What’s freaked Swan out?

As I posted last night, the Treasurer, Wayne Swan, released a rather dour communique to Parliament indicating that Australia was ready to take on GFC 2.0. The timing of the missive seemed fairly random, though it did obviously seek to bring pressure to bear upon Europe prior to the G20, such as it is.

I also speculated last night that it appeared Treasury was getting a little spooked and was preparing the ground for a shift in expectations about the Budget reaching surplus next year, as currently projected.

If it seems a little odd that Canberra is getting worried just as global markets rally on the notion that we’re passed the worst (notion being the operative word), there is one glaring reason why anxiety might be growing in Canberra: the price action in the iron markets. Increasingly, the miracle commodity is breaking down in both swaps and the spot market and, with two rounds of quarterly contracts yet to be negotiated for this financial year, there is a growing possibility that iron ore is about to blow a hole in the Terms of Trade and the Budget. And that does not even account for the greater exposure we now have to very short term contracts and the spot market.

Here’s yeasterday’s forward swaps contract:

We look dangerously like we’re about to plumb new lows. On the longer term chart, the action is worse:

That looks to me like a double top and obviously the down movement has waltzed through the 200 day moving average as well. Now to the spot market itself:

Yesterday, the market took out the Feb/Mar lows that resulted from the Japanese tsunami sell off. The growing rumblings around China’s real estate slowdown are no doubt to blame.

It is not easy to estimate the impact on the Budget of big moves in iron ore. But the following charts from BHP gives you some idea how important it is to their bottom line. First, iron ore makes up close 50% of profits:

Which also shows up as VERY significant in terms of the vulnerability of profits to commodity price variance:

And remember, it’s much higher for Rio.

Finally, here’s a chart that hints at how significant iron ore is to our Terms of Trade, the latest month’s record exports:

As I’ve said before, iron ore has made a goose of me several times and you never know.  But the signs are not good today. Markets seem to be anticipating bigger problems for China than is currently obvious. Such is life with a narrow dependence.

Houses and Holes
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  1. Diogenes the Cynic

    “Ladies and Gentlemen please assume the brace position for our forthcoming crash landing!”

    If BHP and Rio profits halve then their stocks will be slammed by more than 50%. BHP sub $20 per share on that score…

    • I know. Even though BHP and RIO may appear cheap based on common metrics such as the P/E , PEG and P/B ratios, evidence such as this suggest that commodities are in for a sharp reversal, and stocks such as BHP and RIO will prove to no longer be one of these “too big to fail” companies that benefit from “ever-increasing” demand for commodities.

  2. Perhaps Treasury knows the approach to resolving the financial crisis in Euro is to implement a ‘more of the same’ approach simply won’t work. Add that catastrophe to the mix and the game plan changes dramatically.

  3. Thanks to H&H for bring our attention to this crucial commodity. It was iron ore prices that allowed us to rapidly jack up the savings rate to more than 10% without suffering an economic depression. China’s building binge is unsustainable, and the social housing initiative is widely recognized as a last desperate attempt to keep up the rate of construction. After this piece, there will be no more construction stimuli available in China.

    When iron ore prices fall, our structural CAD will be exposed. If foreigners are unwilling to fund it in this environment, then we will be in the same position as the UK with a hollowed out economy (thanks again to H&H on his recent posts on the death of manufacturing) and overconsumption. We can only look forward to zero-bound interest rates, QE, stagnating economy, rising unemployment and increasing inflation. Not a pretty sight.

    By then, we will realize that the brilliance of Ken Henry’s Treausry and the housing stimulus policies etc, were no cure for our ills. It was morphine administered instead of true medicine.

    I woud really appreciate if H&H can bring us a bit more information on the state of the UK economy. I am afraid that we will be heading their way.

    • Dismal, although I agree with most of your observations, I worry about our reactions to the situation.

      We need to get off our nice comfy chairs, get our backsides in gear to deal with it, and not just allow it to run over us. And in that respect, maybe its’ hats off to Swanee for tipping Aus in general as tp what’s coming..

