Is price inflation good for real estate in Australia?

July 24th, 2011

One of the assumptions made by many people is that rising price inflation is good for property prices in nominal terms. In other words, many people see property as a hedge against price inflation. The experience of the past (especially 1970s) has a strong influence on this belief.

But today, in Australia, from our observations, we believe that the relationship between price inflation and property prices is breaking down. In fact, we would argue that price inflation probably has a negative effect on property prices.

To understand why, recall that we wrote in Does inflation (deflation) benefits the borrower (lender)?,

Debt servicing burden = (Debt payment rate ? Growth in wage) + Price inflation rate

Today, the problem is that in Australia, with the two-speed economy, wages are rising in one section of the economy but is relatively stagnant on the other. In relative terms, mining wages in Western Australia are sprinting ahead of wages at say, office workers in Sydney.

But unfortunately, since the GFC, cost of living has been rising faster than general rise in wages. For example, as Retail therapy impossible in this housing market reported,

Now look at your pay packet, take away the things you can’t avoid spending money on, remove what you’re paying in rent or paying off a loan, and look at what is left. You may find that’s smaller than ever, despite the fact we’re in a mining boom. But the trickle-down effect of that boom seems a long way away from Sydney. We’re part of the second tier of the economy here, the one that isn’t doing so well. Still, rent and housing prices continue to go up. And the bills come first before that new coat, that new stereo . . . even repairing those cracks on the walls or the dents on your car.

As you can see from our simple equation, with the cost of living rising faster than increase in wages, debt servicing burden will increase. Furthermore, the Reserve Bank did not help by raising interest rates. The increase in debt servicing burden puts a squeeze in discretionary spending- that explains why shoppers seems to be going on strike, putting the retail sector under pressure.

This increase in debt servicing burden is putting on the dampener on house prices. It dampens people’s appetite for borrowing more money and increases their propensity to save. Less borrowing means less capacity to bid up house prices. It also pushes more mortgage holders to be delinquent with their home loans, which increases the likelihood of forced sales. This is the first round of effect on house prices.

Rising cost of living pushes the retail sector deeper into trouble as shoppers shut up their wallets. Since consumer spending account for 60% of the Australian economy, a weak retail sector is hardly good news for employment in the country. As we wrote in RBA committing logical errors regarding Australian household finance,

Given Australia?s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises.

Rising unemployment will put further pressure on house prices. As we wrote in Does house price crash follow unemployment or is it the other way?,

[Rising unemployment] will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the? third round of impact.

Now, cost of living is rising despite a rising Australian dollar. What if the dollar falls substantially? What will happen to the cost of living?

Is China’s electricity shortage be the trigger for a crash?

June 28th, 2011

As you read the mainstream media, you will find that more and more attention are paid to the fundamentals of China’s economy. Recently, reports of Chinese ghost cities made its way to the newspapers and TV news reports. Attention are brought into the inflation problem that China is facing, and the efforts by the authorities to clamp down on the property bubble that are brought about by real estate speculation. Then we hear reports on the MSM of characters like Jim Chanos, who famously made the claim that China is Dubai times 1000. So, it is fair to say the mainstream is catching on the scepticism of China’s economic ‘miracle’.

While it is true that the mountains of bad debts, excesses, bubbles, corruption and price inflation in the Chinese economy are unsustainable in the long run, it is another matter to predict when this unsustainable trend will result in an almighty crash. As Professor Chovanec put it astutely, China’s bubble is “extremely persistent,” though he is careful to qualify that that it is by no means sustainable.

So, a week ago, when we saw this news article about electricity shortages, we wondered whether a hard landing for China is near? As that BBC article reported,

Offices and shopping malls in the Chinese city of Shanghai will be urged to close their doors on the hottest days of the year this summer.

The power rationing is necessary due to the country’s shortage of electricity.

The electricity grid serving China’s financial hub does not have the capacity to meet peak demand the authorities say.

China has been coping with power shortages since March, because of coal supply problems and a drought.

If you are curious about the answer to this question, our friend, Paul Adkins, from AZ-China had completed an in-depth study of the situation in China this summer, as the country runs out of electricity. (You can order this report by contacting them on their web site. And note that we do NOT receive any commissions for any sales of their report.) We have read the report and can only provide you with our interpretation of the most important facts…

This is not the first time China is suffering from power shortage. The last it happened was “especially in 2004, but also in 2006 and 2008.” Today, the primary reason for the electricity shortage is the high price of coal. Coal is the main input cost of producing electricity in China. Unfortunately for the power generator, the price of electricity in China is capped by government decree.

