Monthly Archives: September 2014

Straya T’day 30/9/2014

Softness in Asia

August Industrial production (IP) figures were released today for South Korea and Japan, and both were weak; -2.9% for Japan and -2.8% for Korea, both year-on-year. Close to a third of Korean exports and one fifth of Japanese exports go to China, so the recent slowdown in Chinese industrial production and surprise fall in profits are likely to be contributing to regional weakness. This chart from David Scutt paints the picture:

soft-ip-partners

Apart from the always-suspicious absence of volatility in Chinese figures (the latest print did buck the trend there, I suppose), the trend in Japanese IP is clearly of concern. The rebound in IP in 2013 occurred largely as a result of a massive depreciation in the yen, seen in a 33% rise in the USDJPY between late 2012 through to the end of 2013.

USDJPY2013

Two things happened this year; until August the yen was broadly flat, and in April the government raised the sales tax. Since the sales tax hike, IP has fallen in 3 of the next 5 months (month-on-month).

The USDJPY has rallied hard in the past few weeks. It remains to be seen if this can invigorate Japan’s languid industrial sectors. It will undoubtedly help at the margin, but a larger unknown is the outlook for Chinese production, which is of course mostly dependent on the ‘will-they-or-won’t-they’ stimulus outlook.

On a related note, there was a good article in last week’s Economist on Japanese and Korean firms’ tendencies to hoard cash to the detriment of their economies. At the very least, if corporates are concerned with their competitiveness and reluctant to raise wages, dividends should be increased. It would provide a welcome boost both domestically and internationally.

And lastly, while we’re on the topic of a heavy reliance on China, we might as well remind ourselves of some of the other noteworthy countries in that category.

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Chart from Michael McDonough of Bloomberg

HSBC PMI not as buoyant as first thought

The final reading of the HSBC PMI for China was released today, and contrary to the earlier ‘flash’ estimate which had it rising to 50.5 from 50.2 the month prior, it was actually unchanged. While it is welcome to see this figure in positive territory (having spent much of the past two years in negative), the tepid expansion is only being realized via strong export orders.

As I said at the time of the flash release, the strength of exports is likely to be in partly underpinned by Chinese steel mills dumping their unsold stock into global markets, where they can achieve a much higher price than in China. This is of course vulnerable to protectionist responses from governments should their local steel sectors grow tired of ‘making room’ for heavily discounted Chinese steel products.

Moreover, from Australia’s point of view, it is hardly reassuring that the Chinese steel sector is facing such lacklustre demand locally that it is being forced to turn offshore with increasing urgency.

Steel-ore complex

Chinese steel futures retraced their gains late on Friday, and iron ore finished the week flat after looking like finding some buyers during the day. Protests in Hong Kong weighed heavily on prices at the open yesterday, though they gained somewhat throughout the session. Spot iron ore finished last night at $77.70, off 1.15%. It is now down 42% for the year in USD-terms, and 40.80% in AUD-terms. The recent decline in Australian dollar (or rise in the USD, really) has therefore come at a welcome time, though there is much work to be done on that front.

Untitled

After rallying earlier in today’s session, the most-traded rebar contract closed down .4% in Shanghai today. Dalian iron ore gained .7%. Since markets will close for China’s National Day Holiday tomorrow, spot will need to recover yesterday’s loss to avoid an 8th consecutive week of declines. More from Reuters.

In local news, ex-RIO chief Anthony Albanese has joined ex-BHP executive Alberto Calderon in expressing his scepticism regarding the oft-cited iron ore rebound supposedly arriving later this year (if it comes, late October would be my guess). As a reminder, in Q4 2012 spot pieces soared after collapsing on seasonal weakness, and a similar pattern is seen by some as a possibility this year.

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Of course, I’m in agreement with Calderon and Albanese that we won’t see a pronounced rebound this year (bearing in mind that no one, to my knowledge, is expecting the rebound to produce prices comparable to 2012).

