Some Thoughts (and Prayers) on the Australian Wildfires

The wildfires rage on in Australia. Here, we discuss the potential economic impact and the implications for fiscal and monetary policy. Ongoing uncertainty is likely to weigh on the Australian dollar for now, but there is scope for equities and bonds to outperform in 2020. It is very difficult to bring a dispassionate, analytical voice to such a tragedy, and our hearts go out to our friends and colleagues in Australia.

RECENT DEVELOPMENTS

The current brushfire season in Australia has been amongst the worst on record. While the dry, hot summer season typically brings wildfires, the scope and severity of this current season is undeniably worse due to the combination of record-high temperatures and months of severe drought. The fires usually start in October but this time they started in July. So far, the fires cover nearly 40,000 square kilometers and is already greater than the total seen over the previous three years.

Typically, most of the fire activity is further inland. This year, the worst fires have been seen in the coastal areas in southeastern New South Wales, the most populous state where the majority of the nation’s 25 mln population live. As such, these fires have had a much greater impact on the nation as a whole.

Many observers have linked global warming and climate change to the current wildfire crisis. This is particularly sensitive for Australia, as its second-largest export is coal. The nation also uses coal to generate nearly two thirds of its electricity. The current Liberal government reversed the carbon tax that was enacted by the former Labor government. However, current Prime Minister Scott Morrison is simply the latest in a long line of Liberal leaders to downplay the potential impact of carbon emissions on global climate.

Indeed, some believe that this may be Morrison’s “Katrina” moment. Along with downplaying the severity of the fires, Morrison even took an ill-timed vacation to Hawaii just as the situation worsened last month. He eventually returned early but we suspect polls will show a big hit to his popularity. Yet Morrison may not be too concerned now since he just won election in May 2019 and is not due to stand again until 2022.

Morrison just committed AUD2 bln ($1.4 bln) over two years towards recovery and repairs. There has been some relief this past weekend as torrential rain was seen in parts of new South Wales. However, officials warned that temperatures would rise again this week and added that separate fires in the neighboring states of Victoria and New South Wales could meet to create an even larger one. The situation remains fluid, to put it mildly.

 

A BRIEF HISTORY LESSON

So-called Terra Australis first appeared on maps in the 15th century. Latin for Southern Land, its existence was initially imagined and not proven until much later. For instance, the Egyptian scholar Ptolemy posited back in the second century that the lands of the Northern Hemisphere were balanced by lands in the Southern Hemisphere.

The first European explorers are thought to have arrived in Australia in the early 1600s. The Dutch were amongst the first as they sought to expand their influence beyond their base in the Dutch East Indies (now Indonesia). These early Dutch explorers included Jansz, Hartog, and Nuyts. Tasman is considered to be the most important of this group, and his second expedition of 1644 led the Dutch to name this territory New Holland.

Further Dutch exploration was limited, and it was up to the British to further explore and colonize New Holland. The account of British explorer Dampier’s second expedition in 1699-1700 was so negative that the crown had little interest in further exploration for decades. It wasn’t until Captain Cook’s first voyage in 1768 that the British claimed the land as New South Wales. Cook’s two subsequent voyages in 1772 and 1776 were made to other areas in the Pacific and came as British interest in the region picked up.

The British crown decided to colonize New South Wales in 1786 and the process began in early 1788. As Home Secretary, Lord Sydney directed Arthur Phillip to take possession of the entire territory. The widely accepted view is that Britain wanted to relieve pressure on its crowded prisons, sending convicts to the new territory. Indeed, the government planned on developing the local economy using convict labor whilst allowing former convicts to subsist on their own small plots of land.

The first fleet arrived in Botany Bay in 1788, but poor soil and little water led the fleet to sail further north to Port Jackson. Sydney Cove was located deep within that port and grew to become the city of Sydney. Naval officer Flinders was appointed in 1801 to circumnavigate the continent. He established that it was a single landmass and also recommended that it be renamed Australia. This took effect in 1817.

 

ECONOMIC OUTLOOK

The economy remains sluggish. GDP growth is forecast by the IMF at 1.7% in 2019, picking up to 2.3% in 2020 and 2.6% in 2021. GDP growth was only 1.7% y/y in Q3 and 1.6% in Q2, which was the slowest since Q3 2009. Data so far in Q4 suggest further deceleration, with weakness likely to carry over into 2020 due to the impact of the ongoing wildfires. As such, we see downside risks to the growth forecasts. Another reason we are less constructive on Australian growth is that it’s very clear that China policymakers are still struggling to boost growth, as evidenced by the recent 50 bp cut in reserve requirements by the PBOC.

It’s worth noting that natural disasters typically depress economic activity near-term. However, this is usually followed by a strong bounce-back due to reconstruction efforts. November trade will be reported Thursday. Retail sales will be reported Friday and are expected to rise 0.4% m/m vs. a flat reading in October.

