Choosing quality Australian credit
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Tracy Chin is a credit analyst and Aaditya Thakur is a portfolio manager at PIMCO, a global bond manager. The following is an edited version of the original article.
There has been ample analysis of the macroeconomic consequences of the terms-of-trade (ToT) shock that Australia has undergone as the resources investment boom has tapered.
Australia now must contend with a multi-year decline in the ToT and the required rebalancing towards the non-mining sectors of the economy, as the country transitions from the investment phase to the export phase of the resource cycle.
For investors, it is important to assess how these macroeconomic forces will affect the corporate sector in Australia and thereby identify which credits are better placed to navigate the challenges that lie ahead.
Since late 2011, the ToT has experienced a gradual decline that is set to continue as commodity prices moderate due to an increase in supply. The completion of mining-related projects comes at a time when China, Australia's major trading partner, is set to adjust to a slower rate of growth.
Terms of trade from the corporate perspective
For companies, the macroeconomic consequences of a downswing in terms of trade provide both challenges and benefits. The key for investors lies in identifying those firms that can best exploit the benefits and which have the competitive stance to better withstand the challenges.
While a moderate ongoing decline in ToT in the coming quarters will constrain profit growth, there are some benefits that are often overlooked, which should help many Australian corporates maintain strong credit fundamentals and provide investors with a framework for sector and company selection.
First, downswings in the terms of trade generally result in lower inflation. This will likely help contain wages, helping to maintain margins and cushion the fall in profit growth.
The second important impact from a credit fundamentals perspective is that typically during the declining phase of a terms-of-trade cycle, business investment remains below-trend, ensuring that corporates keep leverage contained, and hence, credit fundamentals remain positive for investors.
Finally, as the benefit of the investment phase is realized, business productivity should begin to lift. The most recent report on productivity, from the first quarter of this year, offers some sign that productivity growth has stabilized and should start to improve.
In the current environment, currency appreciation is also a factor. Exogenous forces are keeping the Australian dollar more elevated than what fundamentals and the experience of prior terms-of-trade episodes would imply.
As a result, the Reserve Bank of Australia will likely have to lean more heavily on interest rates as a lever to help rebalance the economy.
Companies that optimize the mix of these offsetting dynamics and enhance productivity will be better able to withstand the headwinds to corporate profitability.
Thus, in evaluating the Australian corporate landscape under the prevailing macro environment, we place great importance on identifying firms that possess these features:
• They hold oligopolistic or monopolistic positions that ensure greater pricing power and hence retain margins;
• They operate within their geographical footprints (whether domestically or internationally) on a competitive basis and are beneficiaries of supply and demand fundamentals; and
• They focus on cost control, while improving efficiency, operational leverage and thus productivity.
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