The Slo-Mo Depression

Here’s a philosophical question to start today’s reckoning: Does your perception of time alter the universe, or even time itself? The question is inspired by the 2012 film Dredd. The film is a remake of the 1995 classic Judge Dredd, arguably Sylvester Stallone’s finest work. Government bond investors should watch both films without delay.

In the 2012 version (the better version of the comic book story), there’s a drug called ‘slo-mo’. You inhale it. And then everything slows down. It alters your perception so that the world passes by at about 1% of the speed you’d normally perceive. The fictional drug probably includes a lot of endorphins or dopamine, so that your vastly slower experience of time is also vastly more pleasurable. (Otherwise, what’s the point of taking it?)

More slo-mo for Europe, please. 50-year government bonds in Spain yielding 4% are the financial market version of slo-mo. It’s a sure-fire way to prevent a deflationary depression from becoming a political and social crisis (revolution). You don’t change the underlying facts of the financial situation. You stretch them out over a much longer period.

The Spanish government sold €1 billion worth of 50-year bonds at the aforementioned yield of 4% overnight. A few years ago, 10-year Spanish bond yields were 7.5%. Australia, by comparison, still enjoys a AAA credit rating on itsCommonwealth bonds. Yet Australian 10-year bonds yield 3.3%. Judging by the convergence, Spain is not much riskier than Australia.

That’s how you solve a sovereign debt crisis, people! You refinance it out past the grave of half the living population. And then you let somebody else deal with it. The Europeans may be on to something. More drugs for everybody!

Later this week, they may be on to something more. The European Central Bank (ECB) meets on Thursday to discuss what other unconventional measures it might take to combat the ‘spectre of deflation’. In June, ECB Governor Mario Draghi took deposit rates negative and announced a ‘targeted long-term refinancing operation’.

Have you noticed that central banks get more and more like the Pentagon every day? They give their policies names as if they were invasions. You had ‘Operation Enduring Freedom’ in Iraq. The ECB gives us TLTRO. What’s next, Operation Deflation Must Die?

For Aussie investors, the ECB’s announcement on Thursday matters more than the lethargic Chinese Purchasing Manager’s data yesterday. Why? It’s all about liquidity. If the ECB announces some sort of Quantitative Easing, it could push government bond yields lower. The flipside of that is that the lower government bond yields go, the more it pushes money into higher-yielding equities.

Of course, it depends on what the ECB actually does. Sovereign bond yields have already moved lower in anticipation of a move. Will the Bank confine itself to purchases of asset backed securities? That would serve the goal of creating more credit. Or will it pull a bunny out of the hat and do something crazy? Stay tuned!

Meanwhile, let’s return to the subject of Australian corporate profits. The seasonally adjusted estimate for company gross operating profits fell 6.9% in the June quarter 2014, according to data released by the Australian Bureau of Statistics yesterday. You can see the data in chart form below. Let me preface it with a claim: We have entered a global era of structurally lower profit margins.

You can’t reach too much into quarter-over-quarter data to determine a long-term trend. But of the 15 industries included in the survey, only three — accommodation and food, construction, and information media and telecommunications — saw an improvement in gross operating profits. The other 12 saw a quarter-over-quarter decline in gross operating profits.

It’s hard to make a buck these days. It may be hard for a good long while.

But there is hope! There is always hope. The ABS also released exploration spending data from the minerals and energy sectors. It wasn’t great news for bulk minerals from Queensland and Western Australia. In trend terms, total exploration spending for minerals fell by 9.6% in the June quarter. It fell by 14.5% in WA. In seasonally adjusted terms, mineral exploration spending fell by 24.5% in Queensland.

The pictures below tell the shifting balance of power in the resource industry. Bulk materials are out. Oil and energy are in. You can see a massive fall in mineral exploration for base metals, iron ore and gold since the peak in 2012. Meanwhile, petroleum exploration is booming.

You can subdivide the petroleum expenditure numbers into off-shore and on-shore. That division makes all the difference if you’re looking for the best punts in the oil and gas sector. For example, South Australia saw a 39% increase in exploration (in trend terms) while the Northern Territory saw a 210% increase (in seasonally adjusted terms). The NT exploration is largely offshore. The SA exploration is largely onshore in the Cooper Basin.

The argument for oil and gas is easy: Energy is a national security commodity. The more unstable the Middle East gets, the more valuable other sources of supply are. Australia has a lot of exploration potential. And onshore gas could be a booming industry, which I’ll come back to in a second.

The argument against mineral and base metal exploration is just as easy: Production volumes from previous capacity expansion are now coming online. In a low growth world, there is already too much supply. Only the high-volume, low-cost producers will thrive. Looking for more ‘stuff’ now is a bad investment.

But back to oil and gas. ‘Refusing to develop coal seam gas as matter of political expediency would cause needless further job losses in a manufacturing sector already under extreme pressure,’ wrote Craig Emerson and Greg Combet in today’sAustralian Financial Review. Both former Labor cabinet ministers may be trying to save their party from following the Greens back to the Middle Ages with a carbon-free energy policy.

‘Saying no to coal seam gas,’they continue, ‘would constitute the worst of all possible worlds: exporting Australian manufacturing jobs to the United States while increasing carbon emissions at home.’ Clearly, neither man ever intends to stand for public office again. Without having to lie to get elected, they can deliver voters some home truths about energy in Australia.

Victoria and New South Wales will face higher energy costs unless they produce more natural gas. As LNG starts to leave from Gladstone later this year to customers in North Asia, domestic Australian gas prices will begin their long climb to parity with international prices. Producers will always choose to sell at a higher price.

That means domestic consumers of gas — some utilities and manufacturers — will face even higher energy costs. Who do you think those costs will be passed on to? Go on…have a guess. That’s right. You. Combet and Emerson agree that the solution to higher prices is more gas. But politically, there are lots of obstacles, given the shrill and non-scientific nature of the debate over shale gas.

I’ll leave those obstacles for tomorrow, though. Also tomorrow, more on whether your money in the bank is really yours. A lot of handy links have come in to clarify the matter. I’ll do more research and present the results tomorrow. Until then!

Dan Denning+
For The Daily Reckoning Australia

Read the rest of this article at The Daily Reckoning