What's the outlook for the new year?
There was an interesting report recently from one of our fund managers, Pimco Australia. It was so good, we wanted to share it with our readers here too. Originally posted here
"The Australian economy remains heavily reliant on the mining and housing sectors for its growth outlook and both of these sectors are well past their peaks.
Bond markets, which are forward-looking in their pricing, are clearly telling us that the prospects for Australia’s economy are expected to be weaker than the U.S., at least for the next few years. For the first time in 20 years, short-term bond yields in Australia are approximately equal to, and arguably going to move lower than, comparable rates in the U.S., with the 2-year government bond in both countries offering a yield of approximately 1.77% as at 21 November. Investors should not underestimate the significance of this change.
20 years of change … in Australian debt
In 1997, we were in the midst of the Asian Financial Crisis and the dot-com bubble was just starting to inflate. Australia was considered a relative economic dinosaur with its focus on mining and banking. At that time, the Australian dollar was in the mid-60 cents versus the U.S. dollar, on its way to sub-50 cents, and the Reserve Bank of Australia’s (RBA) official interest rate was around 5%.
In the decades since, through a series of alternating booms – housing, then mining, then housing – Australia has avoided a recession and expanded faster than the U.S. in terms of aggregate real GDP. Yet nothing much appears to have changed in our corporate sector. To illustrate the point, Australia’s top six listed companies by market capitalisation remain almost unchanged since 1997. Today, it is the four major banks plus BHP Billiton and Rio Tinto, whereas 20 years ago it was the four major banks plus BHP and 21st Century Fox (which was subsequently delisted). Unsurprisingly, mining and housing have remained our only two key growth engines in recent years.
Whereas in the innovative U.S., compared with 1997, only Microsoft remains in the top six companies by market cap today. General Electric, Coca-Cola, Exxon Mobil, Merck and Citigroup have been replaced by Apple, Google, Amazon, Facebook and Berkshire Hathaway.
Over this same 20-year period, Australian households have amassed significantly more debt than their U.S. cousins. Household debt to GDP has increased from around 60% to 80% in the U.S., while Australian household debt relative to GDP has risen from around the same starting point to more than 130%.
The Australian economy remains heavily reliant on the mining and housing sectors for its growth outlook and both of these sectors are well past their peaks. Mining will continue to be an important economic growth driver even in a world where China’s economy becomes less resource-intensive, although we expect commodity prices to soften gradually into 2018. Housing is expected to be more challenged in terms of its contribution to growth, given elevated property prices accompanied by high household debt levels. But Australia is running out of booms, and given the lack of innovation and evolution of growth drivers, the bond market is likely correct in its pessimistic assessment of Australia’s relative near-term growth prospects.
What does this mean for Australian investors?
The lack of growth drivers and significant rise in Australian household leverage suggests the RBA will be on hold at 1.5% for most, if not all, of 2018. This would mark by far the longest period of unchanged interest rates since the RBA first established its 2% to 3% inflation target in the early 1990s. RBA Governor Philip Lowe has made it clear that we should not expect any more rate cuts given the level of household indebtedness and major city property prices. However, he has also been quite explicit that rate rises will not be possible in the near term.
While low interest rates for longer might be expected to support Australian equities and property prices, they also imply that growth in these sectors from current valuations will be challenged since earnings/rents will barely rise in a highly levered economy expected to grow around potential, at best. In this environment of declining or negative interest rate differentials, we would also expect the Australian currency to have fewer global supporters as the historical carry advantage evaporates further.
Given this reduced resilience of the Australian economy, we believe it makes sense for investors to consider whether their portfolios have a sufficient allocation to actively managed bonds and sufficient diversity away from the aging boom sectors of housing, banking and mining. At current valuations, the prices of risk assets, such as equities, look increasingly vulnerable to a correction if the robust global growth environment shows any signs of faltering. Bonds generally have a low or negative correlation to risk assets like Australian property and equities. This means that adding bonds alongside these other assets can help to minimise overall portfolio risk through diversification and offer a hedge against equity market downturns."