per cent of the United States steel capacity stood idle.

Today there is vast amounts of steel capacity standing idle also. Lets compare.

Kingdom of Rust

According to latest research from Macquarie Bank, there is some 362 million tonnes per annum of unutilised steel capacity in the world.

Chart 3: Today, around 25 per cent of the world's steel capacity is sitting idle.
Source: Macarthur Coal Presentation - 17 June 2009

To put this into perspective, this is equivalent to:
- every single steel mill in Europe, Japan and Korea shutting down OR/
- ¾ of China’s steel production closing down.

With all this recent iron ore hype in the Australian sharemarket (in the last couple of months), just stop for one moment and envisage 3 out of every 4 steel mills in China closing down. Only the lowest cost (lowest debt) iron ore, coking coal, steel producers could survive a sustained turn down. Clearly there is too much capacity worldwide. This is not unique to just the steel/iron ore industries. The capacity for most goods today is built on the premise that the current monetary system will continue to work, that the world economy will continue to expand at a rapid rate, and that our tolerance of debt will continue to expand.

All this extra capacity will have to be removed from the system. Many companies will continue to go under. This is only natural. In the boom times too much competition led to cheaper cars and airfares, and even steel was pre-fabricated in China and exported back to Australia! There needs to be a giant shake-out across industry worldwide. Give it a few years..

Baltic Dry Index

Much of the gains on the Australian Securities Exchange (ASX) in recent months have been on the back of a bounce in commodity prices (ie. A fall in the US Dollar), and increased shipping movements out of China for Australian iron ore and coal. This has also lifted the Baltic Dry Index (BDI), which had a major crash in 2008. The BDI is a daily number published by the Baltic Exchange – it tracks world wide international shipping prices for dry bulk cargoes such as iron ore. It shot up in the boom years, and crashed big time last year as the following chart demonstrates.

Chart 4: Baltic Dry Index crashed 94 percent when the resources boom bust, its now rebounded on growing Chinese iron stockpiles.
Source: Bloomberg

The following chart from Alan Kohler pictures an interesting relationship between the BDI and movements in the Australian and US Dollar. Positive movements in commodity prices (particular in US terms) and the BDI - is a positive force for the Australian sharemarket.

Chart 5: Baltic vs AUD
Source: Kohler, ABC News

I believe its now time for the BDI to fall sharply once again. The third quarter of the calendar year is traditionally the worse for commodity prices (from my experience, particularly in base metals). Apparently about 10 per cent of the world Capesize ships (the largest) are sitting of Chinese ports, unable to unload their iron ore. The two largest iron ore terminals in China are said to be close to full capacity. Now that the 2009/10 iron ore benchmark prices have been finalised (with Japan and Korea), my bet is the Chinese have done most of their shopping for this year, and will try to manipulate the market in the short-run to really hammer down prices come next year.

World Trade

Ok, so i've talked about the BDI - what about world trade as a whole?

The following chart from Alan Kohler paints a bleak picture for world trade. It uses a base of 100 for the peak in world trade (some 12 months ago). Already we have gone from a massive boom, and the big bust continues at a greater magnitude than the 1929 trade bust. Just like the 1920s America – there is significant overcapacity in the world. Trade flows are stalling.

Chart 6: World trade has fallen off a cliff much higher then the Great Depression slump.Source: Kohler, ABC News

Covering up debt - back to the suitcase method

We all know what hiding bad debts can do... Subprime mortgage-backed securities, bundled together, given a AAA rating and sold overseas to unknowing investors worldwide. This grand scheme worked for a while... now it appears the humble suitcase is back in vogue to move Government debt around.

Here is a rather amusing article. If this were true... the US/Japanese Governments are running out of places to hide their debt!!

Suitcase With $134 Billion Puts Dollar on Edge

Two Japanese men are detained in Italy after allegedly attempting to take $134 billion worth of U.S. bonds over the border into Switzerland. ..

The trillions of dollars of debt the U.S. will issue in the next couple of years needs buyers. Attracting them will require making sure that existing ones aren’t losing faith in the U.S.’s ability to control the dollar. ..

Think about it: These two guys were carrying the gross domestic product of New Zealand or enough for three Beijing Olympics. If economies were for sale, the men could buy Slovakia and Croatia and have plenty left over for Mongolia or Cambodia. ..

