Further deceleration in the Australian credit impulse – Feb 2017

The latest RBA credit and lending aggregates for Feb 2017 show that the growth in new credit has continued to decelerate.

Total Private Credit – growth in new credit decelerates further in Feb to -$24b

The growth in new credit at the aggregate level (total private sector) began to decelerate sharply from April 2016. Since then, the annual growth in new credit has gone from +$30b in April 2016 to -$24b as of the latest February 2017 data. This is now approaching the lows reached in mid-2013:-

Source: RBA, The Macroeconomic Project

The main driver of this slowing growth in new credit has been business credit, which has continued to slow since June 2016. The growth in new credit for mortgages started to accelerate in November 2016, but this has not been large enough to offset the deceleration in business credit growth.

Progressively smaller increments in the growth in new credit are likely to result in lower spending and growth. Consider that the annual growth in the stock of total private credit in February 2016 was $161.9b and this annual growth in credit slowed to $137.9b in February 2017 – overall, this is -$24b less annual credit growth in the economy. This equates to approx. -1.4% of nominal GDP.

Given the recent strength in economic growth data (which is so far only the Dec ’16 quarter), the question is whether other sources of spending growth, such as income, are accelerating to offset this deceleration in total private credit growth.

Read more on the Australian Debt and Credit Impulse page of this blog.

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, 7^th 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.

Wage growth in Australia keeps slowing – Sept 2016

The Wage Price Index data for the Sept 2016 quarter shows that wage growth in Australia has yet again slowed to its lowest level since the data was first collected.

The annual nominal growth in total hourly rates of pay excluding bonuses (seas adj) for the year to Sept 2016 was +1.88%. Growth in the latest quarter was +0.4%. This includes both public and private sector hourly rates of pay. The public sector wage price index is growing at a faster rate than that of the private sector, but is clearly also slowing:-

Source: ABS

In real terms, the change in the Wage Price Index is much lower and is barely positive. Annual growth is +0.14% and the latest quarter growth is +0.05%:-

Source: ABS (deflated using trimmed mean CPI)

Since late 2012, the wage price index in real terms, has been flat – growth in hourly rates of pay have (barely) kept pace with growth in core CPI.

Source: ABS

This most likely means that disposable income has not kept pace with CPI growth. For disposable income to remain constant in real terms, wages growth must actually exceed CPI in order to account for the impact of taxation. The chart above clearly shows that real total hourly rates of pay have been flat since the end of 2012.

The slight uptick that is obvious from June 2015 is the result of core CPI falling, rather than wage growth picking up.

Implications for growth

Putting this into context of where spending growth will come from (debt and/or income), highlights that we might expect private sector demand growth to come under pressure in the near term.

Wage growth is just barely ahead of core CPI and most likely, disposable income has been falling (slightly) over the last few years. There has been “relief” for those managing a mortgage because variable rates have gone down. But on the flip side, low rates have hurt those relying on interest income. Globally, interest rates have started rising and, if this continues, this will place greater pressure on spending by indebted households where disposable income/wage growth has not kept pace with inflation.

The other important source of spending growth, credit creation, has recently started showing clear signs of deceleration. This is an early warning sign that private sector growth in Australia may slow further. Read more about the credit impulse in Australia – Sept 2016.

Growth may be increasingly reliant on increases in government spending. At the same time, government borrowing rates have already started rising. The other issue for the government is the ongoing slow-down of wages growth and what it means for the budget. The 2016/17 budget assumptions had the wage price index growth accelerating to 2.5%. We end the first quarter of the financial year well below that assumption.

Credit impulse in Australia turns negative in September 2016

An update on the credit impulse and debt levels in Australia has been posted on the Australian debt and the credit impulse page on this blog. You can read the latest results in more detail, as well as an explanation on measuring the credit impulse on that page.

The growth in new credit for the total private sector has been decelerating since April 2016 and the level of deceleration has been gathering pace over the last five months. In Sept 16, the growth in new credit for the total private sector became firmly negative for the first time since Sept 2013. This is a particularly negative change in the trend.

Source: RBA, The Macroeconomic Project

The level of deceleration in the credit impulse for total private debt, especially over the last three months, has been driven by the deceleration in the growth in new credit for business and, to a lesser degree, the growth in new credit for mortgages. Since Jun 2015, there was at least a slightly accelerating rate of growth in new credit for business (but still low in comparison to other expansions), which was supportive of growth in aggregate demand and broadly supportive of at least more stable employment growth.

The growth in new credit across all sectors (business, mortgages and other personal) is now negative. That means that while total private debt is still growing, growth is no longer accelerating. To generate spending growth or asset price growth, credit growth (and/or income) needs to accelerate.