To reiterate, my reasons for this are:

  • India knocked some 100m tonnes of annual supply out of the seaborne market fairly rapidly in 2012 with its ban on mining in Goa, which followed similar restrictions in Karnataka in 2011 (total traded iron ore was about 1100m tonnes in 2012). If memory serves, Macquarie reckoned these moves added about $20 to spot prices throughout 2013.
  • Chinese stimulus via fixed asset investment flowed freely in 2012, and, critically, the property sector commenced a strong upswing around the time iron ore bottomed. Property is moving in the opposite direction now, and like much else in the Chinese economy, oversupply is becoming an issue. It remains to be seen whether the government is prepared to allow this process to run, or whether they cave and unleash another ‘big bang’ stimulus, as many analysts and commentators are now clamouring for. My base case is that the government institutes mild stimulus measures to support overall demand, without igniting another explosion of shadow banking excesses or wasteful fixed asset investment. But it’s roulette really, all you can do is monitor the situation in Beijing closely.
  • Due to a renewed upswing in Chinese demand, the loss of Indian supply tightened a market in which suppliers already held considerable pricing power. As everyone is surely aware, that is no longer the case now, with Morgan Stanley putting this year’s surplus at around 50m tonnes, growing to 150m next year. It has decisively shifted to a buyers’ market.
  • The displacement of high cost supply, which the majors adduce to justify their enormous supply expansions, will help stabilise prices in time. But so far this has occurred much more slowly than anticipated, and I expect this continue and high cost supply to exit only incrementally, rather than in a rapid manner that shrinks available supply and compels Chinese steel mills to suddenly scramble for stockpiles.

Thus, short of a ‘big bang’ stimulus from the Chinese government, the recovery in spot iron ore later this year is likely to be much more muted than in previous years. I still would not be surprised to see it rebound to around the high-$80s, but there is a good chance that the impetus for Chinese steel mills to restock as they typically did in the past just isn’t there now that the market is firmly in structural surplus.

Update

Spot fell to $77.50 today, 8th week of declines, down 12% for September. Again, I’d be surprised so see another monthly decline in October as it usually ushers in restocking activity; it’ll be interesting to see if tradition is upheld this year!

Straya T’day 26/9/2014

Memo to RBA from former self

Former RBA senior economist Jeremy Lawson has delivered a gentle rap across the knuckles of his previous employer for the state of housing, albeit with the insistence that it wasn’t mendacity but rather an underestimation of the ‘investor pulse’ in Australia that led the RBA to sit by while housing market inflated. I have covered the rise of the Australian property investor here, so it goes without saying that I mostly agree with his appraisal.

Much has been written this week about Stevens’ ‘backflip’ on macpru regulation, centred on his somewhat flippant description of these tools as an international ‘fad’, just last month. What he actually said was;

As for what one does about (the boom in property investment in Sydney and to a lesser degree Melbourne), apart from just warning—and the warning is probably ignored—I think the next step is to then press through the supervisory mechanism for the lenders to know who they are lending to, take care, keep giving the message about leverage and take a close look at standards of lending. APRA already has been communicating with banks about those types of issues, and I imagine we can probably step up that scrutiny and make it a little bit more targeted if it is appropriate to do so over time. The strongest step would be the dreaded macro prudential tools—they are the latest fad, internationally. And I have said that I do not rule out the use of those or asking if APRA will use them, if needed. That would remain on the table as a possibility as well.

His choice of words was unfortunate. He wasn’t wrong that macpru policies have gained popularity in the international policymaking community in the wake of the GFC, however this was a necessary response to the catastrophic failure of conventional thinking on central banking and macroeconomic management that resulted in the crisis. So macpru is no fad, at least I certainly hope it’s not. But despite his seemingly dismissive tone, Stevens clearly had not ruled out the dreaded macroprudential tools.

Returning to Lawson’s comments, the one criticism I think can be fairly levelled at the RBA over its lackadaisical approach to housing is the failure to learn from recent history both here and abroad. As I have detailed previously, the past two decades have deeply implanted the notion in many Australians that property speculation is a low-risk, high return investment strategy, and understandably so. There have been persistent warnings of the dangers of leveraged property bets, and none of these ‘doom-mongering’ exhortations have been vindicated (remembering, of course, why this has been the case). Therefore, as the RBA pushed the real cash rate into negative territory, it should have been acutely aware of the high probability that this would ignite another investor surge in the property sector. It would have been entirely appropriate to deploy some manner of macpru tools before the cash rate was dropped as low as it was. Whether these would have worked, we do not know. But as Stevens has belated accepted, there was little downside in trying.

Shining lights in the darkness

Michael Pascoe and Adam Carr have both come out swinging as a mood of foreboding supposedly descends upon the nation. Carr is sounding increasingly unhinged as he lambasts everyone from ‘property doomsters’ to our esteemed policymakers. What can you say? Anybody who declares property investment a no-brainer under any and all circumstances has obviously done their credibility a disservice (remembering the extreme historical anomaly that Australia’s experience with property have been over the past two decades).

