Tag Archives: iron ore

Australia’s boom in one chart

Since the turn of the millennium, as the composition of Chinese demand became increasingly dominated by state-directed investment spending, China has accounted for roughly 85% of the increase in world steel output. In nominal terms, this drove Australia’s iron ore export earnings up 15-fold between 2004 and 2014.

This boom has peaked, and indeed, as I pointed out a number of times last year, current levels of steel production in China are only being supported by strong growth in exports; domestic consumption actually declined 3.4% last year, to 738.3 million tonnes.

Although the growth in Chinese steel demand has crested (unless the government decides to reverse its policy stance and announces a big stimulus program), I also see little chance of it falling precipitously in the near future. But this lack of growth in output still presents a big challenge. We simply aren’t going to see the billion tonnes of annual Chinese steel demand by the end of the decade that was conventional wisdom until very recently. This means that iron ore producers are fighting over a shrinking pie and iron ore prices will continue to slide, I would say for another two years at least.

PBoC finally caves

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Reigning in a credit bubble before it bursts is a mightily taxing task. China’s authorities have been holding firm admirably in the face of China’s cooling economy, but the chilliest property market in a long while has at last provoked a response: tonight the People’s Bank of China cut benchmark interest rates for the first time since July 2012.

Bloomberg has details:

The one-year deposit rate was lowered by 0.25 percentage point to 2.75 percent, while the one-year lending rate was reduced by 0.4 percentage points to 5.6 percent, effective tomorrow, the People’s Bank of China said on its websitetoday.

The reduction puts China on the side of the European Central Bank and Bank of Japan in deploying fresh stimulus and contrasts with the Federal Reserve, which has stopped its quantitative easing program. Until today, the PBOC had focused on selective monetary easing and liquidity injections as China heads for its slowest full-year growth since 1990.

…

Aggregate financing in October was 662.7 billion yuan, the central bank said Nov. 14 in Beijing, down from 1.05 trillion yuan in September and lower than the 887.5 billion yuan median estimate in a Bloomberg survey of analysts. New local-currency loans were 548.3 billion yuan, and M2 money supply grew 12.6 percent from a year earlier.

As that article notes, credit growth in October was weak despite the widely-publicised shift to looser mortgage conditions in September. This change in policy stance provoked an avalanche of new property starts, which will in turn keep the pressure on prices.

This interest rate cut does look entirely appropriate in the context of China’s economy today, and to be honest there was little choice for the PBoC given the extraordinary depreciation in the yen and signs that the ECB could be joining the party before too long. (See this post for more on that.) The economy has continued to weaken in the past few months, and although it’s too early to judge the effects of recent changes to mortgage lending rules, it does seem that more needs to be done to arrest the decline in property prices, especially seeing as the market is now almost certainly structurally oversupplied (a point that was less clear in 2012, when property last turned down).

As I’ve emphasised many times on this blog, one of the trickiest things about forecasting Australia’s short-term outlook is the ever-present Chinese policy enigma. Many commentators are eager to point out that China’s slowdown this year, with its knock-on effects to Australia’s key export commodities, has been purposely engineered by its masterly policymakers. Thus, when things look like slowing down too much, all that needs to be done is a slight easing off on the brakes and a light tap to the accelerator, and all will be well.

The obvious problem with this appraisal is that China’s debt levels have exploded since 2008 under the deft touch of China’s policymakers:

China’s total debt reached 251 percent of gross domestic product as of June, up from 234 percent in 2013 and 160 percent in 2008, according to Standard Chartered Plc estimates.

Fortunately, they seem to have a firm grasp of their failings in this regard, and policy has been crafted this year with a clear objective of credit rationalisation: slow the overall rate of credit growth, hit shadow banking hard, and take the froth out of property prices. The great challenge of course is that China’s economy has grown hugely dependent on this model. As credit growth slows and questionable investment spending is restricted, the economy slows.

Along with the changes to mortgage rules in September, this interest rate cut sends a clear message that China’s authorities have become uncomfortable with the resulting hit to the economy from their credit tightening, and are prepared to tolerate looser conditions.

