Outlook for China's equity markets

The Shanghai Composite index appears to be in a free-fall. I have just signed off on an article on our sister website 'Critical Media Group', where I describe the outlook for Chinese equity markets.

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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

Should we be worried about global inflation?

There is a gross straw argument being perpetrated by economists and market pundits, and that is the prospects of 'rising' or run-away inflation, or at least the ominous threat of such. It is important to note two things:
1. Inflation is a monetary phenomenon
2. Inflation is a red herring
3. Commentators don't even know what inflation is

Consider the following article from Ben Eisen at MarketWatch.com. The concern is that there is 'low fears of inflation'. The reason this is bad is purportedly because:

"Most economists believe some level of inflation is important to a healthy economy".

The problem with this perspective is that they think general price variance is a 'demand phenomenon' rather than a monetary phenomenon. The reason they think its not a 'monetary phenomenon' is because the Fed has launched a monetary stimulus program, and according to them, it disproved the Austrians who argued it would cause inflation. That might well be the argument of some or all Austrian economists, however I would counter that 'cost-of-living' inflation is not the only form of inflation. In an era of ultra-easy monetary conditions (i.e. low interest rates), money has fuelled a speculative bubble. It is easy to observe this in two respects:
1. The high prices for property in Western markets
2. The indebtedness associated with derivatives contracts has ballooned

The reason why we aren't seeing a lot of 'cost-of-living' inflation like in the 1970s and 1980s is simply because in those times there was no prospect of wage restraint. Unions were unfettered in their capacity to demand higher wages, so any rise in prices was destined to trigger a wages spiral. Today, there is no prospect of a wages spiral, not because unions have been busted, as that was merely the 'effect'. The reason is that unskilled workers in Western countries are in a very weak position to demand higher wages. Few industries are in a position to demand higher wages, and the reason is that:
1. Few industries (like mining, ports and government services) can get away with it without precipitating a shift in services offshore to emerging markets where labour is far cheaper.
2. There is no peer support from other unions for such rises. They are a collective organisation. You are not going to see 80% of union members supporting wage increases for 20% of members.

The flipside was that union membership has fallen instead because unions can no longer deliver on what members wanted - higher pay.

So what do we make of this logic?

"The U.S. central bank is targeting a 2% annual rise in consumer costs. The drop in market forecasts for inflation implies investors think the Fed will abandon that mandate and raise rates".

The reality is that the 'cost-of-living' inflation is destined to tread a path broadly inline with the rate of money supply increase. The reason is not because money supply is increasing, but because governments look to rising inflation to finance government. Governments don't want to be obliged to raise taxes. This was why it was so hard for the Japanese government to raise taxes. It would have been felt by the people. This is not a concern in other Western economies, where economic activity in rising, population is growing. Japan was unable to rely on these forms of stimulus because of its conservative people. The government was confronted with an unpopular choice - allow relaxed immigration, raise taxes or print money. It decided to print money and raise taxes. It scarcely delivered on the reform it promised.

You might wonder whether we need to be worried about rising interest rates. The answer is no. The Fed might well allow interest rates to rise, but they will never be allowed to rise more than enough to squash rampant speculation. The housing market is not overly priced. Current price levels are sustainable because there is simply no reason for raising rates, and current prices are actually reasons not to 'scare asset markets'.

Deflation is not actually bad; its just bad for government. Deflation is a natural inclination for markets because its a signal of rising purchasing power that is associated with wealth creation. It is not however conducive to governments raising revenue, so governments like some 'healthy inflation', or easily-won taxation. Governments don't like to have to qualify their actions because we have so little trust in them.

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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

Rebuttal of Krugman's inflation critique

Paul Krugman is an annoying person. He is annoying because his entire modus operandi is attacking neo-conservative idiots on the right, whilst ignoring his own shortcomings. His short comings arise from his:
1. Gross ignorance about economics as a compartmentalised irrelevant economist
2. Engagement in straw arguments, or false dichotomies between left and right when the real game is the ascension of libertarianism.

