Wednesday 29 August 2012

Australia - running out of luck

More on the Australian economy - from an investment point-of-view

Australia: Running Out of Luck Down Under
By Jonathan Tepper, Variant Perception

28 August, 2012

Australia has been described as the lucky country, but it is running out of luck and has a terrible combination of fundamental factors. In fact, Australia reminds us in many ways of the housing bubbles in the UK, Spain and Ireland. In each case, the country experienced a banking crisis.

Australian growth has been dependent on two huge bubbles: a domestic housing market that is one of the most overvalued in the world and a reliance on the Chinese fixed asset investment craze. Despite extraordinary commodity exports, Australia has run current account deficits and has a terrible international investment position. A substantially weaker currency in Australia is inevitable given fundamental factors. Oversized banks dependent on external financing, a bursting housing bubble and a slowing Chinese economy are all fundamental factors which are likely to weigh on the currency. As we explain, a weaker currency can either come in the form of the Reserve Bank of Australia (RBA) reducing interest rates or a balance of payment-like crisis in which foreigners pull funding from the banking sector. In both cases, the RBA would likely have to expand domestic liquidity substantially to prop up the banking system.

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Australia is a classic case of the Dutch DiseaseThe Dutch Disease denotes the loss of competiveness in the tradable manufacturing and industrial sector as a result of a resource/commodity boom which leads to an overvalued real exchange rate. In Australia, the mining sector has crowded out almost all other sectors of the economy and also funnelled credit and liquidity into a housing bubble in the real estate sector.

Australia net external debt levels resemble those seen in the European periphery; the currency is fundamentally vulnerableAustralia has been running a persistent current account deficit since 1980 and the country’s negative net international investment position is one of the largest in the world. On this background, the strong currency makes no sense and fundamentally the currency is very vulnerable to capital flight from the banking system.

Australian banks and corporates rely heavily on foreign funding; the RBA will have to provide liquidity through LTROsStructural global deleveraging and stop-go flows add volatility for Australian banks. As the housing market continues to correct, it may be difficult for Australian banks to fund themselves. Lowering interest rates will hurt the margins of the banks, and the RBA will likely be forced into domestic liquidity operations to prop up its banks.

Two options to weaken the currency, lower rates or a balance of a payments crisisThe Australian currency will weaken in one or two ways. Either the RBA gradually reduces interest rates to accommodate a structurally slowing economy and a relative end to the mining boom or the economy will suffer from a balance of payment crisis as external financing dries up due to the decline in the terms of trade exposing the negative current account.

Australia’s commodity sector is tied to a structurally slowing Chinese economyThe commodity sector remains a force to be reckoned with in Australia and will remain cyclically tied to China. Still, the Chinese economy is structurally slowing down and this will impact the growth rate of mining and resource related activities in China. Australia is likely sitting on significant overcapacity in the mining sector which will be difficult to transfer to other sectors.

The Australian consumer is overlevered, but demographics are relatively positive going forwardThe correction in the Australian housing market is far from over and the Australian households remain overlevered. Yet, the savings rate has already increased substantially and in the long run demographics look far more robust than in eg Europe.

Stay long government bonds in Australia on convergence towards low interest rates in the rest of the OECDWhether it be as a result of the RBA gradually cutting rates to reflect slower growth or because foreigners start bidding up Australian bonds due to carry, yields are going down in Australia. We continue to like being long government bonds in Australia.

Our long-term technical buy signal on Australian equities is in effect, but avoid miners and banksWe currently have a long term technical buy signal in effect on Australian equities as a result of the recent sharp sell-off. This is usually followed by good returns over the next 6 months or so. Although the market cap on the ASX 200 strongly favours overweight in mining and financials (market weight), we would avoid these two sectors and buy into defensives (consumer staples and health care) as well as industrials.

Industrials and manufacturing will outperform on lower interest rates and a weaker currencyThe gradual end to Dutch Disease will eventually lead to outperformance of the industrial sector. In the long run, our view is that the Australian equity market cap will re-weight away from mining and financials towards industrials and eventually consumer and retail.

Buy CDS on big four Australian banksAustralian banks remain the weakest link in Australia’s economy, and they are too big to fail. We like buying CDS on Australian large cap banks as an outright trade or as a hedge against the long-term technical buy signal on Australian equities mentioned above.

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