September Economic Update – 2018

September Economic Update – 2018

This month we speak with Shane Oliver head of investment strategy and economics and chief economist and AMP Capita about falling house prices, economic warning flags, and how the US and China are positioning themselves in the early days of a trade war. Brought to you courtesy of Kaplan Professional.

Question 1

Despite high commodity prices giving a boost to national income, the RBA is predicting that terms of trade will decline over the next few years but remain relatively high. Do you agree with their analysis and if so, why?

What the Reserve Bank is saying is that we still have relatively constrained commodity prices … Everyone thinks that the iron ore price — we’ve had a bit of a run-up in the iron ore price — it’s risen to levels that are perhaps a little bit higher than the Reserve and the Federal Government were looking for, now they’re looking for a bit of a drip back lower again. I don’t have a problem with that in a broad sense. I think that’s probably a reasonable assumption.

In the very short term I’d have to say, assuming that we don’t have a disastrous global trade war that collapses global growth, then there’s probably … a bit more upside in commodity prices, particularly the oil price, with tensions in the Middle East. Global growth is relatively strong, so those things actually point upwards for commodity prices in the short term. So, my feeling would be that, yes, they probably will drip down eventually, but in the short term, providing the world economy doesn’t fall apart, there might be a bit more upside.

Question 2

A report by [The Sydney Morning Herald’s] Domain states that the national median house price fell by 1% over the June quarter. This is the first fall in in six years and is largely a result of tumbling house prices in Sydney and Melbourne. What is your view on home prices?

What we’re seeing so far, I have to say, is not that surprising. The big surprise for me was that the boom went on for so long in Sydney and Melbourne, but with all of these things they ended up going too far. Sydney and Melbourne property prices became exorbitant. Unaffordability became a major problem. Debt-to-income ratios went through the roof, and of course there was a deterioration in the margin and lending standards. So, I think a lot of those issues are now starting to be redressed.

We’re seeing prices come off, led by Sydney. Melbourne is following. We’re seeing an increase in supply of properties, so that’s a contributing factor to the weakness we’re seeing. The banks have tightened their lending standards, and all up we’ve still got more downside to go. Top to bottom I’m looking for, roughly speaking, a 15% fall in Sydney and Melbourne property prices of which we’ve already seen a little bit of that over the last six months or so, but I would point out I don’t think this is a crash. Prices went up somewhere between 50–70% over the previous 5–6 years, so it’s really just giving back some of that.

The other aspect to note is that other cities are in a totally different situation. Perth and Darwin, to me, look to be bottoming out or close to the bottom anyway. I don’t know when the precise bottom will come, but I think they’re close to the bottom rather than about to take another leg down. The other cities, Adelaide, Canberra, Brisbane, have just been seeing moderate growth. That will probably continue. Hobart has been going through a bit of a boom. That will probably go on for a while yet before that slows down.

The overall environment is a softer one nationally, but [you’ve] just got to be careful in terms of which city you’re referring to because they are in very different cycles. The big picture issue is, “Are we going to have a crash”? As I mentioned, I don’t think so. The reason for that is unless you get much higher interest rates, much higher unemployment, or a massive tightening on lending standards, it’s very hard to see a crash unfolding.

Don’t forget Australians have to service whatever amount of money they’ve borrowed. They can’t just hand the keys back in because property prices fall below the amount of debt they have. By and large, most Australians are comfortably servicing their mortgages despite the media scare around this issue.

Question 3

There’s talk of warning flags in the economy, such as overvaluation in the stock market, and the flattening yield curve in the US is also a concern, but other economic indicators are going strong. Why the mixed signals?

It’s often the case that we do get mixed signals. Now we’re at a point where we’ve moved well beyond the low point in the economic cycle which, depending on how you look at it, was several years ago now. It was either in the last recession globally, back in 2009, obviously the recessions in Europe around 2011/2012, but we’re a long way from that. We’re also a long way away from the last downturn, which was around 2015/2016.

So, we’ve moved up through the cycle. We’ve seen a pick-up in inflation. We’ve seen the US central bank raising interest rates, so in that context it’s natural to see the yield curve flattening out. Some people regard that as a guide to what will happen next in terms of economic growth. Historically, in the US there’s been a good leading relationship between the shape of the yield curve and whether America has a recession or not, so that flattening obviously has created some consternation.

But there are other indicators which are nowhere near as negative as that. Firstly, it’s worth pointing out the yield curve in the US is still positive, as it is in other countries; it hasn’t gone negative, so we’re not inverted just yet. Secondly, there’s a debate about what the yield curve itself is telling us. Some people say, “The longer-term end is distorted”.

In fact, the US Federal Reserve would argue, “Well, maybe you’ve got to look at a shorter-dated yield curve”. So, the gap between two-year bond yields and short-term interest rates, it’s actually been rising. It’s giving a different message again, despite having given the same lead over recessions in the past as the longer-dated yield curve.

The point here is don’t get too hung up on yield curves. They can give different messages.