The annual growth in total private credit as of Sept 2015 was $153.5b. As of Sept 2016, the annual growth in total private credit has slowed to $138.9b – which is $14b lower. The question is whether other sources of spending, such as income or a lower saving rate, are accelerating to offset the deceleration in credit growth.

Indicators of National Income are only available to Jun 2016 at this point – and it’s been mainly in the 3 months since Jun 16 that we’ve started to see growth in new credit start to decelerate at a faster pace.

Source: ABS

From Sept 2015 to Mar 2016, the quarterly growth in Real Net National Disposable Income was accelerating – this has likely been helping to off-set decelerating total private credit growth during that time. Growth in Real Net National Disposable Income has slowed in the latest quarter (Jun 2016), so it will be important to see if this trend continues or not. If National Income continues to slow while credit growth also decelerates, then it’s not likely that we will see growth in aggregate demand accelerating. Growth will be more likely to slow down in the near term and we are more likely to see weaker growth in employment aggregates.

Growth in new credit decelerates – March 2016

The update to the Australian Debt & the Credit Impulse page has now been posted – you can read the results in more detail including background on the credit impulse measure on that page.

The latest data shows that for the total private sector, growth in new credit is decelerating.

The annual growth in new credit has slowed from $27.2b in February to $23.3b in March 2016. This has been predominantly driven by the deceleration in new mortgage plus other personal credit growth.

Source: RBA, The Macroeconomic Project

The performance of the components making up total private credit are mixed.

Business – The growth in new credit for business has accelerated slightly from $14.7b in Feb to $16.6b in Mar. Despite a few up and down periods, the overall trend since June 2015 has been accelerating credit growth. But it hasn’t been a very steep curve and this point matters. Since June 2015, the growth in new credit has accelerated from $7.4b to $16.6b over the ten (10) month period. Compare this to the first ten (10) months from the May 13 bottom where the growth in new credit for business accelerated from -$33.6b to -$1.8b in ten (10) months – a much bigger move and a clearly steeper curve. The implication is the steeper the curve, the higher the growth in new credit which means more growth in spending by business. There was a clear pickup throughout the economy during that time, especially evident in the turnaround in the labour market as business increased hiring. For the moment, the slower acceleration means more of a steady course in activity, rather than implying stronger growth in the near term.

The pick-up in credit acceleration for business in the latest month, and if it continues to improve, may be a better sign for labour market conditions in the near future.

Mortgage plus Other Personal – Unfortunately, the slightly more positive acceleration in new credit for business has been more than offset by the deceleration in the growth of new mortgage plus other personal credit. The chart above includes ‘other personal’ to provide a more consistent trend given the large adjustments made in both data sets. This measure has decelerated from +$12.3b in Feb to +$6.6b in March. Both mortgage and other personal contributed to that deceleration. Growth in new credit for mortgages decelerated from +$27.6b in Feb to $23.4b in Mar (-$3.9b). Other personal also decelerated from -$15.3b in Feb to -$17b in Mar. The deceleration in new mortgage credit continues to imply lower growth in house prices in the future. There has also been a loose relationship with retail sales and mortgage growth throughout these last few years of higher house price growth, so the deceleration is likely to affect spending in these areas as well.

You can read more details here.

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 1^st 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 4^th 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.

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.

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

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

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

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

The “income recession” in charts

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

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

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

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

Source: ABS

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

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

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

Source: ABS

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

Source: ABS

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

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

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

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

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

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

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

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

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

Source: ABS 5206.07

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

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

So is the penny about to drop again?

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

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

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

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

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

Source: ABS 5676.11

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

Source: ABS 5676.11

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

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

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

Source: ABS 5676.11

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

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

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

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

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

Growth in wages & consumer prices still low

The latest data on consumer prices and wages for the March 2015 quarter highlights that price pressures across the economy continue to abate. Headline CPI growth for the March quarter, and for the year to March 2015, was very low, mostly as a result of the large fall in fuel prices over the previous two quarters. Adjusted for outliers, the measures of core or underlying price changes have remained fairly stable and are just below the middle of RBA 2-3% target range. Over the last few years, CPI growth has been trending down and this latest CPI data is in line with that trend – still reflecting softer demand conditions. Wage price growth confirms that weaker demand for labour still exists despite some recent indications that there has been a pick-up in the labour market.

