- Australian economy overly dependent on banking and mining
- Chinese investment, housing bubble insulated Australia from the global crisis
- 2015 likely to see a move from dividend-paying blue chips into resources
By Steen Jakobsen
Australia is in every sense an amazing place but as an economy, it pretty much has all the wrong incentives and structures in place. Nowhere is this more visible than in the housing market, where "negative leverage", the use of super funds assets and a massive banking sector creates a bubble which to my eyes is equivalent to the one we saw in Spain and the US before the GFC (as they call the global financial crisis down here).
Negative leverage is the ability to take losses on rental properties and deduct it from your income. A super fund is the Australian equivalent of a 401K , which can be used to buy a second home, and the banking sector is presently seeing a record level of profit-to-GDP (while the ASX 200 index is now is 42% banking). Sydney must be the most overbanked city in the world, you can hardly walk 200 yards without passing a bank branch.
Lesser-known landmarks of Sydney. Photo: TK Kurikawa \ iStock
The ASX is probably a good place to start an analysis of Australia's economic conditions. Banks, as noted, represent 42% of the index. Information technology is less than 1% and materials (with the main export being iron ore) represent less than 16% of the key Aussie index.
I have to admit that I was surprised to learn this. Australia has become a "dividend yield-dependent" nation. Investors are long on blue chip names with high dividends; it's a presumed-to-be safe play, but it also reflects an economy that remains a "one trick pony". The bigger trade for 2015 may be a move out of these dividend plays into resources (specifically mining).
Why, you may ask?
For three reasons:
1.) A need to rein in the banking sector's dependence on mortgages, creating a need for the macroprudential framework to be changed.
2.) Marginal cost of capital will rise due to both this and the increase in capital requirement needed to rebalance profit away from dividend yields into a more secure (and supportive in the long term) banking system.
3.) There is a great deal of pressure on the overall funding cost of Australia due to its rising current account deficit and now also its budget balance (which has moved from a balanced 2017/18 budget outlook to an accumulated loss of $A100 billion even before the expected December budget update).
A move out of financial stocks and into the mining sector
could reward Aussie investors in 2015. Photo: iStock
The Reserve Bank of Australia, will need to cut interest rates to 2.0% (if not 1.75% or 1.50%) as the Australian economy absorbs the impact of a slowing China, a 40% fall in iron ore prices (year-over-year), and budget deficits that are growing each quarter due to smaller tax revenues.
The problem, of course, is that any indication of lower rates will further fuel the housing bubbles. The RBA will need to step up the so-called "macroprudential framework" and increase capital requirement for the banking sector. The fact that banks are making record profits (and awarding record bonuses to management) is not in and of itself the problem. The macro problem is that too much money remains on their balance sheets and in the hands of their shareholders.
From the mid-1980s to 2007, the Australian banking system's asset-to-GDP ratio rose from 50% to over 200% The money stays in a closed loop between dividend-paying banks and their shareholders. The spill-over into the real economy decreases with every earnings report.
That's why RBA needs to play a rebalancing role. They want to make the banks stronger (rather than simply more dividend-intensive), hence the macro prudential move to more and stricter capital requirements (plus a change to mortgage lending). Mortgage lending is close to 60/70% of total lending now in Australia, and the banking system remains highly dependent on wholesale deposits to fund its activities.
We are soon releasing our Outrageous Predictions for 2015, and don't be surprised if you see a call for a 20-25% drop in Aussie house prices. This would force a crisis in Australia, but it would be a crisis that I think would represent a positive and much-needed mandate for change.
Australia remains one of the most complacent places I visit during my travels, and there are some good reasons why this is so. Its geographic isolation makes it '"immune" to outside forces; the political agenda and business is relatively domestically driven; and the number of foreign CEOs is limited (partly due to immigration rules, partly due to high taxation).
Together with Poland, Australia is one of the few countries not to experience a recession through the GFC. It achieved this, however, by first riding the Chinese Tiger's massive investment expansion from 2008 to 2012, then continuing the ride through the creation of (or at least through allowing) the housing bubble as China slowed down.
As the Chinese economy began to burn lower, Australia's housing bubble was seemingly permitted to take up the slack. Photo: Liufuyu \ iStock
While the data show that Australia's 2014 growth is in "dwelllings", the ascent of the housing market (and its associated services) is directly proportional to the big drop in mining investment. The "dwellings " category is up 4% year-over-year while mining investments are down 4% for the same period. Private consumption and consumer confidence is sliding and tax revenue is coming up short (meaning the December budget will see a shortfall of at least $A10 billion, if not $A15 billion).
Yes, a perfect storm is coming to Australia in early 2015, but do not lose hope.
A mini-crisis is exactly what Australia needs. I have said it before and will say it again: Australia in 2014 reminds me of the UK in 1979. That year, "a Lady with a handbag" took over the political leadership of the UK (and Europe). She was handed an economy that was over-unionised with high labour costs, a weak currency, budget deficits, and political leaders without vision or guts. Does this reminds you of something? Yes, indeed.
Australia needs its "Eureka!" moment because if there is one country in the world which can deal with its own problems, its Australia. The nation features strong social welfare, a robust education system, great resources, and risk-taking business people, but it needs to get its incentive structure right.
It needs to stop making investment in paper money, bricks and mortar more attractive than investment in people. Reduce the red tape, reduce the government's role in the economy, and free up (and protect) the massive cohort of small- and medium-sized companies that constitutes 80% of the economy and 100% of all new jobs.
Australian SMEs are being short-changed on credit and in terms of political capital. This is the way to balance out an economy which has never been more one-sided, more dependent. Australia has one customer (China), one major industry (banking) and one big cost problem (the highest labour unit cost in the world and an economy which is stuck in the 1970s in terms of labour market conditions and welfare transfer).
At this point, reality has arrived, and things are so bad that it's actually good. I am a big buyer of Australian assets in 2015, a year in which I see the AUD bottoming out at $0.80 to the dollar (and trading in a $0.80 to $0.90 range), where I see yields in 10-year AUD bonds go to 2% (the best investment from now to cyclical bottom in Q2/Q3), and where the banking sector will sell off, and where I foresee low commodity prices creating massive discounts on names like Fortescue and the other mining giants.
The idea is to set up a pair trade where you go long on resources and short the dividend blue chips. By mid-2015, you close the short dividend plays and open a net long commodity play as the world is healing due to both the passage of time and the most powerful tool to reset an economy: doing nothing on the macro front. In this area, less is more.
As Winston Churchill famously encouraged us, "if you are going through hell — keep going".
Steen Jakobsen is chief economist and CIO at Saxo Bank – the home of social trading.
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