The result?

As AZ-China’s study reported,

High coal prices and relatively lower electricity price increases have combined to deteriorate the fiscal situation of power producers, making power plants lose motivation to increase capacity utilization.

Now, the current ‘shortage’ of electricity is not due to a real physical shortage. The power generators, in fact, have excess spare capacity. As the study continued,

The utilization of thermal generators has not reached the historical maximum point.

Utilization hours of thermal power equipment was 5,031 hours in 2010, 16% lower than 5,991 hours in 2004, indicating the [Independent Power Producers] IPPs can improve utilization. On a theoretical basis at least, they can fill the power supply gap; it should only be a matter of time before the National Development and Reform Commission releases policies for stimulating increased power generation.

And here is a very interesting dynamic that is happening in China. As Paul Adkins wrote in his blog article,

The electricity generation companies have been baulking at paying the high price, and running only on contract coal, which they purchase for a much lower cost.That?s on the surface, but there?s more to it. The power generation companies certainly buy coal at a lower price than the spot market. But here?s the rub. They are re-selling their coal back into the spot market. they take as much coal as the contracts allow, then sell ?surplus? coal. In some cases, their reported profits have come more from reselling than from power generation.

So, the power generator ran out of coal, but it becomes the Government’s problem.

Now, you may wonder, in an authoritarian country, why don’t the government order the power producers to produce more and solve the problem at a stroke?

Well, here is the power of incentive at work. As Paul wrote in his blog article,

Because the key people in every layer of management are measured by the Communist Party?s Organisation Department, using profit growth as the key measure. Careers are at stake, but they are built not by doing what is best for the country in some altruistic way, but through turning in a report card that shows you made money during your tenure in that job.

Once you understand the situation, you will be able to understand that the present electricity shortage is due to economic policy screw up, not due to an actual physical shortage.

Hence, the quickest remedy the government can make to alleviate the situation is to raise the price of electricity. But wouldn’t this result in rising price inflation? The short answer we can give you from reading AZ-China’s report,

A moderate power price rise won?t be a great influence on CPI.

That’s the good news. The bad news is that this is a temporary fix for 2011. The problem is in 1 to 2 years time,

… as the failure to keep investing in thermal power generation creates an ever-larger gap with demand.

That’s when the real physical shortage will occur.

So, if someone’s going to short China today on the basis of the present electricity shortage, we wish them good luck!

Does house price crash follow unemployment or is it the other way?

June 8th, 2011

One of the most common idea floating around in Australia is that as long as unemployment rate does not spike, mortgage defaults will not rise and consequently house prices will not crash from mass foreclosure selling.

That idea, taken in isolation, is self-evidently true. But is it logically correct to leap from this idea and jump to the idea that as long as the tide of unemployment holds low, there wouldn’t be a housing crash in Australia?

To answer this question, let’s take a read at this interesting article from MacroBusiness,

Australian banks pretty much only know how to lend against property. From time to time they rabbit on about lending against cash flow, but the truth is they do not have the skills. They vanished in the 1990s when merchant banks started disappearing. ?Investment banks are just financial tricksters fiddling with assets. As we see with Macquarie?s fate, they do not know how to invest in real businesses that achieve steady growth from serving customers.

There has been a sharp rise in business credit for SMEs since the mid 1990s, which pretty much tracks the property asset bubble.?In 1996 it was about $13 billion, two thirds of which was secured against property. By 2008 it was $63 billion, 75% of which was secured against property. In 2010, it fell to $56 billion. Again, about 75% is secured against property. About two thirds is secured against residential property.

This level is high by developed world standards. According to the World Bank,the average for developed economies is to have 56% of SME loans secured against property.

Banks are still lending, but mostly only where the loan is fully secured by tangible assets and personal guarantees (and, in some cases, key man insurance). Where there is an existing loan, banks are requiring additional security. Members stated that lenders were no longer prepared t provide finance on ?soft? security ? such as cash flow or good will (unsecured finance) ? as had been available pre-GFC.

