Going Short Australia

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 |  Includes: EWA
by: Justin Kuepper

Australia has seen a lot of upside over the past couple of decades, thanks to commodity demand from its neighbor to the north. In fact, the country largely avoided the Great Recession that affected the rest of the world in such a big way. But China's slowdown could have a profound effect on the small island country's economy.

Australia is All-In on Resources

Australia has gone all-in on its resources sector, which has led to declines elsewhere in its economy. For instance, the country's manufacturing sector has shrunk from nearly a third of its overall economy to just 8.6% today and continued to shrink in 2011. Surprisingly, this is even worse than the struggling U.S. manufacturing sector, which still makes up 11% of its economy.

Meanwhile, China has grown to become the country's biggest trading partner by buying huge amounts of iron-ore, coal and natural gas. Ben Hunt, an economist at the IMF, recently estimated that about 12% of the country's GDP growth during the past 10 years can be attributed to trade with China and that figure could increase to 35% over the next decade.

While this may be great when demand is strong, Australia is subject to both changes in this demand and the whim of Chinese policymakers. China recently lowered its GDP growth target to 7.5% for the first time in a long time, while a change in leadership adds additional uncertainty. Combined, these are two negative factors that could weigh on the country.

Economic Indicators Turn Negative

Many economic indicators are also demonstrating the effect of China's slowdown on Australia's economy. The country's GDP grew just 0.4% in the fourth quarter, which was half the rate that many economists were expecting, according to a Bloomberg News survey. This prompted back-to-back interest rate cuts that crushed the Australian dollar.

Things aren't exactly picking up either. Australia's GDP growth rate will fall to 3% next year due to lower demand for its commodities, according to the government's statistics agency. Meanwhile, housing prices fell by the most on record in 2011 and unemployment remains very sluggish given the cutbacks in its largest sector.

Dow Chemical CEO Sums It Up

Dow Chemical Company (DOW) CEO Andrew Liveris summed up these problems in a speech that he gave at the University of Technology in Sydney, where he was unveiling a plan to revive the country's manufacturing sector.

In a Fox Business News article, he was quoted as saying:

We are seeing troubling signs for our economy at large, maybe even signs of a coming downturn … We have seen factories and the jobs in them shipped overseas as other countries become more competitive and we've become less … Unfortunately, we have seen a lot of warning signs in recent months. Australia has seen its employment growth slow, its global competiveness indicators are actually falling and its GDP growth rate is indeed slipping … You could reach the conclusion that with all these indicators that Australia's current growth trajectory is in fact unsustainable.

Finding the Best Trade

Australian assets have certainly taken a hit over the past few weeks, but this may represent just a fraction of the potential downside. Keep in mind that the Australian dollar has risen more than 80% since late 2008 alone, and reached a 30-year high in mid-2011. Meanwhile, commodities remain at elevated levels that may not be fully pricing in a Chinese slowdown.

The iShares MSCI Australia Index Fund (EWA) is also trading up sharply from its lows seen in early 2009. After the country's negative reports as of recent, the ETF fell only modestly from an interim high of $28.27 to its current level of $23.13 per share. Investors may therefore want to take a look at purchasing longer-term puts that can be hedged by writing shorter-term puts.

For instance, investors could purchase at-the-money 23 January '13 puts for $2.65 per contract and write out-of-the-money 21 May '12 puts for $0.25 per contract. The short-term written puts can help offset the cost basis for the long-term purchased puts over time, while still giving the investor exposure to significant downside in the ETF.

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