The famous British racing driver, Stirling Moss, was once asked why he won every race in which there was a car crash? ‘It is simple’, he said, ‘when I see a crash I put my foot down a little bit because I know everyone else is lifting theirs a little bit.’ Charlie Scandrett examines what the current financial car crash means for printers and where the opportunities are to be found
Real economies and bubbles?There are three actual economies,
1.The Real Economy that we work in, it is farms, shops and factories, it is where buildings and people produce tangible wealth, the Gross Domestic Product (GDP).
2. The Equity Economy of the share market, where emotion and calculated risks produce prices of shares in the Real Economy.
3. The Finance Sector which lends money for #1 and #2 above. It is expected to be a stable provider of funds in good times or bad.
Then there are journalists, who create a virtual economy in the mind of media consumers. Journalists can watch share prices rise over time at several times faster than the Real Economy can actually produce wealth, and then blithely say ‘the share market is strong’. But when the market realises that a share’s value is proportional to the wealth that companies can really produce, then the price must go down accordingly. Journalists then declare doom and disaster, ‘Wall Street plunges to a five year low’.
They neglect to mention that the ‘five year low’ is still regarded as overvalued in any return on investment analysis. I eagerly await the financial journalist who has the courage to report, ‘Today greedy expectation of further price rises pushed share prices further above the point of any reasonable dividend return. When prudent investors pull out of the market, prices will quickly drop to sensible levels and the speculators will have lost billions of dollars of paper dreams, not much actual cash.’
Robert Shiller, an economist at Yale, puts it bluntly, he says, “The notion that you lose a pile of money whenever the stock market collapses is a fallacy. The price of a stock has never been the same thing as money - it’s simply the best guess of what the stock is worth.
“It’s in people’s minds,” Shiller explains, “We’re just recording a measure of what people think the stock market is worth. What the people who are willing to trade today - who are very, very few people - are actually trading at. So we’re just extrapolating that and thinking, well, maybe that’s what everyone thinks it’s worth.”
• A share value at 12/1 price-earnings (PE) ratio is reasonable and thus a sustainable price. At a PE of 20/1, the earnings of the company must significantly increase in the near future or the price is not sustainable. Over 20/1 and we are entering bubble territory and the price must come down. The Standard and Poor’s (S&P) index over the last five years has averaged about a PE of 20:1. But the historical average is about 15:1. In June 2008 the S&P’s PE ratio was 25:1, so any large drop is reasonable, not a disaster.
• A house value is similarly determined by numbers. If the average wage earner cannot possibly afford to buy the average house, or an investor cannot buy it and get about 12/1 PE (when capital growth and rent are included), then the price is not sustainable. At PEs higher than that, we would be entering a bubble real estate market.
• A printer should approach a new machinery purchase in the same way. Once he decides engineering and service issues, the choice of a new machine is one where the new productivity must more than pay for the repayments. This makes new machinery a sound investment in good times or bad. Upgrading productivity is just more urgent in bad time because price competition penalises old technology (See Stirling Moss quote above!).
When share market prices rise many times faster than GDP and the PE is over 20:1, then it is really a very weak market and a correction must come sooner or later. We are used to the cycle of boom and bust in the minds of share owners. However the Real Economy just plods steadily along, usually growing just a few per cent each year.
When real estate prices grow many times faster than GDP or wages, and the financiers also start to believe that prices will rise forever, then the Finance Sector can become a speculator and enter the boom-bust cycle by embracing risky lending. Over the last five to ten years in the USA, there was too much lending at terms that were too easy. Now for the first time in economic history, the Finance Sector in the USA has created a bubble market in money.
Finance companies are simply money distributors and they typically borrow for 90 days at a time, and must continually roll over 90 day paper to fund their businesses. As soon as the interbank lending market thinks the actual retail loans are not good because the asset bubble has collapsed below the loan amounts, then the cash stops flowing. The world financial crises is not actually a failure of the Real or the Equity Economies, it is a credit squeeze caused by speculators in the Finance Sector. If Finance Sectors cannot freely lend to the Real Economy, then it slows down considerably and the Equity Economy panics. You can see that now in the world share market prices, one bursting US real estate bubble has burst a worldwide finance bubble that has burst a worldwide share market bubble. Little kids play with bubbles don’t they?
What went wrong with America?
Americans spent nearly $9,000,000,000 (nine trillion dollars) over ten years on new houses, many financed with very high Loan to Value Ratio ( LVR) and no-recourse loans.
• No-recourse means mortgage borrowers in the USA can mail the keys back to the finance company (called jingle mail) and walk away from the loan without even a negative CRA report.