Liberals love this game because it keeps them 'self-important'. The world will not miss Paul Krugman. He will fade into obscurity. But before he does, lest we be criticised for attacking the man without argument, let us focus on his arguments for asserting that there is no inflation, and that its not coming. Well, in truth, he is 'right'....yes 'right' in a sense, and wrong in a sense. There is bugger all 'cost-of-living' inflation. The problem with his arguments is:

1. Krugman does not understand inflation
Krugman thinks inflation is a 'cost-push' phenomenon caused by excess demand for goods and services. He thus celebrates the lack of demand for goods evident in the absence of evidence for inflation, measured empirically by CPI indices. The problem is that the 'goods and services' measured by the CPI are not exactly a useful basket, as some indices exclude the 'volatile' items in order to give a seasonal account. The greater issue however is the 'qualitative' adjustments governments make to inflation numbers, as they are not always comparing like items, i.e. A 286 computer in the 1980s bears no easy comparison to the modern computer. How do you account for the fact that you no longer need anti-virus software as an bundle of inflation costs. Finally, Krugman ignores the 'asset inflation' that exists in many countries. If these assets were to collapse, thanks to higher interest rates or correction to an impending asset bubble, then you would indeed expect inflation. The problem is 'not that the conservatives are wrong', but that their concerns are misplaced. i.e. Inflation is not in the short term from costs, but in unsustainable asset prices. The problem is that 'the problem' is concealed as a 'benefit' for some, because people in the cities like to see their property prices rise. Those buying late are happy as long as the correction in asset prices doesn't show. i.e. They are not concerned until there is a collapse, and even then they might not care if the collapse does not send them broke, precipitate the loss of their job, or their interest repayments does not exceed what they would otherwise have paid in rent.

2. Krugman cannot forecast inflation
Krugman is akin to the environmentalist who points at 'evidence' and decries how bad or wrong people are. He is a tragic soul who understands nothing. He has no credible analytical proscription for how the world works. This is why he cannot offer an explanation of the world; only criticism when others are wrong. He cannot tell us when inflation will appear; if it ever will, and he cannot offer an explanation of why. Firstly, we need to deal with what inflation is.

Inflation is a broad indicator of price movements relative to purchasing power; which is itself tied to the productive capacity of any economy and the supply and demand for money. 

The Austrian School is correct insofar as they regard there to be a relationship between the supply of money and the productive capacity of the economy. Their failure is to not convey an understanding of the dynamics that actually drive price movements. i.e. There is a tendency to speak 'broadly' (by definition) and not see the differentiated foundation for supply and demand in the economy. They fail to see that there are several pertinent factors, namely:
a. Wage restraint prompting an overweight investment in investments like productive property, productive capacity and securities that help finance that capacity, prompting an excess of savings over consumption, i.e. we see a deferment of spending. They fail to realise that this is caused by the autocrats of developing countries causing a pent up supply of labour, suddenly released in the 1980s. It will take us another 15-20 years to balance this global labour distortion, but the impact will be 'mass stimulus' to the global economy, the persistent of the 'super cycle', and low inflation. There will be no wages spiral, though we might expect some unionisation in Asia. There is however no culture of this, and Asia will need to compete with Africa, South Asia on labour costs.
b. Low interest rates prompting speculation in assets.

For these reasons, we can say that the global market place will be under low inflationary pressures for another 15-odd years. In that time, we can expect corresponding asset price bubbles. Its inflation, but not the type described by Krugman. He, like the Fed Reserve, like Alan Greenspan, are simply not looking at asset prices as a vulnerability. It is the prospect of asset price collapses that will demand further QE programs. These are forms of taxation rather that cost-of-living inflation. They are destined to recapitalise the value of money; but not cause the type of inflation spiral that is associated with cost-of-living inflation. In fact, the dearth of specialisation and economies of scale, along with productivity gains are destined to see costs under control. So that's the explanation and forecast.

3. Krugman offers no clarity over 'excess money'
Concerns about "excess money and a devalued dollar" is not a problem (as Krugman argues) because there is no such thing as excessive money. Even in the context of a 'balanced labour' market, the problem is not wage demands; the problem is that they able to be extorted from business by unionised labour. We are however under the illusion that unions are good, because they lead to better worker conditions. They don't. They take what business would have been forced to give (belatedly) or they extort that which business cannot afford to offer, so being forced to close business and go overseas, or go broke.
Krugman suggests that the USD is not weak, but in fact it is relative to hard currencies in Asia. He does not realise this because he selectively compares USD value with other major currencies, like the Yen and Euro, which are also weak, or those economies whose pricing is tied to the USD, whether its the managed 'mercantilist' currency regimes of Asia, or even the USD-denominated currencies of commodity producers like Australia, South Africa, Canada et al. It does not help that these countries borrow in USD. The implication is that all these currencies become immutably tied to the USD. The fact is that there is no country pursuing a 'productivity' based wealth strategy to prompt higher currencies. They are pursuing an 'economic stimulus' strategy, which attempts to create the illusion of wealth creation. Observe that households are working harder than ever, with two or more contributors to income, and they still struggle to live. Home prices are 10x average earnings in many cities. Unskilled labour is having a harder struggle still. This is the constituency that 'applaudes' Krugman's negativity, but he is unable to offer a solution. He can only knock down straw arguments.

