GDP

Negative outlook for GDP – Sept 2016

There are several concerning aspects to the Sept quarter decline in Australian GDP.

The main one is that this was not the result of an external shock forced upon our economy. It is a reflection of the state of our low growth economy and how vulnerable we are to quarterly gyrations in spending. On a broader level, investment spending continues to detract from overall growth. Even growth the strongest area of spending, household consumption spending, is starting to slow. Whilst there were a few bright spots, there is some evidence to suggest that this may not be the ‘one-off’ event.

Sept qtr GDP declines by -0.47% in real terms, annual growth slows to +1.76%

Over the longer term, real GDP growth has continued to trend lower and even more so since 2011:-

Source: ABS

There was little surprise in the contributors to the latest quarterly decline in GDP:-

Source: ABS

Public and private investment spending were the main contributors to the quarterly GDP decline. Private investment spending has been a drag on growth for several years now.

Net exports also made a negative contribution in the latest quarter. The net export result (exports less imports) was actually positive for the third quarter in a row, but that ‘surplus’ in real terms was smaller than in the previous quarter.

On the positive side, household consumption spending continued to contribute to overall GDP growth. Growth was not strong enough to offset the declines elsewhere and household consumption spending is continuing to slow.

Public and private investment spending is a drag on growth

The decline in private investment spending, due the end of the mining investment boom, continues. But it was also public investment, dwelling related construction investment and new non-dwelling building construction that drove the overall decline in investment spending in the latest quarter:-

Source: ABS

Most notable was the “improvement” in the latest quarter for private business investment which made a positive, albeit small, contribution to quarterly GDP growth. This was driven by three of the four areas –

  • There was a small improvement in investment spending on machinery and equipment – but total spend in real terms remains 16% below the peak
  • Cultivated biological resources (small) and intellectual property products both grew in the quarter

These areas off-set the 12% quarterly decline in the non-dwelling construction spending component of total business investment – this includes mining related engineering construction.

One thing caught my eye in the non-dwelling construction data. It was actually a speech by the Treasurer, Scott Morrison that led me to this. First the quote:-

“In this new data, though, released today, new building construction was also down 11.5 per cent for the quarter. That was impacted by some weather events during the course of the September quarter, as we know can affect these figures from quarter to quarter, when you break it down to that level. It was also the result of some larger projects coming to an end. But with such a change in both engineering and building construction, there could not have been a more important time to have passed legislation to restore the Australian Building and Construction Commission…” Australian Treasurer, Scott Morrison, 7th Dec 2016

The full transcript is available at http://sjm.ministers.treasury.gov.au/transcript/178-2016/

I was curious about the 11.5% decline in new building construction. Non-dwelling construction is one of five areas that is measured as a part of total private sector investment spending in Australia and accounted for approx. 30% of total private investment in the latest year to Sept 2016. New building construction falls under this category and while it isn’t the largest area of spending in non-dwelling construction, it might say something about sentiment. The following chart looks at the trend in private non-dwelling construction spending since Sept 1976:-

Source: ABS

What immediately stands out to me is the cyclical nature of new building investment spending over time. Note that this chart is in real dollars, so we can compare spending over time.

Splitting out new non-dwelling building construction strips away the overriding influence of engineering construction spending of the mining boom – that is when this cyclical trend becomes evident.

All of the obvious major declines in non-dwelling construction of new buildings correlate in time with our largest episodes of economic weakness: recessions of ’81 and the early 90’s, the dot-com bust in 2000 and the GFC in ’08. Which leads me to ask: is the decline in the Sept 16 quarter a warning that this is not just a ‘one-off’ in GDP decline? The decline doesn’t appear to be related to any mining slow down, as spending on non-dwelling buildings continued to grow while construction engineering (the mining element) started declining from the Dec 2013 quarter. Actual spending on new non-dwelling buildings only topped recently in the Dec 2015 quarter, but fell much harder in the Sept 2016 quarter. The deceleration in new credit for business at the same time, is also evidence that something may have shifted in the spending and investment patterns of business in Australia.

This is only one quarter of data. The forward looking nature of construction investment spending lends itself well as a proxy for business sentiment. At the very least, it is an interesting chart and it will be something that we will continue to monitor.

What is likely to change with regard to investment spending?

Public investment spending is likely to be subdued unless the government changes its focus on reducing spending to improve the budget deficit – but that focus is not likely to change:-

“Once borrowing for recurrent expenditure is under control, we will have more headroom to take on and deploy so-called good debt,” Scott Morrison, Australian Treasurer, 14 Dec 2016, in response to calls for the government to take advantage of low interest rates and boost investment spending on infrastructure.

Whilst private investment spending is still detracting from growth, the impact wasn’t as negative as in previous quarters:-

Source: ABS

But investment spending intentions are still lacklustre for the rest of the 2016/17 financial year. The latest capex survey (which doesn’t cover every industry – approx. 60% of the ‘value’ of private investment spending) highlights that non-mining investment spending will remain fairly flat, with only minor increases versus the year prior:-

Source: ABS

The overall -17% decline equates to approx. -$21B less investment spending versus the prior year.

As mentioned, the credit impulse for business shows a sharp deceleration in growth for business credit. This will need to reverse and turn positive before we anticipate improvement in business spending.

Household consumption is the key growth driver – but growth is slowing too

The strongest contributor to GDP growth remains household consumption expenditure. Household expenditure accounted for 57% of real GDP in the year to Sept 2016 – the single largest area of measured spending in the economy.

But quarterly growth in household consumption spending is continuing to slow.

In the latest quarter, household consumption spending in real terms grew by +0.44% – and has been slowing for the last 3 quarters. It is now at its slowest level of quarterly growth since 2012:-

Source: ABS

The state split of household expenditure provides some interesting insights into the growth shift among the states:-

Source: ABS, the HH Final Consumption Expenditure figures are sourced from the State Final Demand worksheets. The total of State Final Demand is more or less the equivalent of Domestic Final Demand (GDP less inventories, net exports and statistical error). The contribution figures are based on total state final demand.

On an annual basis, NSW and VIC accounted for the largest share of the total growth in household spending. But in the latest quarter, there has been a clear shift away from NSW, the single largest state driver. Growth in household spending in NSW has slowed fairly significantly over the last two quarters from +1.1% in Mar 2016 qtr to +0.08% in the Sept 16 qtr. On the positive side, household spending in QLD has accelerated higher in the latest quarter to be the strongest performing state.

The slower growth in household spending is not surprising when you consider the weaker labour market, record low wage growth and the deceleration in new private credit growth. If these three trends remain firmly in place, the expectation will be for continued lower growth in household spending.

National income growth – improving off the back of commodity prices

The growth in the Real Net National Disposable Income is the best indicator of changes in national income and annual growth is now up to +3.2%.

Source: ABS

Unfortunately, we can’t break this data series down into its income component parts, so we need to look at Gross National Income at current prices to see how this improvement has been shared throughout the economy.

In the last two quarters, it’s been the return of corporate profits (orange bars, chart below) from a negative to a positive contribution that has been a major driver of domestic income growth – this is not surprising given the improvement in the Terms of Trade (ToT).

In context of history, overall income growth is still extremely low (all four coloured stacked bars add up to the annual rate of growth in GNI in each quarter):-

Source: ABS

There has been a small improvement in the annual contribution of compensation of employees over the latest quarter (red bars). But at the same time, annual small bus profits (Gross Mixed Income) declined after a solid performance during 2015.

Hours worked grew in the Sept quarter GDP and the rate of growth is consistent with that reported by the monthly labour market reports. The latest GDP results show hours worked in the economy grew by +0.49% for the Sept qtr versus +0.41% for the Sept qtr using the latest month labour force data (Nov 16). The labour force data highlights that this is growth is driven by PT hours worked, which grew by +1.26% for the Sept qtr versus +0.24% growth in FT hours. This helps to explain why the contribution to of compensation of employees remains low.

The most concerning part of this report is the government response to it. The economy is clearly not getting better and we face more headwinds in the form of potentially higher interest rates and slowing growth in China (Chinese authorities are trying to deal with internal liquidity issues). Yet, no one seems to want to face the giant elephant in the room – our economic model, based on accelerating debt growth and house price growth is faltering. Not that it should be saved. This should be an opportunity to start the process of reform in our economy, to manage our country away from this debt-driven model – but this is not happening. We are falling behind in our standard of education and we have one of the poorest performing broadband networks in the world. We have tax incentives targeted at speculating on property rather than rewarding labour and entrepreneurship. This is hardly the stuff of the agile economy for the future.

Declining consumer prices – March qtr 2016

Last week, the ABS released the March 2016 quarter CPI data. This was attention grabbing stuff with headline CPI falling -0.2% in March. Suddenly, we were in the grip of deflation and many news outlets were quick to latch onto this story. I’m the last person to joke about deflation. Asset price deflation is a very serious threat to our country because we are so highly leveraged and our financial system is ‘all-in’ on housing. I’m also less positive than most about economic growth and recent developments in the labour market. But not much time was spent looking through the CPI data before jumping straight to the “deflationary” headlines last week.

The deterioration in CPI growth between the last two quarters from +0.4% in the Dec quarter to -0.2% in the Mar quarter can be attributed to categories that have more external/international exposure, rather than categories that are more of a reflection of domestic conditions.

That doesn’t mean that domestic factors haven’t played a role in the slowing of CPI growth over a longer period of time. The economy has been growing at below trend/potential as it transitions from the peaks of the mining investment boom and especially since the terms of trade (ToT) started to unwind. This has been highlighted by the RBA for several years now and policy settings have been focused on supporting demand during this transition. But is this CPI print a reflection of how demand in the economy has deteriorated in the latest quarter?

Headline versus core CPI measures

The RBA does not tend to rely on the headline CPI figure in evaluating consumer price pressures for interest rate policy. The focus is more on measures of core inflation – the weighted median and the trimmed mean. Both of these remove the volatile items to provide a measure of underlying strength in consumer prices within the economy.

Annual growth in the trimmed mean has slowed to its lowest level and quarterly growth was +0.2% in March. Annual growth in the weighted median also slowed to its lowest level of growth of +1.4% and +0.1% for the quarter. Both measures are outside of the 2-3% average inflation rate.

Source: ABS

Both of these measures have been trending lower for a while and the RBA has tended to ‘look through’ this slowing of consumer price growth. Throughout 2015, there were signs of improvements in the Australian labour market, despite lower wage growth, moderate economic growth and a weakening AUD. From the April board meeting, the RBA assessment was for “reasonable prospects for continued growth in the economy, with inflation close to target” (RBA Minutes April 2016). That was four weeks ago.

Do we still have ‘reasonable prospects for growth’?

In short, when demand conditions are weak, inflationary pressures are likely to be less. In other words, softer price growth, or price declines, are another way of assessing the strength of demand in the economy. The question is whether this CPI decline is indicating a slowing in domestic demand conditions enough to warrant further interest rate cuts.

The tradable v non-tradable CPI series provides the most important insight on price pressure in the economy

An insightful way of assessing the source of consumer price pressures is to look at the tradable versus non-tradable series of the CPI. Consider the example of falling fuel prices throughout 2015. Fuel prices have fallen globally and aren’t necessarily an indicator of a fall in our own domestic demand – we are a price taker in such commodities.

I’ve referenced this RBA paper before and its worth revisiting here – The Determinants of Non-Tradables Inflation. There are several important points:-

“Non-tradable items are exposed to a low degree of international competition. This includes many services that can (in most cases) only be provided locally, such as hairdressing, medical treatment or electricity. The prices of these items should be driven mainly by domestic developments. Therefore, inflation for non-tradable items should provide a relatively good sense of the extent to which demand exceeds (or falls short) of supply in the domestic economy.”

“Tradable items are much more exposed to international competition. This includes many imported manufactured goods such as televisions and computers, as well as some food items and services such as international travel. The prices of these items should be less influenced by conditions in the Australian economy, and more affected by prices set on world markets and fluctuations in the exchange rate.”

And a word of caution about these classifications:

“The RBA acknowledges that in practice, drawing a precise distinction between a tradable and a non-tradable item is difficult. The exposure of an item to international competition is both complicated to measure and a matter of degree. The Australian Bureau of Statistics (ABS) classifies an item as tradable where the proportion of final imports or exports of that item exceeds a given threshold of the total domestic supply. Any item not meeting this definition is classified as a non-tradable. In general, many goods are classified as tradable while nearly all services are classified as non-tradable.”

Throughout the last several decades, annual non-tradable inflation has grown at a higher rate than tradable inflation in Australia:-


Source: ABS

Since mid-2013 though, non-tradable inflation has started to abate as the ToT has unwound and as income and wage growth has slowed.

When we break down the growth in tradables versus non-tradables to a quarterly basis, it becomes clear which area contributed to the much lower CPI print in the March quarter.

In the latest quarter, tradable CPI declined by -1.37%. That is a significant fall in just one quarter. On the other hand, non-tradable inflation increased by +0.45% in the quarter – but this is also still below the average for the last several years.


Source: ABS

The trend over the last 12 quarters highlights the volatility of the tradable series (this is also evident in the annual series).

We can go a bit deeper. In the latest quarter, the index of tradable categories contributed -0.55% pts to the -0.22% decline in headline CPI. The non-tradable categories contributed +0.33% pts to the -0.22% decline.

Source: ABS

Looking at CPI from this perspective suggests that it is less likely that the shift to a negative CPI in the March quarter came as a result of deterioration in demand, or events, within the domestic economy. It appears most of the ‘deflationary’ pressure came from those categories that are more exposed to international competition.

Where did the tradable deflation come from?

Tradables reversed from contributing +0.19% pts to CPI in the Dec quarter to detracting -0.55%pts to CPI in the March quarter. Many categories classified as tradable contributed to this reversal – there were twenty six (26) categories where the change in contribution slowed between the two quarters – that’s over half of the categories classed as ‘tradable’, so the slowdown in price growth was broad. The largest contributors to this reversal came from four (4) main categories:

  1. Tobacco price index in the Dec quarter contributed +0.26%pts to CPI growth. In the Mar quarter, price growth slowed and only contributed +0.03%pts. This was the single largest contributor to the -0.78%pt decline in tradable inflation between the two quarters. The tobacco federal excise tax biannual tax indexation came into effect 1st Feb 2016.
  2. Automotive fuel price index contributed -0.18%pts in the Dec quarter. This decline accelerated to -0.31%pts in the Mar quarter. Fuel prices look to have stabilized for now.
  3. Int’l travel accommodation price index contributed +0.6%pts to CPI growth in the Dec quarter. This reversed to detracting -0.5%pts to CPI growth in the Mar quarter.
  4. Fruit price index contributed -0.03%pts to CPI growth in the Dec quarter. This accelerated to -0.13%pts in the Mar quarter.

