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Overview

The Australian economy has been the subject of speculation and renewed interest from investors and financial commentators on Seeking Alpha in recent months. Initial interest was generated from Igor Novgorodtsev's article "An Epic Australian Bust." Renewed interest has obviously piqued in recent weeks with trending lower iron ore prices as written about (and correctly called) by Paulo Santos (here) and the subsequent flow on effects for miners Rio Tinto (NYSE:RIO), BHP Billiton (NYSE:BHP), Vale Resources (NYSE:VALE) and some of the smaller miners like Fortescue Metals (OTCPK:FSUMF). Also written on are the near term impacts on the Australian dollar ($AUD) by authors Dr Duru (here) and Ralph Shell (here). While the near term impacts present opportunities for short positions, there are long term opportunities in play that should also be considered.

This article (in two parts) will seek to present a balanced overview on the state of play for financials in Australia and reinforce the underlying value of the Australian economy within the global marketplace. Investors long and short can refine their own positions as appropriate - the comments section on many of the above articles is where the real interest and debate has and continues to occur.

Resources

The boom is over, long live the boom! This has been the catch cry of the last two weeks as iron ore spot prices reach new lows, the miners start to rein in spending, and slowing growth from China causes even the most optimistic of punters to take a revised view of their positions. BHP has placed its Olympic Dam expansion on hold, RIO has shelved plans, and even the bullish Fortescue Metals Group has announced it will delay capital expenditure plans. Trading of the stocks are trending down, but inside buying in some cases is trending up. In the case of Fortescue, founder Andrew "Twiggy" Forrest has been buying, recently picking up $40 million in shares at a significant discount to what he believes it is valued at. The CEO of OZ Minerals Group has been doing likewise.

Iron Ore Pricing

As iron ore prices hit what was previously considered to be its floor, the bottom line of production costs and hedging strategies come to play. The miners that will be successful are those that successfully hedge their forward contracts, and those that can retain/sustain their profit margins by squeezing every possible cost reduction from production and distribution. Onshore infrastructure costs are relatively fixed, rail lines are built and port berths can cope with current capacity. Offshore costs such as shipping are competitive given the abundance of dry bulkers. China's growth while slowing is still growth - other countries beside China require natural resources for their growth and development, and these requirements provide a steady state of demand for suppliers (though at an emerging lower profit margin). Naturally a strong Australian dollar hampers Australia's competitiveness as an exporter.

Housing (The Elephant In The Room)

Ever since the global financial crisis (GFC) hit, caused by the American sub-prime mortgage collapse, critics of Australia's property market have been voicing the inevitable - the great property crash is coming to Australia. They are still saying the end is near, though apparently four years on the end is a little further away than they first expected - that or they don't understand the Australian property market.

The two-speed economy of Australia has been driven by the spoils of the commodity markets, and obviously has had an impact on disposable income (for a small part of the community - 2% of jobs reside within the mining industry) and housing prices in select locations (Perth and Port Hedland are two examples). That said, the supply and demand of housing drives the market in Australia (in the main), and the biggest impacts have already occurred. Australian banks do not fund a great deal of low documentation loans, and many of the riskier low doc loans were wiped out in the GFC. Those loans that still do exist represent a minor load of lending by the banks, and mortgage loans in Australia are secured against the borrower and covered by mortgage insurance.

Property values underwent a period of retracement following the GFC, and to a large extent have plateaued, or in certain areas have begun moving forward again. The Australian property market has a tight rental market, and the tight control of land for building underpins the basic premises of supply and demand. There are exceptions though, and the market is very geographically biased. If you want to live in Sydney, then you are faced with exceptionally high entry costs to the market, which drives the price of housing up. If you want to live in a small country town in regional Australia, then your entry costs are lower, as should be your expectations for capital growth over the long term.

Major government or private enterprise developments are often the real catalyst for change in certain markets; i.e. basing large numbers of military personnel in Darwin, concurrent to the development of many new natural resource projects in Northern Australia, led to a significantly turbo-charged expansion of the housing market there. The real key to the impact of a housing correction is the entry price and time made entering the market - if you bought into the property market in Darwin as the natural gas projects commenced, you are likely to be sitting on a reasonably valued asset that can weather some retracement in price. If however you bought land in the small towns close to the Olympic Dam site in anticipation of an influx of miners, then you are probably sitting on a very expensive hand of poker. Prudent analysis of investments should always come first. Would I pay $900K for a three bedroom terrace in Sydney? No, but then again I don't want to live in Sydney. But plenty of people do and that underpins the market. The market price is what the market says.

Keep this in mind; Australia is almost the same size as the US, but only has a population of 22 million versus 312 million. Immigration is (relatively) more controlled than America (so population growth is more predictable), and the housing market is to a large extent centered on where it needs to be and has only been built to satisfy (current and future) demand. Is there a housing bubble in Australia? Personally I say no, though my perspective is different to someone who just bought a $900K house with 5% down and the remainder financed on a variable interest rate (against their fly-in-fly-out job in the mines which they only started last week).

Summary Part 1

This article has addressed the pressures being imposed on the economy due to the slowing of the mining boom and reduced iron ore spot prices, as well as issues that affect the Australian housing market.

Part 2 will focus on funding pressures facing Australian banks, the impact and effect the Reserve Bank's monetary policy has on the economy, and will conclude with a comparison on where the Australian economy sits in the global environment.

Source: Is Australia Still The Lucky Country? (Part 1)

Additional disclosure: I have direct property investments and holdings in listed property trusts. I have exposure to a number of stocks mentioned through managed funds in Australia and overseas.

Continue to Part 2 >>