Key Economic Stats

Summary Statistics

Cash rate remains at 1.5%
Economic growth for the calendar year 2017 was a positive surprise of 3.0%
Inflation remains below RBA target at 1.8%
Unemployment was at 5.4% with a 3.0% growth in employment
Wage growth moved off near nothings to 2.0%
Australia is the world’s largest exporter of Lithium and holds the fourth largest reserve. Lithium prices were up 29% in 2017. We really are the lucky country.

Unbridled optimism for 2018

Our nightly news feed is inundated with the latest natural disaster, mass shooting, threat of civil war or the latest Trump tweet. As a regular consumer of media, you might be mistaken for thinking the world is falling apart.

Yet, the global economy, technology revolution and continued improvement in global living conditions steadily marches on and improves.

This month, TIME magazine is being edited by Bill Gates and fittingly the theme is optimism. The developments outlined within Mr Gates’ introduction to the magazine are significant (full article available here):

“In 1990, more than a third of the global population lived in extreme poverty; today only about a tenth do. A century ago, it was legal to be gay in about 20 countries; today it’s legal in over 100 countries. Women are gaining political power and now make up more than a fifth of members of national parliaments—and the world is finally starting to listen when women speak up about sexual assault”.

And perhaps the most compelling measurement:

“Since 1990, that figure [of children who die before the age of 5] has been cut in half. That means 122 million children have been saved in a quarter-century, and countless families have been spared the heartbreak of losing a child”.

Closer to home (in Australia), dinner table conversations shift pessimistically between the ineptness of our political leaders, lack of direction of the economy or everyone’s favourite topic, outrageous property prices.

Yet, despite the general negativity regarding politics and the economy, 2017 proved to be a rather productive year on both fronts. We saw significant media reform, a new national energy policy, needs based education funding, financial services reform, one Royal Commission hand down findings into institutional response to child sexual assault, another Royal Commission announced into financial services, huge infrastructure spending programs and right at the death of 2017, marriage equality pass into law. These achievements, involving both sides of politics, are significant, especially amid ceaselessly negative media presentations.

Economic growth remained stable and resilient, markets (especially in the second half of 2017) were buoyant, and we just saw the largest volume of investment into the renewable energy sector in Australia’s history, something that may again be surpassed in 2018.

Annual renewable energy project commitments

We are optimistic about Australia’s economic future. Having successfully transitioned from a mining boom into a housing construction boom, we are presently amid another transition from housing construction investment to infrastructure and renewable energy investment.

Given how much we waxed lyrical about renewable energy only a few quarter’s back (see update here), we won’t get carried away this quarter, but remember this industry is still just taking off. Beyond renewable energy and infrastructure, the more distant future sees significant green shoots in the fledgling FinTech and space services industries. Whilst these new industries emerge, education, agriculture, mining and services sectors continue to remain strong.

Emerging and disruptive industries like renewables and space services are tough places for investors. It is challenging for the investor to take a winning position too early.

Emerging and disruptive industries however, are wonderful for consumers. New technologies democratise access to information, products and services globally.

I was lucky to be given Gail Kelly’s book “Live, Lead, Learn” at Christmas. It was a pleasantly surprising read. One of the many lessons I took from this book is that we can “choose to be positive” and “the powerful impact this has when you realise it’s a choice”.

We are choosing to be optimistic for the year ahead and also broadly for the longer term. The following two economic observations underpin our optimism.

Economic observations

Innovation and progress have their own inertia

The Incas, Mayans, the Roman Empire and countless royal families and have all come and gone. History is littered with grand civilisations that have since disappeared. In our optimism-tinted glasses, our current global society displays unique characteristics which might prevent it going the same way as past civilisations. Civilisations of history tended to centralise information and control, often by necessity and a lack of any other way to rule effectively.

Centralised control makes civilisations fragile. One small misstep at the pointy end can see a ruler or ruling class toppled. Autocracy has never survived (we are happy to be proven wrong). Even the British royal family have relied on cessation of control and authority to uphold their title.

