Month: September 2015

They say we’re in an ‘income recession’…

That was one of the main take-outs in the mainstream press from the last round of National Accounts data released a few weeks ago now.

That soundbite is based on the National income figures – in real terms showing that National income has fallen for two consecutive quarters. It makes for a dramatic headline, but it doesn’t tell us much about the source or distribution of this fall in National income – employee compensation and/or business profits. The main source of this fall in National income can be traced back to private non-financial corporations, more specifically, to those in the mining industry. Given the fall so far in the Terms of Trade (ToT), this should be no surprise. That said, the impact is large. For the moment, the other important elements of National income, non-mining profits and compensation of employees, are both still growing, but that growth has at least halved over the last five years as the ToT has started to fall.

Will this latest fall in mining profits be absorbed by the corporate sector or will it trigger another round of falls in non-mining profits and employee compensation?

The “income recession” in charts

The ABS produces a number of National income measures. There are two important ones.

Firstly, Real Gross Domestic Income (real GDI) – “Real Gross Domestic Income (GDI) measures the purchasing power of total incomes generated by domestic production by including the impact of the ToT on GDP” (source: ABS)

Given our ToT have shifted dramatically both up and down over the last fifteen years, GDI is a better measure than GDP of the impact on our living standards.

On an annual basis, real GDI has declined at an annual rate of 0.1% and 0.2% over the last two quarters respectively.

Source: ABS

This chart highlights just how far below trend real income growth has been in Australia since 2011. This has been triggered by falls in the prices of our major commodity exports and helps to explain why the economy is experiencing lacklustre growth.

So far, the annual fall in real GDI has been small relative to the major downturns, but growth has slowed from high levels, so the move is still a large one. There is likely to be a continued impact on National income as further falls in the ToT are expected.

The second, even better, measure of National income is Real Net National Disposable Income (real NNDI). This adjusts GDP for shifts in the ToT, nets out depreciation and takes account of net income flows to foreigners. It indicates the real net income available to Australians. On this basis, National income has fallen even faster – by -0.2% and -1.1% on an annual basis over the last two quarters respectively.

Source: ABS

On a per capita basis, the effect is even more dramatic – real NNDI per capita has been falling on an annual basis for the last twelve (12) quarters – and that decline has accelerated over the last couple of quarters:-

Source: ABS

The decline in real NNDI is not yet of the depth that we saw during the major downturns of the early 80’s and 90’s – but the economy isn’t technically in a recession as it was during those periods.

Breaking down National income growth – business profits and compensation of employees

The data provided by the ABS to get to this further level of detail is in current prices – which means it hasn’t been adjusted for price inflation so will differ slightly to the data above. Where necessary, I will adjust.

The bulk of our National income is 1) compensation of employees (48%) and 2) the gross operating surplus of business (31%). The “gross operating surplus” is a proxy for business profits and this 31% figure represents private non-financial corporations, public corporations, financial corporations and I’ve also included un-incorporated business in that figure, which is usually separate, called “gross mixed income”.

The two biggest areas of, and the two biggest contributors to, overall National income growth are private non-financial corporations and compensation of employees. Together they provide some insight into the performance of the economy – consumer/household spending decisions and business activity with regard to expansion or contraction of activity.

Over the last year, the gross operating surplus of private non-financial corporations was the only area that detracted from National income growth. The biggest area of National income, employee compensation, made the largest contribution to overall growth +1.07%pts.

Source: ABS 5206.07 – I have used ‘income from GDP’ in order to get the most detailed breakdown of Gross Operating Surplus and Factor Income. Total GNI and income from GDP are similar, but not quite identical.

It’s hard to know whether this is good or not without looking at how these measures have changed over time. The overall level of growth and its composition over the last 5 years tells a far more important story of the Australian economy.

In the last 2.5 years, overall growth has slowed from over 8% on average to below 2% in the latest quarter. The blue and orange bars are of special interest in the chart below:-

Source: ABS 5206.07

Growth in compensation of employees has more than halved (blue bars). Even though employee compensation is still making a positive contribution to GDP growth, growth has become significantly lower over the last 5 years. The average growth of employee compensation has slowed from 7.1% to 2.4% during the first half of the last five years versus the second half. This is also a factor behind the lower level of National income growth. Part of the reason for this slow-down in employee compensation growth over the last five (5) years may be as a result of that first fall in private non-financial corporate profits back in late 2011 (the orange bars). Despite private non-financial corporate profits improving into 2013, growth in employee compensation has remained at this low level. At the same time, there has been a higher proportion of part-time workers in the economy, much slower growth in wages across a wide range of industries, lower level of employment growth, higher unemployment and lower overall labour force participation.