It is true that many free marketers and conservatives have been expecting inflation. His argument is not entirely invalid; but this is not a man with much interest in truth; so much as disparaging counter-thesis to his own delusion.

In conclusion, we can expect more asset bubbles, with the prospect of more bail outs by government of banks or maybe creditors. We can expect no sign of inflation for more than a decade. We can expect those traditional indicators of inflation, the precious metals, like gold, silver, palladium and platinum to rise in price slowly, as they are among the cheapest assets. They will not however do as well as demand-based commodities in the short term, or as well as emerging market property. The reason being of course the low-yield on these asset classes. They will however be helped in time by the low yield on equities and property. This will take time to unfold. This is a super-cycle...so don't be tragic. Though it will be harsh times for unskilled workers in the West. They live in an over-priced, high cost markets, and without exployment opportunities in the third world, they are really between a rock and a hard place, with no preparedness to address their problem.

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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

Understanding inflation in the current context

David Gallaher: "I'd like opinions on the future of inflation in US dollars".'

You won't see inflation (as its measured through the Consumer Price Index) since wage levels are low (because of global wage disparity causing jobs offshoring) and low interest rates. Interest rates are not just to generate new credit/loans, its to keep asset prices high. High asset prices mean less spending on non-assets, more saving, so avoids current account issues. That's why they subsidize interest rates. The question is what can undermine asset prices which they can't control?  Bird flu? The government doesn't care where the money goes, as long as it keeps asset prices high. So it's invested in derivatives. For financial institutions this is appealing for a number of reasons:
1. They expand earnings
2. They can defer taxation by not selling,   but simply opening a contrary position.
Credit keeps growing as long as asset prices are stable and that means low interest rates.

So what would end this state of affairs?
Well, there are a number of potential sources for a financial collapse:
1. Evaporation of wage disparity - When third-world labour is fully absorbed this will result in a rebalancing of labour costs. It will make sense to work. This could however be expected to result in more workers in the West, with the discretion not to work, deciding to re-enter the workforce. Of course people don't at the high-end work just for the money, but they tend to at the 'low end', and it can be construed as partially resulting in the casualisation of labour, as well as the employer's desire to avoid 'added costs' of medical care, super contributions.
2. Serious collapse of confidence. Hard to think of what might cause this other than a run on the banks and a bird flu. If people stopped spending for a sustained period, this would cause a loss of jobs. Personally, I don't see this because of inability to undermine confidence, and the inability for a viral outbreak to get far. i.e. Its too easy for people to hoard food and stay at home. It would have to be a 'well engineered' pathogen with a long latency in the human body. i.e. Like AIDs but airborne.
3. Computer hacking of banks. Might some foreign government or anarchist undermine the Western banking system by plundering them through the international banking system. Hard to believe. Crisis of confidence? Govts would probably just guarantee the paper, which is of course backed by tangible assets, which greatly outweigh the 'paper'.
4. Rise in interest rates. You might wonder whether there might be some reason for interest rates to rise. It would be hard to believe that the banks don't know what the governments are doing; indeed I'd expect that the govt would have orchestrated its current policy with the banks. Basically, governments are favouring the banks with current policy because its injected funding into banks, who have used that funding for portfolio investment rather than home loans. Why? Because interest outlook can only deteriorate, because lack of confidence means jobs at risk. Institutional financing made more sense because derivatives gives investors long & short exposure to the market. Those positions get unwound when interest rates rise. There is however a 'systematic risk' caused by this since institutions pay tax on profits. In a trending market, they are destined to 'sell' losing positions to cover profits.
It is mooted that Chinese, Arab withdrawal of financing would be a possible cause for a collapse. I don't see that because China and Arabs have a vested interest in persisting with such support. Might they invest in their own countries? Yes, but that is the next phase, pursued by Japan to the extent that Japan's depopulation makes investing locally possible or plausible. The same issue for China. It cannot just spend money on infrastructure if there are insufficient Chinese people able to afford those expenditures. That just creates an expensive maintenance burden on the govt. Instead they have financed US government debt. Wise move? You could consider it a diversification strategy.
5. Financial failure is considered to be a reason for higher interest rates. I would doubt that unless precipitated by 'systematic tax' issue because these instruments are destined to 'balance risks', so it will take a systematic risk to undermine them. This government imposition is not something they can avoid; particularly as these large institutions can't so readily expand interest deductions to offset tax.