So, is this enough to fundamentally shift the outlook for the Middle Kingdom, and with it Australia’s?

I’m sceptical that this cut alone will be enough to reignite the credit binge necessary to produce a large upswing in activity, more likely it’s intended to help the economy glide towards slower growth rather than crash. And I wouldn’t be jumping to the conclusion that the government has abandoned its commitment to credit rationalisation. My view is that authorities are looking to place a floor under growth, rather than blow the roof off again.

I know I’ve said it a few times in the last couple of months, only to see the market cruelly mock my optimism, but I’ll try again anyway: I won’t be surprised if this move from the PBoC offer respite to our beleaguered iron ore miners by seeing off a new low in spot this year. By don’t expect a stomping rebound, since nothing has fundamentally changed in the market, and do expect a resumption of pain next year.

AUD has been heavily bid since the announcement, up about a cent against the USD, as have equities.

RIP Restock

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Throughout the Great Iron Ore Rout of 2014, we’ve comforted ourselves with the knowledge that, regardless of what came beforehand, at least the fourth quarter would deliver respite from the market’s flagellation, as Chinese steel mills hastily replenished their depleted stockpiles of iron ore.

I’ve been something of a sceptic when it came the promised restock. Back in mid-September, my thoughts were:

I have been loath to commit to the point too aggressively, lest a strong Q4 restock befool me, but there are very good reasons to suspect that this year the iron ore rebound will be much more muted than it has been in recent years. We should still see a rally from current low prices by the end of the year, but the risks are heavily skewed to the downside.

I laid out a more detailed reasoning for this scepticism later that month:

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.

Well, we’re through the halfway mark of Q4 and there is no restock in sight. Quite the opposite, in fact; iron ore has capitulated horribly.

And on the subject of capitulations, the sell-side is hurriedly accepting that iron ore is in serious trouble, and the downgrades are flowing freely. I noted with particular interest this comment from CommBank, included in today’s Reuters update:

“We no longer expect a meaningful iron ore restock later in the year as steel mills in China are content to purchase iron ore at their convenience, either from the port or from domestic producers, due to its wide availability,” Commonwealth Bank of Australia said in a note. “Tighter credit is also forcing many steel mills to adjust to lower inventory levels.”

This reflects the fundamental shift in the iron ore market that has transpired this year. It is obviously no secret that the sellers is now firmly locked in a chronically oversupplied market and fighting to the death. It was always likely that this change in the market would kill off the restock-destock cycle, or at least greatly reduce its impact on pricing. The reason being that steel mills don’t need to worry about losing access to supplies as they did when shortages reigned, so there’s little pressure to aggressively scoop up stocks when they have the opportunity in anticipation of tight supply down the track.

We’ll see buying before too long; these prices are surely looking enticing to some. But the shift in the market this year is structural, and we’ve got loads more supply coming next year. Any bounces into the year’s end are therefore immaterial, the sector’s fortunes are not going to be revived unless there is some radical shift in Chinese policy, and whether such a shift is even feasible anymore is debatable.

Strayan Rates – October Update

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The Australian cash rate is one of the focal points of this blog. In my first post on ‘Strayan rates, I wrote:

Picking the path for the RBA’s cash rate is a prime task for any would-be economic forecaster, as it’s both a key indicator of economic conditions as well as a critical determinant of them.

Whenever the RBA next adjusts the cash rate, it bears acknowledging that the 25bp move isn’t likely to be the critical determinant of economic conditions at that point in time. It will have an impact, but my focus has more to do with what the move will intimate about the state of the economy.

With this in mind, my first series on rates sought to sketch out a portrait of the Australian economy. My conclusion was that the evidence pointed to a greater probability that rates would fall with the next move, rather than rise.

Each month or so, beginning with this post, I’ll provide an overview, of varying detail, of the most important economic indicators for Australia, and update my view on interest rates accordingly.

Onya, Timmy!

Before I begin I want to mention the work of Tim Toohey, head of Macro Research for Australia and New Zealand at Goldman Sachs. I intentionally singled him out in that first post two months ago, as the loss of his rate cut call at the time left blanket agreement across institutional research teams in Australia that the next move in the cash rate would be up. (What better moment to dive in and swim against the tide, I thought!)

