Exposure appeals as recession looms

What chance recession?

For the past two decades, Australia has beaten the business cycle. For 22 years, we've avoided recession. Who would want to challenge a track record like that and suggest we may be on the verge of one? Well, I would. I believe there's a 50:50 chance that Australia will enter a recession next year.

When a boom is driven by higher borrowing without an underlying improvement in our ability to pay the interest, that boom will eventually implode.

Such a fate awaited Australia in 2003 as the Reserve Bank succeeded, at least for a while, in pricking the growing housing bubble. Then our famed good luck kicked in.

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 and, in US dollar terms, did not peak until 2011.

Inevitably, booms end. A rising exchange rate brings higher wages and suffering exporters. Left unchecked, these non-mining "tradeable" sectors are "hollowed out". Meanwhile, new commodity supplies drive down the prices that encouraged them. What was a shortage becomes a surplus and prices crash. This is where we are now in iron ore, thermal coal, and, to a lesser extent, coking coal. In three years, LNG may well be in the same position.

The cost of doing business in Australia is at extreme levels. We are uncompetitive on every measure. Unless our cost base falls with commodity prices, there will be no new investment to keep the economy growing as the boom ends. We have limited choices. One would be to borrow via the public sector to support growth and incomes, and reduce interest rates to ease the repayment burden on the private sector.

The second approach would be an exclusively internal devaluation, under which government spending would be cut, not expanded. In this scenario, growth would be so lousy, the debt burden would increase, despite spending cuts. Australia is better placed than Britain due to the built-in increase in LNG exports. While LNG may offset the deflating boom in coal and iron ore, it won't get us out of trouble. That means Australia is most likely to pursue the British 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 Britain in the only other option that helps a country devalue its currency quickly: recession.

Against this threat, the temptation for investors is to gravitate towards cyclical stocks, such as banks and retail - even property - in the search for yield. This is already happening. But given the possible severity of the looming correction in the real economy, and the already inflated prices in cyclicals, it's a strategy that favours risk over return.

A better approach would be to look to a lower Australian dollar for upside. When it falls - via rate cuts or hollowing out - the earnings of dollar-exposed firms will grow strongly. That may make mining stocks a buy at some point, although falling commodity prices still makes them risky. Dollar-exposed industrials are better bets, particularly those already succeeding despite the dollar holding them back - stocks such as ResMed and Computershare. The tougher things get for Australia, the better things could be for the earnings of companies such as these.

This article contains general investment advice only (under AFSL 282288).