The Global Economy: It's all about gambling, right? / by Adam Howard

Welcome back to The Update.  For the past few months I have been banging on about productivity; what it means for the lower and middle class worker bees, and how it appears to be lacking in the upper class C-level folk.

Thought I would veer away from that this month and move back to a topic that has people worried at the moment:  the state of the global and domestic economy.

Before I launch into this I need to point out that "The Economy" wasn't really even a thing until about 20 years ago.  I don't mean in a literal sense, as the economy has existed in one way or another, or one size or another, for millenia.

I mean in the context of the relationship between the media and it's customers, the economy is a relatively new topic.  

But these days the breadth and depth of coverage on the economy is exhausting.  It really takes so long to read it all, and if you don't know what specific terms mean you are in strife.

But it sells.  People lap it up with a spoon.  BUT, this Update is not a critique of the media's irresponsible drive to stoke the fires of public anxiety.

I thought, instead, I would provide a quick overview of what's happened over the past 8 years since the GFC to get us to where we are today.  Maybe provide a quick economic and financial history lesson to provide some context.

First.  Who are "We"?  We are all major economic areas in the world:  The US, the Eurozone, China and Asia.  But then, you and I living in Perth, or Australia as a whole.

And second; where are we?  Scared that we are on the brink of another GFC.  Debt-riddled, experiencing low economic and wage growth, working long hours trying to juggle expenses.  Thinking about the new "idea's economy" but not really understanding what this means.  Questioning do we spend our way out of this, or do we save our way out of this?  Feeling strangely optimistic about the future but wondering how we are going to pay the electricity bill.  In a word, conflicted.

Here's a quick snippet from "Wall Street" that explains it nicely:

So, to history.

In 1971 the US President Richard Nixon stopped direct convertibility of US dollars into gold; known in economic circles as "The Nixon Shock" or "Leaving  the Gold Standard."  This was replaced a couple of years later by the introduction of our current system of freely floating currencies, which is why at the end of the finance news each night Alan Kohler tells you "what is happening on the cross rates."

Maybe the reason why Nixon could do this was the US had become THE Global Superpower, and instead of having to use something everyone had access to; gold; as the benchmark measure of value, it was now possible to use US dollars as that benchmark.  Hence the term "reserve currency".

Where countries used to use gold reserves or holdings of other sovereign bonds, since 1971 they use US dollar reserves, because everyone now accepts US dollars as a store of value and medium of exchange.

Another affect of the loss of the gold standard was increased speculation...in everything.  The past 45 years have seen an explosion in gambling on the future value of pretty much anything you can think of.

Why?  Because volatility means uncertainty, and uncertainty means risk, and risk is just uncertainty with a price.  As soon as there is uncertainty regarding the real value of anything, someone will try to make money out of that ignorance.

I asked my Dad, who is 77, if in the mid 1970s he could recall anyone being known as an "investor"?  He said no.

These days, EVERYONE is an investor.

Back to history.

Equities were already in play.  But dropping the Gold Standard meant that foreign currency could now be traded by Mums and Dads.  Government Bonds had been tradeable for a long time, and the value of these bonds determined prevailing interest rates.

But now, with floating exchange rates, the comparative value of bonds, and hence interest rates, started to swing wildly.

This rate volatility meant it was now much more profitable to trade in bonds, as there was an increased level of ignorance about the true value of a bond.

This lead to increased corporate bond use and speculation, which in the early 1980s spawned the junk bond explosion and crash, while at the same time, Lew Ranieri and his fat Italians at Salomon Brothers worked out how to bundle thousands of home loans together and sell them as mortgage backed securities.  The birth of the mortgage bond market.

New toys to play with.  New nags to bet on.

Governments then helped Mum and Dad's become investors by deregulating their banking sectors.

Even so, they came late to the party, taking until the mid 1990s to work out how to use debt to speculate in residential property.

