The argument for paring back your exposure to Australian equities is building momentum as the risks rise. Just lately, professional investors have been seen to lift their exposure to Aussie and international real estate investment trusts (AREITS), unhedged international shares, fixed interest and cash. While no one is dumping Aussie equities – there is still plenty of opportunity on the Aussie bourse - portfolio reshuffles are currently taking place as the fundamentals shift.

But what about China?

There’s no denying the fact that China is an important market for Australian resources, and the growth rates of the world’s second largest economy directly affect our growth rates at home. China is anticipated to grow by almost 9% in 2012, which bodes well for Australia. Debt dramas in Europe and the US can continue to play out while China booms. Over half of Australia’s exports go to Asia, and a much smaller amount head to the US and Europe. Indeed, Australia has the benefit of factor X, and that’s China.

But it’s not Europe, or the US, or China that professional investors are worried about. It’s Australia.

Listed companies are starting to complain about poor sales; investors are pessimistic about the future; consumers are tightening the purse strings. The decade long boom in Australia that boosted earnings of Australian listed companies, across retail, banking and broad industrial stocks, were built on rising home equity courtesy of the property boom and loose credit standards. Aussies borrowed and borrowed some more, and the aspiring consumer renovated houses, bought luxury cars and fashion. As such the share prices of the companies selling such goodies soared.

Not so now. Retail sales fell by 0.1% in June, the second consecutive month, following a 0.6% fall in May. Retail spending rose a miserable 2.6% for the 2010-11 financial year, which is the worst annual growth in 50 years. David Jones experienced its worst mid-year sales in 20 years. To top it off, Australians are becoming increasingly comfortable purchasing online, and particularly from overseas websites offering bargains that are cheaper still when snapped up with the highly valued Australian dollar. Struggling retailers have resorted to heavy discounting, which is a short-term fix and can be detrimental over the long run as consumers begin to expect, and wait for, discounted periods. Margins are shrinking and inventories are rising. There’s no bright spot for retail on the road ahead.

The high Australian dollar is continuing to reap havoc on the earnings of exporters. Companies like paper merchant Paperlinx are racking up losses as the pricey Australian dollar slaughters their international competitiveness. Paperlinx faces the added blow of being exposed to faltering markets in Europe, the United Kingdom and the US. Australian miners are also vulnerable as the high Australian dollar eats away at their earnings year after year. If commodity prices sail lower, then miners could start to feel the heat – regardless of the demand from China, or India for that matter.

Much bad news and risk has already been factored into international sharemarkets, but not so Australia, which means that international shares could be regarded as cheaper than shares at home.

Now earnings season is upon us and listed companies are going to show us how tough it has been, or how tough it’s going to get. Earnings downgrades will be common across the board following a year of natural disasters and sluggish consumer and business spending. Cyclical stocks, that rise and fall with the pace of economic growth, will be most vulnerable to earnings shortfalls, while defensive stocks across consumer staples, transport and healthcare will probably be the winners of the day. Many brokers are pinpointing stocks like Wesfarmers, Woolworths or Metcash as safer bets in this environment. Deutsche just upgraded toll road investor Transurban to a Buy.

That isn’t to say that no stock in Australia will go up this coming year, or that no listed Aussie companies are in strong financial health.  Gold miners are benefiting enormously from the soaring price of gold as risk-adverse investors around the globe hide their wealth in what feels like the only safe-haven left. Gold miners are on broker buy lists, such as mid cap gold miner Alacer Gold - recently upgraded by UBS to a Buy rating. Coal miners, too, are popular bets with brokers, such as Gloucester Coal which Merrill Lynch lists as a Buy.

Aussie banks, too, are posting enormous profits on a decade of Government policies geared to their ongoing wealth. Mining goliaths like Rio Tinto and BHP will continue to take centre stage based on a bullish outlook for iron ore.

And then there’s China.

Treasurer Wayne Swan is betting the house on China, and so far he has been right. But the more we rely on the fortunes of one country, the greater our investment risk becomes. Any demand shock from China would put Australia into a tailspin and Aussie equities would be hit across the board.

By diversifying into more defensive Aussie stocks, and into other asset classes not affected by a possible fallout in Asia such as AREITs and international stocks, Australian investors would be largely spared the drama.

TheBull is certainly not calling it the end of the day for China. It’s just that the risk for being totally exposed to Australian stocks is building.

>>Back to the newsletter to view other articles - August 13th 2011