Asian property markets outperforming Japan Foreclosed Guide Philippines Property Guide
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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com

Buy gold - the Bank of England is printing money

There was an important development for gold pundits this week. The British Treasury on the advice of the Chancellor of the Exchequer is to engage in quantitative easing or 'printing money'. Resorting to printing money to finance government expenditure has not been used for decades because of its unsavioury association with inflation. Printing money directly links the government to inflation. The justification for this is of course the fact that the banks cannot lend funds because of their parlous condition, plus the fact that asset prices are still falling. The proceeds will be used to buy company IOUs and other assets held by banks. This will boost the reserves of the banks, and thus allow them to make new loans, which will support asset prices in the economy. But I would suggest not until asset prices find a base. The rationalisation for the move is the threat of deflation. The reality is that they will not stop deflation, but it will eventually cause inflation when asset prices bottom of their own accord. The interest rate is already 1%; but new bank lending capacity is unlikely to finance much except new gold mines given that gold prices are taking off.

The question is - when will other government treasuries show their folly by printing money as well. The reality is that the treasury of many governments has been so decimated by their prior loose monetary policy, that they can no longer debt finance, and they will be forced to print money. Asian and Middle Eastern treasuries might be questioning their prior support for the USD. No doubt they will be buying gold. I would suggest as modest wealth holders - buy gold stocks for better leverage to this emerging speculative boom.

The price of gold has been moving up $US15/oz a day of late, and is close to $US1,000/oz. We are tipping $US2,000/oz by the end of the year. Gold tends to create its own momentum in such times. Check out our gold stock selection tips here.
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Andrew Sheldon www.sheldonthinks.com

Conversations with a trader

I have been having a conversation (or disagreement if you like) with a forex trader which will provide an insight into 2 people’s thinking on a few issues...people get pretty heated when it comes to understanding the global economy, but hang in there. This trader kicked off the dialogue with a press release. I'll disguise his identity because it serves no purpose to disclose it, and it was a private conservation.

Over the last couple of years a couple of the major warnings we have been clearly stating have taken hold this year;

1. Credit to implode: started, but we should have a long way yet to go as subprime and highly leveraged instruments are the first two steps in a 50 year overuse of credit.

2. Short Financials: spot on

3. Looking for a massive devaluation of all assets and major pullbacks in most major indices and markets: underway

4. Looking for either Ford or GM to not exist within the next 2-5years: cracks becoming more evident now, lets see what the government pulls out of its….hat.

5. Dollar strength as a safe haven and place where unwinding assets highly leveraged would have to go: underway

There are a number of other opportunities that have arisen but these as you are likely now aware of, are a few of the bigger ones.

The question then beckon’s….where do we go and what do we do for 2009???

The biggest answer is going to be CASH! Cash takes a number of forms in deflationary periods, such as increasing savings and paying down debt…….but another cash play that the average person cannot usually take advantage of is the trading of financial instruments such as currencies and indexes, bonds and commodities.

Well this differed from my view of the outlook so I was intrigued....I responded....

Why does there need to be an asset price collapse? Can't currency just be debased by creating more credit or printing money? Do you think the government is going to do nothing? For that reason I just bought a house in NZ. They produce food. I guess South Africa would be good too given the precious metal exposure, but the crime, and also a lot of these precious metal producers will go broke when the currency rises again, as happened last time. So for silver/gold stocks Aust is better, or USA/Canada.

Hi Andrew, it is all just a matter of opinion and analysis, but the devaluation of assets should encompass all assets in even the countries you mention according to our analysis. NZ has already experienced a 30% drop across many areas, hope you were able to buy after the dip. Australia I feel will eventually experience even heavier falls than NZ as they have a larger economy reliant on commodities as you mention and larger debt. NZ is often a safe haven currency and at some point shall find a reasonable bottom as
debt will only run so far in NZ versus countries such as Australia. As far as Gold/silver we have already seen 38%-45% drops already which may mean we are close to a bottom, but I wouldn't be looking to those assets as lifesavers during the next couple of years particularly....CASH will be King!

Yep, I appreciate the need for asset deflation, but there is also an opportunity for ‘cost of living’ inflation as well. Afterall in an emergency governments can also print money or subsidise debt creation. I think NZ is just as reliant on commodities as Australia, just Australia has more diversity, and obviously more towards minerals. NZ has greater welfare statism, less savings, but a new PM should change that. NZ debt is pretty bad as well, but Aust has compulsory savings scheme of around 9-10%, compared to just 2-4% in NZ. I wouldn’t call NZ or Aust safe haven currencies, as they are both extremely volatile, which is why they are traded relatively more compared to their economic significance. They are great countries though because they have a natural hedge. Commodity prices collapse, so does the currency, which is why you buy assets in such countries - - when they are cheap that is. When asset prices bottom as you are alluding too, we will see more ‘cost of living’ inflation. The governments will not allow a total wasting of assets, so there will be some stimulus. And I agree with gold, we should see some upturn soon, though the best equity prices I think were available in the recent dumping.