In the past I’ve argued that slower CPI growth was one piece of a bigger picture showing that the Australian economy has been growing too slowly as it transitions away from the investment phase of the mining boom. While some argue that economic growth is reasonable at current levels, unemployment and underemployment have continued to grow and income growth has stalled as a result of significant falls in the Terms of Trade (ToT). Hampering the transition for the non-mining sector, has been a persistently high AUD despite the falls in the ToT.

Across a range of indicators there isn’t much evidence of inflationary pressure in consumer prices the economy, although there is some risk that further falls in the AUD will result in higher imported inflation.

Underlying CPI growth remains in the middle of the RBA range and is stable

The headline measure of CPI for the quarter grew by a mere 0.3% and by +1.33% over the year (seasonally adjusted). That’s a very low level of CPI growth and sits well outside of the RBA’s 2-3% band. But the large outlier in that data is the fall in fuel prices over the last two quarters.

Source: ABS

The trimmed mean and weighted median, which are the preferred measures of core or underlying price growth trends, removes these types of outliers. The chart below reveals that while headline CPI growth has slowed considerably, both measures of core CPI sit well within the RBA band, ticking up slightly in the latest quarter:-

Source: ABS

Annual growth of the weighted median is now +2.43% and the trimmed mean is a little lower at +2.32% – the trimmed mean is the preferred measure of the RBA.

On a category basis, we can start to get an idea of the outliers driving this much lower headline figure:-

Source: ABS

Over the last two quarters in particular, petrol has had the single largest negative impact on headline CPI. Falling fuel prices have helped to offset growth in prices across a range of categories. Fuel is also a production input.

Unfortunately, continued declines in fuel prices are not going to last. According to official data collected by the Australian Institute of Petroleum for the week ending the 3^rd May 2015, the benchmark price for fuel in Australia (Singapore prices for 95 Octane petrol) has increased by approx. 20% since it bottomed in late January/early February 2015. This will likely show up in the next quarter CPI – reducing the stimulatory impact on both households and businesses.

Growth in Education in the latest quarter is largely the result of seasonal factors (start of the new school year).

Housing (mostly the purchase of new dwellings) continues to contribute to price pressure throughout the domestic economy. Of all the categories that make up the CPI, the purchase of new houses by owner occupiers has made the largest contribution to growth in the CPI in the last year of +0.64% points of the 1.4% point increase.

Strangely enough, the only categories that didn’t contribute to price growth over the last couple of quarters were those with some exposure to the recent falls in the AUD – Communication, Furnishings & Household Equipment and Clothing and Footwear all have high imported content. Some more on this shortly.

An insightful view of the drivers of price pressures in the economy is that of tradable versus non-tradable categories. This helps to isolate the price changes in the domestic economy (“non-tradables”) from those impacted by global exchange (“tradables”). Changes in non-tradable CPI is thought to reflect changes in the domestic economy such as labour costs and productivity.

Non-tradables continue to be the main contributor to CPI growth

During the investment phase of the mining boom, higher demand for labour and other productive inputs placed greater pressure on prices in the domestic economy (“non-tradables”). As we transition to the production phase, non-tradables continues to be the main contributor to CPI growth but domestic price pressures are now well below the decade long average, picking up somewhat in the latest quarter:-

Source: ABS

More than half of the domestic price growth in non-tradables over the last year is coming from a concentrated core of four categories – these are: Purchase of New Housing by Owner Occupiers, Medical and Hospital Services, Rents and Domestic Holiday and Travel.

The growth in non-tradable CPI is likely to have more to do with the ongoing rise in house prices (new home sales in this case), fuelled by none other than lower interest rates.

Separating out price changes for goods versus services is also a good way to ascertain the role that labour might be playing in driving consumer prices (services contain a higher labour cost component). Historically, prices within the Services component of CPI have grown at a faster rate than Goods, but that trend has shifted over the last three years:-

Source: ABS

Looking at the change in prices for market goods and services ex volatile items, growth in Services prices has slowed, especially over the last year, and at the same time growth in Goods CPI has increased. Both are now growing at the same rate annually, around 2%. This suggests far less pressure from labour/wage growth within the economy.

Growth in wages remains at record lows

Last week the ABS released the Wage Price Index data for March 2015 and this confirmed that wage growth continues to slow down. Wages are growing at the slowest rate since data collection on this series commenced. If you use core CPI to deflate the series, then real wages are not growing at all.

Source: ABS

The slowing wage growth data confirms that tight labour market conditions are not driving domestic price growth.

The latest slowdown in the growth of wages is widespread across industries. Only a handful of industry sectors recorded either no growth or an increase in the annual rate of wages growth between December and March quarters. These were: Info media & telecoms (0% pt change), ‘Other services’ (+0.07% pt change) and Mining and Retail Trade wage growth declined only slightly by 0.1% points.