He abandoned this call with considerable reluctance, and last week he reiterated why that was the case:

A feature of our research over the past 18 months has been to break away from the guide posts that have served us well in obtaining a read on the future direction of economic activity over the past decade. Historically we had looked to easing financial conditions, rising confidence and rising wealth as important touchstones for a future acceleration in economic activity. These were indicators that had proved their worth over the prior 30 years. As such, our decision to adopt a far more cautious view than the consensus over the past two years was not born of the idea that these indicators were suddenly of less worth. They were born from the idea that there were other forces that were likely to be more powerful, namely the likely sharp decline of the terms of trade, the likely sharp decline in mining investment and a lack of economic incentives to drive a pickup in broader business investment, the likely persistent challenge of fiscal consolidation and an uncompetitive production base relative to Australia’s trading partners.

As will be clear to anyone who has read Strayanomics in any detail, this matches my own view of the economy with precision. (The most prominent voice advocating this view has long been David Llewellyn-Smith of Macrobusiness, to whom I owe much. Lately, Stephen Koukoulas has also joined the merry men, and is the only economist of 27 surveyed by Bloomberg who expects the next move to be a cut. For a longer-term perspective on why those of us calling rates lower are doing so at this time, see Ross Garnaut’s Dog Days, an immensely insightful book.)

Back to that first ‘Strayan rates post:

In a country like Australia, changes to interest rates tend to be quite effective in influencing economic conditions. Lower rates stoke borrowing, asset prices and consumption, giving way to higher rates, and vice versa. Why then are we drifting across a calm blue ocean of low interest rates?

Primarily due to the uneasy schism that has emerged in our economy. On the one hand we have the descent from what has almost certainly been the biggest terms of trade/investment boom in our nation’s history. On the other we have a raging house ~~bubble~~ boom. Which force prevails in this struggle will determine the short- to medium-term direction of interest rates.

As the rest of that series made clear, I have based my forecast for lower rates on the view that the terms of trade decline, the mining investment wind-down, lacklustre business investment ex-mining, the fiscal squeeze, and weak competitiveness would outweigh the impact of rising asset prices, speculative activity and consumption demand that have flowed from the last easing cycle. When Mr Toohey discarded his longstanding rate cut call in mid-August, he was conceding to the power of the latter.

Nevertheless, he has made a strong case for the ongoing possibility that rates could fall further, and his thesis is one that I think deserves attention.

Outline

The rough qualitative model I’ve been using essentially places the terms of trade and mining investment downturns, along with weak government finances and Australia’s poor competitiveness, into the structural basket. On the other hand, brisk gains in house prices, which have been driven increasingly by investor mortgage lending, and the boom in residential construction (especially apartments), I place in the cyclical basket, as they’re directly attributable to the last easing cycle. It’s a slightly clumsy oversimplification of terminology, but it serves its purpose.

Broadly speaking, structural forces argue for lower rates, whereas cyclical forces tentatively argue for higher. This, of course, is exactly the dynamic Tim Toohey and others have been emphasising.

Terms of Trade

Commodity prices have seen further deterioration in the last couple of months. Iron ore and coal contribute approximately 35% of Australia’s export revenues. LNG contributes much less at present but its share is set to jump enormously over the next few years.

As reported in the Australian, there was some hope of a rebound in coking coal recently.

Like iron ore and thermal coal, prices for coking coal — Australia’s second-biggest mineral export earner — have been hard hit this year, falling by 24 per to $US113.50 a tonne on a spot basis.

But the call has gone out that prices have bottomed and are set to bounce back to between $US130 and $US150 a tonne in the near term, and $US170 a tonne in the longer term.

Unfortunately, this optimism was short-lived, from Bloomberg:

The quarterly benchmark price for metallurgical coal dropped to a six-year low, according to Doyle Trading Consultants LLC, amid a slowdown in Chinese demand for the steelmaking ingredient.

Australian coal producers and Japanese steel mills agreed to a fourth-quarter price of $119 a metric ton, down a dollar from the third quarter, Grand Junction, Colorado-based Doyle Trading said in a report yesterday.

