Paths of recession

As I wrote this morning, I’m of the view that global equity markets have begun to price a forthcoming Western recession. Since then markets have rallied hard on the hope of QE3 tomorrow, which would change the game, but I thought anyway that I would trace the possible lines of weakness in the global economy and see how they lead back to Australia.

I can think of three potential points of transmission of global weakness into the Australian economy. The first is bank funding pressures arising from rising funding costs.  As I pointed out earlier today, big bank CDS prices have risen very quickly:

CDS prices can be seen as a proxy for the banks underlying funding costs. Equally as we have seen over the past year in the context of European sovereigns they can also be used as a pressure point to undermine confidence which then drives funding costs higher in a negative spiral. However, for real damage to transpire, as seen in 2008, funding pressures must remain elevated for an extended period.

Even then, if liability pressures overwhelm the banks, the Australian Federal government can step in and guarantee the debt, making it manageable. That is, so long as the Government retains its AAA rating and, crucially, that markets believe that Australia, unlike the most of the rest of the Western developed world, can actually afford to do so.

The second point of transmission is through a crash in commodity prices. That is going to hinge on what happens in China. The notion that China can withstand western economic weakness is bunkum – Chinese growth will be damaged by any fall in Western consumption via its exports.

The process of  a recession is actually well understood. Following whatever shock it is that upsets a business cycle – whether that be a financial crisis or rise in interest rates – consumers retrench their spending. Businesses suddenly find themselves with excess inventories. They cancel new orders for more stock and begin to draw down on those inventories. This knocks the stall onto production. All businesses begin to sack workers to address a suddenly excessive cost base which feeds back into the negative inventory cycle by hitting demand.

It is similar with the services sector of the economy. People stop spending in restaurants and cafes, stop hiring consultants or having their car washed by someone else. They might even switch from Foxtel to Freeview. But the impact is the same, excess inventory in services and a negative feedback loop until consumers come back and spend.

So, if the Western powers re-enter recession, China losses its biggest customers and markets and by definition Chinese production must fall, just as it did in 2008:

As Chinese production slows,  it’s businesses too will sack workers and its own internal inventory cycle will transpire.  

That will inevitably also damage Chinese demand for commodities and prices will fall, including those exported by Australia. Here are a couple of charts of Australia’s export mix. Firstly, note the dominance of non-rural goods:

 When we break up the non-rural goods exports, we find it is dominated by ores and coal:


Now, I can hear the China watchers amongst you cry “those commodities are for fixed-investment projects” not Chinese export production. And you’d be right. But, I’m willing to bet that any hit to Chinese exports and the subsequent internal business cycle would also result in a slowdown of construction activity, at least for a time, and until the government can launch a new program of bridges to nowhere.

Moreover, it would not take that much of a slowdown in Chinese commodity demand to set off a second inventory cycle, this time in their commodity stocks. During the 2009 recession, for a time China drew down on its commodity inventories as demand fell away. Following is a chart of iron ore stocks at Chinese ports. Note the big dip in late 2008:

Note as well how much higher current ore stocks are. China could easily draw down for a period and severely disrupt iron ore pricing. The same thing could transpire with coaking coal.

However, Australia has one protection from this outcome, the quarterly contract pricing mechanisms for iron and coal would ensure that falls in prices were delayed and, because they’re averaged from the a time series of the spot price, prices would fall more slowly as well. So although falls in the vital bulk commodity exports would thump GDP, they would not do so straight away.

But, that brings us to the third point of transmission. In an economy where one part is “booming” and the other is virtually already in recession, this could be enough to tip the whole economy over as it feeds into what is happening already. Consumption would fall further, even from current weak levels, along with the destruction of wealth in the  falls in the sharemarket, falling house prices and increasing debt revulsion. This could lead Australian business further into its own internal inventory cycle, with all of the rises in unemployment and falls in GDP that that entails.

This is all quite plausible without imagining anything disastrous transpiring in the housing market. Of course, if a housing bust did ensue, things would get very nasty indeed.

Houses and Holes
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  1. Agree totally with what you’ve said. As the US/EU are the two biggest export markets for China if they move further into a prolonged slow down it will at some point impact Australia.

    We were told in China while there in April that the central government will do all it can to stop social unrest and that is one of their greatest fears. Based on that they are trying to develop the centre of China now, but all I could see when I was there were idle building sites, and likewise on rail construction.

    As has been discussed here a few times credit is tight and more is moving to the shadow industry so no one should think China is all roses.

    my 2c

  2. I would have thought Swanny would be making a public statement about the FCS limits soon. Its up for revision on the 10th Oct,
    Oh there it is,
    “The CFR has recommended that the FCS cap should be reduced to a level between $100,000 and $250,000”

    Look for a nice CDS spike around the public announcement.

    Onto todays events, there was rumors around that Asian Central Banks we involved in the huge run up.

  3. Heard Chief Economist of Bank in HongKong (Bloomberg) saying that of course a recession in US/Europe would lead to reduced demand for Chinese manufactured goods, something the Chinese government was well aware of – the Chinese government’s response would be more stimulus, even saying there were still another 5 million or so apartments needed!

    My personal view is that, apart from some sort of armageddon scenario arising, that stimulus is exactly what the Chinese will undertake, for social stability and to ride out a recession of (1,2,3 quarters in the West).

      • Wasn’t trying to debunk – think it makes the likelihood of your third point, an extension of the two-speed economy we currently have, only more extreme a reasonable contender.

          • Indeed. If Rogoff has any influence it will be QE on a major scale but the form will be of interest…

            Also saw Richard Koo again talking up the need for significant and continuing government stimulation, the only way out of this balance sheet recession. And yes, if all this goes ahead put Australia in both an enviable and unenviable position simultaneously.

  4. It could not be clearer now: China is digging their own grave if they keep fixing the exchange rate to the USD. It made sense when the US economy was strong but now it does not anymore.

  5. I’m of the view that global equity markets have begun to price a forthcoming Western recession

    Er, didn’t you get the memo. The recession ended a bit after 11 this morning, and the ASX promptly gained more than 6% in a few hours.

    QE Party!

  6. “rallied hard on the hope of QE3 tomorrow, which would change the game”

    How? I’m looking around me, here on the east coast of the US, and I’m seeing zero from 1 and 2. So how will 3 change anything? Short term stimulus? Pfft. Meaningless.

    • In our case, retail industry is literally the canary in the coal mine… and our miners sent it there.

      • Are you kidding. The miners sent if there? Excessive debt and consumer restraint sent it there. Nothing to do with the miners.

  7. While I agree with your points HH, you haven’t mentioned any policy responses, be they monetary or fiscal, which would undoubtedly be utilised if any of your predictions eventuated.

    A RBA cash rate of 3% or 2% would go a long way to propping up the housing market (just as it did three years ago), so would a no doubt expanded FHOG and some other stimulus spending. Forget the pledge to balance the budget by 2012 or whenever, the government would far rather avoid a recession than have to ditch a promise like that.

    And while inflation is a problem now, if your predictions due eventuate than we can expect falling prices as commodities and demand collapses, including the oil price.

    • it would prop up the housing market assuming that we dont have a Japan type situation where no matter how low rates are people/companies are just unwilling to get into debt…