While this is not strictly about infrastructure, it is the end of the year and that usually brings out a range of prediction pieces. This article takes a slightly different approach on this theme. Prediction is hard – and in the words of Yogi Berra (or according to some sources Neils Bohr) – especially when it’s about the future. So rather than try and predict what will happen next year – I wanted to write about the 2019 events or factors that I wish I knew today. That is, what has the potential to be a pivotal driver of financial markets and, hence, investment returns in 2019?
To try keep it simple, I think there are three:
US wage growth
China has been trying to manage a transition from a fixed asset investment/debt fuelled economic model to something more sustainable. This has necessitated a delicate balance between tightening credit growth while at the same time trying to maintain overall economic growth, as well as manage their fixed capital account/currency. This would be a difficult challenge for policy makers at the best to times (history suggests most credit booms end in big busts – rather than gentle slow downs), but the Trump inspired trade war with the US adds a significant additional challenge.
How this works out is very difficult to predict – but is hugely important for investors – particularly Australian investors. China has accounted for a disproportionate share of our economic growth over the last decade. Its seemly insatiable appetite for raw materials has underpinned Australia’s exports. Its citizen’s desire for offshore real estate has even probably had a meaningful impact on Australian house prices.
A downturn in China would have global implications and Australia is squarely in the line of fire. Against this, it is important to remember that Chinese policy makers will not sit idle in the face of a downturn. The GFC era stimulus package – and resulting construction boom – was a perverse saving grace for Australia through the GFC. That said, China’s starting position, particularly in terms of leverage, is very different now and this may constrain (or change) the nature of the policy response.
All in all, I don’t know what will happen, but I do know that it will be important. The accuracy of Chinese data adds a further challenge for investors – perhaps this means the exchange rate (and potentially Chinese stock prices) are more useful real-time indicators.
US Wage Growth
One of the mysteries of the last few years is that the seemly strong recovery in employment in the US hasn’t translated to a meaningful pickup in wage growth. Perhaps this is an impact of globalisation. Perhaps it is the doubly lagging nature of wages. That is, employment growth lags GDP growth, and then wage growth lags that.
Either way, wage growth is very important. Strong wage growth would increase inflation expectations and put pressure on the Fed to keep marching up interest rates. Higher rates would put pressure on already stretched equity market valuations and are particularly important to infrastructure investors. Higher wages would also erode profit margins – which have been unusually high. A constrained Fed would have less flexibility to respond to weakness in financial markets with easing (that is, goodbye to the Greenspan/Bernanke/Yellen put). Higher US rates would be likely to be associated with a higher US dollar, and its associated funding pressures on emerging markets.
Higher US wages and the resulting pressure on interest rates could significantly change traditional equity/bond correlations. Investors’ portfolios are designed on the assumption that falling bond yields (rising bond prices) would cushion the blow of equity market weakness, in an environment of accelerating inflation and constrained central banks, this fundamental portfolio construction assumption could break down.
Now for something closer to home (no pun intended). Australian house prices are elevated on any measure, and affordability is a real problem. Modest falls and, in particular, wages growing materially faster than house prices is clearly a good thing.
However, housing is the largest single component of household wealth. Lending against housing represents $1.7 trillion of assets on bank balance sheets (circa two thirds of all lending or alternatively roughly five times the big four banks equity market captialisation). A transition from a modest slowdown to a serious housing slump (say the difference between a 5% national fall and a 10-20% fall) would have severe implications for economic growth (construction – all sectors – is ~8% of GDP), government finances and the health of Australia’s banking system.
We have already had an approximately 5% fall over 2018 (and closer to 10% in Sydney and Melbourne) a key question for Australian investors is whether this moderates or accelerates in 2019?
2019 has all the hallmarks of being a pivotal year. Who knows what the new year will bring – but these are three things I will be watching closely as the year unfolds.