Chinese imports in August were 39 percent lower than a year earlier, according to customs data, amid a glut of domestic steel. Iron ore demand is also suffering, with prices at a five-year low.

May I say, the idea that coking coal is going back to $170 is fanciful for the foreseeable future. Not even the BREE expects this, despite its unimpeachable record of overestimating future commodity prices.

Likewise, thermal coal offers little cause for cheer, squeezed by continued (though reduced) oversupply globally and the shale boom in the US (which has seen gas displace coal as a power source).

From the BREE:

Coal prices are forecast to remain subdued throughout the remainder of 2014 in response to weaker import demand from China and a continued abundance of supply. At lower spot prices many producers are unprofitable, which is expected to support further cost-cutting measures and signals the risk of more mine closures or production curtailments over the remainder of the year.

While coal consumption is forecast to remain robust in 2015, particularly in the Asia-Pacific, the global supply overhang is expected to persist and contribute to continued softness in prices. Contract prices for JFY 2015 are forecast to decline by 6 per cent to settle at US$77 a tonne. From 2016, the market balance is expected to tighten as import demand continues to increase and lower prices during 2014–2015 reduce investment in new capacity and force less competitive operations to close. The contract price is projected to rise to US$86 a tonne (in 2014 dollar terms) by 2019.

Despite tougher times, coal isn’t going anywhere. Aggressive expansion plans are being tempered, but the industry will continue to make a significant contribution to Australia’s economic output and export earnings. Nevertheless, the days of coal serving up windfall profits and tax revenues are past.

As you can see from the chart below, Australia’s exports of LNG are set to skyrocket over the next couple of years, making Australia the world’s largest supplier.

This will improve Australia’s trade balance and therefore boost headline GDP, however we’re unlikely to see the kind of boom in corporate profits that characterised the iron ore and (to a lesser degree) coal booms over the past decade. I have written about LNG here. Since the impact on domestic demand will be minor once the surge in exports begins, and may even be negative as local gas price leap and construction workers are laid off, LNG offers little in the way of upward pressure on Australian interest rates.

With the glory days of coal long since past, the burden shifted to iron ore to keep the party alive. Sadly, as you can see from the RBA’s chart, iron ore has had a particularly rough ride in 2014. Here is my own year-to-date chart:

This year’s decline is directly attributable to soaring supply from major producers, especially Australia.

Rising volumes are offsetting some of the squeeze on profits margins, but not enough to prevent a big hit to the economy if prices remain at or near current levels.

Recently I noted that the worst may well have passed for the iron ore miners in 2014. Spot found legs for a solid bounce after that, however as you can see it didn’t manage to hold its gains. Still, buying returned at the end of last week around the $80 level, and it looks unlikely we’ll see falls much below this for the remainder of the year, owing to much improved profitability amongst Chinese steel mills, a thawing of credit conditions in China and some degree of seasonal inventory restock into the year’s end. However, without a fundamental shift in Chinese policy settings, the bounce will be short and soft relative to past years. And with no sign of a let up in the pace of supply expansions from the majors, further declines in iron ore next year are virtually baked in.

China

It should be no secret by now that China faces an immediate choice between slower, sustainable growth that is much more biased towards domestic consumption in place of investment, or faster growth that’s increasingly unstable and ultimately unsustainable. The government is more than aware of this trade-off, and has largely opted to curtail the excesses of previous years (without being too aggressive). Should the government’s resolve waver in the face of a more serious downturn, then risks would increase of a ‘big bang’ stimulus that could temporarily elevate demand for raw materials and most likely provide a sufficient boost to Australia to see rates rise, also temporarily, as cyclical influences take precedence.

China has witnessed a noticeable slowdown in the property sector this year, which has weighed on growth.

Along with the usual monthly data indictors, we received China’s national account data this week. As you can see, the growth rate of real estate investment continues to slide.

This is dragging down fixed asset investment generally, which is by far the most important form of spending for Australia’s economy.

I only have data going back a decade, so all I can say is that this is the slowest pace over the period I can see. But I would be very surprised if this were not the slowest since the Asian Financial Crisis or earlier.

