The Global Banking System, On the Road to Fragility

The market has called Bernanke's bluff. The melt-up is on. After spending the past few months trying to convince the market that the US economy is improving, putting an end to QE and zero interest rates, the market isn't buying it.

It's seeing more of the same. That is, an economy keeping its head above water, which keeps inflation subdued, which gives Bernanke cover to maintain his US$85 billion a month QE program. It doesn't get much better for the speculators...and make no mistake it's the speculators driving this market.

To new highs, we might add. As the Wall Street Journal reports:

'The Dow Jones Industrial Average broke a three-session losing streak, climbing 128.48 points, or 0.8%, to 15628.02, to top last week's peak. The blue-chip average has set 29 closing highs this year, the most since 34 in 2007, the year stocks peaked before they plunged during the 2008 financial crisis.
'The S&P 500-stock index added 21.14 points, or 1.3%, to 1706.87, rising over 1700 for the first time to notch its own record, its 24th this year.'

As we said, it's a melt up. The economic news is just good enough to keep the speculators in the game but not so good it brings about any real fear of tapering...or any lasting fear at least.

To give you an idea of what passes for acceptable these days, Chinese manufacturing data buoyed the market yesterday because it came in at 50.3...only just signalling expansion (anything over 50 indicates expansion). At the same time, the 'non-official' HSBC reading came in at an 11-month low of 47.7. The market chose to go with the glass half full viewpoint, no doubt influenced by Bernanke's very dovish monetary policy statement that preceded it.

Regardless of Bernanke's words, the Asian region remains a drag on global manufacturing growth. Here's a summary of the manufacturing PMI data from JP Morgan:

'National PMI suggested that the Asia region was the main drag on global manufacturing growth during July. Production volumes declined in China, India, Taiwan, South Korea and Vietnam, stagnated in Indonesia, while growth slowed to a five-month low in Japan. Elsewhere, Spain, Brazil, Russia, Mexico, Australia and Greece also reported contractions.
'In contrast, output growth hit a four-month high in the US, near two-and-a-half year high in the UK and returned to expansion for the first time since February 2012 in the eurozone.'

So while most of the traditional global manufacturing centres appear to be slowing, it's the highly indebted developed nations generating growth. Maybe QE works after all!

We jest of course. QE doesn't solve anything. It gives the appearance of solving problems in the short term while it studiously works away at long term ruination.

Our friend Dylan Grice (who presented at Port Phillip Publishing's inaugural investment conference in 2012) wrote about this in the latest issue of the Edelweiss Journal. Citing Nassim Taleb's recent book, 'Antifragile', Grice says, 'Before each episode of instability was an episode of stability.'

But the problem is that the episode of stability is a manufactured one. A bit like QE. It's stabilising the situation for the time being...for how long it can do so is the question.

Grice continues:

'During each manufactured stability, absence of evidence was mistaken for evidence of absence. Furthermore, in each episode subsequent events revealed the manufactured stability to have been manufactured with shoddy engineering techniques. The theories used to guide policy were simply wrong.'

This makes it terribly hard for investors (as opposed to speculators) to make rational decisions in today's market. People with a sense of history know this will all end in tears. But the question is, when? Do you run with the bulls and risk getting trampled, or sit on the sidelines and miss out on all the fun? There is no easy answer to these questions.

Our mate over at Money Morning, Kris Sayce, has remained steadfast in his belief that central bankers would continue to pump asset prices higher, and subscribers of his publication, Australian Small-Cap Investigator, are loving it. But even the biggest bull in the office reckons you should only punt around 10% of your capital on small caps.

And then you have to take into account that Australia isn't the US. Our financial market hasn't (yet) taken over government and the RBA, and it can't do much about our proximity to China.

This is why the Australian share market isn't 'melting-up' in the same way as the US. What's more, we have a dysfunctional government scrapping their way toward an election, introducing new taxes almost daily as their finances deteriorate just as quickly.

The Financial Review reports today that in the current financial year, the federal government's revenues could be around $30 billion LESS than previously expected. To plug this hole, the government is making changes to Fringe Benefits Tax, tobacco excise and, as announced yesterday, an insurance 'levy' on bank deposits.

Of course, any such levy will be passed on to savers, providing another disincentive to be financially prudent. It's argued that Australia should impose a levy, because, well, other countries around the world have one too. But it's insurance savers are forced to pay, whether they want it or not.

Does such a levy make the system stronger, or weaker? Well, consider this. When a bank is insolvent, it means its equity holders are wiped out. That represents around 5-7% of the bank's assets. After the equity holders you have unsecured and secured lenders to absorb losses before you move onto depositors.