Let’s assume for a moment that these U.S. bonds are real. That would make a mockery of Japanese Finance Minister Kaoru Yosano’s “absolutely unshakable” confidence in the credibility of the U.S. dollar. ..

Bad news can only be covered up for so long. Question everything!

Scott

Boiling Frog Syndrome

Boiling Frog Syndrome

Ted Butler of www.investmentrarities.com summed the current situation up best.

People do not appreciate the current economic events, because every day there is more and more bad news. We start to tune out of it after a couple of banks go under. It starts to feel normal (or common). People also just do not like to hear bad news. It's a bit like hearing terrible war stories from Iraq or Afghanistan. We do no truly appreciate the true seriousness of events over time, only if it personally affects us.

If you put a frog into a pot of cold water and increase the heat gradually to a boil, he won’t jump out.

The heat is on the world economy and now is the time to wake up. Don't wait for the water to reach boiling point. Major banks and insurance companies which go back to the mid 1800s do not suddenly go bankrupt for no good reason.

(Ted's boiling frog explanation was originally in relation to a retail shortage in the silver market. I have yet to find time to discuss the opportunity in silver on my blog, but right now there is a 10 week wait to take delivery of any silver in Australia. There is a worldwide shortage, yet the price of silver is still low because of market manipulation by a couple of US Banks. More to come on this subject..)

To avoid the boiling frog syndrome you must have i) an open mind, ii) change your context and iii) take action.


Last week in Review:

U.K. Trillion Dollar Bailout

Last Wednesday 8 October 2008, the UK government announced a £400bn bank rescue package to help increase bank capital and sure up loan guarantees.

The chart below puts some perspective on the bailout plan:

Six central banks cut rates

Also on Wednesday, six central banks cut interest rates by half a percentage point (following Australia 1.0 percentage cut on Tuesday). The US official interest rates are now 1.5%, and the European Central Bank (ECB) has its rate at 3.75%.

"Free-Fall" Friday

Sharemarkets continued to fall dramatically last week, with many stock exchanging closing at one point due to indexes falling by over 10% (Indonesia and Japan). The worst falls by far came on Friday.

- Australian ASX down 8.2% (down 16.2% for the week!)
- Japan's NIKKEI down 9.62%
- UK FTSE down 8.85%
- German DAX down 7%
- US Dow Jones down almost 10% at start of trade, but ended up closing 1.5% lower.

The Australian Sharemarket has now fallen 42.5 percent since its peak on 1 November 2007 in about 243 days. This bear market is officially worse then most previous bear markets.

Prime Minister Rudd Guarantees bank Deposits

Political pressure came to be, with the Australian Prime Minister would guarantee all bank deposits in Australia for the next 3 years. This is estimated to cover about A$700 billion. The government also doubled to $8 billion the funds available to improve liquidity in residential mortgage-backed securities.


Main discussion point today: Shake up for world Industries

Automotive

The US car industry, in particular, has been in dire straits for a number of years. The only reason General Motors (GM) and Ford have not gone into insolvency is because the US Congress keeps throwing tens of billions of dollars at them. A couple of weeks ago $24 billion was thrown.

The US Government is not prepared to see GM and Ford collapse. They are bigger then many countries in terms of annual revenue and employment.

Ford currently has a market cap of US$4.55 billion. Ford lost US$12.6 billion in 2006, and US$2.7 billion in 2007. In the 2nd Qtr 2008 it lost $8.7 billion! (in only 3 months).

GMs share price is now at the levels of 1956, with a market capitalisation of US$2.77 billion. GM lost US$38.7 billion in 2007, and US$15.5 billion in the 2nd Qtr 2008! (in only 3 months).

Companies which are loosing tens of billions of dollars every year should not be kept in business. New car sales in the United States are now at their lowest level in 15 years. The US Government and taxpayers have always subsidised the auto industry, but the cost of doing so today is for its very survival. If they were allowed to fail, many hundreds of thousands of workers would loose their jobs world wide (think of component manufacturers and indirect jobs). I suspect the main reason for keeping GM and Ford alive is all about confidence. In the early 1930s, Ford laid off 10,000s of workers, which helped fuel further unease in the outlook for US economy.

They represent manufacturing and economic activity. With millions of American's foreclosing on their homes over the last few years, no one is looking for a new car. People go back to basics and if the 2nd hand car works, why replace it?

