Australia: Good news and bad news

First, the good news from the RBA chart pack.

Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Business investment remains weak and is likely to impact on long-term growth in both profits and wages.

Australia: Business Investment

The decline is particularly steep in the Manufacturing sector and not just in Mining.

Australia: Business Investment by Sector

But government investment in infrastructure has cushioned the blow.

Australia: Public Sector Investment

Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.

Australia: Non-Financial Sector Profits

Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.

Australia: Job Vacancies

The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.

Australia: Housing Prices and Household Debt

House prices are shrinking despite record low interest rates.

Australia: Housing Prices

Broad money and credit growth are slowing, warning of a contraction.

Australia: Broad Money and Credit Growth

Bank profits remain strong.

Australia: Bank Profits

But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.

Australia: Bank Capital Ratios

One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.

The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.

I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.

I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.

China: Activity

12 Charts on the Australian economy

Australian GDP grew at a robust 3.1% for the year ended 31 March 2018 but a look at the broader economy shows little to cheer about.

Wages growth is slowing, with the Wage Price Index falling sharply.

Australia: Wage Price Index Growth

Falling growth in disposable income is holding back consumption (e.g. retail spending) and increasing pressure on savings.

Australia: Consumption and Savings

Housing prices are high despite the recent slow-down, while households remain heavily indebted, with household debt at record levels relative to disposable income.

Australia: Housing Prices and Household Debt

Housing price growth slowed to near zero and we are likely to soon see house prices shrinking.

Australia: Housing Prices

Broad money growth is falling sharply, reflecting tighter financial conditions, while credit growth is also slowing.

Australia: Broad Money and Credit Growth

Mining profits are up, while non-mining corporation profits (excluding banks and the financial sector) have recovered to about 12% of GDP.

Australia: Corporate Profits

But business investment remains weak, which is likely to impact on future growth in both profits and wages.

Australia: Investment

Exports are strong, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Iron ore export tonnage continues to grow, while demand for coal has leveled off in recent years.

Australia: Bulk Commodity Exports

Our dependence on China as an export market also continues to grow.

Australia: Exports by Country

Corporate bond spreads — the risk premium over the equivalent Treasury rate charged to non-financial corporate borrowers — remain low, reflecting low financial risk.

Australia: Non-financial Bond Spreads

Bank capital ratios are rising but don’t be fooled by the risk-weighted percentages. Un-weighted Common Equity Tier 1 leverage ratios are closer to 5% for the four major banks. Common Equity excludes bank hybrids which should not be considered as capital. Conversion of hybrids to common equity was avoided in the recent Italian banking crisis, largely because of the threat this action posed to stability of the entire financial system.

Australia: Bank Capital Ratios

Low capital ratios mean that banks are more likely to act as “an accelerant rather than a shock-absorber” in times of crisis (2014 Murray Inquiry). Professor Anat Admati from Stanford University and Neel Kashkari, President of the Minneapolis Fed are both campaigning for higher bank capital ratios, at 4 to 5 times existing levels, to ensure stability of the financial system. This is unlikely to succeed, considering the political power of the bank sector, unless the tide goes out again and reveals who is swimming naked.

The housing boom has run its course and consumption is slowing. The banks don’t have much in reserve if the housing market crashes — not yet a major risk but one we should not ignore. Exports are keeping us afloat because we hitched our wagon to China. But that comes at a price as Australians are only just beginning to discover. If Chinese exports fail, Australia will need to spend big on infrastructure. And infrastructure that will generate not just short-term jobs but long-term growth.

3 Headwinds facing the ASX 200

The ASX 200 broke through stubborn resistance at 5800 but is struggling to reach 6000.

ASX 200

There are three headwinds that make me believe that the index will struggle to break 6000:

Shuttering of the motor industry

The last vehicles will roll off production lines in October this year. A 2016 study by Valadkhani & Smyth estimates the number of direct and indirect job losses at more than 20,000.

Full time job losses from collapse of motor vehicle industry in Australia

But this does not take into account the vacuum left by the loss of scientific, technology and engineering skills and the impact this will have on other industries.

…R&D-intensive manufacturing industries, such as the motor vehicle industry, play an important role in the process of technology diffusion. These findings are consistent with the argument in the Bracks report that R&D is a linchpin of the Australian automotive sector and that there are important knowledge spillovers to other industries.

Collapse of the housing bubble

An oversupply of apartments will lead to falling prices, with heavy discounting already evident in Melbourne as developers attempt to clear units. Bank lending will slow as prices fall and spillover into the broader housing market seems inevitable. Especially when:

  • Current prices are supported by strong immigration flows which are bound to lead to a political backlash if not curtailed;
  • The RBA is low on ammunition; and
  • Australian households are leveraged to the eyeballs — the highest level of Debt to Disposable Income of any OECD nation.

Debt to Disposable Income

Falling demand for iron ore & coal

China is headed for a contraction, with a sharp down-turn in growth of M1 money supply warning of tighter liquidity. Falling housing prices and record iron ore inventory levels are both likely to drive iron ore and coal prices lower.

China M1 Money Supply Growth

Australia has survived the last decade on Mr Micawber style economic management, with something always turning up at just the right moment — like the massive 2009-2010 stimulus on the chart above — to rescue the economy from disaster. But sooner or later our luck will run out. As any trader will tell you: Hope isn’t a strategy.

“I have no doubt I shall, please Heaven, begin to be more beforehand with the world, and to live in a perfectly new manner, if — if, in short, anything turns up.”

~ Wilkins Micawber from David Copperfield by Charles Dickens

Goldman describes Australia’s lost decade | Macrobusiness

Posted by Houses and Holes. Reproduced with kind permission from Macrobusiness.