At a prudently run bank, with genuine lender of last resort backing from the central bank, it would be extremely rare to call on depositors to take a hit on a banking collapse. Not impossible, but rare.

Is it the government's job to 'protect' depositors? We thought that was the role of the bank's management and board in running a prudent operation.

This is all about injecting 'confidence' into a fragile global banking system. It's not just a tax grab. It's just another example of the abrogation of personal and corporate responsibility to the nanny state.

Make mistakes, but don't worry....the government will bail you out. And if a bail out is never required? Will the government ever return the levy to the savers who paid it?

Of course not. So you're forced to pay a levy you don't want to pay, to receive protection you never asked for, for the government to eventually use in a totally unrelated way?

It reminds us of a quote a reader sent in earlier this week:

'I sit on a man's back, chocking him and making him carry me, and yet assure myself and others that I am very sorry for him and wish to ease his lot by any means possible, except getting off his back.' - Leo Tolstoy

To finish off the week, here are a few more of your responses on the topic of residential property:

'Opinions on property are like the proverbial: everybody has one. Mine is
that one of the biggest problems is also one that is least discussed, namely
Too Big To Fail syndrome. I think that buyers have a general sense
(probably justified) that the government/RBA would rather let the economy go
up in flames than allow house prices to fall.
'One need only look at Britain to see this policy in action: Permanent Zero interest rates, pressure on banks to forbear, taxpayer subsidised deposits for new buyers (or rather vendors) and so on.
'To work properly, markets need the two countervailing emotions: Greed and Fear. Abolish fear and only greed remains.
C'
'Yes, please let me hear your thoughts on the Australian Property Market. Give me something else to worry about besides the Stock Market, The Gold Bullion Market and the current Political Circus.
Regards
P'
'Hello Greg,
'...you have one small problem understanding the retail property market, it's called supply and demand. All the economic theories and imbalances quiet simply fails to address the problem of housing and its cost in Australia, specifically its capital cities and principally Sydney, Melbourne and Brisbane.
'The "land bank" and the cost of development underpin all costs and it is this expense you cannot get your head around. Further to this is negative gearing and a surplus of investment cash that is happy to buy retail property at returns less than bank interest rates, but with a hoped for capital/inflation driven return at a future time.
'You see "gold" as a keeper against "the crash" and many Australians see property the same.
DP'
'The idea that Aussie property will continue to increase in price defies all reason and reality. It is already unaffordable for most people and those who do manage to buy can only do so by indenturing themselves to a bank for most of their working life.
'The banks in turn don't have enough deposits to fund their mortgage lending so are borrowing overseas for short terms to lend for long terms and must keep rolling over their borrowing. With a falling AUD they now have to increase their borrowing just to roll over past borrowing.
'Meanwhile we have the lowest manufacturing sector in the OECD. In addition, over the past three decades our farmers, fishermen and small miners have been reduced to a quarter or less in numbers chiefly through increasing taxes, demands and restrictions. Over the past decade our food prices have increased more than any other OECD country at a rate double the OECD average.
'We have lived extravagantly on inherited mineral wealth but the GFC and economic restructuring in China have ended the commodities boom for the foreseeable future. Cost blowouts exacerbated by government imposed fees, taxes, delays and demands have brought an end to the mining boom.
'Over 10,000 jobs in the coal mining industry in NSW and QLD have been lost in the past 10 months. Very few of those $100,000 p/a workers will find a comparable job elsewhere.
'The party is over. Governments everywhere are faced with growing deficits and increasing obligations with tax revenue at or near maximum yield levels. Australia is no exception and is more dependent on imports than most other nations. With the AUD, commodity prices and demand all declining, the already chronic trade deficit is set to blow out. With more unemployment, decreasing company profits and big new mineral developments finishing up government revenue is set to decline and deficits to only increase.
'With consumers already stretched to their limit by exploding living costs and facing even more, where will the money come from to sustain current house prices much less even higher ones? Houses are a cost of living. Their real condition declines over time. Their productivity is nil.
'In the end extravagant real estate prices are only an increase in the cost of living. Having the most expensive housing in the world in the country with the most unused real estate is an economic travesty. Having most of the nation's capital tied up in unproductive real estate is stupid. Having most of the population indentured for life to the banks just to own a house is obscene.
'Although Australia is indeed the lucky country, luck is by definition not an assured condition. The current economic situation is unsustainable and some fundamental changes are unavoidable. Among them a significant decline in real estate prices is not only a necessity but despite some considerable pain in the process it will be of much greater benefit in the longer term.
WS'