GDP growth has lifted in 2017 and the labour market has tightened.
Our base case has these trends continuing over the next two years, but there are a number of downside risks.
The ability of monetary policy to support the economy in the event of a negative shock is more limited than in the past thereby exacerbating the potential impact that any negative shock may bring.
On some important metrics it’s been a reasonably good for year the Australian economy. The labour market has tightened courtesy of very strong employment growth and real GDP growth has lifted. At the same time, nominal GDP growth has been buoyant due to firmer commodity prices when compared to a year earlier. Wages growth, however, remains soft and real wages are barely in positive territory.
The house view is that the improvement in the labour market continues over the next two years and the unemployment rate should continue to grind lower. But there are plenty of risks that would change the outlook if they were to materialise.
This note discusses some of the key global and domestic risks to the Australian economy. It begins with an outline of CBA’s base case for the economy over the next two years before delving into some of the potential risks. This is not an exhaustive list, but rather it covers a few areas that the author considers to be the most acute risks to our central scenario. They are: (i) the capacity to respond to a negative shock with monetary policy (and to a lessor extent fiscal policy), (ii) a solid fall in commodity prices; (iii) a sharp correction in dwelling prices; (iv) a policy “mistake”; and (v) a fall in net migration via a policy change.
CBA’s central scenario
CBA’s base case for the economy over the next two years is a benign one. It is broadly similar to the RBA’s forecast profile for the economy which is also not dissimilar to the consensus view.
On the key components, we see output growth continuing to lift to a pace of around 3%pa in 2018 (chart 1). We put potential growth at 2¾% (population plus productivity growth) which means our forecast profile has a gradual decline in the unemployment rate as spare capacity recedes (chart 2). In 2018, most of the key components of the economy are expected to contribute to growth, with dwelling investment the exception.
The capacity of wages growth to slow further from here is also limited in the event of a commodity price shock. That is because wages growth is already at record lows and wages growth is sticky downwards. A fall in wages growth was able to cushion the most recent terms-of-trade shock (late-2011 to early 2016) because growth in wages slowed in line with the weakness in commodity prices. This helped to support the labour market and keep the unemployment rate from rising as much as it otherwise might have. But this time, a fall in wages growth will not be able to absorb the shock to the same extent given wages growth is already so low.
A sharp correction in dwelling prices
The single biggest risk to the domestic outlook looks to be a sharp correction in dwelling prices. In our view, this carries a greater risk to the real economy than it does to financial stability given the banking system is well capitalised.
There is a commonly held belief in Australia that the main trigger for a fall in dwelling prices is a rise in unemployment. This seems logical because rising unemployment would generally be associated with a lift in mortgage delinquencies which would put downward pressure on prices. But the data suggests that employment is more likely to lag changes in dwelling prices rather than lead (chart 12). The obvious question to then ask is why? We attribute the answer, in part, to the wealth effect and the recent track record of monetary policy in smoothing out the business cycle.
In periods when employment growth is slowing, the RBA is generally easing policy. When this is occurring, as long as the RBA can fend off a recession, falling interest rates tend to push up dwelling prices via cheaper credit which in turn encourages spending and supports employment growth. Of course, it’s a different story if employment growth falls too fast and unemployment rises sharply. But so far, at the national level, this hasn’t happened since the recession of the early 90s.
The risk of a material correction in dwelling prices looks higher now than it has been for a long time given: (i) the incredible lift in dwelling prices over the past five years; (ii) mortgage rates are probably unlikely to go lower and indeed can’t go much lower; (iii) household debt to income is at a record high; and (iv) dwelling supply is in the process of lifting quite significantly in some jurisdictions.
A soft correction in dwelling prices would probably have no material negative impact on the labour market. But there is a risk that a hard correction in prices (a fall of 20% or more) would lead the economy into a downturn via the wealth effect (i.e. the notion that changes in demand are influenced by changes in the value of assets). Since income to one person comes via the spending of another, there is a risk that falling home prices leads households to put the brakes on spending which ultimately drags consumption and employment growth lower.
