[Satyajit Das, Contributing Writer, Money Morning]

Australia has been one of the world’s best performing economies. But its success in avoiding the worst of the global economic problems may not continue. Australia’s future is inextricably linked to China and the commodity “super boom”. Australian economic prospects remain vulnerable to international developments outside its control.

Escaping Acronyms…

The popular narrative is that Australia escaped the GFC (global financial crisis – Australians are acronymic) through their own planning.

The country was certainly in a better position to cope with the problems. The Federal government did not have much debt. However, some State governments have significant borrowing. Governments also systematically shifted some of their debt into public private partnerships (“PPP”). Because of the strategic nature of this infrastructure, these projects de facto enjoy the indirect support of governments. Private household debt is also high.

At the start of the crisis, Australian interest rates were relatively high, providing greater flexibility.

But Australia did not escape the crisis unscathed. One major bank lost nearly a billion Australian dollars. Investors, including a number of charities and local councils, suffered significant losses from investments in various financial products. A number of highly leveraged infrastructure and commercial real-estate investors failed.

Local banks escaped the problems of their overseas counterparts. The near death experiences in the recession of the early 1990s encouraged them to stay home eschewing overseas adventures and complex financial structures. That said, another year or so, they would not have been so lucky.

The local banking regulator, APRA (Australian Prudential Regulation Authority), and politicians take credit for the banks being relatively unaffected. This is curious given that banking regulations are largely uniform around the world. One can only assume that Australia has superior regulators and politicians to the rest of the world – an example of “Australian exceptionalism”.

In reality, Australia’s swift recovery was driven by large cuts in interest rates, government guarantees for banks, government stimulus and a commodity boom.

The central bank reduced interest rates (from 7.25% per annum to 3.00% per annum). The fall of 4.25% per annum translates into a fall in monthly mortgage repayments of nearly 30 % or around $7,000 per year on a 20-year mortgage of $250,000. A government guarantee on bank deposits and borrowing ensured that financial institutions were insulated from many of the problems.

Government spending minimised the effects on the real economy. Cleverly directed cash transfers to lower income households rapidly stimulated the economy. As part of the ESP (Economic Stimulus Package), government spending on education, housing and infrastructure was also increased.

Some of the spending was not well directed. Environmental initiatives, subsidies for home insulation to reduce energy consumption, have proved less than successful.

The main driver of the recovery has been a commodity boom. This is not a new phenomenon in Australian history. It can be traced back to the famous gold rush of the 19th century when many travelled to Australia in search of their fortunes.

Boom…

Former Prime Minister of Australia Paul Keating recently remarked that Australians were luckier than most races having been given an entire continent. He might have added that it was also remarkably rich in mineral wealth.

Australia has benefited from a substantial increase in demand for and prices for its mineral products. The country is enjoying its best terms of trade (measured as Price of Exports divided by Price of Imports, showing the quantity of imports that can be purchased theoretically from the sale of a fixed amount of exports) in 140 years. Australia’s terms of trade have improved by 42%, just since 2004.

The commodity boom is driven by a sharp increase in demand, supply constraints because of under-investment in mineral production and associated infrastructure and some unexpected effects of the GFC.

In the 1990s, as a result of persistently low prices, mining companies did not invest sufficiently in expanding production capacity or infrastructure, such as transport, refining or processing capacity. The increase in demand from purchasers, particularly emerging economies, quickly created bottlenecks and shortages. This led to sharply higher prices as well as improved volumes for many commodities.

The GFC also boosted investment in commodities. As traditional investments fared poorly (stocks, interest rates and property prices all fell), investors switched to hard assets, like commodities. The underlying logic was that these were real assets with genuine underlying uses rather than the fictions created through financial engineering.

Low interest rates also assisted demand and prices as it cost less than before to buy and hold commodities, which paid no return.

As central banks commenced printing money in an effort to restart growth, investment in commodities increased further as investors sought a hedge against the risk of inflation. Former Board member of the Reserve Bank of Australia, Professor Warwick McKibbin suggested that perhaps as much as 40% of the improvement in Australia’s terms of trade surge was being driven by US and European monetary expansion.

One of China’s priorities is to preserve the value of its foreign exchange reserves, currently around US$3.2 trillion. The bulk of these funds are invested in US dollar, Euro and Yen denominated securities. To reduce the risk of losses as these securities lose value due to the actions of governments to devalue the currency against the Renminbi, China has purchased and stockpiled large amounts of strategic commodities.

Boomier…

The economists, who failed to forecast the rise in commodity prices or the GFC, now speak of a “super” boom lasting decades. The boom is more fragile than currently understood.

As growth in China and other emerging countries decelerates, demand for commodities is likely to slow. High prices have encouraged investment in expanding existing mines, building new mines and additional infrastructure as well as exploration. As new capacity and supply comes on stream, there will be pressure on prices.

Australian mining entrepreneurs and politicians point to a massive pipeline of projects, which will underpin Australian prosperity. The Australian Mines and Metals Association estimate that there is A$427 billion of resources in train, including A$146 billion in Liquid Natural Gas alone. A$236 billion of projects are current under way with a further A$191 billion awaiting approval.

There is also A$770 billion of infrastructure spending required to renew and develop Australia’s economic and social infrastructure. This will compete with commodity projects for funding. Chairman of Infrastructure Australia Rod Eddington has warned that financing will not be available for many projects. Infrastructure Australia has identified a smaller list of priority project totalling A$86 billion.

Commodity projects depend on demand for the product and also on the ability to finance it. Deterioration in money market conditions and also problems in the banking system mean that the availability of funding is becoming more restricted and expensive. If previous commodity booms are a guide, then many of these projects may not eventuate.

Sinophilia…

Around 23 % of Australian exports now go to China. The real quantum is higher as some Australian exports to Asia are then re-exported to China.

China currently faces significant challenges. Its two major trading partners – Europe and America – face serious problems which will lead to a slow down in our own exports. Recent statistics, such as the volatile Purchasing Managers Index that measures manufacturing activity, suggest a sharp slowdown. In turn, this will affect suppliers such as Australia by way of lower demand and also lower prices for commodities.

Unlike 2008, China’s capacity to respond to any slowdown is reduced. Then, China increased lending through our policy banks to boost demand. In 2009 and 2010, loan growth of around 30-40% of GDP drove growth. Unfortunately, unproductive investment will result in bad debts for the banks. The need to support the banks and cover their bad debts will restrict China’s ability to support the economy.

Around US$ 800 billion or 25% of China’s US$3.2 trillion in foreign exchange reserves is invested in “risk free” European government bonds. Continued losses in these investments and on investments in US government bonds also further restrict our flexibility. China’s economic growth may be slower than widely anticipated.

European Tsunamis…

Australians believe that physical distance from Europe and proximity to China and Asia affords protection from European debt problems.

Despite record terms of trade and high export volumes, Australia continues to run a current account deficit with the rest of the world of around 2-3% of GDP, around US$30-40 billion per year. This must be financed overseas. Sovereign debt problems and the resultant problems in the banking system will affect international money markets for some time to come. Australian borrowers will face reduced availability of funding and increased borrowing cost.

