NAB: 7 reasons why Paul Krugman and the doomsayers are wrong about Australia

Peter Jolly, the NAB’s global head of research, has taken issue with the growing negativity about the Australian economy coming from offshore investors, but particularly New York Times columnists and Nobel Laureate, Paul Krugman.

In a note to clients yesterday, Jolly said that Krugman’s negative assessment of the outlook for the economy, when questioned by a Fairfax reporter this week, was off the mark.

First, here’s what Krugman said:

There’s going to be a hit to the Australian economy (from China), maybe even a recession. He added, “Probably it’s time for the Reserve Bank to be thinking about cutting interest rates, probably thinking about, but not yet doing anything on the fiscal side.

Jolly reckons the economy is doing better than this and has outlined 7 detailed reasons why Krugman, and the voices from offshore, are wrong about Australia’s economic outlook. He’s given permission for Business Insider to republish his excellent thesis.

1. The Chinese economy is slower but it’s not collapsing.

Australian commodity producers are battling big headwinds:

    1) the Chinese economy is slower;
    2) the Chinese economy is pivoting away from fixed asset investment towards consumption; and
    3) there has been a big ramp-up in the supply of all commodities globally.

The chart above shows that steel production has flat-lined and even fallen a little at the global level. The somewhat good news is that Australian iron ore exports remain at a high level and even picked up in August. In short, demand has slowed but not collapsed.

2. Commodity prices are lower but Australian producers have lowered their costs and are profitable.

Iron ore hit its low point in July near US$45 a tonne and has since recovered to $57.
Iron ore prices might remain under pressure in the next 6-12 months due to rising supply but the good news is that Australian companies are 1) low cost producers of iron ore and 2) have successfully lowered their costs even further recently - a combination of lower energy prices, lower royalty payment and production efficiencies.
Our mining expert and head of Credit Research Michael Bush has just updated his cost of production curve (above right), and now puts the cost of production for Rio and BHP near $25 a tonne, Hancock Prospects Roy Hill near $36 and Fortescue around $37.
Operational profits have been slashed but their mines are still profitable.

3. The $A has fallen a long way. It has also fallen more than commodity prices.

After a stuttering start, the $A has fallen sharply in recent times and is now doing a lot of work required to both support and balance growth in the economy. The left hand chart shows the $A TWI at 59.4 is now below the post float average of 61.5, meanwhile the right hand chart shows that despite steep declines in commodities, the RBA’s commodity index remains 22% above its post float average.
There is increasing evidence the lower $A is supporting the economy. An example is the tourism industry, where more of us are holidaying at home and more foreigners are coming to Australia.

4. Non-mining economy is improving. RBA normally hikes when business conditions are this strong.

The headwinds the mining sector face are well understood but what is less well understood is that the non-mining economy is responding positively to the combination of low interest rates and a lower exchange rate. My colleague Tapas Strickland has produced the left hand chart above, with the red line being a proxy for annual growth of the non-mining economy from the national accounts.
On this measure the non-mining economy grew at a 3.1% yoy pace to June 2015, above the 2% growth rate of the broader economy which was held back in Q2 by falling mining investment and weaker exports.
Looking ahead, the non-mining economy has tracked business conditions from the NAB survey quite well and the good news is that business conditions in August (out yesterday) improved from +6 to +11. The right hand chart shows that when business conditions are this robust the RBA is normally lifting their cash rate target, not lowering it.

5. The unemployment rate has stabilised and jobs are being created.

Labour markets outcomes have improved recently. After some lean years between 2011 and 2014, the pace of jobs growth has lifted in recent quarters to between 15-20k per month – left-hand panel.
Indicators like rising job ads and the NAB Survey suggest this better trend will continue for at least a few more months. Better jobs growth have combined with a slowdown in population growth to allow the unemployment rate to flat line over the past six months between 6.0%-6.3%. The right-hand chart shows recent labour market outcomes are better than the RBA thought would be the case at the time of their May MPS.
The ABS will release updated labour force data today, which we expect to be a mixed bag. After strong employment gains in recent months we expect more modest +6k jobs for August but we also expect a partial reversal of last month's unexpected jump in the unemployment rate – we expect the unemployment rate fell to 6.2% in August from 6.3% in July.

