This is the tenth in a series of articles that makes a fundamental macroeconomic sectoral flow analysis of the economies of key countries across the globe. The purpose of the review is to see if the local stock market is worth investing in via exchange traded funds (ETFs). These funds are available to all investors, even for non-residents or those not able to trade in the stock market of that country directly.
In this article, we examine Australia from a sectoral flow analysis perspective to see if the private sector, containing the local stock market, is getting the support it needs from the government and external sectors to continue its march upward. Details of the methodology employed to analyze these opportunities are available in the sectoral analysis section found later in this article.
The magic formula for success is:
P = G + X
And you can read more about that below.
Which Countries Are Doing Well?
The first port of call is the ETF page at Seeking Alpha and a look at country ETFs and how they are performing.
One notices from the list the following items:
Latin American countries head the list; what are they doing right?
- No European countries head the list.
- Only three "developed" countries are near the top of the list: New Zealand, Canada, and Australia; what do they have in common?
- The U.S. is green and showing promise, though far down the list. Why?
- Mexico, a Latin American country, is near the bottom. Why? What is it doing wrong?
All these questions and more will be addressed in forthcoming articles on a country-by-country basis from top to bottom. Most countries on the list are in the red and are of no further interest, though we could learn from them what to avoid, as could their governments and politicians. But, as investors, we will leave that to them.
Since the start of this series of articles, Australia has fallen from tenth to eleventh place. Australia still shows a 30% growth rate over the last twelve months. Australia has been displaced by Norway the first of the Europeans to make it out of the red and come to our attention and will be the feature of my next article.
One can find the iShares MSCI Australia Index Fund (ETF) (NYSEARCA: EWA) near the top of the SA ETF list, and the current fiscal situation is as follows:
The near-term government budget picture is shown in the chart below.
The chart shows that the government sector is net adding to the private sector but that this trend has been in decline since peaking in 2010.
While running budget deficits shows that a government is supporting the nation's economy with spending and investment not all deficits are supportive in intent. There are two broad types of budget deficit one is structural, and the other is expansive. The deficit budgets that Australia has been running are mainly structural. A structural deficit is government spending "forced" by the implementation of automatic stabilizers in the form of unemployment benefits for people who have lost their jobs and cannot find another one due to an economic contraction.
It is not the case that Australia's leadership are showing foresight and vision by making strategic investments in the health, education, and infrastructure of the country. It is the case that the government is being forced to spend by the poor condition of its economy. The more one contracts the economy with contractionary policy settings the more unemployed people there are to support and there is less production of goods and services. Aggregate demand is lower as well.
A review of the latest mid-year budget shows that all these positive areas of nation building have suffered reductions.
"In the 2016-17 Budget, the Government announced a change to its stated fiscal strategy, relative to the 2015-16 Budget. While the strategy largely stayed the same, the Government's 2016-17 fiscal strategy suggested that it was prepared to be more flexible and interventionist in using fiscal policy to manage the economy. The Government stated that the fiscal strategy 'will set medium-term fiscal policy while allowing for flexibility in response to changing economic conditions. Moreover, the fiscal strategy included a further element of 'supporting revenue growth by supporting policies that drive earnings and economic growth. Further, the Government has also abandoned the target of surpluses of one per cent of GDP by 2023-24, and altered the target for debt from Commonwealth Government Securities on issue (synonymous with gross debt) to net debt. These changes to the fiscal strategy suggest that the Government may be more inclined than it was previously to be flexible with fiscal policy and taking on additional debt where that will, in the Government's view, contribute to economic growth....The underlying cash deficit is expected to be $37.1 billion in 2016-17, compared to a deficit of $33.7 billion projected in MYEFO. The underlying cash deficit is expected to be to $15.4 billion in 2018-19, compared to a deficit of $14.2 billion for 2018-19 published in the 2015-16 MYEFO."
This budget is interesting as it comes from a conservative government normally associated with fiscal austerity. Normally there is hand-wringing over the national debt and a genuine belief that it would be better to make cuts in health, education, and infrastructure now. In the future, a generation of less healthy, less educated Australians will have access to an electronic bank account at the Treasury, with dollar credits in it. Dollar credits will be of little use for buying aged care products and services from a smaller economy without the productive capacity to produce them or the infrastructure to deliver them in sufficient quality and quantity due to past austerity. Our children will inherit all the infrastructure and real resources that we accumulate and build for them now. So if the government were to change to a more socially aware one, the situation could only get better.