A policy “mistake”
We consider a policy mistake by the central bank to be a risk to the economy given how much debt the household sector is carrying. Specifically, if the RBA hikes too early it could derail the improvement in the labour market that has been underway over the past two years. The record level of debt being carried by the household sector means that interest payments as a share of income will rise quickly if/when rates move higher (chart 13).
The construction sector in Australia, for example, is proportionately bigger than the construction sector in most other advanced economies because strong growth in people means that more needs to be built – dwellings, roads, schools, hospitals, ports etc. Finally, at the margin, a strong population growth rate at a time when there is labour market slack is likely to be putting downward pressure on wages as workers from offshore add competition to domestic labour.
At present, both major sides of politics (i.e. the Liberal-National Coalition and the Labor party) support maintaining a high permanent migrant intake every year. But there is a risk that one of the major parties opts for a different policy stance. The example here is to be found in New Zealand where there has been a change in immigration policy following the recent election outcome that means migration should drop substantially over the next few years. As a result, a change in immigration policy cannot and should not be ruled out in Australia.
A material reduction in net migration to Australia would increase the risk of a fall in dwelling prices as well as weigh on total output growth (not GDP per capita) and negatively impact the construction sector. But it would also likely put upward pressure on wages growth by reducing the pool of workers in many occupations. In that context, it’s not so much a downside risk, but rather one that would see a shift in the economic outlook that would have both winners and losers. From a policy perspective it’s about assessing whether there is a net societal benefit. But that’s a question for another day.
Australia is headed for a period of political uncertainty, while tighter Chinese monetary policy and a crackdown on capital outflows will slow the local real estate boom. Employment is strong but low wage growth suggests under-employment.
Reliance on mining and real estate as the backbone of the economy is bound to disappoint. What the economy needs is a vibrant manufacturing and tech sector but this is shrinking rather than growing, with investment in machinery and equipment falling from 8% to almost 4% of GDP over the last decade.
Stocks are rising but we need to temper our enthusiasm with a hint of caution. The ASX 200 is testing medium-term support at 5900. The tall shadow on Friday’s candle indicates continued selling pressure. Breach of 5900 would warn of a strong correction to test primary support at 5650, while respect (indicated by recovery above 6000) would confirm an advance to 6250 (5950 + 300).
I remain wary of the banks because of their low capital base and high mortgage exposure. Reversal below the medium-term trendline warns of a correction to test the band of primary support between 8000 and 8100. Recovery above 8800 is less likely.
Miners are more bullish despite the low iron ore price. The ASX 300 Metals & Mining index is testing medium-term support at 3300. Respect is likely and would signal another advance.
GDP growth for the third quarter is out and I can see little to indicate that growth is improving despite tweets to the contrary from the White House.
Nominal GDP is growing at just over 4 percent per year, continuing the narrow band established since late 2010. Growth closely follows our monthly estimate: total weekly hours worked multiplied by the average wage rate.
Real GDP, beset by problems in accurately measuring inflation, grew by 2.3 percent over the last 4 quarters. But growth remains relatively soft and our latest monthly estimate (growth in total weekly hours worked) slowed to 1.2 percent in September.
The S&P 500 powers on, climbing to a new high of 2581, while rising Twiggs Money Flow signals buying pressure.
Retracement of the Nasdaq 100 successfully tested its new support level at 6000, confirming a fresh advance.
Bellwether transport stock Fedex is advancing strongly while a Twiggs Money Flow trough above zero suggests strong buying pressure. A bullish sign for broad economic activity.
Stage 3 of the bull market continues.
It was never my thinking that made big money for me. It was my sitting…Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn.
Bill Evans at Westpac sums up their outlook for the Australian economy:
….Constraints on growth next year are likely to centre on a lack lustre consumer who struggles under the weight of weak wages growth; high energy prices and excessive leverage. Conditions in housing markets, particularly in the eastern states, are likely to soften while the residential construction boom will turn down.
