Australia - Progress Report

The Australian economy has long been recognised as a `commodities play` because of its reliance on mineral & agricultural exports, but in fact the economy is considerably stronger than that precisely because of that dependence. If global demand for commodities subsides the $A declines and offshore commodity revenues (priced in $US terms) are preserved. Better still - the country benefits from increased tourism. The housing markets tend to suffer from higher interest rates as the Reserve Bank of Australia attempts to stabilise the economy. The economic paradigm has changed recently though.

Political Organisation
Australia has a stable democracy. The encumbent Prime Minister John Howard is the longest serving PM since his mentor Bob Menzies held power in the 1950s and 1960s. Both leaders led their conservative Liberal Party to successive election victories. Both leaders oversaw periods of economic prosperity, but in Howard`s case, it was largely by default, with no meaningful opposition.

The Howard government has however been disciplined in reducing the huge public deficit accumulated under the Labor Party in the 1980s. The debt has been reduced from $168billion to just $28bil, and that is likely to be a bottom given the desire to retain a liquid bond market.

My belief is that the Australian government will attempt to expand its immigration program to lift subdued domestic demand in future, as well as provide marginal support to nation-building infrastructure programs. In the process it hopes to stimulate new investment in under-funded infrastructure, as well as reducing debt in per capita terms.

Economic Activity
The Australian economy has been one of the fastest growing OECD countries over the last decade - largely as a result of labour market reform, privatisation of key state-owned enterprises and subsidies to the housing sector, in addition to falls in interest rates. The late 1990s and early 200os were particularly strong as mineral export prices & volumes improved and housing prices took off. In the last 3years, China largely accounted for the bulk of the incremental demand, and that demand will evaporate in future when the US & Chinese property markets fall.

Improvements in Australia`s terms of trade have been matched by increasing imports from China, which have helped to keep domestic inflation low, as the $A has rallied from $US0.48 t0 $US0.80, and since fallen to $US0.76. During the 1995-04 property boom, housing prices rose by an average of 250%(?), going from 3x annual average incomes to 9x, as prices rose with incomes and their capacity to borrow (new jobs & lower interest rates). The concern is that the bursting of the US housing market by high oil prices & excessive household debt will undermine global economic activity. We can thus expect a much lower $A and higher interest rates, which will take a huge hit on the Australia property market.
There remains considerable optimism about the health of the global economy. Iron ore & coal annual contract prices are up 50%, and such companies along with the oil companies are sparking an investment boom in WA and NT. These investments will take 2-4 years of construction. Investment in other areas is less active because mineral prices in Australia have not risen greatly in $A terms because of the strength in the $A. The positive is that as mineral prices fall, so will the $A. Just gold prices in $A terms will perform very well.

Equity Markets & Corporate Earnings
Australian equities posted solid earnings in 2004-5, and the minerals sector which renegotiated annual contract prices in Mar'05, will see stronger earnings this year, and those contract prices are likely to be preserved in coming years if the $US weakens.
The broader market is not likely to repeat its strong 2004 growth since high household debts and rising interest rates are likely to undermine retail sales. Inflation initially can be expected to boost earnings since the value of capital will boost balance sheets, whilst corporations are able to pass on costs. Corporates have resorted to boosting dividend pay-out ratios (DPRs) from 77% in 2004 to 80% in 2005. Two companies going against the broad trend:

1. BHP Billiton has the made the lowest dividend payout ratio of 23% in years as it embarks on a $6bil capital expenditure program to boost output. This trend is evident across the resources sector, with Div Payout Ratio (DPR) in the resources sector falling from 49% to 31% between 2004-05, suggesting resource companies will have some nice profit/dividend growth in future, whilst the broader market is stretching itself. Clearly they are hoping the market will react to stronger metal prices in the short term and higher dividend yields (DPRs) as the commodity prices correct.
2. Telstra: The new CEO of Telstra has disclosed that the company has under-funded capital expenditure by $2-3billion over 3-5 years to boost earnings, whilst at the same time delaying the adoption of ADSL at $30/month. Under-investment in the past (reflected by 14% line faults) means higher investment in the future, so lower earnings, and likely squeeze on margins, particularly if the Fed govt proceeds with a break up of Telstra. Lower dividends, particularly since the payout ratio from earnings is very high.
   Telstra’s dividend of 40c per share was based on a pay-out ratio of 93% (up from 75%) - suggesting they retained only 7% of earnings for capex. Its intention is of course to boost the share price for the privatisation, whilst not disclosing the capital investment required to maintain services. Telstra had to borrow $550mil from its Special (share premium) Reserve to fund this dividend, and the same for the special 2006 dividend.

Housing Market
Recent housing figures (July'05) suggest households are taking comfort in the persistence of housing prices, interest rates and strong labour market. The consequence has been a strong recovery in the housing refurbishment market. The consequence of this is likely to be a lift in interest rates by 0.25%, particularly as inflationary pressures are high.

Inflation
Strong inflation has yet to register in the CPI figures, but it seems likely in coming quarters as:

1. Wages rise: Wages rose 7.4% annualised in the Jun’05 qtr.
2. Employment: The labour market remains tight with the unemployment rate still at 5%.
3. Purchasing Power Index: The PPI, a measure of producers cost variability has increased due to higher fuel & material costs.

The Forex Market
The $A can be expected to trade higher due to the strong momentum in the housing market. Australia will also benefit from strong terms of trade as the recently negotiated mineral export contract prices still have some time (9mths) to run. A lift in interest rates will only help the $A remain high, but in6mths time it will come off strongly as commodity prices fall.