John Abernethy, Chief Investment Officer at Clime Asset Management Wednesday, 20 November 2013
The recent release of the Reserve Bank of Australia (RBA) Economic Chart Book creates a good opportunity to review some key drivers of the Australian economy. More importantly, it allows us to put both current conditions and the economic outlook into a proper world context.
In summary, the developed world continues to move through a low growth era with immense government debt and high levels of unemployment. In contrast, Australia has probably seen the best of capital investment and resource prices. The Australian economy’s transition could be challenging with both Federal and State Governments having paid scant attention to economic and industrial developments.
The charts paint the potential for a slowing Australian economy, with low investment income affecting retirees and high debt inhibiting householders. The relatively high $A is hindering industrial development and returns on potential capital investment. Government debt remains at internationally low levels but has jumped across all levels of government.
In particular, Australia is increasingly becoming reliant on the fortunes of China. This is not only related to growth but also implies an increasing dependency on the level of the Chinese currency and its rate of inflation.
First, world economic growth continues to slow with the chief culprits remaining the weak economies of the Eurozone. Australia’s major trading partners continue to grow faster than the world as a whole and this growth is focused upon China, with Japan lifting off the ground. Last night, the OECD downgraded their growth forecasts for both 2013 and 2014. World growth this year is projected to be well below 3%.
Figure 1. GDP growth – world Source: ABS, CEIC Data, IMF, RBA, Thomson Reuters
The advanced economies have declined from 60% of world GDP in 2000 to their 50% share today. Growth remains weak with the USA holding at 2.5% annual growth. Meanwhile Japan has responded to a massive Quantitative Easing (QE) program and growth lifted to 3% p.a. in the June half. This has now slowed to 2% p.a. as the initial QE “sugar hit” wears off. Across in Europe, the growth rate remains too low to measure.
Clearly the recent excitement surrounding the sightings of “green shoots” of economic growth in Southern Europe seem to be a mirage generated by low cash rates. Noteworthy is that the UK is recovering. Growth in 2014 is expected to be 1.4% after years of no growth.
Figure 2. GDP growth of Euro area, Japan and US Source: RBA, Thomson Reuters
Whilst China’s growth seems to be controlled at about 7% per annum, the growth rates in India are sliding as it grapples with its massive population and poor distribution of wealth.
Figure 3. GDP growth – China and India Source: CEBC Data, RBA
Weak growth in Europe results in unemployment that remains intransigently high. Indeed it is worth noting that Europe is concurrently battling high youth unemployment and an ageing population base.
Figure 4. Unemployment rate of Euro area, Japan and US Source: RBA, Thomson Reuters
In Japan the ageing population problem is immense and birth rates remain low. Importantly, Japan is not attractive for immigrants, unlike the US and some parts of Europe. Despite this, Japanese unemployment remains relatively low because there are as many people retiring as there are entering the workforce.
In the US, the reported decline in the unemployment rate has been created both by a lift in employment numbers since the GFC and a significant drop in the participation rate.
Australian employment trends
In Australia, the unemployment rate is moving slowly upwards as the resource capital investment cycle slows and the manufacturing base continues to shed jobs. Like the US, the participation rate in Australia is declining as about 150,000 people have ceased looking for gainful employment in recent years.
Figure 5. Unemployment and participation rates of Australia Source: ABS
The effects of a high $A and a weakening investment cycle (see below) are exhibited by the job creation trends across sectors. An alarming drop in employment across manufacturing, media and agriculture has been offset by government-related employment. Therefore, should the current government seek to rectify the poor budget outlook by aggressively cutting public servants then unemployment may exceed current market forecasts. A lift in unemployment affects growth, consumption and demand for credit.
Figure 6. Contributions to employment growth Source: ABS
In retrospect it is clear China’s growth sheltered Australia from suffering a recession following the GFC. The next chart (Figure 7) shows the continued massive reported growth in key sectors of the Chinese economy. In particular the growth in electricity output and steel production are confirmed by Australia’s growth in iron ore and coal exports.
Figure 7. China – output indicators Source: CEIC Data, RBA
The growth in Australian iron ore exports has become more impressive than that of coal. Indeed the outlook for coal volumes and prices is being affected by environmental concerns in China and the emerging gas developments in the US. Therefore, developments for Australia’s second largest export commodity need to be monitored closely.
Figure 8. Australian bulk commodity exports Source: ABS, RBA
Overall the prices of Australia’s exports have clearly peaked. 2011/12 was possibly “as good as it gets” for Australian exporters (as measured by commodity export prices) and consumers (the high level of the $A). During this period Australia moved into a large trade surplus position and our current account moved to historic lows.
Figure 9. Current account balance of Australia Source: ABS, RBA
Investors need to take note of the RBA’s recent comments. Declining export earnings, a capital investment cycle in downturn and an “uncomfortably high” $A will put pressure on the Australian economy. In our view the lowering of economic growth forecasts in 2014 to about 2.5% is justified by the above developments and declining commodity prices.
Figure 10. RBA index of commodity prices Source: RBA
The household sector
The Australian household sector has responded to the GFC in similar fashion to the rest of the developed world’s householders. Whilst we do not have the high unemployment of the US and Europe, we do have an ageing population which has been forced into adjusting consumption and increasing savings for retirement. Low interest rate settings, supposedly benign inflation and a general concern for the world economy have lifted savings ratios.
Figure 11. Household saving ratio* Source: ABS, RBA
A scan across credit growth shows it is concentrated in the housing sector.
The recent rapid growth in residential loan approvals in NSW is not captured by the next chart (Figure 12) but it is clear banks are growing assets with a focus on residential loans. In particular, credit creation for small business has fallen to a very low level of growth.
