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Global waves shouldn't capsize the good ship Australia - from Equity Magazine

Caution warranted, but global waves should not capsize the good ship Australia
By David Bassanese, Chief Economist at BetaShares

As a still relatively small and open economy, Australia is naturally buffeted from time to time by global developments. This year has been no exception. Already we’ve had to deal with concerns over a slowdown in the Chinese economy, the United Kingdom’s decision to exit the European Union, and wavering by the United States Federal Reserve over whether it should raise official interest rates.

We needn’t stop there. We can throw into the mix the ongoing scourge of global terrorism, the “hijacking” of the United States presidential election by Donald Trump, global warming and cyberattacks.

The good news, however, is that the Australian economy still appears to be coping with these shocks relatively well.  Economic growth has been above trend of late, and the unemployment rate has held below 6%.  Business confidence is at above average levels, house prices (at least along the east coast) are rising and consumer spending has been fairly robust.

Low inflation has also allowed the Reserve Bank of Australia to recently cut interest rates further, and the market is anticipating at least one more rate cut over the coming three to six months. The RBA is openly targeting stronger growth in the economy and a decline in the unemployment rate to around 5% at least.

So what are we to make of recent global developments, and could further shocks still threaten to rock our boat?


Let’s start with China. Although analyst concerns over China continue to wax and wane, to my mind the economy is still likely to muddle along, albeit with growth continuing to steadily ease due to slowing population growth and less productivity catch-up potential due to rising living standards. At present, Chinese authorities have set a growth target of 6.5 to 7% for this year, which so far still remains on track (to the extent that official Chinese statistics can be considered robust!).

The challenge for China is that it has quickly lost its “workshop for the world” status thanks to rising wages, rising inflation, and an inflexible currency peg to the rising US dollar. This has been evident from weakness in exports and a major drop in private investment over recent years. 

China has made up for this lost source of growth by encouraging domestic home building and infrastructure development – typically via State owned enterprises financed through the banking sector.  So far so good, but China has now built too many apartments – particularly in 2nd tier cities outside of Shanghai and Beijing.  It has also already built a lot of questionable transport and other social infrastructure projects for its major cities.   These investments, while keeping industrial activity ticking over, are not overly profitable, which is why debt levels have increased to plug the financing gap.

Rising debt is seen as a worry in China, but the reality is that this is effectively a State subsidy provided through the State-controlled banking sector, and the central government can and will likely pick up the cheque should China’s banks get into trouble.  At 250% of GDP, China’s overall debt level may seem high, but it’s still well short of the 400% of GDP debt load in Japan – which has been playing a similar game of debt-fuelled capital works projects since its own bubble-economy burst two decades earlier.  And as in Japan, most of China’s debt is locally owned.

What does this mean for iron ore prices?  They seem to have defied reality for several months now, helped by yet another Chinese stimulus package for the already over-extended housing sector.  A weaker $US dollar and local investor speculation has also helped prop up prices, but given the likelihood that Chinese steel production is still trending down and iron ore supply is still ramping up, iron ore prices should at best move sideways, and at worse re-test their lows of late last year at some stage in 2017.  In this regard, it seems premature to be backing resource stocks and a resumption of a bull market in commodities any time soon.


As for Brexit, as some have suggested, this now appears to have been a storm in a British tea cup.  Global markets seem to have dealt with the shock decision pretty well, helped by the promise of ample further central bank monetary stimulus if need be.  At face value, the huge potential disruption to trade relations with Europe should be a sufficient shock to UK firms that it sends the British economy into recession. 

Against this, however, the British Pound has weakened and interest rates have fallen, providing some offsetting stimulus.  And it also appears that the UK Government won’t formally trigger its exit from the EU until such time as it has negotiated a clearer set of new trading arrangements.  Although it’s still early days, judging by the encouraging post-Brexit rebound in UK stocks, it seems investors are debating whether the economy will tumble into recession after all.

What’s more, from a global perspective, we should not lose too much sleep if the UK did buckle, given it only accounts for around 2.5% of global GDP.

The US of A!

That then leaves probably the biggest challenges still facing the global economy – the fate of the world’s largest and most important economy, the United States.  One challenge is the fact that America’s post-financial crisis “sweet spot” - of reasonably good economic growth unchallenged by rising interest rates due to lingering spare capacity and low inflation – appears to be coming to an end.  The economy is now close to full employment and wage growth is starting to stir. The Federal Reserve, long loath to raise interest rates, is running out of excuses and has recently hinted it could raise interest rates as early as September, and if not, December.  Unless the US economy slows of its own accord, the Fed will likely raise interest rates by year-end.  Either way, with equity market valuations pushed up by very low interest rates, and earnings growth still sluggish, Wall Street faces an increasingly troubled road ahead.

The other challenge in the United State is Donald Trump, whose controversial positions over recent months suggests he might derail US business and investor confidence were he to be elected to the most important office on the planet.  For what it’s worth, however, he’s still trailing badly in the polls and most experts think he has little chance of beating establishment-candidate Hillary Clinton.  But even if Trump did win, I have a sneaking suspicion he doesn’t really believe half the extreme things he’s said over the past year - and that they were instead all part of a clever ploy to win over the hard right delegates that ultimately decide the Republican nomination.  Of course, it’s better not to have to hope that Trump would be more circumspect once in office, and instead I prefer to hope that the current polls will be proven right.

Investment Implications

For investors, while the current global economic outlook is not as bad some may suggest, it still warrants a degree of caution. While China’s economy is unlikely to crash, for example, its demand for our key commodities should still slow, meaning our resource stocks could continue to face a challenging environment. And while fallout from the Brexit decision is likely to remain contained to the relatively small UK economy, a far bigger issue is the maturing of America’s economic expansion.

Either through higher interest rates, or slowing US economic growth, Wall Street’s admirable resilience of late it likely to be tested in the months ahead. Our market will not be immune.

Accordingly, to the extent investors still desire some exposure to the market – if only because of the attractive dividend yields on offer – they might consider more defensive high-income focused sectors and strategies and/or risk-managed equity products which offer more downside protection.

Investors might also consider some exposure to less cyclically sensitive global industries which offer “secular” growth opportunities, such as for health care and food.





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