Australian shares ended their spectacular 10-year bull market relative to the global benchmark in 2008. They have since lagged the global average by about 25% over the past four years. The yield curve inverted and has remained flat as long-term interest rates have dropped, even though the RBA has been cutting short rates. One of the headwinds that explain why Australias economic and financial market fortunes have taken a turn for the worse is the weakness in commodity prices. Historically, Australia has always been a commodity play, but its dependence on commodity exports has increased massively since the beginning of the last decade. The share of commodity exports has risen from less than 45% of total exports in 1996 to more than 72% in 2011-12. It is worth noting that the increase in Australias terms of trade during the last decade was both one of the largest and longest in over 100 years. According to the Australian Treasurys 2012 report, the improvement in the terms of trade contributed to about half of the overall annual increase in Australias real gross national income over the last decade. For example, mining sector employment has tripled, investment has increased by about 600% since the early 2000s and was responsible for 2.2% of the 3.6% total real GDP growth in 2012. The problem is that mining investment is now projected to decelerate sharply over the next five years. The value of committed mining investment projects peaked at A$270 billion (18% of GDP) in 2012 and the government is projecting that it will likely drop to A$30 billion (less than 2% of GDP) by 2018. This staggering decline, if it were to play out as expected by the government, would be a massive structural headwind for Australia. In addition, despite the recent drop in the Aussie dollar, its real effective exchange rate is hovering around its multi-decade highs, putting enormous pressure on Australian non-mining businesses along with the overall economy. The Aussie stock market will continue to lag until the Aussie dollar weakens substantially.
Historically, adjustments in the Australian dollar have been a key factor in coping with terms-of-trade shocks and fending off either inflationary or deflationary pressures. But since the end of 2011, when commodity prices began to weaken, the AUD has acted less like a shock absorber.
Although both metals prices and Chinese real GDP growth argue for a much weaker Australian dollar, the AUD has remained strong relative to what the terms of trade would suggest. One key reason for the unusually strong AUD is because of the high interest-rate spread between Australia and the rest of the world.
As well, during the European debt crisis, Australia attracted large inflows of capital, seeking safe-haven assets. Australia is considered a fiscally-conservative economy, with a government debt-to-GDP ratio among the lowest in the developed world.
A significant fall in the AUD from its current overvalued levels would help revive a slowing Australian economy, but that would require a substantial reduction in domestic interest rates. This is already at play, but the rest of the industrialized world is running a monetary policy that is still much looser than the RBAs.The relative performance of Australian equities depends on whether the RBA eases policy more aggressively to get itself ahead of the curve. We think that more currency depreciation and RBA easing are needed for Australian stocks to cease underperforming. The almost-inverted yield curve suggests that RBA policy is still too tight.
This post was originally published by the BCA Research blog.