Figure 12. Credit growth by sector Source APRA, RBA
The next chart (Figure 13) is alarming when taken in context. We have observed that savings ratios have lifted since the GFC, but the level of household debt remains stubbornly high. As an ageing population increases its savings, the younger generation is increasing its residential debt. Inflated housing prices, driven by low supply and offshore investors, is ensuring household debt remains high.
Interest paid by households as a percentage of income appears to be moderating but this percentage appears to be understated by the growth in the number of ageing households with no debt. Those households with residential debt have a high level when measured against their income levels. Anecdotal evidence suggests the average householder with mortgage debt is paying between 20% and 30% of income servicing interest.
Figure 13. Household finances* Source: ABS, RBA
Whilst it is difficult to accurately assess the net wealth of Australian households, the RBA notes that the general increase in equity values over recent years has lifted wealth back towards pre-GFC levels. The following charts suggest household wealth is still 15% or about $1 trillion below 2007 levels.
Today, on the basis household income from all sources is about $1 trillion per annum, we can derive that household debt approximates $1.5 trillion, financial assets are $3.2 trillion and the value of dwellings is $4 trillion. This results in net household wealth (disclosed) approximating $6 trillion.
The following chart (Figure 14) shows that whilst net household debt does not appear to be a problem when represented against total household assets, it hides the fact that banks have provided high levels of debt. Recent bank results indicated mortgages provided by banks across their full mortgage book have an average loan to value ratio of about 70%. It is clear younger householders with debt are highly leveraged and do not own significant financial assets outside their homes.
Figure 14. Household wealth and liabilities* Source: ABS, RBA, RP Data-Rismark
The recent lift in Sydney property prices, following on from Melbourne, is good news for household balance sheets. However the expected and so-called “wealth effect” has been tempered by low interest rates and consumer confidence remaining subdued. Asset values have lifted but investment income has fallen and this has kept consumption growth benign. This unusual effect from current low interest rates is also seen across Europe, Japan and the US. An ageing population and asset price inflation have constrained the effects of low interest rates rather than augmenting them.
Figure 15. Dwelling prices Source RBA, RP Data-Rismark
The lift in property values with lower mortgage interest rates may suggest improved affordability for first home buyers. Even so, the increase in demand for mortgages and the increased level of construction appears focused on higher density housing and not detached housing. First home buyers seem reluctant or unable to buy detached dwellings.
Figure 16. Private residential building approvals Source: ABS, RBA
As noted previously, housing loan credit has been the largest growth category for banks. However, the growth in housing loan approvals has not been slanted towards first home buyers. Rather investors are moving into the market as low interest rates drive investment capital to seek out better yields than bank deposits. Investment property has become a target for both self-managed super funds and offshore buyers.
Figure 17. Housing loan approvals Source: ABS, RBA
Australian banks and corporate profits
The general rise in residential property prices and steady employment growth are positive for Australian banks. Doubtful debt charges have declined whilst return on equity has held at reasonable levels.
Figure 18. Bank profitability* Source: RBA, banks’ annual and interim reports
Away from the banking sector, corporate profits have struggled to grow since the GFC. The mining sector recovered strongly as Chinese demand lifted both volumes and prices. Meanwhile the non-mining sector has struggled to grow profits faster than GDP. The subdued performance of the stock market was therefore justified until market prices generally lifted over 2012/13 as investors began to chase yield in the equity market.
Figure 19. Private non-financial corporation profits* Source: ABS, RBA
It is interesting to note that a significant portion of the weak reported profit growth resulted from the capital raised during the GFC. The Australian corporate sector was highly leveraged pre-GFC and equity capital raised was primarily used to replace debt. This reduced interest payments as a percentage of profits.
Figure 20. Business finances Source: ABS, APRA, RBA
The transformation of the Australian economy is well represented by tracking the output of various industrial sectors. Our manufacturing base has been in a continual relative decline for twenty years. Despite the rapid growth of Asia, the relative importance of food manufacturing is remarkably low. The growth sectors have been mining and financial services.
Figure 21. Industry share of output* Source ABS, RBA
Whilst the level of non-government bonds, representing bank funding, has been fairly controlled since the GFC, the level of total government debt (Commonwealth and State) has raced upwards. The proposed increase in the Commonwealth debt ceiling is clearly needed but the debate conveniently ignores the growing level of State debt.
Figure 22. Bonds on issue in Australia Source: ABS, RBA
Despite the well documented economic theory concerning money printing, the world economy has not been confronted with inflation. The recent high Australian dollar has held reported inflation in check in this country.
The reasons for low world inflation are many but two long term trends stand out.
First, the end of the US Industrial Century featured the advent of massive technological advancements which drove down both the costs of production and the need for labour in the production of goods.
Second and importantly now, the advent of the Chinese Industrial Century has delivered another sweeping decline in the cost of production. The West has succumbed to the world’s need for competitive labour costs and has transferred too much industrial production to China and other developing economies. Low developing world labour rates and improved manufacturing quality have cruelled the developed world’s industrial base.
From an Australian perspective, this plays out in declining import prices which drive down inflation. The large increases in the local cost of living (healthcare, power and education) are offset by lower consumer good prices from China. Therefore, inflation is not the 4% that confronts retirees but the 2% that is measured by the RBA.
Figure 23. Non-tradables and tradable inflation Source: ABS, RBA
This remains a painful period for retirees, but it will eventually come to an end although probably not in 2014. One factor we need to carefully monitor is the revaluation of the Chinese currency and the level of Chinese inflation.
Figure 24. Chinese Renminbi Source: BIS, Bloomberg, RBA