Key points

• Australian shares have disappointingly underperformed traditional global shares over the last year on the back of monetary tightening, worries about a housing bubble, the strong $A and Chinese tightening.
• Many of these concerns should be largely factored in & we see better returns this year, but some linger so it is too early to say the relative underperformance is over.
• However, on a five year basis, the combination of higher dividends, better growth prospects, less structural constraints and franking credits for Australian based investors suggest investors should maintain a bias towards Australian shares.

Introduction

At the end of 2009 there was much optimism Australian shares would continue to outperform their counterparts in other developed countries. In particular Australia had come through the Global Financial Crisis in good shape without the structural constraints facing many other developed countries, the Australian economic outlook looked good and Australia was well keyed into high growth Asia.

However Australian shares have disappointed over the last year: returning just 1.6% in 2010 whereas global shares returned 10.4% in local currency terms. Global shares have reached new recovery highs whereas Australian shares are still below April high.

So what happened? What drove the underperformance? Is it just a short term setback in Australian shares or does it signal something more fundamental?

This note focuses on Australian shares relative to traditional global equity markets, as opposed to Asian and emerging markets where we generally expect underperformance by Australian shares.

Australia’s relative underperformance

Australia’s relative underperformance over the last year appears to reflect several factors:

• Rising interest rates at a time when interest rates were at or near zero in other developed countries and, in some instances, monetary conditions were still being eased. This led to concerns about the outlook for domestic cyclical sectors, notably retailing and housing, and bank credit growth. It also made bank term deposits look attractive compared to shares (unlike in the US where yields on term deposits are poor).
• There has also been concern internationally that Australian housing is in a bubble that is about to burst, with bad consequences for Australian banks.
• The strong Australian dollar has weighed on internationally exposed companies that don’t have a hedge in the form of high commodity prices.
• Concerns Chinese authorities will over tighten and crash the Chinese economy in an effort to beat inflation have also weighed on the Australian share market, given the degree to which many global investors now see Australia as being connected to China.
• These concerns have all been reinforced by earnings downgrades in Australia whereas earnings expectations have been upgraded globally – see next chart.

Source: Thomson Financial, AMP Capital Investors

This has all seen the price to forward earnings ratio for Australian shares fall from 15.3 times at the end of 2009 to 12.7 now, whereas that for global shares has fallen by a smaller amount (ie, from 14.1 times to 12.5 now).

In an absolute sense we see Australian shares rising this year as the global recovery continues. The PE contraction has left Australian shares reasonably attractive, profit growth locally should be solid and Australian companies have scope to re-leverage, reflecting high cash levels and low gearing – see the next chart.

Source: Reserve Bank of Australia, AMP Capital Investors

However, it is too early to say that the relative underperformance of Australian shares has run its course. Concerns about an imminent collapse in Australian house prices resulting in massive damage to Australian banks are overdone. The threat to domestic growth from the strong Australian dollar and rising interest rates should be largely factored in and in any case recent benign inflation data and the disruptive effects from the floods suggest that the RBA will be on hold out to mid year. However, concerns about Chinese, and, more generally Asian tightening may linger for a while yet. So, on balance, we see global and Australian shares having similar returns this year.

A longer term perspective

It is worth noting that despite Australian shares lacking the breadth and diversification of global shares, over the last 110 years Australian shares have had better real returns than most global share markets (Swedish shares being the exception). See the next chart.

Source: Global Financial Data, AMP Capital Investors

However, within this long run outperformance there have been lengthy periods of relative underperformance (such as in the 1970s due to relatively poor economic management in Australia) and the 1990s (the global tech boom) but also on a short term basis (say in 2003 in the first year of recovery from the tech wreck).

Source: Thomson Financial, AMP Capital Investors

While it’s too early to say the relative underperformance of the last year is over, there are several reasons to believe the longer term period of outperformance in Australian shares that started in 2000 will continue:

Firstly, Australian shares still pay higher dividend yields than mainstream global shares. The average dividend yield on Australian shares is 4% versus 2.6% for global shares. This is important because over long periods dividend payments constitute a significant component of the return an investor gets and so the higher the dividend yield the better (assuming it is not debt financed). Moreover, high dividend yields augur well for future returns, as they signal corporate confidence about future earnings and excessive retained earnings are often wasted.

Secondly, the Australian economy offers higher growth potential than the US, Europe and Japan. Australia has stronger population growth which is feeding through into much stronger labour force growth. Australian households have not seen the same deterioration in their net wealth as has occurred elsewhere, public sector debt is very low and Australia is heavily exposed to high growth Asia and strength in commodity prices. All of these considerations are likely to translate into higher growth in earnings for Australian companies over the medium term compared to earnings growth in traditional global share markets.