Goldman’s Tim Toohey has quantified the unwinding commodity super-cycle for ‘Straya’:

Lower commodity prices risk $0.5trn in forgone earnings
The outlook for revenues from Australian LNG and bulk commodities shipments – which account for almost half of total export earnings – has deteriorated significantly. To be clear, overall revenues are still forecast to increase substantially over the coming years – underpinned by a broadly unchanged strong outlook for physical shipments (particularly for LNG). However, in a nominal sense, the outlook is far less positive than before. This owes to a structurally weaker price environment, with GS downgrades of 18% to 25% to key long term price forecasts for LNG and bulk commodities suggesting that cumulative earnings over the years to 2025 are on track to be ~$0.5trn lower than previously forecast.

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… and will erode Australia’s trade/fiscal positions
The deterioration in the earnings environment naturally has direct implications for Australia’s international trade and fiscal positions. On the former, a return to surplus by CY18 no longer looks feasible, and we now expect a deficit of ~$15bn. On the latter, relative to the 2014 Commonwealth Budget, we estimate that weaker commodity prices will cause a ~$40bn shortfall in tax revenues over the next four years. Given our expectation that Australia’s LNG sector will deliver no additional PRRT revenues over the coming decade, and the ~$18bn downgrade to commodity-related tax in the December MYEFO, we therefore see a risk of further material revenue downgrades at May’s 2015 Budget.

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Resulting in changed GDP, RBA cash rate and FX forecasts
Although the commodity export changes mainly manifest through the nominal economy, there are significant impacts back through to the real economy. Lower export earnings result in lower profits, lower tax receipts, lower investment and lower employment. We continue to expect just 2.0% GDP growth in 2015 but have lowered our 2016 to 2018 real GDP forecasts by an average of 50ppts in each calendar year. As a consequence, we have moved forward the timing of the next RBA rate cut to May 2015, where we see the cash rate remaining at 2.0% until Q416, where we expect a 25bp hike. We now expect just 75bps of hikes in 2017 to 3.0% and rates on hold  in 2018. Despite the recent move in the A$ towards our 75c 12 month target, the reassessment of the medium term forecast outlook argues for a new lower target 12 month target of 72c.

OK, that’s quite a piece of work and congratulations to Tim Toohey for getting so far ahead of pack. I have just two points to add.

The LNG forecasts look good but as gloomy as his iron ore outlook is, it is not gloomy enough. $40 is a more reasonable price projection for 2016-18 and we’ll only climb out of that very slowly. That makes the dollar and interest rate forecasts far too bullish and hawkish.

Second, even after these downgrades, Mr Toohey still has growth of 3.25% GDP penned in for 2016 and 3.5% for 2017. We’ll have strong net exports and is about it. With the capex unwind running right through both years, housing construction to stop adding to growth by next year, the car industry wind-down at the same time, political strife destroying the public infrastructure pipeline, the terms of trade crashing throughout and households battered half to death by all of it, those targets are of the stretch variety, to say the least.

The analysis is exceptional, The conclusions, sadly, overly optimistic.

Currency manipulation cost US economy up to 5 million jobs

Extract from a research brief by by C. Fred Bergsten and Joseph E. Gagnon, at Peterson Institute for International Economics, published December 2012:

More than 20 countries have increased their aggregate foreign exchange reserves and other official foreign assets by an annual average of nearly $1 trillion in recent years. This buildup — mainly through intervention in the foreign exchange markets — keeps the currencies of the interveners substantially undervalued, thus boosting their international competitiveness and trade surpluses. The corresponding trade deficits are spread around the world, but the largest share of the loss centers on the United States, whose trade deficit has increased by $200 billion to $500 billion per year. The United States has lost 1 million to 5 million jobs as a result of this foreign currency manipulation.

Read more at POLICY BRIEF 12-25: Currency Manipulation, the US Economy, and the Global Economic Order.

Hat tip to Simon Kennedy at Bloomberg.

What to do about the US currency war | Alan Kohler | Business Spectator

Alan Kohler writes about the Fed’s quantitative easing strategy which is effectively debasing the US dollar:

Because it is trying to reduce the world’s reserve currency, the Fed is effectively giving other countries two choices: either allow your currencies to appreciate against the US dollar and thus make your economies less competitive and crunch your export industries, or print money with us and risk (or perhaps guarantee) inflation.

It is a Hobson’s Choice, and like most other countries’ central banks, the Reserve Bank of Australia doesn’t quite know what to do.

The strategy is also debasing the more than $2 trillion of US Treasuries held by China and Japan, placing these Asian exporters in an awkward position. Repatriating their investments would send the dollar plummeting against the yuan and the yen, reversing their export advantage maintained over the last two decades through capital account inflows into US Treasuries. Capital inflows were used to offset the current account outflows and prevented the yen and yuan from appreciating against the dollar. If the flows reverse, the US will enjoy an unfair trade advantage from an under-valued dollar.

Methinks those who predict a globally dominant China with continued growth rates of 7% to 8% are a mite premature. …….Possibly a century or two.

Read more at What to do about the US currency war | Alan Kohler | Commentary | Business Spectator.

Don't Expect Consumer Spending To Be the Engine of Economic Growth It Once Was

By William R. Emmons:

The recession itself could be described as a period in which consumer spending contracted sharply, while other sources of private demand were unable to offset the shortfall. The subsequent recovery, such as it is, largely has been the result of massive government interventions in the form of financial rescues, unprecedented monetary stimulus and record-breaking government budget deficits. We’re left with extremely low short-term and long-term interest rates, as well as historically large budget deficits—all of which must reverse at some point.
…..To assure strong, sustainable growth in the long term, the U.S. economy needs to include a larger role for business investment and exports than has been the case in recent decades.

via Don’t Expect Consumer Spending To Be the Engine of Economic Growth It Once Was.