These top four categories were -0.57%pts of the -0.78%pt deterioration in price growth between the two quarters. There were 12 categories where price growth accelerated and 9 categories where there was no change in growth between the two quarters.

Non-tradable growth has been low in historical terms throughout 2015, but did pick up in the March 16 quarter. Nearly half of all categories classed as non-tradable recorded an acceleration in price growth in the latest quarter – this acceleration was broad based. The largest contributors were medical and hospital charges, secondary education, childcare, household fuels including gas and restaurant meals. There were ten non-tradable categories where price growth slowed between the two quarters, but there was only one large one – domestic holiday and travel, which went from adding +0.16%pts to CPI in Dec quarter to detracting -0.05%pts in the Mar quarter.

The notable slow down on the domestic inflation front has been from a slowing contribution from new dwellings and rents. This has been a function of slowing income/wages growth, a tightening of lending standards for housing to curb riskier lending by banks with regard to investor/interest-only mortgages and a general slow-down in housing demand, especially in key mining areas.

What is it saying about the economy?

The split between tradable and non-tradable inflation over the March and Dec quarters suggests that the decline in CPI was not led by the domestic economy. But growth in non-tradable inflation has been lower than average for a while and it is fair to say that this is a reflection of spare capacity in the economy.

The RBA has asserted that ‘transition’ (from mining) will be assisted by wage restraint, stimulatory interest rate policy and a lower dollar (“Managing Two Transitions”, Deputy Governor Philip Lowe 18 May 2015). Based on this, there are several important considerations for the RBA in assessing interest rate settings:-

Wage growth and the labour market – over the last 12 months, spare capacity in the labour force especially, has been reduced, as evidenced by an improved LFPR, a decline in the unemployment rate during 2015 and generally stable levels of GDP growth. Some of the lower wage pressure can be traced back to a rotation out of much higher paying mining-related jobs that may no longer exist into more average-wage jobs. From the last board minutes, the RBA expected a softening of labour market conditions, given the improvement throughout 2015. My last labour market update highlighted that momentum in the labour market is waning. Without accelerating employment growth, lower wage growth will place a brake on domestic spending and demand.

Housing and credit growth is likely to be an issue. A crack-down on lending standards, a focus on increasing bank capital buffers, and in some cases higher overseas funding costs, has led many lenders to raise mortgage rates and slow their investor mortgage lending – the opposite of stimulatory monetary policy. This is going to weigh on the RBA decision making. House price appreciation has been slowing and is falling in some markets. It’s another story altogether whether banks pass through any further rate cuts.

A lower AUD has been one of the key pillars to support the shift toward non-mining industries especially services exports. The strengthening in the AUD/USD since February could be cause for concern for the RBA. This has been partly driven by the US Federal Reserve putting the brakes on further US interest rate hikes. This has weakened the US dollar against most major currencies, but has also helped to stabilize global financial markets.

The minutes from the April meeting on monetary policy certainly opened the way for monetary policy to be “very accommodative”. The ultimate question is whether another rate cut is the stimulus that the economy needs to kick start growth again. Overall lower-than-average trend growth persists, not just in Australia, but globally. The RBA Governor asks whether we are ‘reconfiguring’ to this lower trend growth (“Observations on the Current Situation”, Glenn Stevens, 19 April 2016):

“That would help to explain why ultra-low interest rates are not, apparently, as successful in boosting growth in demand as might have been expected. The future income against which people would borrow looks lower than it did, not to mention that the current income against which some already had borrowed has turned out to be lower than assumed”

“If we could engender a reasonable sense that future income prospects are brighter, that there is a good return to innovation and ‘real economy’ risk taking, and so on, then people might use low-cost funding for more productive purposes than just bidding up the prices of existing assets”

In addressing the issue of lower trend growth, the RBA is also pointing to the need for more action on other policy fronts to support monetary policy.

“It is surely time that policies beyond central bank actions did more in this regard”

There may not be enough evidence just yet for another rate cut, but it’s likely to be a matter of time.

Transitioning well? Australian GDP & National Income – Dec 2015

At first glance, the data relating to the 4th quarter GDP was fairly straightforward. The Australian economy grew by +0.6% in the final quarter of 2015, better than the +0.4% growth expected, but well down on the previous quarter. The upward revision to the previous September quarter growth from +0.94% to +1.09% growth resulted in annual GDP growth upgraded to +2.96%. This bumped up annual GDP growth to just above average trend growth for the last 10 years. This got quite a few people excited and soon many had jumped back onto the bandwagon that the economy is transitioning well out of the mining boom. It’s always worth looking deeper into the drivers of growth and this quarter is no exception. Whilst this isn’t a bad result at all, there is still enough in the data to challenge the narrative that Australia is transitioning well.

December 2015 quarterly real GDP growth +0.63%

Despite being well down on the previous quarter, GDP growth for the December quarter was very much in line with the average for the last 10 years. This is clearly not a bad result looking at the quarterly results over the last 20 years.

Source: ABS

Of all the components that make up GDP, household consumption spending made the largest contribution to GDP growth on both an annual and quarterly basis.

Source: ABS

Household spending contributed over half of the growth for the year and two thirds of the growth for the quarter. It didn’t take long before this was labelled the ‘strength in the household sector’. I’ll come back to this point later.

Government consumption expenditure and net exports both made a strong positive contribution for the year, but barely contributed to growth in the latest quarter.

Private investment continued to go backwards for the year and the quarter, but government investment spending made a surprise and welcome positive contribution to growth in the latest quarter.

Inventories made a positive contribution in both the quarter and the year. Inventories represent work in progress, materials and finished goods etc. that are owned by the business, whether they are held at the business premises or elsewhere and are recorded at book value at the end of the quarter. It’s difficult to pinpoint what this means – either inventories were ramped up on higher demand expectations or lower than expected sales resulted in increased inventories. The higher contribution is the result of the ‘change in inventories’ going from negative in the previous quarter to positive in the latest quarter.

But real National Income keeps falling

Real GDP growth is a measure of the growth in the underlying output of the economy. But National Income is a better measure of the income derived from/generated by that output. The ABS recommends Real Net National Disposable Income (RNNDI) as the best measure of changes in our “economic wellbeing”. This measure “adjusts the volume measure of GDP for the terms of trade effect, real net incomes from overseas and consumption of fixed capital” (source: ABS). Using this measure, National Income continued its recent decline, falling another -1.1% for the year and -0.1% for the quarter. A big driver of this decline was the latest 12% fall in our terms of trade (ToT).

The real NNDI measure isn’t broken down into its component parts so that we can understand where/what part of National Income is driving this decline. There are several elements that make up the National Income figure – employee compensation, the gross operating surplus (corporate profit proxy) and gross mixed income (surplus/deficit from the operations of smaller unincorporated enterprises). In order to go to this more detailed level, I need to revert to Gross National Income (GNI) in current prices (nominal). In real terms national income is falling. But in nominal terms, gross national income is growing at +2.6%.

I’ve used the chart below before because it provides perspective on how much our National Income growth has slowed over the last five (5) years.

Each bar represents the annual growth in Gross National Income and shows how each component has contributed to growth in that year. Whilst National Income growth, and the contribution from its component parts, is not on its lows, it hasn’t accelerated higher in the latest year either (and we know that in real terms, National Income is declining).


Source: ABS 5206.11

The annual rate of growth in GNI has remained fairly stable over the last two quarters. But a different picture emerges when you look at the quarter on quarter growth rates.

The latest quarter National Income growth is slowing

The December quarter growth was in fact slower than in the previous quarter. The chart below looks at the same National Income components, but using the quarter on quarter growth for the last eight (8) quarters:-

Source: ABS

There are two important points I want to make about the December quarter results.

Firstly, there was a larger contribution from ‘Gross Operating Surplus’ (GOS) in the December quarter (orange bars in the chart above).

This needs to be broken down further because it doesn’t tell us much in aggregate. The GOS is the sum of private, public and financial corporation surplus (a profit proxy), general government surplus and the surplus generated by dwellings owned by persons. Here is how each of those components has contributed to growth over the last eight (8) quarters:

Source: ABS 5206.07 – the sum of these components represent the “GOS” component of National Income.

The contribution from General Government and Dwellings is fairly consistent. Business profitability, on the other hand, tells us something important about the trading environment.

According to the National Accounts, in the chart above, private non-financial corporations have made the largest contribution to growth only in the last two quarters (light blue bars), which is a large turnaround in performance compared to the prior six (6) quarters. This is the single largest component of the GOS and is probably the most important to look at in relation to underlying business conditions. We know that Mining has a large influence on the outcome of this measure. The ‘Mining’ industry accounts for a substantial 26% of corporate profits (Source: 5675.11) – no other industry group comes close to this.

According to the data in 5675.11 Business Indicators, the performance of Mining in the Sept quarter (versus the June quarter) was actually positive and which made a large contribution to the positive shift in corporate profits. But according to the same data source, Mining profits fell again in the December quarter. That would then mean that Non-Mining business profits would have had to have accelerated in the December quarter in order for total private non-financial corporations to continue to make a positive contribution overall (again I’m referring to the December quarter light blue bar in the chart above). This would be an important insight about the performance and transitioning of the economy. So did non-mining profits accelerate?

We can only get down to industry-level data by looking at Company Gross Operating Profits released by the ABS as a part of Business Indicators (5676.11) data release. You can also use 5676.15 – the direction of the data is the same between the two data sources. According to the ABS:

“Company gross operating profits data are used to compile estimates of gross operating surplus of private non-financial corporations” (Source: ABS Business Indicators)

The two measures of company profit aren’t identical, but are very similar. Comparing the results of the two measure over time, there are consistently differences in the rate of growth between the two measures, but rarely do they point in opposite directions/conflict. Except for this quarter.

Breaking down the result by industry in 5676.11 yields a very different result to that of the National Income figures.

At a total industry level, Company Gross Operating Profits declined by -2.8% in the December quarter versus the National Income figures which shows that the Gross Operating Surplus of Private non-financial corporations grew by +0.9%.

According to the data in 5676.11, the decline in Company Gross Operating Profits was driven by both Mining and Non-Mining industries in the latest quarter:-

Source: ABS 5676.11

The only quarter where Mining profits were positive was in the Sept 15 quarter, which is consistent with the stronger results in the Sept quarter.

Non-Mining is the big news here – corporate profit growth has deteriorated in the last two quarters, so much so that Non-Mining Company Gross Operating Profits declined in the December quarter. So if both Mining & Non-Mining profits declined in the latest quarter according to the Business Indicators data (5676.11), then how can the similar measure of “Private Non-Financial Corporations GOS” from 5206.07) make a larger positive contribution to National Income growth in the latest quarter?

From the ABS website (Business Indicators 5676 page):-

COMPARISON BETWEEN COMPANY GROSS OPERATING PROFITS AND GROSS OPERATING SURPLUS

Valuation changes have had an impact on the value of inventories held by Australian businesses this quarter. An inventories valuation adjustment (IVA) is applied in the calculation of the gross operating surplus of private non-financial corporations (GOS) estimate in the Australian National Accounts. The IVA for the December quarter 2015 is -$1,369m which is $1,974m lower than the September quarter 2015 IVA of $605m.

No adjustment is made to the company gross operating profits (CGOP) estimate in this publication and, as a result, users should exercise caution when comparing CGOP and GOS (my emphasis). It should be noted that there are other differences between the two series. In particular, changes are made to GOS when annual benchmarks are applied and slightly different seasonal factors apply to the two series. Given this, while CGOP movements are an appropriate indicator for GOS, the two series will not have equivalent seasonally adjusted movements from quarter to quarter. (Source: ABS – Business Indicators Dec 2015)

So comparison between the two measures is problematic. If no adjustment has been made to the CGOP in Business Indicators, then did the application of a lower inventory valuation actually increase the GOS in the National Accounts in the latest quarter? Could differences in seasonal adjustment account for all of the difference? Which indicator is then the more accurate representation of underlying business profit performance? As mentioned, non-mining industry performance is an important indicator for how the economy is really transitioning.

At best there is a question over the real direction of profit growth at an industry level. I have put this to the ABS for clarification.

The second point relates to the slow-down in growth of Compensation of Employees.

Employee compensation is the largest proportion of National Income at 50% and provides some basic context for the scope of spending growth in the economy.

The accelerating growth in employee compensation since the December 14 quarter has been consistent with an improving labour market at the same time. Except in the latest quarter, when growth in compensation more than halved between the two quarters.

Source: ABS 5206.44

I’ve compared the growth in Sept (Sep v June) and Dec (Dec v Sep) by state (5206.44) in the chart below. Breaking the data down to state level gives some indication of performance differences between mining and non-mining states. It’s not a perfect proxy.

Only in WA and ACT did the growth in compensation of employees improve over the last two quarters. In WA, the best thing you can say is that employee compensation didn’t continue to fall.

Source: ABS 5206.44

Most of the slow down between the two quarters can be attributed to the private sector which accounted for two thirds of the slow down.

Private sector employee compensation growth slowed the most in NSW – again, the engine room of the so-called transition – from +2.5% to +1.1%. This is actually consistent with my previous labour market update highlighting that NSW labour market was no longer looking as strong as it had been.

VIC had the highest quarterly rate of employee compensation growth in December of all the states. Although growth has been slowing for two quarters now, it is still around the average:-

Source: ABS

The main problem state is QLD – the decline in private sector compensation of employees has been accelerating over the last two quarters – the first time since the GFC:-

Source: ABS 5206.44

This is unfortunately at odds with the previous labour market update, which showed employment growth in QLD still at its peak as of the end of 2015.

The situation is similar in South Australia – private sector employee compensation growth has slowed over the last three quarters and has now turned negative in the December quarter.

