Bankers and miners under pressure

Christine St Anne  |  16/01/2013Text size  Decrease  Increase  |  
Christine St. Anne: Well, 2013 is already upon us. Today I’m joined by Ibbotson’s Daniel Needham to give us his snapshot to the Australian economy? Daniel, welcome.

Daniel Needham: Thanks, Christine. Happy to be here.

St. Anne: Daniel, how do you think that sectors of the Australian economy will play out this year at least for the medium term?

Needham: The Australian economy at the moment is going through a lot of change. I think we've had an extremely positive two decades, a combination of the deregulation of financial markets providing affectively the expansion of credit by the banking system. There was a bit of trouble in the early '90s obviously. We had a very deep recession of financial crisis. But coming out of that, we've had continually expanding credit. We had declining inflation. So that’s helped interest rates to come down. We've seen household debt build up to astronomical levels, supported by ever increasing house prices. We've had very low unemployment. We've had a mining boom. We've had two really significant periods of increasing commodity prices, and that’s being followed up with significant expansion of mining investment over the last couple of years.

So, I think we've gone through an extraordinary period, and I think that the Australian economy is unlikely to experience that kind of prosperity over the next decade. So, I think we're going to be transitioning into a period of change. So I think it's going to be a difficult environment. I think banks are going to be challenged. They've expanded their balance sheets quite significantly. They have benefited from rising house prices, double-digit credit growth for over a decade.

And when you think about where are the banks going to increase their profits, I just struggle to see it. I think margins are, if anything, likely to come down. They obviously have a fairly protected position, the big four banks in Australia, but again I think the good times are probably behind us.

I think it's going to be a more challenging economic environment. So, look, I think we've had a strong dollar. That's really hurt the external sector outside of mining. Mining hasn't been as affected by the strong dollar, because obviously the bulk commodities are priced in US dollars, and there has just been such a significant increase in the price of iron ore and coal that that's sort of taken over any effect of currency for those guys. But I think it's more the sort of manufacturing export sector that struggles.

So I think there could be opportunities in the kind of more beaten down sectors over the next couple of years in the Australia economy that have maybe struggled a lot under relatively high interest rates and also a strong currency. And so, I would say that it's kind of outside of the financial sector and outside of the mining sector that I think the industries in Australia could do relatively well. It’s going to be a tough environment, I think, for all of them.

St Anne: You mentioned the mining boom. Rio Tinto already this week has come out with some solid production numbers, but has signaled that their profits could fall. So, do you think that the commodities boom could be easing?      

Needham: It's difficult to say because China is pretty much the key marginal consumer of most commodities now around the world. What China does from sort of a government policy perspective, investment spending primarily, really does dictate the marginal demand for commodities especially in iron ore because of steel production. But if you look at just the extremes that have built up in the demand for iron ore, effectively steel production, the amount of steel capacity in China especially, I think it's unlikely that we’re going to see the type of growth in demand or growth in production, I would say, now in over the last 10 years. If anything I think we're going to see easing demand in iron ore and easing demand in steel product and certainly easing steel production.

So I don't think that bodes very well for iron ore producers. I mean, I think you've got some really great assets that both BHP and Rio Tinto owned, and I think they are very low marginal cost assets. So I think they can be profitable with the iron ore price well below it is today, but are the profits that mining companies are generating right now sustainable at these margins? I don't think they are. I think a lot of the strong mining companies will still be profitable with iron ore, well below where it is today.

So, I think we're likely to see weaker longer-term commodity prices, and also I think we're likely to see probably slower growth in volumes as well. So, you combine those two together with a lot of excess supply that’s come on. There has been huge investment spending in the iron ore sector over the last few years, and I think that's actually going to create some downward pressure on prices and a combination of sort of slowing volumes and falling prices is never good for the profits of mining companies.

St. Anne: Daniel, given that China was such a key driver behind the mining boom, do you think that the slowdown in that economy is temporary or more fundamental?

Needham: I think GDP growth rates of 10 per cent per annum like clockwork are behind us. I think that the Chinese economy is going through a significant change both political as well as economic change, and so I mean history suggests that if something can't go on forever, it doesn't. So, the talk of credit growth and investment growth – investment spending growth in China looks very unsustainable, and I think that we are likely to see a slowdown of investment spending in China over the next decade. I think the contribution to GDP growth from investment spending in China is going to decline, and I think that the rate of the expansion in consumptions growth isn’t going to be anywhere near as bullish as what people expected.

So, I'll say could be some transitions in the economy that we could mean that there are other parts of the economy that pick up. I just think the rate of growth is likely to be closer to 6 per cent over the next decade than say 12 per cent which probably people had experienced. People's expectations were, say, maybe five years ago that China could keep growing at 12 per cent. So, I think that lower growth is a more reasonable outlook, although it’s very difficult to predict these things.

St Anne: Finally, Daniel, do you expect some New Year cheer for 2013? Do you think investor sentiment could come back?

Needham: Well, I mean, I think that Australian stock market was up 20 per cent in 2012. I don't think it was a bad year for sentiment. I find it quite funny because there seems to be this kind of perceived wisdom out there that everybody is bearish and that people are mistreating equities, but when I look at the year, I think, the US stock market is making – it's trading over 14 to 17, I think is where it is at the moment. I mean it bottomed at 667 in the GFC, I mean it's up more than 120 per cent. You've had bonds that have given people returns over 10 per cent. Equities, Australian equities were up 20 per cent, Australian listed property was up 30 per cent in 2012.

I don't think things – are people bearish, I mean the markets are up 20 per cent, maybe I'm talking crazy pills, but when I look at the markets, I think people are very positive. I think sentiment is fairly positive. I think you've seen iron ores bounced a lot, from the June lows. You've seen markets up very high.

So, I mean it's equity participation isn’t anyway like it was in 2006 and 2007, but I think there needed to be a normalization of the massive over-weights that people had in equities pre- the GFC. So, I don't see pessimism, – I think people are more aware of the risks. People are more aware that Europe is a potential problem, there is debt problems in the US, that China is probably going to be slowing down, the past processes are probably unsustainably high in Australia and that – we've – that the mining boom might ease.

So, people are probably more aware of the problems, but I don't see that translating into defensive behavior. People have been buying equities, people have been buying credit, people have been taking more risk in their portfolios. They've been reducing the cash exposure. Maybe there are some pockets of individual investors that have got large amounts of cash, but I would say on the whole institutional investors in Australia are pretty aggressive. So in that regard, I'd say sentiments are quite positive going into 2013.

St Anne: Daniel, thanks so much for your insights today.

Needham: No worries. It's my pleasure. Thanks, Christine.  

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