At the same time, banks began promoting the use of your primary place of residence as an Automatic Teller Machine (ATM), using your equity to help you buy some shares, a boat or a new car.  Or even just a line of credit if you needed funds to gamble on something a little more exotic.

But, where did all this new money that was being invested come from?  Cue, the boom of the fractional banking system; the system where commercial banks only need to hold about 10% of their loan book in hard cash.

It goes something like this.  With the explosion in the corporate bond market banks could now quite easily raise funds for new lending by selling a corporate bond to either investors, or their own Central Bank.

So, a bank sells a corporate bond worth $3 Billion to whomever happens to be a buyer.  The bank then holds that $3 Billion in capital somewhere in a deep, dark vault and in return gets to extend loans of up to about $30 Billion.

That’s based on what’s called 10% capital adequacy, or the bank having to hold 10% of the value of it’s loan book in capital.  Rough calcs, but you get the picture.

Now, the bank has to pay interest on that bond, but if it is a strong, credit-worthy bank, this interest won’t be too high.  The bank then pays interest on it’s bond at A%, and charges the borrowers A+n%, pocketing the difference.

So, the fractional banking system doesn’t actually create new money; it creates new debt, which we call money…

Crazy, right?  But true.

And, in a nutshell, that’s how we got here. 

And HERE is a state where we have lots of debt, tonnes of uncertainty, not a lot of growth and way too much anxiety.

I hope that’s an easy to understand summary of the past 45 years of financial history.  It's important, because our current state grew out of everyone being able to speculate in everything.  From the price of a bushel of wheat to the likelihood a company will default on it's debt.

Everyone was a potential speculator...a gambler by any other name.

This leads onto the second thing I wanted to do, which was provide a brief snapshot of the global and local economy, and see if I can shed some light and what’s really happening.

So, first, Oil.

Oil was one of the first commodities to be subject to volatility and speculation, with the mid 1970s Oil Supply Shocks.

We are seeing something very similar happen now, with oil’s price per barrel dropping from a high of $140 per barrel in 2008, to it’s current level of $41 per barrel.

Global oil supply determines oil price.  The more oil, the lower the price.  The less, the higher.  And oil supply is controlled by the Organisation of the Petroleum Exporting Countries (OPEC), with Saudi Arabia the unofficial leader.

Oil is a source of energy, as is natural gas and other forms of gas, like shale gas.

Big economies need a lot of energy.  The USA is the world’s biggest economy…by far, and it has a prodigious appetite for oil and gas.

For decades the USA and Saudi Arabia were super cosy.  The USA needed a stable and reliable source of oil and the Saudi’s needed protection.

But over the past decade some things have changed.

First, some Saudi’s started to get VERY involved in global terrorism.  Next, the USA discovered it had large reserves of shale gas and also worked out how to extract and refine these reserves.  Finally, the USA started to get a lot more friendly with Iran, Saudi Arabia’s great Middle Eastern rival.

Saudi is Sunni, Iran is Shia.  Saudi loves the USA, Iran hates them.  The USA supported Iraq in the Iran Iraq War.  The old USSR supported Iran.

So, when the USA declared that with the high oil prices it was going to use shale gas for it’s domestic energy needs, the Saudi’s thought “I don’t think so….”

After all, without oil as the leverage, maybe the Saudi’s didn’t have the awesome friends they thought they did in the USA???

The market has been flooded by OPEC oil, with the Saudi’s trying to force higher cost shale gas from the market, even if it means sending other OPEC member states (Russia and Venezuala) into recession.

This state of affairs has also had an impact here in WA, with Woodside declaring a 99% drop in Net Income from 2014 to 2015, dropping to $26 Million on the back of lower revenues and over $1 Billion in write downs of it’s USA shale gas assets.

This is a bloody great thing for us as consumers though, as it looks like lower petrol prices might be around for a while.

China

What’s really happening here?  Too much data with no-one really knowing what it means.

Here are my thoughts, based on facts from a few different sources.

