Investment in 2011: a false start

Kathleen Brooks gives a revised outlook for Australian investments in 2011.

At the end of last year there was no stopping the Aussie dollar.

It reached another record high against the greenback and the outlook was positively bright: global growth would remain strong, boosting demand for commodities and enhancing Australia’s terms of trade in the process.

It was forecast this would be positive for the equity market, as the basic materials sector make up nearly 30 per cent of the entire ASX 200.

The booming export industry would weigh on inflation pressures, causing the central bank to continue its hiking cycle, fuelling even more gains for the currency.

But that was then and a month is a long time in the financial markets. The outlook for Australia has been shaken after the flooding in Queensland.

The scale of the devastation has altered the growth outlook dramatically and reduced expectations of interest rate hikes in the near-term. Thus, although we are in the middle of February, it’s time to revise our 2011 outlook for Australia.

An uneven pace of growth

Extensive flooding has altered the growth and inflation dynamic in Australia. Disruption to exports, especially of minerals, coal and corn, could weigh on growth in the first quarter.

However, the rebuilding in the region will artificially boost growth in the second quarter.

So far the economic indicators have been muddled.

Job creation was stronger than expected in January at 24,000 versus expectations of a 17,500 gain. Although this was the 11th straight month of jobs gains, the detail of the report was not so impressive.

Full-time jobs declined while part-time jobs rose. The statistics bureau said the Queensland flooding had disrupted the survey, so it may be a couple of months before we can really get a grip on the labour market.

Construction work, retail sales, exports and Australia’s balance of payments positions are all expected to have been adversely affected by the flooding.

However, after a temporary blip, growth could bounce back strongly as reconstruction efforts in Queensland get underway in the second quarter.

On a short-term basis, output growth will play catch-up and the estimated AUD$20 billion cost to rebuild homes, businesses and local infrastructure will boost construction and could also weigh on inflation. This greatly impacts the outlook for monetary policy.

The RBA’s difficult policy path

The Reserve Bank of Australia (RBA) has hiked rates by 1.75 per cent since September 2009 and at the end of last year analysts were predicting further rate increases in order to stem inflation pressures.

However, after the flooding and Cyclone Yasi, the RBA would be considered heartless at worst and disrupting the recovery efforts at best if it moved on rates at this current juncture.

Accordingly, the market has also pared back its rate expectations, 40 basis points of hikes are currently priced in, with the RBA making its first move by October.

But there are upside risks to this forecast and the RBA may not be as patient as some think. Its February Statement on Monetary Policy was more sanguine than some in the markets expected.

It noted that flooding could cause “temporary effects on GDP [gross domestic products]”, but growth should be back to normal by the second quarter.

It noted that the labour market remained strong and “looking ahead, a gradual increase in wage growth is expected as the labour market tightens further".

While the bank acknowledged that underlying inflation pressures are a little lower than they were in 2010, a tight labour market and strong growth warrant attention.

The bank predicts core inflation (without energy or food prices included) at 2.75 per cent at the end of this year, the high end of the bank’s 2-3 per cent inflation target, which suggests rates may well rise sooner than October if inflation pressures start to mount.

This could have big upside ramifications for the currency as well as the Australian equity market.

Aussie dollar stalls

The price action in the Aussie dollar has been interesting to observe in recent weeks. While investors pared their long Aussie positions in the wake of the floods, the decline was fairly short lived, based on CFTC futures data.

This suggests that investors were not happy to short the currency and even after appreciating nearly 15 per cent last year, investors still think it has further to go.

While traders have tried to digest the impact of the flooding, the Australian dollar has managed to remain above parity against the greenback.

There are two reasons for this fairly robust performance: firstly, investors quickly realised the negative impact of the floods would be temporary and the RBA would maintain its hawkish stance and, secondly, the outlook for growth in China would remain strong in 2011.

The Chinese connection

Traders and investors alike have to juggle two balls at once when they talk about Aussie assets.

They are considered to be 'risky' and thus do well in a 'risk-on' environment because they are driven not only by domestic concerns but also by the health of the global economy.

Due to the dominance of the export sector in Australia’s growth mix, it’s important to keep an eye on the health of the economies that suck up Australian goods.

Right now the bulk of those goods (mostly commodities) go to China. So if China sneezes, Australia will catch a cold.

China is still growing at an extremely fast clip, leaving developed markets in its wake.

However, it has to do its bit to help rebalance the global economy and move away from a commodity-intensive export growth model to one based on domestic consumption.

Where does this leave Australia?

Investors need not panic. China won’t stop purchasing Australian exports any time soon.

The 'rebalancing' of its economy will take decades and at growth rates close to 10 per cent per annum, China is still an energy-intensive economy. However, it has pledged to try and stop its economy from overheating and is embarking on a rate tightening cycle.

The fear for investors in Australian assets is that China makes a policy mistake and its economy slows too sharply, thus suddenly reducing demand for Aussie goods.

While this is definitely a risk for Australia going forward, we think the chances of it happening are very small.

The authorities in Beijing have been very transparent and responsible about signalling to the markets well in advance of their intentions to continue to hike rates this year, and so far hikes in increments of 25 basis points roughly once every month are too small to slow China’s juggernaut economy.

What it means for Australian investors

At this stage there is nothing to suggest that this will be a bad year for Australian assets.

Stocks are likely to perform in line with global equities, and by hanging on to relatively high levels versus the dollar during the floods the Aussie is on a good footing to stage a rebound later this year. But the outlook is undoubtedly less bright than it was this time last year.

The biggest risks to the Australian economy and thus asset prices are internal rather than external.

This is why the Aussie dollar seems to be unable to break above the 1.0200 highs reached on New Year’s Eve.

And the irony is not lost that the last trading day of 2010 was a triumph for the Australian currency.

2011 has definitely heralded a very different, more challenging environment for Australian investors.

Kathleen Brooks is the director of research at Forex.com.