The employee compensation element of National income is not in an “income recession”, but it is contributing to overall lower growth in National income. Whilst compensation of employees is currently growing at +2.2% in current prices, in real terms, it is growing much less, around +0.9% (deflated using the IPD for HFCE). So far, other sources of income are supplementing employee income in this lower growth environment – net household savings has been declining -4% on average since Sept 2012 (source: ABS 5206.20) and household debt continues to reach new highs.

So is the penny about to drop again?

Private non-financial corporate profits have been falling for the last three quarters on an annual basis (the orange bars above). The last time this happened (2012), there was a corresponding fall in compensation of employees as corporations cut costs in order to protect profits. If this is a ‘widespread’ fall in corporate profits, then there is a risk that we may see further falls in employee compensation and a further weakening of the labour market.

So far, the bigger falls in corporate profits are “limited” to mining, but there is weakness among other industries.

The gross operating surplus of private non-financial corporations – mining versus non-mining

The decline in mining profits, driven by the fall in commodity prices, is so large that it affects the aggregate picture of corporate profits in Australia. In terms of its profits, mining represents 28% of total private non-financial corporate profits. The next largest industry by this measure is manufacturing at a 10% share. That gives you a sense of the scale and likely impact of falling mining profits.

While mining profits detracted over -7% pts from growth in corporate profits, non-mining still contributed +3.4% pts to growth.

Source: ABS 5676.11

But over time, we’ve also seen the profits of the non-mining sector slow. Between Mar 2000 and Dec 2009, corporate non-mining profits grew by +12% on average. Since the peak of the ToT in 2011, non-mining profits have grown by a paltry 1.8% on average.

Source: ABS 5676.11

On a bright note, in the latest quarter, the annual rate of growth in non-mining company profits jumped to +5%. This was primarily driven by two sectors – retail and wholesale. This is mostly likely linked to the end of the financial year and “Tony’s Tradies” taxation incentives from the 2015 budget. Since June, retail sales have dropped back somewhat.

The problem is that in some of the bigger non-mining industries, profit growth is not yet accelerating – despite lower interest rates and a lower AUD.

In the chart below, company profits in the first nine (9) industries listed in the chart detracted from growth in the latest quarter. That represents a negative turnaround from a positive annual rate of profit growth in industries such as construction, transport/postal/warehousing, arts & recreation, admin services and accom & food services.

Source: ABS 5676.11

As mentioned, the second largest industry by share of company profits is manufacturing, representing 10% of profits. Company profit growth in manufacturing staged a great comeback throughout 2012/13 but that stalled throughout 2014/15 and manufacturing continues to detract from overall company profit growth. Manufacturing company profits remain 20% below where they were 5 years ago.

Construction is the third largest industry by share of company profits (8%) – growth in profits has slowed consistently over the last several years and in the latest quarter, profits fell versus the previous quarter as well as versus the same quarter a year ago.

Of the six industries that contributed profit gains, the largest was wholesale trade, which together with retail, is likely to be only a fleeting effect, given the latest retail sales data.

At best, non-mining corporate profit growth is weak. In this environment, there is a risk that compensation of employees will be impacted further and, in real terms, could start to decline.

So far, the source of the ‘income recession’ can be traced back to the fall in profits within the mining industry. If mining profits continue to fall, then there is likely to be continued spill-over effects into related and supporting industries as well as employment. At the same time, profit growth in non-mining industries is also languishing. After 3 consecutive quarters of declining company profits, corporates will be under pressure to continue to cut costs. It’s unlikely that the corporate sector will just continue to absorb these falls. The immediate risk is to the labour market and compensation of employees. So while the “income recession” has so far been driven by one sector, there is a risk that this could spread into the other areas of National income.

Capital expenditure in Australia continues to fall – Sept 2015

Private capital expenditure in Australia continues to decline and there is little sign of a turnaround in the coming year.

We always knew that capex would be impacted as the commodity boom started to shift into the more operational phase of the commodity cycle. The recently released National accounts show a continued decline in real capital expenditure (Private Gross Fixed Capital Formation) of -4%, subtracting -0.9% pts from the latest annual GDP growth. Most of that decline was driven by a fall in “engineering construction” as a result of this transition in the phase of the mining boom.

What was hoped for by the RBA was that a ‘rebalancing of growth’ could be engineered by lowering interest rates to stimulate non-mining investment and by weakening the AUD. We now have lower rates and the AUD has depreciated to levels that should improve our export competitiveness. Rather than see a continued pick-up in non-mining investment activity, the latest business capex expectations showed that capex intentions outside of Mining for the next financial year are also likely to fall. The quarterly Survey of Private Capital Expenditure (capex) showed that while mining capex is expected to fall by -37%, non-mining capex is also expected to fall by -5%. Overall, capex is expected to decline by 23% in 2015/16. At a total level, this is a fairly significant decline.