Before the crisis, Australian bank deposits totalled 50-60% of loans made. The difference was funded in wholesale markets, generally from institutional investors.

In 2007, deposits made up around 20% of bank borrowing down from 34% a decade earlier. Domestic wholesale borrowing and foreign wholesale borrowing were 53% and 27% of bank balance sheets.  Following the GFC, increases in the cost of overseas funding and regulatory pressure, Australian banks significantly reduced their loan to deposit ratios, with deposits now around 70% of loans. They also reduced their dependence on international borrowings.

Nevertheless, Australian banks face significantly international re-financing pressures, needing around A$80 billion in 2012. Around A$35 billion are AAA rated government guaranteed bonds, which will need to be financed without government support, unless the policy changes. In addition, the banks have a further A$28 billion worth of bonds that mature in the domestic markets.

In the period before the GFC, Australian banks relied on securitisation to raise cheap funding from overseas. When these markets closed, Australian banks used debt guaranteed by the Federal Government to raise funds. With the guarantee now not available, Australian banks are increasingly using covered bonds to raise funds.

Covered bonds are secured over specified assets such as a pool of mortgages, giving investors priority over depositors. Regulators have limited the quantum of covered bonds permitted to a maximum of 8% of assets, limiting the ability of banks to use this form of financing.

To date, covered bonds have not proved a cheap source of finance for banks, as originally envisaged. Inaugural international issues by ANZ and Westpac have cost around 1.50% over inter-bank rates. In early 2012, the Commonwealth Bank issued at around 1.75% over interbank rates in the domestic markets. Given that the covered bonds enjoyed the highest rating of AAA, the funding cost for Australian banks for unsecured borrowings would be around 2.00-2.50% over inter-bank rates, a sharp increase over the last 6 months. This higher cost will be passed on to customers at some stage.

In testimony to a parliamentary committee, John Laker, the head of APRA, acknowledged the funding challenge. He hoped that improvements in market conditions would allow the Australian banks to access the overseas funding required.

Money Too Tight To Mention …

Facing reduced availability and higher cost of funding, Australian banks may reduce loan volumes and increase rates to customers.

The problems of international banks, especially European banks, previously active in financing local businesses, will compound the problem. These banks are required to increase capital to cover losses, including those on their sovereign bond investment. As they can’t or do not want to issue equity at deeply discounted prices and the limited investor appetite for such issues, the banks may sell assets or reduce lending to raise the required capital. Estimates suggest that these banks could have to sell (up to) $2.5-3.0 trillion in assets, resulting in a sharp contraction in availability of credit.

Before the GFC, European banks provided around 35% of loans to Australian corporations. This has fallen to around 16% in 2011 and is likely to decline further as a result of losses on sovereign bond holdings, pressures on bank capital and increases in US$ funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures. They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe.

The reduced participation reflects losses on sovereign bond holdings, pressures on bank capital and increases in US$ funding costs. European banks are actively looking to sell all or a portion of their Australian loan portfolios to alleviate the pressures. They are also cutting back on new lending to Australia clients, focusing on their home markets in Europe.

Given that Australian companies will need to re-finance around A$80 billion of maturing loans in 2012, these pressures are not welcome. The problems of European banks, active in commodity financing, may reduce the supply of credit to the sector by about 25-30%, which would impact Australia’s resources businesses.

The contraction of credit will also affect Australia indirectly. The withdrawal of European banks from Asia and other emerging markets is affecting the ability of companies to finance trade and investment projects. This affects Australian exports.

In 2007, European banks and US banks accounted for 30% and 10% of loan in Asia-Pacific. This has fallen by around half to 15-16% for European banks and 5-6% for US banks. The level of participation is likely to shrink further as a result of the problems of these banks. Troubled French banks account for about 11% of maturing loans in Asia Pacific. It is unlikely that these banks will maintain their level of commitment. Asia-Pacific banks have taken up the slack but are not sizeable enough to fill the gap completely.

Australian companies’ overseas earnings also face significant pressure due to economic weakness in Europe and its effect on the other markets. A proportion of Australian retirement savings are invested overseas. These will also be affected by the problems in Europe and internationally.

The European crisis has affected Australian public finances. Falls in income and capital gains have reduced tax revenue. The government is cutting expenditure and tightening taxes to offset the reduction in revenue. Falls in income on retirement savings, reduced business investment and general loss of confidence is likely to adversely affect the domestic economy. Australia may not escape the possible European tsunami.

© 2012 Satyajit Das All Rights Reserved.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011). He is a keynote speaker at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney’s Intercontinental Hotel.

Ed Note: Tomorrow, Satyajit Das examines the Australian housing market and the perfect storm that could engulf Australia.

From the Archives…

Facebook Shares – Notice for Mad Punters: Buy This Stock

2012-02-03 – Kris Sayce

Why Your Money is Better Off in Stocks Than in the Housing Market in 2012

2012-02-02 – Kris Sayce

Why You Should Pay Attention to the ASEAN Bloc

2012-02-01 – Cris Sholto Heaton

Will Australian Property Prices Keep Falling?

2012-01-31 – Dr. Alex Cowie

Is Ben Bernanke Secretly Buying Gold and Silver Stocks?

2012-01-30 – Dr. Alex Cowie

For editorial enquiries and feedback, email letters@moneymorning.com.au

There are three reasons to look at a stock’s dividend yield.

The first is to see how much money you’ll make by holding it. The higher the yield, the more money you’ll earn.

The second reason is to use it as a guide for how risky the stock is. The higher the yield, the riskier the stock.

And the third reason is to judge whether it’s an income stock or a growth stock. New companies and those with uneven cash flow tend to be growth stocks. Mature companies or those with consistent cash flow tend to be income stocks.

We mention this because of the hoo-ha surrounding the high dividends you can collect if you own Australian bank stocks.

Just this week, David Potts wrote in the Sydney Morning Herald:

“So instead of putting money in the bank, it might be better to buy a bit of it. You’ll be mates [with the banks] in no time. I can tell you, a shareholder gets paid a lot more than a customer.”

In today’s Money Morning, we’ll explain why high bank dividends are a sign of a declining industry that is desperate for investors rather than an industry that’s trading at a bargain.

You see, the Australian banking sector is now in the last phase that all ex-growth companies go through: the mature or decaying phase.

It’s all part of the business lifecycle.

It’s this lifecycle that usually determines whether a stock is a growth stock or an income stock.

Whether you can expect to see the share price rise spectacularly for big share price gains… Or whether the share price will do nothing, but at least you’ll get a decent income from dividends.

As an investor, if you get on board an investment at the wrong stage of the lifecycle at the wrong time in your life, it can have a big impact on your investments.

Let me explain…

The image below shows how the business lifecycle works. It’s crude and not every business will follow this same pattern. But it’s pretty darn close to how most businesses develop:

Successful businesses start… they have a big growth spurt… they consolidate… have another period of growth… and then they reach maturity.

Of course, at any point during the lifecycle a business can fail. For instance, most start-up companies fail before they achieve any growth. Whereas others go through the full lifecycle before time and innovation finally catches up with them – Eastman Kodak is a great example.