Both commentators are chiefly concerned with the ‘Hanrahan chorus’ wailing about imminent collapse. The point being, either Australian property is heading for a US subprime-style meltdown, or it’s fine. Reality is a little more nuanced than this simple bifurcation implies. As the RBA’s Financial Stability Review showed, Australian banks are not engaging in the scale of risky lending that has characterised other property bubbles. So the risk of a complete systemic meltdown seems remote. But this doesn’t mean that having a property market in which median prices are over 8 times incomes and investors account for over half of mortgage issuance, as in Sydney today, is a good idea. You can still seek to optimise economic policy outside periods of imminent doom.

Moreover, there are considerations regarding property that go beyond the threat to financial stability. Australia is in the grip of the most serious downturn in national disposable income in at least three decades, perhaps much longer. The household debt-to-income ratio is stable but high (having risen slightly in the past couple of years). This situation can easily deteriorate as incomes fall, however, either through loss of purchasing power if the nominal exchange rate keeps falling, or rising unemployment if it does not. So it ought not to be too controversial to highlight that it’s undesirable to have a seriously stretched residential housing market at this point in our economic cycle

Macpru is therefore an eminently sensible option. If it totally fails, and if the housing market continues to march inexorably higher, then we may have to countenance higher rates. But the hurdle is very high for higher rates, since as I have mentioned a number of times, nothing else aside from the speculative end of the property market argues for them.

Bounce in steel, iron ore to end the week

Better news in the steel-ore complex today, with futures up in China; a welcome end to another dour week.

Ugliest of all this week was news that growth in crude Chinese steel consumption in has ground a halt this year, for the first time since 2000. The mantra in the iron ore industry is that the 2014 rout has been a supply-side phenomenon; demand is fine. However, the assumption driving higher iron ore output was that Chinese steel consumption had much further to rise. So flat steel consumption, and therefore relatively weak growth in seaborne iron ore demand, is what has made the iron ore supply ramp-up into a problem.

Unless spot stages an almighty rally today, this will mark the 7th straight week of declines. China’s National Day ‘Golden Week’ holidays begin on Wednesday, running to the following Tuesday. There’s a fair chance we see a bit of restocking activity once that’s out of the way, but unless the government the signals a meaningful shift in policy that will reinvigorate demand for steel, the Q4 rebound is likely to be underwhelming this year.

Friday Muzak 

Because econ can wear you down after a while…

Straya T’day 25/9/2014

Cheer up!

John Edwards, a member of RBA board, today delivered a pointed rebuttal to the doom-mongers talking down the economy. (We have nothing to fear but fear itself, my friends!)

The gist is:

The boom was not as big as is widely thought; it has on the whole been sensibly handled; and in any case it is not yet over.

Edwards has of course never heard of Strayanomics, but his arguments are recognizable in their opposition to most of what has been written on this site in its brief history.

The gist of Strayanomics:

The boom was very big, the biggest in Australia’s history; it has not been handled in anything like an ideal fashion; it will, of course, not end overnight, but it is unequivocally in the process of ending.

Readers are at liberty to explore my reasons for these positions on the blog. Or they could turn to the RBA itself, since, as Leith van Onselen of Macrobusiness noted in his takedown of ‘Mr Rainbow’ this morning, the RBA’s own research contradicts Edwards’ message.

No sense of occasion 

Displaying scant regard for the timing of Edwards’ feel-good riposte to the merchants of doom, the slide in steel and iron ore futures continued on its merry way today. Here’s the daily piece from Reuters. No sign of a turnaround yet.

And here’s what spot looks like.

IO-2014

As I never tire of repeating, Australia’s immediate economic fortunes are massively dependent on the decisions taken by a few men in Beijing. If the Chinese leadership presses ahead with reform efforts, more pain lies ahead. If they baulk at the task and revert back to fixed asset investment and loose credit, we’ll enjoy a reprieve. (But note that in due course the pain will eventually arrive; credit booms are inherently unstable, the longer they run, the more tottering they become.)

As such, any indication of wavering resolve is cause for excitement. There was one such indication yesterday when the Wall Street Journal reported that pressure was mounting to replace the reform-minded chief of the People’s Bank of China (China’s central bank). If true, it could usher in a more accommodative monetary policy stance, which should support China’s economy and its demand for raw materials. The PBoC has denied this, for what’s worth, but the situation should be watched closely.

Chinese stocks greeted the news with some enthusiasm, however sadly the same cannot be said of the steel and iron ore.

