Australia's Economy 'Unexpectedly' Contracts: Expect This to Continue

Includes: BHP, EWA, FXA, VALE
by: Individual Global Investor

Economic data from the Reserve Bank of Australia yesterday showed the first quarterly decline in Gross Domestic Product (GDP) in more than eight years. The decline was 0.5% in the fourth quarter of 2008 (ending December) as compared to the third. This was “unexpected” because Australia had largely been expected to sidestep the worst of this global recession and it has so far. Similar numbers for the US and Japan are -6.2% and -13% respectively. When compared to the same quarter in the prior year (the other way of looking at GDP), the numbers are a bit less scary:

Should it be surprising that the Australian economy is beginning to contract? No. In general, the Australian economy is composed of two sectors: resources and financials. The dynamics of the Australian economy is not unlike that of Canada. Take a look at the major index of Australian Stock Exchange (ASX), the S&P/ASX200; two thirds of the market value of this index is made up by financial, materials, and energy companies. Like Canada, the Australian banks and financial firms have been smartly regulated and have largely avoided the mortgage mess in the US and the structured financial products that have brought down the likes of Citi (NYSE:C), Bank of America (NYSE:BAC), and the Royal Bank of Scotland (NYSE:RBS). There has been a fair bit of colossal destruction of shareholder wealth in the Australian financial sector such as Babcock & Brown (symbol BNB on the ASX), a lesser investment bank, and Centro Properties (CNP.ASX), both down more than 99% since their 2007 highs. All things considered, though, banks such as Commonwealth Bank of Australia (CBA.ASX), Westpac (WBC.ASX), and the National Bank of Australia (NAB.ASX) have all held up reasonably well. Their success or failure going forward will depend on how well the domestic economy holds up. Australia has no subprime; the RBA has not moved to panicked zero interest rate policies like its Anglo-Saxon brethren; the unemployment rate is still at 4.8%.

So what is going right and will it stay that way? Commodities prices have not fallen very much. Australia’s central bank, the RBA, keeps its own index for commodities prices. Most global commodities indices are dominated by crude oil prices which we all know have fallen from $147/barrel last summer to around $40/barrel of late. But the RBA’s index does not include oil (Australia produces virtually no oil for export), focusing more Australia’s top export commodities of coal, iron ore, gold, wheat, and beef. Based on this index, prices have only corrected back to last September, just before the collapse of Lehman Brothers and the world economy went into a tailspin.

So how is it that Australia commodities prices have corrected only back to the fall of 2008 when the rest of the world is comparing their economic malaise to that of 1982 or 1974 or 1933? The answer: annual pricing contracts. Big resource players like BHP Billiton (NYSE:BHP) and Rio Tinto (NYSE:RIO) renewed annual pricing contracts with customers in China and other parts of Asia just at the right time. These two companies, combined with VALE of Brazil form the bulk of the iron ore market. Iron ore is the raw ingredient for steel production. BHP and Rio inked new pricing contracts at the exact peak of the market, getting more than 80% price increases last summer.

This is holding up the pricing index – and the economy by extension. How long will it last? Only about 6-9 more months, I expect. Pricing contracts will be up for renewal this summer (2009) and take affect by the fall. The effects will bleed into results for the quarter ending Sept. ’09 and the end of the year should be particularly ugly for these companies. This will ripple through to the overall economy into GDP, into unemployment, into bank credit costs from defaults.

In relative terms, Australia has a sound economy and a bright future. The emerging economies need the coal, iron ore, grain, and meat that its companies produce. But to think that Australia is somehow immune to this global recession is just wrong. Australia’s exports are mostly raw materials and are further back in the global supply chain. They will be the last domino to fall. The government entered this downturn in good shape fiscally and the currency has fewer failings than the British Pound Sterling, the US Dollar, or the Euro. Few big resources companies will fail (although many small ones will) because China needs them to succeed.

On February 13, 2009 Rio Tinto signed a A$30 billion deal with the Chinese Aluminum giant Chinalco. Rio overextended itself in the purchase of Canadian rival Alcan during the boom time and was caught this year with far too much debt. Chinalco was all too happy to provide a mortgage on Rio’s future. They get a big stake in Rio but more importantly Chinalco will have far more say in price of the raw materials it buys from Rio going forward. Expect this be the model for the next 1-2 years. The Australian economy will survive the inevitable recession but it may have to give away some of its future pricing power to do it.