In a speech earlier this week, Deputy RBA Governor, Philip Lowe stated that “restraint in aggregate wage growth” will assist in the transition of the economy as mining investment declines and we look to non-mining activity to fill the void. Restraint in wage growth may be required, but current low growth is the result of the relatively high levels of unemployment and underemployment that currently exists in the labour market – in other words, less demand for labour. The RBA is focused on doing what it can to support business via lower wage growth, a lower dollar and lower interest rates in the hope that this will lead to higher employment growth. As the economy is experiencing, these measure take time to embed. That said, there have been some encouraging signs of improvements in the labour market. Mostly, there has been improving levels of male participation and, for the first time in a few years, there have been consecutive months of a slight reduction in the total number of unemployed persons. These have been welcome improvements, but they have been moderate at best. There still remains significant excess capacity in the labour market, which is why wages growth continues to slow. If this improvement in key labour market metrics continues and accelerates, we may start to see growth in wages, but only once some of this excess capacity is reduced.

While lower growth in wages may help to improve the competitiveness of local business, in the short term it could also limit consumption growth and borrowing capacity.

In the past, lower growth in wages could easily be ‘supplemented’ with a dose of debt-driven consumption via lower interest rates. Forces are combining to place pressure on this model working as successfully as it did in the past – interest rates are already low, household debt is already high both as a % of GDP or as a % of income, wages growth is low and importantly, concerns about unemployment are at high levels. The recent NAB Quarterly Consumer Anxiety Index for March 2015 shows that consumer spending intentions in the face of these challenges are focused on non-discretionary items.

Source: NAB

Increases in intentions to pay off debt and to save/add to Super and investments highlights a more conservative approach to spending and consumption. Yet at the same time, intentions between the last two quarters have also increased for ‘use of credit’. This suggests some pressure already on the household budget – especially given the obviously low, and falling, level of spending intentions in the more discretionary areas (eating out, entertainment, personal goods etc.). While these pared back intentions are likely to keep a lid on consumption growth, a reasonably favourable Federal budget seems like it could boost confidence.

“It is, however, unlikely to be in Australia’s long-term interests to engineer a consumption boom by encouraging people to borrow large amounts against future income. This is especially so when debt levels are already high and prospects for future income growth are not as positive as they once were”, Deputy RBA Governor, Philip Lowe, 18 May 2015, Managing Two Transitions

Despite falls in the AUD, tradable CPI growth remains low even after adjusting for fuel

Since the start of the decline in the ToT (during the Dec 2011 quarter) the AUD has remained persistently high. The RBA has continually tried to talk down the AUD, claiming that it was overvalued given the large falls in the ToT and commodity prices. The AUD peaked back in mid-2011 and remained elevated for some time (above parity with the USD). The most substantial falls have occurred during two periods 1) early-mid 2013 and 2) Aug 14 to Mar 15. Since its peak, the AUD has fallen by 30% against the USD and is currently trading at around US79c – the RBA wants the AUD lower, closer to US70c in order to provide support for non-mining export and local importing competing industries.

“The Australian dollar has declined noticeably against a rising US dollar over the past year, though less so against a basket of currencies. Further depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices. “RBA Governor, Glenn Stevens, May 2015 Statement on Monetary Policy Decision

Source: RBA

On a trade weighted basis, the AUD has fallen by approx. 20% and the AUD trade-weighted exchange rate index, adjusted for relative consumer price levels has fallen by approx. 15%.

From a prices perspective, the theory goes that as the currency falls, import prices rise. The surprising thing is that there has been less negative impact on tradables than expected, given the declines in the AUD so far. According to the Westpac 2015/16 Budget Report (page 12), import prices are not as heavily weighted to the USD as our exports. According to Westpac, approx. 70% of our exports are denominated in USD.

Several trade exposed categories have in fact experienced ongoing deflation i.e. technology products. Upon closer inspection, there is some evidence that imported inflation has been picking up.

In March 2015, annual CPI increased by 1.4% points over the year prior. This increase was made up of non-tradables contributing 1.77% points to that increase and tradables contributing -0.37%points to that increase. As mentioned, the decline in contribution of tradables over the last two quarters has been driven by lower fuel prices.

Source: ABS

Even adjusting for the decline in fuel over the last 2 quarters, tradables would continue to make a smaller, albeit positive, contribution to overall CPI growth. The contribution of automotive fuel to the total CPI has been quite stable over the last several years (prior to the recent fall in oil prices), so the average back to June 2011 is fairly representative. Using this average in place of the actual index for fuel over the last two quarters shows that tradable CPI would still be making a smaller and slowing contribution to overall CPI growth.

