SPECIAL AUSTRALIAN ASSET CLASS REVIEW
I am writing this report on the ferry boat from Sydney to Manley, where I will attend a gathering of Australia based hedge fund managers to absorb their collective wisdom. I have deliberately taken the slow boat, so I have the time to give this report the depth it deserves. The Australian swim suit model sitting next to me will just have to wait and enjoy the scenery.
When I first came here in 1976, women were not allowed into the pubs, and drinking was the national pastime. Today they still drink like fish, but the prime minister is a woman, Julia Gillard, although probably not for long. It’s proof that if you live long enough you get to see everything.
They call this the lucky country for very good reason. It is surfing the crest of a decade long resource boom to prosperity. Virtually everything it produces in size, including iron ore, coal, and gold, have seen enormous price increases over the past decade. The cities of Sydney and Brisbane are vibrant and bustling. The department stores were besieged with women buying hats for the upcoming Melbourne Cup, the country’s premier horse racing event. Talk to people and they are optimistic and upbeat about the future. It is all very refreshing. Only a people with Australian levels of self-confidence and brass will be told that construction of their bold new opera house in Sydney was beyond the reach of modern engineering, and then go ahead and build it anyway.
My Favorite Australian
In Brisbane, I saw a lot of kids racing hot new expensive imported cars. When I remarked to a local that there must be a lot of rich parents here, he replied “It’s not the parents, it’s the kids who are making the money.” By working a “21/9” schedule, which means working ten hours a day for 21 consecutive days at a distant mine, and then getting 9 days off, a 20 year old here can earn A$200,000 a year. Now, workers in other industries want a larger piece of the pie. Australia is one of the few countries in the world where you actually see strikes. Indeed, the antics of the Qantas union, the national airlines, made traveling to and from the country challenging at best.
Hey, Junior, Can I Borrow the Car?
The boom has fundamentally remade the Australian economy. Over the last 15 years, mining has jumped from 4% to 10% of GDP and management services from 10% to 15%. At the same time, manufacturing was pared back from 15% to 10%. That enabled the country to more easily absorb the blow when China took over the world’s low end manufacturing industry, which has caused so much damage in the US.
Today, services of all descriptions account for 69% of GDP, which gives it a crucial buffer against the extreme volatility in commodities prices. But it is not immune. During the 2008 crash, shares in mining and energy giant, BHP Billiton (BHP), the country’s largest company, and the third largest in the world, collapsed by 80%. Competitor, Rio Tinto (RIO), plunged by 90%. As much as Australians are complacent in their belief that they are immune from the world’s problems, that is anything but the case. A dependence on foreign oil imports of 80% presents another big risk.
Much of today’s prosperity can be traced to groundbreaking reforms of the financial and tax system in 1983. These enabled the country to replace colonial ties that were severed when Britain joined the European Community in 1973 with trade relations with neighboring Asia. It was a natural and inevitable geographic realignment. China now absorbs far and away the largest share of exports, followed by Japan and South Korea. Australia is also host to 120,000 foreign students, mostly from Asia, further adding to the newfound muscle in the service sector.
Although Australia has been running large current account deficits for 50 years, the shortfall has been more than made up of large foreign capital inflows. Most recently, China has attempted to take large minority stakes in several firms, especially in the resource area. This will accelerate in coming years to the extent that Australians permit it. A capital shortage in the country there is not.
Today, Australia ranks 10th in per capita GDP at $39,764, behind the US at $46,810 (7th), but well ahead of China at $7,544 (94th). You can expect those numbers to converge in coming years, with America continuing its fall and the Land Down Under rising. A debt to GDP ratio at an enviable 22% has made Australia one of the few to maintain its triple “A” credit rating. GDP growth has averaged a blistering 3.6% rate for the past 15 years.
Another Favorite Australian
If there is a dark cloud hanging over this economic miracle, it is a rampant property bubble. Prices have doubled or tripled since 2003, and homes now sell for a sky high seven times average annual earnings. The post-crash US is seeing homes selling at multiples of three to four. Houses can be bought for as little as 5% down, and many individuals have been pouring excess savings into multiple real estate purchases.
There are a whole host of tax subsidies that favor home ownership. Liberalization of real estate purchases by foreign investors has further thrown the fat on the fire, attracting massive Chinese buying. House prices are now rising at triple the inflation rate. These are all signs of coming trouble that can only end in tears. But point this out to newly enriched Australians, and I get the same chill I received from Americans in 2005.
Which leads us to the question, “What to do about Australia?” If you are Australian, it is easy. Sell your home. Take the money and run. This is the easiest cash you have ever earned, and you are unlikely to experience such a windfall again. Rent, don’t buy. As Americans proved so amply, the home ATM doesn’t stay open forever.
