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Many international investors think of Australian equities as a pure commodity play, or even just a China commodity play. But there’s much more depth Down Under than that – and many reasons for investors to consider adding Australian equities to their portfolios. Andrew Sisson, Managing Director of Franklin Templeton’s Balanced Equity Management team based in Melbourne, analyzes some of the biggest challenges and opportunities in the Australian market. He also shares his view on the recent interest rate cut from the Australian Central Bank, including whether he thinks more easing is needed, and what it could mean for investors.
Managing Director, Balanced Equity Management
Lead Analyst/Investment Manager
Over the past decade, the US and Eurozone economies have struggled with debt crises, which pulled both into recessions. While the US has largely recovered from its 2008 – 2009 subprime mortgage crisis, many European countries are still grappling with a sovereign debt crisis of their own.
Relatively speaking, Australia has managed to do quite well and has maintained positive growth rates throughout each of the past 10 years, and growth has averaged above 3% over the past 20 years.1 In 2012, its GDP growth bettered both the US and Eurozone economies. Inflation and unemployment have remained low, giving the central bank flexibility, and the country’s banking sector appears healthy. Australia’s gross government debt, at 27%, is also much lower than many other developed economies, including the US, Japan, and Germany.2 Allowing for cash held, net debt is only 12%.3
We think these numbers explain why Australia has been able to avoid most of the problems plaguing many other developed countries and deliver what we consider to be satisfactory market performance.
Commodity Dependence – A Double-Edged Sword
Australia is one of the world’s largest producers of commodities. Demand, particularly from China, has helped keep the economy strong. In the last 10 years, global prices for Australia’s resource exports (in US dollar terms) have more than tripled.4
But we see Australia’s natural resource dependence as a double-edged sword: its reliance on commodities is an area of uncertainty today in part because it can’t count on the continued growth of the Chinese economy. We expect China’s prior levels of growth could likely slow, as it transitions its economy toward a domestic-consumption model.
While a dip in growth rates in China to the range of 6% – 8% going forward would certainly be impressive given the size of its economy, the end of the double-digit growth rates of years past is something many investors and economies will need to adjust to. Right now, it’s simply an unknown. That said, we take a long-term view, and this shift could ultimately prove positive as China’s economy becomes more consumer-oriented and less dependent on export-led growth, and embarks on reform efforts to strengthen its markets.
What we have seen over the last decade has been not only increasing volumes in Australia’s exports to China but also high prices. While we believe the volume of exports could likely continue rising, the rate might not be as fast as in the past. We expect commodity prices to fall back as supply and demand are more in balance.
If export volumes continue to rise, the impact on employment in Australia should be fairly muted, but the impact on the profitability of natural resource companies could be negatively impacted by lower prices. The impact on government revenue could also be negative. This is why we believe in the importance of an active approach, and in carefully selecting individual companies based on what we believe are the best long-term prospects. While we pay attention to macroeconomic trends, we take a bottom-up approach when it comes to stock selection and shifts in our portfolios.
Rebalancing the Australian Economy
There have been efforts by the Australian government to rebalance the economy so it is not so dependent on commodity market cycles. It’s very difficult to analyze whether its efforts are working, but the goal is to help other areas pick up the slack when one area is slowing to keep the economy moving ahead at a decent clip.
Even though Australia has a much bigger proportion of its economy devoted to natural resources than every other Western economy, it’s not a huge proportion of the total – not as much as many international investors might think. The services sector is actually the largest part of the Australian economy, accounting for about 70% of GDP5, and only about 5% of the labor force is employed directly in natural resources or servicing natural resource companies.
However, Australia’s government revenue over the last decade has become very dependent on commodity export growth, along with the high commodity prices we have seen over this period. At its peak, the resource sector made up about a third of the Australian share market. Today, it is around a quarter of the market—but nevertheless, it is a significant part of the potential companies in which we can invest. And the fortunes of resource companies certainly do have an impact on the overall Australian equity benchmarks.
The Australian currency is an important part of this equation. Over the last decade, as commodity prices rose, the Australian dollar also rose. That took some steam out of manufacturing unrelated to commodities and out of the services sector, and freed up resources that were then deployed into the mining space.
What we would like to see is a reversal of that process; in other words, as the mining sector slows, we would hope to see the Australian dollar come down enough to make services and other areas of manufacturing more competitive, picking up the slack. While in the short-term that may not help overseas investors holding Australian shares (unless they can hedge their currency exposure), we believe the ideal scenario is to see the Australian dollar settle at lower levels.
We have seen the Australian dollar drop this year, and even though the fall has been material (down nearly 15% vs. the US dollar), the Australian dollar is still at historically very high levels. If you go back through the 1990s, for example, the Australian dollar was trading around 70 cents US; it’s now at about 90 cents US.6 I think if we do see a decline in commodity prices, we’ll need a further fall in the Australian dollar for exporters to remain competitive.
The Central Bank’s Part
Looser monetary policy can cause a currency to weaken. Unlike most other Western economies recently, Australia has had interest rates at positive real levels. In other words, inflation in Australia has been running around the 2.5% mark on a year-over-year basis (as measured by the consumer price index); until recently, short-term interest rates were at 4%, meaning that real rates (adjusted for inflation) were at 1.5%. That has enabled the central bank to cut rates, which it has been doing over the past 12 months. Now, with the benchmark short-term lending rate lowered to 2.5% in August, real levels are down to about zero, and it’s uncertain how much further cuts can be made.
I think further central bank action will depend on the progress of the economy. If the economy is weaker than expected, more cuts could be in the pipeline. If, on the other hand, the lower Aussie dollar revives the non-resources segment of the economy, perhaps the central bank has made enough cuts already.
But there’s a risk in this equation. Over the last six years, Australia has had a Labor government, and for the last three years the party hasn’t had an absolute majority in Parliament. Australia’s elections are coming up in September, and the potential changes in its Parliamentary balance are another thing that we need to take into account when we consider the Australian market. But overall, we think Australia is advancing and is a good place for investors to be.
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What Are the Risks?
All investments involve risk, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability, and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.
1. Source: Australia Bureau of Statistics.
2. Source: © 2013 International Monetary Fund, World Economic Outlook Database. General Government Gross Debt.
3. Source: © 2013 International Monetary Fund, World Economic Outlook Database. General Government Net Debt.
4. Source: Australian Government, Department of Foreign Affairs and Trade.
5. Source: CIA the World Factbook.
6. As of August 8, 2013.