Reflecting the last two points, return projections (see below) based on current dividend yields and likely earnings growth tend to favour Australian shares. Over the medium term (say, five years), a good starting point to project likely returns is to add current dividend yields to likely long term nominal GDP growth as a proxy for earnings growth and hence capital gains from shares.

Australian shares with a five year pre tax return projection of 9.5% pa come out well ahead of traditional global shares with a return projection of 6.9%.

Finally, franking credits add over 1% to the post tax return from Australian shares for Australian investors. The higher dividend yield from Australian shares and franking credits mean Australian shares have a 2.9% pa return advantage over traditional global shares for Australian based investors.

Concluding comments

Australian shares have underperformed traditional global shares over the last year on the back of monetary tightening, worries about a housing bubble, the strong $A and Chinese tightening. While many of these should be largely factored in and we see better returns this year, some still linger (notably Chinese/Asian tightening) so it is too early to say that the period of relative underperformance is over.

However, on a strategic, or five year basis, the combination of higher dividends, better growth prospects, less structural constraints and franking credits for Australian based investors suggest investors should maintain a bias towards Australian shares over traditional global shares, although maybe not as big a bias as was warranted a decade ago.

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Key points

• Australian shares have disappointingly underperformed traditional global shares over the last year on the back of monetary tightening, worries about a housing bubble, the strong $A and Chinese tightening.
• Many of these concerns should be largely factored in & we see better returns this year, but some linger so it is too early to say the relative underperformance is over.
• However, on a five year basis, the combination of higher dividends, better growth prospects, less structural constraints and franking credits for Australian based investors suggest investors should maintain a bias towards Australian shares.

Introduction

At the end of 2009 there was much optimism Australian shares would continue to outperform their counterparts in other developed countries. In particular Australia had come through the Global Financial Crisis in good shape without the structural constraints facing many other developed countries, the Australian economic outlook looked good and Australia was well keyed into high growth Asia.

However Australian shares have disappointed over the last year: returning just 1.6% in 2010 whereas global shares returned 10.4% in local currency terms. Global shares have reached new recovery highs whereas Australian shares are still below April high.

So what happened? What drove the underperformance? Is it just a short term setback in Australian shares or does it signal something more fundamental?

This note focuses on Australian shares relative to traditional global equity markets, as opposed to Asian and emerging markets where we generally expect underperformance by Australian shares.

Australia’s relative underperformance

Australia’s relative underperformance over the last year appears to reflect several factors:

• Rising interest rates at a time when interest rates were at or near zero in other developed countries and, in some instances, monetary conditions were still being eased. This led to concerns about the outlook for domestic cyclical sectors, notably retailing and housing, and bank credit growth. It also made bank term deposits look attractive compared to shares (unlike in the US where yields on term deposits are poor).
• There has also been concern internationally that Australian housing is in a bubble that is about to burst, with bad consequences for Australian banks.
• The strong Australian dollar has weighed on internationally exposed companies that don’t have a hedge in the form of high commodity prices.
• Concerns Chinese authorities will over tighten and crash the Chinese economy in an effort to beat inflation have also weighed on the Australian share market, given the degree to which many global investors now see Australia as being connected to China.
• These concerns have all been reinforced by earnings downgrades in Australia whereas earnings expectations have been upgraded globally – see next chart.

Source: Thomson Financial, AMP Capital Investors

This has all seen the price to forward earnings ratio for Australian shares fall from 15.3 times at the end of 2009 to 12.7 now, whereas that for global shares has fallen by a smaller amount (ie, from 14.1 times to 12.5 now).

In an absolute sense we see Australian shares rising this year as the global recovery continues. The PE contraction has left Australian shares reasonably attractive, profit growth locally should be solid and Australian companies have scope to re-leverage, reflecting high cash levels and low gearing – see the next chart.

Source: Reserve Bank of Australia, AMP Capital Investors

However, it is too early to say that the relative underperformance of Australian shares has run its course. Concerns about an imminent collapse in Australian house prices resulting in massive damage to Australian banks are overdone. The threat to domestic growth from the strong Australian dollar and rising interest rates should be largely factored in and in any case recent benign inflation data and the disruptive effects from the floods suggest that the RBA will be on hold out to mid year. However, concerns about Chinese, and, more generally Asian tightening may linger for a while yet. So, on balance, we see global and Australian shares having similar returns this year.

A longer term perspective

It is worth noting that despite Australian shares lacking the breadth and diversification of global shares, over the last 110 years Australian shares have had better real returns than most global share markets (Swedish shares being the exception). See the next chart.

Source: Global Financial Data, AMP Capital Investors

However, within this long run outperformance there have been lengthy periods of relative underperformance (such as in the 1970s due to relatively poor economic management in Australia) and the 1990s (the global tech boom) but also on a short term basis (say in 2003 in the first year of recovery from the tech wreck).

