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Is China the centre of world trade?

December 27, 2010

Problems abound but the outlook for Australia is good, writes Maris Beck.

IN HIS classic Australian history, The Tyranny of Distance, Geoffrey Blainey wrote: ”So far as we know, Australia had only one commodity which was valued beyond its shores towards the end of the eighteenth century – the trepang or sea slug …”

A few centuries later the country is in the throes of a commodities boom – and sea slugs have sunk from export prominence.

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Times have changed and they will change again. The question is how.

As investors position themselves for the year ahead, the mining sector and Australia’s largest trading partner, China, are central to their considerations.

Many believe the commodity bonanza and sustained Chinese growth saved Australia from the worst of the 2008 crash.

But as the stalled engines of global growth sputter back to life, Macquarie’s global head of economics, Richard Gibbs, has warned that the mining bonanza is ”a fool’s paradise”. He believes China will increasingly look to Africa and Latin America as alternative sources of crucial commodities.

”As each year goes by, we get closer to the year when the Chinese are going to bring to the table significant new competing supply.”

Australia’s ”two-speed” economy, in which mining services growth outstrips other sectors, is a liability, he says. ”In the same way the gains in China were magnified in the Australian economy, any losses in China will be magnified. It is a double-edged sword.”

Investors should position themselves for a rocky ride over the next few years, he says. ”I’d be looking at companies with good cash flow … continuing to keep some of my cash locked down in term-deposit facilities.”

But a report by the Morgan Stanley global economics team says the mining boom is less vulnerable to China-related setbacks now because it is increasingly investment driven, rather than terms-of-trade driven as it has been.

Roaring Chinese growth has fuelled inflation this year and a surprise Chinese interest rate rise in October spooked Australian investors.

Many fund managers fear that if China slows its growth, its demand for Australian commodities will drop off and share prices will follow, at least in the short term.

But even if China does crack down on inflation, Ian Christie, director of research at Argonaut Securities, which specialises in mining services, says the risk needs to be kept in perspective.

”If China goes from 10 per cent-plus growth down to 8 per cent, it’s not the end of the world; but if it goes down to 6 per cent and below then it is going to create a few problems because demand within China is not going to be sufficient to keep the same demand for commodities.

”I don’t think that is going to happen.”

He says 2011 will be ”a little soft” for the mining services sector, but that 2012 and 2013 will be ”exceptionally good” as new projects bear fruit.

UBS strategist David Cassidy says any tightening will ensure Chinese growth is more sustainable. Furthermore, he says fears of Chinese macro and monetary tightening are ”overdone”, because recent inflation has been driven by food prices and is not due to excessive monetary expansion.

In a note to investors, he says that 2010’s earnings have been ”firing on one cylinder”- commodities.

He expects more sectors to be profitable next year because of a flatter trajectory for commodity prices and the Australian dollar, better financial conditions, investment-driven domestic growth and marginally better US growth.

Banks will not benefit immensely, he says, because they have become a ”political football” and may face more regulatory constraints as they struggle with continuing margin pressures.

A report by Citi head of equities Tony Brennan and equities strategist Richard Schellbach says ANZ and NAB will fare better than the other banks because business lending, which is a larger share of their assets, will rise.

”Growth is expected to be moderate as more subdued credit conditions persist in the economy. Nevertheless, bank earnings could still grow reasonably well compared to other areas of the market.”

BBY’s head of financial sector equity research, George Gabriel, says he expects the banks to be ”trading-range bound” for the next six months because of potential regulatory reform, uncertainty about new rules on capital adequacy that will apply from the first quarter of 2011, and a challenging revenue outlook, with question marks over loan growth and fees.

But he sees the big banks doing better than the regionals because they will be able to fund covered bonds more cheaply and if mortgage exit fees are banned, they will suffer less.

”Safe as houses” is a well-worn expression, but MLC Investments strategist Brian Parker says the notion that Australian real estate prices can move only one way could go out the window this year. ”Residential property looks absolutely obscenely overvalued and seems to offer very, very poor investment prospects,” he says.

Morgan Stanley economist Gerard Minack has echoed a recent International Monetary Fund report in a note to clients, warning of a housing bubble in Australia. He says that while the market may not crash, it could flatline.

Australians are saving more and spending less, recent Bureau of Statistics data shows. Gibbs of Macquarie says people are ”self-insuring” after the financial crisis. Penny-pinching has hit retailers hard this Christmas and the trend may continue well into next year.

UBS strategist Cassidy says investors should not give up on shoppers just yet, but Citi’s Brennan expects discretionary retailing to fall further next year.

Retailers may not be pleased, but Reserve Bank governor Glenn Stevens has welcomed high savings rates, so long as they do not impede higher productivity.

The frugal trend could deter the RBA from raising rates beyond

4.75 per cent when it meets again in February.

HSBC economist Paul Bloxham has forecast that inflation pressures and high commodity prices will cause the RBA to raise rates by 100 basis points to 5.75 per cent over the next 15 months, which would boost incomes and investment.

Interest rates, along with commodity prices and the direction of the greenback, will play central roles in the trajectory of the dollar, which has already brushed parity several times this year.

Many observers foresee a risky bond market over the next few years. Gibbs of Macquarie says debt looks ”far too cheap” at current levels. ”It has raised the spectre of asset-price bubbles, in parts of the global sovereign debt market in particular – also you could argue in the corporate market. We’ve got to watch that.

”It would be unlikely that investors will want to bid down yields any more, and they have got down to fairly marginal levels.”

MLC Investments strategist Parker says: ”Nobody is going to get rich lending money to Barack Obama and earning 3.5 per cent.

”One of the great ironies of markets right now is that the traditional safe-haven assets look the most dangerous to us. The yields you are getting on global government bonds just don’t look all that flash and they don’t seem to be pricing in any of the risks that seem to be out there.”

He says investors have to assume that either Greece, Ireland, Spain or Portugal will default on their loans over the next few years.

European sovereign debt, which has erupted into crisis proportions this year, remains a touchy subject for investors. The US, which has extended Bush-era tax cuts and borrowed money to finance its stimulus program, could end up trading its growth problem for a debt problem, with profound consequences for international markets. These issues will continue to weigh on investments into the coming year.

The investment landscape for 2011 holds significant risks, but most commentators believe Australia’s economic fundamentals are strong. They say the sharemarket is well positioned to make solid gains, with observers forecasting the benchmark S&P/ASX 200 Index to be between 5000 and 5750 by the end of 2011.

UBS strategists Cassidy and Dean Dusanic say the market’s price-earnings ratio could expand moderately in 2011, to just over

13 times, with the index targeted to hit 5500 by the end of 2011. The executive director of investment strategy at Morgan Stanley Smith Barney, Malcolm Wood, is more optimistic. ”Earnings growth in Australia will be pretty solid. I’ve got a target of 5750, which is roughly a 20 per cent upside.”

Commentators are at odds over exactly where the market is headed and exactly where the bets should be placed. But one thing is exceedingly clear – the era of sea-slug ascendancy is well and truly over.

Sourced & published by Henry Sapiecha

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