On steel, Bloomberg has a fascinating story today which provides a neat follow-on from a point I made earlier in the week. The September HSBC PMI showed considerable buoyancy in exports, which I suggested may partially reflect the accelarating offloading of unwanted steel products on to global markets by Chinese mills, which seems to be gathering speed as domestic prices collapse.

From Bloomies:

After the Chinese steel industry expanded by 50 percent since 2010 to keep up with surging demand, mills can produce 210 million metric tons more than the market needs and a quarter of capacity sits idle, according to data compiled by Bloomberg Intelligence. With economic growth slowing, producers are reluctant to close plants, forcing a record pace of sales overseas, where competitors accuse China of dumping.

China, which produces almost half the world’s steel, shipped 52.4 million tons in the first eight months of this year, up 36 percent from a year earlier and more than the 42.5 million exported over the same period in 2007, when sales were at an all-time high, government data show. By year-end, the 2014 total may reach 85 million tons, according to Hu Yanping, an analyst at custeel.com, a researcher in Beijing. That’s 44 percent more than the 2007 record of 59 million tons.

More of the surplus is heading to other countries. In the U.S., the sixth-largest buyer of Chinese steel, hot-rolled coil imports cost about $683 a ton on Sept. 19, the most since June 2012, according to data from Metal Bulletin. That compares with $487.50 for Chinese hot rolled coil exported on a free-on-board basis, the lowest since November 2009, the data show. The premium of about $196 is the biggest since December 2008.

As the premium collapses, the calls for protection from Chinese imports will grow louder, and rightly so. What is left of the US steel industry has no obligation to bail out beleaguered Chinese mills who’ve wrecked their margins after years of capacity over-investment.

As the article notes:

The country won’t be able to increase exports next year “without encountering resistance,” said Shi Shengwu, a manager at the international trade unit of Wuhan Iron & Steel Co., a producer based in Wuhan. “It’s a very touchy issue.”

Indeed. China is set to produce a bit above 800 million tonnes of steel this year. Australia’s iron ore expansions have been undertaken on the assumption that this rises to a billion tonnes by 2020. As it stands, this looks very unlikely to transpire without absolutely eviscerating the world price (forcing some production to idle and therefore preventing the increase in output).

Deficit yawns

The Final Budget Outcome for 2013-2014 is out and showed a substantial deterioration from 2012-2013, roughly in line with the government’s expectations in May. Unfortunately, although the iron ore price slid throughout the last half of FY2014, it is looking like being much lower this coming financial year (see above spot price chart), setting Hockey up for an even worse 2014-2015 budget. Those who thought the Treasurer was low-balling forecasts to engineer a unexpected improvement will be disappointed (for instance).

Still, they’ll always have John Edwards to turn to if things get really glum.

RBA gets onboard the macpru train

The RBA released its biannual Financial Stability Review yesterday, offering the usual trove of insight to anyone interested in such troves.

One big takeaway is that the central bank is now unambiguously acknowledging the dangers emanating from the housing market (which I’ve covered in the series on interest rates):

The low interest rate environment and, more recently, strong price competition among lenders have translated into a strong pick-up in growth in lending for investor housing – noticeably more so than for owner-occupier housing or businesses. Recent housing price growth seems to have encouraged further investor activity. As a result, the composition of housing and mortgage markets is becoming unbalanced, with new lending to investors being out of proportion to rental housing’s share of the housing stock.

If we jump to the Australian Financial System section, the RBA had the following to say:

Australian banks are benefiting from improved wholesale funding conditions globally and, in turn, an easing in overall deposit market competition. Lower funding costs are facilitating strong price competition in housing and commercial property lending. Fast growth in property prices and investor activity has increased property-related risks to the macroeconomy. It is important for macroeconomic and financial stability that banks set their risk appetite and lending standards at least in line with current best practice, and take into account system-wide risks in property markets in their lending decisions. Over the past year APRA has increased the intensity of its supervision around housing market risks facing banks, and is currently consulting on new guidance for sound risk management practices in housing lending.

And again in the section on Household and Business Finances:

The pick-up in household risk appetite that was evident six months ago appears to have continued, as has the associated willingness to take on some types of debt. Housing prices have been rising strongly in the larger cities. To some extent, these outcomes are to be expected given the low interest rate environment and the search for yield behaviour of investors more generally, both here and overseas. However, the composition of housing and mortgage markets is becoming unbalanced.