Source: Thomson Financial, AMP Capital Investors

While it’s too early to say the relative underperformance of the last year is over, there are several reasons to believe the longer term period of outperformance in Australian shares that started in 2000 will continue:

Firstly, Australian shares still pay higher dividend yields than mainstream global shares. The average dividend yield on Australian shares is 4% versus 2.6% for global shares. This is important because over long periods dividend payments constitute a significant component of the return an investor gets and so the higher the dividend yield the better (assuming it is not debt financed). Moreover, high dividend yields augur well for future returns, as they signal corporate confidence about future earnings and excessive retained earnings are often wasted.

Secondly, the Australian economy offers higher growth potential than the US, Europe and Japan. Australia has stronger population growth which is feeding through into much stronger labour force growth. Australian households have not seen the same deterioration in their net wealth as has occurred elsewhere, public sector debt is very low and Australia is heavily exposed to high growth Asia and strength in commodity prices. All of these considerations are likely to translate into higher growth in earnings for Australian companies over the medium term compared to earnings growth in traditional global share markets.

Reflecting the last two points, return projections (see below) based on current dividend yields and likely earnings growth tend to favour Australian shares. Over the medium term (say, five years), a good starting point to project likely returns is to add current dividend yields to likely long term nominal GDP growth as a proxy for earnings growth and hence capital gains from shares.

Australian shares with a five year pre tax return projection of 9.5% pa come out well ahead of traditional global shares with a return projection of 6.9%.

Finally, franking credits add over 1% to the post tax return from Australian shares for Australian investors. The higher dividend yield from Australian shares and franking credits mean Australian shares have a 2.9% pa return advantage over traditional global shares for Australian based investors.

Concluding comments

Australian shares have underperformed traditional global shares over the last year on the back of monetary tightening, worries about a housing bubble, the strong $A and Chinese tightening. While many of these should be largely factored in and we see better returns this year, some still linger (notably Chinese/Asian tightening) so it is too early to say that the period of relative underperformance is over.

However, on a strategic, or five year basis, the combination of higher dividends, better growth prospects, less structural constraints and franking credits for Australian based investors suggest investors should maintain a bias towards Australian shares over traditional global shares, although maybe not as big a bias as was warranted a decade ago.

The post Why are Australian shares lagging? Will it continue? appeared first on AdviserVoice.

The big picture

One of the biggest furphies in 2009 was the claim that Australia had a ‘bubble’ in the housing market. It didn’t and still doesn’t but to some extent you can understand where some commentators were coming from with the claims. In Europe and the US, home prices generally tanked in 2009 but Australian home prices softened, didn’t crash and then began to grow again. The view was that the day of reckoning had merely been delayed.

Where the commentators got it wrong was by glossing over a key fundamental determinant of housing demand – population. In most advanced nations population growth is very modest. In fact in many European economies population is barely growing or is flat. In Japan, the population is actually contracting and in the US, annual population growth is around 1 per cent.

But in Australia, population growth had been steadily lifting since the mid noughties. In June quarter 2004, annual population growth was just 1.2 per cent or an extra 230,000 people. And of that total, migration accounted for an extra 100,000 people.

But those migration levels began to lift markedly over the noughties in response to the PPP policy of Federal Treasury – productivity, participation and population. The PPP strategy is an attempt to soften the blow on the economy from the ageing of the population.

In the year to March 2007, over 200,000 extra migrants came to our shores. And by December 2008 annual migration numbers had lifted to over 300,000 people. Now given that the ‘normal’ number of homes built in Australia each year is around 150,000, a lift in annual migration numbers of around 200,000 would be expected to have a big impact.

And as always appears to be the case, the lift in migration numbers wasn’t universally understood by businesses, government departments and builders. Demand for homes has tended to outpace supply over the past 3-4 years. In late 2007/early 2008 there was double-digit growth in home prices. Demand for homes was temporaily choked off by higher interest rates but at the trough, home prices were down just 2.5 per cent on a year ago.

Home prices returned to double-digit levels in early 2010 in response to lower interest rates but a combination of increased home building (more supply), slower migration and higher interest rates again have caused home prices to soften with annual growth now around 6.5 per cent.

It’s important to note that, despite the ebbs and flows of interest rates and building over time, there is no evidence of a generalised over-supply of homes. In fact in the Sydney market the rental vacancy rate stands at just 1.2 per cent. And affordability? The RP Data/Rismark measure that is well accepted by the Reserve Bank has continued to go sideways over the past six years. Hopefully we will hear a lot less about ‘bubbles’ in 2011.