In Australia, residential properties underpin much of the collateral for SME loans. The implication of a decline in house prices is the reduction in the value of the loan collateral. That will result in a tightening of credit. A precipitous decline in house prices will result in a credit crunch for SME. A credit crunch for SME will result in cash-flow problems, which in turn will result in mass layoffs (i.e. higher unemployment). A decline in house prices will also sap away consumer confidence via thewealth effects, which in turn will drain consumer spending out of the economy, which in turn will result in high unemployment in the retail sector.

So, the first round of impact from falling house prices will be rising unemployment. That will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the? third round of impact.

Also, falling house prices can happen at the margins. You don’t need a mass selling panic to trigger a fall in house price. As we wrote inSpectre of deflation,

One thing many people fail to understand is that values of financial assets can vanish as easily as they are created in the first place. It is a fallacy to believe that just because money has to move somewhere from one asset class to another, the overall valuation in the financial system cannot contract. The very fact that all the money in the world cannot buy up all capitalisation is proof of that fact. This leads us to the next question: how do financial assets derive their value?

As we mentioned in The Bubble Economy, we have to understand the principle of imputed valuation. Suppose you have a house which you bought for $100,000. What happens if one day, your neighbour decide to sell his house (which is similar to yours) for $120,000? When that happens, your house would have to be re-valued upwards to $120,000 even though you had done absolutely nothing. The same goes for stocks. All it needs for a stock to increase in value is for a pair of buyer and seller to transact at a higher price. As long as the other shareholders do absolutely nothing, that higher price will be imputed into the values of the rest of the stocks. Thus, when asset values rise, all it takes is a handful of them to trade at higher prices in order for the rest to be re-valued upwards. If assets can ?increase? in value that way, it can ?decrease? in value that way too.

To put it simply, credit drives house prices, which in turn drives credit. Falling house prices will drain credit, which in turn pushes down house prices.

Thinking of shorting Australian house price?

May 10th, 2011

Recently, we received an email from one of our readers:

Just wondering if you’d like to touch on possible investment ideas for hedging australian real estate?

I’ve had a look at puts on the banks before but the banks have mortgage insurance along with an implied guarentee from the gov so I was thinking that while their may be some correlation, it may not be as high as one would like when the chips are down.

As such any other possible hedging ideas would be appreciated, ideally it would have to be highly leveraged to act as a suitable hedge.

Looking at other places that suffered a debt/property collapse with a low housing supply may be a good place to start? (UK?)

Today, we will talk about this topic. We haven’t talked about Australian property for quite a long time. But you can read through our old archives and know where we stand on this topic. Also, please take note that nothing that is said in this blog should be construed as financial advice. Instead, we are just voicing out our ideas and suggestions for discussion and brainstorming. With that disclaimer, let’s dive into it.

It is no secret that Australian house price is heading for stagnation at best and a crash at worst. Even the most optimistic forecasts from the vested interests call for stagnation. Already, house prices in Perth have been falling for over a year already. There are reports of rising supply of homes for sale while at the same time, demand is weak and auction rates are weakening.

So, if you reckon Australia is heading for a house price bust, what are the ideas for shorting/hedging Australian house prices? Since there exists no financial instruments that can short Australian house prices directly, we can only do so indirectly through the side-effects of falling prices.

First, before we run off to take up short positions, it is helpful to envisage a few possible scenarios:

  1. Professor Steve Keen sees that we are facing a scenario whereby house prices fall 40 percent in nominal terms over a period of say, 15 years. That’s basically the Japanese scenario whereby the housing bubble deflate with a slow hiss. In this case, the fall in prices will be so slow (a few percent a year) that it becomes almost imperceptible.
  2. A rapid fall of say 10-15% followed by slow deflation.
  3. A big crash of say, 40-50% in a short period of time, say a couple of years.

In the first scenario, there is nothing much to short. The economy may be able to muddle through in stagnation for a very long time.

In the second scenario, the banks will suffer heavy losses but they will probably survive. The obvious idea is to short the bank shares. In this scenario, we can imagine consumer spendings will be depressed as well. Therefore, shorting retail related stocks is another idea. Property developers and builders will be shorting candidates as well. In this scenario, we imagine that the AUD will be weak as well, as the RBA will have to cut interest rates.

