Australia: Hard times

You don’t have to be an Einstein to figure out that 2023 is going to be a tough year. Australian consumers have already worked this out, with sentiment plunging to record lows.

Australia: Consumer Sentiment

The bellwether of the Australian economy is housing. Prices are tumbling, with annual growth now close to zero.

Australia: Housing

Iron ore, another strong indicator, rallied on news that China is easing COVID restrictions but prices are still trending lower.

Iron Ore

The Chinese economy faces a host of problems. A crumbling real estate sector, over-burdened with debt. Threat of a widespread pandemic as COVID restrictions are eased. Private sector growth collapsing as the hardline government reverts to a centrally planned economy. And a major trading partner, the US, intent on restricting China’s access to critical technology.

China

Rate hikes and inflation

The RBA hiked interest rates by another 25 basis points this week, lifting the cash rate to 3.1%. But the central bank is way behind the curve, with the real cash rate still deeply negative.

Australia: RBA Cash Rate

Monthly CPI eased to an annual rate of 6.9% in October, down from 7.3% in September, reflecting an easing of goods inflation.

Australia: CPI

But a rising Wages Index reflects underlying inflationary pressures that may force the RBA to contain with further rate hikes.

Australia: Wages Index

The lag from previous rate hikes is also likely to slow consumer spending. Borrowers on fixed rate mortgages face a steep rise in repayments when their existing fixed rate term expires and they are forced to rollover at far higher fixed or variable rates. A jump of at least 2.50% p.a. means a hike of more than A$1,000 per month in interest payments on a $500K mortgage.

Australia: Housing Interest Rates

GDP Growth

The largest contributor to GDP growth, consumption, is expected to contract.

Australia: GDP Contribution

Real GDP growth is already slowing, with growth falling to 0.6% in the third quarter — a 2.4% annualized rate. Contraction of consumption is likely to take real GDP growth negative.

Australia: GDP Contribution

Plunging business investment also warns of low real growth in the years ahead.

Australia: Business Investment

Record low unemployment seems to be the only positive.

Australia: Business Investment

But that is likely to drive wage rates and inflation higher, forcing the RBA into further rate hikes.

Conclusion

We may hope for a resurgence of the Chinese economy to boost exports and head off an Australian recession. But hope is not a strategy and China is unlikely to do us any favors.

We expect rising interest rates to cause a sharp contraction in the housing market, tipping Australia’s economy into a recession in 2023.

Acknowledgements

Charts were sourced from the RBA and ABS.
Ross Gittins: Hard times are coming for the Australian economy

Productivity not population key to Aussie living standards | Macrobusiness

From Leith van Onselen at Macrobusiness:

Former ALP minister Craig Emerson has penned an article in The AFR calling on the Morrison Government to tackle Australia’s declining productivity growth, which is central to boosting the nation’s living standards:

“Productivity growth has contributed 95 per cent of the improvement in Australians’ material living standards since 1901”.
“From the turn of the century, Australia’s productivity performance began to slide and the longer it has gone on the worse it has gotten”.
“Over the period from 2015 until the COVID-19 pandemic struck, actual productivity growth was worse than the low-productivity scenario included in the 2015 intergenerational report”.
“In the decade since 2010 – even excluding last year – Australia recorded its slowest growth in GDP per capita of any decade in at least 60 years”.
“Without a comprehensive economic reform program, Australia will inevitably have weak growth in living standards during the remainder of the 2020s and into the 2030s”.

Craig Emerson’s assessment is broadly correct, as evidenced by the stagnant real per capita GDP, wage and income growth experienced over the past decade (even before the coronavirus pandemic).

Sadly, however, the Morrison Government with the help of the Australian Treasury seems hell bent on leveraging the other ‘P’ – population growth – to mask over Australia’s poor productivity performance and to keep headline GDP growing, even if it means per capita GDP, income growth and living standards deteriorate.

Rather than using the coronavirus pandemic as an opportunity to reset the Australian economy to focus on quality over quantity, the Morrison Government is intent on repeating the policy mistakes of the past by returning to the lazy dumb growth policy of hyper immigration.

Rebooting mass immigration will inevitably contribute to Australia’s poor productivity growth by:

  • Crush-loading cities, increasing congestion costs and rising infrastructure costs;
  • Encouraging growth in low productivity people-servicing industries and debt creation, rather than higher productivity tradables; and
  • Discouraging companies from innovating and adopting labour saving technologies.

