November Economic Update – 2018

November Economic Update – 2018

Welcome to our Economic Update for November, courtesy of Kaplan Professional. Along with Sunsuper’s chief economist Brian Parker we will examine the Royal Commission’s Interim Report and its effect on the economy, rising geopolitical tensions, and the drivers behind the ASX’s October fall.

Question 1

In October, markets — including the ASX — had their biggest fall since 6 February 2018. This was seemingly driven by falling tech stocks in the US. What is going on in this sector to have this affect?

I think it’s a bigger issue than that. If you look at tech stocks in particular, in addition to some concern about the prospect of regulation in that sector, to be honest they also were priced pretty much for perfection. These stocks had had such a good run for so long, some kind of a pull-back was inevitable.

The bigger picture though really is about what’s happening in bond markets. It’s interest rate markets … If you think about the years we’ve had since the GFC, for a lot of investors out there, with interest rates so low and bond rates so low, equities were very much the only game in town. You had a lot of people really buying equities in search of a return because conservative assets just didn’t provide the kind of return people needed.

Well, that’s now started to come into question because as the Federal Reserve raise interest rates, as bond yields around the world have risen, especially in the US, but also to some extent elsewhere, the balance is a bit skewiff if you like. People are now starting to question whether equities is still the only game in town, as bonds have become somewhat more attractive than they were 12 months ago.

Question 2

The RBA said it’s concerned that the Royal Commission’s Interim Report could have the effect of banks further tightening their lending. Do you share the RBA’s view?

I do share some concern. So far, it’s mostly been anecdotal, although it is starting to appear in some of the data. Up until recently, most of the talk was banks are simply making people dot I’s and cross T’s more rigorously than they were, but there wasn’t really an aggressive tightening of standards. I still think that’s mostly true.

In other words, if you’re a creditworthy borrower, you can still basically get a loan. You may have to jump through another hoop or two, but it’s not as if credit is drying up in the economy to creditworthy borrowers. That’s really, really important because if that weren’t the case, that would be a major alarm bell for growth.

Now, at the moment it certainly does bear watching. Whether it’s just because of concerns about the economic environment or concerns about the level of household debt or the Royal Commission, [it] isn’t really relevant for the economic implications. It is absolutely something to watch, but so far there is not any great evidence that creditworthy borrowers are being unduly constrained by what the banks are currently doing.

Question 3

Australia’s terms of trade have increased over the past couple of years due to commodity prices and are now at relatively high levels. What foreseeable factors are likely to change that?

The big downside risk to it would be a slowdown in global growth in general, but Chinese growth in particular, especially when you talk about things like iron ore, coke, and coal. Certainly, you’ve seen quite a pick-up in iron ore prices and coke and coal prices courtesy of what is a very, very healthy environment at the moment for Chinese steel demand.

Big downside risk is really that if you were to see, for whatever reason, a more pronounced slowdown in Chinese growth and hence in Chinese steel demand, than people are otherwise anticipating, that could put a serious dent in our terms of trade. I don’t think we’re in for it any time soon. The Chinese authorities have taken steps to protect Chinese growth against, for example, the impact of a trade war. But certainly that is the big downside risk at this point.

Question 4

What’s the current state of play between China and the US?

The state of the relationship, the best way to describe it at the moment would be not great. To put an optimistic slant on it, if you look at the way the Chinese have actually responded to the various tariff measures that Trump has imposed, whenever Trump has imposed a tariff of X, the Chinese have responded with X, less a lot. In other words, they haven’t gone one-for-one with the Americans on tariffs. They’ve responded in a fairly timely way, but they certainly haven’t responded to the same magnitude as the American measures, and that does suggest the Chinese are playing the long game here.

The Chinese are basically working on the assumption that at some point Trump will depart the scene, whether that’s in two years or six years or whenever, and that eventually normal service will be resumed. They will get an American President that is a bit more amenable and has a bit more understanding about the way global trade actually works.

That’s the optimistic slant on it. The pessimistic slant on it is that really the trend is not your friend at this point, that more and more measures are being put in place; and in particular this idea that this is all Trump’s doing and that these sorts of anti-China measures don’t have a degree of bipartisan support in the US, I think that is mistaken.

China does not seem to have a lot of friends, especially in a trade sense. China does not seem to have a lot of friends across the American political spectrum. The Democrats in Congress seem to be quite supportive of actually taking on China in a trade sense. There is a lot of support for the view that China has not behaved well in international trade, intellectual property [IP] rights in particular, but not just IP rights.

So, there is more support than the optimists would perhaps care to acknowledge for what Trump is doing on trade, even though the atmospherics of it and Trump’s explanations of it do suggest that he doesn’t really understand very much about the way trade or indeed tariffs actually work.

I don’t think we’re at a stage yet where the trade measures that have been imposed are going to seriously derail world growth. I don’t think they’re going to seriously derail global trade, but certainly the trend is not helpful at this point, and certainly this could go on for quite a bit longer than many people are currently anticipating.

Question 5

And what does this mean for Australia, as in some ways it is stuck between the two of them?

As basically an open, very trade-oriented economy, anything that adversely impacts world trade is going to be felt here, but it’s not that simple either.

