Diversification: A case for adding Australia

Australia has been called “the lucky country” — abundant in natural resources and insulated from problems elsewhere in the world. Perhaps for these reasons, it has among the best record for equity market performance over the long-term.

Australia tends to be a relative beneficiary of higher inflation given the composition of the index toward basic resources (c. 16-17%), real estate and infrastructure (c. 10%), and financials (c. 35%) which are all much higher than in the S&P 500 and other indices. Commodity prices, property rents and tolls are of course linked to price readings, while empirical findings for Australian financials suggest a positive sensitivity to interest rate increases (which coincide with higher inflation).

Sources: RBA; Stooq.com; MeasuringWorth (full citation below) for CPI data; author’s calculations.

Sources: Australian Bureau of Statistics; U.S. Federal Reserve; author’s calculations. September data for ToT approximated by the change in iron ore price.

Commodity prices have clearly increased substantially in the past year, leading to an improvement in Australia’s balance of payments fundamentals, as summarized in its terms-of-trade (right). Over long periods of time, the A$ has a strong relationship with this variable with the currency appearing quite cheap on this metric.

Source: FXEmpire; St. Louis Federal Reserve; author’s calculations. Uses M1 for China and M2 for the US.

Australia would also be a major beneficiary of China easing monetary conditions — where the policy stance appears to have shifted in recent weeks. China anchors the growth rate in money supply (M2) to the nominal growth rate in the economy and it has likely fallen somewhat below levels consistent with this aim following deleveraging by developers.

A reduction in Fed purchases could be accompanied by higher U.S. and global interest rates as a price-insensitive buyer of c. 50% of treasury net supply is removed from the market, albeit bond yields have shown an inconsistent relationship in the past. Looking over long periods of time (on lower right), there appears to be a modestly positive relationship to interest rates, where higher rates are associated with higher values for the ASX indexed against the S&P 500. The chart below plots the two on a log-scale to compare.

Australia may also stand to gain from a potential cooling of trade tensions with China following the directive by Chinese authorities to secure energy supplies such as coal ‘at all costs’ . In fairness, however this may not be imminent in light of the recent AUKUS naval agreement.

Long-term valuation measures such as the relative CAPE P/E ratio are also supportive and would suggest robust relative performance over the next several years.

Source: CAPE P/E ratios provided by Barclays.

A major risk factor for Australia would clearly be a further major deceleration in Chinese economic activity, perhaps tied to the spill-over effects from Evergrande outweighing policy easing. But given that China’s economic cycle tends to lead the developed world (below), slowdown risks seem better reflected in the East than in the West. In the second chart below, one can see that Australian equities tend to be perform alongside coincident economic indicators for China. So in conjunction with a defensive equity market posture in the U.S., Australia could represent an attractive bet on a troughing of Chinese growth with supportive valuation and fundamentals.

Source: Investing.com; author’s calculations

Source: MacroMicro; Author’s calculations.

Citations:

Diane Hutchinson and Florian Ploeckl, "What Was the Australian GDP or CPI Then?" MeasuringWorth, 2021 URL: http://www.measuringworth.com/australiadata/

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