October Economic Update – 2018

October Economic Update – 2018

Welcome to the Economic Update for October. This month Kaplan Professional speaks with RBC Capital Markets’ chief economist and head of Australian research Su-Lin Ong, about everything from Australia’s slow wages growth, to the property market and the effect of the emerging market on the Australian dollar.

Question 1

Australia is entering its 27th year without a recession, and the Federal Government recently announced the economy had grown at an annual rate of 3.4%. What do you think lies ahead for our economy?

There’s no doubt the economy has performed really well in the first half of 2018, with growth running at an above-trend pace. I think for us where the upside surprise has been is in the resilience of household consumption, as well as the residential construction cycle, which appears to have a fair degree of longevity. They have been quite key factors in terms of stronger growth.

Looking ahead, we’re not so sure those two components of growth will be as resilient and strong as they have been in the first half of this year. We know from the leading indicators of construction, that residential construction, while there is considerable pipeline activity going on, it will become increasingly less and less, and ultimately we expect that to detract from activity, probably more so in 2019.

That slowdown in residential construction, the weakening in house prices we think, is an added cyclical headwind for consumption as we go forward. So, the consumer faces a number of structural headwinds already.

We know household debt is high. We know wages growth is pretty tempered. We know there’s a squeeze going on in disposable income. When you add to that the slowing in the housing market, it’s hard to see how the consumer can continue to be as strong as they have over the last few quarters. We’re a little bit more cautious going forward.

Having said that, we know there are bright spots in the Australian economy. We know the net export side, and particularly as LNG [liquefied natural gas] comes onstream, is encouraging. We know that public spending, particularly at the state level with capital expenditure, is extremely strong. So, there are a number of bright spots. Private business investment looks a little firmer too.

So, overall growth for the current year we think will be 3.25%, maybe easing a little next year to around 3%. But that’s a decent piece of growth and above trend. So, it’s an economy that’s in reasonable shape, notwithstanding some of the challenges for the dwelling sector and for household consumption.

Question 2

The former Treasurer Scott Morrison has just become our Prime Minister, and Josh Frydenberg is now our Treasurer. What are your expectations for the economy with these two at the helm?

It’s very early days at the moment. The new Prime Minister has barely been there a few weeks. The very early signs are encouraging. We know that there are a few policies that they’re looking at that we’re hopeful are supportive of the economy, both near and medium term.

The discussion around the bringing forward of company tax cuts for small businesses is accelerating — that I think is a positive. We know small businesses are the bulk of businesses and key in terms of employment, so that’s a good sign. Discussion around a drought package is important as well. The farm GDP is about 2.5% of overall GDP, and big swings can have an impact on the economy. So, the drought continues to be a significant factor. Assistance on that front will help temper the impact … So, that’s reasonably encouraging as well.

There are a few policies that look interesting and are supportive. Importantly, we know that the new Prime Minister, formerly in his Treasurer capacity, was very committed to returning the budget to surplus by 2019/20. The revenue looks like it’s running ahead.

Forecast? There’s a good chance we will see, at the mid-year uptake in December, that that story continues and a surplus as well within target over the next 12 to 18 months. I think that will remain a feature of the Morrison Government, so that is encouraging as well.

It’s not all roses though … I think, medium-term, there will need to be some discussion over real reform — whether that’s labour market reform or tax reform — and the big uncertainty is around energy policy. The NEG [National Energy Guarantee] is probably not going to get up in its current form. There continues to be a great deal of uncertainty over energy policy. If you speak to businesses, that remains their key concern, so there are still a number of challenges. It’s early days, but what we’ve seen so far is reasonably encouraging.

Question 3

Our household debt is now at 190% — up from 160% five years ago and 70% 30 years ago. How severe is this problem and is there anything more we could be doing to manage it?

The household debt situation is significant for Australia. We’ve long said that it’s really Australia’s Achilles’ heel. By both historic and international standards, Australian household debt is very high. That means in times of stress or shock, that the economy is more vulnerable than would otherwise be the case.

This is particularly [true] if the unemployment rate rises significantly. If interest rates move up sharply for whatever reasons, it does suggest that households and consumption will come under significant pressure.

There have been a number of measures put in place in recent years to help address levels of household debt and to encourage at least a plateauing of that debt, which we’re hopeful we’ll see in the coming quarters. I guess that’s around the macroprudential measures that have been put in place over the last few years, initially very much targeted at investors to try and reduce lending to that cohort, and to temper some of the rapid lending growth that was occurring there. Some households are probably taking on too much debt, and that has no doubt had an impact.

We’ve seen a very sharp slowdown in investor lending. In recent years, it’s barely running at a 2% pace year-on-year at the moment, so the measures have been really pretty effective.

More recently, the measures have shifted somewhat to looking at loan-to-income valuations, in particular scrutinising the income side of that equation and expenditure. So that’s tightened up as well. The lending that’s occurring — and again, we’re seeing households that aren’t really getting these loans and probably rightly so. That, as well, is improving the overall lending and lending standards in the economy. The banks’ lending standards are tighter. It goes a long way in underpinning overall stability in the economy. So, I think there are measures in place.