Nervous about housing and laying much of the blame at its own feet (low interest rates). As I’ve said a number times, the robust housing sector is the one area of the economy that argues for higher rates, whereas slumping commodity prices, the wind-down in mining investment and weak domestic demand generally all argue for lower.

A look through the Review’s charts helps elucidate the situation in housing.

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I have previously discussed the property investment frenzy which took hold in the early years of the millennium, and this is clearly visible in the above charts (note the investor share of housing loan approvals includes refinancing in that chart, my own chart did not). Indeed, by the standards of 2003-04, the current run-up in investor borrowings looks paltry. However, it must be remembered that we began from a much higher base in 2013. Moreover, the national figures mask the fact that the current boom has been centred on Melbourne and Sydney, with the latter easily accounting for the most fevered activity. This we can observe in both the pace of house price appreciation in Sydney (above) and the parabolic explosion in investor loan approvals (below).

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The RBA believes the primary threat this poses is to real macroeconomic conditions, rather than to the stability of the financial system (which would exacerbate the damage the macroeconomy, of course). For now, I think this is a fair assessment, since we haven’t seen the kind of deterioration in lending standards that usually characterises bubbles that go on to destabilise financial systems (though this is heavily dependent on how serious the terms of trade downturn gets). The adverse impact of falling prices on lenders occurs when loans repayments become impaired; house prices can fall without borrowers necessarily defaulting, provided they have sufficient net worth to weather the capital loss on property assets. Low net worth buyers are simply being priced out of the market, so the argument goes, and therefore we don’t need to worry about surging non-performing loans in the event of a property downturn.

Nevertheless, Australian households remain highly indebted, and the debt-to-income ratio is exposed to a shock to incomes arising from the falling terms of trade and resource-sector investment. So even if the banking system doesn’t suffer systemic instability, there is still scope for the housing market to hit consumer spending.

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To my mind, the issue is that housing risks inflicting a wealth shock on Australian households at the same time that they experience an income shock due to the unwinding of the twin booms in the terms of trade and resource-sector investment. Households exhibit measurable propensities spend out of their current income, which is hardly surprising, but spending patterns also react to changes in wealth. By allowing house prices to appreciate as they have, policymakers added another unwanted risk to the economy as it enters the post-boom adjustment.

What to do?

If the housing boom was primarily a response to low interest rates, and if little else in the economy argues for higher rates aside from booming housing, then the RBA is plainly in a bind. The economy would be suffering grievously today if the RBA hadn’t reduced the cash rate over the period it did (late 2011 to late 2013), but it now has a disconcerting housing boom on its hands as a result.

As it turns out, this is a widespread dilemma which many developed economies have had to contend with in recent years. Largely due to structural changes in the global economy, over the past decade and a half, many developed economies have faced low inflation and weakening labour markets (especially amongst low-skilled workers). The popular prescription to this problem was to lower interest rates. As it turned out, lower interest rates exhibited a tendency to drive credit growth and asset prices higher, to a much greater extent than goods and services inflation. This was a challenge to orthodox thinking on economic policy.

A suite of policy tools have therefore been gaining popularity since the GFC as a way of addressing this conundrum. Known as macroprudential regulations, these tools are aimed at curtailing the speculative excesses that tend to appear when interest rates are low, thus avoiding the need to hike interest rates in environments that would otherwise not warrant them. The Economist has a useful primer on macroprudential policies.

The RBNZ introduced macpru policies last year, chiefly restrictions on high loan-to-valuation residential mortgages, and this seems to be having the desired effect. After vocal calls for the RBA to adopt (through APRA) a similar approach in tandem with its cuts to interest rates, we are finally seeing some receptiveness on the Bank’s part. I have highlighted the relevant comment from the Review, which strongly suggests regulators are preparing to introduce these policies.

Then, early this afternoon, we received virtual confirmation that the RBA will push ahead with macpru controls to address the investor segment of the property market. This is a most welcome development and sensible policy. Stevens is correct that there is little downside to experimenting with these policy options, which was always one of the foremost points of recommendation.

The AUDUSD was hammered on Stevens’ remarks; the FX market knows as well as I do that the investor property boom is the chief factor holding up interest rates!

AUDTSvenes

Straya T’day 23/9/2014 (updated)

HSBC flash PMI firms

The HSBC flash PMI for September was released this morning and showed a slight bounce, coming in at 50.5 on expectations of a flat 50, from 50.2 last month. Full report.