China consumed concrete, iron ore, base metals and metal additives at a frightening rate in the 2000s, and over the course of 15 years a lot of cities were built.  Not sure if everyone will have heard the statistic that between 2011 and 2013 China consumed 6.6 Billion tonnes of concrete...which is about 2 Billion more tonnes than the U.S.A. consumed in the entire 20th Century?

This was done on the ol' Field of Dreams strategy.  You know, "Build it and they will come..."

I consider this a ballsy strategy; one that flies in the face of the Harvard/Ivy League MBA method of determining the rate of return on an investment, and only proceeding if it is possible to display a short to medium term commercial return on that investment.

The Chinese have a cultural history of planning in the longer term, and if we look at this plan of theirs over the longer term, it appears to be working.

In 1990, only 26% of China's population lived in urban centres.  Now, that is at about 55% and forecasts indicate about 70% of the population will be urbanised by 2030.

It's been called the largest human migration in history, with over 1 Billion people moving to city living over the course of 45 years.  Impressive...

China's GDP growth rates over the past 15 to 20 years have come about as the construction industry has had an almost insatiable appetite for raw material as the construction of these so-called "ghost cities" was completed.

Now, as we hear in the media, the Chinese central government is waiting for the newly created Chinese middle class to start spending, and this spending will pick up the slack left by the end of such prodigious construction.

And it WILL happen.  

It's just a matter of waiting for three factors to move in the right direction:  wages need to rise to allow large numbers of citizens to buy urban property; wages need to rise again to allow large numbers of citizens to start purchasing consumer goods, and finally; the cultural attitude of the rural poor to save all surplus needs to give way to the attitude of the urban middle class to spend a higher proportion of their household income.

China currently sits inside the World's Top 10 for household savings, as you can see form the attached link:

Savings Rates By Country

But, when those 3 categories move in the same direction there is absolutely no question China will have the world's largest economy, as it's simply a matter of numbers.  350 Million people cannot compete with 1.6 Billion.

The sad thing is, humans being humans and being pretty bad at handling delayed gratification, this transition is going to take a long time.  So, don't hold your breath.

Oh, and what does this mean for Western Australia and our resource sector??  Well, the last time we had a resource boom that resulted in real estate prices doubling in WA in 3 years was between 1974 and 1977.  

Given it took 25 years from the end of the first boom to the start of the second, it might be reasonable to think we could have another boom sometime after 2030.

Europe

Once again, a brief history lesson.  Europe's wars have almost always been about matters economic.  Comparative wealth, access to ports for trade, access to water ways for trade, access to natural resources.

Then World War II scared the shit out of everyone and everyone played nice for 70 years.  

The common myth is the Euro (the common currency) was born out of this niceness.  Some serious esprit de corps showing that everyone was pulling in the same direction.

But, in truth, it came about because of the movement away from the gold standard and towards freely floating exchange rates and the ridiculous volatility created by having over 20 mature economies all in close proximity, trading freely with each other.

The comparative buying power of a Belgian and a German or Italian fluctuated too wildly as a result of nothing more than political rumour, obscure economic indicators or plain speculation.  Have a look at the following link for a breathtaking example of this:

How George Soros Broke the Pound

So, the common currency was born.

Now, however, we all know enough about the retrospective arguments criticising the Euro: no single Parliament, Treasury, Central Bank or Budget.  Different economies.  Different cultures and attitudes to work.  Different attitudes to regulation.

The Eurozone appears to be trapped in a jail of it's own making.  A common currency designed to reduce volatility has now meant the German juggernaut is priced in the same currency as the sleepier Greek economy.  It's not fair and that unfairness is being paid for by citizens of all Euro countries.

The solution to a debt and growth crisis suggested and now employed by the brainiacs at the International Monetary Fund and European Central Bank??

Spend less (austerity), create more debt (quantitative easing) and make it easier to borrow that extra debt even though there is less income to service it (zero interest rates).