• Many mortgages had 1 per cent introductory rates for a year, leading to reckless speculation on asset price growth.
• Of existing American mortgages, over 4 per cent are now non-performing, which means that about $350bn worth of American housing is just sitting there, not earning interest or repayments.
• Prices have collapsed by up to 30 per cent or more, and the Finance Sector does not dare to auction off $350bn worth of housing because they are required by law to mark to market, which means they have to write down their whole asset base to current market pricing, even if that is temporary and the other assets are performing. This causes margin calls from the parent lender, which causes asset sales and further price reductions. Mark to market is a recipe for an accelerated finance collapse and you are seeing it now.
• The collapse means that the normal circulation of capital within the finance sector has dried up because the income on 4 per cent of the real estate assets has dried up, and banks no longer trust each other’s balance sheets.
• The USA has less than 65 per cent home ownership, and about 2 per cent Federal Reserve interest rates. This means they don’t have a significant means of pumping cash into the consumer economy by reducing everybody’s mortgage payments. They will find it difficult to create a consumer led recovery, funded by cash instead of credit.
• American GDP growth will be flat or slightly negative for about year, however we need to remember their GDP is $14,290bn and that is a very serious amount of wealth generation even if it does not grow.
What is right with Australia?
The Australian banking system is completely different.
• We do not have no-recourse loans, so people tend to persevere with mortgage stress.
• Introductory rates offered were only just below actual market rates, so purchasers had to be serious if they were buying.
• Thus our non-performing mortgages are reported at 0.315 per cent of the total, a record low.
• Our banks have already collectively lost some billions of dollars on worthless USA real estate securities a few months ago. However those losses were only a few per cent of current bank profits and thus it made little change to their strong balance sheets.
• Australian real estate prices are much more stable, and still growing in some states.
• Australians have more than 80 per cent home ownership and currently a high home loan interest rate. Half of these people have mortgages.
That means the Reserve Bank of Australia (RBA) can reduce interest to banks in order to pump cash spending money into the hands of more than 40 per cent of consumers. Because the rate is high, they can continue do this for some time and thus maintain economic growth at a healthy level. Just before the recent 1 per cent drop in interest, the International Monetary Fund (IMF) statement predicted that Australian GDP growth would drop from 2.5 per cent this year to 2.2 per cent in 2009. The RBA obviously has plans to keep it higher than that
• Australian commodities exporters of food, textiles and minerals have record contract prices. Currently they still have to construct a significant proportion of the infrastructure needed to supply current export contracts in minerals and coal. Our overseas customers could reduce demand by a significant amount and we would still have to grow our economy. There are no stockpiles of unsold commodities, not even wool.
What is going to happen?
IMF headlines seem very negative, but if you look at the actual text they predict a global slowdown of growth to 3 per cent positive. They do not even predict a recession in the USA but events have overtaken this prediction since then. Credit scarcity alone will slow down the USA domestic building and automotive industries, but US exports are doing well.
The IMF predictions are:
• Commodities prices will drop over five years back to historical levels. (they take 1995 as the index and it is about the average)
• World growth (which Australia depends on for export) will drop from current 3.9 per cent to 3 per cent next year, supported by developing economies continued strong growth.
• Europe, USA and Japan will drop from 1.5 per cent ( 2008) down to 0.5 per cent next year or probably into slight contraction.
After 10 years of greater than 3 per cent growth, I think this correction is hardly a disaster. It cannot even be compared to the 25 per cent GDP contraction of the Great Depression, except by some village idiot journalists who sensationalise the normal workings of a market. From a wide reading of experts, my predictions are:
• The tightening of interbank credit will even have the very stable Aussie banks looking around for any cash to lend. The world credit market is connected to every bank.
• International 90 day paper interest rates are going up, these are the short term interbank borrowings. However that will be more than balanced by continual reductions in Reserve Bank of Australia lending rates. Finance companies borrow from both sources and so retail interest rates will come down over 18 months.
• We have central banks now. The lack of central banks in 1929 meant that governments had no economic levers to prevent a depression back then. We are adequately protected from a Real Economy collapse by the co-ordinated international central banking system. Note the simultaneous cut in interest rates worldwide recently.
• The low Aussie dollar will benefit the Aussie economy far more than it will penalise new machinery buyers. In terms of the monthly cash cost of owning new imported machinery, the 2.5% total reduction in interest rates expected by Christmas in Australia exactly offsets a 10 Yen or $0.10 USD reduction in our exchange rate. Australia’s four major banks expect the Aussie / US exchange rate to settle at $0.75, and similarly against the Yen it should settle at around ¥75 for some time. Do not whinge about JPY and USD levels, the low exchange rate is protecting your economy even if it postpones overseas holidays and makes imported machines seem more expensive.
