Macro investing: Recession risk? Pt 2

In part 1 we examined how Australia arrived at its current predicament and what the various policy options were. Whatever the RBA and the government of the time choose, we’re all in a race against time.

As explained in The coming iron ore glut, our terms of trade will probably continue to decline. That will keep downward pressure on national income for the next three years, especially given that the huge investment spike in mining is at or even past its peak. The country’s ability to avoid a recession is therefore based on delivering, from somewhere, increased economic activity to fill the gap vacated by the decline in mining investment.

Interest rates cuts and budget deficits are two measures already deployed to encourage that. But their success depends on the steepness of the cliff, and judging where the point of inflection occurs.

Chart 1 shows the diversity of opinions regarding these points. According to Morgan Stanley, the mining investment boom has already peaked and is in decline. Other private forecasters see a more rapid decline, especially the ANZ. As for the RBA, its forecast seems to imply the mining investment cliff isn’t a cliff at all, rather a gentle, ambling slope.

The big risk in all these forecasts is that the pipeline of projects on which they rely will be cut further, making these estimates look much more benign than the real life effects. The current and emerging surplus in bulk commodities will push prices down even further. That will weaken the investment case for new capital expenditure programs, increasing the chances of them being cancelled.

Mean reversion

President Obama recently committed the US to the pursuit of gas exports for its growing shale gas glut. After Woodside shelved the massive Browse project, new Australian LNG projects are highly unlikely. And before you dismiss the ANZ estimates, which are actually the most thorough of the private forecasters, the long run average of mining investment to GDP is 2%. ANZ is simply forecasting a reversion to the mean. The RBA forecast gets nowhere near it.

Of course, there will be areas of growth that will offset these declines. The RBA rate cuts have already stimulated consumption and a modest rise in housing investment. We can also expect rising export volumes, although much of this will only kick in after 2015. Last week’s interest rate cut tells us all we need to know about this precarious position.

There are two main points to make, the first concerning the short term. Much uncertainty still surrounds the timing and pitch of the mining investment cliff. We may be past the peak already and its slope may imply up to 5% could be withdrawn from GDP over the next three years.

Then again, we may not go over it until year-end and the hit may only be half that. This uncertainty places the economy in a perpetually vulnerable state. It could be sailing along fine one quarter and be shrinking the next. If the last few years haven’t trained you to expect volatility, you’re going to get more time to learn.

The second point is longer term in nature. We are at only the start of a historic adjustment in the Australian economy that will run for the next three years at least. Rate cuts continue because the RBA has so far failed to stimulate the economy enough to see us through the ongoing terms of trade correction and approaching mining investment cliff.

Lower dollar

Most importantly, it has not yet succeeded in lowering the dollar. Rate cuts will therefore continue, perhaps even until the cash rate has a one in front of it.

The temptation will be for investors to gravitate towards cyclical stocks like banks and retail, even property, in the search for yield. Clearly, 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 is to look to a lower Australian dollar for upside. When it falls – either via rate cuts or the hollowing out process – 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 on the other hand are our best companies; those already succeeding in the global economy despite the dollar holding them back. The tougher things get for Australia in the future, the better things get for their earnings. Stocks like ResMed and Computershare, both on Share Advisor’s Buy list, are two good examples.

Prepare, don’t predict

The over-arching point is this: Australia’s great run is coming to an end. The chances of an actual recession are probably already above 50%, although it need not end this way. If we can reprice our economy quickly enough, through an exchange rate that falls sooner rather than later, we may avoid recession. But the longer that takes, the greater the risk.

This is not to predict a recession, merely to suggest that it might pay to prepare for that possibility now.

With that in mind, your research team is currently working on four year-end special reports that will highlight cheap stock opportunities in these areas. We’ll have more detailed information to you shortly. What we can say is that we think you’ll find them to be of great value at a time when, at least locally, there doesn’t seem to be much of it around.