Dependent Australia isn’t so Safe
Jonathan Shapiro - Commonwealth Bank
Australia is a safe haven? You’re having a laugh. That’s the sentiment of London-based bond fund manager Andy Seaman, who has been in Sydney talking to local investors about his Wealthy Nations fund – which has delivered 30 per cent returns since inception in September 2009, almost double those of the JPMorgan Global Aggregate bond index.
The API Capital Wealthy Nations fund has based its investment thesis on a very simple concept: lend money to those that don’t need it.
The measure Stratton Street Capital uses to determine the wealth of a nation is not debt to gross domestic product but net foreign assets to GDP, or the extent to which a country relies on foreign capital for financing.
At negative 81 per cent, Australia isn’t even close to clearing that basic hurdle, categorically screening any sovereign or corporate bonds from Down Under out of the Wealthy Nations’ portfolio. Australia has run a current account deficit for 30 years and is now at its widest level since early 2010, demonstrating its need for foreign funds.
Seaman pays close attention to investment-grade countries with liabilities that are close to or above 100 per cent of GDP – which has helped it avoid downgrade disasters such as Iceland, Portugal and Greece in the past three years.
At present, there are five investment-grade countries with liabilities close to their levels of GDP that are on his watch list, including Spain and Australia. The comparison to Spain has been made frequently by Standard & Poor’s Financial Services sovereign analyst Kyran Curry, to much derision. But there is no denying the persuasion that it’s safer to lend to those borrowing to help their economies grow than to those borrowing to pay the bills. Arguably, the world’s most successful hedge fund investor, Ray Dalio of $US100 billion behemoth Bridgewater Associates, also creates an investing framework by dividing the world into debtor and creditor nations.
It must be pointed out that Australia has been the one sour note in otherwise stellar picks by Stratton Street’s currency hedge fund. The Australian dollar has gained in value in spite of Australia’s debtor status.
The big question is whether the Australian dollar’s strength is sustainable, or whether it’s a matter of time before the fundamentals force foreign funds to take flight.
Seaman stumbled on the idea to lend based on net foreign assets in the mid-1990s while conducting research about the fair value of currencies and deduced that in a bull market, funds will flow from creditors to debtors as money chases higher returns, but in a deleveraging world, the reverse occurs as capital drains back to creditors.
That’s led him to favour bonds of the national energy company of Abu Dhabi at a 15 per cent discount to bonds of Indonesia and British retailer Tesco.
Japan is another interesting case to test the thesis. The country’s debt-to-GDP position is nothing short of diabolical at almost 250 per cent of GDP, leading prominant hedge funds such as Hayman Capital Management to revive the ever fruitless “widow-maker” trade to short Japan’s bonds.
“Bonkers!” says Seaman. On a net foreign assets measure, Japan measures a healthy 62 per cent of GDP, meaning it has plenty of funds offshore.
As for Australia, the analysis is food for thought. So far, the large reliance on foreign capital has been negated by prolonged periods of economic growth, but we are still a creditor nation. With such a large portion of the liabilities residing in the private sector through the banks, Australia’s public debt has to be kept at a minimum to appease the rating agencies. But any sign of weakness leaves both the AAA sovereign rating and the AA rating of banks, a function of the sovereign rating, at risk.
The coming year should provide the true test to the safe haven status of Australia as it faces the difficult adjustment to the post-mining-boom future. While we may be an anomaly, the reality remains that we are far more vulnerable than we’d like to believe.