Australian stocks for the long-run: validating the Pitchford thesis

Plus, US February non-farm payrolls

The Credit Suisse Global Investment Returns Yearbook 2023 once again confirms that Australian equities have outperformed global equity markets since 1900. The US comes in second place. Australian equities are also less volatile than their US peers, so the outperformance holds on a risk-adjusted basis.

This outperformance reflects a higher equity risk premium than the US, although Japan’s equity risk premium is higher than Australia’s on the CS measure, no doubt a product of very low bond yields. Japanese stocks are historically more volatile than Australian or US stocks.

RBA research using hand collected historical data suggests the Australian equity risk premium may in fact be a little lower than previously thought and lower than the US. But the RBA still found total returns on Australian stocks in line with those in the US.

The long-run performance of Australian equities makes a case for some home bias in the equity portfolios of Australian investors. You can obtain a long-run return similar to that on global equities with a domestic portfolio, without the additional costs sometimes associated with holding offshore equities, although these costs have come down significantly over time. The usual arguments for diversification still hold though. Australia could be hit by a country-specific negative shock.

As Joey Politano highlighted in a recent post, the Australian economy has outperformed its peers in recent decades, so there is a fundamental basis to the outperformance of Australia’s equity market, although over the longer-run, the relative performance of the Australian economy is more mixed. Prior to the 2001 recession in the US, there was a long-run equilibrium relationship between the Australian and US economies. Together with a high level of capital market integration, it is not surprising to see a similar long-run equity market performance.

In the late 19^th century, Australia enjoyed the world’s highest living standards, with real wages around twice the level of the United States (don’t tell Noah Smith). But the 1891 Depression and the inward turn at the time of Federation in 1901 led to decades of underperformance that was only turned around with the re-internationalisation of the economy in the 1980s and 1990s, recovering some of the economic openness that drove the prosperity seen in the late 19^th century. As I showed in this report, there is mixed statistical evidence for long-run convergence between Australian and US living standards and productivity.

Australia scores well on measures of institutional quality, not least on economic freedom, and benefits from relatively secure property rights and the rule of law. Australia scores modestly higher than the United States on the Fraser Institute’s measure of economc freedom. Australia’s outperformance of the Canadian economy was coincident with a sharp narrowing in the economic freedom differential in Australia’s favour. Australia seems to have captured more of the productivity gains from past economic reforms than Canada or New Zealand, despite implementing similar reforms.

It was superior labour productivity that underpinned Australia’s position on the global frontier of living standards in the 19^th century. While this is often atrributed to its resource endowment, that endowment means little unless it can be efficiently extracted and delivered into world markets. Australia’s mining sector is highly capital intensive and the technology now used in mining would shame many in what we think of as the tech sector. Australia is consequently at or near the bottom of the global cost curve for many of the commodities it exports.

Ironically, it is Australians rather than foreigners who have most lamented the economy’s supposed dependence on resources, despite it being a small share of total output. The desire to diversify Australia’s export industries away from resources has been a recurring theme in Australian public policy debates, but comparative advantage has invariably won out over this impulse.

Validating the Pitchford thesis

The long-run outperformance of Australian equities can be viewed as validating the Pitchford thesis, which maintains that Australia’s historical current account deficit and associated foreign capital inflows reflect the strength of domestic investment opportunities relative to those found abroad and therefore is not a problem from a macroeconomic or public policy standpoint. There have been only 24 years between 1861 and 2018 in which Australia ran a current account surplus.

However, Australia has been exporting capital on net over the last three years, even before the onset of the pandemic. Australia recorded another big current account surplus in the final quarter of 2022 equal to 2.3% of GDP, the largest since Q3 2021. The modest deficit previously recorded in Q3 was revised to a modest surplus of 0.1% of GDP due to a combination of updated data and the annual seasonal reanalysis. Looking at the financial account, Australia exported a net $9.9 billion in capital in Q4 and $22 billion over the year.

The net direct investment numbers are particularly grim.