Growth in employee compensation in WA has been negative for the last four quarters, but in the latest quarter, it has stopped declining, which means it’s still on its lows. In TAS and NT growth in employee compensation also slowed to virtually zero in the latest qtr.

Only in ACT did the growth in compensation of employees accelerate higher in the latest quarter:-

Source: ABS

Across most of the larger states, growth in employee compensation looks like it is slowing, if not outright declining. I’m using the eastern seaboard states (especially NSW and VIC) as proxies to gauge the ‘transition’ from mining states to non-mining states. The original point was about highlighting the slowdown in employee compensation growth between the two quarters. Most of this slow down can be attributed to NSW, VIC & QLD, with NSW by far the biggest contributor to the slow down between the two quarters. It could be a one off for NSW as there is no established trend there at the moment, but this outcome is consistent with my previous labour market outlook for NSW. This puts a dent in the narrative that the economy is transitioning well.

But there is more.

This slowdown in the growth of employee compensation in the December 15 quarter came at a time when growth in hrs worked has been accelerating higher over the last 3 qtrs. The growth in hours worked in the latest quarter is the second highest since the GFC and growth accelerated from 0.4% in the September quarter to +1.17% in the December quarter.

Source: ABS

This has brought the annual rate of growth close to pre-GFC highs. Growth in hours worked has been accelerating since late 2012.

Source: ABS

Yet, output hasn’t grown along with hours worked. In fact, output per hour worked (labour productivity) has been slowing since late 2012 and has started declining.

Source: ABS

In the December quarter, labour productivity declined by -0.6% to bring the annual decline to -0.4%.

The concept of “unrequited input growth” was raised in a Productivity Commission report into falling Australian productivity (source: Productivity Commission Report, “Australia’s Productivity Growth Slump: Signs of Crisis, Adjustment or both?” April 2012):-

“And so, in proximate terms, the decline in MFP [multi factor productivity] growth was associated with ‘unrequited input growth’ — strong acceleration in input demand that was not matched (or stimulated) by an acceleration in output growth. This is the key to understanding Australia’s much poorer productivity growth. Explanations must tell us why Australian businesses used a lot more inputs, without getting more growth in output ”

This was from a paper written in April 2012, so is not referencing this current labour productivity situation. The quote goes on to say that such a situation is not sustainable:

“The notion of unrequited input acceleration does raise the question of how such a phenomenon could be sustained. Typically, output growth provides the additional income needed to fund additional growth in inputs. Consequently, unrequited input growth does not make financial sense, unless there is another source of income growth. Chapter 2 also shows that profitability not only held up, but actually increased in the 2000s. The extra input accumulation was fuelled at least in part by increased profits and profit expectations. Clearly, productivity was not the source of growth in output and income that it was in the 1990s. Rather, the broad productivity trends of the 2000s seem to have been more the outcome of strong input growth driven by marked changes in prices and profits.”

In other words, the ‘returns’ were generated by increases in, and expected increases in, prices including commodity prices, rather than higher productivity generating greater profits.

We no longer enjoy those ToT benefits. Which brings me back to the idea of sustainability of input growth (increasing hours worked) without getting more output growth as a result. The annual growth in hours worked chart suggests that in recent times, when growth in hours worked has resulted in negative labour productivity, hours worked has started to fall. We are now at that stage of the cycle where labour productivity growth has turned negative and we’ll see whether this higher growth in hours can be sustained.

So far ‘rebalancing’ or transitioning has seen higher hours worked but no discernible increase in output growth, and in fact, if you use the Business Indicators data, declining company profits across mining and non-mining in the latest quarter. In the absence of price growth, this is not likely to be sustainable.

So how can Household consumption be the main driver of economic growth?

My final point on the December GDP result and the idea of the transitioning economy, relates to our single largest driver of economic growth at the moment – households.

The big news from GDP was the strength of household expenditure and its resilience in the face of our transitioning economy.

Whilst the contribution from households is large, the direction of spending growth has remained fairly steady over the last few years – not accelerating growth. The current annual rate of growth in real household consumption expenditure is now +2.9% (+4.6% in nominal terms). On a quarterly basis, growth pulled back only slightly from +0.9% in September to +0.8% in December.

Source: ABS

Compared to recent history, growth in household spending has been growing at a fairly consistent rate of just under 3% for the last 18 months.

This rate of growth is not great when you consider that the rate of household consumption growth has been much higher in previous years. But how could household spending be any higher? The context from National Income shows that employee compensation growth (and wages) has slowed considerably over the last five years and in some states, employee compensation has recently turned negative. This has translated into slowing growth in household gross disposable income as well.

Gross disposable household income growth has been slowing since it peaked in 2007 at +12% annual growth – growth is now running at +3.1%. Adjusted for CPI, gross disposable household income is only growing at 1.4% in real terms. This rate of growth is low and is slowing:-

Source: ABS

Maybe the real question is how household consumption expenditure growth has remained at this constant level while household income growth has been slowing?

One reason is due to falling net household saving. Note that the ‘net savings’ measure is actually a calculation of the difference between income and spending of households. As spending increases faster than income, net saving falls. This is what has been happening since the peak in net household saving since mid-2012. In the last year, net household saving has fallen 15%.

Source: ABS

This fall in net saving is partly funding the growth in household consumption.

The other important source funding household spending growth is household debt. While growth in household disposable income has been slowing and is now at a relatively low point, real mortgage debt as a % of real GDP has been rising to its highest point – accelerating in fact since mid-2014. The stock of outstanding housing debt now represents 85.5% of real GDP (total real private debt represents 140% of real GDP):-

Source: ABS, RBA

Compared to household disposable income, household debt now represents in excess of 175% of disposable income.

It seems we might be pinning our hopes on a transition based on continued spending by households that have been facing lower income growth and greater levels of indebtedness. Whilst the GDP top-line results look good, the underlying factors say that the success of the ‘transition’ is on shaky ground.

Capex survey points to further falls in investment – Dec qtr 2015

The Australian capex survey results for the December quarter are disappointing on all levels. Capex remains firmly lower than last year, forecasts are for further declines in the next two quarters and the first view of 2017 looks like capex will continue to fall. There is one small bright point – actual December capex increased over September. This may be positive for the December quarter National Accounts. The reason for the increase can be traced back to activity in NSW and unfortunately, the forecasts by business suggest that it is not likely to continue.

Estimate 5 for capex in the 2015/16 financial year highlights that total capex is still expected to fall by -17% or $26.6b below last year

Expected capex for the full financial year to June 2016 is forecast to come in at $124b, which is 17% below last year. So far, the Sept plus Dec 15 capex actuals are tracking at -17.8% below the same two quarters last year in real terms and -15% in nominal terms.

The benefit of estimate 5 data is that it is made up of 50% actuals and 50% forecast. The forecast period now looks out over a shorter time frame (next 6 months) so is becoming a more accurate view of capex plans:-

Source: ABS

The decline in capex for this financial year, at estimate 5, is looking like it might reach levels not seen since the last recession in 1991/2.

It doesn’t matter whether you look at capex expectations by industry or asset type – ALL areas are contributing to the decline. But the decline is being led by Mining and Buildings and Structures:-

Source: ABS

The only positive in this is that expected capex in Manufacturing doesn’t look like it will decline as much as it did last year. Apart from that, capex in Other Selected Industries and Mining will fall faster than last year as well.

But are the actuals in the GDP results following the capex survey? The data is only up to the Sept qtr and for the moment, yes, private capital investment is following the lead of the capex survey. But we haven’t seen the larger falls in capex that the survey is forecasting. That said, capex has been slowing, then declining since 2012:-

Source: ABS

At estimate 5, we have two quarters of actuals and two quarters of forecasts for capex. The Dec quarter actuals came in higher than the Sept qtr actuals and this could be positive for GDP in the Dec qtr. I’ll come back to this in more detail shortly. But this means that the bigger falls in capex are forecast for the last two quarters of the 2015/16 financial year (which I’m calling ‘Half 2’ – H2 in the table below). From ABS 5625.01(a) and 5625.01(b):-

Actual Capex for H1 v Forecast Capex for H2 2015/16 Financial Year

Source: ABS, $ M, original, current prices

Across every industry, businesses are forecasting capex in the March and June 16 quarters to be between 15 and 20% below capex for the first half.

These forecasts for the March and June 16 quarters do not compare well with actual capex for the same quarters last year either:-

Actual Capex for Mar & Jun 2015 v Forecast Capex for Mar & Jun 2016

Source: ABS, $ M, original, current prices

I’ve outlined before that the Capex Survey (what this post is based on: ABS 5625) doesn’t cover all industries and tends to overstate the size of Mining. The industries that are excluded are: Agriculture, Forestry and Fishing (Division A), Public Administration and Safety (Division O), Education and Training (Division P), Health Care and Social Assistance (Division Q), Superannuation Funds (Class 6330).

The size of the capex change tends to be overstated in the survey compared to the actuals in the National Accounts, but are directionally in line. The Capex survey data is used in the development of the quarterly National Accounts.

The first look at expected capex for 2017 looks just as poor

“Non-mining business investment is forecast to pick up in the second half of the forecast period, reflecting the improvement in domestic demand”, RBA, Statement on Monetary Policy, February 2016

Estimate 1 for the next financial year 2016/17 was also released with the December data. This is a 100% forecast and is looking further out to the full financial year 2016/17, so its accuracy is lower than later estimates.

The view at estimate 1 tends to understate final capex. So adjusting the estimate using the 2016 realisation ratio for estimate 1 (which bumps up the estimate by 20%), we get our first capex estimate for 2017 of $99b. Let’s assume that 2015/16 capex spend comes in at the estimate 5 forecast of $124b. That means that estimate 1 is pointing to a further 20% fall in capex for 2016/17.

The falls in capex at estimate 1 are across the board as well:-

  • Mining – estimate 1 adjusted upward based on a +3% realisation ratio = $35b, which represents a further 33% decline on current forecast for mining capex of $53b in this 2015/16 financial year
  • Manufacturing – estimate 1 adjusted upward based on a +27% realisation ratio = $8.3b, which represents a further 1.1% decline on the current forecast for this financial year
  • Other Selected Industries – estimate 1 adjusted upward based on a +49% realisation ratio = $62b, which still represents a further 1.5% decline on the current forecast for this financial year

(The realisation ratios that I’ve used here are the larger of the last 5 years)

But according to the RBA in the latest Statement on Monetary Policy Feb 2016:-

“The ABS capital expenditure (Capex) survey of investment intentions and the Bank’s liaison point to a sharp fall in mining investment in 2015/16. The subtraction from GDP from lower mining investment is expected to peak this financial year.” RBA, Statement on Monetary Policy February 2016

Here’s hoping that the later estimates of the 2016/17 financial year capex improve, because so far, the falls for next year are looking just as bad as this year.

But actual capex in the survey INCREASED in the Dec quarter

It looked like there was a spot of good news in the capex survey data. Actual capex in the December quarter grew by +0.8% in real terms. A turnaround possibly? It unfortunately didn’t take long to see that this is all driven by one state – NSW, which contributed +1.97% points to the +0.8% quarterly increase in actual capex. The only other states to make a positive contribution to growth in the latest quarter were VIC and SA – and contribution to growth was small at best.

Source: ABS

But its nots looking like NSW is on a new investment trajectory either – the latest quarter of higher growth seems like a function of a lower result in the Sept qtr.

Source: ABS

Capex in NSW is still 8% below its 2011 peak in real terms and 4% below the Dec 14 quarter (same time last year).

Reverting to current prices, capex in NSW for the next two quarters is also forecast to be 18% lower than in the actuals in the Sept15/Dec15 quarters. NSW capex in Mar 16 + Jun 16 is forecast to be $11,051m versus the Sept 15/Dec 15 actuals of $13,544m. In other words capex in NSW is not likely to continue increasing in this financial year.

With capex falling and business continuing to forecast lower capex for 2017, the signs for the Australian economy are not good. While mining has mostly been leading the falls, the declines in capex are now evident many across the other industries – which suggests that the ‘transition’ has so far been tepid at best. Business remains wary of investing to increase capacity in light of overall lower growth.

GDP top-line looks better than it really is – Sept 2015

The GDP result for the September quarter came in ‘better than expected’. In real terms, the economy grew by 0.9% in the Sept qtr and +2.5% for the year. This is historically low growth, but given the scope of the adjustment currently underway in the Australian economy, it’s not a bad result.

This is a case though where the ‘better than expected’ top-line result isn’t representative of the underlying performance. Our latest growth figures were mostly the result of an unusually high contribution from net exports in the quarter. Investment spending continues to fall and household consumption spending was at best, on par with previous results and not really trending either way. The less-worse National income figures were due to Terms of Trade that didn’t decline as much in the Sept quarter.

Indicators of domestic activity show that the economy is continuing to languish. One measure of domestic activity known as Gross National Expenditure or GNE (which is just adding up the contribution of all consumption spending, investment spending and inventories), shows that growth was negative in the latest quarter:-

Source: ABS

There are several important points about the September quarter results.

Net exports made an unusually high quarterly contribution to GDP growth

…and the question is whether this latest quarter of net export contribution can be sustained. The analysis below is based on chain volume measures ie removing price effects. The situation would look different if you looked at nominal results.

The size of net exports in the Sept quarter was unusually large and was the combination of two factors 1) larger-than-normal growth in exports and 2) a corresponding contraction in imports.

To provide some historical context – the contribution of net exports to real GDP growth in the Sept 2015 qtr (last orange bar) was the fourth largest quarterly contribution since the start of this data series:-

Source: ABS

The chart above suggests that these ‘blowout’ quarters are infrequent, but not impossible, events. Net exports have been making a larger contribution to GDP growth since 2010.

Exports – Of the $4b growth in exports for the quarter, $3.9b of that was due to growth in goods exports. The biggest contributors to growth in goods exports for the quarter were non-monetary gold ($2.36b), metal ores ($1.24b) and then coal ($0.9b), in real terms. So actually, the largest contributor to our export growth for the quarter had nothing to do with mining. The size of the Sept quarter export growth for non-monetary gold was unusually large. But all it represented was a return to a fairly normal level of exports – it was actually the previous quarter fall that looks like the anomaly.