The property-related slowdown has been sharp, and so far as I can discern, only a jump in net exports has cushioned the blow to GDP growth (cynical observers may be less charitable). For a large part the slowdown is the result of policy restrictions on mortgage lending this year, among other measures. However, unlike the previous cooling in 2012, the property market now appears to be structurally oversupplied (and even more overvalued). Looser credit conditions could certainly mitigate the severity of price declines, but it would require a complete abandonment of credit rationalisation to reignite the boom, which the government has long been reluctant to do.

Thus it was to much fanfare that the government eased restrictions on mortgages late last month. This is apparently already lifting activity in tier 1 cities. Credit growth remained subdued in September, and this is going to be the key indicator going forward determining whether the looser policy stance translates to a meaningful resumption of price gains and investment activity. I don’t think we’ll see this, but I wouldn’t be surprised to see the slowdown moderate, or mild gains in prices over the next 6 months. Nevertheless, I’m highly sceptical that this moderation, if it does manifest, will be enough to mop up excess steel supply, and even less so excess iron ore, implying more pain for the latter next year.

It appears that China’s rebalancing (which is a polite way of saying ‘slowing’) is continuing, albeit with the government easing its foot off the break a little. I still do not see a resumption in the kind of frenzied building that delivered Australia’s commodity bonanza and was extrapolated far out to justify surging investment in capacity (and still is). With another wall of iron ore supply careering towards markets next year, policy shifts from China have not yet been substantive enough to change my view on Australian interest rates.

Investment

Not much to report here since my post on engineering construction work a couple of weeks ago. The outlook remains soft as LNG mega-projects wind down.

A couple of charts from the RBA help paint the picture.

Mining investment is set to decline sharply over the next two years, and non-mining business investment will need to be revived to mitigate this. To do so, the AUD will almost certainly need to come down markedly. In the absence of this, business investment is going to be a big drag on the economy and will argue in favour of lower rates.

Public Finances

The federal government handed down a tough budget in May in a bid shore up public finances. Partly owing to this effort, the deficit is expected to decline over the next few years.

It is very hard to see this happening with iron ore where it is. The AUD is lower than was forecast, but this has not been enough to offset the larger-than-expected decline in the terms of trade. In addition, the government has had great difficulty getting its savings measures through the Senate. Do not be surprised if the mid-year economic and fiscal outlook (MYEFO) in December shows a marked deterioration compared with what the government had intended.

State balance sheets are also under pressure, and it’s only been the property booms in Sydney and Melbourne that have prevented much worse outcomes in NSW and Victoria this year. By their nature, the support from these booms will prove transitory.

The pressure on public balance sheets will in turn keep the pressure on governments (both state and federal) to search for further savings, which households will not like. The outlook for the Australia’s fiscal settings therefore offers scope for further monetary easing.

Housing

The housing sector remains robust, with no let up in prices over the past month.

And for a longer term perspective:

Naturally, this has been driven by surge in mortgage lending over the past 2-3 years.

Notably, however, owner occupier lending has clearly flattened out this year, while remaining at an elevated level (the share going to first home buyers has collapsed).

This has meant local investors and, to a degree we can’t fully ascertain, foreign ones, have become increasingly dominant in the Australian housing market, especially in Sydney and Melbourne.

With strong prices in the capitals, dwelling construction is booming, at least relative to recent history. (It is true that Australia has long underinvested in housing, though not the extent that it can fully explain recent price gains.)

One result of this building boom has been a shift in the relative economic performance of the states. Reversing the pattern of previous years, state final demand has been contracting in Queensland and WA, while being stronger in NSW and Victoria.

This excludes exports, so it’s misleading to say QLD and WA are in recession. However, foreign purchases of a state’s export commodities don’t necessarily provide much in the way of direct support for local jobs; it was monster profits and hurried investment that had a big impact on local economic conditions. And this is a reality that will be felt more acutely in the coming years as profits continue to fade and investment winds down.

In spite of healthy growth in demand in NSW and reasonable growth in Victoria, unemployment rates remain elevated, with Victoria faring the worse of the two.

