Australia: What Recession?

Includes: EWA, FXA
by: Elliott Gue

The US market is enjoying a cyclical recovery in the context of a secular bear market. The situation is similar to that of the 1968-to-1982 era: We’re likely to see far more extreme business cycles and vicious recessions than during the benign post-1982 secular bull market.

In the October 24 installment of Personal Finance Weekly I noted that there’s always been a significant cadre of pundits who are permanently bearish and thrive on pointing out all the headwinds facing the US economy while claiming to “call” every market correction. Like the broken clock, they’re right occasionally.

I disagree with their approach to the market. Investors must be willing to suspend long-term beliefs to play cyclical rallies. Slavish devotion to the bear thesis this year would have spelled disaster; catching rallies, such as the move off the March low, will be critical to making money in US stocks. The most successful bears--for whom I have enormous respect--are willing to shed their long-term prisms to play specific opportunities.

Nonetheless, the perma-bears are correct about longer-term fundamentals. The US economy faces significant, intractable headwinds, including excessive household debt, the prospect of confiscatory taxes, and the biggest debt-financed government spending boom since World War II. These challenges are just the tip of the proverbial iceberg.

Fortunately, not all countries face the same obstacles. In recent years there’s been significant debate concerning the potential for some foreign economies, particularly emerging Asian nations, to “de-couple” from the US.

Some are now arguing that last year’s financial crisis is proof that there is no de-coupling--all stock markets and asset classes sold off in tandem.

But don’t be so fast to draw that conclusion. Although most global markets performed poorly amid last year’s financial crisis, global economies didn’t follow the same path. And as credit markets began to heal this year, some countries have been far quicker to recover than others.

I’m not just talking about emerging markets. Consider the case of one of the most promising markets, Australia.

Source: Bloomberg

There’s considerable debate about what exactly constitutes a recession. In the US, the official start and end dates for recessions are set by the National Bureau of Economic Research’s (NBER) business cycle dating committee, which looks at a wide range of economic data. Others prefer to define recession as two consecutive quarters of negative growth in gross domestic product (GDP).

But no matter how you might care to define recession, it’s hard to argue that the chart above depicts an economy in recession. Australia’s GDP saw a sharp slowdown from mid-2008 to early 2009, but the economy never shrank on a year-over-year basis. In fact, contrary to expectations from most economists, the Australian economy grew by 1 percent in the first half of this year instead of contracting.

Now, economic growth appears to be re-accelerating. Australia is the only developed country that you can legitimately argue didn’t experience a recession last year.

The labor market is a major concern in the US. While unemployment always turns lower long after the economy begins to recover, double-digit unemployment and the particularly fast pace of layoffs this cycle are undoubtedly going to delay any recovery in consumer spending.

Check out Australia’s employment picture.

Source: Bloomberg

This chart shows Australia’s official unemployment rate going back to the 1970s. As you can see, unemployment has been hovering just under 6 percent of the labor force for the past several months; in fact, barring another global credit crunch it’s likely that the unemployment rate has nearly topped out for this cycle and will begin to fall soon.

Granted, unemployment is up sharply from early 2008 levels. But back in 2008 unemployment stood below 4 percent in Australia, a historic low.

Unemployment at that level is not usually desirable because it means that businesses are having a tough time finding qualified workers. Unemployment that low can also lead to accelerating inflation as companies bid up pay packages to attract talent. That said, most governments in the developed world would be happy to have Australia’s unemployment problems.

The long-term chart of unemployment also illustrates the important change underway in Australia’s economy since the early ’90s. Back then, Australia’s unemployment rate jumped well into the double digits; it’s fair to say that Australia suffered a worse recession in the early ’90s than most other developed nations. Since then, however, the cycles have remained comparatively mild.

I could go on with charts of housing statistics, interest rates and industrial production, but the Reserve Bank of Australia (RBA) summed up the situation well in the press release accompanying its recent decision to boost rates for the second straight month:

Economic conditions in Australia have also been stronger than expected. In contrast to other developed economies, the Australian economy is estimated to have expanded, albeit modestly, over the first half of the year and recent data suggest that this expansion has continued into the second half. Confidence has improved and spending has been supported by stimulatory settings for both monetary and fiscal policy. The Australian economy has also benefited from the strong bounce-back in Asia, particularly in China, with export volumes remaining broadly unchanged during a period in which global trade fell markedly.