The week ahead

For those unlucky enough not to be on holidays, there is little economic data to digest in the coming week. In Australia the offerings are confined to population data on Tuesday accompanied on the same day by minutes of the last Reserve Bank Board meeting held a fortnight ago.

In the US there is a bit more to focus on, but all the indicators are congregated on just two days – Wednesday and Thursday.

Turning to Australia first, it is likely that the latest estimates will show a further slowing of population growth. In the March quarter of 2009 Australia’s population was growing at a 2.2 per cent annual rate – the fastest rate in 40 years with both migration and the birth rate boosting the result. But in the latest result for the March quarter of 2010, population growth has slowed to 1.84 per cent – still above the longer-term average but clearly a softer result.

The slowdown in population growth is due entirely to a reduction in migration. When the job market weakened over 2009, the Federal Government thought it would be appropriate to cut back migrant numbers. However the softer job market was very much a temporary situation. Now businesses are crying out for staff but the government has been slow to respond by allowing migration levels to rise. Clearly this is a situation that must be addressed over the next few months otherwise it risks a marked tightening in the job market, forcing up wages, prices and interest rates.

Hopefully the release of the June quarter population figures on Tuesday will revive the debate on migration and population growth rates. It is very much in Australia’s short and longer-term interest to have a well balanced labour market.

The other event of note in the coming week is the minutes of the December 7 Reserve Bank Board meeting. As widely expected, the Reserve Bank left rates on hold at that meeting. This was well flagged by the Reserve Bank Governor and he also provided guidance that the next move in rates wouldn’t occur any time soon. Clearly investors will be looking for further guidance in the Board minutes. Investors will also be seeking to identify the ‘hot button’ issues that bear watching. That is, those issues that are in the middle of the Reserve Bank’s radar screen and therefore may be triggers for the next move in rates.

In the US, the main focus is on the housing market. On Wednesday the FHFA home price index is released with data on existing home sales released the same day. Economists expect that home sales rose by more than 5 per cent in October to a 4.7 million annual rate. As always the amount of stock on hand and movement in home prices will also be watched closely.

And on Thursday, economists similarly expect that new home sales recorded a solid lift of almost 7 per cent. Again stock levels and prices will also be in focus. Overall there is evidence that the housing market has found a floor. But with unemployment still high and a significant amount of stock on the market, no one is expecting building activity to lift markedly any time soon.

Also in focus over the week is the final estimate of economic growth for the September quarter. Currently the economy is tracking at a 2.5 per cent annual pace but some economists believe that growth could accelerate to 3.5-4.0 per cent in 2011 given the amount of stimulus being applied to the economy.

The economic growth (GDP) data is due on Wednesday. And on Thursday, orders of durable goods, personal income & spending, weekly jobless claim and consumer sentiment data are all scheduled. Economists tip another solid result for spending, up another 0.4 per cent in November after a similar gain in October. But the measure of business investment – durable goods – may prove soft with most tipping a fall of just under 1 per cent in November.

Sharemarket

While there is still just over a fortnight until the end of the year, it is already clear that Autos & components has been the strongest sector this year (up 62 per cent) but it is dominated by one stock – Fleetwood Corp. Next best has been Pharmaceuticals and biotech’s (up 10.5 per cent), followed by Materials (up 10.1 per cent). However only six of the 21 sub sectors actually recorded gains over 2010. The weakest performing sector was Consumer durables and apparel (down 19.2 per cent) followed by Retailing and Telecom (both down 18.8 per cent). The insurance sector also took a hit losing 17.3 per cent.
Interest rates, currencies & commodities.

There is still plenty of data to be released over the next two months before the Reserve Bank next meets to decide interest rate settings. Financial market pricing suggests a rate hike in February is pretty much a non event. In fact the pricing for a 25 basis point rate hike is just 7 per cent – which is entirely appropriate. While parts of the economy like mining will do well in 2011, exporters and tourism will continue to do it tough. And then there is the added uncertainty in activity levels given the inherent conservatism being shown by consumers and weakness in business trading conditions. CommSec expects the next rate hike to take place in April with the cash rate lifting to around 5.25-5.50 per cent end of 2011.

Is the US economy about to take off?

Will China continue to dominate?

Will the Aussie dollar be stronger for longer?

How high will interest rates go?

Is there a housing bubble?

What we will be the impact of climate change policies?

Will inflation or deflation rule?

How long before shares return to record highs?

How tight is the job market?

Click here to download this document (pdf)

Key points

• Australian housing is not in a bubble but it is very overvalued, and combined with high debt levels leaves Australian households vulnerable should anything significantly threaten house prices. It is a reason for the RBA to tread carefully in raising interest rates.
• Poor and worsening affordability will likely lead to soft house prices over the next year or so. Key factors to watch for in terms of the risk of a substantial housing slump are a collapse in China leading to much higher unemployment, excessive tightening by the RBA and a big increase in the supply of housing. None seem likely in the short term, but are worth keeping an eye on.