Sometimes it takes a conservative government to do things that a socially aware government would like to do but is constrained from doing by the opposition. It is seen as an exception and no threat to the status quo and is the right result at the right time.
When one reads through the latest budget and policy statements, one can sense the intent to want to return to a surplus budget. A genuine desire to drain money out of the private sector as soon as possible. The budget is full of the same excuses and contractionary intentions as those seen in the New Zealand and Canadian budget statements. They too are running deficit budgets but are very apologetic about it and have explicit plans to return to a contractionary policy setting.
This budget though expansionary is still only a structural deficit mostly forced on the government by the level of unemployment there.
Australia is running a nominally structural fiscal expansionary budget and plans to do so for many years to come and has explicitly retired the goal of running a budget surplus at all.
The long-term government budget picture is shown in the chart below:
The chart shows that the government sector has a chequered past in its support for the private sector. There are long time periods where it was consistently running contractionary budgets and actively shrinking the private sector. The recessions of 1981, 2001 and 2008 were preceded and worsened by prior contractionary budgets.
A sovereign government that is the monopoly issuer of its currency has a responsibility to provide a steady supply of fresh money into the economy to allow for an ever expanding number of transactions to take place. If there is too little currency in circulation then deflation results, if there is too much in circulation then inflation results. The level of money can be controlled by government spending and taxation.
This then raises the question: if you are net spending over decades, why tax at all? One simply needs to spend the difference required and leave the rest of the cash in the private sector.
When such a government chooses to provide this new money via a government bond issue a bond "debt" develops to bondholders, and one can watch this debt grow year by year. It is better for a government to simply spend this additional money into the economy by way of a citizens' community dividend by providing more education, health, and infrastructure to the community that it serves. The spend is simply the gap between taxes and government spending. This method of increasing the amount of currency in circulation is less stressful for a population that might otherwise wring its hands over the level of "debt" thus accumulated.
If every country in the world repaid its national debt, there would be no money in circulation and the balances at the Treasury would be returned to zero. This is a simple fact of accounting and mathematics.
Another consideration to issuing the currency in this debt free way is that it releases the government from the opinions and suggestions of private sovereign bond rating agencies forever calling for surpluses and "balanced budgets" that only work to contract the economy to maintain the desired bond rating. With their recommended contractionary government budgetary policy setting the only way the money supply and the economy can grow is from net inflows from the external sector.
Another plus for Australia is foreign trade. The near term can be seen in the chart below.
The chart shows that the balance of trade is negative and contracting the private sector. The last quarter shows a very rare surplus position.
The long term balance of trade picture is shown below:
The chart shows that Australia has had a consistently poor balance of trade for decades and trade has been a net drain on the private sector for decades.
This is remarkable as Australia is known for its export of sheep, wheat, iron ore, coal, gas and many other commodities. The entire economy is built on the wealth created by its export-oriented economy, the miners and farmers earn the money and the banks leverage it into expensive housing which the Australians then sell to one another. Most Australian towns, no matter how small, have a real estate agent's office on the main street. In Germany it would be an insurance office and in France a baker.
Australia has long been criticized for exporting basic materials and then re-importing the same material back as a finished manufactured good where most of the value and profit was added in the manufacturing process that took place overseas. On the other hand, the pollution associated with industrial production was also exported overseas, and this is a benefit that few consider and is hard to monetarise. One can ask a citizen of Beijing what the value of clean air might be and contrast that with the opinion of a citizen of Sydney or Melbourne.
One could run a good argument that the taxation system could be reconstructed to reward the things we want such as work and creativity by removing taxes on it. Similarly, the things that we do not want to see, such as pollution, finite resource wastage, obesity, substance abuse, land hoarding, etc., could be discouraged by taxes.
In one sense it is a good thing that Australia has traded dollar credits for real resources and that foreigners are prepared to hold their savings in Australian dollars. Similarly by exporting its manufacturing pollution overseas, every Australian enjoys a cleaner environment within which to live.
The chart below shows the near term flow situation.
The chart indicates that there are net inflows adding to the private sector in Australia and this is a good thing as it expands the circular flow of income by that exact amount.
The influx of foreign direct investment has been strong in the longer term as well as the chart below shows. The consistently positive and strong capital flows go some way to offset the long term net drain from the government sector and external sector identified above.
One might ask: how is it possible for the Australian government to have consistently contracted the private sector over decades and for the external sector to have also been a net drain on the private sector? Where did the missing liquidity come from? The answer is through capital inflows and private debt. The spending gap has been made good through massive private indebtedness.