Technology, free markets and globalisation shape the flow of information, knowledge and even how this information is controlled in wholly different and usually better ways than past civilisations. Scientific pursuit and productive investments are not exclusive to a ruling political class. These functions are in the domain of private enterprise, often supported by public institutions that themselves have a degree of autonomy to set their own agendas.

A Capitalist Society rewards innovation and productivity, and often in overly inequitable ways. This encourages the re-allocation of capital separate to the whims of a ruling class or authority. The autonomy of private capital is a hallmark of modern society which was not a function of previous autocratic civilisations.

If you are presently thinking that perhaps a Trump presidency somehow marks a step back towards an autocratic leadership, we see only positive reaffirmation of the success of modern society. Even though he an individual ill-equipped to be in such a powerful position, it is a timely example of the benefit of inertia of decentralised information and capital, and the loss of ‘old world’ control that sees progress continue to flourish.

An overlooked theme | The Pareto Principle 2.0

In 1906 Vilfredo Pareto, an Italian economist and renaissance man, was researching land holdings in Italy. Vilfredo discovered that 80% of the land was owned by 20% of the people. His research then explored wealth generation in broader Europe and saw similarly findings: 80% of the wealth and income was generated by 20% of people.

Vilfredo’s research then lay dormant for 40 years until an inquisitive Romanian-American named Joseph Juran stumbled across the findings and applied “Pareto’s principle of unequal distribution” to business. He popularised the wide spread acceptance of the 80/20 rule. It essentially states that 80% of a business’s success comes from 20% of a business’ actions. E.g. a small action, like a chocolate left on a pillow after hotel room service, has a disproportionate impact on customer satisfaction.

It became the hit thing to apply this thinking to everything. 80% of problems are associated with 20% of services – 80% of innovation come from 20% of staff etc. etc.

We believe the 80/20 rule is becoming even more acute due to the impact of technology and globalisation:

Technology commoditises services and products. Automating a business’ process increases efficiency, whilst also reducing variances in outcomes for consumers and clients. A homogenised consumer experience magnifies the importance of smaller differences in services/products. (e.g. Just look how similar all smartphones are. Or, ever noticed that most business websites have near identical layouts?)
Globalisation places businesses in a competition pressure cooker. Innovation, which once created barriers to competition, is quickly shared, copied, adopted and improved. In a global market there is little respect for geographic specific regulatory protections or laws. Sometimes the only difference in a product is a brand logo, colour or placement of a button. (Uber didn’t bother abiding by laws; Chinese car, phone and technology manufacturers have no issue stealing intellectual property; clothing nearly all comes out of a handful of countries with little to differentiate between quality).

Pareto’s principle has interesting connotations for investors and consumers. When only small or nuanced aspects of a business have significant benefits, the greatest beneficiary is the consumer. Businesses bend over backwards to go the extra mile, as successful businesses provide the very best customer service. They know it’s the little things that make all the difference.

As investors, there are some particularly interesting outcomes of this heightened Pareto effect. Customer service is more important than ever before, whilst at the same time the next generations (Gen Y and millennials) expect things fast and nearly free. To deliver on either effectively, a business needs to operate on an incredibly large scale to meet consumer expectations and/or deliver exceptional personalised service. Mid-tier businesses that are not personalised enough to be unique or large enough to operate the economies of scale to meet customer expectations may become takeover targets, reinvent themselves or steadily disappear.

Curious Industry Trends to gain momentum in 2018

Gene therapy – In past newsletters we’ve discussed the application of CRISPR technology in the process of immune engineering to tackle specific cancers. CRISPR allows scientists to cut and re-connect a genome essentially allowing the editing of individual genomes. It is not a medical panacea as the applications are predominately limited to disease associated with innate genetic mutations, as opposed to environmental caused disease.

Gene mapping – The price of DNA mapping continues to drop. Data banks of DNA are beginning to proliferate with early adopters like the Melbourne Children’s hospital mapping the full DNA of most newborns. The collection of data expedites genetic research and will likely have a variety of other interesting applications. We see genetic testing becoming more common place in life insurance risk mapping and potentially even as part of employment applications.

