DON’T WRITE AUSTRALIA OFF JUST YET
Roy Davidson, 22 May 2019
It has been tempting to ignore Australia as an investment destination lately. Banks and resources dominate the market, the political environment has lacked stability, and investment returns tend to be more volatile than our own. However, while certainly having its challenges, Australia is home to a number of high quality companies and remains worthy of our attention.
Australia hasn’t been easy for investors
It is fair to say Australia has been a difficult investment environment in recent years. The banking sector (which still comprises more than 20% of the ASX 200) in particular has run into a raft of headwinds. As a result, the major banks (ANZ, Commonwealth Bank, National Australia Bank, Westpac) have struggled to grow earnings and have seen their share prices steadily fall.
The banks faced severe scrutiny during the recent Royal Commission, particularly around culture, misconduct, and the responsibility of mortgage lending. Meanwhile, the operating environment has weakened with new lending slowing, margins being pressured, and falling property prices presenting risks.
We have also seen several high profile companies fall out of favour in a dramatic fashion. Most notably, these have included AMP (due to the impact of the Royal Commission inquiry) and Telstra (as it deals with a very different operating environment).
Banks haven’t been the only sector to bear the brunt of regulatory scrutiny. High prices have brought the electricity sector to the attention of politicians, although Australia appears no closer to having a coherent energy policy. Recently, the Australian Government also announced a Royal Commission into the aged care sector.
On a more positive note, the important resources sector has been a better performer of late, at least at the big end of town. Rio Tinto and BHP have both adopted more shareholder friendly approaches to capital allocation by prioritising shareholder returns, while the iron ore price has proved more resilient than many expected (helped by supply disruptions).
However, this follows the sharp correction we saw over 2014 and 2015 where resource companies were hit especially hard. This highlights the inherent volatility of the sector, where demand from the Chinese property and infrastructure sectors remains the key driver.
The Australian market has still provided decent returns
All of this aside, since the start of 2009 (post the Global Financial Crisis), the Australian sharemarket has actually provided tidy returns, delivering 9.9% per annum (including dividends).
While this is below the performance of both the New Zealand and US markets over the same period (which have returned 13.3% and 14.1% per annum respectively), it’s ahead of most other major regions. Sharemarkets in Europe, the UK, Japan and emerging markets have all lagged Australia over this period by an average of more than 2.0% per annum.
So, all up, Australia hasn’t been a bad investment destination relative to most other markets. The New Zealand market, which we tend to use as a benchmark, just happens to have been an exceptional performer in recent years.
The Australian economy has also proven itself to be quite resilient over a long timeframe. This is evidenced by the fact that Australia currently holds the streak for the longest time without a recession (defined as two quarters of negative growth); 28 years and counting. This beats the prior record of 26 years, set by the Netherlands, between 1982 and 2008.
Australia was able to weather the storm of the Global Financial Crisis better than most other countries and didn’t fall into a recession. This is largely due to the large amount of raw material exports it sends to China, and the ongoing growth in China during this period.
The Australian economy is facing challenges
Despite proving its resilience over a long period of time, we still see the outlook for the Australian economy as more muted, primarily due to a softer property market. House prices are falling, especially in the key Sydney and Melbourne markets and we expect the negative wealth effect from this will weigh on economic growth. This environment is especially challenging for the banks, retailers, and the construction sector.
In addition, the same factor that saw Australia sail through the last global recession, the economy’s exposure to Chinese resources demand, poses risks. China has been slowing as the Government attempts to address imbalances in its financial system and lower debt levels. Chinese GDP growth has fallen to its lowest in ten years while its manufacturing PMI (a key indicator of economic activity) is in contractionary territory. Given its reliance on China, this is a clear negative for Australia.
In the past, the Chinese Government’s response to this has been to provide a shot to the economy in the form of economic stimulus. For example, China’s response to the 2014-2015 slowdown was to direct credit towards the housing and infrastructure sectors, both of which rely on Australian imports. However, this time around the response has been more muted and so far efforts have focused on boosting consumer spending instead (for example, by lowering tax rates).
Nonetheless, we have seen an uptick in credit growth in recent months (which is a leading indicator for economic activity) and we see potential for Chinese authorities to be more aggressive in their response. This would be a near-term positive for the Australian economy directly, and global growth more broadly. However, longer-term issues remain with the world’s second largest economy.
Australia is home to a number of high quality companies
It is easy to think of Australia as just banks and resources, two sectors with challenged or uncertain outlooks. Financials and resources do, after all, comprise over 40% of the Australian market, and 65% of the market cap of the top 20 listed companies.
Likewise, it is easy to only focus on the challenges facing the economy and ignore the fact that there are a number of high quality companies listed in Australia. These are companies that are proven performers, having delivered handsome returns over a long period of time.
Many of these are global leaders that are less exposed to the Australian economy, with irreplaceable assets in attractive markets and defensive characteristics.
This article was first published in the April 2019 edition of News & Views. Craigs Investment Partners clients can read the full version of this article in the latest edition of News & Views by logging in to Client Portal.