Introduction

Australia has come through the global financial crisis in good shape. However, there is one nagging concern – what I have long called Australia’s Achilles heel – and that is the excessive level of house prices and associated household debt. Lately the debate has focussed on whether Australian housing is a bubble, with some saying it’s expensive and therefore must be a bubble, which will burst with disastrous consequences.

This view is epitomised in a recent article in The Philadelphia Trumpet (a US newspaper) that warned “Pay close attention, Australia. Los Angelification (referring to the 40% slump in LA house prices) is coming to a city near you.” The counter view is Australian housing may be expensive but not dramatically so & can be justified by a severe undersupply.

Is Australian housing in a bubble?

It is natural for those in the US to look at Australian house prices and see a bubble. Australian house prices have left US prices for dead over the last two decades.

Source: Case-Shiller, Nationwide, ABS, AMP Capital Investors

But is it really a bubble? An asset bubble is thought to require: overvaluation, easy money fuelling price gains and speculators buying on the basis that past price gains will continue amidst euphoric investor psychology. In terms of overvaluation, Australian housing gets a tick. On most measures Australian housing is very expensive. Australian house prices are running around 35% above their long term trend (see the next chart). According to the OECD the ratio of house prices to incomes is about 36% above its long term average and the ratio of house prices to rents is 58% above its long term average, both of which are at the top end of OECD countries.

Source: ABS, AMP Capital Investors

But other signs for the presence of a bubble are absent.

• Housing credit is only growing at about 8% pa (well down from the 20% pace seen about seven years ago).
• Only 39% of housing finance is going to investors (compared to more than 50% seven years ago).
• There is no sense anymore that buyers are rushing in for fear of missing out.
• Weekend auction clearance rates have slumped.

Source: Australian Property Monitors

• The Australian housing market hasn’t seen the same deterioration in lending standards that occurred in other countries over the last decade: loan to valuation ratios for new dwellings are little changed over the last decade; homeownership rates haven’t increased – in fact they have fallen for the typical first home buyer age group; and non-conventional loans (eg sub prime loans, option ARMs, etc) have never had a strong foothold.
• Most of the increase in mortgage debt over the last few decades went to older and wealthier Australians.
• There is little evidence Australians are struggling with their mortgages. Non-performing housing loans are less than 1% of the total and have been around this level for years. In the US the comparable figure is 8%.

And finally, Australia does suffer from a shortage of housing. In contrast to the US which saw a huge supply surge during its period of strong price gains into 2006, the supply of housing has been subdued in Australia, particularly relative to the expansion in the population, which has been faster than in India over the last five years. As a result, according to the National Housing Supply Council there is now a cumulative net shortfall of about 200,000 dwellings. And on current trends this is set to get much worse. The undersupply is reflected in continuing low vacancy rates in rental housing – currently averaging 1.6%.

Source: National Housing Supply Council

Outlook

While Australian housing is very overvalued, it’s not inevitable it will have a bust. Many of the tell tale signs of a bubble are not present and just because house prices are overvalued doesn’t guarantee a bust. For example, the Bank for International Settlements found that of 16 housing booms studied over the 1970 to 2001 period only six ended in a bust. However, there is little doubt the intersection of high house prices with high household debt levels leaves Australia vulnerable. Key potential triggers for a bust would be a big increase in the supply of new dwellings, a big rise in unemployment perhaps on the back of a collapse in China or a big rise in interest rates. Right now none of these seem likely. There is no sign of any imminent large land release from state governments, China is trying to cool down a food driven increase in inflation but is not likely to tolerate a sharp slowdown in growth and the RBA is likely to tread carefully in raising interest rates, particularly after banks added more to the last rate hike.

The most likely outcome is an extended period of constrained range bound house prices as average income levels catch up. To some extent this is what has occurred in Sydney over the last six years. After strong gains into early this year, house price gains have since been flattened by a return to poor affordability. With mortgage rates rising sharply in November, and more increases likely next year, a further deterioration in affordability is likely and this could well see prices fall slightly over the year ahead. While the shortage of housing should prevent a sharp fall in prices, a rise in mortgage rates (currently around 7.8%) to much above 8.5% could prove to be a big dampener on house prices next year.

Source: Commonwealth Bank/HIA. REIA, AMP Capital Investors

Is housing a good investment?

After allowing for costs, residential investment property and shares generate similar long term returns. This can be seen in the next chart, which shows an estimate of the long term return from housing, shares, bonds and cash.