So, the way out of a debt crisis is to create more debt, make it artificially easier to borrow more, and then have the governments of the region shrink the size of the public sector, thereby worsening the stalling of economies?

Really?  I don't know.  I am no Nobel laureate, but that seems a little dumb...

The Icelandic government went a different way, and seems to have done quite well.  Have a read of the following link:

Iceland's Solution to GFC

First, let the banks fail.  Next, focus on actual productive industries.  Then, send the bankers to jail.  Finally, watch economy recover.

But the Euro is in a state.  Debt crises are really crises of trust, and at the moment, no-one in the Euro trusts each other, and that's frightening to me.

Finally, Western Australia.

A few years ago West Australians were proudly crowing about how we missed the GFC, like we were smarter than that.

Not smarter.  Not at all.  Lucky AT THAT POINT IN TIME that China was buying iron ore, nickel, manganese and zinc like it was the last day on Earth.

Now, however, things are a bit more grim.  Not for all of us.  But very grim for some.

An example.  Newman is a little town of 9,000 people, heavily reliant on the iron ore industry.  I mean, BHP actually own 500 properties in a town of 9,000 people.  

During the construction phase of the resources cycle rental accommodation in Newman was in such high demand that a 4 x 2 house there could potentially be generating $2,000 per week in rent.

This translated into actual values jumping up rather spectacularly as well, as well as the basic specifications of a house changing quite a bit.

It wasn't unusual for a new house to have 4 bedrooms and 4 bathrooms in order to cater for different tenants.

Then the music stopped.

I have spoken to a few investors who had property in Newman, and that led to discussions with the only remaining real estate agent in Newman who was kind enough to send through some sales data for the past 6 months.

In a market where up until 2013 a 5 bed house could fetch over $1 Million, the highest sale price for the 6 months to 29 Feb 2016 was $310k.

In a town of 9,000 people there are over 30 mortgagee sales underway (where, due to a loan going into regulatory default, a bank exercises it's mortgage and sells a property).

Broadly speaking, a 60-70% drop in market values and a total absence of investors.  

That example is at the extreme end of the spectrum, but has been mirrored to varying degrees in Karratha, Port Hedland, Derby and Onslow.

Most of the investors in these towns are Perth residents who would have used their Perth property as part of the security mix to assist with these purchases, so I wonder how long it will take for the lack of rental income, coupled with very high debt, to create a small wave of forced sales in the Perth metro area?

Secondly, our unemployment rate has risen over the past 12 months, but not as much as was expected due to the fact the first to go were the transient expatriate workers.  

I don't want to generalise, but will.  

There were A LOT of New Zealanders working in WA and Queensland up until 18 months ago, and they have been returning home in droves.  So much so, that for the first time in over 20 years there is a net immigration outflow across the Tasman.

One of the common refrains during the upswing of our wonderful boom was about a skills shortage and the tragedy of needing to find skilled workers overseas as we just didn't have them here.

Well, we did find them overseas, and they came, and our population zoomed ahead, until, again, the music stopped and the people stopped coming.

Now, WA has a migration net deficit from the Eastern states, as people go home after losing their jobs.

The above are actually good things for WA households, as it appears more WA residents appear to have retained their jobs than was thought would be the case.

Finally, and this is my final piece of bad and scary news, businesses filing for bankruptcy in WA rose 41% from the 3rd quarter of 2014 to the 3rd quarter of 2015, from about 800, to over 1,000.

Summary?  The brakes are on and we are slowing down.  And the rate of change is more important than the direction of change.  We know things are slowing down, but the impact of this is determined by how fast it occurs.

THAT'S the difference between a soft and hard landing in economic terms:  how fast it occurs.

BUT (there is always a but...always), we are still OK.  I am.  I hope you are.  

Economic cycles come and go.  Booms come and go.  People love to gamble and they gamble on prevailing economic conditions far more than the outcome of a sporting match.

A lot of people gambled on the resource sector and China.  Lots won.  Some lost.

Some didn't gamble at all.

What did you do?

Food for thought....