Australia is a relatively small open economy in a world currently wrought by financial market dislocations, a weakening global growth profile, a slowing Chinese economy, and increasing uncertainty about the future.
That could strengthen the many headwinds the economy faces and it also poses many questions about Australia’s own economic future in the year ahead.
In an attempt to get some clarity from the current fog, Alex Joiner and Alexandra Veroude, Australia economists at Bank of America Merrill Lynch, this morning released a research paper highlighting 10 key themes for Australia in 2016 which they say is a “year of transition”.
The paper pretty much answers every question I have been asked in the first three weeks of January about what the prospects are for the Australian economy. Although the vexed question of where the ASX 200 will end the year remains.
Here is a summary of Joiner and Veroudes’s excellent note.
Theme 1: GDP growth – the end of the bust
Joiner and Veroude said that “Australian growth has bottomed out, but challenges will persist, growth drivers offset by marked declines in resources investment.”
They are looking for Australian growth to print 2.7% in 2016. That’s up from the 2.3% growth rate they have penciled in for 2015 (we are still waiting for Q4 GDP to be released on March 2). But it is also still below trend, they say, as Australia continues to suffer “considerable drag from the decline in the resources investment cycle,” they said.
Because the key thematic for 2016 of strong net export contribution and “relatively soft domestic demand” is going to be similar to 2015, Joiner and Veroude say “the provision of services would need to continue to be the key driver of growth in the Australian economy and, perhaps more importantly, the key driver of employment growth”.
Theme 2: Are services enough?
Joiner and Veroude highlight that: “Services sectors are supporting activity, employment and exports, but do not invest enough to offset declines elsewhere.”
That’s despite the fact they say the “contribution of services to Australian economic growth over 2015 has been significant,” and contributed 1.8% to domestic economic growth in the year to September 2015.
They highlight that “services sectors that account for around 53% of the economy and 59% of employment account for only 36% of the fixed asset investment”. So it’s hard to offset the big falls elsewhere in the economy.
But, “what the sector lacks in capital investment it makes up for in labour demand, with services sectors being significantly more labour-intensive”. That’s why employment has been so strong relative to economic growth, which remains below trend.
Theme 3: Will unemployment keep falling?
Unemployment might have slipped back below 6% over the past two months but Joiner and Veroude don’t believe this is sustainable. “We expect that the unemployment rate will become entrenched at or just above 6% as risks to the labour market persist,” they say.
Their summary of the bad news suggests there is little chance services can absorb all the people who are expected to be laid off this year.
We know more jobs in the resources sector will be lost as the investment cycle winds down – we estimate this to be around 50,000-75,000 positions. We also know motor vehicle manufacturing will cease over coming years. The industry currently directly employs 45,000 people, already down from 81,500 in 2007. There is also likely to be a downward trend in residential construction employment and construction levels starting around midyear, this is potentially an even more serious problem.
With dwelling starts at record highs, direct residential building construction employment is around 100,000. However, services to fit out residential property accounts for 700,000 people. There has also been a material rise in professional services linked to this cycle, including architects and real estate services. The risk to employment will be determined by how quickly will the dwelling construction cycle declines.
And despite good employment growth there will be skill mis-matches in reabsorbing all of these potential job losses. This is as construction and blue collar workers are not easily absorbed into the sectors of employment that are growing – primarily services.
Theme 4: Dwelling price growth to slow
The housing price cycle looks like it has reached its peak for this run, Joiner and Veroude say and there is a chance that not only does price growth “decelerate markedly” but that there is a “risk that prices will decline outright”.
The good news is however that they say “any economic fallout should be limited.”
Factors conspiring to “take the heat out of the market” include the “high prices themselves” and the measures being taken by Australia’s banking regulator, APRA, to take “some of the heat out of the investor side of the market.”
Joiner and Veroude aggressively highlight that while teh RBA might have wanted a housing construction boom to soak up some of the lost construction boom the house price boom that came with it was unwelcome.
In a message for Government they say “Our view is that more emphasis should be placed on employment and income growth to drive household spending not profligate asset price growth.”
Theme 5: The coming residential bust
To reinforce their point on construction and housing, Joiner and Veroude say “the residential construction cycle has peaked at unprecedented levels, the question now becomes how quickly it declines.”
That is an issue because of the unprecedented level of building approvals and the significant part offshore developers played in the current building boom.
That means, “2016 will likely be the year of ‘peak housing’, and by the end of the year, the cycle will likely be receding and detracting from growth and employment,” Joiner and Veroude wrote.
The key point here though is not about the impact on growth. That’s because the authors say even though there has been an unprecedented boom in construction, its peak contribution to growth has been less than half the contribution of past cycle. That, they say, means the bust won’t hurt as much when it comes.
But it is going to really hurt employment, with “the impact in this space will depend on the speed at which the cycle recedes”.
Equally, Joiner and Veroude are worried about offshore events on foreign developers given that: “These developers accounted for about half of total value of building approvals in 2013-14 and this proportion in the past fiscal year is likely to have been significantly higher, especially in the medium density space.”
