More of the same – with a twist
Over the financial year 2014/15, diversifying away from Australian assets (ex-property) was the best portfolio tactic. Investors were well rewarded if they were invested in United States dollars, Japanese equities, Chinese equities (until June) and Australian listed property funds.
The weakness in the $A was pronounced, with the devaluation over 2014/15 against a basket of international currencies of approximately 15%. Today, at about US74 cents, the Australian dollar sits at the midpoint of its trading range over the last twenty years.
Figure 1. The $A to $US exchange rate
Source. Thomson Reuters Data
The $A weakness helped the share prices of Australian companies that have significant offshore earnings. For shorter periods, traders could have profited from various bond rallies but these ended abruptly in April across Europe, North America and Australia. On the shorting side, bulk commodities and oil provided hedge funds with gains as prices retreated. Below average returns were generated by domestic-focused Australian companies, while major Australian commodity and energy companies suffered 20% declines in value.
It was a chaotic financial year, with heightened asset price volatility that has followed years of quantitative easing, the maintenance of near zero interest rates across much of the developed world, and sustained government largesse in the form of large fiscal deficits.
Looking forward, it would seem to be a case of “more of the same” – at least for the rest of this calendar year. Governments and central banks may talk austerity and hard decisions, but they do not have the political fortitude to follow through. For instance even the resolution of the recent Greek crisis resulted in yet another bailout, with enormous “unfunded” funding of Greek banks by the ECB. The Greek Government under duress may lift taxes, cut pensions and sell assets, but no one can see how this “bailout” will result in Greece being able to repay its enormous debt.
But further out…
As we move deeper into 2016, we suspect that there will emerge a few twists for investors to navigate. Many of these twists will flow from the significant issue of excessive government debt. It is clear that government debt will continue to rise around the world, and it will do so at a faster rate than economic growth. This will lead to a growing awareness that it cannot be repaid and stimulate the question as to how it will ever be negotiated? Will it be forgiven or compromised? Or will government debt ultimately be devalued by inflation?
These questions will be the subject of much conjecture. Today, they are treated with too much complacency… and complacency is a by-product of QE.
As time has passed from the GFC, it seems that most governments and bureaucrats prefer to ignore their growing debt obligations. Every government works to a short political cycle and is prepared to allow today’s debt to grow for a future generation to deal with. Many governments and their central banks have used QE to extend their debt maturities and thereby obscure it from the attention of voters; they also open up the possibility of it ultimately being inflated away.
That leads to difficult questions surrounding inflation. Will inflation come and when? Will it be a surge or a slow build up? Will it be the result of growth or excessive speculative activity that results from the devaluation of currencies? Will it hit Australia harder than other countries?
The short term economic outlook in Australia is problematical. Our economic position has deteriorated in the last twelve months as the effects of the commodity price downturn take hold. In spite of this, we remain a wealthy country with about $8 trillion of household wealth and $2 trillion of superannuation assets. Indeed, one of the issues for the next few years is how much of this household wealth, buoyed by residential property, will be affected by slowing growth or by inflation?
Guiding our thoughts through charts
The outlook for world growth can be described as reasonable. There is no forecast of recession for any major trading region. However, the growth projected for Europe (west and east) and Japan remains disturbingly low given the extraordinary levels of fiscal and monetary support.
Figure 2. World GDP*
Source: The Economist
The growth engine of the world remains Asia, and, even though it too is slowing, China. Together with the emerging India, these two nations – which make up a third of the world’s population – will dominate this region’s growth.
Further afield the North American economy is solid but subject to downgrades of expectations. The commodity price decline will hit Canada hard and a rising USD will affect US exports.
The following chart focuses upon the G7 (which surprisingly still does not include China). It is aptly titled “In the doldrums” for it shows that 7 years of near zero interest rates have driven neither economic growth nor inflationary pressures in the Western world.
Figure 3. G7 countries comparison – GDP, Consumer Prices and Interest Rates
Sources. The Economist; IMF; OECD; Central Banks
Apart from rolling QE programs, the two big issues that will affect world growth are the movement in energy prices and world trade with China.
In the second half of 2014, the price of oil dramatically declined as US production lifted and OPEC members refrained from adjusting their supply. Today, the price of oil sits between US$50 and US$60 per barrel and that appears to be a significant level: for while it does not stimulate production activity in the US, it remains a profitable level for OPEC, and yet stimulates economic activity through lower costs for consumers.
Figure 4. Crude oil prices – West Texas Intermedia (WTI) – Cushing, Oklahoma
Sources. Federal Reserve Bank of St. Louis, US Energy Informational Administration
Thus in 2015/16 the maintenance of low oil prices seems likely and the risk of “cost push” to inflation seems unlikely.
