The End Of The Big Rise?
Australia’s superb macro performance over the past two decades has been assisted by two major tailwinds: rising leverage and rising export prices. Both trends seem set to reverse. The prospective shift to falling leverage – particularly by households – and a turn in the terms of trade (export prices relative to import prices) will have important implications for investors. These changes will likely reduce Australia’s resilience to external shock, are important adverse structural shifts for sectors of the equity market, point to significantly lower nominal profits growth and will likely see the currency weaken over the medium term.
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Australia has been the best-performing developed economy through the past two decades. This stellar performance went hand-in-hand with – and, more importantly, was assisted by – a tremendous increase in domestic leverage, particularly by households. Economies in a leveraging phase tend to be resilient: there’s a tail wind of asset price appreciation, monetary policy is very effective (because of the willingness to borrow), and sentiment is strong. The rise in leverage also had sector-specific benefits, notably for housing construction, finance and retail. A second, massive structural support came into play over the past decade: the rise and rise of commodity prices, which pushed Australia’s terms of trade to all-time highs .
These two great trends seem set to go into reverse.
Household leverage has flat-lined over the past four years, and we expect it to fall. The terms of trade fell in the December 2011 quarter. This may not mark the start of a steady decline, but it likewise seems clear that the great rise in the terms of trade will soon be over. A shift to deleveraging and weaker terms of trade will have important economic and market implications. It will likely reduce macro economic resilience to external shocks, reduce trend nominal GDP growth, and with it earnings, lower the AUD over time, and puts a cloud over several parts of the equity market.
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