Why this is important for investors is that the more growth a company achieves, the less likely it is to grow as fast in the future. Even a company like Apple [NASDAQ: AAPL] will one day see revenue and profit growth stop. It will become a mature company…

And may even face the same fate as Kodak.

Right now, Australian banks have reached maturity. They’re at the same place where Kodak was 30 years ago. And unless they can reinvent themselves the only way for them is down.

They’ve benefited from years of amazing credit growth, where even a monkey could run a profitable bank. But now the 40-year credit boom has ended, and so has growth.

Bottom line: Australian banks are heading for years of stagnation or decline. If you’re a bank investor it means you need to make an important decision.

At Best it’s Bad News for Australian Bank Stocks

If you invested in banks for growth, you should sell your bank shares now.

If you invested in banks for income, you need to work out if the return you’re getting is enough to make up for the stagnant – and even falling – share price.

Look, this isn’t a bank-bashing exercise. It’s just a function of how markets and the business lifecycle work. You can see how it’s played out on the chart below of the S&P/ASX 200 Financials (ex-Property) Index:

By the way, stagnation is the best outcome. If the end of the 40-year credit boom results in total bank collapse then it’s game over for all bank stocks.

But what if David Potts is right and bank dividends are a hidden gem? That you should buy the high yields before everyone else finds out about them?

That’s just the thing. Australian banks have paid some of the highest blue-chip yields for the past three years.

The reason the yields are high is because investors now see the banks as we do. They are a mature industry heading for stagnation at best, and decay (possibly death) at worst.

No Growth in Banking

In short, when you look at a high dividend yield it’s not simply a case of thinking about all the cash you’ll earn. You also have to think about why the dividend yield is high.

In the case of a small-cap income stock, it could be that investors are yet to find it (although even that’s hard to imagine given how easy it is to scan for yields using even the most basic software), but that’s not something you can say about four of Australia’s biggest companies.

Australian bank stocks pay a high dividend because the years of growth are over.

You may get a good dividend buying them today, but you have to ask yourself: is it really such a good idea to buy shares in a declining industry where the companies’ share prices are likely to fall and dividend growth will be minimal?

We’ll say straight out that it’s just not worth it. If you hold shares of the four big Australian banks, sell them now.

Cheers.
Kris.

P.S. Buying bank stocks isn’t the only bad idea to avoid. We suggest you check out the latest special report from our old pal, Sound Money. Sound Investments editor Greg Canavan. He’s identified three ways careless investors could lose money this year… and how you can avoid falling into this trap. To see Greg’s special report and take out a no obligation trial subscription, click here…

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[By Keith Fitz-Gerald, Chief Investment Strategist, Money Morning (USA)]

I hear it everywhere I go. I’ll start investing again…

…when the debt problem is fixed.

…when the markets pull back a little.

…when the EU crisis is over.

…when the elections are over.

Chances are you’ve said some of these same things to yourself.

Yet, waiting is exactly the wrong thing to do. Time is something you never get back.

And when it comes to consistent investment returns, time is the one thing you always have to capitalise on – without fail.

Besides, waiting makes it harder to get back in the game. Ask anybody who missed the S&P 500′s 99.53% run up off March 2009 lows that carried things until April 2011.

Or the 87.26% run up through July 2007 following the low set in 2003. Or the 569.25% move from November 1987 (shortly after Black Monday) through January 2000.

No. The way I see it, the thing to do is to begin investing the moment you decide you want to. That way you pique your imagination, your motivation and your returns.

Five Ways to Get Better Results in 2012

Here are five tips to help you get started:

• Have specific goals. Wall Street traders like to beat the S&P 500 or the Dow Jones Industrial Average and they pay themselves huge bonuses for having beat this index or that benchmark. But that’s crap. Everybody I know invests to meet objectives like paying for college for their children or living the retirement of their dreams. Decide what you want and when. Then, figure out how you’re going to get there. You might be surprised how manageable all of this actually is.

• Know why you want what you want. Many investors spend more time analysing a new washing machine than they do picking their next investment. Or, they count on Uncle Bertie and his sure things. Both are bad ideas. Ask yourself if that new hot stock or exchange-traded fund (ETF) fits the goals you’ve laid out for yourself. If so, great. Buy it. If not, pass. It’s a waste of money to have something in your portfolio that doesn’t help you meet your goals, not to mention it’s more risky, too.

• Be realistic. You’d be surprised how many of the investors I meet want to earn 5,000% by tomorrow at 8:00am and only use $100 to do it. Then again, maybe you wouldn’t. It is possible, just not probable. There’s a big difference.

• Take action. The single biggest impediment to success stares back at you every morning in the mirror. Psychologists say we have built in saboteurs; common wisdom says we are our own worst enemies. Both are true. The “enemy” is standing in the mirror and is so persuasive we can talk ourselves out of anything, including success. That’s why actually taking action can quiet the doubt and help minimize any backsliding. Besides, if you hit a few small winners, you’ll have the confidence needed to take even stronger, more decisive actions down the road.

• Don’t stay down. My grandfather used to tell me that it was not how I handled getting knocked down that mattered but how I got up. That’s why sticking to a disciplined plan is a lot better than making panicky decisions. If you’re simply reacting by the seat of your pants, chances are you’re going to get knocked down a lot. But if you get up, plan ahead and take steps to avoid the next stumbling block, chances are you’ll begin to pull ahead. And stay there.

So what about the risks?

That’s a fair question and an important one, especially now when there are so many fundamental problems to consider – Europe, China, US debt, the lack of adult supervision amongst the world’s central bankers, and more.

That’s what trailing stops are for.

If the fire gets too hot, trailing stops will get you out of the kitchen. The important part is to get back to cooking when things cool down.

Keith Fitz-Gerald

Chief Investment Strategist, Money Morning (USA)

Publisher’s Note: This is an edited version of an article that originally appeared in Money Morning (USA).

From the Archives…

Facebook Shares – Notice for Mad Punters: Buy This Stock

2012-02-03 – Kris Sayce

Why Your Money is Better Off in Stocks Than in the Housing Market in 2012

2012-02-02 – Kris Sayce

Why You Should Pay Attention to the ASEAN Bloc

2012-02-01 – Cris Sholto Heaton

Will Australian Property Prices Keep Falling?

2012-01-31 – Dr. Alex Cowie

Is Ben Bernanke Secretly Buying Gold and Silver Stocks?

2012-01-30 – Dr. Alex Cowie

For editorial enquiries and feedback, email letters@moneymorning.com.au

[By Don Miller, Contributing Writer, Money Morning (USA)]

The never-ending hunt for higher yield is leading investors to bet record amounts on emerging market debt.

In just the first two weeks of 2012, governments of undeveloped economies from Asia to Africa sold more than $30.6 billion in dollar-denominated bonds according to Bloomberg News.

That’s up from roughly $19.9 billion in the same period last year and the most since 1999, when Bloomberg began collecting data.

Typically, investors shun emerging market bonds during times of uncertainty in favor of “safer” assets like gold and U.S. Treasuries.

But that has started to change.

The Big Move Into Emerging Market Debt

In fact, investor demand is overwhelming supplies as orders have outstripped the amount of bonds being sold.

