Investing Down Under

May 16, 2016

Investing Down Under

  • Australia has a stable and transparent economy, is rich in natural resources and the AUD currently looks cheap.
  • The Australian stock index consists of mostly financials but all have excellent ratings.
  • Only 0.09% of the S&P 500 revenues are generated in Australia therefore Australia provides additional international diversification.

Introduction

Australia is a country with a population of approximately 23.5 million people, highly developed with a GDP of $47,186 per capita, low unemployment rate of 6.1% and low government debt at 35% of GDP (US 125.3% of GDP). The long term interest rate is at 1.75% and the country is ranked in 13th place on the global doing business list. The Australian economy grew 3% in 2015 and it is dominated by the service sector representing 68%, followed by the mining sector that represents 7% of the economy. The above seems stable and therefore this article is going to provide an analysis about the potential risks and rewards of investing in Australia.

The Australian Stock Market

The most commonly used index for the Australian stock market is the S&P ASX 200. Even if Australia is famous for its mining industry, the biggest weighting in its stock index are financials with 47.7%, followed, of course, by materials at 13.8%.

1 figure asx 200 sector breakdown
Figure 1: ASX 200 Sector breakdown. Source: ASX 200 List.

The financials have the biggest weight in the index as the four biggest companies by market capitalization are banks. All of them have an excellent credit rating which should imply long term stability of the financial system and limit investing risks.

2 figure credit rating banks
Figure 2: Australian biggest banks credit ratings. Source: Relbanks.

The above credit ratings make Australian banks among the best in the world and they seem even better when compared to US peers.

3 US banks credit ratings
Figure 3: US bank ratings. Source: Financial Times.

In relation to valuation, the Australian stock market is not cheap with an average PE ratio of 15.7, but it is cheaper than the S&P 500 with 23.88. The dividend yield is also on the Australian side with an average 4.7% yield versus the S&P 500’s 2.12%.

The Australian stock market shows less historical volatility than the S&P 500.

4 asx 200
Figure 4: ASX 200 index from 1990 compared with S&P 500. Source: .

Australia seems like a stable country to invest in but before directly investing the currency issue has to be assessed.

Australian Currency

With international investing, currencies play a big, if not main role. Economic growth and dividends might not mean much to an investor if currency losses eat up the gains. The main influences on the Australian dollar (AUD) are the interest rate, imports, exports and the stability of the economy.

On May 3, the Reserve Bank of Australia decided to lower interest rates to a record low of 1.75%. Historically the average has been 4.92%. A low interest rate should imply a weak currency as investors look elsewhere for higher yields. An even more important factor for the AUD are commodity prices as the mining industry that comprises 7.4% of GDP is exporting most of its goods. Australia mainly exports iron ore (25% of exports), coal (15%), oil (10.4%) and copper (2.1%). If commodity prices are high then more AUDs are needed to pay mining expenses and therefore the AUD is stronger. In relation to GDP growth and economic stability, the International monetary fund forecasts the Australian economy to grow at a stable rate of around 2.8% for the next 5 years.

5 aud vs usd
Figure 5: AUD per 1 USD. Source: XE.

The above mentioned influences result in a very volatile currency that is very strong when commodity prices are high and weakens as commodity prices drop. The AUD has depreciated against the US dollar by more than 30% in relation to the USD in the last 3 years. A recovery in commodity prices could give a boost to the Australian economy, increasing interest rates and increasing the value of the currency.

Conclusion

International diversification is a very controversial topic as both practitioners and academics constantly research and discuss it. The S&P 500 already generates more than 50% of its revenue overseas so further diversification might be questionable, but Australia stands out as only 0.09% of the S&P 500 revenues are generated Down Under.

Apart from uncorrelated revenues, Australia also offers political and legal stability, economic transparency and a relatively high dividend yield and low PE ratio. The currency will for sure be volatile towards the USD but that volatility might increase the positive returns as the AUD has only been falling in the last few years alongside the fall in commodities.

 

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