|Summary: The Australian economy is holding its ground, but some economists are pointing to weaker conditions – particularly as mining investment diminishes over time. If the economic does go into downturn mode, what are the best strategies for investors? In such a scenario, getting out of the market and moving back into defensive assets would be a good start.|
|Key take-out: Given the absence of any major causes for a downturn in Australia, the equities would likely rebound quite swiftly after an initial slump. Investors would have to move quickly.|
|Key beneficiaries: General investors. Category: Economics and strategy.|
Bank of America Merrill Lynch received plenty of headlines in recent days with its outlier call of a 25% chance of recession as the mining boom unwinds.
Now, as regular readers will know, I don’t think Australia is headed for a downturn. But as a rational investor it is always worthwhile thinking about what steps to take in this eventuality – how to risk manage it and protect our wealth, or even try and profit from it. Either way, you’ll find that ‘cyclical’ stocks – those companies that are most exposed to local downturn – are the ones you have to watch very closely.
Sign posts to a slump
The first thing that needs to be established are the likely sign posts to a slump. There are six:
- A sharp slowing in global growth: Luckily for Australia, the global growth indicators are accelerating, especially in the US.
- A collapse in mining investment: This is the great fear, but at this stage only a forecast. Actual leading indicators point to ongoing strong growth in mining investment for the next two to three years.
- A lengthy slowing in consumer spending: There is evidence that consumer spending has slowed quite sharply over the last three quarters, growth has halved since the middle of last year, while at the same time interest rates have been cut – very unusual.
- A sharp rise in the unemployment rate: Typically when Australia has had downturns, the unemployment rate has spiked by 2-3% points or more. That means if Australia is headed toward a downturn, the unemployment rate will rise closer to 7-7.5%. Thus far the unemployment rate is barely up 0.25%.
- No pick-up in housing investment: Thus far the latest statistics show a clear pick-up in housing investment.
- No pick-up in non-mining investment. Indicators are mixed here; business investment still remains very weak outside mining, but some leading indicators suggest a turnaround.
Of those indicators, only numbers three and six give any signal that the Australian economy is headed for a downturn. Yet even they are not equivocal. Number two is a special case: many forecast it and it is the accepted wisdom, but there is little in the way of evidence to support it.
So with that in mind, the recession risk as now known is low to very low. But in the event that the signals do start to turn, we need to figure out how that will roll. One thing to note is that the downturn, if it comes, will have some unique characteristics. Namely, that it will come without any cause (none) and so it will be very short-lived. Remember that most downturns, in modern economic times at least, have been policy induced – think oil crisis, or inflation fighting.
What happens in those circumstances is that central banks push rates much higher, bank lending rates shoot up, spending and lending drops sharply, and people lose jobs. You sell banks, discretionary stocks, industrials etc and buy defensives – health, telecoms and staples. You know the drill. Instead, the cash rate and lending rates are at record lows, consumer balance sheets are in tip-top shape, with most holding low to no debt and solid savings. Wealth is at or near a record.
Indeed, the annual Cap Gemini report released this week reveals Australia’s 207,000 millionaires have enjoyed a 6% lift in their investable assets to $625 billion.
An additional problem, if we do have a downturn, is that most of those defensives are already pushing into rich territory. CSL and Telstra, in particular, are at or near record price-earnings (at around 30 and 16 respectively) and even forward estimates are rich (at around 25 and 15, respectively). So if we are going to have a downturn, are investors really going to pile into the already expensive defensives? Maybe initially, simply because investors won’t know what else to do. But I think appetite will wane very quickly, and there is a limit to how high those stocks – those defensive sectors – will push.
The bigger truth is that international investors will exit our market in droves without regard to sector allocation (this is what we’ve seen recently outside of resources), although they hit a higher peak. This will be driven by two factors:
- The scope for massive earnings disappointment, and:
- The possible collapse in the Australian dollar if the pessimists are correct. International investors won’t want to take the exchange rate hit.
Strategies for a downturn
So what to do? Well, an extreme option would be to get out of Australian stocks altogether and sit outside the market for a bit. Alternatively, depending on when you bought in, you might have ample time to just sit and wait.
But, if your position is more delicate, you might want to have a look at some hedging strategies – some put options (which give you the right but not the obligation to sell at an agreed price). You don’t want to rush into selling though; if it all comes to nothing you’ll have sold at a low point.
The game here is to wait, to wait for the inevitable policy response – because there will be one. A few things are worth noting.
- That the Reserve Bank will take the cash rate toward zero and engage quantitative easing. Why? Because that’s the consensus response and what The Fed et al have done. Truth is, it would be pointless and have limited impact on the economy other than to further weigh on confidence, but it would allow for point two above, which would offset that.
- The government will go on spending spree (think Japan). With policy aimed at three things:
- Lifting consumer spending: welfare, tax cuts, disincentives to save.
- Boosting housing investment: housing grants, stamp duty relief etc deductions for developers.
- Increasing non-mining infrastructure investment.
There is virtually no chance that a newly elected government would allow the economy to fall into a downturn on its watch. The reason the above three points are weakening at the moment is because confidence is so abysmal – it’s not high consumer debt, as most Australians have little to no debt – that’s a fact. We haven’t had a housing investment boom, so there is no excess to work through and no structural impediment to a lift in housing investment – and it’s the same with non-mining investment. Companies have actually been under-investing. The thing is, unlike monetary policy, fiscal policy doesn’t require confidence to make it work.
A renewal of fiscal policy will feed straight through to the ‘real economy’ that is, it will feed straight through to the cyclical stocks ... the very ones that would be hit first in the event of a possible downturn. Ironically for key cyclical stocks such as Boral, JB Hi Fi, Harvey Norman or Lend Lease they will fall first in a slump and rise first in an economy which is being ‘rebooted’.
More to the point, an incoming government is well placed to do this. With a downturn, the Budget would go from close to balance now to a small deficit. Additional spending from that point would be neutral given the RBA’s QE program. That means that, in practical terms, the lift in government spending need not even lift, in radical terms, the government’s already low deficit and debt burden. This is because the central bank would be buying government debt and holding it to maturity, like the Fed, BoJ and BoE do. Any interest payments the government then makes on that debt then gets returned as a dividend from the RBA.
This means that one way or another, the above three sectors are going to pick up – whether I’m right on my domestic view or wrong. In the downturn scenario, you get out of the market soon, wait for a very short period (six months or so) and then go overweight stocks exposed to the stimulus response. Given the absence of any actual cause for the downturn (see my piece of April 29, Recession calls are ringing hollow) the turnaround in equities would be swift after the initial slump – say six to nine months maybe. So investors would have to move quickly – just like in 2009.