Ultimately, it’s going to take time. As house prices continue to fall and hopefully over time, wages growth picks up a little bit, those debt-to-income ratios should start to plateau and come down slightly. But we’re coming from very elevated levels here, and we need to be mindful that they absolutely pose a risk to the economy in the event of an external shock.

Question 4

Australia’s economy has grown and corporate earnings are up, but slow wage growth continues. Why? And what needs to happen for it to accelerate?

The wages story in Australia is actually a pretty simple one. The Australian economy and the labour market still has considerable slack in the system. We’ve got an unemployment rate that’s, in trend terms, a little bit below 5.5%. It’s come down very gradually over the 12 months from 5.6% to 5.4%, and it’s moving in the right direction. At the end of the day, we’re about 0.5% above full employment.

On top of that, our underemployment is very elevated as well, so these are the people that are still working but would like to work more hours. They’re really part of that surplus capacity too. It’s a pretty simple story in Australia — you need to get your unemployment rate down further.

You also need to get your underemployment rate down quite considerably. At the moment, underemployment is about 8.5%. It’s barely 0.5% off the historic high. There is slack in the system. Until that slack is absorbed, wages will not pick up on a significant nor sustained basis.

Now, we’re making progress. The labour market is in reasonable shape. We’re getting a good 20,000 to 25,000 jobs created every month. The unemployment rate is coming down very gradually, as is the underemployment rate, but it takes time. So, I think that’s what we need. We need a period of sustained above-trend growth, above-average employment generation, and ultimately that will translate through to slightly higher wages growth.

We will caution that the international experience suggests that there’s a number of structural factors going on as well. Wages growth is pretty modest right around the developed world, despite pretty tight labour markets. So, we know that there are a number of structural factors that seem to be suppressing wages growth; whether it’s globalisation, automation, a long period of low inflation that’s entrenched low inflationary expectations.

We know there are a number of factors here which apply to Australia as well, so Australia’s got a bit of a double whammy. Cyclically, the slack means wages aren’t picking up substantially, and the international evidence suggests some of these structural factors are probably also tempering wages growth. So, it’s going to be a slow process.

We are hopeful that wages pick up a little over the next 12 months, but in the Reserve Bank Governor’s words, wages [growth] needs to start with a ‘three’ before we see core inflation very consistent with target, and that looks to be a good 12 to 18 months away.

Question 5

The major banks have been lifting their home loan rates as property prices have been falling — at least in Sydney and Melbourne. What’s in store for these property markets?

What we need to do is put some of those falls in context. Sydney house prices have been falling since late 2017, but it comes after a period of substantial rise — more than doubling over the last five years. Year-on-year at the moment, Sydney house prices are down about 5%, but like I said, it comes after an extraordinarily strong period.

Melbourne year-on-year prices have only just turned negative, and they come after an even stronger pickup over the last five years. So, these are very modest falls we’re talking about in the context of a bigger picture.

Not surprising either, we’ve seen what has been the longest and strongest residential construction upswing … so supply is coming onstream. A lot of it is concentrated more in apartments, multi-storey, compared to previous cycles.

We know that the macroprudential tools as well have tightened up lending, so demand has eased. It’s really a pretty simple story of demand and supplier forces here that are tempering house prices after a very strong period. The odds are those two key factors, supply as well as the ongoing impact of macroprudential [tools], will continue to keep house prices pretty subdued in both Sydney and Melbourne.

We would expect Melbourne to fall a little bit further from here. It’s only just, like I said, moved into negative territory — Sydney as well, before bottoming out probably sometime later in 2019. So, we are in for a period of adjustment, not really a bad thing all round.

We’ve got to look at some of the brighter aspects of it, including what looks to be a return of first home owner demand. Affordability has been so poor for so long, and they’ve been priced out of the market … What’s important, as well, is that we look at it very much in context, so from that perspective, we’re reasonably relaxed.

What it does mean though is we could see pockets of much greater weakness in parts of Sydney and Melbourne. We know, for example, there is substantial oversupply in inner-city Melbourne, so the double-digit falls that we are seeing in certain parts can absolutely continue. Again, it’s supply coming onstream.

Question 6

The media continues reporting about the threat of a trade war between the US and China. Will a trade war really eventuate or is it still very much a tail risk?

You wouldn’t want to underestimate the possibility of an all-out trade war. We’ve already seen steps towards that. The current tariffs that are in place between China and the US are fairly modest, around $50 billion, but there are threats of substantially more.

The US is now suggesting the dollar terms that they’re talking about is pretty much tariffs on all of the exports from China that come into the US, so that’s not insignificant. It’s a little under $500 billion. That’s a different story. It’s tenfold what it is now.