• Well known printing finance brokers, Bill Coote from Laurentide and Mike Stiles from Stiles Sheffield, tell me that finance is freely available for well prepared applications. I expect small businesses on the edge of a lender’s criteria might now find it much harder getting credit.
• I am advised by lenders that fairly high LVR real estate loans will remain freely available in Australia, which suggests no serious housing price downturn is expected here. The doubling (and trebling for new construction) of the first home buyer’s grant by the Federal Government will help support the housing industry.
• China will spend some of its cash reserves to maintain itsgrowth at a reduced 8 per cent by switching emphasis to domestic infrastructure, and they have assured Australia that commodities demand will remain high. They have saved for this rainy day but they will demand and receive lower prices.
• Fuel will be less than $1 per litre and this will benefit transport in our sprawling economy.
• Australian GDP growth will be in the 2 per cent to 3 per cent range, supported by Chinese buying and RBA interest cuts.
• Because of a lack of business and consumer confidence, and misunderstandings from journalists predicting another depression, you can expect demand to be sluggish, and thus you can expect printing prices will be very tight. If Prime Minister Kevin Rudd introduces his proposed one-off tax cut of more than $5bn before Christmas, advertising print demand will rise significantly.
What to do about the coming changes?
The same as always, it is the wages-to-productivity ratio. In any fierce price competition, the business that can produce 50 per cent more with the same wages and costs will always win. They simply have more room to move and can ‘buy’ the sales volume and still make a profit.
You need to find ways to get more invoicing out of the same wages bill, or to get more recovery out of that invoicing by bringing some subcontracting back inside.
• Don’t sell your shares and don’t worry too much about your super. Selling at the bottom, or near bottom of the market, is senseless. It is always good to own shares in the Real Economy in Australia. The prices must come down to reasonable levels as they always do.
• Machines are much cheaper than people. A borrowing of $560,000 for new wage-reduction productivity, depreciated over 10 years, is equal to paying one wage and the cost of managing that wage earner. Some of your competitors will continue paying much more in wages than they have to, just to ‘save money’ but they are not in reality doing that.
• Expect the old pre-1995 printing presses to become completely uncompetitive now, and to be gone from the market by late 2010.
• Expect the two- colour 52cm press to virtually disappear over the next two to three years because even short run two-colour work is now more economical printed in CMYK on more competitive and productive four colour 52s.
• Expect digital printing to grow significantly in good times or bad. But 52cm four colour offset will remain competitive at 500 copies and very competitive over that number of copies. Digital cannot compete with offset on fixed image, long run work and it never will because of imaging costs. Work with digital, do not fear its impact on traditional offset, it will grow the print market.
• Try to achieve 10 to 15 minute make-readies, this is the new benchmark of profitability in offset. The productivity competition will be keen and runs will get shorter, so makeready is the focal point.
• Publish a quarterly newsletter to clients and hot, warm and cold prospects. If you don’t you will be giving up the significant increase in new sales and existing client loyalty that newsletters bring. You own a printing press, you should use it.
• Borrow money with delayed payments if you can buy superior productivity with it. Remember that some of your competitors cannot borrow and you will have a significant competitive edge in a price war. Get new machinery now and start paying in late 2009 or early 2010, after the global downturn. Use the productivity to do more work at the same costs.
Stay calm, real wealth does not evaporate. The houses built in the last decade in the USA have not been bulldozed, the factories all over the world still work. Food is grown, sold and eaten everywhere. With deposits now guaranteed, the only way to destroy cash is by inflation, because no-one actually burns it. Money will circulate again as confidence returns. Paper profits in share market prices will be diminished until PE ratios of 15:1 are achieved. Some overseas banks will lose a lot of value because they speculated too much, but even their branches and ATMs will still be run by the bank that takes them over. If we wait for the investors’ fear to subside in the share market, we will realise that the GDP of the world goes marching on and each of our local businesses has to be simply more efficient to succeed in this tight economy.
The market is there to beat, the odds are always in favour of careful planners who let the numbers do the talking.
About the author: Charlie Scandrett
Charlie Scandrett was born on a cattle property in far north-west Queensland. He graduated from Queensland University and ran a book printing firm for 15 years. He has worked in Russia and consulted in China. He is currently CEO and co-owner of machinery distributor Pressnet Australia.
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