According to a mid-December report by the Australian Financial Review, the Australian Prudential Regulation Authority’s (APRA) worst-case scenario for the aftermath of a Europe-driven credit crunch envisions 12 percent unemployment, a 30 percent decline in home prices and a 40 percent decline in commercial property values.

It might go without saying that such circumstances and the decline they represent for the Lucky Country suggest a broader calamity for the world at large, a breakup of the European Union and war over the Strait of Hormuz followed by another contested US presidential election. Of course none of these is likely to happen, let alone all three at the same time.

That won’t stop each basic issue on its own–European sovereign credit, geopolitical tension over Iran, its oil and economic sanctions, jockeying by American politicians ahead of the 2012 vote–from causing a disturbance or two over the course of the year.

There can be primary impacts as events related to these issues turn. For example international term funding is likely to become more expensive for Australia’s Big Four banks as a result of tension on the Continent. Overreaction to this financial system stress is likely, however, to result in opportunities for investors to establish positions in high-quality businesses at attractive prices.

Stepping back from the apocalypse, it appears the latest US economic indicators have taken a favorable turn. A variety of data, for example, suggest an improving labor market. Critically, new claims for unemployment insurance continue to decline. On Jan. 6 the US Dept of Labor Bureau of Labor Statistics (BLS) reported that seasonally adjusted nonfarm payroll employment increased by 200,000 in December, bringing the average monthly gain for 2011 to 136,000. The December strength was confirmed by estimates of an increase of 176,000 jobs reported by the separate BLS survey of households and 325,000 according to ADP’s direct payroll calculations.

This is not to say all is well. We’d need 30 more months just like December to get the number of workers on nonfarm payrolls back up to where it was in January 2008, let alone to catch up with population growth over what by then would have been six and a half years. Nevertheless, every little bit counts.

The PMI based on the ISM survey of manufacturers rose to 53.9 in December. A value above 50 indicates overall economic expansion. The December reading is the best in the second half of 2011 and slightly above the long-term historical average of 52.7. And because the “jagged and sluggish” them still prevails, you want to see better than that given how much below capacity we’ve been. And auto sales also continue at levels well above the recession lows but well below what we used to consider normal.

There are legitimate reasons for concern. One is that we’ll endure a repeat of last summer’s US budget fiasco. Another is that tension among the US, China and Iran stemming from enforcement of economic sanctions designed to discourage Iran’s nuclear program degenerates into a destabilizing conflict.

The financial situation in Europe boils down to borrowing costs, movements in interest rates and whether/whose budget deficits are likely unsustainable. Spreads between three-month and overnight interbank euro borrowing rates remain elevated, another indicator that concerns about the soundness of European banks haven’t gone away.

The rocky US economic recovery continues, but one step of progress in Europe seems to be followed by one and a half back. Right now the political system–including fiscal as well as monetary authorities–are stuck in a rut that seems to mandate reactions to improving economic news that will ultimately frustrate continued improvement. Perhaps 2012 will resolve this tension.

In the meantime we’ll stick with high-quality businesses that build wealth by growing dividends.

In Focus

This month we take a close look at Threats from Abroad: European Sovereign Debt, Australia and the Big Four Banks.

Australia’s globally respected financial system is rooted in four solid banks. These banks are rooted in domestic deposits, which will likely provide their base layer of insulation against the threat a European meltdown represents to their long-term well-being.

Australian consumers aren’t spending money on fancy new clothes, but they are using essential services, including saving money at big banks such as our favorite of the big Four, Australia & New Zealand Banking Group Ltd (ASX: ANZ, OTC: ANEWF, ADR: ANZBY).

Sector Spotlight

Rio Tinto Ltd (ASX: RIO, NYSE: RIO) has grown earnings at a double-digit rate over the past five years and raised its dividend an average of 5.7 percent. Yet the stock is basically flat over that same time frame, following a 28.6 percent decline in US dollar terms in 2011.

One of the world’s biggest miners is poised for a share-market recovery this year, even as it continues to hum along operationally.

Oil & Gas

Oil Search Ltd (ASX: OSH, OTC: OISHF, ADR: OISHY) is a pure-play on liquefied natural gas (LNG) demand in emerging Asia. A major project with Super Oil ExxonMobil (NYSE: XOM) and Australian giant Santos Ltd (ASX: STO, OTC: STOSF) will provide the foundation for sustainable dividend growth.

Oil Search boasts a net cash position and a strong balance sheet, solid armor as questions are starting to pup up about the ability of companies to bring major LNG projects in on time and on budget in and around Australia. And there are also questions about whether there be enough demand for all this LNG.

Oil Search has compelling answers.

Portfolio Update

For Americans, investing in Australia at this moment in time takes a lot of effort. As the performance of our Great Eight since AE’s Sept. 26, 2011, debut suggests, there’s plenty of payoff at the end of the day.

Here are the basics on how to buy Australia and updates on existing Portfolio Holdings.

News & Notes

Australia via Germany: Several stocks under AE How They Rate coverage, including specialist driller Ausdrill Ltd (ASX: ASL, Germany: FWG), contract mining services provider MACA Ltd (ASX: MLD, Germany: MKM) and earthmoving equipment outfit Emeco Holdings Ltd (ASX: EHL, Germany: E3A), all three of them buy-rated, are listed in Australia as well as in Germany.

This is significant for AE readers who have accounts with brokerage firms that provide direct access to Canada, the UK, Canada, the UK, Japan, France, Hong Kong and Germany but not Australia, such as E*Trade. You’ll pay extra to trade on the foreign exchange, but these stocks don’t trade on the US over-the-counter (OTC) market.

More Analysis: Bloomberg’s system of standardizing recommendation language across brokerage houses and borders provides an interesting way of tracking sentiment among an important group of market participants. As we’ve learned by engaging in a similar exercise in AE’s sister letter Canadian Edge, the analyst community is conservative and moves pretty much as a group. Their focus, as a rule, is on capital appreciation, with price targets a close second to the straight-up action advice on the priority list.

In addition to MACA Ltd (ASX: MLD, Germany: MKM) one other AE Basic Materials company posted a perfect buy-hold-sell line, new Aggressive Portfolio addition Rio Tinto Ltd (ASX: RIO, NYSE: RIO).

Dividend Watch List: The business of Australian Edge is to identify businesses capable of paying sustainable and growing dividends over time. The corollary of this mandate is to identify those businesses that are not capable sustaining or growing dividends.

The ADR List: Many Australia-based companies that list on the home Australian Securities Exchange (ASX) are also listed on the New York Stock Exchange (NYSE) or over-the-counter markets as “sponsored” or “unsponsored” American Depositary Receipts (ADR). Here’s a list of those companies, along with an explanation of what these ADRs represent.

Note that MAp Group Ltd is now Sydney Airport (ASX: SYD, OTC: MGPYF) under Industrials and that we’ve moved Campbell Brothers Ltd (ASX: CPB, OTC: CBEBF) from Consumer Goods to Industrials, better reflecting the fact that 97 percent of its revenue comes from its ALS testing division. We’ve also added Australia’s largest airline to How They Rate coverage under Industrials, as Qantas Airways (ASX: QAN, OTC: QUBSF) joins the adventure.

In Closing

Thank you for subscribing to Australian Edge. We hope you find the information we provide both informative and profitable. And we look forward to hearing feedback about how we can improve the service.

David Dittman and Roger S. Conrad

Editors, Australian Edge