Going back to the examples of consumer durables with high imported content – motor vehicles, furniture & furnishings, clothing & footwear and audio, visual & computing equipment, the view of the RBA is –

“for much of the past five years or so the pace of deflation for these items had been more than expected given movements in the exchange rate, partly as a result of a reduction of margins along the supply chain“, Source: RBA Statement on Monetary Policy, May 2015 .

Work completed by the RBA on retailer margins (RBA Statement on Monetary Policy – Recent Developments in Retail Prices and Margins, February 2014) suggested that retailer margins had not been decreasing and instead retailers had more success in negotiating lower prices via wholesalers, bypassing wholesalers altogether within the supply chain and/or sourcing cheaper alternatives globally. Pressure not to pass on higher import prices to consumers is also the result of softer trading conditions domestically. There is evidence to suggest that local firms have taken advantage of improvements in technology and global wage disparities to source and deliver cheaper products, even in the face of a falling AUD. For example, retailers such as Target, K-mart or H&M can import ladies t-shirts manufactured in Bangladesh, retail them in Australia for $5 a unit and make a profit – rather than source them locally.

Looking at the Import Price Index, there is clearly some price pressure within these categories as a result of the recent fall in the AUD. The point is that some of the price pressure from a lower AUD doesn’t show up in the CPI – which doesn’t mean it isn’t there. In the latest quarter, Fuel was the off-setting factor, but most other categories, especially the larger categories by weight/import volume, saw increases in import prices. In fact, the two largest categories by weight in the index – Misc. Manufactured Articles and Machinery & Transport Equip made the largest contribution to the overall increase in import prices in the latest quarter:-

Source: ABS

The price index for Machinery and Transport Equipment, which accounts for over 40% of the import price index by weight, jumped by 5% in the latest quarter. This category is made up specialised machinery for industry, power generating machinery, telecoms, road vehicles (including air cushion vehicles), electrical machinery and other transport equipment. The correlation between the change in import price and the change in the AUD is strong at -0.89. This is how the relationship has been trending:-

Source: ABS

The other significant contributor is Misc. Manufactured Articles, which accounts for approx. 14% of the import price index by weight. This price index increased by 5.4% in the latest quarter. As the name suggests, this category includes misc. articles such as Furniture, Clothing, Footwear, Prefab Buildings and Structures, Professional, Scientific and Controlling Instruments and Photographic and Optical Goods, among other things. Again, the correlation between changes in the AUD trade weighted exchange rate and import prices for Misc. Manufactured Articles is strong at -0.91.

Source: ABS

For the moment, the AUD remains at around US79c, which will keep further import price increases low for now. But it also might take some time for the effect of recent falls in the AUD to make their way to consumers via higher prices as supply agreements are renegotiated etc.

Inflation expectations remain low compared to historical averages

On balance, inflation expectations have been trending down and remain below historical averages. This reflects expected lower wage growth, excess capacity in the economy and lower economic growth. This is likely to keep expectations for future interest rates low.

Source: RBA

As we transition from mining investment boom to the production phase, growth has slowed and this has resulted in excess capacity across the broader economy. Lower CPI growth and higher unemployment reflect these relatively weaker conditions. Is growth likely to improve? The economy has received several boosts recently – a significant, and somewhat unexpected drop in fuel prices (which is now reversing), a fall in utility pricing related to dropping the carbon tax, a decline in the AUD and two further interest rate cuts so far in 2015. It would be difficult to argue that these have not had some positive effect on various parts of the economy – house prices aside. The economy certainly hasn’t fallen into a heap, but despite these measures, the outlook remains soft. How much powder do we really have left should things worsen from here?

• Employment, demand and confidence are already soft – a worsening in any of these elements could hit a tipping point.
• The Government deficit is already high and any requirements for a solid stimulus spend might see the AAA rating removed.
• Household debt is already high and with wage growth slowing, there is less capacity for households to take on more debt to stimulate the economy.
• To that end, interest rates are also low and seem to be losing their ability to generate a productive investment response outside of housing speculation. But interest rate cuts are good for households strapped by mortgage repayments.

The one area of potential is business. Debt levels remain well below historical levels, so there is capacity to take on debt to invest. The federal budget was certainly favourable to small business – at least in encouraging small business to go out and buy (on credit) equipment to write-off immediately. There may be a good sugar high from that. The effect of falls in the AUD on local competitiveness will likely take some time to manifest. Fingers crossed business decide now is the time to ‘have a go’.