Altered states: An investment view of Australia
Summary: Australia's biggest listed companies have operations across the country, making it difficult if not impossible for investors to quarantine themselves from the economic conditions in specific states or territories. But macro forces can definitely give a clear indication of which segments to avoid, and where the biggest economic threats are likely to be arise. |
Key take-out: NSW and Victoria are still riding high on the housing market, but investors should watch carefully for signs of weakness as this will have broad implications for the national economy. |
Key beneficiaries: General investors. Category: Economy. |
New South Wales (NSW) has the country's fastest growing economy, according to CommSec's quarterly State of the States report. Victoria and the ACT were the other standouts.
The report, which compares the states on the basis of eight different economic measures, continues to show a two-tier economy. States such as NSW and Victoria continue to pull ahead on the back of rising house prices; by comparison, Western Australia and Queensland continue to struggle as mining investment crumbles.
The broad rankings are included in the graphic below including areas of strength and weakness:
According to CommSec, NSW has been the top performer for both retail spending and investment. Victoria and the ACT take up the next two spots in each category.
Perhaps the most striking element in the figure below is the sharp decline in investment across most Australian states. From an economic standpoint the decline in equipment investment across WA has been quite remarkable and it is expected to fall further over the next two years.
These rankings are often used by state governments as a way to promote the success of their economic program or to justify economic reform. However, the rankings themselves are also somewhat simplistic and don't provide much in the way of broader context.
So I thought it might be worth exploring how the Australian economy tends to work and how that feeds into these national rankings.
NSW and Victoria continue to outperform the national average on the back of strong house price growth and associated spill overs in the form of stronger retail sales and residential construction activity.
This housing boom has, in some degree, been a product of strong population growth, primarily driven through migration and capital inflows from abroad. Population growth serves three main purposes in the modern Australian economy:
- to offset lacklustre growth in productivity and spending per capita;
- to push up house prices and household wealth; and
- to support retail spending.
Population growth has been used, particularly in Victoria, as a means to paper over their economic cracks. From an investor's perspective, however, the main takeaway is that higher population means bigger markets and that encourages greater earnings and valuations.
Of course a rising population needs to be housed and fed. This supports house prices and rents and spills over into stronger retail spending, particularly with regards to household durable goods and motor vehicle sales.
Strong population growth in NSW and Victoria has also been supported by trade flows. Both states run a sizable trade deficit, which has widened significantly over the past three years. This has been financed by the trade surpluses maintained by WA and Queensland.
In other words, the two resource-rich states bring the money in and our two most populous states spend it. Since economic conditions in WA and Queensland are so weak, firms are choosing to save rather than spend and that money is being borrowed by NSW and Victoria to fund property investment and household spending.
What strikes me about this scenario is that growth of this nature isn't sustainable in the long term. As mining investment in WA and Queensland stabilises we are going to see a sharp convergence between the mining and non-mining economy.
The trade deficits run by NSW and Victoria are not sustainable if aggregate demand in WA and Queensland begins to improve. Firms will save less and that money will be used in the resource-rich states rather than to push up house prices in the eastern states.
Furthermore, the economic success of our two biggest states is so closely intertwined with the success of the housing market. Any economic or financial shock that hurts the property market will push NSW and Victoria towards recession.Â
The situation would be different if the recent economic success of NSW and Victoria was built on higher productivity growth and investment. Unfortunately productivity gains tend to be more difficult in service industries, which dominate the economies in both these states.
WA and Queensland are much better set up for long-term economic success. Their main issue is that their success is dependent on global markets for commodities such as iron ore, coal and liquefied natural gas.
This creates a great deal of volatility in the mining states, which results in a more frequent boom-bust dynamic. But over a period of 10 or 20 years I would expect the resource-rich states to outperform states such as NSW and Victoria that require massive trade deficits to maintain living standards.
A high reliance on population growth also leaves NSW and Victoria susceptible to changes in government policy. The recent changes to the 457 visa program, which are basically temporary visas designed to deal with skill shortages, is one recent albeit minor example.
But the broader shift towards nationalism, including the rising popularity of One Nation and the ‘Australian-first' rhetoric coming from Malcolm Turnbull and the federal government, does raise the possibility that big changes to immigration policy could be on the way.
From an investors' perspective the state dynamics are complicated.
Active investors will be focused primarily on industries and asset classes that are highly exposed to NSW and Victoria; they'd also be focused less on the mining sector, though they may believe that the market is undervalued.
But in many cases state lines don't mean a lot to corporate Australia. It's not always possible to identify which companies do a lot of business in NSW and which generate sales primarily from WA. Many firms are also dynamic, so that their sales profile reflects underlying state demand rather than any concerted effort in any given state.
The most important point, though, is simply the fact that the recent economic success of NSW and Victoria is built on what I consider to be flimsy foundations.
Investors should keep a close eye on the housing market – which I'm sure many of you already do – as any downward shift in that market has huge implications for the broader economy.
Any news on immigration policy is also worth incorporating into your economic outlook and earnings expectations.