Australians love a good downer. It’s part of our DNA.
The Australian clergyman and poet Patrick Joseph Hartigan, who wrote under the pen name John O’Brien, hit on a cultural winner with his 1921 poem Said Hanrahan, in which the poem’s pessimistic bushman constantly lamented, “We’ll all be rooned” regardless of conditions in the bush. This expression is now part of the Australian lexicon as a jocular response to predictions of disaster or hard times.
Australia stands out for sailing through the global financial crisis with uninterrupted economic growth, no major bank failures and only a modest rise in unemployment; in fact it is falling on a monthly basis.
Today our economy’s steady growth, falling unemployment rate, national wealth and relatively low public debt are the envy of the world.
Yet, media and financial market commentary are relaying fears our golden nation’s prosperity is about to crumble. We’re a strange lot. On one hand we negatively gear our properties like there’s no tomorrow, which is an aggressive strategy, but on the other consumer confidence is no better than long-term averages and is more sensitive to negative headlines than positive ones.
It’s the job of equities analysts to look through what the market consensus thinks now to what’s coming next. We have been consistently more optimistic about the Australian economy than the market, and has been vindicated. Since the Reserve Bank’s last cash rate cut in April 2015, we have said this would be the last cut this cycle. In contrast, most investment bank economists called for further rate cuts that never came and to this day expectations for rate cuts continue to be pushed further out with declining conviction.
Separately, where others said unemployment would rise towards 7 per cent, we said unemployment would extend declines below six per cent. Last week the ABS reported March unemployment down marginally to 5.7 per cent.
Investors should manage their portfolios against a set of economic forecasts likely to be proved correct. Australia’s economy has now steadily transitioning from mining investment-led growth to an expansion driven largely by services. What does this mean? Here are the factors growing employment:
• Construction, manufacturing and transport sectors
• Population growth
• LNG (liquid natural gas) exports
• Stronger private consumption due to a falling household saving rate from GFC highs.
• Growth in net exports of services, especially inbound tourism and education (Admittedly retail spending is ordinary given slowing wages growth).
Investors should expect steady GDP growth of around 2.5 per cent over the year ahead with upside from improving private investment. Surveyed business conditions are their strongest for eight years, hiring intentions are improving and the number of job advertisements has strengthened so employment growth should continue.
At the same time, manufacturing activity has expanded strongly over the last nine months. Capacity utilisation is at its highest in five years and spare capacity has declined for three years, which should start to challenge firms’ pessimistic outlook for investment and capital expenditure.
Admittedly this will require listed companies push back against shareholder demands for higher dividend payout ratios.
Also, banks have retreated from investor housing lending but are reweighting to business lending for expansion, a leading indicator of hiring and capital expenditure. The transition to non-mining growth could be about to change up a gear.
Source: NAB
Based on this outlook we forecast no severe deterioration in underlying bank bad debts expense across the general economy.
The first-half bank results due in early May will suffer from a jump in institutional (large corporate) loan impairments. The major banks have varying degrees of exposure to Arrium, Peabody, Slater & Gordon, Dick Smith, McAleese and the Wiggins Island Coal Export Terminal. Total exposure to these companies is ~$3 billion and the interim results will expense extra institutional loan impairment provisions of around $1.2 billion. We think ANZ will cut its full-year dividend and the others will hold their dividends flat.
But there is no evidence of the housing crash predicted by hedge funds. Outside the obvious weak pockets, for example mining regions and inner-city units in Melbourne and Sydney, mortgage loan quality remains excellent with no leading indicators of deterioration.
While interest rates remain low and unemployment steady, this should remain so. Average house prices are having a soft landing. Outside volatile institutional loan portfolios, bank bad debts expense is set to normalise slowly.
In our view, the major banks are undervalued even factoring in earnings five per cent below consensus, higher funding costs, flat or lower dividends, dilutive dividend reinvestment plans, 1-for-30 rights issues to top up regulatory capital and higher discount rates in the valuations.
The institutional loan impairments are large but outside the resources sector they are random and tell us little about the broader economy. The banks are pricing in a recession we think won’t happen. This, the undervaluation and the probability of steady economic growth could make banks a surprise outperformer on the sharemarket after the interim results as impairment provisions meet expectations and managements reaffirm generally good economic conditions and loan quality. And no one is talking about that.
There is one imminent risk to watch though. Australian dollar depreciation has driven much of the transition from mining. Our positive outlook would be undermined by a sustained further surge in the dollar, which would dampen services and manufacturing net exports. The currency should match commodity price falls and the deterioration in Australia’s current account deficit but this isn’t happening because ultra-low and negative interest rates in other jurisdictions encourage strong capital flows into Australia’s AAA-rated and superior government bond yields. Government and the RBA are missing in action on what to do about this problem. We need to hear more.
Written by David Walker, Senior Equities Analyst. The following article was appeared in The Australian, 19 April 2016.