During a recent auction, the Philippines received $12.5 billion of orders for $1.5 billion of 25-year bonds, pushing the yield down to a record-low 5%. Indonesia sold 30-year bonds at a record-low yield of 5.375% and Colombia sold $1.5 billion of 29-year bonds at 4.964%.

Analysts say the debt crisis in Europe, along with record low yields on U.S Treasuries, has investors on the hunt.

They are now buying the debt of undeveloped nations like Indonesia, Mexico and Brazil, even though credit-rating firms rank them as more risky than their European counterparts

“What we’re seeing is a re-evaluation of sovereign-credit risk, increasingly being driven more by fundamentals than by classifications,” Eric Stein, a portfolio manager at Eaton Vance Corp. (NYSE: EV) told The Wall Street Journal.

According to the J.P. Morgan Emerging Markets Bond Index, investment-grade sovereign emerging-market bonds are yielding an average of 4.7%.

By contrast, Italian 30-year debt yields 7%, while Spanish 30-year debt yields 6.1%.

One reason emerging market bonds are attracting interest is that investors recognise the difference between the debt problems faced by Western economies and healthier emerging markets.

The debt levels plaguing the world’s largest and most developed economies – like the United States, the United Kingdom and France – exceeds 70% of their gross domestic product (GDP) according to the International Monetary Fund.

By comparison, many emerging market economies have debt-to-GDP ratios of less than 40% — including Brazil and Mexico – the two undeveloped economies that have been the biggest sellers.

“The Europeans and the Americans need to borrow a lot more than the Asian countries and they use the money for the wrong thing: to fund somebody’s consumption,” Endre Pedersen, director for fixed-income investments at Manulife Asset Management told Bloomberg.

Emerging Market Upgrades

Indonesia is benefiting from a December promotion to investment-grade status by Fitch Ratings Inc. after losing that status 14 years ago during the Asian financial crisis.

The Indonesia upgrade opens its debt markets to a number of bond funds that had been prohibited from investing in the country. That makes Indonesia an alternative investment opportunity for a whole swath of investors.

Most analysts are speculating that other small economies will soon get the same treatment. Meanwhile, Fitch and Standard and Poor’s earlier this month downgraded the debt outlook for France and 12 other euro countries.

Still, some see emerging market debt as a reasonable alternative to the tiny yields offered by Treasuries and other government-related debt.

U.S. government 10-year notes traded Wednesday at a record low 1.87%. At an auction in early January, Germany sold $4.96 billion of debt that had an average yield of negative 0.0122%, the first time that yields on German debt moved into negative territory.

At those rates it’s not hard to see why many investors are willing to step out of their comfort zones to get a better deal.

Don Miller

Contributing Writer, Money Morning (USA)

Publisher’s Note: This is an edited version of an article that originally appeared in Money Morning (USA).

From the Archives…

Facebook Shares – Notice for Mad Punters: Buy This Stock

2012-02-03 – Kris Sayce

Why Your Money is Better Off in Stocks Than in the Housing Market in 2012

2012-02-02 – Kris Sayce

Why You Should Pay Attention to the ASEAN Bloc

2012-02-01 – Cris Sholto Heaton

Will Australian Property Prices Keep Falling?

2012-01-31 – Dr. Alex Cowie

Is Ben Bernanke Secretly Buying Gold and Silver Stocks?

2012-01-30 – Dr. Alex Cowie

For editorial enquiries and feedback, email letters@moneymorning.com.au

In yesterday’s Money Morning, David Stevenson showed you the most bearish chart in the world – the Baltic Dry Index (BDI).
Well, we think we’ve found one that’s at least as scary. A chart that’s so bearish it just could be a signal that it’s time to buy. But first a recap…

The BDI charts the strength (and weakness) of commodity shipping rates.
Right now the index is on the weak side… the very weak side. As this story from Bloomberg News shows:

“D/S Norden A/S (DNORD), Europe’s biggest publicly trading commodity shipping company, hired a Supramax vessel at no cost other than fuel charges, its first such transaction in a quarter century.”

Then there’s this story from BusinessWeek yesterday:

“Glencore International Plc hired a commodity ship with the operator of the vessel earning nothing and contributing to some of the fuel costs after freight rates for hauling raw materials had their worst-ever start to a year.”

Free shipping! It’s one thing to get free shipping for a book or pair of pants… But free shipping on a Supramax ship that can carry more than 45,000 tonnes of iron ore or grain? That’s something else.
Especially when these voyages can take weeks or months (it takes the world’s largest iron ore miner, Vale do Rio Doce, 45 days to ship iron ore from Brazil to China). So it tells you something about the state of the shipping industry if a firm is willing to give away cargo space rather than wait for a paying customer.

Super-Charged Buying Signal

But it’s not just the BDI that gives an insight into world shipping. And it’s not just commodity shipping either. As the HARPEX index of container shipping shows, container rates are low too… near 2008/09 financial meltdown levels:

The HARPEX index provides similar data to the BDI. The difference is, rather than monitoring the cost of dry bulk shipping (grains, ore, salt, etc.), the HARPEX monitors shipping costs for container ships.
From the 2008 peak, the BDI is down 86%.
As for the HARPEX, from the peak in 2005 to today, the index is down 78%.
Long term buyers of those indexes have taken a bath. And as recent news reports show, low rates are actually sending some shipping firms bust. Those that haven’t gone bust are only just hanging in there.
Shares in U.S. bulk shipping firm, Frontline Ltd [NYSE: FRO] have fallen 81.7% in 11 months.
But that’s exactly why we see both indexes (BDI and HARPEX) as potentially bullish indicators. Here’s why…
If you look at the HARPEX index and a longer-term chart of the BDI you’ll see something interesting. You’ll see they are a super-charged leading indicator.
That is, when the economy shows signs of promise, these indexes don’t just go up a little bit… they take off.
In fact, they tend to rise so quickly, that in the case of the HARPEX it gained 293% in two years… while the Aussie S&P/ASX 200 index gained just 40%.

Leads the Stock Market Up… and Down

But here’s the thing. When something takes off that quickly, it’s hard to keep up the momentum. So even though the stock indexes continued to go up for another two years, by 2005 the HARPEX began to fall… so that by late 2006 it had halved.
A similar pattern happened in 2009/10… the HARPEX index tripled while most stock indexes gained 50-100%.
But now, with both shipping indexes heading towards rock bottom that tells us it could be a great time for you to look at adding volatile high-growth stocks to your portfolio. For the simple fact that when you give stuff away for free, you can’t go much lower.
Shipping rates can only go up from here. Firms will go bust and excess ships will go to the scrap heap. That will leave surviving firms in a much stronger position. And hopefully allow them to raise their rates again.

