The graph below, from the Bureau of Resources and Energy Economics, indicates that the resource super-cycle is well and truly over, with the value of “current and likely” project investments forecast to decline by 75 per cent (from $270b to $70b over the five years to 2017).

The shelving of $150 billion worth of mining and energy projects over the past year, combined with above predictions, has put Australia’s resource service sector into a deep recession.

Over recent weeks, many companies servicing Australia’s resource sector have announced severe declines in their outlooks. The extent of this downturn seems to have caught the management of these companies by surprise. Taking a look at just ten of these companies reveals something of a problem for the rest of the country. Given that the stock market tends to cast its shadow before it, the average share price decline of 50% this calendar year – an average capital loss of 10 per cent per month, is an ominous sign indeed!

We now believe that this ‘average share price decline of 50 per cent’ could be a prelude to further severe earnings reductions for resource service companies in the year to June 2014 – and in the year to June 2015.

Additionally, small miners will feel the heat because they cannot obtain funding. Large projects are being shelved and a new brand of manager is running them, for shareholders rather than for growth. Finally, our assessment of commodity prices (iron ore in particular) is that they have peaked, and now risk falling significantly – thanks in part to China’s current oversupply of everything from ‘ships to solar’.

A logical progression would then be that this pessimism spreads to the currently indifferent Eastern Seaboard of Australia – at precisely the same time that many stocks look a bit stretched from a valuation viewpoint.

Indeed, if we figure that the contribution to GDP growth from mining capital expenditure was one to two per cent over the last few years, then its demise will put a real dent in the overall pace of economic expansion. Without another sector, such as residential construction, government spending, or household consumption taking up the reins, the risk of a recession is very real.

Back in 2011 on the US game show Jeopardy, “Watson” – a question answering computer system built by IBM – managed to easily beat two of the show’s greatest champions. Having thus established its credentials, a version of Watson will now field customer enquiries in ANZ’s wealth management division.

With the ability to process the informational equivalent of a million books per second, and a capacity to learn from its mistakes, Watson offers a formidable capability that will only improve from here.

At Montgomery, we are big fans of using computers to make our work more efficient, but perhaps we should think about how we will respond when the machines start to apply for Australian Financial Services Licences, and want to set up their own funds management boutiques.

Just in case we find ourselves on the losing side in future, let me put this on the record: I, for one, welcome our new robot overlords!

But we are now moving onto the next idea, which is finding some traction at Montgomery. That idea is hanging, like a fog, around a simple question: If the one sector of the economy (mining) that was keeping Australia out of a recession, falls into one, what happens next?

We will spend the next few weeks thinking about (and perhaps acting on) the idea that tumbleweed returns to the streets of Perth and the city’s influenza eventually spreads to the currently indifferent Eastern Seaboard of Australia, at precisely the same time that stocks all look expensive.

In the meantime, and in case you missed it, you can catch up on the statements mining services companies have been making below and now add Fleetwood to the mix.

“As a consequence of flat or weaker trading conditions in the group’s principal markets, profitability during the second half of the year has not met expectations … The softening resources sector, resulting in an oversupply in Karratha, has had an effect on the earnings attributable to the Searipple village … The extent of commitment to the Gladstone village is the subject of continuing review, having regard to fluctuating market conditions and a reassessment of major projects in the region.” – Fleetwood (ASX:FWD) Announcement

For those who missed it, we wrote last week about a few more declarations here and we repeat their statements below:

“Ongoing uncertainty and volatility in commodity markets have driven a continued slowdown of capital investment in the resources and infrastructure sectors with further delays of major projects impacting revenues in the Engineering business. Additionally, the cost management programs of the major miners have led to scope reductions and cancellations across UGL’s operations and maintenance business.” – UGL Managing Director and CEO, Richard Leupen – market update

“Market volatility and weak conditions in the Australian resources sector continue to provide a challenging trading environment. While recent conditional environmental approvals for key projects were positive signs, continuing delays in final environmental and investment approval has resulted in further project slippage with flow-on impacts on anticipated revenues in the second half of FY13.” Sedgman – market update