Key themes:

  • Exports are leading the charge
  • Prices continue to ease as deflationary impulses arising from severe overcapacity exert themselves
  • Employment exhibiting a slightly worrying trend (bearing in mind the relatively narrow scope of this survey)

This survey is broadly in tune with the trends prevailing in the Chinese economy at present. These are; ongoing structural adjustment of growth patterns, a property sector shakeout, and abating price pressures in industries suffering overcapacity, especially those tied to the property sector (i.e. steel).

Without knowing precisely what is driving rising export orders in this survey, it is reasonable to surmise a significant contribution from steel exports (improving US demand for consumer goods is likely the other main factor). The most recent reading on the steel industry showed weakening domestic demand, partially offset by surging exports. Chinese steel products are becoming the solar panels of previous years, with sizeable excess supply being dumped into global markets after years of over-investment in new capacity. This process looks to be accelerating sharply now owing to weak domestic demand. We have already seen signs that foreign governments will not tolerate this indefinitely. With steel prices still sliding (the most-traded rebar contract was down again this morning, despite the PMI), the tidal wave of steel hitting global markets is unlikely to slow any time soon. It will be very interesting to see how long it takes for an international backlash to turn China’s excess supply back on to itself.

The situation in the steel market is a neat microcosm of the broader state of the Chinese economy. When the GFC hit, China switched its primary source of final demand from foreign consumption demand to domestic investment demand. Without external surpluses, China had to flood its economy with credit to facilitate extremely high investment levels. Now that China is approaching the limits of this growth model (willingly, for now, but note that the adjustment would have been forced upon it eventually had the government persevered with debt-funded investment spending), any help it can get from external consumption demand would lessen the slowdown it must endure as it rebalances its economy. In other words, trade surpluses will help China ‘grow out’ of its debt burden. The question is, Are other countries able and willing to run the corresponding deficits to enable China to pursue this policy? A USD bull market means the US could assume the role of international debtor nation, but whether it is foolish enough to adopt that model again, so soon after it proved so ruinous, is a question I would rather not speculate on.

Anyway, for now Aussie markets are enjoying some much-needed relief courtesy of the better-than-expected data, which isn’t especially surprising since both equities and the currency looked oversold on a short-term basis.

ASX200daily

AUD 23:9chart

Update 1

No relief for steel or iron ore futures today, despite the PMI lift. More at the usual place.

SPI futures and the AUDUSD are giving up their gains accordingly, though sagging European growth prospects are certainly weighing on equities markets generally this evening.

Yesterday I mentioned the horror show that is the WA budget, which has become reliant on frankly ridiculous forecasts for iron ore prices. Today we finally received an admission from the Treasurer that current prices are starting to fray nerves in the West. Gone are the days of WA’s GST largesse being redistributed to the laggard states of the Federation. This is not good news for my home state of South Australia, which is grappling with its own budget mess. As an aside, the current government may blame the industrial composition of the state for its economic travails, but it certainly cannot blame the Federal government for its public finance issues. The ALP has been in power in SA since 2002, it has had ample time to address the weaknesses of the economy. Instead it came to rely far too heavily on the promise of Olympic Dam, to the detriment of its own budget position.

Straya T’day 22/9/2014 (updated-2)

Steel and iron ore limit down!

Not much to add really, the title speaks for itself (limit down is -4% for rebar and Dalian iron ore). Singapore contracts are also trading under $80. This is getting very ugly for Australia now. I scarcely want to imagine where spot will finish up tonight, but unless there’s a big recovery in paper markets this afternoon, it’ll be below $80.

The Federal budget in May forecast iron ore at $100, a price many commentators thought was overly pessimistic (thus allowing the crafty Treasurer to claim a ‘surprise’ revenue beat). Well, triple figures looks like a dream from where we are today. And let us not forget the three ring circus that is the WA budget, which forecast iron ore at $122 across FY2015. There will have to be a substantial redistribution of GST revenues given the ruinous WA budget, which will further weigh on the Federal budget.

I said it at the time, the Coalition chose a fiendishly bad moment in Australia’s history to assume the reins in Canberra, considerably worst than Labor in 2007.

It’s a shame our house prices are so high relative to incomes, as they add yet another layer of risk to the unfolding Australia bust.

Update 1

Unfortunately there was no recovery in paper markets this afternoon.

Here’s the daily Reuters piece. It’s a bloodbath, basically.

Update 2

Spot down to $79.80, now off 40.5% this year in USD terms. More from FT.

spot IO

Only sliver of good news is that AUDUSD is still getting pumped, meaning spot is now down 40% in AUD-terms, after exceeding USD-denominated losses for most of the year. Thank the almighty Fed for the USD rally, Nev.