While there has been a slow-down in growth of our largest export, metal ores & minerals, volumes are still at all-time highs. The current level of contribution to growth is actually above just above average. At the time of writing, iron ore spot prices have now fallen below US$40/mt. The ongoing fall in prices is likely to result in a shake-out among higher cost producers, but the impact on our export volumes will be dependent on how low prices fall and how much Chinese economic growth slows (our largest export market). By all accounts, growth in China is expected to slow in 2016 and this will likely have adverse effects on our exports.

Despite the higher growth in the latest quarter, annual growth in coal exports have been negative over the last two quarters.

A significantly smaller amount of our export growth, $140m, was attributed to growth in services exports in real terms (source: ABS 5302.06). Growth in service exports have slowed in the last two quarters. There is no doubt that the growth in services exports has benefitted from the falling AUD, but the size of the sector for the moment is still small – approx. 20% of overall exports (in real terms). There is still much work required to further develop our service export industries and the Productivity Commission released a draft paper in August 2015 “Barriers to Growth in Services Exports” outlining the barriers and potential remedies.

It’s likely that we will continue to see higher than average contribution from exports (in real terms) to GDP growth in the near term, maybe just not to the same degree as this quarter.

Imports – Imports contracted by over $2b in real terms for the quarter. This is now not an unusual event, but the recent trend is somewhat unprecedented in the history of the data.

Goods imports peaked in June 2012 and are now 2% below that peak. Service imports peaked later in June 2013 – and are now 16% below that peak.

Source: ABS

Most of the decline in services imports can likely be attributed to the falling AUD. Since Sept 2013, price deflators (price index) for service imports increased by over 24% versus the Sept qtr 2015. The average quarterly change in the import price index during this time was +8%.

Not all of the decline in the import of goods can be attributed to the effect of the fall in currency. The import price deflator for goods also increased, but to a lesser degree averaging 2.3% since June 2012 (which is roughly around CPI levels). The areas that have contributed to the slowing in the import of goods is the area of capital goods. Since mid-2012, the import of capital goods has contracted by over 26%. This is mostly the result of the decline in mining investment spending, but is not limited to mining.

In the latest quarter, the largest part of this contraction was lower imports of Intermediate and Other Merchandise Goods for groups such as processed industrial supplies, iron & steel, lubricants and other parts for capital goods. While this could be just a quarterly aberration, there is an important point to this. What sits in these groups are inputs for industries such as car manufacturing. As this industry in particular starts to wind down in Australia, lower imports here could start to become the norm (but will be replaced by imports of finished product).

Demand for imported consumption goods continues to grow – food & beverage, household electrical, non-industrial transport (cars), textiles, clothing, footwear, and toys, books and leisure goods all grew in the latest quarter. Annual growth of imports of consumption goods is over 10%.

It may not be so unusual now to see further declines in imports and this will add to net exports.

Taking a step back though, the theory is that net exports are supposed to take over from where the mining investment boom left off. But it’s not likely that the spoils of an export boom are shared throughout the economy in the same way as an investment boom. Think wages, prices, employment, investment – all of these have been falling as we’ve moved into the more volume, cost and efficiency focused phase of the mining boom. The export boom still supports some level of local employment, government revenue and mostly corporate profits. But this is highly dependent on commodity prices. The Sept quarter was essentially a breather from the more aggressive falls in our major commodity prices – iron ore, coal (bulk commodity prices) and oil. The falls have now continued on in earnest – this will be reflected in the Dec data.

The decline in mining capex spending isn’t being offset by other investment spending

There has been a narrative that the housing construction boom can and will fill the gap left by mining investment.

As of the latest quarter, private dwelling investment spending contributed +0.5% pts to annual real GDP growth, whereas total private business investment detracted -1.5%pts from annual real GDP growth.

Source: ABS

Housing construction has at least taken up some of the slack left by lower mining investment, especially for employment.

According to GDP figures, we are well and truly into the housing construction ‘boom’. Currently, dwelling investment spending, including alterations and additions, is growing at over 10%:-

Source: ABS

In historical terms, this level of growth is just above average, but it has been accelerating since 2012.

There are many factors that weigh against the ongoing growth in the housing construction boom. Household debt (mortgages) is already at all-time highs, banks are tightening lending standards, negative wage growth, likely lower demand from foreign investors, slowing population growth and interest rates that have little room to power further growth. On the plus side, with prices starting to cool in some parts of the country, it could start to encourage those who have been priced out of the market (FHB’s).

There is no evidence to suggest that the growth generated by dwelling investment spending is or will be remotely close enough to filling the gap left by lower mining investment. It’s likely that we will continue to see further declines in overall investment spending. The latest capex survey highlighted that these declines were not limited to mining either. Manufacturing and services were also expected to see lower capex in the coming year. In fact the survey highlighted that some of the bigger falls in spending were to be expected from 2016, although the capex survey does tend to overstate the extent of capex changes.

Public sector activity lags

The falls in investment spending are not limited to the private sector, with public investment spending also detracting from GDP growth. The worrying element is the rhetoric of the new Treasurer who believes that we have a spending problem, not a revenue problem. It’s fully expected that the December MYEFO will highlight a further deterioration in the budget deficit and this will only add further pressure to the level of public spending.

Household consumption spending growth is trending along, but not accelerating

Household consumption spending is still the largest part of our GDP. Growth in household consumption spending has been fairly stable over the last year, but still well below the growth levels pre-GFC:-

Source: ABS

For the moment, household expenditure is neither accelerating nor decelerating. On an annual basis, the falls in investment spending (public & private gross fixed capital formation) were only just offset by growth in consumption spending – with GNE growing by 0.24%. But in the latest quarter, the growth in consumption spending, both public and private, is more than offset by the declines in investment spending resulting in GNE declining by 0.6% on a quarterly basis.

At least the slight improvement in Compensation of Employees in the last few quarters, and mortgage/house price growth, will continue to help underpin spending.

National income improved in the latest quarter

The analysis so far has focused on the economy in ‘real terms’ – removing the effect of price changes to understand the actual level of activity. But an important consideration is how much income we as a country generate from our productive activity. One of the more important determinants of our National income at the moment is movement in our terms of trade (ToT). As mentioned, the Sept quarter was a breather from the accelerating falls:-

Source: ABS

This is a slightly different view of movement in the ToT because I wanted to highlight that while the ToT still declined in the latest quarter, the level of that decline was smaller than in the June quarter. This was the result of more stable commodity prices during the September quarter.

Growth in the individual components of National income improved in the latest quarter, ‘saved’ partly by less-worse Terms of Trade falls and better labour market data. We still seem a long way from the income levels pre the ToT peak (2011):-

Source: ABS

Part of this recent improvement is not going to last, especially the improvement (or the less negative contribution) in the gross operating surplus of private non-financial corporations, given the ToT declines have continued to accelerate in the December quarter.

An interesting point is that Gross Mixed Income (GMI) is making a larger contribution to overall to income/nominal GDP growth and has been trending this way all year. “GMI” represents unincorporated enterprises. Could this be the result of a growing group of self-employed people?

What isn’t adding up is the labour market. The relationship between Gross National Expenditure and hours worked has a reasonable level of correlation over its history (r=0.65). In the last few quarters, growth of the two measures have diverged – hours worked continues to grow and GNE is slowing (in the quarterly data GNE is actually declining):-

Source: ABS

For the moment, labour market indicators show that the labour market is actually quite stable. Hopefully this means that GNE will follow hours worked.

As always, GDP is backward looking. As of early December, we are looking at renewed falls across commodity prices, continuing poor data out of China, a worsening budget situation and a housing market (Mel & Syd) that looks like it is starting to cool.

Setting the scene for 2015

There are several important drivers that are likely to affect and/or continue to affect the Australian economy in 2015. The list below is not intended as a predication or as a projection – many of the themes below are currently in place. This list is intended as a collection of the most important issues facing the economy and will provide context for the posts here during 2015.

How to characterise the current state of the economy? Its mixed coming into 2015 – some indicators are stronger than this time last year, others weaker.

Overall, the current rate of economic growth in Australia remains below the longer term average and this has been the case since 2008/09. Below is the Department of Treasury growth estimates for 2015 and beyond, as outlined in the MYEFO in December 2014.

Real GDP Growth & Projections

Treasury Growth Forecast at MYEFO Dec 2014

Source: MYEFO December 2014

The projections by the Australian Treasury for growth over the coming year is equivalent to the growth of the last two (2) years, approx. 2.5%. Using this growth figure as a starting point will help to guide the expectations of the performance of major macroeconomic components.

In a previous post, I outlined that this recent period of lower growth had coincided with an equally lengthy period of unemployment growth. Under the growth assumptions outlined above, it’s likely that unemployment and under-employment will continue to persist during 2015. At the end of 2014, just on 770k persons were counted as unemployed. That’s an increase of 55k people over 2014. For comparison, the average annual growth in unemployed persons as at December over the last 10 years was +15k. Overall economic growth will need to accelerate well above the current level and the long term average and remain there consistently before this level of unemployment is reduced. An important feature of the labour market in recent times has been the higher growth in part time over full time employed persons, as well as overall lower growth in employment. Total employment will need to grow by over 200k persons on an annual basis just to match the current level of population growth, let alone start to reduce the level of underemployment. Annual employment growth at Dec 2014 was +158k persons.

This lower growth has also coincided with lower growth in the general price level, with the exception of housing. While this lower level of price growth opens the way for the RBA to continue to stimulate via interest rate cuts, the growth in house prices (fuelled by lower rates) will likely hold the RBA back from acting.  Wages growth is the lowest on record and real wages are declining, reflecting the excess capacity in the labour market. The fall in the AUD is likely to result in higher growth in tradable inflation, but will also be offset by some degree by the fall in fuel prices. The slowing growth in non-tradable inflation is more reflective of lower demand in the domestic economy – having been driven up during the Terms of Trade (ToT) boom years. Slowing income growth, reduced business investment and labour market capacity will likely weigh on the general level of prices in the economy.

Either way, I’ll be looking for deviations from this 2.5% rate of growth. The ability of the economy to grow at an accelerated rate will depend on several things:-

The commodity cycle

An enormous amount is happening on this front that will both add and subtract from growth. The transition from the investment to the production phase will have several implications:-

  • Firstly, as the shift to the production phase continues, we are starting to see lower growth in mining jobs and general cost cutting to maximise profits, especially in light of falling commodity prices. Although many claim that mining doesn’t employ many people so shouldn’t have an impact on the broader economy, consider that the average full time wage in the mining industry is double the average of ALL full-time wages in Australia. As these workers shift from resources related projects the expectation is for a lower average level of earnings and hence lower consumption. Cost cutting and lower mining employment growth has already started to impact WA via lower output growth, a worsening state budget, slowing property prices & rents and negative net interstate migration.
  • Secondly, while increased exports should make a positive contribution to overall growth, the most recent BREE estimates for 2014-15 suggests that this will not be the case for the total value of three out of four of our largest exports. For example, volumes for iron ore, the single largest Australian export (by value), are estimated to grow by 14%, but total value is estimated to decline by -24% (source: BREE Dec 14 Qtr. http://www.industry.gov.au/industry/Office-of-the-Chief-Economist/Publications/Documents/req/REQ-2014-12.pdf).
  • Current macroeconomic forecasts by the Australian Treasury are based on a price of FOB US$60 for iron ore for the next two years (source: http://www.budget.gov.au/2014-15/content/myefo/html/01_part_1.htm). This is a far more conservative approach than in recent budgets and the current spot price is sitting around the mid-$60’s. As more supply comes online, there could be further downside to prices.
  • LNG was the only major export where both volume and value were expected to grow in 2015. Latest estimates from BREE forecast export volume growth of 11% and export value growth of 7% as major projects come online for the first time. But from June 2015, the price of LNG may also come under greater pressure given that “LNG contracts tend to be based on average oil prices over the past six to nine months, recent falls [in oil prices] will not greatly impact LNG prices until the June quarter 2015” (source: BREE Dec 14 Qtr. Update).
  • Thirdly, the negative impact on investment spending as major projects come online. Investment in resources projects has peaked and declining investment has been impacting growth for a while, but the expected larger falls in investment spending haven’t occurred yet.
  • Role of lower Chinese demand on our export volume growth. China is our single largest export market, accounting for over 32% of Australian exports (Source: DFAT). There is much talk of a slow-down in Chinese demand linked to the popping of a credit and housing bubble. The best way to measure actual demand changes will be to watch our export growth to China. The second largest market for Australian exports is Japan, accounting for approx. 15% of our exports. The Japanese economy continues to struggle with low growth.

Can interest rates stimulate non-resources investment to “fill the gap”?

There has been some pick up in dwelling construction since the RBA lowered rates, but so far, lower interest rates have not stimulated growth in non-resources business investment. According to the latest GDP results, contribution from dwelling construction has been positive, but far smaller than the decline in private business investment. This is one of the more important indicators to watch – an increase in private business investment will be a positive signal for the economy. For the moment, lower interest rates are helping to fuel higher mortgage growth (mainly investors) rather than productive investment in the economy. Outside of dwelling construction and mining, business investment has been lacklustre in the face of subdued local and global growth. It’s unclear that any further cuts to the official cash rate would in fact stimulate business investment – business will want to see some improvement in the potential return of capex projects first.

Interest rates

  • It’s more likely that rates in Australia will go lower, assuming that CPI growth continues to moderate. It will be hard for the RBA to justify rate cuts in the face of continued house price growth – but other policy measures could be put into place to keep a lid on housing lending growth at the same time (see post here). Any increase in interest rates will be great news for savers, but will be negative overall for the economy given the combination of lower income growth, unemployment and relatively high mortgage debt that is outstanding in Australia.
  • US rates are the ones to keep an eye on for the moment. Any increase in rates in the US will be a step towards tighter monetary policy – this would be a big shift in policy direction, which could have a negative effect on Australian rates (i.e. higher). Despite the talk of rates going higher, current US bond rates suggest that rates will remain low, at least throughout 2015, indicating lower inflation expectations. The actions of other Central Banks also need to be taken into account – monetary policy in Europe, Japan and, to a much smaller degree, China, remain in expansionary mode to counter weaker growth in those economies. More likely rates in the US won’t increase this year, especially while other major economies are maintaining expansionary monetary policies – the impact of a rate rise in the US could see the USD continue to strengthen at a time when its own growth remains below trend.

How far will the AUD go?