It’s time to put the Australian Treasury’s Three-Ps framework to rest once and for all, along with the snake oil solution of mass immigration.

Policy makers must instead focus first and foremost on boosting productivity, followed by lifting labour force participation. These are the two Ps that actually matter for living standards.

We agree with the concern over poor productivity growth, but focusing on labor force participation is putting the cart before the horse. The key cause of low productivity growth is declining business investment.

Business Investment

Without business investment, new job creation and wages growth will remain low. The way out of this trap is to prime the pump. Boost consumption through infrastructure programs — investment in productive infrastructure that will boost GDP growth (to repay the debt). Boost business investment through strong consumption, a lower Australian Dollar and tax incentives (like accelerated write-off) for new investment.

The lower exchange rate is important to rectify a serious case of Dutch disease1 from the resources industry. There are only three ways to achieve this:

  1. Increase imports, which would be self-defeating, destroying jobs;
  2. Reduce exports; or
  3. Export capital, of which Australia has little.

China is doing its best to help us with the second option, by restricting imports of a wide variety of Australian resources, but that has so far achieved little. David Llewellyn-Smith came up with an interesting alternative:

If we accept that the CCP is the latest manifestation of the historical tendency to give rise to political evils intent on dominating the lives of freedom-loving humanity, then why don’t we cut the flow of iron ore right now…….

The results would be instant. The Chinese economy would be structurally shocked to its knees. 30% of its GDP is real estate-related. 60% of the iron ore that drives it is sourced in Australia. Roughly speaking that is 18% of Chinese GDP that would virtually collapse overnight. Vast tracts of industry would fall silent. An instant debt crisis would sweep the Chinese financial system as its bizarre daisy chain of corruption froze. Local governments likewise. Unemployment would skyrocket.

…..What we can say with confidence is that it would pre-occupy the CCP for many years and hobble it permanently. Its plans for regional domination would be set back decades if not be entirely over.

The problem is how to convince the old boys around the boardroom table at BHP that this would be in their interest as well as in the country’s interest.

Notes

  1. Dutch disease is a term coined by The Economist to describe the impact on the Netherlands’ economy of a resources boom from discovery of large natural gas fields in 1959. The soaring exchange rate, from LNG exports, caused a sharp contraction in the manufacturing sector which struggled to compete, in export markets and against imports in the domestic market, at the higher exchange rate.

Australia: Bearish apart from mining

Household disposable income lifted in response to the recent tax cuts but households remain risk-averse, with consumption still falling and extra income going straight to debt repayment — reflected by a jump in the Saving ratio below.
Australia Household Saving

Housing prices are recovering despite high levels of mortgage stress in the outer suburbs but building approvals for new housing continue to fall. Construction expenditure is likely to follow.

Australia Building Approvals

GDP growth is falling, while corporate profits (% of GDP) remain in the doldrums apart from the mining sector.

Australia Corporate Profits

Low household disposable income and corporate profit growth in turn lead to low business investment (% of GDP).

Australia Business Investment

Low investment leads to low job creation. Job vacancies and job ads both warn of declining employment growth.

Australia Job Ads

Cyclical employment growth is expected to slow in line with the fall in the Leading Indicator over the past year.

Australia Leading Employment Indicator

We maintain a bearish outlook for the Australian economy, though Mining continues to surprise to the upside.

ASX 200: Don’t argue with the tape

“A prudent speculator never argues with the tape. Markets are never wrong; opinions often are.” ~ Jesse Livermore

The ASX 200 broke resistance at 6800, signaling a fresh advance with a short-term target of 7200. Declining Trend Index peaks still warn of secondary selling pressure at present. Expect retracement to test the new support level at 6800. Respect of support would confirm the advance.

ASX 200

But divergence from fundamentals is growing.

NAB cut their GDP forecast to 1.5% in their November Forward View.

Housing markets in Sydney and Melbourne have recovered somewhat, but building approvals for houses remain 21% below their 2017 high and 57% for apartments. Construction activity is likely to remain low.

Exports are strong, boosted by increased LNG exports, but iron ore prices are falling. Currently testing short-term support at 80, our long-term target for iron ore is $65/metric ton.

Iron Ore

Business investment has slowed, causing wages to stagnate.

Australia: Business Investment

Retail sales weakened as a consequence, contracting for the first time since the early 1990s.

Australia: Retail Sales

Annual credit growth slowed to 2.5%, the lowest since 2010.