6. The RBA is concerned about house prices.

Mortgage interest rates in Australia are at their lowest point in the history recorded by the RBA since 1960 – left-hand chart above. As I discovered when I was doing a talk in Western Sydney last week, with discounts it is possible to get a variable mortgage rate near 4% or even a bit little under in some cases. These low mortgage rates alongside 1) a supply/demand imbalance and 2) a frenzy in some parts of Sydney continues to push house prices higher.

Since the RBA starting cutting interest rates in late 2011, the nationwide dwelling price has risen 24%. Sydney dwelling prices are up 57% over the same period. As the right-hand panel shows, relative to household income the median house price has now surged to a record level.

The RBA and APRA have sounded concerns on housing for some time now and are looking to reign in lending to the buoyant investor sector. In a speech yesterday, head of Financial Stability Luci Ellis restated the RBA’s caution around recent house price growth.

International evidence is that macro-prudential measures to control lending and housing markets aren’t particularly successful when interest rates are moving in the opposite direction. So while house prices are rising the RBA will be extra cautious about cutting interest rates further.

7. The RBA governor implies the hurdle to cut again is high. Need to consider near and long term factors.

The Governor reiterated in a speech during July that the possibility of further easing “remains on the table”. But in that speech he also implied there was a limit to what monetary policy can achieve and he also said policymakers need to consider the long term consequences of any policy action today and not just the immediate need to support growth.

Specifically, “it is not quite good enough simply to say that evidence of continuing softness should necessarily result in further cuts in rates, without considering the longer-term risks involved…. My judgement would be that policy settings that fostered a return to the sort of upward trend in household leverage we saw up to 2006 would have a high likelihood, some time down the track, of being judged to have gone too far. That is not the case at present, given the current rates of credit growth and so on. But the point is simply that in meeting the challenge of securing growth in the near term, the stability of future economic performance can't be dismissed as a consideration.”

Further:

“ I note that the Board's post-meeting statements routinely refer to seeking a stance of policy that will ‘most effectively foster sustainable growth and inflation consistent with the target’. The adjective ‘sustainable’ is used deliberately and financial sustainability is very definitely one of the things we have in mind.”

Going to the charts, the news is still generally OK on household finances. The savings rate on the right-hand chart remained high at 8.8% in Q2 2015. The left-hand panel shows that after a sharp rise from the early 1990’s household leverage as a share of disposable income has been fairly stable around 150% since 2006. But it’s noteworthy the ratio has risen in recent years and on this RBA data reached a new high of 156% in Q1 2015. Hardly alarming but it’s clearly above the 145% ratio it was when the RBA starting cutting rates in late 2011.

While the RBA was fairly comfortable about household leverage when cutting interest rates through 2012 and 2013, they are understandably a bit more cautious now. They certainly wouldn’t want any future rate cuts to merely push house prices up and encourage more household leverage.

Conclusion

The Australian economy is in OK shape. The overall economy is growing below trend but there is evident strength in the non-mining sectors, buoyed by the positives of generational low interest rates and very significant decline in the $A. The downturn in the mining sector remains a big headwind.

It’s highly likely the RBA will continue with a watching brief on interest rates for some time yet. As noted earlier, NAB economists forecast is for the RBA to be on hold for some time before moving to lift rates from late next year.

Yes, stuff happens and the RBA could well cut the cash rate again. But I expect a fair amount would need to go wrong - not just fail to get better - for the RBA to do so. Put another way, it’s less likely the RBA will be tinkering with 25bps cuts here or there and it may be best to consider their final 200bps as an emergency reserve – i.e. if the economy turns down again (the unemployment rate is headed to 7% or beyond) they will cut very hard.

For now there is no economic case for rate cuts. Indeed, with the hurdle to cut again quite high, the likelihood of a cut before year end still seems very low to me - less than 20%.

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