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Welcome to Thunderdome

Your summer vacation is over which means your lazy portfolio has been kicked off the beach along with the few remaining drunk tourists. Get sober, buckle up and get ready to enter Thunderdome!

If you don’t know what Thunderdome is, then think of it as a much more brutal version of the UFC Octagon except in UFC opponents use protective gloves and mouth guards and in Thunderdome, they use chainsaws and other weapons. Mad Max Beyond Thunderdome was the third sequel in the Mad Max science fiction series, starring Mel Gibson. The movie shows a dystopian version of Australia where lawlessness and violence are a way of life.

Australia hasn’t had a recession in over 25 years so it seems a far stretch to imagine the land down under as anything less than idyllic. During this period of calm Australia has quietly built up one of the largest asset bubbles in the world.

Take a look at the chart below showing Australia’s housing index since 2001 (blue line). You can see that it peaked between 2017-2018 but as early as 2013 the Australian dollar had peaked vs the U.S. dollar and Japanese yen.

One of the key drivers supporting Australia’s currency and thus the entire market was the inflow of foreign capital looking for positive yields in stable countries. Traditionally Australia has always paid investors an attractive yield above most other developed market currencies. In fact, the last time Australia paid a yield less than the U.S. was very briefly in 1997-1998.

Over the last 20 years, Australia’s economy has become more correlated to China’s. If China catches the flu then Australia catches ebola. In Q4 of 2018 when global markets sold off, Australia’s central bank reacted and lowered rates. The last time they went on such a rate lowering binge was in the early ’90s, which coincidentally was the last time Australia did have an actual recession.

With rates now below the U.S. and the trade war between the U.S. and China far from resolved, Australia is highly vulnerable to a sharp sell-off in their equity markets. Banks in particular in Australia will be exposed to the coming collapse in real estate prices. Additionally, FX carry traders, those that borrow in a low yielding currency and invest in a higher one, face the risk of an epic unwind if the world continues to slow down as we believe that it will.

Japan’s currency has been the most popular currency in the world to borrow because of Japan’s historically low-interest rates and Australia’s currency has been one of the favored recipients of these flows. To watch the yen rise for the last five years versus the Australian dollar suggests that we are reaching not just a cyclical tipping point for Australia’s markets but rather a secular one. If our thesis is correct then Australia will find itself in a Thunderdome-like battle to attract capital. But fear not because if Mel Gibson can survive then so can you.