The last twenty years have seen two extraordinary phenomena for investors: the economic ascendance of emerging markets and the economic ascendance of Australia, feeding those emerging markets with commodity exports.
Of the economies that have grown in size and sophistication following the end of the Cold War, the BRICs – Brazil, Russia, India and China – have been among the most impressive. Since 1989, China in particular, has witnessed spectacular growth, its economy evolving from pig iron and bicycles to futuristic skyscrapers and high-speed trains.
Now the world’s second-largest economy, and the undoubted engine of global GDP expansion since 2008, China’s ascent has been an overwhelmingly good thing for Australia, but cracks have begun to form in the economic foundations.
First, China’s growth has long been lopsided, with fixed-asset investment accounting for an inordinate and unsustainable portion of GDP. Second, much of this investment has been financed through opaque and uncommercial loans, giving scope for graft, misallocation and value destruction on an epic scale. Third, China’s development model has helped entrench vested interests – ranging from state-owned enterprises, local governments, party officials and the military – that could seek to block any necessary changes.
As China now attempts wide-ranging reforms, a smooth transition to a more sustainable pattern of growth could thus be stymied, increasing the likelihood of an eventual crisis that nobody can control. With a huge amount of off-balance sheet debt, much of it held in the country’s enormous shadow banking system, there are furthermore any number of trigger points that could bring down China’s economic miracle.
So far, Australia has sat pretty. Aside from falls in the prices of coal and iron ore and notwithstanding a series of interest rate cuts, our dollar remains high and investment in commodity export expansion has kept national income buoyant. Employment too, beyond a declining participation rate, remains solid and despite widespread worries of a major house price correction, investors have propped-up most capital city markets.
But this equilibrium contains the seeds of its own undoing. In Brazil – another BRIC nation that saw rapid development on the back of commodity exports – GDP growth has fallen dramatically to 0.6% annualised, against expectations twice that. Low productivity and high labour costs, like Australia, have hurt other areas of the economy and, like Australia also, Brazilians have been spending the bounty on middle class welfare and expensive homes.
While in many ways Brazil’s poverty alleviation reforms have been world-class, the taxpayer still spends five times as much on mostly rich, white university students as it does on mostly poor, mestiço schoolchildren. And while social housing is clearing the infamous slums of Sao Paulo and Rio de Janeiro, private property has become unaffordable for all but the richest.
According to a recent government study, house prices rose 132% in Sao Paulo and 165% in Rio between January 2008 and February 2012 against an aggregate inflation rate of 25% in the meantime. And while housing credit growth has lagged these figures, a general lack of mortgages (100% down-payments are not uncommon) indicates another concern: that Brazilians are channelling money that could be more productive elsewhere into the property market.
Any simple comparison between Brazil and Australia is of course problematic but there are still lessons that could be learned. Further, while the public policy challenges are largely different, investors are in many ways beginning to treat the two economies the same, as noted economist and hedge fund advisor Michael Pettis wrote in Macro Business yesterday.
Yet hope for domestic investors lies in another comparison Pettis made: the one between Brazil and Mexico. During China’s ascent as a manufacturing powerhouse, Mexico largely suffered as manufacturers were first undercut and then the United States – Mexico’s biggest export market and source of capital – saw the sub-prime crash. Yet by concentrating on core competencies and improving productivity, Mexico is now competing head-on with China in a range of goods and services.
Despite the headlines of Mexico’s drug wars and despite fears over tougher US immigration rules, Mexico outpaced GDP growth in Brazil this year and last. Further, whereas the Brazilian real has stagnated, the Mexican peso has strengthened. Since early 2010 foreign holders of Mexican bonds have more than tripled, according to HSBC.
And although the US fiscal cliff could have flow-on effects for its southern neighbour, Mexico is finally poised to reform its long stagnant but hugely prospective oil sector. Meanwhile, the much-heralded deep-offshore oil developments of Brazil are seeing eye-watering cost overruns that would make even Australian project managers blush.
The rise of economies like Mexico against the relative decline of economies like Brazil has led Goldman Sachs Asset Management – the firm that first coined the acronym BRICs – to create another four-letter word: MISTs. Unlike the BRICs, where the only membership criteria was that you had to be big, the MISTs, which stands for Mexico, Indonesia, South Korea and Turkey, are all economies that are prospective for their competitive manufacturing, liberalising workforces and sustainable, consumption-led growth. And while Australia could hardly be tagged onto the end, not least because it’d ruin a perfectly good pun, the good news for investors is that we still have some of those capabilities listed on our sharemarket.
Beyond talk of the death of Australian manufacturing and besides the fact that our consumers are staying at home or shopping online, when the Australian dollar falls in tandem with a slowing China – and we believe it will in 2013 – the Australian industrial exporters forged in the last ten years of rising costs and falling competitiveness will be better placed than ever to reach their full potential.
For investors, we believe it will be stocks like CSL, Codan and Navitas, not Woodside, Fortescue or Santos, that will provide the best performance and after years of making room for the mining boom, it will be industries of manufacturing, tourism, education and healthcare that will see the higher returns. A call like this may seem bold in the wake of evidence to the contrary, but few would have thought that Mexico – whose similarly under-performing football team beat Brazil to this year’s Olympic gold medal – would enjoy such a resurgence too.
We may not be able to avoid seeing Australia in aggregate hit a BRIC wall in 2013, but as dark clouds approach there can at least be a MIST of silver lining.