Talk on the street is that Ford and GM proposed a merger recently. Current talk is GM is now exploring a merger with Chrysler and Ford is apparently seeking to offload its majority stake in Mazda.

Where ever this goes next, one thing is almost certain and that is consolidation in the automotive sector. There has been too much competition. The car manufacturers have been absorbing rising steel prices, aluminium prices, wage prices etc. As a consequence, they have been unable to pass these costs onto the consumer in full and their profit margins are squeezed. So they have been left caught building increasingly expensive cars, that no one is prepared to buy.

Consolidation across other industries

There will be more consolidation across all other areas of industry. The longer the credit squeeze goes on, the more depsrite companies will be to merge with one another, or face bankruptcy. Right now it is basically impossible for companies to raise equity, to raise debt, or even sell assets to raise cash.

Airlines

The best example of consolidation will be in the Airline industry. We are all familiar with the $1 special sale fare's JetStar and Tiger Airways etc has every few months. Competition is fierce, yet airlines are operating in an environment where fuel has been hurting growth and profits. Air Italia is going under. The low-cost carrier model isn't sustainable. Only the major airlines which consolidate will survive a major global downturn. Many have gone under in the last few years, and this happened in economic good times.

Commodities:

As discussed previously, commodities have had a rough time in the last couple of weeks. Deflation is hitting both hard commodities (metals and energy) and soft commodities (agriculture).

Hard Commodities

In Australia, we should particularly see consolidation in the resources sector. Many high-cost producers and explorers will go out of business. Companies will need to preserve capital, which means less exploration. Those who have plans to start producing 3 or 5 years down the road will find it difficult to get into production. The best near development assets will have to team up (joint ventures) with cashed-up majors or sell equity to overseas investors to get their project into first production. Only the very low cost producers will manage to bring in sustainable cashflows to keep their business going.

Right now the market is factoring in that many resource companies will fail. However, some of the better companies are falling just as hard as the bad ones. Several companies I have come across have a market capitalisation less then the cash they have in the bank (AED, BRM and CFE for example). Maybe the market is factoring in that the Australian Dollar will be worth less in the future :) ?

It was only less than 10 years ago, that many large resource companies went insolvent and closed down their mines. Zinifex (now OZ Minerals) is essentially a repackaged Pasminco. Ironically now that zinc and lead prices are becoming low again, and many mines are being closed and placed on care and maintenance.

Commodities work on boom and bust. This sector works on over confidence or no confidence. You don't want to be holding a commodity stock during a bust. Right now the market is factoring in that the US led global slow down will severely affect demand coming out of China.

Soft Commodities

Soft commodities should fare much better then hard commodities in times of economic depression. Our spending habits change from buying luxury goods (new cars, plasma's etc) to the very basics. At the end of the day people still need to eat, and if it takes 100% of our disposable income to buy food, people will do it (which is exactly what has been happening already in some countries).

However, the global liquidity freeze will affect farmer's world wide. Banks will be less willing to lend debt to farmers for a wide variety of reasons. Many farmers are already in heavy debt, and have less capacity to repay debt in the future. There is always the uncertainty of drought, flood and other forms of crop failure. Farmers have also been absorbing a large slice of the inflation pie in recent years. Rising fertiliser and fuel costs have not been offset by rising food prices. Farmers are still price takers, with many receiving the same prices for potatoes or milk then what they did 10 years ago. They know exactly what inflation is (on costs of production), and they know exactly what deflation is (the price they receive). On top of this, the 2 major supermarkets in Australia are squeezing the farmers (and food manufacturers) out of the market because of their market power. Lastly, rural Australia is already being hit hard by an aging population. There are not enough young people coming through to replace those looking for retirement in the next 10 years. All this factors will mean there will be fewer farmers, less domestically grown food, higher prices, and more food imports to Australia. Couple this with international factors, such as a population the size of Australia moving from rural to urban landscapes in China each year, and a major push for biofuels, and its easy to comprehend that food prices world wide will inflate dramatically in the coming decade.

Investing in a backyard vegie garden might become widely popular again, or be prepared to pay a greater amount of your disposable income on the basics.


The next post will be on Household Debt and why Australia may end up in a worse situation than the US within the next couple of years.

- Scott