“Just pulling more tonnes out of the ground is not enough. The mining sector has experienced significant cost increases in recent years, and it continues to do so. In addition, stakeholder expectations of the industry have also grown … We are targeting cumulative cost savings of US$5 billion over the next two years. This will be achieved through a relentless focus on cost reduction and productivity improvement across all areas of our business.” – Sam Walsh, Chief Executive, Rio Tinto – AGM

“We must challenge ourselves to increase returns from new investment, in the same way that we need to squeeze returns from our installed instrastructure. IN this regard, capital and exploration expenditure for the 2014 financial year will decline significantly, to approximately US$18 billion, and the rate of spend is expected to decline substantially thereafter. By reducing our annual spend and increasing internal competition for capital, we expect to maximise returns from incremental investment…” – Andrew Mackenzie, Chief Executive Officer, BHP Billiton – 2013 Global Metals, Mining and Steel Conference

“Ausdrill’s core business comprising of mining services in Africa and Australia has largely continued to perform as expected due to the focus on production related services. However, the Group’s profits are expected to be impacted by the general slowdown in activity in the Australian mining sector that has occurred from September 2012 onwards, and which has not recovered as previously expected.” – Ausdrill Limited – market update

Nikki Williams, CEO of the Australian Coal Association, said on SBS in January that the Australian coal sector is at “a terrible junction where not only has the international market come off in terms of prices, but our costs and productivity have gone to a terrible place,” … (Until recently Australia was the cheapest place in the world to produce coal) … “And in just five years, we’re now the highest cost producer in the world at $176 a tonne compared to the rest of the world at $106.”

The head of engineering firm, Coffey International, has warned of a protracted economic downturn far wider than the slowdown in the mining sector, with an ‘increasing cascade’ of project delays and cancellations and little chance of a recovery for some time. “What we have been seeing is significant project delays or cancellations that were broader than simply mining,” Coffey managing director John Douglas told The Australian.

Pew Research Centre has released a report entitled “The New Sick Man of Europe: the European Union”. Its findings add weight to the argument that the current state of the European Union is unsustainable. It states, “the prolonged economic crisis has created centrifugal forces that are pulling European public opinion apart, separating the French from the Germans and the Germans from everyone else”. Favourability for the European Union has fallen from a median of 60% in 2012 to 45% in 2013.

It’s a compelling report that is well worth a read. For today’s blog post, we wanted to share the section that we found most interesting – the opinions that Europeans hold of themselves and each other.

Everyone, except Greece, viewed Germany as the Most Trustworthy country (the Greeks saw themselves as being the Most Trustworthy). Italy acknowledged that they have a lot of trust to rebuild. Interestingly, Poland viewed Germany as both the Most Trustworthy and the Least Trustworthy nation. The French saw themselves as both the Most Arrogant and the Least Arrogant, while Italy, Spain, and Greece all saw Germany as the Least Compassionate nation.

And which country do you think was considered the Most Compassionate? Well, each and every country voted for itself.

The Eurovision Song Contest has been running since 1956. With opinions like those shown in this study do you think that the European Union have such longevity?

Included in the worrying recent signs are reports that suggest amnesia is returning to certain credit markets – in other words, the chase for yield may be causing investors to focus on return, while forgetting to take account of risk.

Most recently, Deutsche Bank and Nomura have drawn attention to a 25% surge in the price of junk-rated commercial mortgage bonds since December, and Bloomberg has reported that the issue of dollar-denominated bonds by Asian Corporates is growing at 10 times the rate of global corporate debt markets, as investors chase the relatively higher yields on offer in the region.

For our part, we will continue to be focused on the long game, and where we feel that the markets are not adequately rewarding investors for the risk they are taking, we will choose not to take it. This may mean holding material cash balances in our funds until the balance of risk and return is more favourable.

