Making Sense of Interest Rates, China and the Australian Sharemarket


The Reserve Bank today released the minutes of its Monetary Policy Meeting held on the 5th April. You may recall that the end result of that meeting was that rates were left alone, much to the relief of borrowers around Australia.

The commentary was interesting, even if only for the suggestion that interest rates were probably a bit higher than they needed to be because parts of the economy are quite fragile and could be hurt by higher rates – but that this was reasonable owing to the medium term outlook of high investment, low unemployment and the ensuing pressures that these could put on inflation. So it was ok to have higher rates today because it would hopefully stop the need for steeper rises some time in the future.

It was pointed out in the mintues that the floods here and the earthquake/tsunami in Japan, would create issues to disrupt markets and the economy in the short term but the clean-up efforts and replacement of infrastructure would boost all sorts of industries over the medium term. Keep in mind that Japan is the second biggest buyer of stuff that we Australians sell. In other words, try to ignore the ‘noise’ that these events create and focus on the longer term.

China has released its 12th 5-year plan. Actually, it did this back in March but i’m a bit slow catching up with global events while we pack our little office into boxes for our coming move… Anyway, it’s a bit tricky tracking down a copy of this 112 page document (come on, i know you are all just clinging to the edge of your seats in anticipation of getting your hands on a work of art like this) but once found, it makes for very interesting reading. As a by-the-by, does anyone else find it interesting that Russia’s 5 year plans ended in tears, yet the Chinese seem to be making a rather good fist of actually making theirs work?

“Western” commentators are obviously focussed on hopes that the Chinese will be less export focussed and become more interested in buying Western stuff (aka : goods and services). If they did then it might help balance up some of the huge surpluses and deficits currently keeping economic futurists awake at night.

Word has it that the Chinese autocrats are hoping to keep the economy growing, and improve living conditions so the workers don’t rise up in revolt (Western folk love to suggest that there are “growing signs and prospects for social unrest” in China, which seems a rather large call for a country that has so far successfully moved tens of millions of people out of rural poverty and into a far more comfortable urban form of poverty).

We here in Western Australia worry about whether the Chinese government engineered ‘slowdown’ of its economy will severely impact our own world. If it stopped all in one go then yes, it would have a massive impact – but ‘slowdown’ in Chinese economic terms is a bit like Casey Stoner on a hairpin… yes he may reduce speed to less than our maximum highway limit for a few seconds but that’s a blip on a whirlwind, almost out-of-control seat-of-your-pants blitzkrieg blast through the suburbs. Chinese economic growth moving from nearly 10% to somewhere between 7% and 8% is a large drop but the lower figure is still easily double that of most developed economies. Australia’s economic growth (for the historically inclined, Wikipedia has an interesting summary here, and this more academic note is worthwhile) is rather tame by comparison.

Back to a basic on this one – the Chinese government is trying to reign back inflation. Here’s an idea of Chinese inflation from the website You can tinker with the “Date Selection” to show periods back to 1989.


You can certainly see from the chart that China’s economy was heading into deflation territory at the peak of the Global Financial Crisis, which highlights why the government decided to get things going again with a stimulus spending package of hundreds of billions of dollars. Those dollars were inflated by increased lending by banks and institutions. The end result of such activity is usually inflation, as all that spare money bids up prices for goods and services – and real estate. Clearly, Chinese authorities would prefer that the inflation rate doesn’t keep at this trajectory, as it would lead to all sorts of bad outcomes – like workers agitating for large pay rises to keep up with the cost of living; increased homelessness; less disposable income and greater hardships for those on low incomes.

Now let’s have a look at the country’s track record for the production of stuff (aka : goods and services, GDP). You can see the fantastic rate of growth that China has achieved. Again, you can tinker with the dates to look at the longer term record.


Remember that these increases in production are after inflation – and with inflation at the rates shown above, we are clearly talking about enormous increases in production and capacity.

