Australia: A Structural Story

Around the Curve

Australia: A Structural Story

Despite prevailing pessimism, Australian structural realities support a more optimistic outlook.


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 reelected 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 could be announced as early as this month. 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.
 

Source: Cornerstone Macro. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

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.
 

Source: Cornerstone Macro. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

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 recent focus on environmental policies. Australian iron ore and coal are cleaner substitutes when compared to the resources that can be mined locally; Chinese authorities should continue to import them from Australia as long as the government remains focused on anti-pollution initiatives[RB1] . This baked-in demand could help prop up Australian exports (see Chart 3 below), as well as the dollar.  
 

 [RB1]Link to Tracy Chen blog

Source: Reserve Bank of Australia. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

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.

 

Source: Brandywine Global. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

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:
 

Source: Reserve Bank of Australia. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

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 have 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 U.S. and China continue to hash out their trade dispute while the Chinese government continues to implement its own stimulus.


Definitions:

The Australian Dollar (AUD) is the national currency of Australia.

The real-effective exchange rate (REER) is the weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation.

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

The Organization for Economic Co-operation and Development (OECD) is an international organization that promotes policies to improve the economic and social well-being of people around the world.

Chart 4: These are the appreviations for the national currencies of the countries listed:

TRY, Turkish Lira; COP, Colombian Peso; BRL, Brazilian Real; AUD, Australian Dollar; SEK, Swedish Krona; ARS, Argentine Peso; MXN, Mexican Peso; CAD, Canadian Dollar; PKR, Pakistani Rupee; NOK, Norwegian Krone; JPY, Japanese Yen; ZAR, South African Rand; CLP, Chilean Peso; MYR, Malaysian Ringgit; RUB, Russian Ruble; GBP, British Pound; NZD, New Zealand Dollar; EUR, Euro; HUF, Hungarian Forint; IDR, Indonesian Rupiah; PLN, Polish Zloty; DKK, Danish Krone; EGP, Egyptian Pound; RON, Romanian Leu; CHF, Swiss Franc; SGD, Singapore Dollar; TWD, Taiwanese Dollar; KRW, Korean Won; PHP, Philippine Peso; PEN, Peruvian Sol; CZK, Czech Koruna; CNY, Chinese Renminbi; INR, Indian Rupee; ILS, Israeli Shekel; THB, Thai Baht; USD, U.S. Dollar; HKD, Hong Kong Dollar

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