The third scenario will be the nightmare scenario. Such a precipitous fall in house prices will put the Australian banking system in serious trouble. For one, since property is the most popular collateral for lending in Australia, a house price crash will result in a credit crunch. As you can see what happened in the United States during the GFC, a credit crunch result will ultimately result in rising unemployment, which will in turn will feedback into a second round of effects into the economy through more mortgage debt defaults. If the entire banking and financial system falls into deep trouble, we will likely see an AUD currency crisis (see Will there be an AUD currency crisis?). In this scenario, we will not even bother to short Australian banking stocks. The financial and economic situation in Australia will be unpredictable and volatile. As we wrote in Protecting yourself against currency crisis.

Personally, we feel that the best way to protect yourself from a currency crisis is to leave the country before TSHTF. If not, stock up some physical cash (both foreign and local), physical gold and silver (see our book, How to buy and invest in physical gold and silver) and supplies- these will tide you over while the sh*t is hitting the fan. For the longer term, you may want to move some of your savings overseas- you may not be able to use them in the midst of the crisis, but when it is all over, the local currency may no longer exist (e.g. you may have to convert the old currency to a new one at unfavourable rates).

Even if the AUD is to survive, we may witness rising interest rates as the RBA sought to defend the AUD from speculative sell-off.

Now, some people may ask, what if the Commonwealth government bail out the banks? Will that avert a crisis?

The problem with this question is that the word “bail out” is too vague. Does that question ask whether the government will bail out depositors? We imagine the government will do that. But does it mean that the government will bail out depositors and bank bond holders? Or even better still, will the government bails out depositors, bank bond holders and bank stock holders? Obviously, the more stakeholders the government bail out, the more expensive it is going to be. Will the government be able or willing to fork out that much?

With that, we turn to our readers. What are your thoughts and ideas?

Are tablet computers flash in the pan?

April 17th, 2011

Today, we will divert away from our usual discussions on the macro-economy and look into a big picture trend in the field of technology. If you are looking into investing in technology stocks, this article will give you food for thought…


There is no doubt that Apple’s iPad is a roaring success. Indeed, they are so successful that almost the entire consumer electronics industry is throwing its weight behind the concept of tablet computers. Apple is so successful that it is almost believable that they are the pioneer of the tablet computer.

But the truth is that, Microsoft was in fact the pioneer of the tablet computer.

Before 2000, Microsoft already had a stylus operated pocket computer operating system (Windows CE). As early as 2005, Microsoft was already producing tablet editions of their Windows XP operating system for the first tablet computers. But as we all know, Microsoft?s tablet computing initiative was eventually abandoned and left in the recycle bin.

Then Apple came up with their iPad in 2010. Conventional thinking predicted that the concept of this tablet computer cannot be a success. Physically, its size makes it less portable than Apple?s highly successful iPhone.

Functionally, it cannot do half the things that a netbook computer (that runs Microsoft?s Windows operating system) can do. Therefore, conventional logic says that since Microsoft?s tablet computer failed to take off, then the iPad should suffer the same fate as well.

But amazingly, Apple?s iPad defied conventional logic and became an incredible success?so successful that the entire industry is following the tablet computer bandwagon.

Meanwhile, Microsoft, having failed once with their table computer initiative, was tiptoeing timidly on this bandwagon. As this article reported,

As virtually the entire consumer electronics industry throws its weight behind tablet computers, Microsoft’s global chief research and strategy officer Craig Mundie said today that he did not know whether the booming new category was here to stay.

Speaking at a lunch held in Sydney by the Committee for Economic Development of Australia (CEDA), Mundie, who reports directly to Microsoft CEO Steve Ballmer, said he did not know whether tablets like the iPad would “remain with us or not”.

For this reason, we believe Microsoft is making a major strategic blunder. They have completely failed to read and understand the consumers. In other words, we believe the tablet computer is here to stay and it will continue to grow into a major part of the industry. In fact, recent reports from IDC and Gartner find that tablet computers are cannibalizing the PC market. We believe this trend will continue for quite a long while. Therefore, Microsoft?s continued timidity will see that it will become irrelevant in that part of the technology industry in a few years time.

So, you may wonder why we are so sure of that.

To understand our why we think so, we have to look at this trend from two perspectives?one from the technologists? view and the other from the consumers? view. Since the wish of the consumers will ultimately decide the fate of the industry, we will, it will be the one that is relevant for investors.