Just quickly to clarify, I don't see a turn up soon in Gold....I see a lower bottom followed by a number of years in a range trade that may eventually pop higher. As for governments and their ability to fix problems, I do not agree. I believe governments help make problems bigger and serve to eventually hurt those they seek to protect, therefore I don't agree with much of what you have said regarding debt creation. We are already at an historic high in terms of debt worldwide and that credit bubble is the cause of the problems....creating more debt will not fix the problem. Savings levels in Australia and the rest of the western world is horrendous regardless of the enforced superannuation which really is useless in terms of savings.

I don't understand your reasoning of hedging either? Why would I buy property in those countries if I believe the asset values have a lot further to fall and that the currencies also have a lot further to fall? On the currencies, a major reason volumes had been high in OZ and kiwi dollars was the carry trade and false belief that the commodity boom would last forever based on the China and India phenomenon....a joke in itself that don't have time to cover here. As for inflation, I do not see any chance of it over the next 5 years at least.

Wondering why you are negative on gold? Because of current asset deflation? Holding up quite well really given the collapse of other asset markets. I didn't mean to suggest government was a solution, merely that governments think short term and have a desire to hold up asset prices (keep people solvent) if it serves their short term interests. In that sense I see them increasing spending, in cases like Aust & NZ, and even the USA can print money or underwrite credit creation (since they are the base currency) without much concern. And yes I agree, they can only defer the problem, to the extent that problems can be deferred....that's why I see more inflationary outlook than you, and thus higher gold.

Yep, I agree with some of your points on debt, but in the short term option I think there are more possibilities than simply unwinding private debt through liquidation or foreclosure, though there will be some of that. I think the government will take over where the private sector left town. This will of course debase currencies through inflation & higher interest rates. This keeps asset prices artificially high and tax revenues healthy to fund more unemployment. There is a tendency to treat inflation as simply a demand phenomenon, but it actually has dual elements - assets and cost of living, and they are not just a demand phenomena, but a monetary one, as I see it.

I wasn't suggesting that Australian savings will fully salvage the Aust economy, just its a positive over NZ which has none, but NZ is more positive in that food is a greater necessity (my assertion) than over-supplied iron ore given the capacity increases. More farms are becoming housing, lifestyle jaunts, or unsustainable in the case of Japan, EU and aspects of USA.

By 'natural hedge' I mean that commodities are denominated in USD terms so commodity prices have collapsed, but so have the currencies of commodity produces. If I can shift money from yen or USD to those currencies (as I have done), then I can position myself for the day (say in 4-5 years) when that surplus mineral producing capacity is absorbed. By hedging I mean that as commodity price falls in USD terms, the price in AUD or NZD term improves, or stays steady. Look at gold in $AUD terms, its never been higher. That will eventually be reflected in gold stocks there. The other metals are less impressive because of poorer outlook, say nickel, the collapse in AUD nickel is not as bad given the collapse in currency. That is why Aust always fares better in these times, same as NZ.

You argued that the AUD and NZD will fall further...hmmm..I don't see that because of the hedge impact I am talking about. I've not looked a great deal at them lately because I've been travelling, but I'd see them as close to a bottom. [I would say NZD will fall to USD50c]. That’s fine because the house I bought was on vendor finance and from a low $NZ point, and I have Yen assets to sell as well.

Well I kinda agree with your points on carry trade, other than the fact that I see the carry trade opening up again some time in the future when Japanese have more confidence. The currency is low, it offers superior yields to yen, the $A denominated revenues from mineral exports will be high, so Japanese investors who sold can now rebuild these positions. The carry trade is dynamic. Confidence was undermined, as it should have been, once the market sees a bottom, they will do it again. Clearly you see further falls, so that thinking might perturb you. I dare say Japanese investment banks will wonder about Aust+NZ monetary policy for a while, maybe wait to see the swap rate widen again.

Wondering why you dont see any change in inflation?

Interesting to see where you are going with your line of reasoning, but I tend to think we are in a completely different situation than the recent past. I see the majority of the world coming together in an almost zero rate monetary policy in reaction to these stresses, and therefore much of the carry trade thinking will have to change especially amongst the majors for a sustained period I would think. I don't believe interest rates will increase for a number of years.