And so we come to the 5-year plan. It includes fantastical figures for contruction and development – all of which would consume very large amounts of raw materials. Here are some of the bigger ticket items mentioned in this plan:

  • move 10,000,000 people a year from rural areas into urban areas
  • find new jobs for 45,000,000 workers over the next 5 years
  • build 36,000,000 affordable apartments for low income people
  • bring its high-speed rail network up to 45,000 kilometres of track
  • increase its highway network to 80,000 kilometres

A more comprehensive look at the major items is highlighted in this post from the website China Law Blog.

From a West Australian point of view, all of these items are likely to keep the demand for iron ore, nickel, copper, lead, zinc and other hard stuff quite high. With copper still over $4 a pound at the moment, the demand at a reduced level may not be quite supportive and may even cause a bit of a fall – but even with a fall it is reasonable to expect that the new “support levels” would be higher than the long term averages, and therefore beneficial to Australian mining companies.

The ‘however’ that goes with this is the rider that prices for companies exposed to China’s need for raw materials have already been bid up on speculation that there are more rises again. Analysts may set price estimates for the next 6 months but any drop in the growth rate would usually be seen as a negative. That is, companies in this area are usually priced for their capacity to grow even further than they already have. If China’s need for raw materials stabilises then the room for growth becomes lessened, and the books of those companies will become all that is available to base a valuation on.

To explain that a bit further, big mining projects involve big lumps of capital and therefore big risks. If BHP plans to spend the next 5 years of its income on building bigger and better mines then that reduces its capacity to wear price, legislation, technology and cost changes, as well as its ability to grow through acquisition. That is ok if there are positive expectations for the prices and volumes it can achieve. It is not so good if either or both of these are held in question. Therefore, the relative risk for every dollar of dividend increases and there is little blue-sky left. In a situation like this, investors will generally apply a lower multiple to any income BHP pays, resulting in a price drop or stabilisation.

This is where the real risk lays in expectations of reduced growth potential. And so we come to the current state of play. Australia’s terms of trade are at record levels – this has been covered in previous posts. If the demand/supply of various rocks and ores stabilises then it is reasonable that prices would retrace from the current levels.

It would be logical for this to impact our metals and mining companies. In a small way, that has happened in the last week or so. The chart below represents the ASX300 Metals and Mining index plus dividends. You can see the very strong recovery in prices for mining company shares over the last year, and the short blip from recent times.

The ASX Metals and Mining index up to April 2011

The prices of mining companies have followed rising prices for their products

This may or may not represent a change in the trend but at this stage Chinese attempts to reign in huge spending isn’t necessarily signalling the end of a “stronger for longer” outcome for Australian mining shares, and a lot of analysts are suggesting that falls in prices at this stage represent opportunities to top up holdings.

Of course that is a short term position. Whether the price of BHP or Rio is ‘high’ or ‘low’ compared to last week or next week is really just the ‘noise’ of daily speculation on the current value of future income streams and the potential for price rises flowing from that. It is also in part, speculation that BHP will do better than other companies – or Rio or Fortescue or any of the many others.

The long term, patient investor will look at those companies in terms of the overall sector, and then compare it with the market as a whole, to gain some idea of the swings and roundabouts in markets. For example, we are currently in a ‘recovery mode’, where sharemarkets generally remain way below their 2007 high points, and yet well above their 2009 low points. There is always hesitation after fast upwards movements, and even with the ‘year of going nowhere’ that we have just been through, many analysts and commentators are more worried about the uncertainties of the future than they are positive about the strength of global recoveries, and the potential for improvement.

S&P/ASX200 Accumulation Index since 2006

The top 200 companies remain at similar prices to 2006

Now we should look back at the Metals and Mining index to see how it has travelled over a similar time period.

Metals and Mining Index since April 2006

The mining company shares have almost recovered their pre-crisis highs

You can see the stark differences in performance. These charts basically tell us that anyone with greater exposure to metals and mining companies over the past 5 years would have, on average, outperformed the general market returns. This is a reflection of selection risk/rewards in play. If you correctly chose mining companies of (say) industrial companies then you would dramatically outperform. That is now a historical fact. The question a current investor needs to ask is how likely that trend is to continue for the next 5 years?