      • I am all for proactivism. But only for the right kind that will sustain us in the future. As H&H pointed out, our manufacturing is dying. But the government only ever tries to administer morphine. Will this steel subsidy work in the long-term? I doubt it. Why can’t we look to the future, instead of looking backwards? For example, our biomedical industry is first class, but it lacks scale. Recently, one of our few profitable biomed company, the listed CST, was taken over by a European predator. Why couldn’t the government support these companies to grow instead? Samething with the stimulus in 2009. It just reflated a terrible housing bubble that was making us all poorer. It could have supported the supply side instead, or at least used the money for funding infrastructure, but it didn’t. We bought imported plasma screens instead.

        I am pessimistic that we will be able to avoid a bleak future for the next 20 years at all.

      • I happen to a small shareholder in another profitable early stage biotech, Sirtex, which produces a world leading liver cancer treatment. Guess what? Its sales in Australia is next to zero, while the sales are growing rapidly elsewhere.

        I am afraid that this company will suffer the same fate as Cellistis (CST) and be taken over by a foreign predator. It will be fine for me personally, as I will realize a a capital gain. But is it good for Australia? Why can’t the government be bold and set up an cancer treatment centre to service the Asia Pacific? It surely would be world class. That would be a real investment.

        Our government is simply not investing in the future. That’s why we will consistently run a CAD and be at the mercy of the overseas financier. I wouldn’t complain if the government is really hands off, leaving everyone equally to the market. But it would support the housing industry, it would support all those losing industries that it somehow favours.

      • What we don’t need is another keyensian labour stimulus package that can be rorted, poorly managed and leave us further in debt. This time let the RBA do the heavy lifting.

        • What heavy lifting? Lowering interest rates to records lows so we borrow more and more? Our private debt is the major problem facing Australia, not our public debt.

  4. I seriously despair (and doubt) Treasury estimates were based on ore prices at peak – but then again you cannot be quite sure which planet economic modellers are on.

    You say “Such is life with a narrow dependence.”

    I can only remind how fortunate we are to have a resource base to depend on from time to time. What else in the current global economy would you suggest. Realistically.


    Probably this: http://www.theaustralian.com.au/national-affairs/opinion/consultants-lawyers-contractors-all-aboard-the-nbn-gravy-train/story-e6frgd0x-1226165286577

    Cost blow-outs up to $28 billion. If ore (and other commodities) plummet – how to foot the bill!

    It ain’t over, until it’s over – which hopefully won’t be any time soon. (Calamities excluded).

    • I don’t know what sort of buffer they build in but if their rhetoric is anything to go by then not much. Then again, Howard/Costello had constantly to upgrade forecasts so they were under pricing then.

      But whatever buffer they’ve priced, ore is falling and looks set to fall further. That’ll make em nervous.

      I didn’t say this was the end did I?

      It may be the end of this cycle, though.

    • I think the NBN is a very important story to watch.

      I smell a huge rat in relation to the possibility of implemetation delays and blowouts.

    • To be honest 3d1k, ever since The Australian declared in an op-ed that it is their mission to “destroy” the NBN, I would take any reports they make on it with a grain of salt.

      Just sayin.

      • J2, I for one am glad The Australian leaves no press release unexamined when it comes to the NBN. There is little other challenge around MSM to various claims, lack of government transparency, lack of cost benefit analysis etc.

        Not only The Australian questions the form and function of the NBN, Malcolm Turnbull is doing a fine job keeping Conroy in anxiety mode.

        Big projects are my thing you could say and on this one I’m with Ceteris above. My gut feel is this project will be beset with delays, blowouts, further regulatory/legal issues and the possibility that technology will have made an exponential leap (a decade hence) – My 2c.

        I note the NBN is a bit of a no-go in terms of MB critique. Curious.

        • If that is a request for opinions on the NBN, I may be happy to oblige. Last week the QLD Young Economists hosted a forum on that very topic (yes self spruik, I am involved in running this group).


          For me the question is a matter of degree. It is not so much whether government policy should be directed at promoting the roll out of optical fibre in some form – I agree it should. But the nature of such a roll out, the degree of private v public investment, pricing structure and third party access regimes and so on are up for grabs.

          Stay tuned

        • Yes technology in a decade will make an exponential leap: fibre optics too. Get the damn thing built now while the country can (just) afford it.

