Hung Down Under

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In an extraordinary way, the August 21 Australia election resulted in a hung parliament, the first in the country since 1940. The latest counting suggests the Coalition and Labor have both won 73 seats, short of the 76 majority needed to govern. The Independents have won 3 seats, and the Greens won 1. Both the Coalition and Labor have started courting the non-party winners, and a new government is likely to be formed in 1 week. While the 3 Independents have previous ties with Nationals, a partner of the Coalition, the candidates claim they don’t guarantee support for the Coalition. Considering the dominant lead Labor had just 1 month ago when the Prime Minister set the election date, the “draw” Labor has to deal with now is rather astonishing, regardless if it will be able to woo Independents and stay in power. A ruling party overseeing a booming economy is on the brink of losing re-election – that is Al Gore-esque. This election is crucial, as we wrote in our July Monthly Market Review. Labor’s agenda – including pursuing a new wind-fall profit tax on the iron ore and coal resource firms, will make Australia less investor friendly in the long run. In addition, Labor’s stepped up government spending programs – specifically the proposal to build a National Broadband Network which promises to provide fiber optic cable to Australian residents in 8 years at an estimated cost $43 Billion AUD ($39 Billion USD), will possibly lead to higher interest rates and a crowding out of private spending in what appears to be an overheating economy. Therefore, a Labor victory will likely result in lower Economic Margins for all firms, and subsequently lower valuations and multiples for traded firms, and reduced overall growth for Australia. For US investors, this will ultimately translate into lower Australian strategic allocations for funds invested internationally. For details of our discussion of Australia’s economy and the election, please read the following excerpt from our July Monthly Market Review.

Click Here to view AFG’s Monthly Market Review (Double Dip, Balance Sheet Recession and Down Under) in its entirety!

If you are interested in global asset allocation, check out AFG's Asset Allocation model here!

We have a quiz for you: Which country hosts the best performing stock market of the past 110 years, and arguably has the world’s most beautiful city?

If you guessed China with the Hong Kong Exchange, and Hong Kong with its glorious Victoria Peak views and magnificent Skyline – you guessed wrong.

If you guessed Singapore with its amazing Marina – you guessed wrong.

If you guessed The United States, with San Francisco’s rugged coast line, swaying Golden Gate Bridge, and rolling hills – you guessed wrong.

The winner is none other than “The Land Down Under”. Recently, Australia was recognized as the best performing , lowest risk stock market of the past 110 years. Further, for those of you that have never visited Sydney, you are truly missing out on a magical city. For Yanks, the easiest way to describe Sydney is to combine the natural beauty of San Francisco, the weather (sans smog) from Los Angeles, and cleanliness of Chicago – truly an amazing combination. Few sights in the world can match the view from the shore framed by the magical Opera House on one side and the iconic Harbor Bridge on the other. Recently I (Rafe) visited Australia as part of a global tour introducing AFG’s Global Research to investment houses in London, Singapore, Hong Kong, Sydney, and Melbourne. While each city has its own special charm, Sydney truly stands out. If you have a chance to visit, you will not be disappointed.

From a finance perspective, Australia provides an interesting case study to the global financial crisis (GFC) experience. Aside from a few speed bumps, it has moved through this period relatively unscathed. Further, Australians have an interesting election choice as two very different philosophies will be on the ballot in a couple of weeks. We will share a few thoughts on each of these issues from a policy and investment perspective.

As we discussed earlier in the letter, the GFC put American companies and consumers in a very defensive position, focusing on deleveraging versus profit and consumption maximization. The Australian experience has been very different. Whereas unemployment in the US soared from 4.6% in 2007 to above 10% and now stands at 9.5%, Australia’s unemployment rate is at 5.3%, down from 5.8% a year ago or its recent peak, and above 4.2% in September 2007, its 33 year low. Where the US Fed dreams to bring rates below zero, the Reserve Bank of Australia has been raising rates since October 2009. (This indicates how strong the Australian economy has been over the past year.) Much like the United States and Great Britain, Australia saw its government swing to the Labor (US equivalents are the Democrats) party after a 10 year run under John Howard and the Liberal Party (US equivalents are the Republicans). The Labor party reacted to the Global Financial Crisis (GFC) in much the same manner as the US – enacting a massive stimulus program. Among developed countries, Australia’s stimulus was the 3rd highest as a percentage of GDP. With the subsequent performance of the Australian economy, Labor insists it is the right and proper economic steward of the country, claiming the Liberal party will likely lead the country back towards economic crisis with miss-directed economic policies. That is certainly the easiest way in which to interpret the flow of events from the start of the GFC, and one Labor hopes will resonate with the electorate.