Banks were spooked last week by AUSTRAC pursuing Westpac for 19.5 million breaches of anti money-laundering and counter-terrorism regulations. The ASX 300 Banks index broke support at 7600, completing a double-top reversal, but this week they consolidated in a narrow range. Expect retracement to test resistance at 7600. Declining peaks on the Trend Index, however, continue to warn of selling pressure. Respect of resistance would confirm the decline, with a target of 6800.

ASX 300 Banks

The ASX 200 REITs index broke out of its descending triangle, signaling another advance. Financial markets are searching for yield.

ASX 200 REITs

The ASX 300 Metals & Mining index penetrated its descending trendline, suggesting that a base is forming. Expect another test of support at 4100 (neckline of a large head-and-shoulders reversal pattern). Breach would offer a target of 3400. The Trend Index penetrated its descending trendline but a peak near zero would warn of continued selling pressure.

ASX 300 Metals & Mining

We shouldn’t argue with the market but we should wait for confirmation; bull and bear traps are common. Investors, bear in mind that market risk remains elevated. I leave you with this quote from Westpac in their recent credit update:

For businesses, the economic backdrop has become more challenging. The global economy is slowing and household spending is soft. In this environment business investment in the real economy has lost momentum across the non-mining sectors – which will weigh on credit demand.

….and on jobs, wages growth and household spending.

We maintain low exposure to Australian equities, with a focus on defensive and contra-cyclical stocks, because of our bearish outlook.

Australia: Headwinds persist

From Elliot Clarke & Simon Murray at Westpac:

…the take home from Budget 2019 is that, while supportive of activity over the long-term, the near-term impact on incomes and activity is limited. Labor’s alternative proposals, as per the budget reply, are also spread out over time. So no matter which party wins in May, the headwinds of persistent weak income growth and declining house prices are set to hold growth well below trend through 2019. This is clear justification for interest rate cuts from the RBA, which Westpac believes will come in August and November.

While the RBA is yet to adopt an easing bias, the April meeting decision statement did emphasise the fluidity of the situation…

The last sentence is important: the RBA has not yet adopted an easing bias. Perhaps because of the housing debt bubble.

Australia: Household Debt and Disposable Income

Business investment has already failed to respond to interest rate cuts.

Australia: Business Investment

10-Year AGB yields are already below US Treasuries but have failed to significantly weaken the Australian Dollar.

Australia: Difference to US 10-Year Bond Yield

House prices are falling.

Australia: Housing Prices

Plunging high-density housing approvals promise a sharp slow-down in housing construction.

Australia: Building Approvals

Dwelling Investment is likely to join Mining Investment in the red, detracting from GDP growth. Windfall iron ore prices (Exports) are keeping the economy afloat, while they last.

Australia: GDP Components

Bank’s impaired and total non-performing assets are low, but likely to rise if the housing fall (and construction down-turn) continues.

Australia: Bank Non-Performing Assets

Bank capital ratios are modest at just over 10% of common equity (CET1) against risk-weighted assets. But that falls to about 5.5% without risk-weighting (leverage ratio). Not a lot of room for comfort.

Australia: Bank Capital

Why the RBA shouldn’t cut interest rates

There are growing cries in local media for the RBA to cut interest rates in order to avoid a recession. House prices are falling and shrinking finance commitments point to further price falls. Declining housing values are likely to lead to a negative wealth effect, with falling consumption as household savings increase. Employment is also expected to weaken as household construction falls. Respected economist Gerard Minack thinks “a recession in Australia is becoming more likely”.

The threat should not be taken lightly, but is cutting interest rates the correct response?

Let’s examine the origins of our predicament.

A sharp rise in commodity prices in 2004 to 2008.

Commodity Prices

Led to a massive spike in the Trade-weighted Index.

Australia Trade Weighted Index

And a serious case of Dutch Disease: the destructive effect that offshore investment in large primary sector projects (such as the 1959 Groningen natural gas fields in the Netherands) can have on the manufacturing sector.

Business investment in Australian has fallen precipitously since 2013.

Australia Business Investment

With wages growth in tow.

Wages Index

Instead of addressing the underlying cause (Dutch Disease), Australia tried to alleviate the pain by stimulating the housing market. Housing construction boosted employment and the banks were only to happy to accommodate the accelerating demand for credit.

Leading Index

But house prices have to keep growing and banks have to keep lending else the giant Ponzi scheme unwinds. When house prices and construction slows, the economy is susceptible to a severe backlash as Gerard Minack pointed out.

How to fix this?

