Inside Goldman’s bullish case for Australia

Advertisement

Goldman has done a huge turn around on Australia in the past few weeks moving from bearish to bullish across the spectrum. Let’s take a look at its case:

erger

As we look out to 2017 and beyond, we believe Australia has moved through an important transition point and with it has emerged the prospect of stronger and less volatile real economic growth. We have upgraded our economic growth forecasts for Australia and now forecast Australia’s economic growth will average 2.8% in 2017, 2.9% in 2018, 3.0% in 2019 and 3.3% in 2020. This represents a 40ppt upgrade in 2017, a 10ppt upgrade in 2018 and a 50ppt upgrade in 2019. We have also upgraded our A$/US$ forecasts from 0.75, 0.73, 0.72 on a 3, 6 and 12 month view to 0.78, 0.77 and 0.75, respectively.

  • A sharp turn in Australia’s national income dynamic, which we flagged in early August, now looks likely to move significantly higher following the spikes in coal and iron ore prices in the closing months of 2016. Although we expect prices to fall from current levels for these commodities, the recent surge transforms our expectation for a modest rise in Australia’s terms of trade in 2017 to a material 8% gain with most of the export price spike to be registered in late 2016 an early 2017. This is likely to set off a chain of events through the Australian economy in coming months. The resulting surge in national income should be reflected via much stronger mining profits, a large taxation windfall for the Federal government (and elimination of the threat of a sovereign downgrade), a restarting of idle capacity in the coal sector, a better climate for broader business investment and ultimately better employment and wage outcomes. It also sows the seeds for a more material handover of the economic growth baton to the private sector, and importantly this transition can proceed despite our forecast of a sharp decline in new dwelling investment in 2017-18. Perhaps the most dramatic transformation will come via Australia’s external accounts with a run of trade surpluses now in prospect for 2017 – indeed the combination stronger commodity prices and the ramp-up of LNG production suggests Australia will post the largest trade surpluses as a share of GDP during 2017 since any time since the early 1970s. Ultimately the state of the external accounts is the truth serum for the currency, and as such we acknowledge clear upside risk to the A$ from current levels.
  • How will the RBA respond? We continue to forecast that the RBA will commence increasing interest rates from 1Q18; however, the skew is now towards an earlier kick-off in 2H17. Much will depend upon the response of the A$ and other asset prices that we capture in our financial conditions index. Of particular interest is that since the 1 September our financial conditions index has moved from a contractionary setting into expansionary territory for the first time in over 12 months. The negative impact from rising bond yields has been more than offset by narrowing credit spreads and rising commodity prices. At this stage the Australian economy has ample spare capacity in product and labour markets and a low starting point for inflation. While this suggests the RBA has time on its side before recalibrating interest rate settings, the RBA’s focus has increasingly shifted under the stewardship of Governor Lowe towards minimizing risks in the financial cycle rather than just the economic cycle. On this score, the RBA may begin to question the rationale for keeping official interest rates at a record low of 1.5%. At this stage we have kept our forecast for the RBA to commence its hiking cycle in 1Q18 with the RBA forecast to increase interest rates 75bps through 2018 and a further 75bps spread over 2019 and 2020 to a 3.0% cash rate. Nevertheless, the risk of the RBA increasing the cash rate in 2H17 has risen materially and the evolution of financial conditions, house prices and underlying inflation will ultimately guide the decision.
sfgaw

A have two key problems with this analysis. The first is that the entire second leg up in the terms or trade (circled) is much more short term bubble than it is growth signal and it will very likely reverse by this time next year. Actually, I think it’ll probably fall even further. The coal shortages were the result of a Chinese policy error that has already been reversed, not global reflation. Iron ore is clearly still in oversupply and will deflate as well, especially as Chinese tightening slows construction at the margin. I still expect as well that China will return to reform post the Communist Party Congress in October.

Moreover, if that is the case, then the rocketing prices will not trigger much renewed investment. That means the income surge will largely bi-pass the real economy and be felt keenly only in two monetary dimensions: mining profits and Budget receipts. The first is already largely priced, the second will be held from impacting demand by ongoing fiscal pressures.

Advertisement

That leads me to the second problem. Goldman’s mooted swing to strong business investment in H2 2017 and 2018 is going to be based on what? Mining investment will still be falling. Dwelling investment will be plunging. Vehicle assembly will be shuttering. There is also a swiftly rising risk of slowing immigration. Regardless, there will a whole new wave of excess capacity in the economy. Who will be investing into that?

Government is the answer but that’s it and it isn’t enough to deliver Goldman’s growth outcomes. As for rate rises, forget about it.

Turning to markets, let’s look into Goldman’s allocations implications:

Advertisement

2016 marked the end of a defensive bull market unprecedented in terms of both its duration and magnitude. ‘Safe’ assets and ‘Secular Growth’ stocks were the main beneficiaries of the ‘low rates/low growth’ trade, while cyclicals underperformed as weaker volumes and prices squeezed already thin margins. Much changed over 2016. Leading indicators increasingly point to a cyclical upturn which has been given a kick along by expectations of fiscal stimulus in the US. Australia’s exposure to these positive reflationary forces without the downside from increased trade barriers, led our regional team in their recent 2017 outlook to move to Overweight the ASX 200 for the first time in over a decade.

We expect most of the trends that are in play as 2016 ends will extend, but at a much more muted pace. Our forecasts call for global bond yields to continue to rise, the USD to strengthen, commodity prices to remain well above 2016’s troughs and the valuation gaps between value/growth and cyclical/defensive stocks to continue to narrow. With most value/cyclical names having re-rated, we think 2017 will be more about what you avoid than what you own. We remain underweight ‘Bond-Proxies’ and ‘Secular Growth’ stocks as despite their recent de-ratings, valuation risk to rising rates remains. Further, given the large fall that a number of market darlings have experienced this year we expect increased investor scrutiny on just how robust many of the remaining growth stories are.

We upgrade Miners to Overweight alongside Banks as our preferred reflation trades. While commodity prices have already enjoyed a large bounce, the sector still presents as one of the few cyclical parts of the market where valuations are not stretched and earnings momentum remains strong given the significant disconnect between the A$ and spot commodity prices. Excluding Banks and Resources we believe many cyclical stocks have potentially run too fast too soon, especially considering the degree of both operating and financial deleveraging that many of these firms have undertaken after years of extensive cost-out/restructuring and balance sheet repair. We expect a more positive reflation dynamic will extend the recent outperformance of large-caps as the valuation premium in many small/mid cap growth stocks continues to unwind. See Exhibit 1 for our updated sector and stock views.

ewrgw

Actually, despite our different views on the economy, I agree here, though not so strongly that I’d shift to buying them. Banks will benefit from the steepening global yield curve (we’ve already seen the start of that) but I wouldn’t buy owing to the same set of circumstances observed for the past year: regulatory risk, rising bad loans and rising funding costs hitting bloated payout rations. Miners are in heaven right now with bulk bubble that has not repriced the Aussie dollar and could have further to run as a result but given I see bulks deflating that’s not a percentage play, either. If the income boost is going to largely miss the economy then cyclicals will benefit from the global rotation more on price than earnings.

So, although it is clearly the case that some form of global reflation is underway, a lot of the market signal for it today is froth that should get blown off over the next twelve months leaving the Australian economy with a handy fiscal boost but as exposed as ever to the dynamics of its lost decade.

Better opportunities still lie elsewhere.

Advertisement
About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.