From a risk point of view, a move out of mining and into a broader mix (such as the S&P/ASX200 index) would provide greater diversification and less exposure to falls in value from any drop in commodity prices. However, the returns will be lower if the ‘stronger for longer’ trend continues to play out. This may be obvious but it is a point often missed when looking at taking bigger exposure to individual sectors or companies.

However, there is more to risk than just shareprices…

The International Monetary Fund (IMF) has released its April 2011 Financial Stability Report, which is fascinating reading for the sleep deprived or economically manic. This is a useful work, even if only for writing interesting cooking recipes in the margins of your printout copy. Actually, the chapters on global housing are the most interesting. It includes this little chart…

IMF graph on global house price trends - April Stability Report, Chapter 3

IMF illustration of house prices over recent years

As you can see, Australia’s housing is currently riding a very strong price wave. In some corners of the world, this would be called a ‘bubble’. However, we are not allowed to use this word, as current incomes, credit positions, terms of trade, legislative policy leanings, social imperatives and cushion-crazed homeowners are all working to support current prices.

Given that Australia’s residential housing stock is worth roughly 3 trillion dollars (and therefore very roughly 3 times the value of the entire sharemarket), what happens to housing has a dramatic effect on the wealth of a nation. If a drop in mining income caused a drop in national income, wages and immigration then the impact on housing could potentially be very strong. Again, this is a risk that is dismissed by many commentators but it remains a risk nevertheless.

The other major risk that sits as an elephant in the room currently is the continuation or not of the printing of money by the United States, United Kingdom and Japan. The USA is due to stop its version of quantitative easing by July, which will take away a large source of funds to markets, and most likely would cause a pause in recovery trends, while investors shift money from here to there and back again, trying to pick winners in a non-easy money environment. Again, this is a short term version of noise, as the stopping of quantitative easing is a sign that the government sees a future of growth in markets, and is indicative of a better long term outcome. It is unlikely that commentators will see it that way should the US stop printing money.

It is one of the conundrums of finance in a recovering world, that logical outcomes should not always be expected from logical moves. Here’s todays’ example. Standard & Poors have put out negative comments on the credit worthiness of the United States – something about budgets being out of order, and debt not being tackled owing to political difficulties. What would you expect to occur in a logical world? Logically, if one of the world’s most pre-eminent rating companies suggests that a country’s soveriegn debt is on a negative, we should see investors sell more of that debt to reduce their risk profile, which would in turn lead to an increase in yield – and an increase in funding costs for that country. That’s the way debt is supposed to work. But what actually happened last night? US Treasuries rose in value, reducing the yield and the effective price for funding of the US debt. Crazy stuff, huh? Here is one blogger’s view on the strange outcomes.

So what does all this tell us?

It suggests that the recovery phase for global sharemarkets remains intact. It tells us that the Chinese authorities are trying very hard to keep their population employed and happy, and that this will mean continued demand for basic metals and commodities. It tells us that there are financial worries around global imbalances, such as China and Germany’s surplus as well as the United States and UK deficits. It tells us that mining companies have done very well but the risks for continued growth are perhaps higher than they have been for a little while. It tells us that the ‘normal’ risk/return profiles may be coming to play a little more each month, as the recovery progresses – ie, a diversified portfolio should generate reasonable returns but individual sectors will show greater volatility as there are winners and losers from the uneven pace of any recovery. It tells us that Australian house prices are an issue but hopefully one that will be supported by the host of positive factors that still exist, even after a large rise in prices.

It also tells us that a lot of things can be used as reasons for doing nothing or worrying to the point of inactivity. It tells us that in a post-crisis environment, we must all learn to tune out a lot of the noise, and focus on our own personal long term objectives, and let the day-to-day minutae swirl around us un-noticed.

At least, that’s my view.

Remember the Great Disclaimer – Nothing in this post or on this site is to be taken as personal advice, even if you are already a client, as these notes do not take into account your personal position or objectives.


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