This is a positive factor in favour of local import competing businesses and export focused businesses. Modelling by the RBA suggests that ideal position for the AUD is around mid the mid-0.70c mark – and we are starting the year at just below US$0.80. A lower currency will also see higher prices for imported products, so there could be some negative CPI impact. Depending on how low the AUD falls, there is a risk that interest rates in Australia may increase.

Housing

Much of our confidence, wealth and debt is tied up in the performance of house prices. Over the last year, house prices have grown by 9% across the 8 capital cities – similar to the rate of growth achieved prior to the GFC. This has been led predominantly by Sydney (+14%) while all other markets recorded growth between 7% and 2.4% (source: ABS). The best leading indicator of house prices is growth in housing finance and while there is no clear trend down, the growth in housing finance is slowing – more so for owner occupiers. Any further interest rate cuts could see another leg up in housing lending, but probably not to the same degree as previous rate cuts given higher unemployment, lower income growth and real mortgage debt almost back to its historic high levels.

The watch out for is ASIC, APRA and/or the RBA to implement policies aimed at slowing housing lending.  All three (3) bodies have indicated a growing concern, especially around the growth in interest only loans.

Lower National income growth impact on consumption & housing finance

The important thing to watch for here is the combination of the continued slowdown in National income growth (and possibly even larger outright falls in National income) due to unfavourable ToT, continued excess capacity in the labour market and unemployment expectations to further impact consumption spending and growth in housing finance.

Ann % Chg Real Net National Disposable Income

Source: ABS

The growth in National disposable income has slowed considerably since 2011 and this is likely having an impact on consumption growth.

Private household consumption spending is the single largest area of expenditure in our GDP – accounting for 55% of GDP. Household consumption spending growth contributed, on average, 2.2% points to GDP growth during the commodity investment boom years (2000 – 2007). The chart below shows that this has slowed notably since the GFC and again, since 2011. In the last five years, household consumption spending has, on average, contributed 1.4% points to overall GDP growth. There is a risk that this could fall further if income growth continues to slow or declines.

Contribution of HH Consumption to GDP Growth

Source: ABS

Government spending

So far the government has failed to generate support for its May 2014 budget. The proposed budget & reforms have not been approved through the Senate and instead of cutting the deficit, the MYEFO in December showed that the deficit has in fact become larger. According to budget analysis, most of the deterioration has been as a result of a slower economy (and overly optimistic forecasts of commodity prices). The upshot is that the budget is likely to have less of a contractionary impact on the economy. Both monetary and fiscal policy are, in effect, pointing in the same direction. Philosophically, the government is not focused on delivering an expansionary fiscal outcome, but that’s in effect what has been achieved. Unfortunately, if there is any further deterioration in the economy, it will mean an even larger deficit – something that ratings agencies will be watching. Any downgrade to our credit rating could also have a negative impact on local interest rates.

An important theme within the area of government spending is whether the government can successfully implement its infrastructure investment plan and various other structural reforms like taxation. Whilst infrastructure investment would enhance output and likely employment outside of housing and mining in the short term, it would also have long term benefits for business development and future productivity growth. The success of such a program depends heavily on whether the investment is strategic and directed to building the infrastructure that will support sustainable business development, innovation and productivity growth. Budget analysis on the future drivers of income growth highlight that productivity growth will be crucial to offset declines in the ToT and the effects of the ageing population.

Consumer prices and the Australian economy – September 2014

Not long ago, I wrote a post arguing why I thought GDP growth was too low. I outlined several reasons in support of this argument: 1) that the pool of unemployed persons has been growing for a duration similar to that of the early 90’s recession and 2) real income per capita was no longer growing. The recent release of Q3 2014 CPI data provides some further evidence supporting this argument. Where aggregate demand is growing faster than its potential rate, demand for resources generally places upward pressure on prices and unemployment declines. The release of Q3 CPI shows that consumer price growth in Australia has started to slow, with growth of core inflation now in the middle of the RBA range of between 2 and 3%. Over the last few quarters, annual CPI growth was at the upper end of the RBA band which seemed at odds with the idea that growth in Australia was too low. There were in fact suggestions that the RBA would need to hike rates. But quarterly CPI growth and other price measures such as wages, commodity prices and Terms of Trade (ToT) have been pointing to an easing in the level of price growth across the economy. Whilst a rate of core CPI right in the middle of the RBA range doesn’t sound like a problem, it’s in combination with indicators such as unemployment growth and income stagnation that point to this as another symptom of a bigger/broader issue.

This situation is not limited to Australia. Globally, price pressures have been easing, with growing concerns of emerging deflation throughout Europe, US, UK and China according to data recently published by The Economist (25th Oct 2014). It’s difficult to pinpoint just one reason for this phenomenon, but slowing global growth is a good starting point. For Australia, the reversal of the ToT boom has been a fairly significant factor associated with slower income growth, growing unemployment and now slowing price growth.

Highlights of CPI Quarter 3 2014

The Sept quarter CPI growth was 0.5%, the same rate of growth in the previous quarter. Quarterly growth at 0.5% is just below the average for Sept CPI growth over the last 10 years of +0.8%.

The quarterly growth trend has been slowing throughout the last four quarters:-

Source: ABS

The annual rate of growth slowed significantly in the Sept quarter from 3% to 2.2% (seasonally adjusted). This large slow-down in annual growth is partly the result of the shift to a higher base used to calculate growth – Sept 2013 quarterly growth was relatively strong at +1.2% (see chart above). That said, the quarterly growth since Sept 13 has been slowing, resulting in annual CPI growth closer to 2% – at the lower end of the RBA range – and reaching this point in a relatively short period of time.

The measures of core CPI growth provide a better guide as to the underlying price growth. Growth in measures of ‘core’ CPI, the trimmed mean and weighted median, eased somewhat in Sept and remain in the middle of the RBA range. The trimmed mean view of consumer prices is the main focus for RBA assessment.

Source: ABS

For the Sep 2014 qtr;

  • Trimmed mean (15% of the smallest & largest price movements are removed or ‘trimmed’) +0.4% quarter on quarter and +2.5% year on year (a slowing of the annual rate)
  • Weighted median (price change at the 50% percentile by weight of the distribution of price changes) +0.6% quarter on quarter and +2.6% year on year (no change in the annual rate)

The biggest contributors to quarterly CPI growth was in Food and Housing categories:-

Source: ABS

The biggest price pressures under Housing were Purchase of New Dwellings and Property Rates and Charges. Both offset the large -0.14 % pts decline in Utilities (Electricity) that also fall under this category.

There was one single significant contribution to growth in Food CPI and that was in the Fruit category.

The big turnaround for the quarter was the slow-down in Health costs, from +0.17% pts last quarter to -0.1% pts this quarter.

Overall, CPI growth is slowing, but for the most part is sitting right in the middle of the RBA range. Based on this, it’s unlikely that there will be pressure to raise rates.

But there is a broader context to this CPI report…

Back in Sept 2012, Assistant RBA Governor, Christopher Kent, gave a speech to the Structural Change and the Rise of Asia Conference titled Implications for the Australian Economy of Strong Growth in Asia. This speech laid out the broad set of factors effecting the Australian economy, namely the impact of economic growth in Asia (China) on driving our Mining boom. The most visible impacts in Australia were the rise in the ToT, an appreciating exchange rate and the growth or “reallocation of productive factors” to resources and resources related industries.

It’s relevant to revisit some of the points of this speech as they relate to the impact on prices and growth now that the positive ‘shock’ to the ToT has started to reverse and the economy has commenced the transition from phase II (investment) to phase III (production and export) of the boom.

“The positive shock to the terms of trade, resulting from a rise in commodity prices, increases income accruing to the resource sector and increases that sector’s demand for productive inputs. Both of these exert a measure of inflationary pressure.” Christopher Kent, RBA Assistant Governor, 19th Sept 2012

“Domestic inflationary pressures, associated with higher wages and incomes, will lead to higher inflation for non-tradable goods and services but, at the same time, the gradual pass through of the initial exchange rate appreciation will lead to lower inflation for tradable goods and services (whose prices in foreign currency terms depend to a significant extent on global considerations). In this way, the appreciation of the exchange rate helps to offset the inflationary impulse from the terms of trade shock, and assists in maintaining inflation in line with the inflation target.” Christopher Kent, RBA Assistant Governor, 19th Sept 2012

We’ve seen all of this happen in the Australian economy.

Firstly, the rise in the ToT generated higher income growth.

Source: ABS

Once the ToT started to appreciate, real GDI started to grow much faster than real GDP – the difference being the impact of the ToT. The ToT peaked during Sept qtr 2011 and is now 21% below that peak. While the ToT did peak, it is still well above its historical levels for the moment – but income growth has stalled nonetheless. More on this later.

Secondly, the exchange rate did appreciate during the investment phase of the boom.

Source: RBA

The real AUD TWI appreciated during the years between 2000 and 2011, with the exception of 2008/9 (GFC). Growth in the exchange rate started to slow from June 2011 but importantly, remained elevated until it peaked in March 2013. Since then, the real AUD TWI has fallen by 7%.

Finally, there was greater inflationary pressure in the non-tradable sector than the tradable sector (see definitions and detail of each here) during the period of the investment phase of the Mining boom.

Source: ABS

It’s hard to look at this chart and ascertain a ‘neat’ relationship between exchange rate changes and annual tradable inflation. The range for tradable CPI growth has been between +4% and -2% during this time, but has generally been lower than non-tradable inflation growth. This can be shown more clearly by reproducing one of the charts from the RBA speech – the ratio of non-tradable CPI to tradable CPI.

This first chart is from the RBA speech as it provides the historical context. The second chart is updated using the latest data (with as much history as available from the ABS).

This first chart reinforces that since the start of the ToT boom, non-tradable inflation has grown much faster than tradable.

The updated data show a fairly important change in that trend – non-tradable CPI growth started to slow from March 2013:-

Source: ABS, The Macroeconomic Project

This is an unusually long period of no change in this ratio, given the growth in non-tradable CPI during recent history. Prices are still growing, but at a slower rate and this is could be an important indicator of slower demand in the domestic economy.

Since June 2013, non-tradable CPI has started to contribute less to total CPI growth. In Sept 2014, non-tradable CPI made its lowest contribution to total CPI growth (contribution data is only available back to June 2012). Since June 2012, tradable CPI also started to have an increasingly positive contribution to CPI growth, but it too made a smaller contribution to CPI growth in the recent quarter. Both tradable and non-tradable CPI slowed in the latest quarter:-

Source: ABS

There are 47 categories classified as ‘tradable’ – which contributed +0.76% pts to CPI growth. In over half of those categories (26), prices are either flat or declining (YoY -0.39% pts), 17 categories contributed +0.31% pts and the top 4 categories contributed the bulk of the price growth +0.86% pts. The categories were Tobacco, Fruit, Vegetables and International Holiday & Travel. The increase in Tobacco prices is due to an excise increase.

By contrast, there are 40 categories classified as non-tradable, which contributed 1.58% pts to overall CPI growth. In only 12 out of 40 categories are prices flat or declining, contributing -0.26% pts to overall growth. The bulk of the growth in non-tradable CPI comes from the ‘middle’ 24 categories which contributed +0.94% pts. The top 4 non-tradable categories still punched above their weight adding +0.87% pts. The top 4 categories are (in order) Purchase of New Dwellings, Medical & Hospital Services, Rents and Other Services in respect of Motor Vehicles.

There is broader pressure i.e. more categories contributing to CPI growth, in the non-tradable sector and our housing market (new dwellings anyway) is driving one of the biggest parts of that growth.

This brings us to the present day – and we are now seeing the opposite effects take place as the ToT boom reverses.

As mentioned earlier, the ToT has declined by 21% from its peak and the most important thing about this in relation to the CPI is the impact on income growth. The most accurate representation of the income effect is to look at Real Net National Disposable Income (NNDI) per capita. During the ToT boom (2000-2011), growth averaged 2.9% (not including the GFC). Since the ToT peaked in Sept 2011, income growth has averaged 0%.

Source: ABS

In per capita dollar terms, real NNDI has declined by -2.6% since its peak in Sept 2011 (ToT peaked at the same time). This isn’t a huge drop (the chart above measures growth not the per capita value) and the decline is not a short and deep correction that you would see associated with a recession, but rather, income growth has stagnated (at best) over a somewhat extended period of time. Unfortunately, further declines in commodity prices are expected and this is likely to maintain pressure on income growth. If National income growth remains low, it’s likely that CPI growth, especially non-tradable CPI, will continue to slow.

Unfortunately, the exchange rate stayed high during the initial falls in commodity prices and the ToT (the ToT started falling from Sept 2011 and the real AUD TWI only started to decline from March 2013). Elsewhere in the economy, it’s likely that the final stages of the Mining investment phase, a continued housing boom (which requires some funding from overseas markets to maintain loan growth) and relatively higher interest rates in Australia since the GFC have kept the exchange rate higher than expected. This has placed some local non-resources industries and the resources sector (due to falling commodity prices and the scramble to cut costs) at a disadvantage. So far the real AUD TWI has only fallen by 7% and the AUD/USD has fallen by 20% but remains above the level that the RBA deems as its ‘magic spot’ of between US$0.80 and US$0.85 (SMH, IMF: Australian dollar should trade at ‘low US80¢'” 25-27 Jan 2014).

This is not a recessionary period and total output has not declined, but activity/growth has slowed. For the moment, income growth per capita has stopped, unemployment continues to rise and price pressures are starting to ease in the domestic economy as our ToT boom reverses and global growth remains low. This situation is likely to continue, if not become worse, as further falls in our ToT are expected. From a policy perspective, it’s unlikely, given this environment, that the RBA will increase interest rates in the short-term. Depending on the size/severity of changes in the ToT, it would be more likely that the next move in the official cash rate will be down.

The huge elephant in the room remains the ongoing strength of the Australian housing market.

 

 

GDP growth needs to be higher

Australian output growth halved in the latest June 2014 quarter. Some of the media commentary established that the result was ‘good’, given that the annual rate of real GDP growth of 3.1% is still above the recent average. Implicit in this line of thinking is that growth at above average is good enough and implies that the economy is performing well. Annual GDP growth of over 3% certainly seems like a good number, but is this current rate of growth high enough? The short answer is ‘no’ – and the reason why is because we have experienced slowing and declining real income growth and the pool of unemployed and under-employed persons in Australia has been growing for several years now. These are both important indicators that growth is not high enough. Structural and cyclical factors will continue to weigh on the performance of the economy. Without a clear strategy to address these issues, at best, we will remain in this new world of lower growth.