The issue in Australia is that the lack of investment growth to help take up the slack now left by lower mining investment highlights a lack of confidence in future growth. This quote from Glenn Stevens (RBA Governor) is as relevant today as it was a year ago:-

“…any plans for growth that might be in the top drawer remain hostage to uncertainty about the future pace of demand”

  • Glenn Stevens Governor RBA, testimony to the Standing Committee on Economics, 20th Aug, 2014

And now, a year later:-

“The missing ingredient continues to be a lift in non-mining business investment, where we are still waiting for convincing signs of a pick-up”

  • Philip Lowe, Deputy Governor RBA, Speech to the Committee for Economic Development of Australia (CEDA) 9th Sept, 2015

Just how bad is the situation with capex?

So far, we’ve had eight (8) consecutive quarters where total private capex has declined (annual % chg based on latest qtr versus the same qtr previous year).

Annual capex growth has gone from a high of +17% in 2011 to a -4% annual decline in the latest June 2015 data.

Source: ABS

From a long term perspective, declines in capex have been infrequent and part of a broader economic slow-down. The capex decline so far is low compared to historical standards, but expected capex for 2015/16 could be more in line with previous steeper declines.

The split between mining and non-mining capex is interesting.

Source: ABS

Whilst the value of mining capex has fallen sharply since 2013, it looks like non-mining capex has started to pick up at the same time – helped in part by lower interest rates and the falling dollar. That said, growth in non-mining capex has been, on average, lower since the end of the mining investment boom, growing at +3.3% on average (between Mar 2013 and June 15) than during the main investment boom years (2000-2012) when non-mining capex grew at +4.2% on average. More recently, while there was some acceleration in non-mining capex growth throughout 2014, that momentum has stalled during 2015.

What has contributed to the decline in private investment?

According to the latest GDP data, the single largest contributor to the decline in private capex is in non-dwelling construction. This is the single largest area of private capex spending, accounting for 35% in the latest quarter. Within non-dwelling construction, it has been engineering construction that has declined significantly – this is the type of large scale construction supporting the development of major mining projects. The contribution of non-dwelling construction to annual private capex growth has declined further in the latest quarter:-

Source: ABS

The only area that has made a more significant, and positive, contribution to private capex growth is Dwellings – which covers construction of new dwellings and additions/alterations to existing dwellings. But the contribution of dwelling construction to overall private capex growth has also slowed between the last two quarters. Again, not a great sign, given we’ve got record levels of lending for housing and very low interest rates. Construction of new dwellings accounted for 25% of private capex spending in the latest quarter.

The one piece of good news was in machinery and equipment expenditure. This is also one of the bigger areas of private capex, accounting for approx. 20% of private capex and was one of the few areas where contribution to overall capex growth improved.

So what does the future hold?

The June 2015 Capex Survey indicates more declines to come in 2015/16

As I’ve pointed out in previous posts, the Capex Survey is not a comprehensive representation of all new capital expenditure intentions in Australia. The dollar value of the capex intentions and actuals, represent just over 40% of the above more comprehensive investment element in GDP (Private Gross Fixed Capital Formation data used above). It still useful in providing some indication about the general direction of intended capex spending across a range of industries. Industries not included in the survey include agriculture, forestry and fishing, education, health and community services and capex on dwellings by households.

This latest survey for June 2015 covered actual capex for the full year 2014/15, as well as the latest forecast capex for the year 2015/16 called estimate 3. Estimate 3 contains a forward view of the next four quarters of capex – at this stage, the data for all next four quarters are estimates (no actuals yet).

For the full year 2014/15, actual capex included in the survey declined by 4.7%, or -$7.3b. Note that this is larger than the -2.6% in latest GDP data, when calculated in the same way.

Unfortunately, the latest forecast for capex in 2015/16 holds little hope that this will improve:-

Source: ABS, est 3 2015/16 not adjusted using realisation ratio

Estimate 3 for expected capex in 2015/16 signals a possible fall of -23% in spending, or a decline of -$39b. The chart above also highlights the concerning trend of this leading element.

It’s fair to say that these expectations have tended to ‘overshoot’ the final ‘actual’ to both the upside and the downside. So at worst case, actual capex will follow that lead, but is not likely to fall further than that.