However, rarely are things as easy as they seem in matters of economics. Niall Ferguson recently prepared a very succinct and insightful analysis of why the Australian experience differed from the rest of the world in the aftermath of the GFC. Summarizing his main points:

1. Luck that Australia did not suffer materially from a sub-prime loan based housing bubble.

2. Proper financial management under the Howard Government – effectively leaving the national debt level at zero from which the Labor Government was able to run deficits at will.

3. A healthy export market for Australian goods – namely resource based exports. Net AUS exports rose from 2.4% of GDP in q1 ’09 to 5.4% of GDP in q1 of ’10. In particular AUS had increased its ties with China, which was perfectly timed to China’s ongoing demand boom for all things resource oriented.

Ultimately, the fact that interest rates increased since the GFC bottom points to an overheating economy, which begs the question of whether such a strong stimulus really made sense. Understanding why Australia has weathered this crisis so well is important for investors and policy makers around the world. From a policy perspective, it is important to decide whether the above factors drove the Australian economy forward, or was it due to a government spending based stimulus, though programs like that have failed to work in virtually every other Western economy. If indeed Australia’s unique economic circumstances lead the way forward, one has to question whether such a massive stimulus was prudent and warrants continued stewardship of the economy, as higher interest rates resulting from an over-heated economy will lead to reduced economic activity in the future. Certainly it is difficult to link a massive government stimulus to such strong exports, and in fact when one considers the effectiveness with which the stimulus was administered, the case for the stimulus driving the economy becomes fairly weak.

Australians have the ultimate stake in understanding this debate, as they will have elections in a couple weeks, and set the country’s tone and direction for years to come. Far be it for a Yank to understand the political nuances driving a foreign country, though it seems two key issues have emerged which represent a larger set of philosophical differences between the parties. The first is to pass a wind-fall profit tax on the iron ore and coal resource firms. Labor supports the new tax law under which Iron ore and coal will be subject to a new, profits-based Mineral Resource Rent Tax (MRRT) at a rate of 30% on profits in excess of a 12% ROI . The Liberal Party opposes it. While such talk is currently limited to these types of resource companies, only a true naïf believes it would be limited to one group of companies as the tax becomes the country’s reality. It is easy to imagine left leaning politicians clamor that “super profits” from all firms should be controlled and subject to government regulation. Regardless of the revenue raising assumptions behind such a tax, actual receipts will almost certainly fall short of projections as companies will pursue policies to minimize their net income, and thus minimize the tax revenues from such a plan, diverting resources from wealth creating activities. Further, one has to wonder about the genesis of the 12% figure. Why not 10%? Also will the government make investors whole in years when the companies generate “super losses”

Another issue that has gained prominence during the past month is the construction of a National Broadband Network that the Labor party is pushing, which promises to effectively provide fiber optic cable to all Australian residents in 8 years. The estimated cost of this program is $43 Billion AUD ($39 Billion USD). The Liberal party has proposed a much more modest $6 billion AUD plan to emphasize wireless technologies. Hayek discusses how centralized planning based economies tend to fail because they do not benefit from the amazing price revelation process inherent to voluntary market transactions. So it is with Labor’s decision. If 100 MPS is the right speed for households, why have they not voluntarily demanded such services from existing providers? Is it not the case that everyone would prefer a Mercedes over a Ford, if given one for free? So it is with demand for goods, more is preferred to less when things are free, but only by considering price can wealth creating decisions evolve. Once the government has spent those funds, what happens to consumers and businesses as new and better wireless technologies continue to emerge (which they will as phone based computer capabilities explode as Apple, Google, and RIMM compete for market share with better and more powerful devices)? Might an individual prefer to have slower overall internet connections, but greater portability?

But most importantly, one has to ask if the government should have the right and responsibility to pursue such projects – if the government will provide services so efficiently, why not open food markets and dry clean shops? Rarely does the government provide services more efficiently or effectively than the private sector. The current price for this program, before inevitable over-runs, (When was the last time a government provided an accurate cost projection for a road repair, not to mention such a big and complex project as this?) is already similar to Labor’s stimulus program, which may serve to put further pressure on the RBA to increase interest rates to avoid inflation. From a National Surplus to national debt, the trend is certainly a bit disturbing.

Through AFG’s research across hundreds of thousands of company/year observations, we know that markets react to regulation, taxes, and inflation. Labor’s agenda will make Australia less investor friendly on the first two counts and through stepped up government spending programs that possibly lead to higher inflation in what appears to be an overheating economy. Therefore, it is with great interest that we follow the upcoming election, as a Labor victory will likely result in lower Economic Margins for all firms, and subsequently lower valuations and multiples for traded firms, and reduced overall growth. For US investors, this will ultimately translate into lower Australian strategic allocations for funds invested internationally. For information on how you can incorporate global insights into your investment decision process, please contact your service consultant.

Click Here to view AFG’s Monthly Market Review (Double Dip, Balance Sheet Recession and Down Under) in its entirety!

If you are interested in global asset allocation, check out AFG's Asset Allocation model here!