GDP Performance

The latest quarter of real GDP growth came in at +0.5%, well under half that of the previous quarter, March 2014 at +1.1%. This resulted in the annual rate of growth slowing from 3.3% to 3.1%.

Over the last several decades, the average annual growth in real GDP has continued to slow. Since the start of 2010, the average rate of real GDP growth has slowed further to 2.8% – the current annual rate of growth is sitting above this average.

Source: ABS

The major difference in contribution to GDP growth between the last two (2) quarters was the turnaround in the contribution of net exports from positive to negative and the change in inventories from negative to positive. The growth result this quarter relied heavily on the growth in inventories.

All other elements of GDP expenditure remained fairly stable:-

Source: ABS

Some points on the general outlook:-

  • Net exports should play a greater role in contributing to GDP growth (it hasn’t this quarter) as major resources projects come on line. There is some uncertainty around expected iron ore demand and slower growth figures coming out of China in the short-term. According to the Bureau of Resources and Energy Economics (BREE) June 2014 Quarterly Report, the value of Australia’s iron ore exports is forecast to increase by 3.1%, supported by higher volumes (+13%) which are expected to offset forecast lower iron ore prices in 2014–15. These figures are based on an average spot price of Iron Ore in 2014 of US$105/t – we are currently sitting at that average YTD (source: Indexmundi). In other words, don’t panic yet.
  • Public sector spending is likely to detract from GDP growth given the fiscal tightening agenda, with the bigger part of those spending reductions to hit during the 2014/15 financial year. If the government can get its infrastructure investment agenda off the ground (and assuming it will be well targeted spending), then this would be a welcome addition to growth and likely help support longer term productivity growth.
  • Private investment is likely to detract from GDP growth in the coming quarters due to the slow-down in Mining capex (as the boom shifts into the production and export phase). Indicators so far suggest that non-mining investment is not likely to fill the entire void, but there are some signs of increased spending in Dwelling Construction. It seems much hope rests on igniting the ‘animal spirits’ of our non-resources business sector to step up and start investing.
  • Household consumption is likely to continue at its current pace given the level of unemployment, under-employment, lower wages growth and increased savings rate. There is some potential for upside, considering the role of credit growth in supporting greater household consumption – if lending remains accommodative then any improvements in labour markets could see an increased appetite for credit. Alternatively, we could see a reduction in the savings rate (which might happen regardless).

From an industry perspective, the slow-down in growth was evident across most major industries, with the surprise exception of Manufacturing. In the June quarter, Manufacturing was the single largest contributor to GDP growth. Given the steady decline of Manufacturing-based industries in Australia (share of income, employment etc.), it’s not likely that this will be a driver of output growth into the future.

Of most concern was the pull back in growth in Construction (although remained positive) and the significant turnaround in the contribution of Mining to growth, especially given its importance to the economy at the moment.

Source: ABS

The broader question is whether growing at trend, or just slightly above, is a “good” result. That’s really the purpose of this post. I follow the labour market data closely and have been witnessing the growth in total unemployed persons for several years now as well as the well below average growth in total employed persons and the declining participation rate. These have been red flags that all is not well.

National Income

A more important view of total output and change in economic well-being (i.e. how much we can spend) is the income that output generates. One of the best measures is real net National disposable income per capita (RNDI) as it adjusts GDP for shifts in the Terms of Trade (ToT), which is currently down over 20% from its peak in Sept 2011, nets out depreciation and takes into account net income flows to foreigners.

On a per capita basis, real net National disposable income growth has been slowing or declining since March 2011. In the latest quarter, real net National disposable income per capita fell by -0.5%.

Source: ABS

The decline in RNDI per capita has implications for our standard of living in that sustained declines, and even slow growth, in income reduces our ability to grow our consumption of goods and services. Growth in income has slowed considerably from the prior two decades, making it that much harder for business to generate growth (without rapid credit expansion and/or draw down in savings). The issue of low growth is not one limited to Australia.

There is a stark contrast between income growth during the 90’s and 2000’s and during this post-GFC period. During the 90’s/00’s, RNDI per capita grew by over 2% on average. Other features of this ‘consumption boom’ included record low savings rates and higher credit growth. During the 2000’s, household consumption expenditure (excluding the period of the GFC) contributed, on average, 2.2% points to annual real GDP growth, which is fairly significant.

In this post-GFC period (area circled in the chart above), average growth in RNDI per capita has slowed to +0.7% and the savings rate is now over 9%. Credit growth, especially for mortgages, is strong on aggregate, but led by several key markets only. Personal credit growth has slowed. As a result, the contribution of household consumption expenditure to annual GDP growth has slowed to 1.4% points. It’s still a positive contribution to growth, but it has slowed considerably.

“The other thing that is in my mind when I think about the consumer is: I do not think we can expect to go back to the consumer leading aggregate demand in the way that they did in the period up to 2006.” Glenn Stevens, Governor of the RBA, Statement to the Standing Committee on Economics, 20 August 2014

This fall in National income per capita is likely driven by the decline in the ToT and it’s expected that prices of our major resources exports will continue to fall as projects come online and supply expands. The question remains as to whether the decline in prices will be offset by the increase in volumes.

The latest 2014/15 Government budget papers clearly outlines the drivers of income growth, both past and future.

“The main sources of income growth nationally are growth in productivity, changes in the terms of trade, changes in output from increased labour utilisation, and growth in net foreign income.”

Future income growth in Australia will be impacted by two key factors – the ageing population and falls in the ToT. The chart below from the Budget Papers 2014/15 highlights the likely decline in per capita income between 2013 and 2025:-

“For annual incomes to grow at their historical average of 2.3 per cent over the period to 2025, annual labour productivity growth would need to increase to around 3 per cent per year to counteract the effects of population ageing and a falling terms of trade. This is well in excess of what has been achieved in the past 50 years, and more than double what was achieved in the past decade.” Source: Budget 2014/15 http://www.budget.gov.au/2014-15/content/bp1/html/bp1_bst4-03.htm

Drivers of Growth in Income – The hatched area represents the additional labour productivity growth required to achieve long run average growth in real gross national income per capita.

 


Source: ABS 5204.0 and Treasury.

“Productivity has consistently been the most significant source of income growth. However, over the past decade or so, it has been the dramatic rise in the terms of trade which has maintained growth in gross national income as productivity growth has waned. Over the next decade, the decline in the terms of trade is expected to detract from growth in incomes. This negative impact will be compounded by a declining contribution from labour utilisation as the population ages.” Source: Budget 2014/15 http://www.budget.gov.au/2014-15/content/bp1/html/bp1_bst4-03.htm

This also highlights the more structural issues facing the economy in the near term with regards to the ageing population.

There are alternative ways to view this same data. Nominal GDP provides a similar view of National output, but at dollar value. This measure overcomes potential issues where ToT declines are outweighed by growth in export volumes. The results are similar and on any measure, Nominal GDP growth is also tracking well below average. On a per capita basis and deflated by the CPI, nominal GDP growth resumed its annual decline in the latest quarter, declining by -1.2%:-

Source: ABS, The Macroeconomic Project

Growing Unemployment

At the same time that GDP has been growing ‘above trend’, the pool of total unemployed persons has been growing and this has been a most telling feature of the state of the economy over the last few years.

The circled areas in the chart below highlight the growth in total unemployed persons during the recession of the 90’s and that of the current period.

Source: ABS

In terms of duration, this current period of unemployment growth is similar to the recession of the early 90’s, which counted thirty-eight (38) consecutive months where the annual change in unemployed persons grew (using trend data). We are currently up to thirty-six (36) months where the annual rate of total unemployed persons has grown (and counting). Over this current period, total unemployed persons has grown by +180k persons – in the early 90’s recession, unemployment grew by over 400k persons.

The current rate of unemployment is higher now than during the GFC – yet output growth remains ‘above average’.

There are other indicators of labour market weakness as well. Firstly, growth in part-time (PT) employment has been the key driver of overall employment growth and proportion of total PT employed persons is now at its highest point, +30.5% of all employed persons. Overall growth in employed persons is currently 50% below its ten year average. This lower demand for labour is showing up in slower wages growth – the slowest rate of growth since the wage price index was first introduced. Finally, the participation rate has been declining since the end of 2010, and is only starting to stabilize this year. Not all of the people dropping out of the labour force are ‘discouraged’ workers, but the decline in participation understates the rate of unemployment in the economy.

Rising Labour Productivity

One of the interesting features of the National accounts recently is that labour productivity growth has been reasonably strong. Labour productivity is measured as GDP per hour worked. This is one part of overall productivity mentioned in the income section.

There has been a sustained increase in labour productivity since quarter March 2011, which, when sustained over time, should be a key driver of National income growth. That National income has been stagnant or falling over the same time suggests that ToT movements are so far having a greater impact on income growth.

Source: ABS

What is driving growth in labour productivity during this time is not clear, but while labour productivity has been improving, unemployment has been growing. The importance of this is that improvement in labour productivity essentially means that less labour is required to generate a given level of output. Going forward, this may mean an higher level of growth is required to start to reduce this pool of unemployed persons.

Defining a ‘good’ rate of growth

At this stage in our business cycle, a “good” rate of growth could be defined as a level of growth that is high enough to reduce unemployment without adding pressure to prices (inflation). A very broad rule of thumb that can provide an indication as to the level of growth that is required, is to add the current level of labour productivity growth with the current level of labour force growth to provide an indication as to the rate of real GDP growth required such that unemployment would no longer rise.

Growth in labour productivity means that less workers are required to produce a given level of output and on the other side, growth in the labour force adds workers to the economy.

The current annual growth in the labour force (at August 2014) is +2%, which equals the ten year average. The current annual growth in labour productivity is +2.8%, which is well above its ten year average of +1.3%. Therefore, real GDP needs to grow somewhere between 3.3% and 4.8% to ensure that unemployment would no longer rise. This is only a rough rule of thumb intended to highlight the level of acceleration that would be required in growth to start to reduce the pool of total unemployed persons.

Forecast Growth

Various forecasts of real GDP growth provide little evidence to suggest that such growth is likely or expected over the next few years (all other things being equal).

The OECD develops forecasts of the output gap (GDP growth less GDP potential). The most recent measurements from the OECD highlights that the current rate of growth is not reaching potential (roughly based on growth in productivity and labour force). The forecast for 2015 is for a further deterioration in that output gap:-

Source: http://stats.oecd.org/Index.aspx?DataSetCode=EO#

The forecasts contained in the Federal Government Budget 2014/15 also show that real GDP growth is expected to remain outside of this required range over the next several years at least.

Source: ABS, Aus Dept of Treasury

Its worthwhile noting that real GDP growth in the financial year ended June 2014 came in slightly higher than forecast, but it still wasn’t high enough to keep unemployment from growing.

Under these growth forecasts over the next several years, it’s likely that unemployment and under-employment will continue to grow. National income growth per capita will remain low in the face of further ToT declines and this will add further pressure to growth and government revenues.

The ability of the economy to grow at an accelerated rate will depend on:

  1. Both monetary and fiscal policy working in the same direction to temporarily fill the gap left by the private sector (investment & household spending). Fiscal policy is currently focused on tightening and is likely to remain that way until such time that there is an economic emergency or external shock necessitating a change. For the moment, it doesn’t seem likely that all budget cut measures will pass the Senate either, adding further pressure to the budget, but also reducing the contractionary effect.
  2. Whether current monetary policy can stimulate non-resources business investment and expansion. This is one of the more important drivers. Lower interest rates are helping to fuel higher mortgage growth (mainly investors/speculators) rather than productive growth in economy. Outside of Dwelling Construction and Mining, business investment has been lacklustre in the face of subdued local and global growth. It’s unclear that any further cuts to the official cash rate by the RBA would in fact stimulate business investment.
  3. Demand coming out of China – for the moment it appears that growth is slowing. It’s hard to know what to expect from China and forecasts span a very wide range of growth possibilities. It’s an enormous economy with huge potential for growth.
  4. Depreciation in the exchange rate – this would no doubt help local producers and exporters. But there is a downside in that a lower exchange rate could place greater upward pressure on interest rates – not great news for such an indebted economy, with higher interest payments adding further pressure to disposable incomes.
  5. Whether the government can implement its infrastructure investment plan (and various other structural reforms like taxation). Whilst the infrastructure investment would enhance output and likely employment outside of Housing and Mining in the short term, it would also have long term benefits for business development and future productivity growth. The success of such a program depends heavily on whether the investment is strategic and directed to building the infrastructure that will support sustainable business development, innovation and expansion. Going back to the budget chart on income drivers, future productivity growth will be crucial to offset declines in the ToT and the effects of the ageing population. I don’t hold my breath on this one, but I am hopeful.

 

The credit impulse strengthens in March 2014

Credit data released by the RBA shows growth in Total Private Credit accelerating, as at March 2014.

This should be a positive sign for the economy – changes in spending in the economy depend on changes in income and changes in net new lending (source: http://www.debtdeflation.com). The components of this acceleration are also important indicators of where the economy may be headed and this is what I want to focus on in this post.

The main contributor to the acceleration in new credit continues to be investment housing credit. No surprise and no change. But the real news in this data is the ongoing turnaround in business credit. Whilst the size of the business credit impulse is still very small relative to the other credit components, it is now in positive territory. I’m far more enthusiastic about the improvement in the business credit impulse than the ongoing acceleration in housing credit growth. Schumpeter argues that there is a link between accelerating debt and accelerating incomes – if that debt has been used to fund entrepreneurial activity. In theory, that’s an investment in building the productive capacity of the economy, which is positive for growth in income and in employment. Certainly a part of the RBA’s intention with lowering interest rates has been to ‘rebalance’ investment towards the non-mining sectors. But business investment has been slow to respond and new credit for investment hasn’t grown on a large enough scale yet.

On the other hand, the change in monetary policy seemed to impact the speculative aspect of housing finance almost immediately. The majority of outstanding debt in Australia is related to housing and continued increases in house prices relies on accelerating housing lending/debt. Unfortunately, a large share of growth in new credit, and growth in household debt, continues to goes towards the transfer of ownership of houses in Australia.

