Feature Stories | Jan 21 2015
This story was originally published on 17 December, 2014. It has now been re-published to make it available beyond paying subscribers at FNArena.
By Greg Peel
This article follows on from Expectations For 2015 Part (1): Global.
The tailwinds that have boosted demand in Australia over the past few decades are set to ease, warns Macquarie, or reverse course. For 24 years, the country has enjoyed a strong run of economic growth, in more recent years driven by a strong terms of trade (exports, specifically commodities, exceeding imports) which has boosted incomes. While Macquarie expects Australia’s GDP to grow again in 2015, the broker points out that the problem for Australia’s GDP is its narrow base.
Resource exports are the major contributor to GDP growth, notes Macquarie, with population growth the other driver. Outside of these two elements, Australia’s economy is weak. Macquarie’s analysts expect GDP ex-resources to decline on a per capita basis through to mid next year, against hopes of the Australian economy being able to transition away from its reliance on mining investment.
The impact of the decline in the terms of trade, driven by lower commodity prices, will persist for some time, the analysts suggest. Stronger productivity growth is the key to preventing further declines in income growth, and subsequent weakness in spending. But Australia is not alone in the world in facing a more modest demand and inflation outlook.
While Australia’s need to transition away from reliance on mining has been understood and anticipated for a number of years now, a fall in the terms of trade was never factored in, at least not to the extent that may now be reality. Suggestions Australia had reached the “end of the mining boom” were misleading, because an end was only nigh for the investment phase. That investment has increased production capacity, so from here on Australia was expected to enjoy the next phase of the mining boom, highlighted by increased production volumes.
As late as October, Australia’s trade data were still showing an increased dollar value of iron ore exports over the month before, despite falling iron ore prices, because exports volumes had sufficiently increased (and the lower Aussie was also helping). Analysts had anticipated a fall below US$100/t for iron ore into China based on Australia’s increased production capacity, but only a lone voice or two suggested a price under US$70/t.
Similarly, analysts across the globe had been assuming all year that were geopolitical tensions to ease, such as in Ukraine and Iraq, the price of oil would fall below US$100/bbl given increasing North American supply. But at that time, no one said US$60/bbl.
Thus when the RBA started worrying about how the Australian economy was going to transition away from mining investment, which created jobs, strong wage growth and flow-ons into the general economy, particularly in Western Australia and Queensland, lower terms of trade were not considered an issue. Indeed, the decline in mining investment meant a reduction in imports of mining infrastructure and equipment, which would help to support the trade balance. But in the space of a few short months, the picture looks different.
The outlook for the economy continues to be clouded by the outlook for commodity prices, note ANZ’s economists. The terms of trade had fallen nearly 9% when ANZ wrote its Australia Outlook and published it last month, driven mostly by a near halving of the iron ore price since January. The more recent plunge in oil prices is problematic for Australia’s future terms of trade, specifically for the big ramp-up ahead in LNG exports.
Lower commodity prices will weigh on profits and wages in the economy, while also reducing both company taxes at the federal level and mining royalties at the state level, This in turn will constrain consumer spending and business investment and lead to an extended period of weaker than normal growth in public demand. ANZ has trimmed its Australian GDP growth forecasts to 2.9% in 2015 and 3.2% in 2016.
That said, the transition away from mining investment appears to be on track, if not at a slower pace than ANZ had earlier assumed. Household consumption has been the key disappointment, growing just 2% year on year in the first half. Consumption accounts for 55% of GDP, so any transition needs to be supported by households. The issue here appears to be one of an ongoing focus on cost-cutting in the private and public sectors. Employment growth has been weak, and thus wages growth has been weak. Lower terms of trade will only serve to foster further weakness.
The post-GFC Australian consumer remains cautious, except when it comes to housing. But paying up for housing means an excessive mortgage repayment burden for many and thus less cash to spend elsewhere, which Australians are tending to save anyway, mostly in term deposits. Money in the bank and money in bricks and mortar suggest a lingering fear of risky investments, such as the stock market. This reluctance to provide businesses with capital (share market investment) leads to less spending by corporations (and more cost-cutting), all of which restricts GDP growth.
The good news, ANZ suggests, is that those who own property are feeling more wealthy. This should lead to a reduction in savings rates, although ANZ expects the rise in house prices to moderate going forward. But there should be at least a modest lift to consumer spending next year. The housing sector is currently carrying the baton for the non-mining recovery, the economists note, and elevated building approvals point to a solid pipeline of activity in the next year or so.
Investment outside of housing remains lacklustre nonetheless. The rate of decline in resource sector investment will accelerate in 2015 and lower commodity prices will ensure new proposals will remain in the drawer. The fundamentals are in place for non-mining businesses to step up production (low interest rates, lower Aussie) ANZ believes, but firms continue to show a reluctance to spend until the pick-up in demand becomes more sustained.
Many an economist has now changed their tune on RBA policy expectations, in the wake of falling commodity prices. At least one, if not two more rate cuts are expected from the RBA next year by one section of the fraternity. ANZ’s economists are not among those, but rather are sticking to their expectation that the next RBA move will be up, albeit they have pushed the anticipated timing of the first RBA rate hike out to November next year.
JP Morgan’s Asia Pacific equity analysts see their base-case for Australia’s economy going one of two ways in 2015. If, perchance, Australia’s domestic growth does accelerate, the RBA will be forced to raise rates sooner and faster than expected and the Aussie will rally, dampening the impact. But the domestic economy could struggle more seriously if the real estate pick-up proves to be just a “sugar rush”, JPM warns, and consumer spending and non-mining capex remain subdued.