That brings us to China and its burgeoning economic shadow. It is China that will dictate the fortunes of world economic growth and particularly that of the Australian economy. The next chart shows the impact that China has on many of its trading partners. China takes about a third of all Australia’s exports, having grown from 10% in 2004. Clearly China has lifted Australia’s growth through its demand for our raw materials.
Figure 5. Exports to China as a share of total exports (%)
Sources. CEIC, Haver, UBS estimates
The last decade saw a sustained period of export volume growth, rising commodity prices and mining capital investment. Either side of the GFC, the Australian economy benefited from a trade surge that lifted our national income.
This is seen in the next chart, where it shows that exports to China today represent 6% of Australia’s GDP. It was a mere 1% in 2004 and it directly added over $100 billion to the Australian economy in 2014. Supporting this growth was capital investment, taxation and employment that each added to Australia’s growth profile in the last decade.
Figure 6. Exports to China as a % of GDP
Sources. CEIC, Haver, UBS estimates
As they say – that is the past. What about the present and the future?
From here, the Australian economic cycle becomes challenged for a number of reasons. First, the precipitous fall in the prices of our major commodity exports to China and Asia have cruelled our export income and trade account. Recently in April, Australia recorded its worst ever monthly trade deficit, and it seems likely that the deficit will exceed $8 billion in the June quarter. This cycle of lower national income is already being felt in the labour market where wages growth is the slowest in a decade.
Figure 7. Australian wage growth
Second, the fiscal situation of the government has become challenged by years of poor macro management and no restructuring of the nation’s taxation base. As noted earlier, Australia is a wealthy country but it has not set its sights high enough for the development of world class public assets or services. The situation has been made worse by a legislated superannuation scheme that attracts massive savings, but with no means to garner it for economic growth. Government debt is rising but remains manageable. However, our wealth will be squandered if no vision is developed for the economy; and
Third, the depressing political leadership and lack of vision has led to a disturbing decline in non-mining business investment. This decline over the last five years spells danger for the Australian economy. History suggests that a sustained period of poor investment leads to low growth and poor economic outcomes. The chart below plots the history of business investment, and it shows that the current decline, which is magnified by the mining downturn, is projected to be the most significant decline in 50 years.
Figure 8. Australian business investment & recessions
Sources. ABS, Macquarie Research
The Australian economy appears to be moving into a low growth cycle. We expect that economic growth will trend at about 2% over the next twelve months. This is despite the tailwinds of a fairly consistent growth in population, from both natural increase and net immigration. Indeed this is a feature of the Australian economy that suggests that we should not slip into recession. The economy will grow but national income will not grow quickly and there will likely be a continuing real decline in income for the average working household. Those events would challenge domestically focused Australian companies and limit profit growth.
Figure 9. Australian population growth
In the period from 2000 to 2007, Australian companies lifted earnings strongly across all sectors. The final chart shows that profit growth from our resource companies has been severely challenged in recent years. First the high $A (until early 2014) and then a dramatic decline in commodity prices over the last two years has checked profits. Meanwhile industrials (dominated by financials) have moved from solid growth to pedestrian growth since the GFC.
Figure 10. Company Profits
Key forecasts for the coming year
The above charts suggest that it will not be an exciting year for investors. We believe that volatility will continue to be a feature with relief rallies and sharp corrections. However, the weakening $A leads us to the following asset allocation comments:
Australian equities will perform moderately but with returns again skewed to income (dividends) and capital growth from international earnings;
The Australian dollar should continue to fall if bulk commodity and energy prices remain at current levels. The poor trade account outcome will stimulate the devaluation;
Australian investors need to accept moderate risk-adjusted returns from Australian assets over the next year and to supplement these with returns from a weakening $A. There seems good reason to expect that the $A will be 10% lower against a basket of international currencies in a year’s time;
The RBA will recognise that continued cutting of interest rates is not conducive to economic growth and that the $A will weaken under its own weight. Indeed historic low interest rates are now perceived to be the chief cause of asset bubbles;
Australian listed property securities are unlikely to repeat last year’s gains. The gains in property securities to 20% above equity value should be banked as the risk of capital loss from these assets over the next few years becomes elevated;
Most bond markets represent poor value when compared to historic average yields and assessed for risk. They have been buoyed by QE and low inflation. However, the fact remains that many developed governments cannot repay their debt and bond prices will eventually acknowledge this risk; and
The sleeping issues for Australia remain our growing dependence on China and the elevated risk of inflation as the $A devalues. In our view, higher inflation will be discernible by mid-2016 and Australia’s rate of about 3% will exceed that of the G7. The RBA will stay behind the inflation curve on this occasion and a difficult period could eventuate where savers are seriously affected.
Once again, we remain cautious with the outlook, but perceive that attractive investment returns can be made from a suitable allocation across asset classes and from active management strategies. Offshore assets should remain a focus for investors. At this point, 2016 presents as a volatile year for markets as inflation re-appears in Australia.
Download: Letter to Investors – July 2015 (PDF, 745KB)
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