A common question from Australian investors in recent years is “Why hasn’t the Australian stock market done as well as the US stock market?” Since the GFC bottomed out in March 2009, the S&P500 Index (excluding dividends) has tripled from 676 then to 2043 now, setting new records, whereas the S&P/ASX200 is only up 50% in that time, and is still a long way short of its pre-GFC peak of 6828 in November 2007.

The short answer is that the US is not only the world’s largest economy, accounting for 22.5% of world GDP; it is also the world’s most advanced economy, in the sense that it exports high value-added goods and services to the rest of the world. US dominance of high value-added sectors such as information technology, pharmaceuticals, and finance is absolute. For example, iPhones are manufactured in China, but their design, production, and marketing are all controlled from Silicon Valley, and the bulk of iPhone profit goes to Apple. Another feature of the US is that exports are not a major part of the economy – only 13% of GDP.

By contrast, exports are much more important for Australia, accounting for 21% of GDP. Most of Australia’s exports are low value-added: for many years, minerals and energy have made up more than half of the value of Australian exports, led by iron ore and coal. In short, although Australia is a developed country, it is a commodity exporter like Brazil and South Africa, rather than a commodity importer like the USA and the EU countries. (Canada is similarly a rich country and a commodity exporter, but its economy is very closely integrated with the US.) The increasing importance of China as a buyer of Australian exports is obvious from the chart below:

CC 2015 12 18_fig 1

In an economy where exports are important, the price of these exports is obviously important too. The “terms of trade” statistic represents the ratio of the prices of a country’s exports to the prices of its imports. The higher the terms of trade, the better for the country, in the sense that the same volume of exports can buy more imports. Between 2000 and 2012 Australia’s terms of trade nearly doubled, driven by rapid Chinese GDP growth which created strong demand for minerals and energy. As the chart below shows, the last resources boom drove Australia’s terms of trade to unprecedented heights:

CC 2015 12 18_fig 2

The consequent increases in Australian GDP, real incomes and company profits were reflected in the fact that the S&P/ASX200 (excluding dividends) more than doubled in five years, rising from 3007 at the end of 2002 to its record high of 6828 in November 2007.

CC 2015 12 18_fig 3

The S&P500 (excluding dividends) didn’t do anywhere near as well in the same time period. It rose from 879 at the end of 2002 to a pre-GFC peak of 1565 on 09 October 2007. Unlike Australia, the US index had only just surpassed its peak during the dotcom boom, which was 1527 way back on 24 March 2000. Thus in the seven years before the GFC, Australia outperformed the US as an economy and as a share market.

CC 2015 12 18_fig 4

The five and a half years since the GFC have been exactly the reverse. Although China’s November 2008 stimulus package supported Chinese GDP growth – and consequently commodity prices – for a couple more years, the writing was on the wall. Since then, China’s GDP growth rate has been falling steadily from 10.6% in calendar 2010 to around 7.0% this year. The decline is due to several factors: the end of the stimulus spending, the over-supply of residential property, the policy switch from investment to consumption, the buildup of excessive borrowings, and the growing importance of the services sector over the manufacturing sector.

Slower Chinese growth resulted in falling demand for minerals and energy. In addition, years of high prices had encouraged commodity producers to expand their production and build new mines, so that large quantities of new supply were coming on stream. Faced with falling commodity prices, most producers, consumers and traders liquidated their inventories as quickly as possible in order to minimize their losses, thereby exacerbating the over-supply problem and pushing commodity prices down even further. As the chart below shows, Chinese growth has slowed considerably from the spectacular levels of the previous decade which caused the global demand for resources to explode:

CC 2015 12 18_fig 5

If we regard Australia as a commodity exporter like Brazil or South Africa, rather than as a developed country like the US or the UK, the future trends of our economy become clearer. In particular, the Australian dollar will keep falling until commodity prices bottom out. It is likely to bottom out around where it was before the resources boom started – that is, below 60 US cents.

Falls of this magnitude are quite normal for the currencies of commodity exporters. So far in calendar 2015, the Brazilian real has fallen 31.5% and the South African rand has fallen 27.8%. In the same period, the Australian dollar has fallen only 12.2% against the US dollar, but it is still 34.6% below its 25 July 2011 peak of AUD110.0c against the US dollar.

Most global investors don’t buy or sell the Australian dollar on the basis of their expectations for the Australian economy. They use the Australian dollar as a leveraged play on the Chinese economy because China does not allow free capital flows in or out of the country. The Australian dollar is a good proxy for the health of China because one-third of Australia’s exports go to China. So when Chinese statistics suggest that GDP growth is still falling, the Australian dollar is sold off because this is bad news for the demand for Australian exports. Therefore a “hard landing” in China would probably push the Australian dollar down even further.

Two implications for investors follow from our view of Australia as a slightly wealthier suburb of the ThirdWorld. First, the continuing downtrend in the Australian dollar implies that Australian investors should keep a large percentage of their wealth denominated in other currencies, particularly the US dollar and the Euro. Second, unless you know exactly where Chinese growth is going in the next year or so, looking for value in the resources sector is like trying to catch a falling knife. It would be safer to wait until there is a clear upturn in commodity prices.

Neill Colledge

December 2015

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