We are also less euphoric about growth prospects for our major trading partners than seems to be the current consensus. We expect China’s growth rate to slow from 6.7% to 6.2% as the authorities step up policies to slow its long running credit boom.
Yet the ASX 200 broke out of its line formed over the last 4 months, signaling a primary advance.
Miners are advancing, with the ASX 300 Metals & Mining Index breaking resistance at 3300.
The ASX 300 Banks Index is headed for a test of 8800. Upward breakout would complete a bullish outlook for the ASX 200.
US hourly wages continue to grow at a subdued 2.5% per year. The Fed will normally only move to tighten monetary policy when annual growth exceeds 3.0%.
Currency in circulation, growing at a healthy annual rate of 7.3%, shows the Fed stance remains supportive.
Turning to corporations (excluding the financial sector), employee compensation remains low relative to net value added (below 70%), while corporate profits are high at 12%. Economic contractions are normally preceded by rising employee compensation and falling profits as in 1999/2000.
The rising Freight Services Index indicates that economic activity is strong.
While a low corporate bond spread — lowest investment-grade (Baa) minus the equivalent Treasury yield — indicates the absence of stress in financial markets.
Job growth fell to 156,000 for August, from a high of 210,000 in June, according to the latest BLS stats.
Unemployment ticked up from 4.3% to 4.4% for August.
What does this mean? Very little, if we look at our real GDP forecast based on total nonfarm payroll multiplied by average weekly hours worked. GDP growth is slow but steady.
The recently published Philadelphia Fed Leading Index for July has slowed but remains comfortably above the early warning level of 1. The index normally falls below 0.5 in the months ahead of a recession.
The S&P 500 is testing resistance at 2480 after a weak correction that respected support at 2400. Bearish divergence on Twiggs Money Flow continues to warn of selling pressure but this seems secondary in nature. Breakout above 2480 is likely and would offer a target of 2540*.
Target 2480 + ( 2480 – 2420 ) = 2540
The Nasdaq 100 is testing resistance at its all-time high of 6000. Bearish divergence on Twiggs Money Flow again warns of secondary selling pressure. Breakout would offer a short-term target of 6250 and a long-term target of 7000.
Target 6000 + ( 6000 – 5750 ) = 6250
The bull market remains on track for further gains.
The ASX 200 continues to consolidate in a narrow line between 5650 and 5800. Declining Twiggs Money Flow warns of selling pressure and breach of support at 5650 would signal a primary down-trend. Follow-through below 5600 would confirm. Breakout above 5800 is unlikely but would test resistance at 6000.
Monthly hours worked are up 1.9% over the last 12 months. Marginally below real GDP but not something to be concerned about unless growth continues to fall.
Iron ore continues its extended bear market rally, suggesting that the next correction is likely to find support above the primary level at 53.
ASX 300 Metals & Mining is also likely to find support above 2750. Respect of support at 3000 would signal a strong up-trend.
The ASX 300 Banks index continues to warn of selling pressure, with declining Twiggs Trend Index and Money Flow below zero. Breach of support at 8500 would signal another test of primary support at 8000.
July labor stats are out and shows the jobless rate fell to a 16-year low at 4.3%. Unemployment below the long-term natural rate suggests the economy is close to capacity and inflationary pressures should be building.
Source: St Louis Fed, BLS
But hourly wage rates are growing at a modest pace, easing pressure on the Fed to raise interest rates.
Source: St Louis Fed, BLS
Fed monetary policy remains accommodative, with the monetary base (net of excess reserves) growing at a robust 7.5% a year.
Source: St Louis Fed, FRB
Our forward estimate of real GDP — Nonfarm Payroll * Average Weekly Hours — continues at a slow but steady annual pace of 1.79%.
Source: St Louis Fed, BLS & BEA
The Nasdaq 100 has run into resistance at 6000. No doubt readers noticed Amazon [AMZN] and Alphabet [GOOG] both retreated after reaching the $1000 mark. This is natural. Correction back to the rising trendline would take some of the heat out of the market and provide a solid base for further gains. Selling pressure, reflected by declining peaks on Twiggs Money Flow, appears secondary.