Theme 6: Consumers to keep punching
But even against their expectation that residential building will collapse, that house prices will fall and unemployment rise, Joiner and Veroude are relatively upbeat about consumers staying the course in 2016.
“Relatively” is the key word here because Joiner and Veroude say that, scarred by the spending binge in “the boom-time household conditions that had characterised the decade before, and immediate years after, the global financial crisis,” Australian households remain circumspect.
“While they are happy to borrow for housing and motor vehicles, they now shun borrowing for spending on retail goods. Personal credit growth, and within that credit card balance growth, has experienced flat annual growth for some years,” the authors say.
Lower oil prices, the impact that has on consumer sentiment, and still strong employment means that “household consumption growth to accelerate to 3.0%yoy by year’s end; still below average but improving”.
Theme 7: Inflation to accelerate modestly
We have little need to fear RBA rate rises on the back of rising inflation, Joiner and Veroude say, because while “inflation will accelerate via import prices & some key export prices, yet the output gap & soft wages will keep overall pressures modest”.
As a result of this mix, BAML has a 2.7% rate penciled in for this year, which is only slightly above the middle of the RBA’s 2-3% target band.
The bad news for consumers though is that Joiner and Veroude say food prices will continue to rise because demand for food is inelastic. That is, we’ve all still got to eat, so we tend to just pay higher prices which have been “impacted by the AUD and, increasingly, global demand”.
That’s also a warning for food retailers who “face cost pressures from higher import prices and global competition”.
Theme 8: A lower Australian dollar, commodities and China
65 cents is where Joiner and Veroude see the Australian dollar heading to against the US dollar in 2016. That’s good news, they say, because “the Australian dollar has been a key factor in facilitating the rotation of growth in the services economy, and export sectors more broadly”.
They add that it won’t just be weakness against the US dollar this year but that the Australian dollar will depreciate “across all our major trading partners, leaving the ATWI around 4½% lower by year’s end. Within this, the USDCNY is expected to be 8% lower and the AUDCNY 2½% lower.”
Joiner and Veroude also say “current volatility emanating from China is negative for Australian resources exports in the short term and also for commodity prices”.
That means the terms of trade will continue to fall which will “also put government revenues under continued pressure”. Joiner and Veroude also note that while the fall in the price of crude is a net win for Australia, the “forthcoming LNG export boom (primarily via take or pay contracts) is going to be less lucrative than initially thought”.
But Australia doesn’t just sell boatloads of iron ore to China. Our economies are getting closer and China is increasingly becoming the dominant service export destination:
AUDCNY is also significant as China is Australia’s largest services export partner with the nominal value in this space rising 18% in 2014-15 to $8.8bn. Tourist numbers from China are growing at 27%yoy, or 20,000 more per month than a year ago, and will overtake NZ as the number one single country source of arrivals. China is already the largest source of foreign students with 22% growth in enrolments and 30% growth in commencements from 2013 to 2015. This is occurring as Chinese household incomes rise and the lower AUD increases price competitiveness.
Theme 9: Government reforms to test sentiment
“Government reforms will test business & consumer sentiment alike,” Joiner and Veroude say, but “fiscal stringency continues despite the need for infrastructure spend”.
So they are calling for government to “reinvigorate the infrastructure agenda (especially outside of NSW) to support economic activity.”
While on reform, they highlight that, “the Federal government, under the still relatively new leadership of Malcolm Turnbull, will be outlining several key economic reforms. It intends to take these to the Federal election due between August 6th and January 14th 2017.”
How the Government sells its reform agenda including potentially GST and superannuation tax changes, and any labour market reforms being sought by business, “will be important in supporting confidence in the economy”.
Theme 10: No more cuts from the RBA
A casual reading of the previous 9 themes might suggest to a reader that the bias for the RBA is to cut rates again sometime this year. Not so, Joiner and Veroude wrote. Rather, they say that “despite downside risks we do not expect the performance of the domestic economy to force the RBA to cut rates again”.
The key for them is that the opening to 2016 is very different to 2015 when the RBA cut rates in February at its first board meeting:
The A$ is lower and so are borrowing rates: business conditions are significantly better; the unemployment rate is stable at worst; and the economic outlook is more robust. On this assessment there should be an absence of any further deterioration in the domestic economy. And therefore the RBA should have no need to ease monetary policy further, especially in the short term, the way it did in early 2015.
Further, Joiner and Veroude appear unconvinced by arguments that a lower cash rate will be a net benefit to the economy.
“We don’t think the RBA would be particularly comfortable easing policy further given the imbalances, particularly in the household sector and property market, which have already emerged. It is also debatable, outside of some downward pressure on the AUD, what stimulatory impact lower rates would have to materially change business and household behaviours for the better,” they said.
The good news is that any chance of a rate hike is not until late this year with the risk “that this will be pushed out into early 2017,” they say.