That will take time. But remember, this isn’t the only hint we’ve had that the market could be at a turning point.
Other leading indicator indexes are flashing buy signals too. We’ve showed you the energy index and the oil services index. Both are near multi-year lows.
That means we’re approaching the stage when – as Slipstream Trader, Murray Dawes puts it – sellers become exhausted. That’s when you get buyers flooding in looking to pick up bargains.
Naturally, buyers don’t always get the timing right. At any point in time, buyers buy because they think they’ve spotted the bottom of the market. But sometimes the market keeps falling.
Yet a point comes where the upside risk is so much greater than the downside risk that it’s worth taking a punt. And right now the indicators and numbers are stacked up in favour of a rally.
Of course, it’s still a big risk. But right now, the potential for big returns is so great we’re happier being a buyer than a seller. And one of the best places to magnify your returns in a rising market is small-cap stocks.

Time to Buy Stocks

The built-in leverage that small-cap stocks provide means they tend to move fast when a market recovers. Simply because investors are happy to take risks.
The only thing remaining is to figure out which stocks are likely to do best in this rally.
That’s something we’ll discuss with attendees at ‘After America’ – the Port Phillip Publishing investment conference – next month. If you haven’t reserved your place yet, it’s not too late. Click here for details…
Cheers.

Kris.

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Today, the Reserve Bank of Australia meets for the first time this year. I’ve spent the last week reading the papers as they make a case for a rate cut this week.

Most papers are keen to analyse the data you’re familiar with, like gross domestic product, retail trade data and inflation-related data. But they ignore another measure of our economy that I believe is a very good indicator of the action the RBA will take on rates.

The thing is, when this economic indicator goes ‘up’ interest rates tend to follow it higher… and when it goes south… well, a cut in the cash rate isn’t far behind.

Glenn Stevens, the governor of the Reserve Bank of Australia, mentions the ‘terms of trade‘ when a policy decision has been made. At the September 2011 meeting, he said it’s ‘…now at very high levels and national income has been growing strongly’.

And he referred to it again when the RBA cut rates at the December meeting: ‘The terms of trade have now peaked and will decline somewhat in the near term, but they remain very high.’

The terms of trade simply reflects the relationship between the prices of exports and imports. So an increase in the terms of trade reveals that export prices are increasing faster than import prices.

I bring the terms of trade up because of the effect it has on Australia’s economic growth.

It’s not the standard measure of economic growth you read about in the papers – GDP (Gross Domestic Product).

The terms of trade is another economic growth measure calculated by the Australian Bureau of Statistics – Real Gross Domestic Income (Real GDI).

The chart below shows these two measures of quarterly national income plotted against each other. GDP is the dark line and Real GDI the light line.

As you can see, when factoring in changes to the terms of trade, Australia’s economic growth is much more volatile. Since 2003, it’s been much stronger than the standard GDP measure would suggest.

Now, look at the chart again and focus on the last few years. Real GDI plummeted in 2008 and early 2009 as China’s economic growth slowed and commodity prices collapsed. But by the time China’s stimulus worked its way through the system, in addition to Australia’s own stimulus spending, Real GDI rebounded strongly.

On this measure, by mid-2010, Australia was experiencing its strongest rate of growth since 1997. Now that may seem absurd given the weak conditions experienced across large parts of the economy.

And yesterday’s retail trade data was the worst in decades.

Despite manufacturing data in January suggesting minimal growth, Toyota sacked 530 Australian workers. Reckitt Benckiser, the company that owns brands Mortein and Dettol shifted its production lines offshore, along with almost 200 jobs. And Westpac shed 560 workers.

And that was just one week!

But that growth in Real GDI was thanks to a soaring terms of trade. And the benefits were felt almost exclusively in the resources sector.

Governor Glenn Stevens is always talking about the terms of trade and its impact on national incomes. So I reckon the Reserve Bank looks very closely at Real GDI when setting interest rates each month.

That’s why rates were slashed in 2008 and then increased more than anywhere else in the developed world in 2010, in line with the sharp downturn and quick reversal you see in the chart above.

If we look at the fourth quarter data (not charted) it tells us that export prices fell 1.5%, meaning the peak in terms of trade is now behind us.

As a result, Australia’s Real GDI – our ‘income’ – has fallen. The further our Real GDI falls, the more likely the RBA will lower interest rates to offset the fall in national income.

You make think falling interest rates is good news. And that’s the way the media will portray it. But it wasn’t good news in 2008 and it won’t be in 2012 either. Falling interest rates are a sign the Reserve Bank has run out of ideas on how to keep the economy moving at the same speed we’re used to. And you should get ready for it to falter.

Greg Canavan
Editor, Sound Money. Sound Investments

From the Archives…

Facebook Shares – Notice for Mad Punters: Buy This Stock
2012-02-03 – Kris Sayce

Why Your Money is Better Off in Stocks Than in the Housing Market in 2012
2012-02-02 – Kris Sayce

Why You Should Pay Attention to the ASEAN Bloc
2012-02-01 – Cris Sholto Heaton

Will Australian Property Prices Keep Falling?
2012-01-31 – Dr. Alex Cowie

Is Ben Bernanke Secretly Buying Gold and Silver Stocks?
2012-01-30 – Dr. Alex Cowie

Could this be the most bearish statistic in the world right now?

Over the past month, one of the world’s key leading economic indicators has tumbled in value by 60%.

That’s not a misprint.

So what is the Baltic Dry Index (BDI) all about? And is this plunge something we should be worrying about?

The Baltic Dry Index Has Tumbled

The BDI is a key barometer of global freight activity. It’s published by London’s Baltic Exchange, the world’s leading market for buying and selling shipping contracts.

The BDI covers 26 major shipping routes. It measures the cost of transport space (shipping rates) on so-called ‘dry bulk carriers’. These carry cargoes of raw materials such as coal, grain, timber, steel and iron ore.

If the BDI rises, it indicates that shipping rates are rising, due to increased demand for transport space for raw materials. If more raw materials are being shipped, it suggests that factories are seeing higher demand for their finished products and so are planning to make more.

This makes the BDI a key leading economic indicator. Rising shipping rates suggest that manufacturing activity is improving, even before it shows up in the official statistics.

On the flipside, a drop in the BDI could suggest that worldwide demand for shipping space – and therefore, for raw materials – is falling. That in turn indicates that the global economy must be about to slow down.

But 2012 has already seen something much worse than a mere slip. The BDI has collapsed in just a month, as the chart below shows.

And if you drill into the details, the picture looks even bleaker.

Some of the world’s biggest ships are known as Capesize vessels. They are so called because they’re too big for the Suez Canal and have to travel around the Cape of Good Hope or Cape Horn.

Shipping rates for these vessels have plunged by an incredible 75% so far this year.

So is the global economy about to implode?

The answer isn’t quite that simple. For one thing, the BDI can be very volatile – much more so than the economy overall. Previous massive drops in the index haven’t always resulted in a re-run of the Great Depression.

That’s because the BDI isn’t just about transport demand. It’s also about transport supply. Remember, the BDI measures the cost of hiring space on a ship. So if you double the number of ships, then demand for raw materials could remain static and perfectly healthy. But shipping rates, and therefore the BDI, would (in theory) fall in half.

And the fact is that right now, there are far too many ships in the world.

Prior to 2008, when the global economy seemed to be booming, dry bulk ship owners got rather over-excited. They convinced themselves that the good times would last for several more years. So – pretty much all at the same time – they placed lots of orders for ships.

