Australia is on the verge of wresting bragging rights from the Netherlands for the longest period on record of economic growth without a recession. The Netherlands achieved its 26-year run from 1982 to 2008 on the back of North Sea oil production.
Whilst this historic event should be celebrated, the future for Australia’s growth may not be as rosy. PIMCO’s base case calls for Australia to keep growing moderately, but if there is any hint of a downturn in developed markets, or if China migrates toward a worse-than-expected outcome, the resilience of the Australian economy over the next three to five years will be extremely challenged.
Australia’s GDP growth has averaged 2.6% since the end of the Global Financial Crisis (GFC), and during this time, the two most important contributors have been mining and housing. Both growth engines are now well past their primes. Australia produces some of the highest-quality and lowest-cost ore and remains a reliable and competitive energy exporter; however, the demand for these exports would suffer under a weak China scenario, given that Asia represents almost 50% of Australia’s export volumes. When it comes to housing, Australian households are already highly leveraged and major city property prices are elevated, so room for housing to add significantly to the economy would be limited in a period of global weakness.
Australia’s economic growth since the GFC has also been supported by other important factors: first, steady growth in the U.S. economy, which is in the midst of its third-longest recovery on record; second, China’s uninterrupted growth, which has been driven by an increase in the national debt level from 161% to 258% of GDP; third, RBA rate cuts from 7.25% to 1.5%, which have kept the economic engine ticking; and finally, Australian households, which have increased debt to well over 100% of GDP even as household debt in other developed nations has decreased.
It’s not all bad news, though. Australia’s sovereign balance sheet remains relatively healthy, which would help cushion a severe downturn in the Australian economy, and Standard & Poor’s recently affirmed its AAA credit rating. Still, the rating agency reminded us with its negative outlook that “economic imbalances in Australia have increased due to strong growth in private sector debt and residential property prices”.
What are the investment implications?
Within this context, there are three big issues that Australian investors are, or should be, grappling with. First, how do you ensure that you are not overly exposed to one of the most expensive assets around – Australian residential property? Second, how do you generate sufficient income in retirement? And finally, what happens to your investments if interest rates increase?
To help investors respond to these issues, investing can be simplified into a few basic principles. To earn a return above the “risk-free” rate (the current cash rate of 1.5% in Australia), you need to take risk. There are only a handful of risk sources, or “risk factors,” to choose from: equity risk, credit risk, illiquidity risk, volatility risk, idiosyncratic risk (unique to a particular asset) and interest rate risk. An efficient portfolio has a combination of these, as risk factors are not all perfectly correlated with one another.
Based on PIMCO’s analysis (published 2 June 2017), Australian retirement portfolios generally rely too much on equity risk and idiosyncratic risk – in this case, residential property risk. So in order to address the big investment issues, Australian investors may need to consider some portfolio changes.
Given the reduced resilience of the Australian economy and the overexposure to equity and property risk factors in retirement portfolios, the most compelling response to tackle the three investor issues is to ensure there is a sufficient allocation to actively managed bonds. Bonds have low (or negative) correlations to risky assets like Australian equity and property. Bonds can generate consistent income, and an active manager can select bonds that can reduce interest rate risk if (and that’s a big if) there is a legitimate risk of interest rates rising significantly in the near future.
Chasing income from deeply subordinated Australian bank hybrid capital and other investments with high exposure to equity and property risk only intensifies portfolio risk concentrations and does little to address the big issues investors are facing. To put it simply, Australian investors need a longer-term plan.
Robert Mead is co-head of Asia portfolio management at PIMCO in Sydney.