Why is the credit impulse important?

The data released by the RBA is the stock of all outstanding credit which takes into account existing debt, new debt and debt paid down. More important than the growth in credit is the growth in new credit that is issued. Starting with a basic premise that borrowing equals spending, its new credit issued in an economy that partly drives new spending in the economy. The other source of new spending in the economy is growth in income – not covered in this post. Consider a simple example – if you borrow $10 each month for six months, total credit grows by $10 each month, but after month one, growth in new credit equals $0 or, in other words, there is constant growth in credit and therefore you only spend $10 each month. But if you borrow $10, then $15, then $25, then $40 and finally $60, then there is growth in credit and growth in new credit of $5, $10, $15 and $20. As a result, spending grows each month. So the importance of tracking the credit impulse is that it is one of two important sources of spending that will impact output and/or asset prices.

I first came across the credit impulse through the work of Professor Steve Keen in his quest is to build a more robust and accurate representation of the role of debt and money creation by financial intermediaries in the economy. In working through the impact of growth in new credit on aggregate demand, Professor Keen’s latest work suggests the impact of the credit impulse is also influenced by the velocity of money. His latest thinking:-

“[This formula corrects] a rule of thumb proposition that I have previously asserted, that aggregate demand is the sum of income plus the change in debt (Keen 2014; see also Krugman 2013b). The correct proposition is that, in a world in which the banking sector endogenously creates new money by creating new loans, aggregate demand in a given period is the sum of aggregate demand at the beginning of that period, plus the change in debt over the period multiplied by the velocity of money.”

Source: http://www.debtdeflation.com/blogs/2014/02/02/modeling-financial-instability/#sthash.p9qge3RN.dpuf

I have not gone into the velocity of money detail for this post. Whilst I have quite simply represented the growth in new credit, it’s a useful view of credit nonetheless.

To what degree does the growth in new credit drive growth in output versus growth in net change in the value of assets? I think this is a fairly fundamental question that faces our economy and it comes down to the source of the growth in new credit.

Total Private Credit

The usual way to present the credit impulse is as a % of GDP so that we can relate the size of the growth in new credit to the size of the economy. But given that March quarter GDP will not be released for another month, I’m opting to present this data instead in its dollar amount in order to understand the general direction of the growth in new credit. All the credit components – housing, business and personal are all expressed in dollars in this post, which will serve as the basis for comparison.

My proxy for the credit impulse – the growth in new credit – bottomed back in the June quarter 2013. Despite being in negative territory, the slope of the curve has been positive, meaning that the decline is getting smaller. Even a negative credit impulse with a positive sloping curve will have a positive impact.

The dollar growth in new credit for total private credit is approaching its two previous post-GFC highs, but is still well down on growth in the years leading up to the GFC:-

Source: RBA, The Macroeconomic Project

This gives you a sense of the relative size of the current growth and its potential impact on the economy. But for the impulse to become a larger proportion of GDP, it needs to grow faster than GDP (we’ll know this when GDP data is released). The current size of the growth in new credit at Mar 2014 is $26.6b, up from $17.7b in Feb 2014.

The question now becomes which of the main areas of total private credit have been driving growth in new credit?

The four components that make up total private credit (each with their share of total outstanding credit) are – owner occupier housing (40%), investor housing (20%), other personal (6%) and business (33%). Below is the growth in new credit across these four (4) components and total private credit over the last twelve months:-

Source: RBA, The Macroeconomic Project

There have been some large shifts in momentum over the last twelve months and a more positive shift in direction in the first quarter of 2014. The obvious one is the improvement in business credit – this has clearly had the greatest impact on the growth in new total private credit. But the actual dollar size of growth in new credit for business is still small relative to the other components (at Mar ’14). Growth in new investor mortgage credit is the largest of all components, which has also accelerated in the first quarter. Growth in new credit for owner occupier mortgage and personal credit are on par, but are, respectively, flat and decelerating.

Housing Credit – owner occupier and investor housing currently 60% of total private credit

Investor housing credit currently makes up the largest proportion of the growth in new credit. In March 2014, growth in new credit was $12b, up from $10.3b in Feb 2014, despite only currently representing 20% of outstanding total private credit. So approximately half of the current growth in new credit in the economy is for investor housing finance.

The growth in new credit for investor housing is close to reaching its second highest point of the last ten years.

Source: RBA, The Macroeconomic Project

This is only one part of mortgage credit. More broadly, the growth in new mortgage credit was $18.5b in March 2014, up from $16.9b in Feb 2014. This includes the change in new owner occupier housing credit of $6.6b in mar 2014, which was unchanged from $6.6b growth in Feb 2014. This signals a slowing in growth momentum for owner-occupier activity.

The slope of the curves look quite different between owner occupiers and investors – steep for investors and less steep for owner occupiers. The steeper curve suggests faster/larger growth in new credit for investor housing and this is consistent with what we have seen in other housing finance data.

Growth in new credit for owner occupiers has been somewhat more subdued and at March 2014, is about half that of growth in new credit for investor housing finance. Although the slope of the curve started to steepen in late 2013, the latest data suggests that the momentum is starting to slow.

Source: RBA, The Macroeconomic Project

The overall growth in total new mortgage credit remains strong and is obviously driven by investor activity.

So what can we expect as a result? Intuitively, you would expect accelerating housing credit growth to show up in asset values. As long as we have accelerating debt, it’s likely that we will continue to see house prices grow. Below is the mortgage credit impulse plotted with the annual growth in the residential property price index until Dec 2013. There is a reasonably strong correlation between the two (0.68).

Source: ABS, RBA, The Macroeconomic Project

Some of the accelerating growth in housing credit will show up in GDP, but to a smaller degree, in Private Fixed Capital Formation. This part of GDP captures the value of the creation of new assets only – new dwellings and new alterations and/or additions will add to GDP in that quarter. This currently accounts for just under 5% of GDP at Dec ’13. According to the latest housing finance data, purchase and construction of new dwellings has accounted for only 12% of total housing finance over the last year (ex-refinancing). Many of the current First Home Owners grants have focused on the purchase of new dwellings as it’s the creation of new assets that is likely to stimulate the economy more because jobs and income are created through new projects, rather than through transferring ownership of existing dwellings.

The transfer of ownership costs (legal etc.) are recorded as a part of GDP under Private GFCF- ownership transfer costs, but includes all ownership transfer costs, not just those on dwellings. This accounts for approx. 1.4% of GDP at Dec ’13.

Overall, the majority of total private debt relates to housing – debt which continues to accumulate, for what is essentially an unproductive asset. The downside to this is that this debt for the most part does not contribute to growing the future earning capacity of the economy, employing people, innovating or generating productivity gains.

Business Credit – 33% of Total Private Credit

The growth in new credit for business was the bright spot in this report. For the first time since the RBA lowered interest rates in late 2011, the growth in new credit for business has reached positive territory. Business investment is the single area most likely to generate income growth, employment, innovation and productivity gains for an economy.

Source: RBA, The Macroeconomic Project

The growth in new credit for business started to turn positive from mid-2013, but growth accelerated recently. In five months, growth in new credit for business has turned from a large negative to positive growth: Jan ’14 -$11.7B, Feb ’14 -$5.2B and Mar ’14 +$2.6b. Looking at the relative peaks over the last seven years (chart above), there is still a long way to go though.

Where is the growth in new credit for business likely to show up?

The labour market has been improving over the last several months – indicating at least progress on business expansion. There has been a shift from PT to more FT growth in jobs, although it appears that hours worked has not grown at the same rate. But this isn’t directly where growth in new credit is likely to show up.

This is more likely to show up in business investment. Over the last year, business investment has been slowing down and some forward indicators suggest that this will continue. One of the key objectives of the RBA in its easing stance has been to influence business investment and specifically to ‘rebalance’ investment towards non-resource sectors in light of the coming slow-down in mining investment. Recall that the first interest rate cut happened all the way back in Nov 2011.

Business investment and capex are measured in several ways. One way, is via the private new capital expenditure and expected expenditure survey (ABS 5625). This is not the equivalent of, or a complete view of the business investment component from GDP, but provides detail of expected capex expenditure, especially with regard to mining and manufacturing. You can read the full details of the inclusions and exclusions on the ABS website, but ‘all other selected industries’ excludes capital expenditure by all private businesses including units classified to agriculture, forestry and fishing, education, and health and community services industries and capital expenditure on dwellings by households.

The slow-down in mining capex is evident in the actual private capital expenditure data (ABS 5625):

Source: ABS 5625

I’ve opted for quarterly growth in this chart because I think it highlights the change in capex perfectly – “consistently slowing”:-

  • Mining capex growth has slowed since Sept 2011 and started to record quarterly declines from Dec 2012. At Dec 13, growth was -0.6% versus Sept qtr. 2013, a far cry from the high growth recorded in the mid-2000 and during 2010/early 2011. But this not the “mining capex cliff”.
  • Manufacturing capex growth peaked in Jun 2011 at 5.2% quarterly growth and since Mar 2012 has been in decline. Over the last year, the quarterly declines have become smaller, but capex spending continues to shrink – it’s not a drop off a cliff, but it’s a consistently lower value. At Dec 13, capex was -1.7% versus the prior quarter.
  • “All other selected industries” capex has been declining quarter on quarter since Jun 2011. There were two brief quarters of small growth in Jun and Sept 2013, but Dec was back to decline of -0.6% versus the prior quarter. As mentioned though, this is a not a complete representation of all other industries. See note above.

If you really want to know what the coming mining capex cliff will start to look like, then look no further. From the same ABS catalogue (5625):-

Source: ABS 5625

I’m referring to the 2013-2014 labelled graph above. The December ’13 quarter is marked ‘5’, which is half way through the 2013/14 financial year. Estimate 5 is made up of actual capital expenditure for the Sept and Dec ’13 quarters (as at the end of the Dec 13 quarter), plus the short term estimate for the Mar and Jun ’14 quarters. At this time, total capex for 2013/14 financial year is estimated to be $167,066m.

At the end of Dec ’13 quarter the first longer term estimate of capital expenditure is provided (E2) for the next financial year. This is the estimate marked ‘1’ for 2014- 2015 – and this is the estimate that has many spooked. Total capital expenditure is estimated at $124,880m, which is -17.4% lower than for the same period of 2013/14. The main reason for this lower estimate was a decrease in mining capex of -25.2%.

As mentioned, these estimates won’t add up to the investment data shown in the National Accounts – it’s a smaller view of what you would see in the GDP figures, but more detailed with regard to an ‘expectations’ view. The full explanation can be found on the ABS website.

So, looking at the more complete view of business investment from the latest GDP figures at Dec 2013 – this is what the quarterly growth in Private Gross Fixed Capital Formation (PGFC) for total private business investment looks like in the National accounts (ABS 5206.002):-

Source: ABS 5206.002

This includes all private business investments in non-dwelling construction, new machinery & equipment, cultivated biological resources and intellectual property. This represents approx. 17.1% of GDP at Dec ’13. I have excluded private fixed capital formation for new dwellings, new alterations to dwellings and ownership transfer costs – as this relates to mortgage activity.

Growth in total private business investment has been slowing since June 2011 and turned negative in the Sept 2013 quarter and the quarterly decline accelerated in Dec ’13. Given this consistent decline, it’s difficult to see that, based on the small size of the growth in new credit for business, that there will be a large turnaround in business investment at this stage.

Other data sources, such as the 2014 quarter one NAB Business Conditions report highlights a pickup in capex intentions in the coming twelve months, but at the same time points to ‘patchy’ investment intentions across the non-resources sectors.

Source: NAB

The latest NAB Business Conditions report for May 2014 (further out than the credit data I have presented here), suggests further gains in capex spending, but not enough to counter the falls in mining investment:-

Source: NAB

Given the size of the growth in new credit for business, I wouldn’t expect to see large improvements in business investment, but would at least expect a slowing of the decline for the March 2014 quarter GDP. There doesn’t yet appear to be high enough non-resources investment growth to counter the end of the mining investment phase.

Personal Credit – 6% of Total Private Credit

Over the first quarter of 2014, growth in new credit for total personal credit has been decelerating. Growth in new credit for personal lending reached a high of $11.6b in Oct 2013 and that growth has virtually halved since then to $5.4b at Mar 2014.

Source: RBA, The Macroeconomic Project

Total personal credit represents activity conducted with a bank on a non-business basis (excluding housing). This includes all manner of personal spending, so there isn’t one good place where you would expect this growth in new credit to impact output. It would likely be a combination of retail sales, new car sales and/or other discretionary spending etc.

Either way, growth in new credit for personal may be pointing to a slow-down in growth of the more discretionary spending categories (this is most likely where you’d find personal credit used).

Has this started showing up in Q1 retail sales? The month on month growth in retail sales has been slowing (sales remain high though), and whilst it does look like there is a correlation between the two measures, the correlation isn’t strong at all (0.23).

There was a stronger relationship between the actual personal credit impulse (as a % GDP) and the annual change in the Household Final Consumption Expenditure (HFCE) component of GDP (0.46) – at Dec ’13. The HFCE component of GDP is the single biggest part of GDP approx. 50%, so clearly spending that shows up here is ‘funded’ by a combination income as well as change in new credit.

Source: ABS, RBA, The Macroeconomic Project

It’s still not an ideal relationship/proxy, but does at least provide a very general view.

One thing to bear in mind is that a slowing in new personal credit growth could also reflect the current improved labour market conditions. It’s possible that income growth via increased labour market activity may counter any slowing in the growth of new personal credit. Using trend numbers for the first four months of this year we’ve seen +50k FT jobs (the first 4mths of 2013 was -11k FT jobs) and +22k PT jobs (the first 4mths of 2013 was +61k PT jobs) added. Unemployment has ‘only’ grown by 6.8K in the first 4mths of this year (versus 26.7k for the same time last year). This may have an impact on consumer discretionary spending, possibly cancelling out any slow-down in growth of new credit in personal spending for now.

Overall, the majority of the growth in new credit is going into housing – via investor activity. But it’s worth noting that growth in new credit for owner occupier housing appears to be slowing. For the moment, this is still likely to result in continued house price appreciation. Whilst business investment and expected capex, so far, looks like it will fall short of countering the drop in mining investment, the growth in new credit for business is an encouraging sign. But this needs to continue to accelerate in order to fuel business investment in new, productive activity in the economy. Business will likely expand investment if there is a strong growth business case. The continued high level of the Australian dollar, any potential impact of a slow-down in China and changes to fiscal policy are going to weigh on these business investment decisions.