The analysts see arguments for the two cases as being finely balanced, and suggest the two indicators to watch are retail sales and business credit growth.
In terms of investing in equities, JP Morgan sees the Australian stock market as problematic. Some 60% of the ASX200 is accounted for by the banks, telco and supermarkets, which are mostly domestic, high-return oligopolies with solid yields. Lower interest rates support this cohort but little upside is apparent for earnings or valuation. Materials and energy make up the bulk of the rest of the index, and both are challenged by lower commodity prices, while other sectors also tend to be overvalued at present.
JP Morgan recommends a weighting towards Australian companies deriving US dollar earnings, which stand to benefit from the falling currency. However, the analysts warn that the Aussie is unlikely to rebase suddenly, given expectations of only a marginal shift in Fed interest rate policy amidst further easing in Europe and Japan.
UBS notes that Australia’s large-cap equity market is disproportionately exposed to three key factors, being interest rates, commodity prices and the Aussie (from a domestic investors perspective), in that order. The first is the most significant, as UBS estimates some 60% of Australia’s large-cap market is acting as a quasi-yield trade.
This means the index is very exposed to a sharp rise in bond yields in the medium term, warns UBS. But the strategists suggest a more moderate rise in bond yields and/or further moderate falls in commodity prices are unlikely to stop the stock market pushing higher over 2015. Like JP Morgan, they see the opportunities lying with those cyclical stocks exposed to US dollar earnings.
From Citi’s point of view, investment in offshore industrial stocks can provide a hedge while domestic-based high yield stocks continue to hold sway in the Australian market. A year ago analysts assumed 2014 would be the year in which bond yields would begin to rise, led by the US, which would render the carry trade in Australia’s high-yielders less attractive, but this has not transpired. Bond yields may still rise only slowly in 2015, but either way a lower Aussie dollar is more likely than a higher Aussie dollar.
Thus domestic investors can afford to trim their exposure to at-risk, overvalued yield plays to gain exposure in those stocks which will benefit from a stronger US economy, the analysts imply.
The rebound in the Australian stock market over 2012-13 brought the market price/earnings ratio (PE) back to its medium-term average, Citi notes. Yet earnings growth has generally remained weak since the GFC, and (as has been noted earlier) investor sentiment has remained cautious. Thus another significant PE re-rating is unlikely in 2015, while earnings growth will remain challenging. This is particularly true now for the resource sector, while cost cutting rather than revenue growth will remain as a fundamental source of earnings growth market-wide, Citi believes.
Citi suggests the Australian economy is likely to record only trend growth at best in 2015 and given pressure on commodity prices, the risk is to the downside.
Much has been made of Australia’s housing sector picking up the slack left by declining resource sector investment, but Credit Suisse believes the right conditions are not yet in place for a multi-year upswing in residential investment. The analysts see the recent upswing in demand for housing peaking in 2015 just as supply is increasing, putting downward pressure on house prices at a time the mining capex downturn is most severe.
[A note here: Commentary tends to divide Australia’s economy into “mining” and “non-mining”. The accelerated downturn in mining capex in 2015 will lend a lot to a decline in LNG capex, as major Queensland LNG projects reach the production phase. In subsequent years, the big new offshore WA and Darwin projects will also reach this milestone. While the oil & gas industry is not really “mining”, and a more accurate term is “resources sector”, the word “mining” is typically implied as a catch-all.]
Credit Suisse’s less positive view on Australia’s housing sector is behind its expectation the RBA will need to cut its cash rate further in 2015, either to minimise a slowdown in housing sector growth, in which the central bank is placing much faith, or to minimise the damage from a cyclical slowdown (exacerbated by mining investment decline).
A trimming of the cash rate by the RBA would be supportive of the Australian dividend trade, Credit Suisse notes, but deep cuts would signal “risk off”, and only defensives would find support.
The other weight on Australia’s economy going into 2015 is, of course, “fiscal drag”, aka the obsession of recent governments of either stripe to return Australia’s federal budget to surplus as quickly as possible for political purposes. The Australian electorate is apparently a lot more comfortable with the word “surplus” than the word “deficit”, even though few would actually be able to explain exactly what a “budget deficit” is, politicians included.
Goldman Sachs warns that the three major challenges for Australia’s economy in 2015 are the sharp decline in mining investment, the (lagged) impact of lower commodity prices, and “the commencement of the next wave of fiscal consolidation”, which refers to the federal budget, whatever that ultimately will look like. These challenges will present during a period of tightening financial conditions and smaller contributions from housing investment.
Goldman’s strategists expect global economic growth to accelerate in 2015, but are forecasting a decline to 2% growth for Australia (currently 2.7% as at end-September). They are among those sticking to expectations the RBA will remain on hold next year, but concede the chance of a first half cut is rising. Goldman is nevertheless tipping the ASX200 to trade at 5700 by December next year, despite no net earnings growth in FY15 as mining contracts.
Goldman agrees that the fundamentals favour US dollar exposures among Australian-listed stocks, but warns valuations do not. The strategists prefer selective domestic cyclicals and prefer “dividend growers” rather than “defensive yield”. It is a year that should provide ample “alpha” opportunities, they believe.
“Alpha” refers to upside/downside risk inherent in a stock which is totally unrelated to overall market, or “beta”, risk. Those who invest in “the market”, by concentrating on a portfolio of large cap names which dominate the index, are investing in beta risk. “Stock pickers”, who select names on individual themes, are investing in alpha risk. Given widespread valuation dispersion across Goldman Sachs’ three key themes (lower mining capex, lower commodity prices, fiscal drag), the strategists expect “alpha opportunities will be abound”.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
