I Say Bollocks to That

I always take the view that the market is far smarter than I am. Actually, it’s not a view, it’s a fact. I think it was Napoleon who said something along the lines of ‘the only one who is wiser than anyone is everyone’.

Except, he may have added, those buying Italian government debt. The Financial Times reports that, at the start of May, the yield on two-year Italian Government debt was minus — yes — minus, 0.172%.

In other words, the bozos buying this paper paid the Italian government a fee to do so.

Not any more. Thanks to the not so sharp market all of a sudden deciding to sit up and take notice of what’s going on in Italy, government bond yields have surged, meaning investors have taken a decent hit on the capital value of their holdings.

The message here is that the market is mostly very efficient. But sometimes it gets it wrong. And the time when it gets it most obviously wrong is at the turning points. That is, when the economic cycle turns, when a bull turns into a bear, or vice versa.

I don’t know if we’re at that point now in the equity markets. But there’s a fair chance that could be the case in peripheral European bond markets. Italy’s finances simply don’t look good, yet the bond market has completely ignored that reality.

Debt to GDP is just over 130%. In 2017, the budget deficit came in at around 40 billion euros, or 2.3% of GDP, a fiscal outcome that strong global economy has actually benefited.

The real shocker is Italy’s government spending to GDP ratio, which is 48.9%. By comparison, Australia’s number crept up to around 24% recently, which prompted Treasurer Scott Morrison to pledge to bring it down to around 23% and keep it there.

A government that accounts for nearly 50% of economic activity? Italy’s motto is clearly this; ‘think not what you can do for your country, but what can your country do for you’. Hmmm…how’s that going for you, Italy?

Not good, is the answer. Italy’s intractable problems are about to come under the spotlight again.

But today I wanted to talk about China, not Italy. China has got its own debt problems. And, as I mentioned yesterday, the IMF reckons we’ll be able to handle a sharp slowdown in the Middle Kingdom.

I say bollocks to that.

Somewhat ignorantly, I haven’t read the research and assumptions the IMF has come up with. But I’m tipping their model makes no allowance for the impact of psychology on markets. I’ll get to that point in a moment.

 

 

Just before the IMF threw in its depreciating two cents on the matter, RBA boss Philip Lowe made a speech warning that China’s massive debt levels are a threat to Australia’s prosperity. As reported by the Financial Review:

It is too early to tell whether the authorities will be successful in managing the transition from a growth model heavily dependent upon the accumulation of debt to one where credit is less central.

It is a very significant task. The experience of other countries suggests caution and, elsewhere, there have been serious accidents along the way.

The saving grace — sort of — for China, is that it is a Communist country where the leaders can do what they want to try and control the banking system. They have many more levers to control outcomes than a western central planner has.

The RBA reckons China’s debt is now around 260% of GDP. That’s huge for a developing economy. If the US and European economies slow into the second half of 2018 and into 2019 (an increasingly likelihood thanks to rising interest rates), then China will feel the effect.

I don’t think China will slow sharply, just because the US and Europe slows. It’s more resilient than that. But for arguments sake, let’s say it does. What happens to Australia?

Well, firstly, iron ore and other commodities prices will drop sharply. That immediately gives Australia a pay cut, via a fall in national disposable incomes. In response, our dollar will fall as it takes the initial brunt of the economic adjustment.

A falling dollar reflects less foreign demand for our currency. This has the effect of making Aussie assets cheaper in foreign currency terms. At some point, this will increase the flow of foreign capital again.

But it depends how bad China’s slowdown is. Foreign investors see Australia as a derivative of China. As we have a $1 trillion plus pile of net foreign debt to service and constantly roll over, we need foreigners to have confidence in our economy.

When China is humming, confidence is strong. When China slows sharply, confidence falters. Our dollar falls, and foreigners demand higher interest rates when our banks go to roll over their loans. This in turn slows the flow of credit to the local economy — or the local housing market to be more accurate. Falling house prices knock consumer confidence and spending, and before long the Aussie economy is on Struggle Street.

Meanwhile, every investor knows that every investor knows that Australia is a derivative of China, so the selling starts in the stock market and gathers pace as the fear rises. The psychology of fear takes hold.

And the IMF thinks we’ll be OK because of more Chinese tourists and students?

Jeez, with economic institutions like this, we’re clearly in good hands for when the next crisis comes along. I can hardly wait…

Regards,

Greg Canavan,
Editor, Crisis & Opportunity


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

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