A recovery in housing construction is now clearly under way, with leading indicators of house building well above the levels of late 2008, although financing issues are constraining activity in the apartment market. There are, however, likely to be ongoing pressures in the housing market over the next few years, with the Australian population growing at its fastest rate since the 1960s. Addressing these pressures will require further steps to improve the supply side of the housing market.

The RBA noted that the economy has surprised its own expectations to the upside thanks, in part, to a strong re-acceleration in trade with developing nations such as China.

Another interesting aspect of this quote is the second paragraph; unlike most developed-world economies, Australia’s population is actually growing at the fastest pace in decades. Thus, while the credit crunch hit residential financing in late 2008 and early 2009, the housing market has reaccelerated quickly. Unlike the US, there’s no excess supply of houses. Australia will need to see more homebuilding to address supply constraints. The contrast with the US condition is stark.

This data points to a strong cyclical recovery in the Australian economy from a slowdown last year. But it’s also important to note that Australia doesn’t face the same debt constraints of the other major developed countries.

The Federal Reserve publishes a debt service ratio that compares the total payments US households must make on debt to their personal disposable income. Currently that ratio is around 13.1 percent, down from its recent highs near 14 percent but well up from its early ’80s levels around 10.5 percent.

The US consumer accounts for about two-thirds of GDP, the consumer’s ability to take on more debt fueled growth in the US, particularly after the mid ’90s.

In Australia, the equivalent debt service measure stood at 10.3 percent in June down from recent highs over 15. That’s a far more comfortable level.

And consider public finances. In the US, the public debt-to-GDP ratio is around 50 percent today and is on its way up to about 70 percent by the end of the coming decade. And that’s based on forecasts that don’t yet include a potential second stimulus package or a new national health care scheme.

In the G10 as a whole, the situation is arguably even worse than in the US. On average, debt-to-GDP in the G10 stands at 60 percent and is on its way to 80 over the next few years.

But the Australian Treasury recently forecast the nation’s net debt-to-GDP ratio will rise from the current 3.7 percent to around 9.4 percent in 2012-13, among the lowest of any country in the world. This is well off its mid-’90s highs of around 18 percent. Although the Australian government, like most around the world, applied some fiscal stimulus to the economy in 2008, it’s one of the only developed countries in the world that can actually afford that stimulus.

Another factor: The Australian banking sector is far healthier than in most other developed countries. Banks Down Under just haven’t experienced the rise in nonperforming loans of their peers in the US and EU.

A nation’s currency is much like the shares in that country. Currencies, like stocks, rise and fall with the fundamental prospects for the underlying countries/companies. Here’s a chart of the Australian dollar over the past few years.

Source: Bloomberg

This conventional quotation for the Australian dollar is the price of 1 Australian dollar in US dollars. In other words, when the line is rising, that means that the Australian dollar is rising in value against the US dollar.

As you can see, the Australian dollar is approaching parity with the US dollar and has nearly doubled in value from its lows of AUD0.50 to AUD1.

Granted, outperforming the US dollar is a bit like bragging about beating a four-year old at a game of chess. But the Australian dollar has also handily outperformed the euro and the Canadian dollar this year.

Australia’s superior economic performance is driven, at least in part, by its trade in natural resources with China and other emerging nations. Because Australia is rich in natural resources and has a population of just 21 million people, it will dominate Asian exports of all sorts of commodities and that will remain a major tailwind for years to come. The rapid improvement in Australia’s economy this year suggests that the Asian economic recovery is for real.

Australia, like the US and UK, has an equity culture. This presents myriad opportunities for investors looking to play Australia’s improving economic situation. The most obvious plays are resource companies; for example, I’ve been recommending exposure to coal companies with significant Australian assets for some time. Australia is the world’s largest exporter of coal, the most important fuel for developing countries. But there are also opportunities in Australian banks, retailers and real estate firms.