The worst response IMO would be to pour more gasoline on the fire: cut interest rates and reignite the housing bubble. Low interest rates have done little to stimulate business investment over the last five years, so further cuts are unlikely to help.

The only long-term solution is to lift business investment which creates secure long-term employment. To me there are three pillars necessary to achieve this:

  1. Accelerated tax write-offs for new business investment;
  2. Infrastructure investment in transport and communications projects that deliver long-term productivity gains; and
  3. A weaker Australian Dollar.

Corporate tax write-offs

Accelerated corporate tax write-offs were a critical element of the US economic recovery under Barack Obama. They encourage business to bring forward planned investment spending, stimulating job creation.

Infrastructure

Government and private infrastructure spending is important to fill the hole left by falling consumption. But this must be productive investment that generates a market-related return on investment. Else you create further debt with no income streams to service the interest and capital repayments.

A weaker Australian Dollar

Norway is probably the best example of how an economy can combat Dutch Disease. They successfully weathered an oil-driven boom in the 1990s, protecting local industry while establishing a sovereign wealth fund that is the envy of its peers. Their fiscal discipline set an example to be followed by any resource-rich country looking to navigate a sustainable path through a commodities boom.

In Australia’s case that would be closing the gate after the horse has bolted. The benefits of the boom have long since been squandered. But we can still protect what is left of our manufacturing sector, and stimulate new investment, with a weaker exchange rate.

I doubt that the three steps are sufficient to avert a recession. But the same is true of further interest rate cuts. And at least we would be addressing the root cause of the problem, rather than encouraging further malinvestment in an unsustainable housing bubble.

Australia: Housing, Incomes & Growth

A quick snapshot of the Australian economy from the latest RBA chart pack.

Disposable income growth has declined to almost zero and consumption is likely to follow. Else Savings will be depleted.

Disposable Income & Consumption

Residential building approvals are slowing, most noticeably in apartments, reflecting an oversupply.

Residential Building Approvals

Housing loan approvals for owner-occupiers are rising, fueled no doubt by State first home-buyer incentives. States do not want the party, especially the flow from stamp duties, to end. But loan approvals for investors are topping after an APRA crackdown on investor mortgages, especially interest-only loans.

Housing loan approvals

The ratio of household debt to disposable income is precarious, and growing worse with each passing year.

Household debt to disposable income

House price growth continues at close to 10% a year, fueled by rising debt. When we refer to the “housing bubble” it is really a debt bubble driving housing prices. If debt growth slows so will housing prices.

House price growth

Declining business investment, as a percentage of GDP, warns of slowing economic growth in the years ahead. It is difficult, if not impossible, to achieve productivity growth without continuous new investment and technology improvement.

Business investment

Yet declining corporate bond spreads show no sign of increased lending risk.

Corporate bond spreads

Declining disposable income and consumption growth mean that voters are unlikely to be happy come next election. With each party trying to ride the populist wave, responsible economic management has taken a back seat. Throw in a housing bubble and declining business investment and the glass looks more than half-empty.

Every great cause begins as a movement, becomes a business, and eventually degenerates into a racket.

~ Eric Hoffer

ASX: Steam or froth?

The ASX 200 broke resistance at 5500. Follow-through above 5600 would confirm a primary advance with a long-term target of 6000*. Rising Twiggs Money Flow indicates medium-term buying pressure.

ASX 200

* Target medium-term: 5600 + ( 5600 – 5200 ) = 6000

The ASX 300 Banks Index has followed through after breaking resistance at 8000. Expect retracement to test the new support level but respect is likely.

ASX 300 Banks

What could go wrong?

….Apart from a precarious property bubble in China fueling commodity exports, a property bubble in Australia fueled by record low interest rates and equally precarious immigration flows, declining business investment and slowing wages growth.

The ASX price-earnings ratio is close to historic highs, suggesting we are in Phase III of a bull market — where stocks are advanced on hopes and expectations of future growth rather than on concrete results. By all means follow the rally, but keep your stops tight.

Australia: Say goodbye to growth

Business investment in Australia continues its sharp descent since the end of the mining boom, falling below 14% of GDP for the first time since the Dotcom crash.

Australia Business Investment
Source: RBA Chart Pack

Apart from the expected “cliff” in Engineering, investment in Machinery and Equipment has fallen to record lows.

Australia Business Investment - Components
Source: RBA Chart Pack

Without investment, growth is likely to contract. The impact on Australian wages is an ominous warning.

Australia Wage Growth
Source: RBA Chart Pack