      • +1
        Though in The Oz’s defense, you have to note the author..
        Kevin Morgan served on Kim Beazley’s ministerial committee on telecom reform on behalf of the ACTU and is an independent telecom consultant.
        Coming to the merits of the article, extrapolating the cost overuns for 18,000 homes (most of those in Tasmania?) to over 12 million premises is highly misleading.
        I thought these people knew something about economics of scale and the fact that costs on the mainland cities, with more densly packed houses, will naturally be lower.

      • Jason2,

        I agree with you that The Australian is a poor excuse for a real newspaper.

        Bur I am still very wary about how well the NBN will be implemented. (No party political inference intended).

        • Ceteris, out of interest which paper would you nominate as a ‘real’ newspaper.

          IMO The Oz is the best in the nation (I am in WA and The West Australian just may be the worst). Pretty sure even Robert Manne recently acknowledged (despite is Quarterly Essay) that The Oz was numero uno.

        • ceteris paribus

          Hi 3d1K

          To answer your question, in my humble opinion, The Australian fails because:

          1. it is filled with material written by a “truckload of opionionati”-facts and data any day over comment.
          2. much of its political and economic commentary appears to me tendentious, not a feature that any serious paper can afford.

          I am do not seek to convince anyone- but my personal preference is for Fairfax’s AFR and The Age in seeking out good stories. And the blogs.

          • My vote is for the AFR as a clear leader (but obviously business-only) with The Age/SMH in second place but a fair way back.

            The Australian is largely a mouthpiece for Murdoch but it can be good reading if you ignore the numerous opinion pieces.

          • MontagueCapulet

            The Age is pretty much owned by the Socialist Left, they don’t even pretend to be objective. Every story gets a leftist slant without exception.

          • I like The Australian, The Fin Review and the Age.

            As log as you stop and think about each masthead and remember who they are writing for they are all good papers.

            Call me easily pleased.

            Besides … nothing beats a paper on a Sunday with toast and coffee.

            I am so Gen X – but I love it.



  5. +10. Great catch and analysis. It is obvious Wayne Swan planned to release it on Carbon tax day, so that the announcement will slip off the MSM headlines.
    So is the Treasury’s prediction of a FutureBoom! that will last 20 years finally and officially over?

  6. So all this stuff I hear about mining only making up 9% of the economy and somesuch is false? We’re really going to swing from growth to recession because 9% of the economy is experiencing a downturn/correction to levels not seen in… 12 months?

    How brittle is this industry?

    • Iron (direct exports) represent 4.17% of GDP (thats ALL Iron exports to Korea, China, Japan etc).

      Iron and Coal exports combined represent 7.29% of GDP.

      • Ah, there is a difference between GDP and nominal national income. The GDP usually quoted measures real product, i.e. tonnes of ore at a constant price. But ore prices have shot through the roof. In fact, we hardly produced more ore, but received 10 times as much money compared to 10 years ago purely from the price. So if ore prices crash 50%, our income from that nice little earner would drop by half.

        Perhaps H&H can tell us how much tax the Treasury is deriving from the iron ore & coal bonanza. Then we know if these 2 commodities crash, how much impact that will be on the promised surplus. I guess it will be tens of billions.

      • MontagueCapulet

        What matters is the market psychology. We tell ourselves this story about Australia becoming wealthy as a result of the mining boom, when behind the curtain it is really a housing bubble.
        Take away that mythology, watch the resources companies the make up a large part of the index slump, see the Aussie dollar get sold off as a result, and the bubble starts to deflate as rising petrol prices, falling house prices, falling share market, falling retail sales etc combine to nudge the herd in a new direction.

  7. “iron ore has made a goose of me several times and you never know.”

    Relax, H&H, your anserine tendencies will never get anywhere near those of the Swan.

    Judging by the article referenced by AaronB (good pick up, btw) Swan is not being conservative enough. Combine the terms of trade issue with NBN cost blowouts and it is not hard to see a budget disaster before the next election. Labor could be out of power for another generation if that transpires.

    • +1

      But the NBN is a Public Good which is why we are supposed to have a Government.

      And … if the Government is in surplus that is bloody awful in my opinion it means that money is not being used ‘productively in the economy.

      Also, Government debt in Australia is feck all – not even a real issue.

      More worried about Bruce and Charlene on Average Street with all their so called Gittins “good debt” uhumm.


      Like your point.