Now, will we get to that? Well, it’s entirely possible, but the odds are we’re going to get part-way towards that, which has enough implications on its own. From that perspective, we are all pretty wary here.

What’s interesting is that it’s partly factored into market expectations that maybe global growth, not so much this year but as we look forward into 2019, will be weaker. There’s a sense in markets that maybe this is as good as it gets for global activity right about now, so it is pretty strong.

We’re probably going to record close to 4% growth for the globe this year. The odds are it’s not going to be quite as strong next year, so it has a number of ramifications for both activity and business confidence.

What does that then imply for hiring and expenditure? It’s not something we take lightly. What is also interesting in all of this is trade wars are not new. We’ve had them many times over the years. What is new this time is we have a President of the United States who operates in quite an unorthodox way, both from his means of communication to his policy announcements. That makes it somewhat more difficult than in the past.

Question 7

If it did develop into a full-blown trade war, what sort of impact are we looking at?

Right now, global activity is probably the strongest and most broad-based that we’ve seen post-crisis. We know the US has considerable momentum. The consumer is firing on all cylinders. Business investment is strong. Labour markets are extraordinarily tight, so that’s the buffer here that at least it’s occurring at a time where the US is very strong.

The developed world looks pretty good. Hence, G7 central banks are normalising rates. That is helpful, but there’s no doubt it will take out from growth. Our US team thinks it will take out at least 0.5% from US activity. Now again, currently the US is growing at 4%. It’s probably going to grow close to 3% for this year as a whole. That’s manageable. The question is, what happens in other parts of the world? Will China, that is slowing, slow much more? That has more important ramifications, particularly for Australia.

Question 8

The Australia’s economy is heavily reliant on China, our largest trading partner. Is it too risky to remain this way? How could we move away from this reliance?

I don’t think it’s a question of too risky. At the end of the day, China is, depending on what measure you use … moderating in terms of it going from double-digit growth down to 6–7% growth, but coming off a much larger base. It is a big, important economy. More importantly, it’s going from a developing nation to much more fully developed, and that has implications for growth more broadly.

And so, it’s not a question of risky. Australia has a very strong comparative advantage in commodities. China takes half of Australia’s iron ore. That’s where the strength of the relationship is.

I don’t think we would ever want to try and shift that relationship, given our comparative advantage, given that it goes to a very large economy and a nation that’s developing. It’s an incredibly important trading partner and export destination.

Do we need to try and diversify a little bit? Should there be other measures in place? Well, we only need to look at what Australia has done in terms of key service sectors. Export tourism and education — they are growth industries. China is very significant in both of those. It has important knock-on effects to the broader economy — when tourists come here, when the students come here in terms of dwelling — in terms of consumption. I think, to some degree, we are doing that already.

The other important part of that story is LNG. The big story in Australian exports last year, this year and into next year is really the growth in LNG exports. Most of those LNG exports at this stage are going to South Korea and Japan. So, there is a little bit of diversification going on there, and what looks to be a structural shift in Australian exports with LNG is increasingly important.

Question 9

How are emerging markets impacting the Australian dollar?

There’s a couple of transmission mechanisms. The first is when emerging markets come under pressure, it prompts a very ‘risk-off’ immediate reaction. That sees, very much, a shift into safe haven assets, primarily US Treasuries, the Swiss franc, yen and gold. It’s a pretty standard reaction.

The Aussie dollar is quite often seen as a bit of a proxy for risk-off, so it quite often gets hit fairly hard, and it’s not really just an Aussie-USD cross, it’s actually the Aussie-yen cross that probably moves the most, and that’s very consistent with risk sentiment. So, that’s how it translates through to the Aussie dollar.

The second is global growth is pretty good at the moment and it’s broad based. I think when there are concerns over emerging markets and concerns that volatility will ultimately be negative for emerging-market growth and the impacts more broadly on global growth; then the Aussie — a traditional barometer of global growth — also gets hit, so that translates through to a weaker Aussie dollar as well.

Thirdly, at times, the Aussie dollar and Australia are perceived as having half a foot in the emerging and the developed worlds. It’s obviously a developed economy — in the G10 space — and has all the characteristics of a developed economy, but its strongest trading relationship is to China. So, at times the Aussie dollar can get hit a little bit on that strength of that relationship, particularly if any of the emerging-market wobbles are related to China, so it’s no coincidence here.

Emerging markets … have been under pressure on and off all of 2018. That largely reflects rising yields and a stronger US dollar. The Aussie dollar up until several months ago was proving remarkably resilient. It only really came under pressure as the Chinese [economy] started to slow quite significantly around Q2 and the middle of the year, and the Chinese authorities started to take some action. [For example], easing rates, removing some of their curbs on lending and quite stimulatory fiscal policy.

And so, China looked like it was slowing quite a lot more than anyone anticipated. No coincidence. That’s when the Aussie dollar started lower and it’s struggling to hold 71 [US] cents at the moment.


Sacha Loutkovsky
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