Nationally, rents are now growing roughly in line with the CPI, while house prices are up around four times that. Rental yields have plunged as a result and will of course continue to do so if prices keep rising. It is often argued that high house prices in Australia can be explained by tight supply. Supply has not been as responsive as it could be, but if it really were a central reason for elevated house prices, then renters should be getting squeezed harder than they are. Since it’s prices that are soaring, but not rents, we can conclude that the demand side of the market is the primary driver of house prices.

So we have a hot housing market that is being propelled by investors seeking returns in the form of capital gains, since income produced from these assets is paltry. As more supply hits the market, growth in rents will remain subdued and may even fall. Low income generation can be justified when interest rates fall significantly, since this reduces the cash outflow from the investment. As prices rise, larger mortgages are required to speculate on houses, weakening the economic case for housing investment. Thus there is a limit to how far a housing boom will run on lower interest rates alone (though what that limit is precisely is a matter for the behaviourists). Indeed, recent consumer surveys have indicated that expectations for house price growth have well and truly rolled over.

In addition, we have the RBA signalling it will implement some form of macroprudential regulation by the end of the year, in a bid to cool investor activity in the housing market. Whether or not this has a significant impact in the absence of rate hikes remains to be seen. But I would expect it to hurt at the margin at the very least.

I can see the boom in house prices continuing for perhaps another 6-9 months before running out of puff. If macpru bites hard, then it may wind down earlier. Exactly when this latest investor frenzy for housing cools is immaterial, what matters for our purposes is that this boom is not translating into labour market tightness or inflationary pressures. On the contrary, the boom is barely holding the unemployment rate where it is. Hiking interest rates to deflate the housing boom would therefore necessitate lower rates in quick succession. For these reasons, I continue to judge that the RBA will not feel compelled to hike rates to quell strength in the housing market, which is likely approaching its denouement anyway.

Consumers

See here for a more detailed treatment of consumer spending.

A large part of the why the housing boom has not had the wider economic impact one might have expected is that households have been reluctant to respond to higher net worth in the usual manner of saving less and spending more.

After a jump into Christmas, retail sales growth has been tepid this year; not what you would expect given the ongoing improvement in household wealth.

I cannot be sure exactly why Australian households have altered their behaviour in this way. Watching financial meltdowns and long, deep recessions across much of the developed world has probably endowed us with a greater degree of cautiousness towards gains in paper wealth. The budget undoubtedly damaged sentiment, and the travails of commodity prices will be hurting as well, especially in WA.

Whatever the cause, consumers have chosen to remain stubbornly parsimonious in the face of rising wealth. Until they throw caution to the wind, there is little in the outlook for consumer spending to recommend higher interest rates.

Inflation

I’ve paid relatively little attention to inflation in Australia in my posts on interest rates, which may seem strange given the primacy of price stability in the RBA’s mandate. The reason I haven’t looked at inflation much is because I don’t consider there to be any serious risk of it posing a problem for the RBA.

There was some hand-wringing this year among more excitable observers as the CPI bumped up against the RBA’s ceiling rate of 3% (the RBA seeks to contain inflation at 2-3%). For the past year I have steadfastly maintained that this was a temporary occurrence resulting from the sharp decline in the Australian dollar last year (which raised the price of imports) and the introduction of the carbon tax. The effect of ‘tradables’ inflation on the CPI, from rising import prices, was especially pronounced.

Rising tradables inflation from one-off adjustments in the value of the AUD is not problematic, in fact it is wholly desirable at this time. As I have discussed previously, one of the central economic challenges for Australia is our elevated real exchange rate, which translates to weak international competitiveness and therefore low business investment in trade-exposed sectors outside resources. The least painful way to devalue your real exchange rate is to reduce the value of your nominal exchange rate (the value of your currency against other currencies) and not offset this with higher wages. Wage growth is very low today and the AUD is falling against other major currencies, so progress is being made. By its very definition, a lower nominal exchange rate implies higher import prices; this is what it means to improve Australia’s competitiveness. For this reason, tradables inflation is desirable so long as the depreciation of the currency does not spiral out of control (and there is very little prospect of that today).