The S&P 500 is also running into resistance, below 2500. Bearish divergence on Twiggs Money Flow warns of moderate selling pressure but this again seems to be secondary — in line with a correction rather than a reversal.
Bob Doll at Nuveen makes a good point about Trump’s failure to get infrastructure spending through the House.
Washington, D.C. seems mired in gridlock, despite the fact that Republicans control the House, Senate and White House. No significant economic legislation has been passed, and the optimism from January about health care reform, infrastructure spending and tax cuts has all but vanished. Political attention will soon be focused on the 2018 midterm elections, and the window for pro-growth policy action is closing.
The lack of fiscal stimulus is disappointing, but it comes with a silver lining: We are unlikely to see the significant and sharp advance in interest rates or in the U.S. dollar that would probably result from such stimulus. The lost opportunity on the political front might therefore have the ironic effect of prolonging the bull market in stocks.
It seems crazy when you consider that both Clinton and Trump campaigned on a platform of major infrastructure programs to boost the economy. Just shows how dysfunctional Washington has become.
But I agree with the silver lining. Infrastructure spending would have boosted employment — the US is already below its long-term natural rate of unemployment — and upward pressure on wage rates. Which would have drawn a sharp increase in interest rates from the Fed, to combat inflation. Populist policies often ignore the hidden/unforeseen consequences and can produce the opposite result to that intended.
ABS June figures reflect solid gains for the labor market. Justin Smirk at Westpac writes:
“….The annual pace of employment growth has lifted from 0.9%yr in February to 2.0%yr in May and it held that pace in June. In the year to Feb there was a 106.9k gain in employment; in the year to June this has lifted to 240.2k. The Australian labour market went through a soft patch in 2016 that was particularly pronounced through August to November when the average gain in employment per month was a paltry 2.2k. We have clearly bounced out of this soft patch and now holding a firmer trend.”
My favorite measure, monthly hours worked, jumped (year-on-year) by 3.1%.
Infrastructure spending, particularly in NSW and Victoria, is doing its best to offset weakness in other areas.
Wage rate growth remains subdued, indicating little pressure on the RBA to lift rates.
Retail sales growth (excluding motor vehicles and parts) slowed to 2.4% over the 12 months to June 2017.
Source: St Louis Fed & US Bureau of the Census
Seasonally adjusted light vehicle sales are also slowing.
Source: St Louis Fed & BEA
Seasonally adjusted private housing starts and new building permits are starting to lose momentum.
Source: St Louis Fed & US Bureau of the Census
The good news is that Manufacturer’s Durable Goods Orders (seasonally adjusted and ex Defense & Aircraft) are recovering.
Source: St Louis Fed & US Bureau of the Census
Cement and concrete production continues to trend upwards.
Source: US Fed
And estimated weekly hours worked (total nonfarm payroll * average weekly hours) is growing steadily.
Source: St Louis Fed & BLS
All of which suggest that business confidence is growing and consumer confidence is likely to follow. Bellwether transport stock Fedex advanced to 220, signaling rising economic activity in the broader economy.
Target: 180 + ( 180 – 120 ) = 240
The S&P 500 broke resistance at 2450, making a new high. Narrow consolidations and shallow corrections all signal investor confidence typical of the latter stages of a bull market. The immediate target is 2500* but further gains are likely.
Target: 2400 + ( 2400 – 2300 ) = 2500
The stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.
U.S. employers picked up their pace of hiring in June. Nonfarm payrolls rose by a seasonally adjusted 222,000 from the prior month, the Labor Department said. The unemployment rate ticked up to 4.4% from 4.3% the prior month as more people joined the workforce…..
Source: St Louis Fed & BLS
Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.
Source: St Louis Fed, BLS & BEA
Declining corporate profits as a percentage of net value added (RHS) is typical of mid-cycle growth, while employee compensation (% of net value added) is rising at a modest pace. Peaks in employee compensation are normally accompanied by troughs in corporate profits…..and followed by a recession.