As far as hedging with commodities, I think that is flawed as commodities and all demand and currencies come off although I agree that the USD should grow in relative strength as time moves forward....the problem is that demand once reduced significantly will mean reliance goes back to domestic demand and therefore negates the idea of hedging based on USD values of commodities.

Gold is down to around 770 at the moment from over 1000 and should target around 580-650 before more of a bottom is hit....and may then experience a few years in a range before it can see nice moves. But as you say if the Aussie gets down to below its previous lows of 45 to the US then Gold will start to gain in relative terms....but at what opportunity cost to other investments?

I don't think it makes much difference whether it’s a zero rate (as it was in Japan) or 3%, if nobody is lending then rates don’t much matter. I paid cash for my house despite having 80% equity. Safest loan they could have, they are just not interested despite the rhetoric of interest rate cuts, and the promise of a first home grant of $21K also makes policy look like stimulus, but if you can't get finance then it makes little difference for anyone except those buying $80-100K rural houses.

The carry trade will always be there, traded in & out of, because it is inherent in the risk premium that countries like Australia and NZ will always require. I was not suggested trading commodities; I was suggesting Australia receives more money in AUD terms because of lower AUD than it would if higher against the USD.

Yep, most commodities will stay weak. I differ on precious metals of course. My argument is that Japan could retain a zero policy rate because it was stimulating the economy with that zero rate by keeping its currency low, exports boosted at a time when it was adjusting to lost competitiveness, ie. shipping manufacturing capacity to China. If no one is growing, then governments are inclined to create stimulus rather than rely on exports. Aust & NZ get it from a lower currency, creditor nations get it by govt spending, debtor nations like USA get it from printing money, as long as they can sustain those policies, and policies only need it to be a short term solution for them to embrace it.

The idea of 'hedging' is used metaphorically. You can't deny if there is no demand for industrial commodities, which we both seem to agree, then the commodity price is low but also commodity currencies. Funds places in those countries make good sense at those levels, though these positions you have several years to place. Also, any export earnings from those countries have a higher local dollar value than they would under a strong economy. The perfect example is gold because it has not change much in price despite the collapse of the metal price complex. It is now in AUD terms far stronger than it was when the AUD was strong ($A1250/oz last time I looked to $A950/oz) before.

As for low inflation...I believe we are headed for deflation especially in the US and Europe. As for OZ and NZ...well, let’s see how the markets react over the next 3 months to get a better gauge. Should be a very telling period as the markets need to make up their minds before committing on a direction and nothing like a nice bounce to find out if the bounce will be a false one or the start of a further rally.

[Didn’t get an answer to my question]. Ok, I think you want to wind up this conversation. I engage in these conversations because you do learn. I learn even by talking to people who know little because they will help me express what I want to say, bring a new perspective, and most of all I am challenging myself by thinking about the words I say. I agree with you on inflation, but its important to differentiate between 2 types of inflation:

1. Asset inflation - currently falling

2. Cost of living inflation - non traded things, mostly expenses like rent, food, but there is some overlap.

That period of supposedly low inflation was actually a period of high (asset) inflation. most people dont even understand inflation. The media doesn't, many economists dont.

Here is a good article from the SMH - just arrived this instance.
http://business.smh.com.au/business/markets/the-bond-bubble-20081208-6td7.html?page=fullpage#contentSwap2
Some inflationary worries - printing money or credit creation it’s all inflationary to me because it’s all money creation with no corresponding productive capacity, not that the economy needs any at this point. But it will hold asset prices higher until prices are eroded by inflation, which as I say will be there intent. They are not going to let asset prices collapse too much, they will debase money to restore a monetary equilibrium.

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Andrew Sheldon www.sheldonthinks.com

Second shortest and best rally in human history

It seems likely that this stockmarket rally will be the 2nd best in human history and the shortest lived if the market behaviour of the early 1930s is anything to go by. Back then the market was extremely volatile. The reason I suspect was the injection of liquidity into the credit market to shore up the banking sector. The reason for the 2nd collapse was likely the resulting inflation. Yes, thats right, the governments and central banks are facilitating another period of debt creation. The difference this time is that there will be less spending, less productive capacity, which meaning a lot more inflation to rebalance markets.
But enjoy the benefits while they last. History has shown that gold prices collapsed 50% in the 1970s before they rallied 800%. I will be watching to see if that happens as it will take a little time for cost-of-living inflation to take off as asset prices (i.e. asset inflation) take off again.
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Andrew Sheldon www.sheldonthinks.com

Will dropping interest rates help the US economy?

