Australia's Economy May Suffer 3 Major Blows

Includes: BHP, CAT, EWA, FXA, RIO, WBK
by: Paulo Santos

This article will deal with how the Australian economy will be dealt three successive blows in the coming year. For a detailed primer on Australia's economy I'd also recommend reading Igor Novgorodtsev's excellent "An Epic Australian Bust." Given Igor has already presented a lot of the data, I will limit myself to explaining each of the three blows.

Commodity Exports

I've chronicled extensively why even though China's economy can continue to grow, there are a few specific sectors, residential construction the most important among them, that are set to see reduced activity. Since residential construction is a large consumer of many building materials/commodities, these will see reduced demand as well. This trend is already ongoing, in that residential prices have already started falling in China months ago, and are now falling ever faster. There are already statistics showing reduced steel demand and production (production fell 13% year-on-year in January).

This is very relevant for Australia, because China represents 23.7% of Australia's export. Also, just five commodities, iron ore, coal, gold, copper and aluminum, represent 45.6% of Australia's exports. Hence, any fall in price or volume in these commodities, especially in iron ore and coal, is sure to have a deep impact on Australia's economy. (source: Department of Foreign Affairs and Trade, "Composition of Trade Australia, 2010-2011")

The reduced demand from China for very specific commodities, due to decreased activity in very specific sectors (auto production, residential construction, shipbuilding) is one of the three blows I am predicting here.

Investment in Mining

Fixed capital expenditures by the mining industry come to about 10.5% of Australia's GDP. This is a very large number, especially since it's just one industry and investments can change rapidly. Indeed, if prices and volumes for iron ore are expected to fall, and given many of these investments are made toward increasing capacity, we can clearly expect a large plunge in these numbers.

To see how far the mining investment could fall, one just needs to look back a few years. Back in 2006, the fixed capital expenditures of the mining industry were one-third what they are today. That could easily be the future, but such a future would imply a -6% hit to GDP all by itself. (source: Australian Bureau of Statistics)

Real Estate

Quite often residential real estate is cited as the largest potential problem for Australia's economy. There has been a RE bubble of epic proportions in Australia, but I still think that mining, through its several impacts (exports, investment, ongoing activity) can have a larger impact. Still, clearly real estate is also important. Construction represents 7.6% of Australia's GDP and more importantly, 9.1% of employment. And as we've seen from the U.S. bubble, a bust in real estate can impact many other activities beyond construction, namely finance.

The bubble in Australia's real estate is obvious. The following two charts showing how prices moved relative to rends and real prices show it beyond any doubt (source: whocrashedtheeconomy blog, ABS, others):

Click to enlarge

Click to enlarge

As with China, and previously with the U.S., we can see that prices have already started their descent. These prices are like a large tanker, once they start moving in one direction they're hard to stop. Plus, when prices start falling, activity is sure to follow. This is the third large blow that Australia's economy will suffer.

Market Consequences

There are several market consequences from these blows. Obviously, Australia's homebuilders/construction companies will be hit much like their U.S. counterparts were after the U.S.'s RE bubble burst. Here, a large impact will also hit those construction companies that service the mining industry. Some of that reduced investment in mining gear might cross the Pacific and hit a few U.S. quoted companies, like Caterpillar (NYSE:CAT). Caterpillar's Resource Industries segment was its fastest growing in the last three years, and accounted for 26.7% of its revenues during 2011. Caterpillar also has a large exposure to the construction industry (33.7% of revenues) but obviously the Australian impact here should be little (source: CAT 10-K).

Also as in the U.S., banks will be hit hard. Here, the only stock that has a U.S. listing is Westpac Banking Corporation ADR (NYSE:WBK). Given the expected bust in real estate, this stock is clearly a short.

The stock market in general will obviously suffer. This can be played through shorting the iShares MSCI Australia Index (NYSEARCA:EWA). The market multiples can be ignored (the P/E is around 15 right now), because the economy's dive will impact earnings substantially.

The Australian dollar will also be hit hard, especially when we take into account what Igor Novgorodtsev has shown regarding how much of the financing of Australia's banking sector is coming from abroad. As the economic trends become clearer, much of that financing will try to get out in a hurry, leading to pressure on the forex rate. This can be played either through selling short AUD/USD, AUD/EUR or through shorting an ETF like the Rydex CurrencyShares Australian Dollar Trust (NYSEARCA:FXA).

Finally, it's also obvious that mining companies should suffer from reduced iron ore demand (as well as other minerals), namely Rio Tinto (NYSE:RIO) and BHP Billiton (NYSE:BHP).

There might be many other not so obvious consequences that are hard to predict right now. The three blows I mention, taken together, will represent a significant hit to Australia's economy and might even make it one of the main stories of 2012 and 2013.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am short AUD/USD.