Source: ABS, REIA, Global Financial Data, AMP Capital Investors

Over the long term, the returns from housing and shares tend to cycle around each other at similar levels. In fact, both have returned an average of 11.5% pa over the last 80 years or so. While housing is less volatile than shares and for many seems safer, it offers a lower level of liquidity and diversification. The bottom line is once the similar returns of housing and shares are allowed for, and these characteristics are traded off, there is a case for both in investors’ portfolios over the long term. For the time being, with housing looking expensive and offering a net rental yield of around 1.5%, shares are probably a better bet as they are cheap on most valuation measures and offer a more attractive dividend yield of around 5 to 5.5% once allowance is made for franking credits.

Concluding comments

At this stage a housing bust in Australia seems unlikely. Key things to watch for though would be a surge in supply, much higher levels of interest rates and anything that sharply pushed up unemployment. In the meantime a lack of supply should prevent sharp falls in prices, but on the flipside, the continuing drip feed of higher interest rates will likely serve to weaken prices slightly over the year ahead.

• Further tightening in China is likely to ensure that inflation expectations remain under control and to mop up capital inflows flowing from US quantitative easing and Chinese resistance to a stronger Renminbi.
• However, with activity indicators having calmed down after last year’s growth rebound and non-food inflation under control, further tightening should be seen as fine tuning rather than a move to crunch the economy. Policies to boost consumer spending and inland growth are likely to remain in place. Growth is likely to remain around 9 to 10% pa.
• Chinese shares are likely to have more solid upside underpinned by reasonable valuations, solid economic growth, foreign capital inflows and a switch by Chinese investors from property to shares. Further monetary tightening is unlikely to have much impact.

What happened to the China collapse?

Sentiment on China seems to constantly swing between expectations of a boom or a bust. Earlier this year the China sceptics were out in force with claims that China was “Dubai times one thousand” and that a collapse lay ahead as Chinese authorities would over-tighten and cause a property crash and a surge in bad debts.

Today there is little sign of collapse. Having just returned from China the economy seems to be motoring along as per usual. Freeways and airports that weren’t even there a few years ago are full, shopping malls that were deserted in late 2008 are now doing well and confidence seems to be running high. This assessment is consistent with macro economic data showing growth down from the overly strong pace of early this year, but still solid. Against this backdrop, and with data showing rising inflation and capital expected to flood in on the back of more quantitative easing in the US, suddenly the sentiment on China seems to have swung back to China being at risk of overheating, and with it a renewed risk of policy over-tightening.

Our assessment is that China’s economy will settle around a 9 to 10% growth rate over the year ahead, that economic policy will continue to focus on fine tuning the economy rather than crunching it and that Chinese shares remain attractive. But first to the sceptics.

China worries

The common worries about China are: it has overinvested; it excessively relies on exports; the property market is a bubble, bank lending is excessive; it is run by communists who can’t get it right; inflation is out of control; and its managed exchange rate is making it bubble-prone. Looking at each of these:

• With per capita income being 7% of US and Australian levels, pent up demand is huge making it virtually impossible for China to overinvest in infrastructure. Today’s glut quickly becomes tomorrow’s shortage.
• Net exports accounted for just 10% of China’s growth over the last decade. Far less than many claim and also suggestive of a smaller vulnerability to slow growth in consumer demand in the US and Europe than feared.
• While bubble like conditions clearly exist in some cities’ housing markets, nationwide house price increases have lagged income gains and moves to slow the residential property market appear to be working with house price growth slowing to 8.6% over the year to October down from a peak of 12.8% over the year to April. What’s more, household debt is low, average deposits are around 30% of values and 20% of buyers pay in cash. Hardly the stuff of bubbles.
• Bank lending has been strong but household debt is low at around 20% of household disposable income and many of the bank loans to local governments to fund the stimulus of a few years ago are really part of fiscal policy so will be backed by the Government.
• Claims inflation is out of control are nonsense. On the latest data inflation over the year to October rose to 4.4%. This sounds high but is not unusual for a high growth emerging country, it is well down from 30% or so levels seen in the past, and most of it is food with non-food inflation running at just 1.6%. Nevertheless the authorities have been right to tighten to ensure real interest rates remain positive and that inflationary expectations don’t increase.
• While it may surprise some that the Chinese communist party can do a good job of managing mostly capitalist growth, the reality is that it has been.
• Finally, the latest worry is that by limiting upwards movement in the Renminbi at a time when the US is increasing the supply of US dollars via QE2, it will see significant capital inflows potentially fuelling asset price bubbles. This is a legitimate concern. By limiting the rise in the Renminbi the Chinese authorities have to buy US dollars with their own currency and this boosts China’s money supply. Effectively they have lost some control over their monetary policy. The authorities are reluctant to rely too much on higher interest rates because it only attracts in more hot money. So to mop up the liquidity, China has been using administrative controls such increasing bank reserve requirements, forcing banks to hold more foreign exchange, directives on bank lending, etc. More of this is likely but it is a relatively imperfect way to control money supply and bank lending and so asset bubbles remain a high risk.