The US Fed Reserve Board is signalling that it will be dropping rates even further. Some commentators are inclined to see these steps as good news....but is it? The rationale for raising rates is:
1. Increase liquidity in the banking system by creating the means of financial institutions to create more financial resources, which allows them to cover any short term incapacity to meet obligations as they fall due
2. Increase the financial resources of banks so they can lend more money to the private sector. In the context of a growing economy that has to be good. In the context of a bad economy, who wants to borrow money? No one wants to buy a house when property prices are falling. And with interest rates still low, clearly there is still a lot of pain to be placed on borrowers before we see a low in property markets.

The implication is then that the Fed moves will do very little except delay a few banking failures. But I suspect the Fed knows that. Politicians and Fed chairnman dont do things because they are logical, they do them because they are the actions expected by the market. They are delivering what perceptions demands of them. They wait for the market to direct them. Cries for lower interest rates - give them what they want. In 2 years when we have run away inflation. Stop inflation, then they apply higher rates.

Really there is no escaping the impact of inflation. If you take a certain set of actions you have to live with the consequences. If you expand the money supply more than the productive capacity of the economy over a sustained period, you will create asset inflation. When asset prices are too high, you undermine the capacity of people to borrow, you deflate that debt-asset pyramid, and the extent to which you do is the extent to which you dont see inflation. But to the extent that people are able to meet their debt servicing obligations, that is the extent to which other people will be hurt by the rising prices for living expenses.

The real cause of inflation

It never ceases to amaze me how ill-conceived the public, media, even economists conception of inflation is. If you believe the rhetoric inflation is caused by an excess of consumption, that if your economy is growing too strong, then you get prices increasing because producers are unable to supply product. This never happens actually. You will find that economies in the long run are always able to meet demand. The reason for this is because of:
1. The almost universal availability of substitutes - If any product becomes scarce and prices rise, buyers are inclined to buy a similar product that serves the same purchase.
2. The pricing mechanism - Price rises in any single product will rise and in the process discourage consumption, or at least defer it until prices fall, or the person's capacity to buy improves through their increasing income or debt raising capacity.

A global economy offers even greater capacity to reduce inflation because there is greater possibility of substitution or competition, but it does have to overcome the added transport and marketing cost of selling that output, and thats a long-run commercial decision.

The 'demand-based inflation' enthusiasts would have you believe that greater wealth creation is creating that demand across the whole economy. Some dont even bother to explain it - its just there 'suddenly'. But thats nonsense because the increase in wealth is due to expansion of economic output. It also does not account for the 'late' arrival of inflation. We have had 13 years of low inflation despite strong economic development. If you think that is a good thing consider that during the Industrial Revolution, under a gold-standard, there was no inflation. Price variable was essentially stable.

The reality though is that we have had inflation over the last 18-odd years, its just that the CPI is designed not to measure it. This is because the CPI measures only the increase in prices in products that are important to the poor. But the inflationary phenomena is a monetary phenomena caused by excess supply of money relative to the amount of goods & services in production. Now since the wealthy hold the bulk of the money and people want to make more, the bulk of this money flows into business & personal investments such as factories, property and stocks, not into household consumption. The implication is that this money is in a sense sterilising the inflation such that price rises dont flow through to basic goods and services. At some point asset prices become overpriced, and are sold down. This process will eventually lead to bankruptcies, whether because interest rates are raised to address inflation or just because of default because the factory sales fell, or the home owner lost their job.
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Andrew Sheldon www.sheldonthinks.com

Australia - Progress Report

The Australian economy has long been recognised as a `commodities play` because of its reliance on mineral & agricultural exports, but in fact the economy is considerably stronger than that precisely because of that dependence. If global demand for commodities subsides the $A declines and offshore commodity revenues (priced in $US terms) are preserved. Better still - the country benefits from increased tourism. The housing markets tend to suffer from higher interest rates as the Reserve Bank of Australia attempts to stabilise the economy. The economic paradigm has changed recently though.

Political Organisation
Australia has a stable democracy. The encumbent Prime Minister John Howard is the longest serving PM since his mentor Bob Menzies held power in the 1950s and 1960s. Both leaders led their conservative Liberal Party to successive election victories. Both leaders oversaw periods of economic prosperity, but in Howard`s case, it was largely by default, with no meaningful opposition.

The Howard government has however been disciplined in reducing the huge public deficit accumulated under the Labor Party in the 1980s. The debt has been reduced from $168billion to just $28bil, and that is likely to be a bottom given the desire to retain a liquid bond market.