Australian Dollar

This need to improve Australia’s competitiveness was why I highlighted the Australian dollar as an additional and important consideration in Part 5 of my initial series on rates. A significant drop in the AUD would alleviate many of the structural weights hanging around the neck of the economy. It would improve the profitability of exporters, and so cushion the blow to public finances from falling commodity prices. If large and persistent (and not offset by higher nominal wages), a fall in the AUD would in time revive weak business investment outside the resource sector. All this ought to support employment. While a lower currency is not a silver bullet for all Australia’s challenges (it would make our over-inflated house prices even harder to justify, for instance), in reducing the drag on the economy from various structural weaknesses, it would reduce the likelihood of rate cuts.

As you can see on the chart below, the AUDUSD had tumbled below support at .9200 and was trading around .8900 at the time of my last Strayan rates post. Since then, it has fallen further but stalled once it hit strong support at the previous low of .8660, set in January this year.

The bears have mounted a concerted effort to break this support on no less than three occasions since the end of September, and failed each time.

Plainly, this support is going to be harder to break than it appeared to me a couple of weeks ago. The picture is has grown a murkier due to the sharp decline in US interest rates last week. Lower interest rates reduce the attractiveness of holding a currency, and so tend to see its value decline. (charts courtesy of ForexLive).

Bonds have settled down after the craziness of last week, but all eyes are now on US inflation data later tonight. Should those data undershoot expectations, and I would say that is a distinct possibility, then US yields would likely come under further pressure, which would of course favour the AUD.

As I argued in my last rates post, I would be looking for the AUDUSD to head towards .8000 before concluding that the case for a rate cut had significantly weakened. Much depends on US data, and at the risk of impeccably bad timing with the US CPI just around the corner, I’ll say that .8660 looks safe for now.

Conclusion

Evidently, the cyclical factors I highlighted at the beginning of this post are under-delivering relative to their historical performance. The most energetic phase of the housing boom has been and gone, without inducing a sustained spending response from households. This has meant that the impact on labour markets has been insufficient to reverse the uptrend in the national unemployment rate. Inflation is benign. China continues to offer a window of possibility that maybe the government will ride to the rescue again, but circumstances have not changed in the Middle Kingdom enough to alter my view that the structural weaknesses bearing down on the Australian economy will lead the RBA to cut rates the next time it adjusts the cash rate.

For now I’m going with Q2 2015.

Data and charts sourced from the RBA’s monthly chart pack, the Bureau of Resources and Energy Economics’ (BREE) latest quarterly report, the Australian Bureau of Statistics, China’s National Bureau of Statistics, and IGMarkets.

Straya T’day 30/9/2014

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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:

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.

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.

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.

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.

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 25/9/2014

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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.

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.

Straya T’day 22/9/2014 (updated-2)

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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.

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.

Straya T’day 16/9/2014 (updated)

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Iron rockets

As discussed on the weekend, Chinese data seriously undershot expectations, taking industrial production growth to the slowest pace since the GFC. I mentioned that the market reaction would be interesting since such poor data would push the government further towards more aggressive stimulus measures (at least in the market’s eyes).

The other point I highlighted in the weekend post was the clear signs of stabilisation in the iron ore and steel markets last week.

With iron ore futures in contango, low steel mill inventories, and terrible data, we had the perfect conditions for a rebound in iron ore, and indeed we got it: spot soared 3.9% to $85.20.

So, the rebound is upon us, with iron ore and steel futures jumping again this morning in China. Mills have been running lean inventories, and many buyers have been sidelined over the past few weeks in anticipation of lower prices. We’ll likely see a healthy squeeze from here, but I will be most surprised if spot makes it into triple figures, given the chronic oversupply situation emerging in iron ore, the ongoing flush out of property excesses, and the inexorable down trend in fixed asset investment (FAI) growth generally.

