Why economic reality points to a future rally

Australian equities are putting in a solid underperformance so far, weighed down by this unrelenting and highly misguided effort to jawbone a weaker Australian dollar.

As I write, our index is up only 5.5% so far this year compared to the S&P 500’s gain of about 18%.   It’s clear that investors, especially international investors, have developed an aversion to Australian stocks. Why? Because of the high correlation between our currency, our equity market and our economy. A weak currency is associated with a weak sharemarket – especially our miners – and a weak economy more broadly. And, on that last point, both the Commonwealth Treasury and the Reserve Bank of Australia released forecasts this month outlining why they expect sluggish economic growth over the next couple of years. Ultimately, the fortune of all three comes down to the panic over the end of the mining boom.

Now, I’ve been arguing the stronger growth profile case for some time and after data released over the last week or so I’m much more confident in that call. Any talk of a downturn here is well off the mark. As a result, I think investors should take heart – this data shows sentiment toward our market will turn. Maybe not in the next three months, but certainly over the next 12.

The bottom line is that this data confirms the RBA’s view of a near-term end to the mining investment boom is misplaced. Indeed, I’m surprised that so many seem to have missed the key point coming from the data, which in fact suggests that the boom still has years to run.  

I won’t run through arguments I’ve presented before, but as an update the capital expenditure estimates I saw yesterday shows total investment is expected to rise about 3% this year after a 30% gain last year. This is expected to be followed by another gain of 13% or so over next year. Mining investment is expected to rise 13% this year after a 74% gain the year prior – and 12% next. No imminent end to the mining boom anywhere to be seen.  So far so good.

More to the point, data compiled by the Bureau of Resource and Energy Economics (BREE) suggests we shouldn’t really be thinking about the end of the investment boom till about 2016 – and maybe not even then.

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BREE puts together a list of major mining projects a couple of times a year, and this time around one chart in particular captured the market interest – chart 1 above. This chart has been used by many to actually back their case – including BREE itself – that the mining boom is over. Look at the likely scenario line in red – it shows the value of committed projects slowly declining this year and next, before falling sharply from 2015. A possible scenario is also shown in orange, which has commitments picking up this year and remaining very high for a number of years before tapering from about 2016.

Headlines from this data were unanimous – the boom had peaked. But I think the headlines missed the point, and the problem is that everyone is using the value of projects committed to make this claim. This is misleading. Committed is not completed. Now recall I don’t dispute that the mining boom will end – obviously it will. I do dispute the timing that the RBA and others have attached to the end though – as in this year. For investors, this fact itself is critical.

If, instead, we look at the current expected completion dates (I’m assuming they pretty much start-up as soon as they’re completed), we get a mining  investment profile that looks a little like chart 2 below.

Recall there is $268 billion worth of projects at the committed stage, and on the current estimates of when they are to be competed (from the companies themselves) this puts the end of the investment boom as we know it now around 2016-17.

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Beyond that we simply don’t know.

It is plausible that the boom won’t even end there. Go back to chart 1 – this was BREE’s attempt at trying to estimate how much of the $400 billion at the publically announced/feasibility phase (i.e. not yet committed) would flow through to the committed phase. It is effectively saying not much. But very small changes in the underlying assumptions could change that. I.e., if it turns out that China is isn’t slowing a lot – even the slightest lift in what is recessionary confidence could see investment committed to surge – and that’s all it would take.   

Even if we took BREE’s still conservative “possible” scenario (chart 1 again), even under that still conservative estimate, we wouldn’t see the end of the mining boom – the actual investment boom, till later this decade – 2018 or even 2020. That’s a long time – a lot can happen and change over that period.

Growing global demand

Underlying it all, we need to consider that China’s economy will be 50% to 70% bigger than it is today over that period. That is, we are going to see the equivalent of another economy the size of Japan or Germany appear over the next four years.  By 2020, China’s economy will be twice the size that it is today – and that’s assuming a significant slowing in growth over that period (let’s say half for argument’s sake).  That is, they will consume at least twice as much energy as today, twice as much steel , copper , iron ore etc etc.  That’s just China, and this doesn’t consider growth in other developing nations.

This is the difference between rumour and fact in the market at the moment. Between perceptions, or perceived risks, and reality. Too many people look at the growth of the developing world (the BRIC phenomenon etc) as some investment fad – like Peak Oil. It isn’t a phenomenon that investment banks invented for the years 2003-2008. The rise of the developing nations is real, it is happening and it won’t stop for decades.  

Noting that, the idea that energy, steel or iron ore demand etc is going to fall over that time period, or that the scope for future investment is somehow limited, simply isn’t believable in my view.

Anyway, the more immediate implications from the data this week is that economic growth is probably going to be significantly stronger than what the RBA, Treasury and consensus expect. Weak growth was predicated on a near-term end to the mining boom.  Mining investment instead looks set to post double-digit growth next year and strong growth this year.

The next 12 months

The way I think it will play out over the next 12 months or so is like this. For the next three to six months, our market will continue to be obsessed with the end of the mining boom. With that, and the ongoing attempt at weakening the dollar, our stocks will continue to underperform. As it becomes clear that the mining boom hasn’t finished, and we see some of those very strong GDP results come in, market sentiment will turn and Australia will become a new darling for global investors, dealing with what will look to be stretched valuations in Europe and the US.

Longer-term, throw in an inevitable turn in non-mining investment over the next four years and it is highly probable, and my base case, that growth will be well above trend, on average, over that period. I would attach a 70% probability of that occurring, with a 25% probability of trend growth and a 5% chance of sub-trend growth.

Don’t forget that since the GFC one of the best ways to make money in this market has been to identify instances when the perceived risks are out of kilter with the real risks. That is either because they don’t exist, or because the probability attached to them is far greater than is warranted by any reasonable analysis. 

Over the years we’ve had a “Grexit” kicking the can, a Eurozone implosion, a US double dip, and a Chinese hard landing. Domestically, we’ve had the consumer capitulation, the great fiscal contraction! I would add to that list the end of the mining boom. Each one of those market misnomers presented an opportunity for investors to profit as it became clear it was false.  “The end of the mining boom” misnomer is simply one more of those.