The current state of economic activity

Recent readings on Chinese growth paint a mixed picture:

• GDP growth slowed to 9.6% over the year to the September quarter, down from 11.9% growth over the year to the March quarter;

• Fixed asset investment has slowed from an annual growth rate of around 35% 18 months ago to around 24% and growth in industrial production has cooled;
• Retail sales growth has slowed, but still remains very strong consistent with policies to rebalance the economy towards consumption;

• Loan growth has slowed from a peak of 34% year on year to 19% year on year, but still remains too strong for the authorities liking; and
• Inflation has risen further reaching 4.4% over the year to October. However, non-food inflation is just 1.6%.

• Finally, house price and sales momentum has slowed.

The bottom line is that further tightening measures are likely in order to ensure inflationary expectations don’t increase, that loan growth slows further and just to soak up the liquidity flowing from China’s efforts to stop the Renminbi from rising. However, with growth indicators pointing to GDP growth running at a healthy pace of around 9 to 10% and non-food inflation running at just 1.6% it’s hard to see further measures becoming aggressive. While it’s reasonable to expect another two or three 0.25% increases in interest rates over the next six months, most of any additional tightening moves are likely to take the form of administrative measures. At the same time measures to boost consumer spending and inland growth are likely to remain in place. Overall, it will remain a case of fine tuning the economy rather than trying to crunch it. As such we remain of the view that China’s economy will grow around 9.5% next year.

What is the Chinese share market telling us?

In recent times the Chinese mainland share market has become a good directional barometer of the Chinese economy. A 30% rebound in Chinese shares since early July is consistent with continued solid growth in China. Certainly the continuing strength in Chinese shares despite various tightening moves over the last month is a very different reaction to the negative response to tightening measures earlier this year, and is consistent with our view that Chinese tightening amounts to fine tuning and as such remains consistent with continued economic strength.

Our assessment is that, after a possible brief pause following recent strong gains, Chinese shares are likely to have more upside. Economic growth remains solid, the authorities will be unable to mop up the entire liquidity surge flowing from quantitative easing in the US and investors will switch from the property market as recent property tightening measures continue to bite. What’s more, despite the huge rally since early July, valuations for Chinese shares are still attractive with the price to earnings multiple based on historic earnings of 22 times, which is still well below the average over the last decade of 34 times.

Given the recent coincident to leading relationship from Chinese to global shares, a likely continuing recovery in the former should be good for the latter.

Concluding comments

Further policy tightening is likely in China, but it will amount to fine tuning and economic growth in China will settle around 9.5% over the year ahead. This is likely to be positive for Chinese shares. It is also likely to be positive for commodity prices and Australian resources stocks.

The world’s largest bond manager, PIMCO, has forecast a positive investment outlook for Australia, due to its fiscal and monetary policy flexibility and its relatively clean banking sector, which differentiates it from most of its developed world peers. This comparative advantage is set to continue and in this climate quality Residential Mortgage Backed Securities (RMBS) stand out as offering attractive relative value, according to Rob Mead, PIMCO Head of Portfolio Management, in the fund manager’s 6-12 month cyclical outlook.

“The comparative advantage between Australia and its developed world peers has been enhanced over time, especially as fiscal positions in the developed world are forecast to diverge further, with Australia expected to be comparatively better off,” Mr Mead said.

As a result, Australia has presented more of a credit opportunity than an interest rate opportunity for most of 2010, and only recently have opportunities reappeared in Australia’s interest rate structure, he said.

“Having already raised rates by 150 basis points (1.5%) since the crisis lows, the Reserve Bank of Australia retains its mild hawkish tone.

“PIMCO continues to believe the RBA will raise rates towards 5%, implying a tightening bias, versus a New Normal neutral rate expectation, which would be approximately 4.75%. However, with the Australian dollar trading close to parity with the US dollar, near-term pressure for the RBA action is reduced slightly,” Mr Mead said.

“As global credit markets have rallied strongly, carefully selected Australian residential mortgage backed securities continue to stand out as offering potential attractive relative value, especially when considering the majority of Australian RMBS naturally de-leverage over time and are self liquidating as mortgages are paid down.”

“While some commentators have claimed Australian housing has become a bubble, various RMBS features provide downside risk mitigation against potential house price volatility. In particular, increased subordination on current vintage RMBS securities provides a cushion for investors while declining loan to value ratios in older vintage RMBS securities provides further protection,” Mr Mead said.