 

 

 

 

 

 

 

 

 

 

 

 

 

Growth Re-balancing & the Credit Impulse in Australia

On the 1/11/11, the RBA Board commenced what has now become a series of eight (8) interest rate cuts, reducing the benchmark rate from 4.5% to 2.5% (as at Oct 2013). These rate cuts came on the back of a relatively strong AUD, weakening commodity prices, falling Terms of Trade, a softening in the domestic labour market, weaker house prices and overall weakening domestic demand as evidenced by lower than expected CPI.

Since the Oct 2012 board meeting, it’s clear the RBA has recognised the approaching peak in resources investment i.e, the “mining capex cliff”. In its own words “it will be important that the forecast strengthening in some other components of demand starts to occur.” Emphasis added by me. Those “other components of demand” include business, personal & housing spending/investment. According to the RBA, the aim of lower interest rates has been to encourage sustainable growth in the economy consistent with achieving the inflation target and to rebalance growth with a combination of depreciating exchange rate and lower interest rates to stimulate non-mining investment. 

So, two years and eight rate cuts later – is there traction in the economy? Is ‘rebalancing’ underway? I want to look at this through the lens of the credit impulse in Australia.

Demand for Credit

Recently, the RBA released its Lending & Credit Aggregates for Sept 2013.


Source: RBA 

Besides the growth in Government borrowing, Investment and Owner Occupier housing finance have been the main drivers of growth in total credit. It’s easy to get caught up in % changes, but these two areas of credit alone contributed 87% of the actual dollar growth (ex Government) in all lending over the last year.

The very big concern is the fact that Business credit growth is low. Business credit represents 34% of total credit at Sept 2013, but only accounted for 9% of the actual dollar growth in credit over the last year. Other Personal credit has similarly underperformed.

Government credit (not included in Total Credit) has seen strong growth.

The Credit Impulse

Growth in credit is the usual way to relate developments in credit with developments in the economy. Possibly a more insightful way to measure this is by growth in new credit issued relative to the size of the economy. From www.clearonmoney.com, if someone is borrowing a fixed amount each month, then spending is constant (the assumption is that borrowing=spending). There is growth in credit, but no growth in spending because the amount borrowed is the same each month. The credit impulse would be zero. If that person borrows more each and every month, then new credit is accelerating and result is that spending is also likely to grow. In this case, the impulse is increasing (there is a positive slope to the line). This perspective follows the change in the flow of money and credit, not the stock. The above chart/table “demand for credit” is the % change in stock.

Total Private Credit Impulse

Below is the estimated credit impulse in Australia for total Private credit comprising Business, Personal and Mortgage credit. It’s calculated by taking the change in new credit expressed as a % of GDP for that quarter. Whilst I have credit data up to Sept 2013, I only have GDP up to June 2013.


Source: RBA & The Macroeconomic Project 

The slope of the line is what counts and since July 2012 the slope has become negative, despite eight (8) interest rate cuts.

Total Private credit has been growing (in nominal terms) but at a decreasing rate. Between June 2012 and June 2013 the growth in new credit has been getting smaller as a % of GDP. For example, new credit grew by $91b between June 2012 and June 2011, but new credit only grew by $61.4b between June 2013 and June 2012. Therefore the change in new credit is -$29.7b or -2% of GDP – a negative credit impulse at June 2013. 

To keep funding new growth, new credit needs to grow by an increasing amount.


Source: RBA, The Macroeconomic Project 

In terms of trend change, real Private credit growth has started to increase again since July 2013 – the red arrow on the chart above. We’ll need to await Sept 2013 qtr GDP figures to understand the size of the impulse.

So with a negative credit impulse, we should have seen a decline in spending in the economy. But the other component to view together with the Private credit impulse is the Government credit impulse.


Source: RBA, The Macroeconomic Project 

Up until June 2013, the Government credit impulse has been strong – as witnessed by the steepness of the curve (chart above). When you compare the change in new credit as a % of GDP (the actual impulse), the positive Government credit impulse of 2% of GDP counteracts the negative -2% print of the Private credit impulse. You could argue that growth in the economy has been held steady by Government spending.

But during July – Sept 2013, real Government credit growth looks to be slowing down again with quite a substantial drop between July & August 2013. Luckily, the growth in Private credit that we saw above may counteract the Government slow-down in this latest Sept 2013 quarter.


Source: RBA, The Macroeconomic Project 

Looking at the Private and Government credit impulse can provide a general view over growth in the economy. One way to look at the effect on the economy is to look at recent trends in GDP growth;


Source: ABS 

Quarterly GDP growth ‘peaked’ around Dec 2011 (trend) and has continued to slow since then. This isn’t the lowest growth environment that we have been in, but the trend in growth in real GDP indicates that the economy is not ‘rebalancing’ after eight (8) interest rate cuts. This is consistent with the low credit impulse in the economy.

But not all pockets in the economy are performing equally. Breaking down the credit data provides some insight as to the areas that have and have not (yet) responded to rate cuts.

Business Credit Impulse

The business credit impulse has been in a down trend since June 2012 qtr and this is the most concerning insight in this study.

Business credit is the second largest area of total credit behind owner occupier housing finance so it has a far reaching impact on the economy. Since Dec 2011, the Business credit impulse has gone from +3.3% to -2.3% of GDP.

Importantly, business investment is the engine of the economy. If business is investing in new technology or additional capacity, then this likely to drive future employment and income growth. This is an important source of the RBA’s sustainable economic growth.


Source: RBA and The Macroeconomic Project 

Growth in real Business lending has been slowing down since June 2012 and started declining (year on year) around March 2013. Make no mistake, the Business credit impulse has been by far the largest contributor to the total Private credit impulse and growth of new credit for Business represents a larger % of GDP than growth in new credit for Mortgages. The performance of the Business credit impulse has shifted dramatically over this time period – as you can see from the chart. Since the RBA started cutting rates at the end of 2011, the Business credit impulse has gone from positive to negative, not the other way around.

Real Business credit growth has been zero or negative since November 2012;


Source: ABS, The Macroeconomic Project 

This means that total outstanding Business debt has been getting smaller – more debt is paid down than new credit is raised.


Source: RBA, The Macroeconomic Project 

As you can see from the chart above, the last 3 months of growth suggest a slightly improving Business credit impulse for Q3 2013. 

Despite eight (8) interest rate cuts, total Business credit has not grown, and in fact has become smaller as a % of GDP – from 62% in 2008 to 47% in June 2013. The impact of this deleveraging is contraction. The only upside is that business will be in a better position to invest should (when) demand conditions pick up.

These next two charts provide some further context about the current business environment – non-mining profits falling as a share of GDP and even mining profits have stopped accelerating as a % of GDP. Business profits have been squeezed and this is showing up (on aggregate) in cost cutting (see recent employment reports) and what appears to be a reduced appetite for debt/investment for future growth.

 

This is another view of business investment – by industry sector. Share of business investment in most industries, with the notable exception of mining, is declining. This is exactly the situation that the RBA is aiming to ‘rebalance’ given the forecast for mining investment to slow. 

 

The NAB Monthly Business Conditions report has shown that excess capacity continues to plague the economy across multiple sectors (including mining). There is clearly no reason for business (on the whole) to invest in building capacity;- 


The one thing that immediately jumps out to me on these last two charts is the discrepancy between the growing share of Mining investment and the low and falling capacity utilisation in Mining. 

The other important factor affecting business (exporting ones) is the exchange rate. The aim of the RBA has been to rebalance growth through a combination of a lower $AUD and lower interest rates. Despite the spike down in 2012 (probably more due to speculation of US FED tapering its QE program than interest rate differential), the exchange rate has remained fairly high. The benefit of a lower exchange rate is that exports become more competitive – which should fuel higher investment and employment locally. It also makes imports more expensive, possibly helping locally manufactured goods to compete domestically, but increasing costs of inputs priced in USD eg fuel.

 

Overall trading conditions continue to be challenging and business has not been investing. In the short-term this does not paint a positive picture for rebalancing economic growth. 

Housing Finance Credit Impulse

This contrasts with the acceleration in mortgage credit growth, especially for Investor housing finance, during this recent rate cut period. There appears to be an increasing disconnect between the relatively weaker underlying business conditions and say, the strength of the housing market.

Since Dec 2011, the mortgage credit impulse in Australia has gone from -2% to -0.09% of GDP at June 2013. The high point was May 2013 at 0.33% of GDP. Clearly a far smaller impact than the Business credit impulse.


Source: RBA, The Macroeconomic Project 

Whilst there is appears to be a slight pull back in the latest months to June 2013, the growth in new mortgage credit (not as a % of GDP) appears to hit a new high in Sept 2013. This is also reflected in the accelerating rate of growth in total real mortgage lending (chart below) – yes that small blip at the end of the chart;


Source: RBA, The Macroeconomic Project 

At this level, we can start to ponder where the main effect of the Mortgage credit impulse is felt. The effect of rising mortgage debt and a rising mortgage impulse (rising faster than housing supply) could be seen in economic growth, but is likely to show up more directly in a change in house prices.

This doesn’t mean that there aren’t benefits from a GDP perspective. These benefits might include transaction costs based on the exchange of dwellings – stamp duty, solicitor fee’s, realtor fee’s etc. Rising house prices can signal the potential for new supply requirements. Construction of new dwellings would have a far reaching economic growth impact through higher employment, income etc. The final way is through higher asset prices – and the ability to use equity to fund more spending. But few scenarios here relate the growth in debt to growth in the future earning capacity of the Australian economy.

Most of the recent lift in the mortgage credit impulse is due to Investment lending. The steepness of the Investor credit impulse curve shows just how strong Investors have been in this market relative to Owner Occupiers.

Since the Dec 2011 qtr, the credit impulse has moved from -1.3% of GDP to +0.17% of GDP in June 2013. It reached a high of 0.7% of GDP in Jan 2013. Again, this is a far smaller impact relative to the Business credit impulse.


Source: RBA, The Macroeconomic Project 

Investors have been leading the way during this spate of interest rate cuts, and whilst the chart above shows momentum stalling, the growth in new credit between July & Sept 2013 has accelerated again. See below growth in real Investment housing credit;


Source: RBA, The Macroeconomic Project 

There has been far more gradual growth in the Owner Occupier credit impulse (below). Despite a negative credit impulse, the slope is positive and that’s the important point. Since the start of rate cuts in Dec 2011 the impulse has improved from -0.8% to -0.27% of GDP in June 2013. The strength in the Investor-led credit impulse has helped to make up for the weaker, but improving, Owner Occupier credit impulse;


Source: RBA, The Macroeconomic Project 

Growth in real Owner Occupier financing has also grown fairly consistently since Feb 2013 and the latest 3 months of data suggests that the credit impulse is likely to continue its modest improvement into the Sept 2013 qtr.


Source: RBA, The Macroeconomic Project 

What it is also saying is that owner occupiers have been quite late to the party on housing.

Personal Credit Impulse

Personal credit has seen a recent uptick in activity which is a positive sign for consumption spending growth in the economy. Since Dec 2011, the Personal credit impulse has gone from -0.3% to +0.2% of GDP. A smaller effect but it will impact spending growth nonetheless.


Source: RBA, The Macroeconomic Project 

Without a doubt, there has been an improvement in rate of growth. But the improving credit impulse can be related back to a slow-down in the decline of real personal credit growth – note the chart below. Current growth is a far cry from the growth in personal credit pre-2008 of anywhere between 5% and 15% growth.


Source: RBA, The Macroeconomic Project 

In the latest months from July to Sept 2013, real personal credit declined by 1% each month – which is an improvement over the June result of -2%.

The stock of outstanding Personal debt has fallen from a high of 13% of GDP to 9% of GDP in the June 2013 qtr.


Source: RBA, The Macroeconomic Project 

The trend is improving but it’s not exactly a ‘snap-back’ rally in personal credit growth. Its also possible that some of the lending traditionally called ‘Personal’ may now be accounted for in mortgages via redraw and offset facilities.  

But with household mortgage debt is back near its highs (84% of GDP), a weak labour market (PT growth over FT growth) and wage growth slowing, its no wonder Personal credit growth is low. 

Unless one of these constraints is removed/reduced, personal credit growth is likely to remain subdued. 

But counteracting this data is the improving consumer confidence index. Together with the slightly improving personal credit impulse, it could be signalling a shift in consumer attitude back to greater consumption. If we see improvements in the labour market, then spending and confidence are likely to improve further.

There have been two key drivers of the credit impulse in Australia over the last six months; 

  • the negative performance of the Business credit impulse, &
  • the positive performance of the government credit impulse

The impact of an improving Mortgage & Personal credit impulse has not been enough to counteract the negative Business credit impulse. Several points about this:-

  • Its been a lucky co-incidence that Government borrowing has helped to stave off the negative impact of the Business credit impulse. But with the Liberal government committed to bringing the budget back into surplus, Government may not be a source of spending growth in the future.
  • In a later post I’ll highlight that the Mortgage impulse and the resulting impact on house prices, does not reflect a broad-based uplift in housing – which is probably why the mortgage impulse hasn’t had a more influencing effect. This is really a much bigger issue. The effect of an improving mortgage impulse will likely stimulate house prices – but is it big enough to rebalance growth in the economy? As more established houses are sold at higher prices, more debt is created but this debt accumulation isn’t an investment in the future prosperity of the economy.
  • The real issue for our economy is the contraction of business activity ie via investment & cost cutting – in response to slack/capacity in the economy. Why is that? Demand for debt (& therefore spending ability) seems constrained apart from investment housing. The shift in interest rates hasn’t moved the credit impulse in a proportional way. Accumulation of debt, together with income, has been a source of spending growth in the past. So do we now have our fill of debt?

The huge fear is that as a result of lower interest rates, we’ve only managed to see rising house prices, more debt, little/no improvement in business investment and therefore no change or improvement in economic growth prospects. If business isn’t investing in expanding capacity or improving competiveness (beyond reducing costs) then the RBA will be hard-pressed to achieve its rebalancing.