AUD22:9

Strayan Rates – Part 5: The End of the Beginning

One of the first points I highlighted at the beginning of this series on Australian interest rates was the overwhelming consensus among local prognosticators that the next move in the cash rate would be up. Since I did not share this view, I wanted to lay out the rationale for my unusually downcast outlook, and perhaps identify any weaknesses in my reading of the Australian economy that might have led me to this contrarian conclusion.

First of all, a quick refresher on where we’re at.

China is leagues ahead of any other country in terms of its contribution to Australia’s export earnings. Our gargantuan northern neighbour’s demand for iron ore and coal has driven our terms of trade to never-before-seen heights, and this has been the key to Australia’s (rich-) world-beating economic performance over the past decade. (See here for more on China’s role in Australia’s foreign trade.)

Real GDP per capita

When we decompose the contributions to Australia’s income growth, we can clearly see what has driven this outperformance. (Chart from the Australian Treasury.)

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Without the extraordinary terms of trade boom that accompanied China’s emergence in the global economy, Australia’s income growth would have been markedly lower in the new millennium. (Well, not necessarily; some would argue that the boom sowed complacency in the political class and stymied reform efforts. Nevertheless, given the changes being wrought on the global economy, it’s extremely unlikely that Australia could have grown its per capita income at anything like the rate it did thanks to the terms of trade boom.)

By allowing the windfall from higher export earnings to filter out into the economy in the form of higher incomes, Australia wilfully recast itself as one of the highest-cost economies on Earth. This is a particularly acute issue for the manufacturing sector in Australia, which is facing a grim future, but it is also evident in other important export sectors, such as higher education.

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Higher per capita incomes are of course the fundamental long-run goal of economic policymaking. They are the reward for producing high-value output. But it is important to recognise the nature of output. Terms of trade booms deliver rapid increases in the value of a country’s output, but are usually transient.

Australia achieved healthy growth in incomes during the 1990s largely as a result of gains in labour productivity which were themselves the result of reforms instituted during the 1980s and early 1990s. In the early years of the new millennium, Australia experienced a credit and housing boom, which provided the appearance of further improvements in living standards. This would have ground to halt after 2004, but for an incredibly fortuitous boom in the terms of trade. (A process I ran through in the last post.)

Since then, as the above chart from Treasury shows, Australia has been heavily reliant on the terms of trade windfall to drive rapid growth in incomes. While this has been a boon for the living standards of Australians, it also leaves them exposed to a downturn in the terms of trade; and unfortunately that is precisely what we are witnessing today. Iron ore was well and truly into its annus horribilis when I started this series, however shortly afterwards I pointed out that it appeared primed for a ‘Q3 capitulation’. This is just what we got, with iron ore falling another 8% since that post, and looking likely to break $80 this week.

So, with the terms of trade now a serious drag on national income, Australia will likely need to endure an extended period of flat or falling real incomes to regain its competitiveness and reinvigorate its non-mining trade-exposed sectors. In other words, it requires a lower real exchange rate.

Digression on real exchange rates

There are three components of the real exchange rate:

  • Australia’s productivity relative to the rest of the world
  • The nominal exchange rate, which is the price of the Australian dollar against other currencies
  • The price level in Australia relative to the rest of the world

If a country is lacking international competitiveness and needs to readjust it’s real exchange rate, arguably the least painful way of doing so is by raising productivity, such that the high cost structure of the economy can be justified by the value of goods and services being produced. There are a variety of policies which can facilitate higher productivity; in Australia they have often been lumped together under the term ‘microeconomic reform‘. Broadly speaking, these were the sorts of policies that drove Australia’s impressive productivity performance in the 1990s.

If a country is severely uncompetitive and heavily reliant on imports, then it may be unfeasible to raise productivity sufficiently in the short-term, and the exchange rate must depreciate. This is best achieved by a swift decline in the price of the local currency relative to international currencies, without a corresponding rise in the domestic price level. However, an interesting case has arisen lately in which a number of advanced economies no long possess the ability to devalue their currencies. These are the countries that have adopted the euro, and devaluation for them means something quite different.