Source: St Louis Fed & BEA
Average wage rate growth, both for production/non-supervisory and all employees, remains below 2.5% per year. Absence of wage rate pressure suggests that the Fed will be in no hurry to hike interest rates to curb inflationary pressure.
Elliot Clarke at Westpac recently highlighted the importance of investment in sustaining economic growth:
The importance of sustained investment in an economy cannot be understated. Done well, investment in real capacity begets greater production volume and employment as well as a productivity dividend. Its absence in recent years is a key factor behind sustained soft wage inflation and the US economy’s inability to consistently grow at an above-trend pace despite the economy being at full-employment and household balance sheets having more than fully recovered post GFC.
The graph below highlights declining US investment in new equipment post GFC.
There are three factors that may influence this:
Accelerated tax depreciation allowances after the GFC encouraged companies to bring forward capital spending in order to stimulate the recovery. But the 2010 to 2012 surge is followed by a later trough when the intended capital expenditure was originally planned to have taken place.
Low growth in personal consumption, especially of non-durable goods and of services, would discourage further capital investment.
The level of stock buybacks increased as companies sought alternative measures to sustain earnings (per share) growth. The graph below shows debt issuance has soared while net equity issuance remains consistently negative.
Net capital formation (the increase in physical assets owned by nonfinancial corporations) declined between 2015 and 2017. While this is partly attributable to the falling oil price curtailing investment in the Energy sector, continuation of the decline would spell long-term trouble for the economy.
The cycle becomes self-reinforcing. Low growth in personal consumption leads to low levels of capital investment ….which in turn leads to low employment growth…..leading to further low growth in personal consumption.
Major infrastructure investment is needed to break the cycle. In effect you need to “prime the pump” in order to create a new virtuous cycle, with higher investment leading to higher growth.
It is obviously important that infrastructure investment target productive assets, that generate income, else taxpayers are left with increased debt and no income to service it. Or assets that can be sold to repay the debt. But the importance of infrastructure investment should be evident to both sides of politics and any attempt to obstruct or delay this would be putting political ahead of national interests.
Australia is in a worse position, with a dramatic fall in investment following the mining boom.
If we examine the components of business investment, it is not just Engineering that has fallen. Investment in Machinery & Equipment has been declining for the last decade. And now Building Investment is also starting to slow.
You’ve got to prime the pump…. You’ve got to put something in before you can get anything out.
In stark contrast to the buoyant recent ABS jobs numbers, the Westpac Leading Index slowed:
From Matthew Hassan at Westpac:
The six month annualised growth rate in the Westpac-Melbourne Institute Leading Index, which indicates the likely pace of economic activity relative to trend three to nine months into the future, eased from 1.01% in April to 0.62% in May.
…..The index is pointing to a clear slowing in momentum. While the growth rate remains comfortably above trend, the pace has eased markedly since the start of the year….
The May 2017 ABS Labour Force Survey surprised to the upside, with employment increasing by 42,000 over the previous month (full-time jobs even better at +52,100). These are seasonally adjusted figures and the trend estimates are more modest at 25200 jobs.
Seasonally adjusted hours worked also jumped, reflecting an annual increase of 2.3%.
The Australian Dollar surged as a result of the impressive numbers but Credit Suisse warns that there may be some issues with the latest strong NSW estimates:
By state, the gains in full-time employment were particularly strong in NSW…..
But beware the sample rotation bias ….the ABS has confessed that for the sixth time in seven months, it has rotated the sample in favour of higher employment-to-population cohorts. Officials report that this has had a material impact on the NSW employment outcomes.
If the numbers are correct, there are only two areas that could account for the job growth: apartment construction and infrastructure. The former is unlikely to last and the latter, while an important part of the recovery process, are also not a permanent increase.
I would prefer to wait for confirmation before adjusting my position based on a single set of numbers.
One swallow does not make a spring, nor does one day.