Elephant in the room is US debt

The recessions that followed the first two oil shocks were caused by monetary policy responses designed to control inflation, not the rise in the oil price itself.

That is not to say $US50-plus oil is not painful – but since it is a product of demand, it should be self-correcting, in the short term at least. The longer-term question of oil production, and whether it is peaking, is not clear, but in that context there are some who say $US100 a barrel is neither out of the question nor, necessarily, a disaster.

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Life seems pretty simple for an Australian investor at the moment: just stay clear of Telstra and News Corp, buy anything else and you can’t go wrong.

The 2003-04 financial year produced a 20 per cent-plus return from the stockmarket; the first three months of 2004-05 have done the same – 5.25 per cent from the ASX 200, even with our two biggest companies on the skids. At the same time, the S&P 500 in the US has returned zero.

Australian investors are reinvesting a dividend flood, and any other spare money lying around, in shares – paying up now for next year’s higher profits and dividends.

But bonds are booming as well and yields have inverted (long-term yields are below cash).

Bond investors are pricing in a global slowdown and a cash rate cut because of the oil price and America’s imbalances.

It is a time of strong opinions: the bulls are ebullient; the bears are grizzly.

The old adage “make the trend your friend” is hard to abide by when there are two of them. Stocks and bonds can’t both be right.

And what about property? Is the recent strength at the expensive end of the market a dead-cat bounce? (Yes – it’s probably just executives hitting their bonus targets en masse and residentially upgrading. Investment property appears to be just plain dead.)

Is Australia an island of stability in a world of risk and slowdown?

Discussing the effect of the latest oil shock on Thursday, the Reserve Bank sort of confirmed this, saying the oil price rise is bad for global growth but not so bad for Australia because this is an energy exporting country.

But it’s important to get the big picture straight: the 2004 oil shock is a symptom, not a cause. And although the price rise has the same effect as an interest rate rise in oil-consuming countries, it’s a demand-side rather than a supply-side shock, which means both its cause and effect are different from the ’70s and ’80s.

There are two great, related macro-economic trends under which all securities and commodities markets are operating, and which are producing the conflicting, strong opinions about their directions. 1. The world’s supply of labour has quadrupled, as Bridgewater Associates pointed out yesterday, because of China’s entry to the global trading system and the entry of India and other countries into global services provision thanks to telecommunications. 2. The existence of the world’s “largest ever vendor finance scheme”, to quote ABN Amro’s Gerard Minack, by which foreign countries, especially in Asia, and especially China, lend America the money to buy their products.

As a result of the first factor, there has been a rapid decline in the value of labour and an equally rapid rise in the value of raw material inputs.

This process has only just begun. According to a recent chart published by Marc Faber, real commodity prices (deflated by the US CPI) are still near 100-year lows despite the sharp rise in the past three years in response to demand from China.

It’s also a fact that the falling cost of labour and the rising cost of raw materials cancel each other out, leaving global inflation low. (In fact, labour costs are a more important component of end prices than raw materials.)

The recessions that followed the first two oil shocks were caused by monetary policy responses designed to control inflation, not the rise in the oil price itself.

That is not to say $US50-plus oil is not painful – but since it is a product of demand, it should be self-correcting, in the short term at least. The longer-term question of oil production, and whether it is peaking, is not clear, but in that context there are some who say $US100 a barrel is neither out of the question nor, necessarily, a disaster.

Then there is the coming American slowdown, which could be a disaster. It will happen because of the second factor above.

The fact that China and other labour supply nations have been reinvesting their trade surpluses in US treasuries – thereby providing “vendor finance” to their main customer – has meant that the US dollar is overvalued and must continue to fall, and that American consumers are overborrowed and must cut back spending.

With total debt now 300 per cent of GDP – easily the highest level ever – America is uniquely sensitive to interest rate changes; as the currency falls, long-term rates will have to rise to attract the lifeblood of foreign capital. US consumers and business are more exposed to bond rates than cash, unlike Australia.

The economic expansion in the US therefore will end in a bigger mess than 2001. Oil at current levels makes that more certain.

There have been four consecutive drops in the Conference Board leading index – something that has happened only 11 times, nine of which preceded recessions or slowdowns.

That’s what the bond markets are worried about, and it’s why the US stockmarket is tracking sideways, in a funk.

Meanwhile, Down Under it’s “what, me worry?”. The market is watching raw materials prices, not debt (it’s not as high as America’s, but it’s still high) and, personally, I can feel a Chinese free-trade agreement coming on.

Alan Kohler also presents finance on the ABC.

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