You might look at, for example, if the Chinese are targeting particular aspects of, say, American agriculture, Australia has the potential to actually benefit from that. If China is targeting particular niche suppliers in manufacturing, for example, or indeed if America is targeting Chinese manufacturers, there is some evidence to suggest that elements of Australian manufacturing could actually benefit from that. It’s relatively small scale, but it just highlights this is a very, very complicated set of relationships.

The other thing really is the Australian dollar. If we were to see a very adverse impact on global trade or the economy, having a floating currency is handy at a time like this. You want a floating currency to sink when required. I think if we were to see quite a serious, even more damaging fallout from this trade war, the Australian dollar would probably fall quite sharply. That would actually provide us with a good deal of cushioning.

The other angle too is if you take the view that what Trump is doing is adversely impacting China’s economy, in particular Chinese exporters, the good news is that a lot of what we export to China doesn’t actually end up being turned into something that China therefore exports to the United States.

Most of what we export to China goes into, for example, infrastructure and residential developments, etc. Almost all of that is really not trade-dependent. Who’s really exposed? Ironically, countries like Korea, Taiwan, Japan — American allies in the region because a lot of what they export to China ends up being embodied in Chinese exports to the United States. They are very much collateral damage in this trade war.

Question 6

You mentioned the Aussie dollar’s ability to fall, but how is it currently fairing on a trade-weighted basis?

It’s a good point. If you think about the highs of this calendar year, which it reached earlier in the year around late January, against the US dollar it’s fallen by about 12%, but on a trade-weighted basis it’s only down by about 6%. So, obviously a large part of this story is a stronger US dollar across the board. It has actually held up remarkably well.

If you think about what’s happened in the Australian interest rate markets, the entire yield curve is trading below US rates and has done for some time now, and yet this view that somehow that can’t happen without Australian interest rates being forced up or the currency falling off a cliff, well that hasn’t proven to be the case. We’ve been able to maintain that without a really adverse impact on the currency.

The big offsetting factor here is really what’s happened and, as you’ve already mentioned, the terms of trade, it’s commodity prices, in particular the bulk commodities we ship to China; those prices are actually quite elevated. So, while interest rate markets are a drag on the currency, what’s happening in commodity markets seems to have more than offset that.

It comes out of a bit of a wash of late, although the currency has clearly come off. It certainly hasn’t come off as far as you might have expected, given what’s happened in interest rate markets. A big part of that story is really the offsetting impact of commodities.

Question 7

Housing markets are continuing to ease, savings are low, household debt is high, and household consumption looks set to decrease. How worried are you about these factors?

A couple of things. Household consumption is not likely to decrease. I think you are going to see that slow down. Yes, you’re right, household debt is very, very high. Yes, you’re right, house prices are coming off. It’s very much a Sydney/Melbourne phenomenon, but given the dominance of Sydney and Melbourne, what a big share of the Australian property market Sydney and Melbourne represent, it is showing up in a slight fall in the overall value of housing in Australia.

The key risk is obviously, so far consumers have been able to maintain a fairly decent pace of consumer spending growth, not spectacular but decent, and a big part of the reason for that is that even though their wages haven’t been growing terribly strongly, employment growth has been pretty solid. But also consumers have been able to reduce their saving rate, so we’ve had a marked reduction in the household saving rate.

Why have consumers been able to do that? They’ve been doing that because their household wealth has actually gone through the roof, courtesy of what we’ve seen in sharemarkets, but also until recently what we’ve seen in property markets.

Wealthier households are generally able to save less than they otherwise would. Think about it this way. People look at their assets and think, “Great, my assets are doing the saving for me. I don’t need to save as much money, therefore I can maintain my spending.”

If household wealth is now being dented by what’s happening in property markets and more recently in sharemarkets, although the jury is still out on the latter point, how long can households continue to maintain decent spending growth? I think they can do it for a while, as long as we continue to see decent jobs growth and as long as we see some kind of acceleration in wages. But I would acknowledge it’s a key risk.

If that weren’t going to happen, if we were to see some unexpected slowdown in jobs growth or if wages did not respond to the improvement we’ve seen in the labour market, then you certainly could see quite a marked slowdown in household consumption. It’s not my base case, but it’s certainly a very, very key risk at this point.

Question 8

Is there anything else you’d like to add?

Just as a very broad point … This is a very, very challenging environment, not just for here in Australia, but globally. We’re faced with a lot of economic and geopolitical risks. We’re faced with those risks at a time when frankly as investors finding value in world markets is very, very challenging, and even after the weakness we’ve seen in share markets over the last little while, it is still tough to find genuine value in world sharemarkets, which means that future returns are going to be considerably more modest.

So, again, as a superannuation fund investor, if I look out five, 10 years, do I expect sharemarket returns to be similar to the returns of the last five to seven years? Absolutely not. I think we’re in for a period of heightened volatility and lower returns.

As a final point, I often get asked, “Is the weakness we’ve seen in the last few days an early warning that we’re in for something worse and soon?” It’s too early in the cycle for that, but nevertheless, I think we are in for this extended period of heightened volatility. We need to get used to that.

 

Sacha Loutkovsky
sacha.l@orionfg.com.au
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