Last week’s year-six father and son breakfast was never expected to throw up any investment ideas. Indeed, I was so focused on the kids that I wasn’t even listening out for investment insights when one hit me, or, to be more accurate, brushed gently before me.

It was a friend of mine, a semi-retired fund manager who now spends all his time managing his own portfolio and cattle farm. He made the observation that everyone is sanguine – if not optimistic – about equities.

“Who are you talking about?” – I asked.

“Everyone,” he answered.

Holed up in our converted warehouse in Pyrmont, far from the distracting natter of daily broker lunches and street corner stock tips, we don’t get much of a handle on sentiment. Fortunately we don’t need to. Other than observing which stock presentations at the Macquarie conference only had one or two attendees (gold) and those which only had standing room (commercial leasing), our ‘reading’ of the level of optimism and pessimism is deliberately restricted to our observation of how many stocks are trading well above our estimate of intrinsic value each day.

Either way, my experience is that the market always does what it needs to do to ensure the majority is proven wrong. And based on the sentiment observed by my very experienced and successful friend as well as the number of stocks trading at discount to intrinsic value (none), it looks like the majority appear to be very long indeed. But is the enthusiasm misplaced?

The number of collapsing retailers and fashion houses, as well as the increasing struggle for local tourism operators and food producers to stay profitable under the weight of the high Australian dollar, suggest that there are few reasons to be overly enthusiastic about local economic conditions.

Long term, the issue for our country can be exemplified thus: Australian supermarkets are committed to delivering lower prices to consumers (beating the competition to it) – no matter what the cost. They will import cheaper products from offshore if it means consumers can pay less, and with weaker international currencies making foreign exports more competitive than our own, it seems like a straightforward plan. The problem with this strategy, however, is that local manufacturers go bust and lay off staff, who then in turn have to call for lower prices because they have lost their jobs.

We simply can’t insist that local businesses deliver products and services at lower and lower prices while also demanding that we get paid time-and-a-half, double time and triple time on weekends. Something has to give. Lower prices will only deliver unemployment and serfdom – while we fuel the improvement of overseas businesses and investment conditions.

Elsewhere, take a look at the balance of payments’ current account deficit and last week’s budget deficit. Not only do these suggest that the business of Australia is in poor financial shape but that it also has poor managers at the helm. So why the investor enthusiasm?

China. With an increasing influence on Australia from the Chinese stock indices, it is not just the high level of iron ore and coal we export to China that ties us to that country’s fortunes.

But what is going on in China now should serve as a warning to Australian stock market and property speculators. The next five to ten years in China will be nothing like the last decade. That country’s positive influence on Australia’s prospects may become proportionally negative and prove just as cyclical as the commodities we export to them.

China is moving from investment-led growth to consumption, but the transition may not be nearly as easy as that statement is to write. Meanwhile debt growth – the product of China’s own quantitative easing to fund increasingly unsustainable rates of economic growth – may be reaching its own limits, and economic growth must slow if household income is not built up fast enough to replace the contraction in government spending.

I personally think, as do an increasing number of others, that even seven per cent economic growth in China will not be achievable beyond this year, and that the motivation for reaching it this year is merely the pride and reputation of the new leadership. More importantly for Australia, even if seven per cent is achieved, it will not be as capital intensive as previous growth – so we can expect slower increases in demand for our iron ore at best.

On the supply side, RIO, BHP, FMG and Roy Hill will all add to iron ore production in the near term. The result? Falling prices. No wonder George Soros is rumoured to be shorting the Australian dollar. The rumours of me having done the same might also be correct.

If you are trying to pick the bottom in iron ore stocks, or worse, justify their purchase on yield, just remember – you are speculating, not investing. Finally, given we cannot find many, if any, bargains in the stock market currently, buying at today’s prices may also be more speculative than rational.

(…tune back in next Saturday for the second instalment in this series)

You can see the dung that people consume in the picture to the left. Kopi Luwak has been called the most expensive coffee in the world with retail prices reaching €550 / US$700 per kilogram.

