CHART 1

CHART 2

KEYNOTES

• The fourth quarter GDP of 2009 surged by 0.9% quarter-on-quarter, the strongest pace in almost 2 years.
• The key indicators signalling sustainable economic growth are: further improvement in the job market, an upswing of exports and a revival of the residential market.
• The Reserve Bank of Australia is leading the way towards global policy normalisation. We expect the cash rate to hit 5% by the end of 2010.
• Despite multiple rate hikes, retail sales marked a solid comeback. Rising consumer confidence, easing unemployment coupled with job creation bolstered domestic consumption.
• When investing in Australian equities, the currency return has historically been an important source of the total return for foreign investors.

Australia is one of the very few developed economies that had dodged the recession triggered by the US subprime crisis. On a quarter-on-quarter basis, following a 0.9% GDP contraction in the fourth quarter of 2008, the economy demonstrated outstanding resiliency and expanded by 0.8% in the first quarter of 2009.

Stronger GDP Growth

On a quarter-on-quarter basis, the fourth quarter GDP of 2009 surged by 0.9%, the strongest pace in almost 2 years, bringing the full-year growth of 2009 to 1.1% compared to a year ago (Table 1). The latest GDP figure reveals that the economy is heading to a stronger growth with notable increases in private spending (up 1.5%) and public spending (up 3.8%). In particular, spending on machinery and equipment spiked 10.9% quarter-on-quarter and contributed 0.8% to the GDP growth, thanks to corporate investment and capex led by the domestic miners. Moreover, household spending grew 1.8% as the labour market and consumer confidence strengthened. Going forward, the key indicators for sustainable economic growth are: further improvement in the job market, an upswing of exports and a revival of the residential market.

The Australian central bank also forecasts that the economy will accelerate to 2% year-on-year in the fourth quarter 2010.

Closer Ties with Asia

Australia's trade with Asia is increasing. Chart 1 reveals Australia’s major exports trading partners. Compared to a decade ago, the role of the US and the EU (European Union) has been declining. From 22% of Australia’s exports in 1999, the proportion of exports to the US and EU declined to 14% in 2009. In contrast, the growth of exports to China is remarkable.

China only accounted for 5% of Australia’s exports in 1999 but the proportion rose sharply to 22% in 2009, making it the largest exports partner. Going forward, the Australian central bank expects China to play an important role in fostering the country’s economic growth in the coming decade.

Interest Rates: Pointing towards a policy normalization

Australia is the first developed economy to kick-off the interest rate hike cycle after the financial crisis. Since October 2009, the Reserve Bank of Australia (RBA) has hiked rate for five times. On 6 April 2010, RBA raised the cash rate by another 25 basis points to 4.25%. In the post-meeting statement, the central bank acknowledged a stronger-than-expected economic growth in 2009 and the recent data reveals that the economy has returned to the growth track for a few months. We expect the cash rate to hit 5% by the end of 2010 which will be closer to the average rate of 5.35% in the last two interest rate cycles. This move also aligns with the RBA’s view of the normalisation process.

Meanwhile, the Fed funds rate is left unchanged at a record low of between 0 and 0.25%. In contrast, Australia's OCR (Overnight Cash Rate) has risen five times, making the differential between the cash rate and the Fed Funds Rate widen significantly to 400 basis points (Chart 2). Currently, the market expects more rate hike pressure for the cash rate than the Fed Funds rate, suggesting a widening of the interest rate differential is more likely to persist in the near future. Being the high yield currency, the AUD would likely come under pressure when the carry trade against the US dollar is unwound.

Retail Sales mark a solid comeback

Regarding the domestic consumption, retail sales jumped by 3.0% year-on-year in January. The rising consumer confidence, easing unemployment coupled with job creation help offset the tightening impact brought by multiple rate hikes and bolster retail consumption. Moreover, the rising Australian Dollar (AUD) increases the purchasing power of the domestic buyers by lowering the imports prices.

Compared to a month earlier, sales in department stores showed the largest growth and spiked 7.2% due to the post-Christmas sales effect. Clothing and food sales delivered a solid gain and soared 2.9% and 1.3% respectively. The only item that recorded a month-on-month decline was cafes and restaurants sales due to a reversal from the strong gain in December. In addition to a firm discretionary spending, these figures indicate a solid comeback of sales activity and a broad-based recovery.

Looking forward, although further rate hikes are underway, the rising consumer confidence, improving employment, rising household income, and the wealth effect brought by the rising asset prices are expected to support domestic activities.

We have highlighted in previous articles that the objective of monetary tightening is to foster the sustainability of economic growth rather than to depress the economy. Therefore, RBA’s growing confidence on Australia's GDP growth outlook hints that the economy is set for a stronger growth. The rate hikes further support such an interpretation. We believe that these actions are steps to normalise the monetary policy and to pre-empt the forming of asset bubbles.

Currency Return Matters!

Historical data shows that when investing in Australian equities, the currency return has been an important source of the total return from a foreign investor’s perspective. Table 2 depicts that from a Singapore investor’s perspective, the benchmark ASX 200 Index gained 173.9% during 2003 - 2007. However, from an Australian investor’s perspective who can only benefit from equity price appreciation, the return was 110.8%. This implies that the attractive total return mainly comes from the currency gain (i.e. the AUD rises against the SGD).

During the course of the financial crisis, the flight to safety by investors caused capital to flow to the US dollar. The depreciation of the Australian dollar also undermined equity performance. In 2009, the ASX 200 gained 30.8% (in local currency terms) while the AUD surged against the SGD, generating a total return of 63% (in SGD terms). Therefore, many Australian equity funds delivered decent returns last year.

Valuation

According to the consensus, the Australian equities represented by S&P / ASX 200 Index are trading at 16.3X and 13.3X in 2009 and 2010 (Australia's fiscal year ends in June, thus FY2009 ends in June 2010). The consensus earnings growths are 18.1% and 16.1% in 2009 and 2010 respectively (as at 13 April 2010). We give Australia a 3.5 stars “Attractive” rating.