Firstly, let?s look at it from the technologists? point of view. As we mentioned before, the tablet computer is not as portable as the smart-phone and not as functional as a full-fledged PC (including netbooks). We may be able to carry a smart-phone with us wherever we are, but not for a tablet computer. There are still many things that we cannot do on a tablet computer. For example, we cannot imagine ourselves writing this article on a tablet computer by tapping continuously on a screen with our fingers. We doubt it is possible to professionally edit videos and photos on a tablet computer. Neither can software be engineered on a tablet computer yet. In other words, from the technologists? point of view, the tablet computer is a half-baked computer compared to the PC.

Now, let?s look at it from the consumers? point of view. The average consumer does not care about the underlying details of the technology behind any gadgets they use. All they care is that the gadget must work instantaneously and reliably anytime they need to use it, according to their expectations. For example, whenever they turn on a tap, they expect water to flow out of it 100% (well, almost) of the time. Whenever they press a button on the microwave oven, it works 100% of the time. When they press the button on the TV remote control, they are able to watch their favourite TV programs in less than a couple of seconds all the time.

But when it comes to the PC, the consumer often sees it as an unreliable, slow and frustrating piece of crap. Most of the time, the PC works adequately. But it has a frequent habit of stymieing the progress of the consumer with incomprehensible and unexpected error messages and other kinds of show-stoppers. That mars the consumer perception of the PC as unreliable, slow and frustrating. The consumer wants his electronic gadgets to be as reliable and instantaneous as his everyday kitchen appliances, without any unwanted surprises.

Unfortunately for the consumers, they are denied this want since the very beginning. They do not know of an alternate universe where computers are gadgets that are a joy to use and can be relied upon as much as their everyday kitchen appliance.

Out of the blue, Apple came up with the iPhone and then followed by the iPad. The consumers suddenly realized that such an alternate universe exists after all! Computers are reliable, instantaneous and work without unwanted surprises after all! They can manipulate objects ?inside? the computers with their bare fingers as if they are manipulating objects in the physical world. Finally, computers are joining their collection of everyday appliances. No, a correction?the tablet computer is no longer a computer anymore. It has become an appliance.

When you look at this from the consumers? point of view, you will then understand why tablet computers are displacing PCs. Once consumers have a taste of that alternate universe, they prefer to stay there. No doubt, tablet computers are not as fully functional as the PCs. But for the average consumer, it is able to do most of what they want to get done. For the things that cannot be done on the tablet computer, they will grudgingly return to their PC.

For now, the capability and functional gap between the PC and tablet computers are wide. But as time goes by, with more and more software being developed for the tablet computer, the gap will narrow. As the gap narrows, more and more consumers will ditch the PC altogether (maybe more and more of businesses? workforce will be dragged along into the alternate universe too).

For Microsoft, their existing Windows operating system has too much baggage of the past to be brought to the alternate universe. In fact, in their reluctance to cannibalize this platform in order to preserve compatibility with the past, they are attempting to fit semblance of the alternate universe into the current universe with their upcoming version of Windows. If they continue along this path, we are afraid that Microsoft is sliding towards irrelevance.

Are you against negative gearing?

March 31st, 2011

Yesterday, the major newspaper reported on the First Home Buyer price strike on the front pages. Judging from the numerous vitriol and insults in the ensuing comments of the article, it is very clear that this social media campaign has touched the raw nerves of many. It goes to show that far too many people in Australia are too emotionally invested in property.

Related to this cause is the issue of negative gearing. Economist Saul Eslake put it the best in yesterday’s Sydney Morning Herald article- Imagine a tax system that penalised work. If you feel very much against negative gearing, you may want to join this Facebook cause: End negative gearing tax subsidy, affordable housing for next generation.

China is slowing down

March 23rd, 2011

Many things happened since we last wrote. The earthquake in Japan was the biggest news of the day. As Japan’s nuclear crisis unfolded, stock markets around the world panicked amidst screams of “nuclear meltdown.” Today, the nuclear situation in Japan seemed to be stabilising, even though the long-term radiation impacts are still unclear at this moment.

To help you keep things in perspective, please note one thing about Japan’s nuclear crisis: despite screams of “nuclear meltdown,” there is ZERO chance of a nuclear explosion. A nuclear reactor is NOT a nuclear bomb. Our guess is that this nuclear crisis is just a blip in the economic big picture, even though in some localised areas in Japan, it is the end of the world (e.g. some areas may not be habitable for a long time). Therefore, contrarian investors may use this opportunity to buy Japanese stocks (we know it is probably too late to do so now).