My belief is that the Australian government will attempt to expand its immigration program to lift subdued domestic demand in future, as well as provide marginal support to nation-building infrastructure programs. In the process it hopes to stimulate new investment in under-funded infrastructure, as well as reducing debt in per capita terms.

Economic Activity
The Australian economy has been one of the fastest growing OECD countries over the last decade - largely as a result of labour market reform, privatisation of key state-owned enterprises and subsidies to the housing sector, in addition to falls in interest rates. The late 1990s and early 200os were particularly strong as mineral export prices & volumes improved and housing prices took off. In the last 3years, China largely accounted for the bulk of the incremental demand, and that demand will evaporate in future when the US & Chinese property markets fall.

Improvements in Australia`s terms of trade have been matched by increasing imports from China, which have helped to keep domestic inflation low, as the $A has rallied from $US0.48 t0 $US0.80, and since fallen to $US0.76. During the 1995-04 property boom, housing prices rose by an average of 250%(?), going from 3x annual average incomes to 9x, as prices rose with incomes and their capacity to borrow (new jobs & lower interest rates). The concern is that the bursting of the US housing market by high oil prices & excessive household debt will undermine global economic activity. We can thus expect a much lower $A and higher interest rates, which will take a huge hit on the Australia property market.
There remains considerable optimism about the health of the global economy. Iron ore & coal annual contract prices are up 50%, and such companies along with the oil companies are sparking an investment boom in WA and NT. These investments will take 2-4 years of construction. Investment in other areas is less active because mineral prices in Australia have not risen greatly in $A terms because of the strength in the $A. The positive is that as mineral prices fall, so will the $A. Just gold prices in $A terms will perform very well.

Equity Markets & Corporate Earnings
Australian equities posted solid earnings in 2004-5, and the minerals sector which renegotiated annual contract prices in Mar'05, will see stronger earnings this year, and those contract prices are likely to be preserved in coming years if the $US weakens.
The broader market is not likely to repeat its strong 2004 growth since high household debts and rising interest rates are likely to undermine retail sales. Inflation initially can be expected to boost earnings since the value of capital will boost balance sheets, whilst corporations are able to pass on costs. Corporates have resorted to boosting dividend pay-out ratios (DPRs) from 77% in 2004 to 80% in 2005. Two companies going against the broad trend:

1. BHP Billiton has the made the lowest dividend payout ratio of 23% in years as it embarks on a $6bil capital expenditure program to boost output. This trend is evident across the resources sector, with Div Payout Ratio (DPR) in the resources sector falling from 49% to 31% between 2004-05, suggesting resource companies will have some nice profit/dividend growth in future, whilst the broader market is stretching itself. Clearly they are hoping the market will react to stronger metal prices in the short term and higher dividend yields (DPRs) as the commodity prices correct.
2. Telstra: The new CEO of Telstra has disclosed that the company has under-funded capital expenditure by $2-3billion over 3-5 years to boost earnings, whilst at the same time delaying the adoption of ADSL at $30/month. Under-investment in the past (reflected by 14% line faults) means higher investment in the future, so lower earnings, and likely squeeze on margins, particularly if the Fed govt proceeds with a break up of Telstra. Lower dividends, particularly since the payout ratio from earnings is very high.
   Telstra’s dividend of 40c per share was based on a pay-out ratio of 93% (up from 75%) - suggesting they retained only 7% of earnings for capex. Its intention is of course to boost the share price for the privatisation, whilst not disclosing the capital investment required to maintain services. Telstra had to borrow $550mil from its Special (share premium) Reserve to fund this dividend, and the same for the special 2006 dividend.

Housing Market
Recent housing figures (July'05) suggest households are taking comfort in the persistence of housing prices, interest rates and strong labour market. The consequence has been a strong recovery in the housing refurbishment market. The consequence of this is likely to be a lift in interest rates by 0.25%, particularly as inflationary pressures are high.

Inflation
Strong inflation has yet to register in the CPI figures, but it seems likely in coming quarters as:

1. Wages rise: Wages rose 7.4% annualised in the Jun’05 qtr.
2. Employment: The labour market remains tight with the unemployment rate still at 5%.
3. Purchasing Power Index: The PPI, a measure of producers cost variability has increased due to higher fuel & material costs.

The Forex Market
The $A can be expected to trade higher due to the strong momentum in the housing market. Australia will also benefit from strong terms of trade as the recently negotiated mineral export contract prices still have some time (9mths) to run. A lift in interest rates will only help the $A remain high, but in6mths time it will come off strongly as commodity prices fall.