The other concerning point from the capex survey is the composition of industries forecasting a decline in spending in the following year:-

Source: ABS, note realisation ratios used mining = 0.89, manufacturing = 1.07, other selected industries = 1.18, total = 1.0

The fall in mining capex has been expected for a quite a while. That said, the expected decline in 2015/16 is fairly large at -37% or -$28b.

The continued decline in capex for manufacturing is an ongoing issue. The high AUD hurt Australian manufacturers during the mining boom and the wind back of industry protection policies over the last several decades has seen the manufacturing sector shrink in size. No doubt globalization has also had an impact on the broader sector as much manufacturing has been outsourced to lower cost countries. The Australian dollar has now depreciated by close to 30% and capex still looks to remain depressed in the short-term. It won’t help that car manufacturing will also cease in Australia by 2017.

A lower AUD is no magic bullet as it will take time to rebuild export businesses and relationships. Manufacturers, and more immediately, service providers, in Australia that compete with imports may see a more immediate effect as the falling AUD filters through the supply chain. But only once there is consistent stronger growth, will capex businesses cases start to look more viable. The one downside to a weaker AUD is that import of capital equipment will become more expensive.

The one bright spot in the survey had been capex for “other selected industries”, which grew by +12% in 2014/15. Expected capex for ‘other selected industries’ is now forecast to decline by 5.3% in 2015/16. The ‘other selected industries’ accounts for a significant proportion of the value of capex in the survey and comprises key services industries. Growth in capex for this group had been stronger, relative to mining and manufacturing, over the last several years.

What does this mean for the Australian economy?

Usually, falling levels of capex are not a good sign for the economy. The fall in investment means that we will likely continue to see lower levels of growth in the economy. This could adversely impact employment, income and output growth.

One possibility is that the fall in mining investment will just be replaced by the increase in commodity exports as major mining projects start to come online. That has been a leading theory of the mining boom, but that’s not what has been happening recently. Part of the issue is that whilst export volumes have been rising, commodity prices have been falling. In nominal terms, net exports have detracted from GDP growth (on an annual basis) over the last five (5) consecutive quarters:-

Source: ABS

The other issue is that if global growth is slowing, then it’s more likely that demand (i.e. volume) for commodities will also fall because they are usually inputs into the production process.

Could housing construction fill the gap? There are still a few important headwinds. APRA is in the process of curbing investment loan growth, rightly recognising that the high proportion of mortgages on bank’s balance sheets represents a ‘concentration risk’ to the financial system. The residential dwelling construction component, whilst growing fast, is still not big enough to fill the potential gap left by mining. Putting aside any question of whether housing construction should fill the capex gap, growth in dwelling construction would need to accelerate from currently 23% to roughly over 40% (assuming that mining investment halves from here and all other components continue to grow at the current rate). With housing lending and household debt already at record highs, interest rates already very low and real wages and income stagnant at best, Australia would probably need to see greater levels of foreign investment in new dwelling projects for this to happen.

Could public infrastructure spending help fill the gap? This might not fill the entire gap, but at least well targeted investment on infrastructure projects would actually be good for the productive capacity of the economy in the future. The government has access to some very low interest rates, but it seems to lack any sense of urgency or leadership to get something done on both the infrastructure and reform fronts.

“A low exchange rate, low growth in wages and low interest rates are not the basis for sustained increases in investment and output. They can certainly help during the adjustment phase, but ultimately we will be better off if increased investment is driven by high expected returns rather than by the low cost of finance or low wages. This is why the focus on improving the climate for business investment is so important. There is no magic bullet here, but surely the investment climate would be improved through a strong focus by both business and government on innovation, productivity, human capital and entrepreneurship, topics that I have spoken about on previous occasions.”

  • Deputy Governor of the Reserve Bank of Australia, Philip Lowe, Speech to the Committee for Economic Development of Australia (CEDA) 9th Sept 2015

Fundamentally, the missing ingredient is growth. This is why private capital investment growth is an important indicator. In a most simplistic way, it’s a sign that business is expecting growth – growth in sales, consumption and/or profits. Investment might take the form of new equipment to expand production or the introduction of a new technology/innovation to improve productivity. Either way, it’s about expanding the productive capacity at a firm-level in order to take advantage of growth opportunities – this is the cornerstone of economic, employment and productivity growth.

Meanwhile, in Australia…

“…firms are more focused on paying dividends than on investing in the future of their businesses or the country. At 91 per cent, the proportion of ASX-listed companies paying a dividend is now the highest on record, up from 83 per cent five years ago. Most of them increased the dividend in the latest year despite flat or falling profits”, Business Spectator, Too much Talk, Not Enough Action, 1st Sept 2015