However, do not let the nuclear crisis distract you to a more important development that is already brewing for quite some time- the coming slowdown in China. This development is far more important than the Japanese nuclear crisis, which by now is no longer a crisis. Remembered we wrote in January last year at Chinese government cornered by inflation, bubbles & rich-poor gap,

By not allowing the yuan to appreciate, the Chinese government shows that at least for now, they fear unemployment and excess capacity more than inflation.

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets.

Today, we can say that the Chinese government are tackling the inflation problem. 2009 and 2010 was the year when they pumped in steroids into the economy. Today, they are dealing with the effects of the steroids- price inflation. China is tightening monetary conditions (e.g. rising interest rates, increasing bank reserves requirements) for quite some time already. They are serious about dealing with price inflation, at least for now. Premier Wen Jiabao had already declared that China’s target for economic growth will be lower (see China lowers growth rate target in sustainability drive), from 8% to 7%. Incidentally, the lower target of 7% is pretty close to Gary Shilling’s (a respected bear on China) definition of a ‘hard landing’ in China, which is a growth rate of 6% or less.

So, it should be extremely obvious by now that China’s economy will slow down this year. In other words, China is aiming for a soft landing.

The big question is, when the slowdown begins to bite, will China step on the accelerator again? Our belief is that there’s too much vested interests in China to keep the growth going and to prevent the bubble from bursting spectacularly. Also, the central bank in China is not independent. Thus, as we wrote in Why should central banks be independent from the government?, without an independent central bank, the bias in China is towards more inflation.

The risk for China (and by extension, Australia- see Turkeys fattened for slaughter in the Chi-tralia bubble) is that the control freaks in Beijing may stuff up and either turn the soft landing into a hard landing or losing control of inflation.

Watch this space.

Deleveraging in the Australian economy bites

March 6th, 2011

If you read the newspaper headlines and billboard advertisements recently, you may notice something interesting (if not, strange) happening. National Australia Bank (NAB) announced that it is ‘breaking up’ with the rest of the banks in a new campaign. That immediately provoked reactions from the other banks, including Suncorp with its “breaking up” theme in a recent billboard advertisement.

Soon, bank investors are fretting about a price war among the banks, which means the race is on to the bottom for profits. As this news article reported,

Investors are becoming nervous about the prospect of a price war breaking out between the banks, with one major brokerage labelling the attacks a ?negative sum game?.

What on earth is happening?

Only as recently as four months, politicians were aiming their gun sights on the banks for ‘lack’ of competition, when Commonwealth Bank (CBA) initiated a rise in their mortgage rates that was almost twice the rate rise of the Reserve Bank (RBA). There were talk about building a “fifth pillar” in the banking system. Today, the banks seem to be starting a price war among themselves, in a race to the bottom.

Well, the reason is dead simple. To put it simply, banks are in the business of lending money. That’s their core business. As we wrote before in The dark side of rising bank profits,

One way to make more money is to increase lending.

Banks, as publicly listed companies in the stock exchange, are always under pressure to increase their profits year after year (i.e. seek growth). Heavens forbid that their profits ever fall! All hell breaks lose if that ever happens!

But there’s one big problem for them today- the savings rate of Australians have shot up to 10%, which is the highest since the early 1990s! That means that Australians are saving more money and repaying their debts. In other words, the Australian economy is now undergoing a deleveraging process. Consequently, it is becoming harder for the banks to make more money by lending more money. A very crude (and thus, inaccurate) analogy would be to compare the banks to dogs fighting among each other for a shrinking pie. As that article reported,

The infighting is an indirect result of the sluggish credit market, with banks under pressure to find growth, the report said.

What does this mean for the Australian economy?

As we explained in detail in Significant slowdown for Australia ahead?, deleveraging sucks away the aggregate demand from the economy. The first to get hit will be the retail sector that is related to discreditionary spending. The structural shift of Australian consumers from shopping in retail stores to shopping in the Internet is a symptom of deleveraging.

Given that the retail sector accounts for approximately 60% of the economy, continuation of this structural shift in consumer behaviour imply that more pain is in store for the retail sector.