The emergence of the darknet – With increases in privacy concerns, a growing ecosystem of legitimate businesses now operate on the TOR browser network. The darknet allows anonymous internet browsing, protects data and user information from internet service providers, as well our data hungry Google and Facebook overlords. With a history of illegal participation, the darknets growing social awareness and legal participation will begin to enter the mainstream in 2018. Browser innovations like “google incognito” have to date failed to meet privacy needs of users and businesses. – more info on the darknet here

The changing nature of smartphones – Digital assistants augment how we interact with the digital world. Currently, the go-to for any question is to quickly key it into Google. The growth of at home digital assistants and voice activated phones means we will stop typing and start having conversations. Screens may too become old fashioned as visual stimuli move to a more seamless overlay of the world around us (augmented reality). Note, we don’t think this will happen in 2018, but we are hopeful to see the first viable alternatives emerge.

Investment Views

Equities

Interest rates rising will be a key factor for 2018. If they rise quickly we will see all positive momentum fall out of equity markets. The worst case scenario would be an interest rate rise sharp enough that it triggered a sharp fall in property prices. This would see bank stock lose value, dragging down the Australian market. We hope the tougher lending rules introduced in 2017 and a responsible RBA avoid this scenario arising.

The rate of change in markets and businesses means that what worked well for investors between 1990-2007, i.e. buying and holding stocks, is far less effective in 2018. We see a mixed year ahead for equities. Businesses not re-investing in their service or products can expect to face tougher operating conditions from the fast-changing business environment. It is not enough to play catch-up either as building a culture of innovation takes time.

The good news for investors is that markets often see significant investment in R&D unfavourably. Where some investors see a large expense dragging on returns, we see reinvestment that future proofs a product or services income stream. We even know of fund managers that won’t considering making an investment in a business if their payout ratio >50%! – A payout ratio is the proportion of earnings paid out as profit (as opposed to being retained or reinvested).

Bank shares remain a terrific source of tax effective income (for Australian investors)… However any material exposure to these businesses comes at the risk of fast paced disruption. Businesses like PayPal, Alphabet (Google), Apple, Amazon, Microsoft and even Facebook might not seem like traditional competition to banks, but their expertise in data and ready access to a global network of consumers makes them dangerous adversaries. Being a little late to the game on investing in some of these businesses is better than missing out altogether.

One of the slogans that stuck with me from 2017 was “Go global for growth, stay local for income” – Charlie Aitken (Global fund manager at AIM).

Property

In late 2016 David Murray stated that the Australian “economy is vulnerable because there is a bubble in the housing market. All the signs of a bubble are there. Many of the signs are the same as the Dutch tulip [mania].”

2017 proved to be a year of action for banks and regulators, introducing tougher lending standards and applying macro-prudential intervention. Regulatory bodies have signalled they are happy to act further to prevent any substantial credit fuelled property growth.

As booming house prices, predominantly in Melbourne and Sydney, was really a credit boom bought on by cheap money (low interest rates), key to projecting what will happen with property is understanding what capacity there is for further household credit growth (demand) and the supply of new property.

The following data is from the RBAs data release in Jan 2018:

Housing approvals have come off their lofty peaks attained in 2016 but remain near record levels. This means there remains a very strong pipeline of property making its way into the market, particularly in apartments – strong supply exists in on property sector.

Private dwelling investment has reversed its five-year growth trend, reducing in 2017 – slowing demand
There was no growth in disposable household income in 2017 – no new demand capacity.
Underlying inflation rose to near 2%. Being at the bottom end of the RBAs target band meaning there is minimal scope to increase cash rates. However, macro-prudential tightening (forcing banks to tighten lending) has increased the spread between the RBA cash rate and household loan rates, essentially creating a pseudo rise in interest rates – demand weakness.

Housing loan approvals have gone a little backwards in 2017, but remains strong. This is yet to flow through to house price and household debt to income ratios – mixed signals.

There are some competing data points, but the balance of supply and demand data hints at a flat-lining property sector for the medium term. Huge volumes of debt have left Australia with a significant debt hangover. There may even be some retractions if apartment oversupply materialises in specific markets. Property remains highly sensitive to any change in interest rates. As future capacity to grow household credit appears limited, it is hard to see where housing price growth would come from.