Price pressures remain low. CPI rose 1.7% y/y, up from the Q1 trough of 1.3% but still below the 2% target. Q4 CPI will be reported January 29 and consensus sees inflation remaining steady at 1.7% y/y. PPI rose 1.6% y/y in Q3, suggesting little in the way of pipeline price pressures. As such, there is nothing in the inflation picture to prevent further easing to shore up economic growth.

At the December 3 meeting, the Reserve Bank of Australia delivered a slightly hawkish hold. This came after it cut rates 25 bp in June, July, and October. At that meeting, Governor Lowe highlighted the impact of previous rate cuts on assets prices and household disposable income. The RBA added that global risks had “lessened recently.”

RBA next meets February 3 and is widely expected by analysts to cut rates 25 bp to 0.50%. Market pricing is not as confident, with WIRP suggesting nearly 60% odds of a cut then. But why wait? The economy was already sluggish and now the wildfires present another headwind to growth. We also expect the bank to signal that the door is open for further easing if needed. Most observers believe that the RBA can cut rates by 50 bp more to 0.25% before unconventional measures come into play.

The external accounts are deteriorating modestly. The current account deficit was an estimated -0.3% of GDP in 2019, and the IMF expects the deficit to widen to -1.7% in 2020. Australia’s Net International Investment Position (NIIP) is nearly -50% of GDP. While this is the lowest since 2014, it still represents a high degree of external vulnerability. With global risk sentiment worsening due to the Iran situation, countries like Australia are vulnerable to these sentiment swings.

 

PAST DISASTERS

There is no rhyme nor reason regarding FX moves after natural disasters. Let’s take a look at some recent examples. The last two (New Zealand and Chile) suggest that their currencies were driven more by the monetary policy response than any other factors. Furthermore, these examples show that after a short-term hit to growth, the economy later recovers robustly.

Japan: Typhoon Hagibis occurred from October 6-13, 2019. The yen initially weakened but has since been stuck in a narrow 108-110 range. BOJ did not ease policy in response. Instead, the government will push through a supplemental budget to help fund reconstruction. Q4 GDP data will be reported February 17. Consensus sees GDP contracting -2.6% SAAR vs. growth of 1.8% SAAR in Q3.

Japan: The Tohoku earthquake and ensuing tsunami occurred on March 11, 2011. The yen initially firmed, quickly reversed, but then continued firming through end-2011 before weakening over the course of 2012. BOJ did not ease policy in response. The economy was already contracting q/q in Q4 2010, but the disaster tacked on two more quarters of contraction.

New Zealand: The Christchurch earthquake occurred on February 22, 2011. Kiwi initially strengthened but then weakened over the next year as the RBNZ cut rates 50 bp to 2.5% in March 2011 and kept them there until March 2014. GDP growth did slow in Q1 2011 but subsequently accelerated over the course of 2011 and into 2012.

Chile: This earthquake occurred off the coast of central Chile on February 27, 2010. The peso initially weakened but then strengthened over the next year as it began a tightening cycle in June 2010. The central bank had already cut rates aggressively in 2009 and so did not ease policy in response. Growth in 2010 was distorted by the low 2009 base due to the Great Financial Crisis and so it’s impossible to discern the impact of the earthquake.

 

INVESTMENT OUTLOOK

AUD continues to underperform. In 2017, AUD was -10% and was the worst performing major currency. In 2018, AUD was -0.4% and ahead of only SEK (-5.5%), EUR (-2.2%), and NOK (-1.7%). AUD is down every day so far in 2020 and at -2.2%, it is once again the worst performing major.

After making a new multi-month high near .7030 last week, AUD has sold off sharply. It has retraced nearly two thirds of its December rally and broke below the 200-day moving average earlier today near .6900. AUD is currently testing the last major retracement objective from that rally near .6860 (62%) and a break below would set up a test of the November 29 low near 0.6755.

Australian equities continue to underperform. In 2018, MSCI Australia was -13.7% vs. -11.6% for MSCI DM. In 2019, MSCI Australia was up 19.2% vs. 25.8% for MSCI DM. So far this year, MSCI Australia is up 0.4% vs. 0.5% for MSCI DM. Our DM Equity Allocation Model has Australia at VERY OVERWEIGHT, and so we expect Australian equities to start outperforming more.

Australian bonds are outperforming. The yield on 10-year local currency government bonds is -16 bp YTD. This is behind only the best performer Norway (-21 bp). Over the past year, Australia is -105 bp and is behind only the best performers Greece (-297 bp), Italy (-152 bp), Portugal (-145 bp), Israel (-137 bp), and Spain (-110 bp). With inflation likely to remain low and the RBA likely to resume easing, we think Australia bonds will continue to outperform.  Our own sovereign ratings model shows Australia’s implied rating remained at AAA/Aaa/AAA.