The Lucky Country is Out of Luck
My analysis suggests that the Australian economy faces a grim future. And it’s my belief that you need to start preparing yourself for what I see as a coming recession ‘down under’.
If you’re 27 years old or younger, Australia has not had a recession in your lifetime.
If you’re under the age of 40, Australia has not had a recession in your adult lifetime.
Australia’s last recession ended in June 1991, over 27 years ago.
The economy shows no signs of entering a recession right now despite slowing growth in recent quarters.
During my first visit to Australia in 1982, I frequently heard Aussies use the term ‘Lucky Country’ to describe their homeland.
The phrase was new to me but had been around for a long time. The term gained traction after 1964 as the result of the publication of a book, The Lucky Country, by Aussie native Donald Home.
The irony of the book title is that Home used it critically, but Australians have adopted it as a term of endearment.
Home argued that Australians were not particularly entrepreneurial or hard working. Instead they rode on the coattails of Brits, Americans and Canadians who used their democracy and capital markets to create real wealth.
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Australians were basically free riders on a system built by others.
What the Australians did have was abundant natural resources and physical distance from the problems of the world that enabled them to grow rich without doing much to ‘earn’ their wealth or democracy.
This was mostly true in 1964, and not much has changed today.
Resources and property drove prosperity
A recent Economic Innovation Index published by The Economist ranked Australia 22nd in innovation, well behind tech powerhouses such as the US, Japan and Germany. Australia also fails to crack the top 20 in similar indices.
Despite that critical thesis, Australians adopted the title fondly. Their reasons are not different from the ones spelled out by Home, but the attitude is positive.
There are abundant natural resources such as gold, iron ore, bauxite, lead, coal, uranium, zinc, lithium and much more.
A moderate climate, a relatively small population — about 25 million in the world’s sixth largest country by land mass — a liberal immigration policy, the English language and a good rule of law have combined to make Australia one of the most prosperous countries in the world and a favoured destination for direct foreign investment.
Australians are not disturbed by being the Lucky Country.
They’re just fine with that status. As a real Aussie would say, ‘Good on ya’.
Economic data backs up this attitude. Housing data is not the full measure of economic success, but it’s a good proxy for wealth creation and general prosperity. The chart below shows Australian population growth and the increase in housing prices since Australia’s last recession.
Australian house prices rise
Two features stand out.
The increase in population has been material — up 35% overall with only a few dips along the way — and the increase in housing prices has been continuous with no material dips, up $500,000 per home on average.
The second feature is the high degree of correlation with population and home prices driving higher hand-in-hand.
Yet, in the past five years, the Lucky Country analysis has taken on a new and more vulnerable cast.
The population increase has not been driven by increased birth rates among the existing residents but by immigration, mostly from Asia, with a large influx of Chinese in particular.
That’s fine for Australia, and accounts in part for the record-setting recession-free stretch, but it begs a question: What happens if inflow of Chinese migrants and capital dries up?
It’s also the case that Australia’s trade surpluses and continuously growing GDP are driven by natural resource exports. Yet Australia’s export market is heavily reliant on Chinese purchases — especially coal for China’s power plants, iron ore for China’s steel mills, and gold for China’s reserve position.
A looming Australian recession
What happens if China slows down and China’s binge on Australian exports slows with it?
Unfortunately for Australia, China is slowing down. Chinese purchases of Australian exports are slowing with it and China has tightened its regulations on outbound immigrants and capital account outflows.
Australia’s ‘Lucky Country’ status became centred on one nation, China, which has now changed the rules of the game.
An Australian recession may be in the offing after all, with predictable effects on Australian fiscal and monetary policy. Anticipating those policy changes presents a huge profit-making opportunity for investors.
With China weakening and Australia in the crosshairs, what’s the outlook for the Australian economy, the Australian dollar, and Australian markets in particular?
The most important set of factors in the current analysis is the evidence for a Chinese slowdown. China’s fixed asset investment has slowed for five consecutive months.
China’s industrial production growth has fallen below expectations for three straight months and is the slowest since early 2016.
Chinese unemployment (a short official time series) surged to 5.1% from 4.8% in June.
Retail sales in July fell from June and missed expectations.
Chinese oil production fell in July to the lowest level since mid-2011.
None of these statistics presage a collapse of the Chinese economy (although none are good), but Australia’s economy is vulnerable to a mere Chinese slowdown, not just a collapse.
China has an even larger problem, which is the 2014–16 partial collapse of its capital account. China had about US$4 trillion in its capital account in early 2014.
That amount had fallen to about US$3 trillion by late 2016. Much of that collapse was due to capital flight for fear of Chinese devaluation. Something which did occur in August 2015 and again in December 2015.
A prime destination for fleeing Chinese capital was Australia, especially the high-end of the Australian real estate market centred in Melbourne and Sydney.
It was the combination of Chinese immigrants and capital flight that drove the big gains in Australian markets prior to 2018.
China’s US$3 trillion of remaining reserves is not quite as impressive as it first sounds. US$1 trillion of that amount is invested in illiquid assets like hedge funds, private equity funds, direct investments, etc. This is real wealth, but it’s not available on short notice to defend the currency or prop up banks.
Another US$1 trillion of Chinese reserves are needed as a precautionary fund to bail out the Chinese banking system. Many observers are relaxed about the insolvency of Chinese banks because they are confident about China’s ability to rescue them.
They may be right about that, but it’s not free. China needs to keep US$1 trillion of dry powder to save the banks, so that money’s off the table.
That leaves about US$1 trillion of liquid reserves to defend the Chinese currency, if so desired. At the height of the Chinese capital outflows in 2016, China was losing US$80 billion per month of hard currency to defend the yuan. At that tempo, China would have burned through US$1 trillion in one year and become insolvent.
China did the only feasible thing, which was to close the capital account. Interest rate hikes and further devaluation would have caused other more serious problems.
From Australia’s perspective, cutting off Chinese capital outflows was like turning off the oxygen to a patient in the intensive care unit.
Slow melt or US style bust?
The impact on Australia’s housing market, growth and exports was immediate and negative. This negative impact can be seen in the chart below that shows a decisive turning point in Australian home prices in mid-2017.
Falling Australian house prices
Source: CoreLogic; Capital Economics
The chart above was prepared by Capital Economics, one of the world’s most widely followed economic research services.
It shows the actual and potential paths of Australian house prices using 100 as a normalised cyclical peak. The solid blue line shows actual prices. The grey line is the US downturn after 2007. The black line is the average Australian downturn over the past 35 years. The blue dotted line is a projection of the existing trend from Capital Economics.
As you can see, investors are making a long-shot bet that the actual path will be better than the average, the forecast, and a US-style worst-case scenario.
In any case, this housing reversal in Australia will put the ball firmly in the Reserve Bank of Australia’s (RBA) court.
The RBA uses the same flawed models as the Fed and, as a result, has the same flawed forecasts.
As recently as 9 August 2018, RBA officially forecasted stronger growth, rising inflation, and gradually rising interest rates.
This forecast has given some strength to the Aussie dollar and to the Australian stock market generally.
Yet the RBA forecast gives no weight to a failing China. Real data, as opposed to model-based forecasts, tells the tale.
China is slowing and Chinese capital outflows have practically stopped.
This pulls the rug out from under Australian asset values. The asset value decline has already started in housing.
The Lucky Country is running out of luck.
I believe that it’s a matter of when, not if, the Australian economy enters a recession.
All the best,