Fragile time for the resources sector

by David Taylor

It’s never a good idea to have all your eggs in one basket. Nor is it a good idea to throw all your money behind one horse. Well enough of the clichés but you get my point. Any good project will have a back-up plan or a plan B. Why then does the Australian government seem so complacent about being void of any solid alternative avenue of wealth generation post the mining boom? Perhaps this week may have rattled a few nerves in Parliament House. Towards the end of the week, the spot price of iron ore slumped 5 per cent. It sent the stock prices of Australia’s biggest mining companies tumbling and brought the Australian dollar down a cent or two against the greenback. So what brought on the sell-off? And what does it mean for Australia’s future? Should we be worried? Those who are not ready to see an end to the boom are being optimistic. Those who can’t afford to be caught wearing no pants when the tide runs out though are drawing up contingency plans. This could be serious.

Many years ago I was working as a journalist in a Sydney newsroom. I came in to work one morning and the room was abuzz. Overnight the Shanghai Composite Index had fallen over 5 per cent. Other markets had followed suit. This was well before the collapse of Lehman Brothers – that was to happen later in the year. No this was one of the earlier signs that the share market boom was coming to an end. Back then I was a strong believer that the Chinese economy would happily carry the global economy forward indefinitely. The sheer scale of their economic expansion was unrivalled and there was plenty of cash pouring into the economy on a daily basis. I was not aware, however, that what was developing was more all-encompassing. It was a systemic failure of the contemporary global economic model. Put simply, we would be facing years and years of consumer, business and investor uncertainty.

A contact of mine working in the corporate finance department of a firm uptown told me she’d just dumped her entire personal share portfolio that morning. Again, I was on the defensive, “don’t you know about the China story?” I said. In hindsight I was almost right, but I didn’t realise just how powerful the rest of the global economy would push investor confidence down, or how much it would hurt the Chinese economy as well. It was a moment in time that captured the mood of investors right around the globe - a mood that was to last for some time.

Investors are still nervous. In my view, last week’s iron ore price drop is similar to that drop we saw on the Shanghai Composite. It doesn’t have to say much about anything else than to say that investors are edgy, and there’s a reason for that.

The price of iron ore – Australia’s largest export commodity – slipped 5 per cent in one session to hit a two and a half year low. Miners BHP Billiton and Rio Tinto fell heavily and the Australian dollar hit a 5 week low. Put simply, iron ore is used to make steel, but some steel mills in China are closing down as demand wanes. Indeed as the economy slows further, and the housing market comes under increasing pressure, the demand for the ingredients used to construct buildings and housing is falling away. Iron ore simply isn’t as valuable as it used to be.

The statistics speak for themselves. According to HSBC research, commodities prices reached their peak in 2011, up 50 per cent from mid-2009. Since then, prices have fallen 13 per cent. Even despite that, the Australian economy is 9 per cent larger than it was four years ago. That’s partly because, notwithstanding the decline in prices, Chinese demand is still roaring along. In fact China’s economy is nearly 50 per cent larger than it was four years ago. But the factors that have led to the price declines we have already seen are still very much present, and it’s only a matter of time before they become more problematic.
China has not yet successfully transferred its GDP bias towards consumption spending. In fact it’s still regarded as having an unusually low level of consumption spending as a percentage of GDP compared to other countries. Much of the growth in GDP in recent years has been export-led, and investment driven. That’s where it gets concerning. The two continents helping to drive much of that investment are the US and Europe. Over the past four years the US has only grown around 2 per cent, and the euro economy is actually 2 per cent smaller.

The sharp fall in iron ore prices we saw last week could be the market correcting itself for what it sees as on-going weaker demand from China. Even one of China’s biggest investment banks, China International Capital Corporation, says the commodities super cycle is coming to an end.

There is reason for hope though. Analysts say two factors will drive Australia’s resources sector for the next few years. The first is the number of mining projects still underway throughout the country, currently valued at $260 billion. That money will keep filtering through the economy. There are also expectations of further stimulus from the central banks of Europe and the United States. Investors want them to print more money! Yikes. It’s led some analysts to conclude that this is simply the lowest point in the iron ore price cycle and prices will start to rise towards the end of the year.

Unfortunately, it’s still not enough to completely lift the anxiety felt by some of the politicians in Australia’s largest mining state. Last week the WA Treasurer, Troy Buswell, told the media he’s constantly monitoring spending, and revenue streams in the economy. That’s not a man who’s relaxed about the medium term. And why should he be calm? An end to the mining boom could wipe $1.3 billion off the WA budget’s bottom line.

Whichever way you look at it, it seems obvious that Australia needs a plan B.

David Taylor

Disclaimer

The content in my blog is non advisory, please do not interpret this as advice in any way shape or form. These are just my thoughts and nothing I say should be acted upon.