A continuation of home price appreciation at these rates is a mathematical impossibility. Once prices stop going up, the hot money will exit post haste. And like real estate markets everywhere, there is a ton of liquidity on the upside and none on the downside. It is your classic “Roach Motel” market. You can check in, but you can’t check out
Will this cause a subsequent crash in the Australian banking sector? That is unlikely. The industry received a firm rap on the knuckles during the 1998 Asian financial crisis. As a result, the country today has one of the most conservatively run banking systems in the world. Leverage is a miserly 10:1. It is highly concentrated, with just four majors, the Commonwealth Bank of Australia capitalized at A$80 billion, Westpac Bank (A$65 billion), Australia and New Zealand Banking Group (A$56 billion), and National Australia Bank (A$55 billion), accounting for the bulk of transactions. By comparison, libertarian America has 14,000 banks. Still, they will get slapped around a bit. Going into the autumn swoon, Commonwealth’s shares were off 25% from their 2010 peak.
Commonwealth Bank of Australia (CBA)
For the rest of us who don’t own Sydney homes with spectacular Pacific views or enormous farms in the outback, the question becomes a little more complicated. Because of a heavy reliance on commodities, Australian financial assets of every description have become a call option on the growth of the global economy. When growth is healthy, Ausie assets outperform on the upside. Look no further than the Australian dollar (FXA), one of the world’s few remaining high yielders, which nearly doubled against the US dollar after financial assets bottomed in March, 2009.
This is why hedge funds have fallen in love with Australia, and why you hear me singing “Waltzing Matilda” in the shower whenever global markets are in “RISK ON” mode. Good times bring massive buying of Australian stocks, currency, and every kind of commodity. During bad times you want to throw all these things out the window. The dark side to this interest from hedge funds is much greater volatility in all things Australian, including the lady sitting next to me. Notice that when “double dip” was on the table during the summer, the Ausie dollar cratered 15% in a few weeks.
Another consideration to keep in mind is the China card. During this trip, I have been constantly queried about the risks of a “China crash.” Put those concerns out of your mind, China isn’t going to crash. Slow down, yes, crash, no. The Midde Kingdom growing at a more sustainable long term rate is a good thing for investors. I will go into the why’s and wherefores in a future country report.
Suffice to say that a China with a $5.5 trillion GDP growing at 7% in the future will generate far more GDP and final demand for Australian resources than one with a $1 trillion GDP growing at 10% ten years ago. In fact the annual GDP increase today is almost as much as the country’s entire GDP a decade ago, and is also much larger than the $300 billion in new GDP the US will create this year at its own arthritic 2% growth rate.
China Isn’t Going to Crash
Australia also has a tailwind behind it which others lack: immigration. This is why America consistently grows 1%-1.5% faster than Europe year in and year out. American fertility rates are close to the replacement rate at 2.1, while those in European countries have plunged to as low as 1.2. They are just not making Europeans anymore as fast as they used to. Australian fertility rate are still up at 1.8 times, and they supplement that with large waves of inward immigration, primarily from Asia.
Having visited this country for 40 years, the change in the makeup of the population is very noticeable. There were no sushi restaurants in Brisbane in the early seventies. Today I am spoiled for choice. And as I constantly pound the table about in my demographic research pieces, higher fertility and immigration create young, faster growing economies, and make far better investments than old slower growing ones with a lot of benefits to pay out. Oz is a perfect example of this.
So what’s the play here? If you are an Australian there are some intriguing opportunities. They used to say that you should buy your age in bonds. Australia is one of the few countries in the world where this is still valid. If you are 70 years old, that means keeping 70% of you portfolio in local bonds and 30% in equities. That guarantees interest from fixed income instruments and reduces the volatility of your income stream as you go into retirement. If you are 30, it means putting 70% of your portfolio into growth equities, and 30% into more sedentary bonds. At your age you will outlive any of the momentary 50% declines that occasionally wrack these securities. Whatever your portfolio allocation, you are really in the sweet spot because most Australian stock and bond alternatives are offering relatively higher returns than elsewhere.
Foreign investors have the luxury of sitting back and waiting for those rare windows that open offering great investment opportunities. If we go into recession next year, as I expect, both the Australian stock markets and currency should see declines of 30% or more from current levels. That would be a great time to load up on long term positions in the resource, energy, and precious metal sectors. You can either index through an ETF like the (EWA) or going for the highest weighted resource stocks in the index, (BHP) and (RIO), which trade like water. You should be able to get great prices that will lead to multiyear gains when the “RISK ON” trade returns. One thing is certain. When the music starts playing again, the same gorgeous girls keep getting invited to the ball, cycle after cycle.
Until then, a position in Australian government bonds, now yielding 4.54%, might be worth a shot. An economic slowdown will send prices for this paper through the roof. Just make sure you hedge out your Australian dollar exposure when you do so. You don’t want to be putting money into one pocket, only to take it out of the other.
As for the exact timing on all of this, when you need to be running a “RISK ON’ or ‘RISK OFF” portfolio, I’m afraid you’ll just have to keep reading the Diary of a Mad Hedge Fund Trader.
Well, the ferry is just tying up now at the Manley dock, the stevedores tossing the heavy ropes on to the pier, and it is time to bring this missive to a close and give my Sheila the attention she so richly deserves.