The view from Wall St: Is Australia China’s slowest growing province?

From overseas, it appears a correction looms for Australian shares and bonds as China slows down.

Summary: Australia’s benchmark index is rising despite growing concerns about key export market China. The Australian dollar is falling, which supports the case for export stocks, bonds look due for a correction. Investors appear to be hedging their bets as the cost of insuring Australian government bonds against default has soared in the past two weeks.

Key take-out: From Wall Street, it appears investors in Australia should look out as China’s economic stress becomes more apparent.

Key beneficiaries: General investors. Category: Economy.

China’s stock market turmoil has woken investors up to the risks lurking in the mainland economy, but it may also be about to leave a memorable welt on Australia.

Xi Jinping and Tony Abbott at Parliament House in Canberra. Source: News Corp Australia

While the gyrations of shares in China don’t dramatically worsen the outlook for China’s slowing economy and its demand for Asian exports, many of the region’s markets still appear to be suffering from Shanghai flu. Malaysia’s benchmark index is down roughly 1.5 per cent, South Korea’s benchmark index is 4 per cent lower and Taiwan’s is down almost 7 per cent. China isn’t the only reason, of course. Signs of recovery in the United States amid weakening global growth are feeding a steady stream of funds out of Asia into US dollars.

Weirdly, Australian stocks appear blithely unaffected. Australia’s benchmark index has climbed roughly 4 per cent despite growing concerns about the country’s biggest export market. Australia’s exports fell 17.5 per cent in the first quarter of this year, led by a 32 per cent drop in exports to China, which accounts for almost a third of Australian exports. Not surprisingly, China-focused exporters haven’t led a market rally: the index has been pulled up by Westpac Banking (WBC), telephone operator Telstra (TLS) and drug maker CSL (CSL), which has gained almost 10 per cent so far this month on news that its new hemophilia treatment is due for review by the US Food and Drug Administration.

Perhaps just as strangely, Australian government bonds have been strengthening alongside stocks: yields on 10-year Australian bonds have dropped from 3.1 per cent at the start of the month to roughly 2.85 per cent. That jibes with this column’s advice back in May, and, combined with rising stocks, suggests Australia is enjoying a cyclical economic recovery.

It isn’t. In its latest regional economic outlook, Morgan Stanley paints a rather bleak picture of conditions in the Lucky Country. While retail sales have been perking up, they’ve been financed by credit and so appear unlikely to last. Private investment is falling, and government spending is unlikely to fill that gap because tax revenues are falling and with them Canberra’s budget deficit. Morgan Stanley expects the Reserve Bank of Australia to cut rates again before the end of the year. But with the Fed expected to raise rates within months, the RBA may be able to stand pat and let its sliding currency do the work.

The Australian dollar has dropped roughly 2.8 per cent since China’s market bailout began and is down 11 per cent so far this year. That supports the case for Australian export stocks, including CSL, since a weaker dollar makes products that they sell overseas more valuable when converted back into the domestic currency. Strategists at Jefferies, however, are less sanguine: this week they lowered their rating for Australian stocks to “bearish.”

Australian bonds, however, look due for a correction. Foreign investors own two-thirds of Australia’s government debt. That makes bond prices as vulnerable to the direction of the Australian dollar as to the relative interest rate. And as yields fall closer to those in the US, where the 10-year yield has edged down to 2.26 per cent, it will make less and less sense to hold Australian bonds and risk further losses on the Aussie dollar.

Investors already appear to be hedging their bets. The cost of insuring Australian government bonds against default has soared in the past two weeks to its highest since early February. True, credit-default swaps have been rising around Asia with rising anxiety about the region’s prospects. But only Australian CDS spreads remain wider than where they were on July 8, when the China panic was most fever-pitched.

That may also reflect deteriorating credit conditions among Australia’s corporate borrowers as the economy struggles. Moody’s noted this week that Australia was second only to China in the number of companies whose credit ratings it downgraded in the second quarter. The ratings agency downgraded five companies, three of them in resources, including Fortescue Metals Group (FMG) and Atlas Iron (AGO).

As China’s economic stress becomes more apparent and global investors grow increasingly skittish about emerging-market risk, look out below.


This piece has been reproduced with permission from Barron's.

Related Articles