It is my humble opinion (still!) that the world is going to enter another recession. The rationale for this can be seen on my recession call post….
and some more recent commentary from the ECRI in this great interview
What’s most telling about this video is the gently mocking tone of the CNBC hosts as they completely fail to grasp that Lakshman Achuthan doesn’t make stock market calls and focuses purely on leading indicators not the co-incident or lagging ones that the market has recently been rejoicing over!
If this macro premise is correct then I believe we will enter another round of the Global Risk OFF game. One of the most appealing risk off trades from my perspective is short AUD/USD which is now quoted at a near 30 year high against the greenback. This idea was first brought to my attention by Chris Pavese at Broyhill and I have leaned heavily on their analysis, they have been onto this trend for a while now. Check out their blog at http://www.viewfromtheblueridge.com/
Australian Central Bank has Started Lowering Interest Rates
The Reserve Bank of Australia cut official interest rates by one quarter of a percentage point to 4.50% on the 1stof November. At the same time it also cut its own growth outlook by 50 basis points for the next 12 months to reflect “risks to global growth and heightened financial volatility”. They also highlighted “changes in household spending and borrowing behaviour” which is crucial to the future I envisage.
In January, the Westpac-Melbourne Institute Index of Consumer Sentiment was down 10.7% in annual terms. Ouch!
The index level is still below where it sat just three months ago and prior to two rate cuts of 25 basis points each from the Reserve Bank of Australia (RBA), in November and December. Rate cuts from the RBA typically are a significant boost to consumer sentiment in Australia, given that more than 90 per cent of the country’s mortgages are set at variable rates. But the rate cuts still aren’t working, perhaps the first signs of an Australian household focus on “debt minimisation”?
An economic slowdown in Australia, which would flow from a global slowdown and a weakening of China’s growth rate, will force the RBA to start cutting rates from their current levels which are far in excess of the developed world average.
Although lower rates will help to ease any slowdown in the Aussie economy it will remove one of the key advantages AUD has enjoyed over most other currencies in the last few years – positive carry. If you can borrow money in GBP, USD or JPY at near zero and then invest it in an appreciating AUD earning 4.5% interest then you can cream off that 4% a year without having committed much, if any, capital. It’s a no-brainer, any old mug can do it, and they have!
There is a very strong correlation between foreign ownership of Aussie bonds and the AUD – this makes intuitive sense because people would have to buy the currency to buy the bonds. It seems likely that much of the money has been flowing to AUD because of its safe haven status and its perceived economic invincibility. As sovereigns around the world get downgraded there is a smaller and smaller “AAA Club” and therefore the pools of capital which are forced to own only the highest quality paper are forced to search further and wider. Should this safe haven status ever be called into question, and no-one is sacrosanct anymore, then those currencies most reliant upon capital flows would be the most vulnerable.
Weakening Commodity Demand from China
They call Australia “The Lucky Country” for very good reason. It is surfing the crest of a decade long resource and real estate boom stemming from China’s credit driven demand. Virtually every material that Australia was blessed with has seen enormous price increases over the past decade. Increased demand for Iron Ore, Gold and Coal has been bolstered by massive price increases to boot.
Australia isn’t just lucky though, its symbiotic relationship with Emerging Market demand, particularly Chinese demand, has been the result of a long courtship. Since the mid 1970’s, when colonial ties with Britain were severed, the Australians have naturally sought to do more business with their nearest neighbours. Ironically, what was once a prison island far away for banished convicts is now arguably the most geographically advantageous land mass amongst all the first world nations. China now absorbs far and away the largest share of exports, followed by Japan and South Korea. As you would expect the share of exports to slow or no growth Europe, US and UK is considerably less.
China accounts for 25.3% of Australian exports in 2010. But Australia’s actual export dependency may be great suggest the Interest Rate Observer, Japan get’s 19% and South Korea 9%, both of whom likely take Australian resources, turn them into high tech capital goods and then sell them to China. That’s close to 60% of exports which are highly sensitive to Chinese growth.
This 20 year boom has fundamentally restructured the Australian economy. Over the last 15 years, mining has jumped from 4% to 10% of GDP. At the same time, manufacturing was pared back from 15% to 10%. That enabled the country to more easily absorb the blow when China took over the world’s low end manufacturing industry, which has caused so much damage to industry and employment in the US and here in the UK.
Because of this heavy reliance on commodity exports and mining as a percentage of GDP, Australian markets, including currency, equities, bonds and real estate have become a leveraged play on the growth of the global economy. My own pet theory is that being bullish on Australia is only a little more nuanced and “safe” than being wildly bullish on China, but it’s ultimately the same trade.
When markets are bullish and the Risk ON trade is in full swing, Aussie assets outperform. AUD nearly doubled against the USD since the March 2009 bottom as the world re-embraced risk, global growth and Antipodean decoupling. When markets turn around and go “Risk OFF” the opposite happens – AUD fell by 15% during the last correction.
What no-one is talking about is that most of the Australian economy is possibly already in recession. This is near unthinkable because the world’s 13th largest economy has not had a year of negative GDP growth since 1991! That is astonishing. To quote James Grant
“To applaud a 20 year recession drought is to subscribe to the unlikely proposition that Australia has gone 20 years without overdoing it.”
My opinion now is that only the filter through from the Sino-Demand related industries is keeping the economy humming along. It was a big shock to me when I saw “The number of companies entering some form of insolvency administration in calendar year 2011 continues to set new records” from Dissolve.
Not to worry, there is investment abound from the mining companies planned for years to come. Direct Mining Investment as a share of the economy has gone from 1% to 3% and is