Many of those vessels have now been completed and are becoming available for hire. Extra shipping space equivalent to 23% of the existing fleet is due to be delivered this year, according to Macquarie Research. That’s “too much capacity in the face of more modest growth of trade volumes”.

In other words, it’s no great surprise the BDI has fallen back. What’s more, says Credit Suisse, there’ll be no respite from the oversupply of dry bulk ships until next year at the very earliest. Even then, the existing fleet will still grow by 9% as new ships are delivered. That could still be tough for the market to absorb.

Clearly, this is all bad news for ship owners. But surely it means that the rest of us can just ignore this scary message from the BDI?

Actually, no, we can’t. The trouble is that the extra ships aren’t enough by themselves to explain this plunge. As Louis Basenese points out on Wall Street Daily, the Harpex – an index of shipping rates for container ships, which carry finished goods – has also plunged, even although the supply of container ships is little changed in the past six months.

Meanwhile, Nick Bullman at risk consultant Check Risks tells Financial News that “this collapse looks similar to the falls we saw in the Baltic Dry ahead of the recessions of the late 1970s and early 1990s – but this drop is actually steeper.”

Continues Bullman: “this is signalling… that the world economy is slowing down much more quickly than people have been thinking.”

Why? It all points to China. The country is the biggest importer of raw materials and we know it’s slowing down. This plunge in the BDI is another reason to believe that China can’t avoid a hard landing. That’s bound to have a knock-on effect all around the world.

David Stevenson
Associate Editor, MoneyWeek (UK)

Publisher’s Note: This is an edited version of an article that originally appeared in MoneyWeek (UK).

From the Archives…

Facebook Shares – Notice for Mad Punters: Buy This Stock
2012-02-03 – Kris Sayce

Why Your Money is Better Off in Stocks Than in the Housing Market in 2012
2012-02-02 – Kris Sayce

Why You Should Pay Attention to the ASEAN Bloc
2012-02-01 – Cris Sholto Heaton

Will Australian Property Prices Keep Falling?
2012-01-31 – Dr. Alex Cowie

Is Ben Bernanke Secretly Buying Gold and Silver Stocks?
2012-01-30 – Dr. Alex Cowie

“What were you on about yesterday anyway?” a friend asked at dinner last night.

“With what?”

“The whole Glencore and Xstrata thing. Sometimes I can’t figure out why you put that stuff in your letter. It makes no sense.”

“Oh. Well, my point was that when you can’t figure out any other way to make more money, you announce a merger. It makes you look busy. Everyone gets excited. You say you’re creating more shareholder value. But really you’re just trying to find efficiencies or “synergies” to squeeze a bit of extra profit out of the business…because the easy profit growth is gone.”

“You should’ve just said that.”

Yep, we should have. So we just have. And today, more proof that the days of easy money selling dirt and coal to China are over. First cab off the rank is the Reserve Bank of Australia’s index of commodity prices. Have a look below.

What you see above is the biggest downturn in the RBA’s commodity price index since the big crash in 2008. Mind you it doesn’t look quite as severe, at least not yet. Last time around in 2008, the rush to cash in global markets caused people to sell a lot of their speculative commodity positions. Base metals in particular got smashed.

Base metals – lead, zinc, copper, nickel, and aluminium – make up 15.7% of the index, according to the RBA. Metallurgical coal (for steel making) makes up 14.7%, iron ore 9.3% and thermal coal (for power plants) makes up 9.7%.

If metals consumption in China is really peaking – the claim we made yesterday – it’s not hard to imagine the index crashing again. And if the index crashes again, it won’t be good news for base metals producers or explorers.

But let’s not be a Danny Downer. Oil is omitted from the RBA index. LNG is included (4.8%). But unconventional energy is not. In other words, a whole sector of the commodities complex that’s in a long-term bull market isn’t measured by the RBA’s commodity index. Do you realise what this means?

It means the RBA’s commodity price index can go suck an egg for all we care. If energy – oil, gas, uranium, and coal – is going to be the most important sector of 2012, the RBA index won’t tell you anything about it. All the RBA index will tell you is if base metals price crash and China’s metals demand has peaked.

We’ll be keeping an eye on it. But in the meantime, one more note about the RBA. It announces its decision on interest rates today. Will the bank cut the cash rate from 4.25% to 4.00%?

That’s an interesting question. But is it relevant? ANZ is just one of the Aussie banks to go on record and say that the RBA’s price of money isn’t what ANZ pays. See the 12 December 2011 Daily Reckoning for more on this. This is the banks’ way of saying they’re not obliged to match the RBA’s rate cuts point for point.

It’s kind of quaint to think there are some people in Australia who think the RBA actually controls the price of money. But some people do! Take Ged Kearney for example. He’s the president of the Australian Council for Trade Unions (ACTU). Kearney told the Herald Sun…

Last year the big four banks made profits of $25.2 billion – easily more than the rest of the banking sector combined. They now have a greater share of the home lending market than before the global financial crisis….If the banks cannot behave in a socially responsible manner, it may be time to consider stronger government regulation to drive greater competition, improved consumer protection and more sustainable corporate behaviour in the banking sector.

Heaven forbid that we’d defend the banks in this space. But someone might want to tell Mr Kearney that Moody’s has just released a report claiming that Australian banks are the “most exposed” banks in the Asia-Pacific to a worsening of Europe’s sovereign-debt problem. What exactly does that mean?

Before you go bagging out Moody’s for being an unreliable ratings agency that shouldn’t be trusted, consider the main point in the note. Moody’s isn’t worried about the amount of European government debt Australian banks own. That’s not the problem. The problem is that Australian banks get at least 19% of their funding externally.

In a genuine liquidity/credit crisis, external funding a) gets more expensive, b) dries up for all but the highest credit-quality borrowers. The cost of money goes up and there’s less of it to go around, in other words. This is why banking is a lousy business in a credit depression and why bank stocks make lousy investments.

By the way, we’d started to go into detail examining the current situation in Greece and Europe…but to be honest, we just couldn’t bear spending another precious second analysing a situation that’s so hopelessly doomed…and so cynically and horribly mismanaged. As our colleague Dylan Grice at Société Générale writes:

Flawed thinking got us into this mess. But rather than change that flawed thinking, our policy makers are applying it with even more rigour: we have more debt for insolvent borrowers, more financial engineering, more complicated banking regulations, more blaming speculators for everything, more monetary experimentation by central banks. Our policy makers have absolutely no idea what they’re doing, but they’re giving it a go!

Grice refers to the “Lost Pilot Effect”. That’s a term invented by behavioural psychologists to explain a certain kind of irrational behaviour. You see it when a pilot gets lost but tells his passengers, “I have no idea where we’re going…but we’re making good time!”

There’s no point in hurrying along somewhere if you don’t know where you’re going. And it’s even more insane to hurry along to a place where you don’t want to be! The best move, if you’re lost, is to get out a map and a compass and find out exactly where you are.

Hopefully Dylan will bring his map and compass with him to Sydney next month. He’s one of our four keynote speakers at the After America conference. We invited a thoughtful group of keynote speakers for our first conference for a reason. We want you to hear from people who can help will help you figure out where we are on the map.