Coming back from lunch today, the Montgomery team remembered how expensive Australia is to hire staff, rent commercial space, drive a car and simply live. And having discussed Australia’s prospects with another fund manager at lunch, it occurred to us that the resources industry is the bean, the cat is the economy and the defected remains are what we will all have to swallow shortly.

Today, the Worley Parsons conference call revealed the change in trading conditions in WA (i.e. down) is worse than what they saw during the GFC. In terms of the rate of deterioration, WOR thought they were close to the bottom back in February, but market conditions have deteriorated further since.

Here’s a list of recent statements made by others with exposure to civets:

“Ongoing uncertainty and volatility in commodity markets have driven a continued slowdown of capital investment in the resources and infrastructure sectors with further delays of major projects impacting revenues in the Engineering business. Additionally, the cost management programs of the major miners have led to scope reductions and cancellations across UGL’s operations and maintenance business.” – UGL Managing Director and CEO, Richard Leupen – market update

“Market volatility and weak conditions in the Australian resources sector continue to provide a challenging trading environment. While recent conditional environmental approvals for key projects were positive signs, continuing delays in final environmental and investment approval has resulted in further project slippage with flow-on impacts on anticipated revenues in the second half of FY13.” Sedgman – market update

“Just pulling more tonnes out of the ground is not enough. The mining sector has experienced significant cost increases in recent years, and it continues to do so. In addition, stakeholder expectations of the industry have also grown … We are targeting cumulative cost savings of US$5 billion over the next two years. This will be achieved through a relentless focus on cost reduction and productivity improvement across all areas of our business.” – Sam Walsh, Chief Executive, Rio Tinto – AGM

“We must challenge ourselves to increase returns from new investment, in the same way that we need to squeeze returns from our installed instrastructure. IN this regard, capital and exploration expenditure for the 2014 financial year will decline significantly, to approximately US$18 billion, and the rate of spend is expected to decline substantially thereafter. By reducing our annual spend and increasing internal competition for capital, we expect to maximise returns from incremental investment…” – Andrew Mackenzie, Chief Executive Officer, BHP Billiton – 2013 Global Metals, Mining and Steel Conference

“Ausdrill’s core business comprising of mining services in Africa and Australia has largely continued to perform as expected due to the focus on production related services. However, the Group’s profits are expected to be impacted by the general slowdown in activity in the Australian mining sector that has occurred from September 2012 onwards, and which has not recovered as previously expected.” – Ausdrill Limited – market update

Nikki Williams, CEO of the Australian Coal Association, said on SBS in January that the Australian coal sector is at “a terrible junction where not only has the international market come off in terms of prices, but our costs and productivity have gone to a terrible place,” … (Until recently Australia was the cheapest place in the world to produce coal) … “And in just five years, we’re now the highest cost producer in the world at $176 a tonne compared to the rest of the world at $106.”

The head of engineering firm, Coffey International, has warned of a protracted economic downturn far wider than the slowdown in the mining sector, with an ‘increasing cascade’ of project delays and cancellations and little chance of a recovery for some time. “What we have been seeing is significant project delays or cancellations that were broader than simply mining,” Coffey managing director John Douglas told The Australian.

Our friend and fellow portfolio manager has just returned from an whirlwind tour of Chinese steel mills to discover that (unsurprisingly) China believes losing money in this industry is acceptable because of the benefits elsewhere in the economy. Keeping people employed is also a priority. Meanwhile Australia’s largest iron ore producers are committed to producing even more. The price of iron ore is going one way.

If you remember that it was the resources industry that kept Australia out of a recession (sound economic management had little to do with it, Canberra), our question is – what will keep us out of recession now that the resources industry is in one?

We already know Australia is the most expensive place in the world – the legal minimum wage DJs or Myer have to pay an inexperienced uni student as floor staff on a public holiday is $54/hour – but what we may not have known is that this expensive stuff we are all about to be force fed comes from the rear end of the world’s problems.