Macro investing: Recession risk? Pt 1

For the last two decades, Australia has beaten the business cycle. For 22 years, Australia has avoided recession. Who would want to challenge a track record like that and suggest that Australia may be on the verge of one?

Well, I would. I believe there’s a reasonable chance that Australia will enter a recession next year. Here, I’m going to state my case and explain what Intelligent Investor Super Advisor members can do to protect and even profit from this potential outcome.

Australia’s remarkable growth story can be divided into three phases, each with its distinct own character. The first, during the nineties, was an economist’s nirvana: strong economic growth and high returns on asset prices driven by high productivity growth.

This performance is frequently attributed to the Hawke/Keating era competition reforms and the IT revolution. Boom periods like this don’t create imbalances because the wealth and spending created originates in the economy’s expanding productive capacity.

As the nation approached the millennium, these influences waned and a new phase of growth took over. Asset price inflation and high consumption continued, but credit expansion rather than productivity increasingly drove it, as Chart 1 suggests.

This kind of growth almost always leads to imbalances that end in financial crisis. The reason is simple enough. The boom is driven by debt accumulation. Unless it’s accompanied by some underlying fundamental shift in the capacity of the economy to service that debt it eventually implodes.

Such a fate awaited Australia in 2003 as the RBA sought and succeeded, at least for a while, in pricking the growing housing bubble. Then our famed good luck kicked in. Rather than having to correct these imbalances, our terms of trade began to rise substantially.

China was our saviour. In buying our resources in huge volumes at ever-higher prices, the day of reckoning was averted. The rest, as they say, is history. The terms of trade kept rising right past the Global Financial Crisis (GFC) and, in US dollar terms, did not peak until 2011.

The mining boom was off and running, effectively voiding the need to pay the price of the credit boom. The huge mining investment response, aimed at producing even more of the suddenly very valuable commodities, meant we no longer had to work harder or smarter to increase our living standards.

So much money was flowing into the country that the banks were able to radically increase their offshore borrowing. The anticipated property market crash never materialised. Even the GFC failed to stop the boom. In fact in 2010, through a huge LNG capital investment program, it resumed in earnest.

Australia is now one of the richest nations in the world, as measured by nominal GDP per capita. The IMF ranks Australia at five and the World Bank, CIA and United Nations all place us in the top 10.

All booms must end

Whether it’s gold as in the late 1800s, wool in the 1950s or iron ore in the current boom, history indicates that commodity booms end. It is in the order of things that they must.

The big income flows associated with a boom drives up the exchange rate. Wages, especially in the boom sector, also rise. Businesses that export or those that manufacture locally but compete against cheap imports, suffer. Left unchecked these non-mining ‘tradable’ sectors are ‘hollowed out’, succumbing to Dutch disease, named called after the 1970s Dutch natural gas boom that decimated the country’s manufacturing sector.

That’s not all. Inherent in all commodity booms is their own destruction. New commodity supply drives down the prices that produced it. Frequently, so much capital has been drawn into new production that it can lead to a glut. Suddenly, what was a shortage becomes a surplus and prices crash. Such is the nature of the commodity cycle.

This is where we are now in iron ore, thermal coal and, to a lesser extent, coking coal. In three years time, LNG may well be in the same position.

As commodity income recedes, elevated prices leave us exposed. Australia’s case is even more vulnerable due to the three sequential booms of productivity, consumption and mining. These have raised wages without interruption for more than 20 years, and pushed household debt levels and asset prices to some of the highest in the world.

The cost of doing business in Australia is now at extreme levels versus just about all other developed countries. This is demonstrated in Chart 2, which shows Australia’s real exchange rate (which includes currency and wages) versus Germany, Japan and the US.

Australia is now very uncompetitive on every measure. Unless our cost base falls along with commodity prices, there won’t be any new investment to keep the economy growing as the mining boom ends.

How to deflate a country

We now live in a country with limited choices. We can continue to borrow via the public sector, as the UK has done, to support growth and incomes. We can also reduce interest rates to ease the repayment burden on the private sector, which has the added benefit of devaluing the currency, making the nation more competitive.

The lower currency may, in turn, spark inflation, which also serves to devalue the debts that are burdening both public and private sectors, and the real price of labour. This the UK has also done. With a bit of luck, there are also some productivity gains, which we are achieving once more.

The second approach a country can take is similar to that Europe's fringe states are being forced to pursue; an exclusively internal devaluation. Government spending is cut, not expanded, and because of the common currency, there is no boost to competitiveness via a falling external price.

In Greece, for example, this has meant that wages are taking the brunt of the price adjustment, which has worked well to boost the external demand for its goods but has also meant that unemployment goes through the roof and social unrest is a constant risk, not to mention general social suffering.

In this scenario, growth is so lousy that the debt burden actually increases despite cutting spending.

Australia is better placed than the UK or Greece due to the built-in increase in LNG exports. But while LNG may offset the deflating boom in coal and iron ore, it won’t get us out of trouble altogether.

That means Australia is most likely to pursue the UK model of adjustment. Budget deficits are now accepted and interest rates are on an inexorable slide. But these policy measures may not get us out of danger altogether. We may find ourselves again following the UK in the only other option that assist a country to quickly devalue its currency: recession.

In Part 2, we’ll look at the chances of Australia entering recession, how you can protect your portfolio against that risk and, potentially, even profit from it.