The particular map we’ll be looking at is the Asia-Pacific region. The main players are China, the United States, and Australia. It’s a big map. It covers a lot of territory. There’s a lot to talk about. But hopefully the conference is small enough – only space for 344 attendees – that we’ll be able to really dig into some of these ideas.

By the way, we’re opening up the conference to the general public later this week. You can still get the early bird price of $799 for a few more days. After that, the price moves up to $999.

It’s been an eye-opener organising a conference around one big idea. One mistake we realise we made is not giving people enough time to make travel plans and arrangements. We won’t make that one again! In fact we’re already planning next year’s show.

Another concern is location. Up until now, all of our events have been in Melbourne because that’s where we are. We thought an event in Sydney would make it easier for readers in New South Wales and Queensland to attend. Hopefully we can have events in Brisbane, Perth, and Adelaide too. But maybe not this year.

Price is an interesting one. One friend told us that for the line-up we had put together and the small crowd and the number of new ideas from Port Phillip Publishing editors, the price seemed too cheap. Another financial professional told us that when you factored in travel and hotel arrangements, the price was too expensive.

Either way, this is not a money-making venture for us. For five years we’ve been having a conversation with you about Australia’s future. We thought it was high time to set aside a few days, invite some guests, and really talk about it, including some specific ideas. It’s going to be a cracking show.

One of our other keynote speakers is Dr. Paul Monk. Like Dylan, Dr. Monk is interested in how we think, how we make decisions, and the quality of our knowledge. In the article below, he reviews Daniel Kahneman’s latest book on how we think.

The Brain: A machine for jumping to conclusions
By Paul Monk

Daniel Kahneman’s Thinking, fast and slow should be required reading for everyone this summer. Not because it is entertaining or a mere diversion, but because it is a subtle and beautifully scientific guide for the perplexed. If you see yourself as a citizen in a democratic polity, read this book. Self-indulgent cynics and self-important ideologues probably won’t read it, but they are the ones most in need of what it has to teach. Do yourself a favour, whoever you are: rush out, buy this book and read it quietly and thoughtfully, absorbing its highly readable insights.

Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002 for his work on prospect theory. To understand what is meant by this, how Kahneman got into thinking about it and what his key insights were – in collaboration with his long time research partner Amos Tversky – go straight to chapter 26 ‘Prospect Theory’. It’s a fascinating excursion into clear thinking all on its own. Prospect theory is about gambling, risk-taking and expected returns. It’s a body of theory with considerable practical relevance to the king-sized mess both welfare economics and financial markets got themselves into by the late 2000s.

Kahneman re-examined the fundamentals of utility theory, articulated by Daniel Bernoulli, almost three hundred years ago. He did this long before the past decade or two’s extravagant follies came close to wrecking economies from California to Greece. Utility theory lies at the foundation of modern economics and there is a rather urgent need right now to understand what has gone so awfully wrong in so many economies. Falling back on Marxism or some kind of self-satisfied ideological cliché does not amount to such understanding. Kahneman confers considerable understanding. That’s why he deserved his Nobel Prize.

Thinking, fast and slow has five parts: Two Systems, Heuristics and Biases, Overconfidence, Choices and Two Selves. It also contains, as appendixes, two of the classic papers for which Kahneman won his Nobel: ‘Judgment under Uncertainty’ and ‘Choices, Values and Frames’. Part I sets cognitive science in an easy to understand frame of reference which acts both as a disciplined corrective to a good deal of pop psychology and a lucid introduction to the theoretical work in the following four parts of the book.

He suggests that we think of our brain – our “machine” for making judgments – as consisting of two basic systems; which he calls System 1 and System 2. He describes the characteristics of each and explains how their faults and standard ways of interacting result in many kinds of error, bias and illusion – universally and predictably, not in merely unusual or idiosyncratic cases. System 1 is the intuitive, unconscious, fast reaction part of the brain. It is emotional, holistic and instinctual. It is, as he expresses it, “a machine for jumping to conclusions”.

In certain circumstances and often in everyday life, its functions are reliable, rapid and even remarkable. But when it comes to matters that require complex, abstract thinking it is in deep trouble. System 2 is better equipped – if trained and switched on – to handle such matters. The problem with System 2 is that it is lazy and highly inclined to rationalize rather than critically examine the intuitive judgments of System 1.

In Parts II, III and IV of the book, drawing upon the work of many psychologists and cognitive scientists, Kahneman offers an endlessly fascinating dissection of the brain of Homo sap. The chapters include ‘The Law of Small Numbers’, ‘Anchors’, ‘The Science of Availability’, ‘Availability, Emotion and Risk’, ‘Causes Trump Statistics’, ‘Intuitions vs Formulas’, ‘Risk Policies’ and ‘Frames and Reality’. And at every point Kahneman exhibits a demeanour at once keenly curious, meticulously scientific and utterly unpretentious. The implications of what he imparts are enormous and need to be digested by our education systems (not least all business administration courses), our public policy systems and our methods for public debate.

An indication of the ways in which such insights can be applied was offered several years ago, in Richard Thaler and Cass Sunstein’s Nudge: Improving Decisions About Health, Wealth and Happiness. Originally completed in 2007, it was reissued in 2008 with a Postscript titled ‘The Financial Crisis of 2008′. They drew attention to the alarming reality that almost no economists or financial analysts had foreseen the crisis, or issued public warnings as it approached. They praised the behavioural economist Robert Shiller for having done so.

Shiller’s warning in 2005 had been that “social contagion” was creating a massive housing market bubble that would inevitably burst. Shiller’s books, Irrational Exuberance (2000) and The New Financial Order: Risk in the 21st Century (2003) are recommended reading. Thaler and Sunstein’s own observation is that sound public policy, informed by the insights of cognitive science and behavioural economics, needs to invent ways (they suggest a number) to prevent or defuse such outbreaks of social contagion, or what Charles Mackay long ago called ‘extraordinary popular delusions and the madness of crowds.’

As Michael Lewis’s peerless writing shows, a little thoughtful analysis can reap enormous dividends. If markets and capitalism are to flourish and the costs of human stupidity are to be contained in future, then many things will need to be rethought and reformed. Lewis’s latest book, Boomerang: The Meltdown Tour, a characteristic tour de force shows this from Iceland and Ireland to Greece, Germany and California. If you don’t read Kahneman this summer, you simply must read Lewis.

Kahneman, meanwhile, is hard at work trying to engineer better thinking in the marketplace, or at least to nudge the unwilling and unwitting in that direction. He is a partner in a firm called Greatest Good, committed to applying cutting-edge data analysis and the insights of behavioural economics to real business challenges. His associates are a highly impressive group of people, including Steven Levitt (of Freakonomics fame), innovative economists Gary Becker and John List, the checklist manifesto man Atul Gawande and the brilliant theoretical physicist Lisa Randall. Now that, to paraphrase Groucho Marx, is a club of which I’d like to be a member.

About the author: Dr. Paul Monk has a PhD in international relations from Australian National University. Paul worked for the Australian Department of Defence and the Defence Intelligence Organisation, where he later became head of China analysis and chairman of the inter-agency working group on China. He is a keynote speaker at After America: the Port Phillip Publishing Investment Symposium, March 14th-16th at Sydney’s Intercontinental Hotel.