Why you have to change your idea of ‘investing’ in the coming years to come

February 16th, 2011

The global economy is in a diabolical dilemma right now. If the world economy is paralysed by deflation (which is Bernanke’s nightmare), prices of many things will fall. For example, as we wrote in How to buy and invest in physical gold and silver bullion,

In the second half of 2008, the world experienced unprecedented asset and commodity price deflation. As noted earlier, oil prices fell from a high of almost US$150 to just over $30 over the space of months. Base metals and agricultural commodities plunged along with a panic in the stock market. The US dollar and US Treasury bonds surged (at one point, short-term US Treasury bonds had a negative yield). Statistically (in terms of price volatility), the panic in 2008 was worse than the crashes of 1929 and 1987.

Despite the mainstream commentary screaming “Disaster,” we believe such extreme deflation wasn’t that evil in the bigger scheme of things.


If you believe that burning fossil fuels causes climate change? or that Peak Oil is one of the greatest threat to humanity, wouldn’t such extreme deflation give planet Earth an urgently needed respite? Wouldn’t the collapse of global demand for goods and services save planet Earth for the sake of the next generation? Since 2008, the world witnessed a ‘recovery’ (that was brought about by massive money printing).

But what do we get out of that ‘recovery’?

Surging price inflation that threatens the poor with starvation and pushed many from middle-class to poor.

For example, as Food prices at dangerous levels, says World Bank reported,

The World Bank says food prices are at “dangerous levels” and have pushed 44 million more people into poverty since last June.

This, our dear readers, is just the beginning of a more serious global food crisis. Australia’s CSIRO scientist, Julian Cribb wrote a very sobering book, The Coming Famine: The Global Food Crisis and What We Can Do to Avoid it. As this New York Times book review wrote,

Like many other experts, he argues that we have passed the peak of oil production, and it?s all downhill from now on. He then presents evidence that we have passed the peaks for water, fertilizer and land, and that we will all soon be made painfully aware that we have passed it for food, as wealthy nations experience shortages and rising prices, and poorer ones starve.

This is the price that the this and the next generation will have to pay if we keep up the current way of exploiting planet Earth for the sake of economic ‘growth.’ Hardly surprisingly, a recent Wikileaks revealed that Saudi Arabia cannot pump enough oil to keep a lid on prices.

Dear readers, don’t you see that this economic ‘recovery’ is an illusion?

The ultra-rich, on the other hand, have less to worry about starvation and more to worry about how to preserve the purchasing power of their existing surplus wealth. Some of them will rush to hoard agricultural land and commodities, which will exacerbate the plight of the poor.

The middle-class will see their standard of living being eroded by rising food and energy prices. As we wrote in April 2007, Smart money in alternative energy?Part 1: current energy quandary,

The most important ingredient that drives the efficiencies, comforts, automation and wonders of today?s modern way of life is energy. The trains, cars, ships and aeroplanes that transport massive quantities of people and goods over vast distances quickly require energy in the form of fuel. The heavy machines that do heavy physical work far beyond the scope of human labour require energy too. The powerful computers that process and store vast amount of data and information as well as automate mental labour requires energy in the form of electricity. The heating in winter and cooling in summer of our abode requires energy too. Take energy away and our modern way of life will very much grind to a halt and bring us back to the hard life of our ancestors. In fact, contemporary life rests on the premise of abundant and cheap energy. Therefore, whoever controls the supply and provision of energy controls power and wealth.

When energy prices go up, the prices of everything else will go up. When the prices of everything else go up, your standard of living will go down.

Some of the poor, who are already spending a large portion of their income on food, will have to starve. But before that will happen, we will witness increased incidence of revolutions, wars and conflicts. What we see in Tunisia and Egypt is just the beginning- there will be more.

Dear readers, after reading all these, wouldn’t you come to the realisation that this will have grave implications on the idea of ‘investing.’ Normally, investing is associated with ‘making’ money. But in the context of surging price inflation, ‘making’ money becomes meaningless as the value of money diminishes.

In the next article, we will talk more about this implication. In the meantime, have a think about it.

Marc Faber: correction coming

January 31st, 2011

In a recent interview (about a week ago), Marc Faber warned of a coming correction in asset prices. In this correction, he reckoned that emerging markets (e.g. China) will fall harder than the markets of the developed world (e.g. US, Europe).

As he elaborated further, for the past two years, the emerging markets and commodities were doing very well. In fact, so well that there’s talk that China’s economic/political model is superior to the model of the Western liberal democracies because it managed to dodge the GFC and thrived in the aftermath while the developed economies were going nowhere and being plagued by sovereign debt crisis.

