Rumble Down Under: Australia will soon face reality.

Raging bushfires ripped across southern Australia, soon matched with heavy rain and tornadoes. The extreme weather events of January were as heated as the political turmoil that will place the country on a shaky path full of uncertainty. Australian summers are always a bit wild, and its politics follow the same type of disorientation. The long campaign season leading up to the September election is likely to steer conversation away from critical economic matters for the sake of a popular agenda that is common on all sides of the political spectrum. Like the US, Australia will face long-term fiscal problems and will lack the right leadership necessary to grow an economy that's actually in a better condition than most. This has some near term market implications which will hopefully be a signal for responsible leadership.

 Political Uncertainty

The political turmoil began in the summer of 2010 when then Deputy PM Julia Gillard was elected unopposed as Prime Minister after the former PM Kevin Rudd lost the support of his party and resigned. Despite weathering the global economic storm of 2008 by avoiding a negative hit to GDP, Rudd's controversial policies regarding climate change and a mining tax were largely opposed by both opposition and members of his own Labor party. At this point, it was assumed that Gillard's administration was better able to correct those unpopular moves and get the job done. In the words of her right hand man Treasury Secretary Wayne Swan: returning to a budget surplus will be done "come hell or high water."

The Labor party is riddled with failed promises after implementing a complex mining tax and a continuous budget deficit. Much of this has been blamed on the high value of the Aussie dollar and external pressures on commodity prices which weighs on mining activity. Tax revenue is on the decline, but there has been little effort to get a handle on spending. PM Gillard has called an election for September 14th in order to allow more time for a healthy political debate. In what will mark the longest campaign session in Australian history, this leads many to believe that the real reason is for the Gillard administration to show economic proof in hopes of a better turnaround. While no one expects a budget surplus in time for the election, there are some hopes for a pick-up in economic activity abroad during the latter part of this year which can have a positive effect on Australian output. So far, voters are not buying it.

As the Labor party looks more unstable, polls are showing a greater preference for the current opposition leader Tony Abbott. The polls are a blow to Gillard and shows that there is a growing mistrust for the Labor party on key issues such as the mining tax, immigration policy, and the economy. Rudd is more popular than Gillard, and there is some speculation that he might be drafted to lead the party despite his expressed lack of interest to do so. Throughout all of this political turmoil, the market response has been largely muted; guidance has been provided from a mix of risk appetite and the slump in commodity prices. However, the market is not quick to lay its hand off the economic pulse.

Economic Risk

It's clear that Labor hasn't held up to its promise. The Australian economy is largely held up thanks to the limited downside during the 2008 crisis under Rudd's leadership. Housing prices are still high and haven't seen a significant correction yet. Structural issues are evident and unemployment is still elevated for the nation.

The more pressing issue that will likely stem out for a long time is the looming budget crisis. Treasury Secretary Swan revealed a collapse in tax revenues of nearly $4bn mainly due to a slowdown in mining activity. Swan stated that the government will need to raise revenue and cut expenses, but spending cuts are essentially part of an austerity agenda. "Delivering another deficit is driven by Gillard government's core values about jobs or working Australians" said Swan. The RBA has already taken measures to offset future austerity measures by cutting its official cash rate.

Hopes for a pick-up in mining activity are complicated. The latest mega-project Origin Energy's Australia Pacific LNG project amounts to a whopping $2bn development budget while also freeing up expenses by slashing 850 jobs. The fact of the matter is that costs are building up and there is a capital strike. Similar to the US, Australian shareholders are demanding dividend income. Shell's plans are on hold for its Gorgon LNG project in hopes of getting a hold on higher capex expectations. A Dec FT article warns:

"If these issues are not addressed then new investment in Australia’s LNG industry could dry up in 2017, warn industry executives and analysts, and new suppliers based in Canada, east Africa and the US will move to capture a lucrative prize: 90m tonnes of annual uncontracted Asian LNG demand. 

Australia is poised to overtake Qatar as the world’s biggest LNG exporter as seven colossal projects reach full capacity over the next five years. But the industry is also facing serious headwinds as a consequence of its rapid growth. A second wave of developments and project extensions, worth an estimated A$150bn, is at risk from rising labour costs, infrastructure bottlenecks and the strong Australian dollar." 

Tony Abbott has a plan to boost productivity by way of a major infrastructure-spending boom if elected in September. This is not the way to go as the government will just break even with a return through tax revenue. It will just swell the deficit to another low level with no long term objective of fostering sustainable business activity. But Gillard has no star plan of her own and will likely keep some form of the mining tax with no efforts to offset lower revenue with spending cuts. Australia cannot continue to rely on the sways of its offshore trading partners to dictate economic conditions at home.

The economy is still relatively stable despite these looming fiscal troubles. The recent lift in consumer sentiment could indicate more breathing room for the RBA. The rise in share prices is also welcomed. However, lower commodity prices and concern that risk taking has gotten too far could stall significant  growth. Consumers are still cautious about taking on more debt despite the pick-up in household wealth. Consumer spending and unemployment expectations have leveled out. Australian households are cautious about job prospects which is keeping the consumer on the sidelines - and businesses are taking note as well by holding onto cash.

More room for an Aussie decline, but expect a bumpy road

AUD/USD is trading along a declining channel, with a recent slump attributed to a Reuters report on chatter in global markets that a hedge fund had been liquidating positions in commodities. RBA members have also expressed concern about the effects of a high AUD. These concerns were actually brought up at the start of this year when AUD/USD traded around 1.0590, and has since declined off those levels. Concerns about an overvalued currency are also seen in New Zealand where RBNZ Gov Wheeler stated that the NZD is still too high and that the RBNZ is ready to intervene if necessary despite some signs of a stronger than expected economic rebound.

The recent decline in AUD/USD is also correlated to lower risk appetite following the latest FOMC Minutes which suggests some unease among Fed members about a scale-back in asset purchases.

Moments ago, AUD/USD was given a boost after RBA Gov Stevens expressed confidence in the current level of interest rates. He went on to state that the high AUD/USD was weighing on the economy which inspired the previous rate cuts. However, Stevens did reiterate that rate cuts are more likely than increases. The recent lift in AUD/USD might be the result of over reaction from the markets given the lower outlook by the RBA. The central bank lowered its growth and inflation forecasts and pointed to concerns that mining investment could reach a crest this year. Lower hiring demand from resource companies could also lead to a softer labor market. Additionally, the strength of the Aussie is being watched for indications of higher inflation.

The lengthy political debate and fiscal issues deserve great attention. Investors should keep an eye on Australia especially given the recent evidence of declining money flows. FT Alphaville published an insightful article which cites data from the Japanese Ministry of Finance showing that Japanese investors were selling Aussie assets at an increasing rate. Japan holds about 20% of Australia's national sovereign debt, according to FT.