Regards,

Dan Denning
Editor, The Daily Reckoning

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Will These Commodities Help You Claim The Best Investment Gains Of 2012?

[By Matthew Partridge, Contributing Editor, MoneyWeek (UK)]

What’s been the main driver of the gold bull market?

Low interest rates? Fear of inflation? Currency wars?

Each of the above has certainly played a role in gold’s decade-long winning streak.

But, according to a fascinating new piece of research from US fund manager GMO, the biggest reason for gold’s rise is something that most investors still don’t fully understand.

And it suggests that gold’s bull market could have some way to run…

Who’s Been Buying All the Gold?

Gold bears often argue that the gold market is now at the mercy of demand from speculative investors, who have piled into exchange-traded funds (ETFs), chasing gold higher. The danger is that if the market turns sour, they could pull their money out en masse and send the price plunging.

But according to a study by Amit Bhartia and Matt Seto of US investment firm GMO, the majority of physical gold purchases in the past decade have not come from speculators in ETFs. Indeed, ETFs only account for a tiny fraction (around 7.5%) of the near-30,000 tons of gold purchased between 2000 and 2010.

The demand didn’t come from developed market investors or central banks either – in fact, central banks have been net sellers.

Instead, nearly 80% of the total demand for physical gold has come from retail purchases in developing markets. China and India’s combined demand alone amounts to more than that of the entire developed world.

In other words, “the main driver for gold’s dramatic rise has been the emerging markets consumer”, say Bhartia and Seto.

Why? It’s pretty straightforward. While trade liberalisation and the commodity boom enabled emerging markets to prosper, their financial systems have not kept up with the pace of modernisation. Combined with a tendency to save – rather than spend – money, this has led to a large build-up of savings. (Or, as economists call it, a “savings glut”).

Now, what can all these savers in emerging markets do with their savings?

One solution is to invest it abroad. Some argue this led to the low interest rates that drove the credit boom in the US and Europe (as money from Asia flooded into US Treasuries and the like, driving down bond yields). However, capital controls mean that investing savings abroad directly is not really an option for retail investors. And the domestic stock markets – particularly in China – are far too volatile to be trusted with your life savings.

There are of course domestic savings accounts. Unfortunately, in many countries the banking system is either corrupt or state-run. Negative real interest rates (i.e. adjusted for inflation) making saving money little better than burning it.

The final course left is to invest savings in hard assets. Property has proven popular. But with prices – in China at least – at record levels, and now starting to fall, this has become less attractive. That leaves gold.

“Combined gross savings in China and India increased from $557bn in 2000 to $3.4 trillion in 2010,” say Bhartia and Seto. In short, there was a huge rise in the amount of money available to invest, “and given the lack of good alternatives, gold was a preferred choice.”

What Does this Mean for Gold Prices?

You might assume that the tough patch that the Indian and Chinese economies have seen would therefore hit the price of gold. Not necessarily. Economic problems in these countries could in fact encourage people to double down on gold, especially if the banking systems and the property markets bear the brunt of the damage.

Indeed, there is already evidence that far from reducing demand for gold, the collapse of informal lending networks and the end of the property bubble in China have pushed investors further towards precious metals. Year-on-year sales of gold in China increased by nearly 50% in the holiday period from 22 to 28 January.

Gold sales in India also rose strongly last month. Meanwhile, there have been unconfirmed reports that its central bank will pay for its energy supplies from Iran in gold, in order to sidestep sanctions.

That raises the prospect of other potential threats to the gold price. Beijing seems to be becoming increasingly uneasy about domestic money going into gold purchases rather than low-yielding bank accounts. At the end of last year, the Chinese government closed down all but two of the myriad of domestic financial exchanges where gold was traded. Although this doesn’t directly affect individuals, it could be a first step toward restrictions on retail investors.

On the other hand, a more open financial system could also impact on emerging-market demand for gold. If capital controls are reduced and Indian and Chinese citizens had more freedom to invest abroad, their demand for gold could drop. And if emerging-market consumers start spending more and saving less in general, then this could hit demand for all savings products.

The Gold Bull Market Looks Set to Continue

However, no significant reforms are anticipated, while capital controls are likely to get tighter – not looser – in the near future. Therefore the short-term prospects for gold are excellent.

Plus, as Bhartia and Seto point out, the importance of the emerging-market consumer means that those who argue that gold has become a hugely crowded trade among investors in the developed world are simply wrong.

“This analysis indicates that ‘conventional wisdom’ demand is far from saturated.” Both central banks and developed world portfolios have a lot of catching up to do, suggesting that “gold prices may very well experience another leg up.”

We’ve long been fans of gold, and the GMO paper does nothing to change our minds on that.

Matthew Partridge

Contributing Editor, MoneyWeek (UK)

Publisher’s Note: This article originally appeared in MoneyWeek (UK).

Sick of all the jabber about the Facebook IPO?

How can a company that makes $1 billion a year be worth $80–100 billion to the market? And who cares? You’ll have to go through a whole lot of rigmarole to invest in it even if you want to.

So rather than join the hype and speculation, we thought it might be more valuable for you if we looked back at what happened when a similar stock went public in Australia…

You know what we’re talking about…

Telstra Corporation Limited

It might seem like a stretch to compare Facebook with Telstra. But when you think about it, it’s really not…

You see, in its heyday, Telstra offered the latest in communication technology…

In fact, it gave you a way to keep in touch with your friends, your family, your business acquaintances via your home phone, mobile and email… It gave you a way to say hi, share news and photos, invite them to your birthday party, or tell them about your lousy day at work – pretty much what Facebook does.

And like Facebook, Telstra makes a fair chunk of its money selling ad space in the Yellow Pages. (Sensis, ‘Telstra’s wholly owned advertising and directories arm’ produces it). And of course it makes money selling phones, line rental and calls, too.

Do you remember what happened when Telstra first offered its shares to the public in 1997?

This chart (below) of Telstra Corp [ASX:TLS] only goes back to 1999. That’s when the second round of share buying opened to the public. The IPO was in 1997 – and shares were $3.30…

At its height in 1999, Telstra had an average price-to-earnings (P/E) ratio of 30. And cashflow of 51 cents per share.

Telstra Corporation Limited Share Price History

Source: Google Finance

As you can see in this chart, after opening at $8.41 (and treading water for 6 months) Telstra shares began a steady descent that now sees the shares trade for $3.36 each. It’s lost 59.98% of its price in 12 years.

Today, Telstra has an average P/E ratio of around 13… And cashflow of 21 cents per share. And the shares currently trade just above the IPO price of $3.30.

The problem is investors overpaid. And why did they overpay? Because of the euphoria of being the first to buy ‘the next big thing’… The fear of missing out… The promise of blue-sky projections…

And it pushed the share price up 154% on the $3.30 IPO in 1997… Only to see it come crashing down to earth once the euphoria wore off.

Will it be the same story for Facebook shareholders?

Aaron Tyrrell
Editor, Money Morning