However, Marc Faber reckoned that for the next few months, this trend can reverse for a change. The implication is that US Treasuries, US dollar may do very well, while US stocks may outperform emerging market stocks by falling less. So, the S&P500 may correct by say, 10% while Chinese stocks may correct by say, 20-30%.

For investors, it is easy to get lost in the minute details and lose sight of the forest for the trees. For one, it is clear to us that even though the massive money printing exercise of the Federal Reserve is not showing up in the US, price inflation is rearing its ugly head in the emerging economies. In other words, we believe that the US is exporting its price inflation to the emerging economies. This is because all nations are engaging in competitive devaluation of their currencies (to protect their exports in order to ‘stimulate’ their economies). However, since the US dollar is still the world’s reserve currency, the US is able to export the resulting price inflation to the emerging economies.

The price inflation had been growing for the past two years. At first, it seems benign and even seen as a badge of vindication for countries like China. And if you read our article, Turkeys fattened for slaughter in the Chi-tralia bubble, the growth and inflation is fueled by a massive credit bubble and monetary inflation. Since it is an axiom that all bubbles deflates/bursts eventually, there are speculation of when the bubble in the Chinese economy is going to burst.

Judging from the chatter in the blogsphere and mainstream news article, it seems that the spotlight is shifting towards the price inflation and asset price bubble in China. More and more articles like Crouching tiger, soaring cranes, rumbling doubts are telling us that there’re growing doubts on the Chinese economy. As we wrote 12 months ago in Chinese government cornered by inflation, bubbles & rich-poor gap,

But there will be a day when they have to tackle the inflation problem. As long as the inflation problem is not solved, there will be rising prices and bubbles in the asset markets.

Indeed, price inflation is turning into a serious problem in China. As Patrick Chovanec wrote,

China used to be cheap.? According to figures the World Bank uses to calculate Purchasing Power Parity (PPP), in 2003, a dollar?s worth of currency bought nearly five times as much in China as it did?the U.S.? A?bag of groceries,?or a hairdo, or a hotel room?that would have cost $50 in the U.S. cost only RMB?90, or roughly $11, in China.

Talk to anyone in China, though ? local or expatriate ? and they?ll tell you that, lately, things have been getting a lot more expensive.? When I went back to the U.S. a few months ago, I had the?strange sensation ? for the first time ? that a lot of things were actually cheaper there than in Beijing.

We are increasingly seeing signs that the Chinese government are taking more and more actions to attempt to control price inflation via administrative measures. But with money supply increasing 50% over the past two years, such measures are mere pin-pricks. The exploding supply of money is the root of China’s price inflation problem. And the reason why the money supply is exploding is the peg of the RMB towards the USD (see Why is China printing so much money?).

Unfortunately for the Chinese people, there are too many vested interests (e.g. corrupt officials, provincial governments, big businesses with links to government) in China who wants to keep the credit and asset price bubble going. Since asset price bubbles and price inflation are the symptoms of a common course (monetary inflation), the bias of the Chinese government (and for most governments in the world for that matter) is towards more inflation. Once the root cause of the price inflation is tackled, the asset price bubble will deflate/burst as well. With that, the massive wealth of many vested interests will deflate/disappear as well. Since we doubt those vested interests want that to happen, the price inflation problem will continue to rage in China.

Now, here comes a crucial point. As long as the masses in China believe that the government is working towards ‘solving’ the inflation problem, there are still hope. Indeed, a friend in China told us that her country (i.e. government) is “working its brains” to solve the inflation problem. Unfortunately, this is something that has yet to be dawned on her. As Patrick Chovanec wrote,

I find it incredibly ironic that the two hot populist issues among Chinese citizens these days are the high price of housing and U.S. pressure for a stronger RMB.? People are hot under the collar about both issues, but they never draw stop to think that China?s position on currency (maintaining a weak RMB) might be fueling inflation in the form of?rising housing and other living costs.? ?Of course, I don?t expect average citizens to draw the connection, but economists should.

However, the truth is this: the vested interests who control the government are NOT serious about solving the price inflation problem. The danger is that once the masses realise this, hyperinflation begins. As we quoted Ludwig von Mises in What is a crack-up boom?,

But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against ?real? goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.

So, as it becomes increasingly clear that the current trends in China is unsustainable, investors should watch the reaction of the Chinese government.