Advice for investors

Mr Mead said investors should look to generate real investment returns with manageable levels of risk using active management.

“Given the RBA’s inflation management credibility, which has realised a CPI rate of approximately 2.5% for the past 15 years, Australian investors have an excellent opportunity in the current markets to earn real (net of inflation) returns of 3%-4% via Australian bonds or global bonds hedged to Australian dollars.

The investment landscape is also expected to remain volatile, which provides active managers with significant opportunities to obtain alpha for investors through both top down and bottom up drivers.

“Investing passively in this environment or with too narrow a focus could result in lower return expectations,” Mr Mead said.

1. Is the World about to collapse due to record levels of government debt in Europe and, more particularly, the US?
   The incredible reaction to the GFC by developed nation governments, in terms of massive stimulus, does come at a future cost. Governments have racked up substantial (and increasing) levels of debt, not seen since just after World War II. The G7 countries will likely see public debt increase to over 100% of their GDP by 2015. In the absence of any fiscal control, the net debt to GDP ratio would exceed 200% by 2030 and this has many commentators worried (not so much by the Greek situation given it is such a small economy). The big anomaly is that the best way to get debt down in the longer run is to ensure you have a growing economy (which may involve even further stimulus short term). So what do we think about this?
   • Firstly, governments are not like individuals. They have the ability to collect taxes in perpetuity. This means they can sustain much higher longer term debt than individuals
   • For governments to sustain high levels of debt, there must be other entities (typically the high-saving emerging economies) willing to buy their government bonds/treasuries
   • This works fine, provided everyone has confidence that the government can reduce their debt burden in the long run
   • If that confidence evaporates (such as we have seen in the past with many developing nations) that’s when we see massive problems with inflation and currency devaluations
   • Countries with large debt levels can not grow their economy in the future as fast as they otherwise would, as they slowly cut costs and raise taxes to repay debt.

   The bottom line is a huge long term issue that, in many ways, is a necessary outcome of the GFC. The big governments have had a healthy wake up call from the PIGS (Portugal, Ireland, Greece and Spain) and we are already seeing some moves to cut public service costs and government pensions in major economies. Whilst the press can be very alarmist over this issue, these debt issues can be seen as a longer-term drain on the economic growth of these indebted nations, rather than a cause for immediate panic.

2. Why do the Chinese continue to fund the US by buying US Government securities (treasuries)?
   This question gets asked a lot. People see debt issues in the US, coupled with low interest rates and logically ask why would you want to buy US treasuries?
   The bottom line is that the US treasuries, despite the GFC and US issues, still remain one of the most most liquid and secure places for holders of substantial funds to invest. As money pours into China from abroad to pay for their massive exports, they need a safe liquid, globally tradeable asset to invest in which rules out most other alternatives (even the physical gold market would be too small).
3. China has lots of issues and we are too dependent on them – what’s going to happen if they have more problems?
   Australia’s natural resources and proximity make us close to China economically. While there are big issues (pollution, maintaining growth to avoid civil unrest, property market bubble etc), we don’t see Chinese growth stumbling too far in the near term. As a communist Government, China has shown a tremendous ability to control its economy and keep growth bubbling along, with the vast population gradually increasing their wealth from a low base. China’s one-child policy will likely lead to a quickly ageing population. However, by the time that happens (say ten years plus), Australia may take greater advantage of Indian growth where the population is much younger. That said, much of Australia’s wealth is made from exporting to China (now the World’s second largest economy and Australia’s biggest export market), so Australia’s growth prospects are in part tied to China.
4. What’s going to happen to Australian house prices – some people say they are the next bubble?
   World capital flows are so large and volatile, bubbles can and will be created in the future. So, looking out for and avoiding the next bubble is a great way to think about investing. Australian residential property is more of a local market and prices are high when compared to many other markets. I’m reminded of a conversation with renowned US Economist, Professor Robert Shiller, where he pointed out that in the very long term property prices are related to affordability but there can also be long periods of prices getting ahead of affordability and vice versa. The following chart gives one example that can justify why prices have risen, with housing starts being outstripped dramatically by population growth. I believe that residential prices will cool with rising interest rates, but supply/demand factors will most likely keep prices from suffering a major short term fall.
5. I’m just too worried about losing money with shares, shouldn’t I wait until everything settles down?
   We live in a dynamic, globalised world and there will always be some form of negativity in the headlines. However:

• Historically, over the longer term, shares increase in value.
• Various academics are of the view that the best time to invest in shares is at times of the greatest market uncertainty. Waiting for absolute certainty could be the worst time to invest, as sharemarkets tend to do well before any economic recovery is certain.
• A diversified portfolio that also includes some defensive assets, such as Government bonds, should ensure that you can sleep at night!