Without a nominal exchange rate fluctuating against many of their major trading partners (other Eurozone countries), if countries using the euro find themselves in an uncompetitive position, they must turn to the final component of the real exchange rate; the domestic price level. This means that lower domestic prices are required to regain competitiveness, with the most important price being the price of labour (wages). Unfortunately wages are usually quite sticky, meaning they adjust downwards slowly and reluctantly, through high and protracted unemployment. The parlous state of the periphery economies of Europe in recent years reflects this slow, painful process of ‘internal devaluation’.

Back home: the dollar dilemma

The RBA has long grappled with the stubbornly high Aussie dollar (Australia’s nominal exchange rate). Indeed, one of the most familiar phrases to keen readers of RBA communiques is surely “the Australian dollar remains high by historical standards.” The reason much of the policymaking establishment in Australia has been eager to see the Aussie dollar fall alongside the terms of trade is so that we may avoid the fate of the European periphery, and readjust our cost structure without the painful experience of high and protracted unemployment.

The price of the Australian dollar against other major currencies (and minor ones of countries with whom we compete) is therefore an important determinant of the interest rate outlook. At the time I began writing this series, the AUDUSD was trading around .9300; at the close last week it sat at .8926. As I noted this week, the timing of the fall this past fortnight caught me a little by surprise. It came courtesy of a sharp rally in the USD, and although USD strength has been a central theme of my market view for around 18 months, exactly when it was going to break out I could not say.

The USD is now in the process of establishing a firm, if belated, uptrend. Only a sudden and unexpected deterioration in economic conditions in the US will derail it now, and this could have important ramifications for Australia. A sharp depreciation in the AUDUSD (sub .8000), would take a great deal of pressure off the RBA. It would support exports and jobs, and should revive investment in non-mining tradable sectors. It would also support state and federal budgets by raising company tax revenues. The real value of household income would be reduced by the higher cost of imports, and this would crimp consumption somewhat, however this is the entire purpose of a real exchange rate depreciation, and therefore unavoidable. Also, the loss of household purchasing power could well take the steam out of house prices, which would provide the RBA with more freedom to cut rates, since strong house prices have been a growing concern for policymakers. Overall though, a sharp depreciation in the Australian dollar would lessen the need for the RBA to cut interest rates.

Triumvirate in control of the cash rate

The overarching theme as I commenced this exercise was that the twin determinants of the next move in the cash rate were house prices (and by corollary, household spending habits) and the terms of trade. To be wrong in my view that the next cash rate move would be down, I argued the following scenario would need to transpire: the housing market leap out of the winter lull and record brisk spring price gains, and iron ore rebound smartly, albeit likely to lower levels than earlier this year (for this to happen I expected China would need to revert to loose monetary settings and another splurge in fixed asset investment).

This scenario seems to be growing less likely as the weeks wear on. As Stephen Koukoulas pointed out recently, the housing market is actually showing few signs of a continuation of the past couple of years’ gains. I certainly think it’s too early to say that the top is in, but with the market ever-more dependent on speculative demand for investment properties, and national income growth being eroded, the the bullish case for house prices is increasingly tenuous. The news has of course been considerably worse for the terms of trade; the iron ore bounce I heralded early last week turned out to be a rigid moggie. Now that we’ve printed a new low I won’t even venture a guess at where this ends in the short-term. A Q4 rebound will almost certainly happen, but that doesn’t mean much if it only rebounds to say, $90. If that’s all we get out of the Q4 restock, severe pain looms in 2015. As always, we watch China closely for signs of meaningful monetary and fixed asset investment stimulus. But the signs of stimulus on  the magnitude we’d need remain elusive.

Thus, on those two counts, the evidence is accumulating in favour of a rate cut. But given the developments in currency markets over the last fortnight, to these I think we can add a third determinant: the AUDUSD. Should the AUDUSD fall hard and fast enough, it may relieve the RBA of the need cut interest rates again. But it will need to be a big drop, and it will need to occur without corresponding increases in nominal wages (the take-home pay of workers) as the CPI jumps temporarily.*

So I am going to stick to my rate cut call, with an eye to late Q1 2015 or early Q2, on the assumption that iron ore receives some relief into the end of this year, house price growth is subdued and the Australian dollar does not rapidly devalue below .8000.


*This must be monitored closely as it could present an ugly situation for the RBA: It would negate the improvements in Australia’s competitiveness from a lower AUDUSD, since in real terms the exchange rate won’t have fallen by as much as in nominal terms, and so jobs growth and investment spending won’t recover as strongly. This would argue for lower rates. But if wages start to jump in response to high consumer prices, then the RBA would arguably be compelled to hike. Still, for now I believe this ‘stagflation’ scenario to be a remote possibility.