The chart below shows the high level of consumer debt to GDP.
The chart below shows the steady decline in household savings over the long term. Net savings steadily decline after 1980 with the deregulation of the financial industry and the rise of the financial engineer. The key thesis is that the money supply, oil in the engine, is provided by the private banks at interest, instead of by the government, and that every citizen be loaned up from the cradle to grave in a toll booth economy run by private banks and large corporations.
This is a trend that has reached almost all "advanced" economies in the world today and is at the core of the financial crisis of 2008.
This is the neo-liberal paradigm that has controlled economic thought and practice for the last 30 years. Australia is one of the more extreme examples, and best illustrates the trend.
The key problem with this paradigm is that at a certain point there are no more creditworthy borrowers left, asset prices fall, the debt remains, and aggregate demand is not enough to provide full employment as it is diverted to debt and interest payment to private banks. Private debt funding fundamentally nets to zero if and when the debt is repaid, whereas government deficit spending is "fresh water" that can remain in the circular flow of income.
The Australian government has abrogated its role as the provider of the currency unit to the private banking industry, and this is reflected in the high level of private debt.
The current Prime Minister Mr. Malcolm Turnball is a former Goldman Sachs banker. One can, therefore, expect more of the same going forward.
A forecast for Australia going forward under these conditions is graphically presented below and is from Australian economist Professor William Mitchell.
This is not a good looking future.
Sectoral Analysis Methodology
Each nation state is composed of three essential components:
- The private sector
- The government sector
- The external sector
The private sector comprises the people, business and community, and, most importantly for investors, the stock market. For the stock market to move upward, this sector needs to be growing. This sector by itself is an engine for growth and innovation. However, only it needs income from one or both of the other two sectors to grow.
The government sector comprises the government with its judicial, legislative and regulatory power. The key for the stock market is that this sector can be both a source of funds to the private sector through spending and also a drain on funds through taxes. The government through its Treasury also sets the prevailing interest rate and provides the medium of exchange. Too much is inflationary and too little is deflationary. It puts the oil in the economic engine.
The external sector is trade with other countries. This sector can provide income from a positive trade balance, or it can drain funds from a negative trade balance. One should note that a negative trade balance also means that a country has traded currency, that is in infinite supply, for real resources that have a finite supply.
For the stock market in the private sector to prosper and keep moving upward, income is required to be put into the flow. Otherwise, the sector can only circulate existing funds, or is being drained of funds and is in decline.
The ideal situation is that the private sector has a net inflow of funds and is constantly growing, thus giving the stock market headroom within which to expand in value. For this to happen, one or both of the other sectors have to be adding funds to the circular flow of income.
This relationship can be expressed by the following formula:
Private Sector [P] = Government Sector [G ]+ External Sector [X]
For the best investing outcome, one looks for countries where the government sector and external sector are both net adding to the private sector and causing the local stock market index to rise with the receipt of additional funds.
Australia is a tentative buy, and there are other countries with better prospects to choose from however as part of a diversified investing strategy Australia could make up a small part.
The government sector is net adding to the private sector if only in a "forced" structural deficit way. The expansionary government policy setting is planned to run for several years longer. Historically the government sector has been a net drain on the private sector and can be expected to resume this unhelpful role over the long term.
In a similar vein, the external sector is not a big help to the private sector as despite a very atypical recent trade surplus the long term trend is for trade to be a net drain on the private sector. Export volumes are large and growing and when commodity prices do strengthen less of a drain can be expected going forward. There is upside potential here despite a dismal long-term past performance.
The main compensating factor that rescues Australia are the large historically strong and consistent capital inflows.
Of great concern are the extreme private debt levels and a consumer that is all loaned up and unable to save. This makes the role of the government sector all the more important in sustaining growth by maintaining aggregate demand through full employment.
One can get investment access to Australia via these ETF funds:
iShares MSCI Australia Index Fund
WisdomTree Australia Dividend Fund (NYSEARCA: AUSE)
Aberdeen Australia Equity Fund Inc (NYSEMKT: IAF)
Index IQ Australia Small Cap (NYSEARCA: KROO)
Ishares MSCI Australia Small Cap ETF
LYXOR ETF AUSTRALIA (SWX: LYAU2-USD
UBS MSCI Australia UCITS ETF (SWX: AUSAUW-AUD
In the next article, we will take a look at Norway.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.