To see iron ore stage a sustained recovery above $100 we would need to see a complete abandonment of the Chinese leadership’s commitment to structural reform, and a wholesale re-adoption of FAI stimulus. This remains a remote possibility. Just last week, Chinese Premier Li Keqiang had the following to say at the World Economic Forum:

Growth in emerging market economies has slowed down, and the Chinese economy faces greaterdownward pressure. Facing this challenging environment, we have continued to follow the general principle of making progress while maintaining stability. We have stayed thecourse and pursued a proactive approach. Instead of adopting strong economic stimulusor easing monetary policy, we have vigorously promoted reform and economic readjustment, and made efforts to improve people’s lives.

Despite growing downward pressure on the economy, more jobs were created, thanks to new steps of reform taken.

The message is unmistakable: As long as employment growth is holding up, China is not going to undertake large-scale stimulus of the sort that sends demand for steel and iron ore soaring. As China shifts to a more services-oriented economic model, with a higher share going to consumption, it is quite possible for it to sustain adequate urban jobs growth, without pumping up FAI, aided as always by gushing credit. (I’ve discussed this process in more detail in a previous post).

We saw a limited set of supportive macroeconomic policy measures from the second quarter, lasting until about a month ago. This in turn supported demand for raw material imports, but as soon as the policy support faded, iron ore and steel tanked, exacerbated by seasonal factors.

Without massive monetary support for property, iron ore is not going to go much above it’s last high of $98 on this bounce. And if it does, it will not last long. In that scenario, which is my base case, the iron ore miners will begin toppling in earnest from late Q1 2015 onwards.

Arrium’s recent equity raising was but a taste of the pain to come.

Update

The bounce in steel is looking decidedly lacklustre, with rebar pretty much falling across the curve today. This has taken the steam out of iron ore futures, with the January contract managing a mere .3% gain.

I have been loath to commit to the point too aggressively, lest a strong Q4 restock befool me, but there are very good reasons to suspect that this year the iron ore rebound will be much more muted than it has been in recent years. We should still see a rally from current low prices by the end of the year, but the risks are heavily skewed to the downside.

Straya T’day 10/9/2014

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Confidence Ebbs

The NAB Monthly Business Survey for August was released yesterday, and showed a moderation in sentiment from last month’s strong result.

As in the Roy Morgan survey, NAB’s continues to show the finance and insurance sector, as well as the real estate sector, tearing it up, countering ongoing weakness elsewhere. Notably, the survey found a “sharp decline in profits and sales” leading to the lower result, though both remain positive.

Overall the survey is consistent with a gentle if fairly uninspiring expansion in activity.

Sadly the news wasn’t so sanguine on the consumer confidence front. Consumer sentiment was poleaxed in the wake of the first Abbott/Hockey budget. There have been signs of a thawing lately, but this survey pours cool water on that promise.

Main takeaways:

Federal Budget concerns remain at the forefront. This is likely to be an issue going forward since the recent drop in iron ore, if sustained, will further weigh on budget revenues. The Mid-Year Economic and Fiscal Outlook at the end of the year could therefore see a further exacerbation of budget worries.
The five year economic outlook took a beating, indicating that households are cognisant of the problems unfolding due to the passing of the twin terms-of-trade and investment booms.
Consumers expect further gains in house prices, however there was a dive in the proportion of respondents agreeing that is good time to buy a house. The housing market is entering treacherous waters.

Not good news, and if it translates to more scrimping by consumers, will weigh on business sentiment.

Iron ore

More harrowing news on iron ore, I’m afraid, with spot dropping to $82.22. This was in spite of a big bounce in Dalian futures after an absolute hammering in early trade. The market is fishing for bottom, but unfortunately that’s going to be difficult to find while steel keeps bleeding; until there is a material improvement in Chinese steel prices, spot iron ore can happily continue the slide. And there is little to arrest the decline in steel demand as long as the property sector continues to reel.

Employment, Ahoy!

The big release tomorrow is employment. The market will be looking for a solid improvement, with expectations for a gain of 15k jobs over the month and confirmation that the last unemployment figure was largely a statistical aberration. The Aussie battler has copped a hiding this week, crashing out of its multi-month range.

The market is very long, and the .9200 level very important. Tomorrow’s employment data is therefore about as critical as you get. If it beats strongly, the market will gleefully gobble up the battler and we can probably put this down to a false break. If, on the other hand, it misses, the chance of a big move lower is high.