Likewise, when you look at the US, and I’m focusing here on the US because it’s further advanced through the cycle than say Australia or Europe or Japan … other indicators are a lot more benign. We’re not seeing anywhere near the housing boom that we saw prior to the last downturn in the US. We’re not seeing a business investment boom. It’s picked up, but it’s still pretty modest compared to what it was prior to the tech wreck in 2000.

If you look at overall cyclical spending in the US economy, allowing for consumer discretionary spending, it’s also a relatively low share of GDP, so we’re not seeing exuberant excesses that you normally see prior to a recession. We’re not seeing a breakout yet in inflation. Inflation pressures are rising — by the same token, there is very low wages growth in the US.

So, a lot of the things you normally look for to see a recession just aren’t there yet. Maybe we will get there at some point down the track, maybe 2020, maybe 2021? I don’t know precisely when, but the point is we’re not there yet. That tells me the broad environment for growth assets, assuming we avoid a full-on trade war, is still a reasonably positive one.

Question 4

As you previously stated, the issue of a trade war has been done to death, but it won’t go away. The Chinese appear to be targeting [President] Trump by putting a tariff on soy beans, an important industry for his support base, and Trump has offered $12 billion in emergency aid to those affected. As forecasting how this will play out is inherently difficult, a more apt question is, “How are the US and China positioning themselves, and what options are they giving themselves for their next moves?”

What’s happening at the moment is that they’re digging themselves into a bit of a corner and neither side wants to give in. If you think back a little bit, this trade debate actually started in the presidential election campaign in 2016. Last year, President Trump focused on tax cuts and deregulating the US economy, which in hindsight looks like he was planning to shore the economy up for this potential trade war this year.

So, he’s bolstered the US economy ahead of tougher policies that he would implement this year … He started early this year with solar panels and washing machines — not much impact there — but it moved on to steel and aluminium.

Again, this was seen on a global basis and of course more recently, since late-March, focused solely on China because that’s where America’s biggest trade deficit is … Also, America has these gripes with the Chinese who haven’t been respecting US intellectual property appropriately, so a lot of the dispute is with China.

Initially, there was some progress. In May, we did see negotiations between the Chinese and the US in Washington. Looks like they came to a good deal. President Trump was tweeting about it positively the next day or so, then he got a bit of a backlash from some of his supporters that said he’s not tough enough, and within a week or so he’d actually backtracked and that deal was out the window.

What’s happening now is that the American side is feeling somewhat emboldened and the US economy is strong. We’re seeing support for Donald Trump actually maintain its pre-trade skirmish levels. In fact, if anything it’s gone up a little bit. So, he’s thinking, “Well, I’ve got to keep going down this path. It might help me or my party get re-elected come the mid-term elections in November this year.”

So, he’s sort of dug in on one side and the Chinese are saying “We had a deal with you and then you cod-washed it. So, we don’t trust you anymore.” They’re digging in on the other side, so I suspect this conflict with China could go on for a little bit longer, quite possibly into next year, and therefore we may see more of those threatened tariffs imposed on China.

It is worth bearing in mind here that the amount of imports coming to the US at the moment that have been subject to these extra tariffs are around 3-4% depending on how you measure it, so it’s relatively small. This is not 1929/1930 when the Smoot-Hawley Bill put a 20% tariff on all imports, so we’re a long way from a global trade war at the moment, but obviously the risks are worth keeping an eye on.

Question 5

With this in mind, what is happening with synchronised global growth?

Synchronised global growth is a term that often gets bandied around, and it was bandied around towards the end of last year, the start of this year. We did seem to see the situation where all countries were seeing an improvement in growth, so it became more synchronised. As we’ve come into this year, it’s become less synchronised.

The US economy has accelerated, particularly it seems through the June quarter, whereas other parts of the world have slowed down, notably the Europe Union or Europe generally, Japan and to a lesser degree China. So, we seem to have moved into a less synchronised phase. Obviously, if some of these tariffs ramp up in some countries and not others, then they get more affected than others. That could add to that de-synchronisation. To some degree, that’s a concern.

In other ways though, as long as the aggregate number is still okay, you don’t worry about it too much, and in relation to China where the biggest risk is at the moment. And don’t forget Donald Trump is a little bit right here when he says it’s easy for America to win a trade war because America has a trade deficit with the rest of the world.

In other words, they’re importing more stuff than the rest of the world and they’re exporting to the rest of the world. That’s particularly the case with China. China is quite vulnerable in that sense because they import less from the US than the US imports from them. In that sense, China is vulnerable, but the Chinese have recognised this and they’re starting to ease up on the policy break.

Now we are seeing monetary stimulus kicking in. There was some focus on getting credit growth down. That focus seems to be proceeding a little bit. Likewise, there’s talk of more proactive fiscal policy in China, talking tax cuts, infrastructure, spending and so on.

This is not 2008/2009 where we’re going to get a massive spending boom, but it does seem as if the Chinese are going to head off any significant slowdown in their growth via stimulus measures. That says to me when you look out there globally, it’s become a bit messier than it once was. It’s not as synchronised as it once was, say nine months ago. But by the same token, it’s still a reasonable global growth backdrop.

 

Sacha Loutkovsky
sacha.l@orionfg.com.au
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