My View On The Australian Economy As 2015 Draws To An End

I think throughout my posts, my concerns over the Australian economy permeate throughout my posts over time. It may be hard to follow when they appear all over the place. This post is to summarise my current thoughts on the Australian economy in a more concise form. Please note that it is not an exhaustive list and that little of what follows would crystallise into my thinking when picking stocks (however it may help me identify potential bottom-up candidates) I still think it’s important to stay on top of it all – or as much as you can. 

My View On The Australian Economy

The economy is transitioning from mining investment-led growth to a broader-based form of growth. With the RBA cash rate at record lows, the intentions of the low interest rates have not had the desired outcome as business investment has not been ideal. This comes at a time when above average economic growth is tapering off as the investment boom comes to an end. Consensus economic growth for 2016 sits at around 2.5-3.0%. However, there is downside to this forecast and economists are consistently revising their numbers.

Secondly, the economy is undergoing a “wage growth” recession. As the mining boom continues to taper off, highly paid mining jobs are being replaced with lower paid roles putting downward pressure on income growth. Recent consumer sentiment & retail sales numbers have been "steady" but this has been supported by the “wealth effect” whereby increasing asset prices (especially house prices) have meant people are feeling richer and so are dipping into their savings which is stimulating consumer spending. You can see this by noting that the average household savings has fallen. This trend is expected to continue as long as asset prices continue to rise. However, with the ASX achieving relatively flat results for 2015 (which is expected to continue short-term) and house price appreciation forecasted to fall by about 7.5% in 2016, it is hard to see how the consumer (in at least the short term) will contribute to GDP growth.

Lastly, the labour market has held up well in recent times with net job ads improving but not impressive. In order to fill the gap between the fall in mining investment related jobs and the broader economy, the job ads will need to improve.

The Australian Economy More Closely

There are several key headwinds that the Australian economy is facing. The lower A$ hasn’t yet sparked a strong surge in non-mining exports, we should at some point see this trend turn though. The most recent GDP growth number for the September quarter of 0.9% was particularly surprising and was primarily driven by strong net exports. Whether or not this continues, I cannot say much but as the A$ comes off, you should see non-mining exports pick up. Major detractors of growth were the sharp decline in mining capex and investment, the stubbornly resilient A$, and cuts to government expenditure. As China’s demand for key commodities continue to decline and our terms of trade with it, it is constraining income growth which is constraining domestic demand growth.
As noted above, it is expected that consumer spending will grow but correlate with growth in asset prices, not wage growth. However, consumer spending should be supported by population growth.

My Take On The Equity Market

I’m treading in uncharted waters here, but what I’m seeing is that the Australian market is diverging. However, with this divergence the risk-reward trade-off is not really justifiable. Many sell-side analysts are recommending the same longs, as they do so, it’s driving the prices up and so newcomer’s returns are not as appealing. As a result, buying into the “consensus growth” is reducing in its attractiveness. Similarly, in the value end of the market (dominated by miners & energy related companies) it isn’t any easier to buy given their inherent business models are dependent on commodity prices and resulting lack of accuracy in forecasted figures.

According to Robert Buckland, chief global equity strategist of Citi in an investor presentation said that the recent market correction has removed EPS growth expectations and the market is now fairly valued. Put differently, Robert believes that the market was pricing in a circa 10% EPS growth, however, the recent correction has wiped this out and now the market isn’t pricing in any EPS growth or falls in EPS. Thus, the market isn’t overvalued nor is it undervalued. I believe there is little reason to make a call that P/E multiples should expand in the near term as the fundamentals don’t look strong enough. The funny thing about markets though is that anything can happen, be mindful.

Earnings are expected to grow in the low single digit (pulled down by resources). The same trend of 2015 has continued and it appears as though will continue into the start of 2016 – slow revenue growth and margin expansion driven by cost out and restructuring.  As a result, we should expect only very modest growth in the Australian equity market in 2016 (other things remaining equal). However, the low interest rate environment and strong dividend yields should support the market.

A key question now is how you should translate this (top-down) thinking into portfolio positions. I would argue that banking should be a beneficiary as their dividends should support their prices, despite ROEs falling as a result of capital raisings on back of new regulation introduced by APRA. Alternatively, US$ exposure is also attractive. Lastly, lower A$ exposed industry’s also look attractive, such as tourism, education and so on. On the other hand, as a sector I’m bearish on materials. While there is value there, it’s a hard game to play. Oversupply of key commodities and demand side pressure from China and other key emerging markets signals more risk for the sector.

The fundamentals of the economy suggest that it is hard to see why the Australian economy will continue to grow at above-average levels in the near term. Rather, it is expected that the economy will continue to grow but at a more “normal” rate in line with the long-term average.

There are however a number of factors (but not limited to) which may shake or permute my reasoning. The following factors are important considerations:

1. Firstly, changes in the RBA cash rate should change the dynamics by bolstering business investment, support the construction sector, and unfortunately support riskier assets such as shares among others. The strong GDP number in the September quarter suggests rate cuts are unlikely until early-mid 2016.

2. Sustained strength in the A$ will also put pressure on non-mining exports. A sharp decline in the A$ might see key export services flourish with key beneficiaries being tourism, education, agriculture and so on.

3. Uncertainty around the 2015-16 federal budget. Given that government expenditure has come off, a change in this may boost growth or have an alternative effect if the political party in charge decides to tighten fiscal policy further.

4. Business & consumer confidence levels are key to our growth. With the evidence suggesting downward pressure on consumer confidence, business confidence might pick up in 2016 on the back of low interest rates and low A$.

5. Lastly, China’s economic slowdown is also another key factor for our markets. Any shifts here will also shift our growth story.