Around the Curve

Australia - A Structural Story

By Stephen S. Smith, Managing Director and Portfolio Manager
July 2019
There seems to be a lot of doom and gloom hanging over markets right now, but structurally bullish cases do exist. Australia is one of them. Sure, Australia's economy has slowed, but sluggish growth is currently a global issue. Against a fairly pessimistic backdrop, what makes Australia stand out are the following structural factors:
  • Imminent tax cuts
  • Twin surpluses
  • Real effective exchange rate (REER) of the Australian dollar
  • Macroprudential policies
The recently re-elected government is expected to pursue a pro-growth agenda therefore, we expect different sources of stimulus to support the Australian economy. For example, tax cuts have been announced and legislated. These tax cuts wouldn't be possible - or at least prudent - without the country's twin surpluses, a facet of the economy that inarguably makes Australia attractive from an investment perspective. The country currently runs a budget surplus, and as shown in Chart 1 below, the budget as a percentage of gross domestic product (GDP) should move into positive territory in 2020.
Australia also runs a current account surplus, which we think the country will be able to comfortably maintain for two reasons. Firstly, capital expenditures (capex) have increased across all sectors, pushing investment to levels seen in the 1990s, as shown in Chart 2. We are encouraged that companies are committing to capital-intensive projects and believe activity may have found a bottom in 2018.
Secondly, the recovery in capex could partly be explained by Australia's commodity-centric exports, which have received continual support from Chinese demand for iron ore and coal. The demand for these two Australian commodities could remain relatively insulated from other potential headwinds because of the Chinese government's strategic focus on environmental policies. Australian iron ore and coal are cleaner substitutes when compared to the resources that can be mined locally. So Chinese authorities should continue to import them from Australia as long as the government remains focused on anti-pollution initiatives. This Chinese demand could prop up Australian exports (see Chart 3 below), as well as the dollar.
The Aussie dollar is undervalued on a REER basis as shown in Chart 4 below - making it one of the most undervalued currencies in our universe based upon this metric.
The Reserve Bank of Australia (RBA) seems to agree and has projected that the currency could comfortably appreciate to around $0.75 from its current level without hindering growth. Chart 5 illustrates the central bank's projection on the currency.
The RBA also recently cut rates, which implies that Australia doesn't have an inflation problem right now - another constructive sign for investors. Perhaps inflation remained benign as Australia's previously overheated housing market began to cool off. A few years ago, the government required borrowers to undergo stress tests in the event of a rising rate environment. The policy was meant to rein in real estate prices, which seems to have worked since home prices have been weak for the last 18 months. Now, the government is expected to relax these stringent requirements to reinvigorate the housing market.

We think these collective structural forces could create tailwinds for the Australian economy. The country's twin surpluses afford the luxury to pursue ambitious stimulus efforts as a way to revive the economy without sacrificing the currency or a benign inflation backdrop. However, risks certainly remain as the US and China continue to hash out their trade dispute while the Chinese government continues to implement its own stimulus.
Legg Mason Asset Management Australia Ltd (ABN 76 004 835 849 AFSL 240827) is part of the Global Legg Mason Inc. group. The information in this article is of a general nature only and is not intended to be, and is not, a complete or definitive statement of the matters described in it. Although statements of fact in this article have been obtained from and are based upon sources Legg Mason Asset Management Australia Limited believe to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions and estimates included in this communication constitute our judgement as of the date of this communication and are subject to change without notice. This article originally appeared on Brandywine Global’s blog, Around the Curve. Brandywine Global combines expertise in value investing with a global perspective to bring differentiated solutions and investment insights to clients worldwide. The views expressed are for informational purposes only and subject to change; this information should not be considered a solicitation or an offer to provide any Brandywine Global service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Additionally, any views expressed by Brandywine Global or its employees should not be construed as investment advice or a recommendation for any specific security or sector. This content may not be republished without permission. Brandywine Global is not affiliated with any third-party sites, and is therefore not responsible for the content, terms of use or privacy or security policies of such sites. www.brandywineglobal.com