What are the key risks facing the Australian economy?

By Gareth Aird, senior economist at CBA:

Re-published with kind permission from Macrobusiness.

Key Points:

  • 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.


Our base case has inflation remaining soft due to elevated slack in the labour market which is suppressing wages growth. We have core inflation tracking at the bottom of the RBA’s target band (chart 3). This means that a rate rise still looks a long way off. We have commodity prices drifting a little lower which means that we expect the terms-of-trade to ease over the next few years, but to remain above its trough in early 2016. As a result, nominal GDP growth should step down.


We don’t explicitly forecast dwelling price growth. But the most likely outcome, in our view, is for dwelling price growth to slow and converge with household income growth (i.e. a low single digit annual growth rate). Such an outcome would also represent a best case outcome from a financial stability perspective.

We expect housing credit growth to continue to slow driven by a further easing in lending growth to investors.

The capacity to respond to a negative shock with monetary and fiscal policy

Monetary policy: While strictly speaking not a risk to the economic outlook per se, in many ways the reduced capacity to respond to a negative shock, particularly via monetary policy, is the biggest risk to the economy outlook.

Over the past 30 year the interest rate lever has been used to smooth out business cycles. When output and employment growth have fallen and/or the outlook for inflation has been lowered, interest rates have come down.

Conversely, the policy rate has been raised when it’s been necessary to slow the pace of growth and inflation in the economy. That process has worked relatively well. But it may have a limited shelf life because it’s required a structural decline in interest rates to support the economy over the past 30 years (chart 4).


The amount of fire power the central bank has on the cash rate front is effectively the difference between the current policy rate and the lower bound. We aren’t at the lower bound yet. But with a current cash rate of 1.5% we are close. In our view, a policy rate of around 0.75% would probably be the lower bound in Australia, which is higher than the lower bound of many other advanced and bigger economies. In the Eurozone and Japan, for example, policy rates have gone negative. But these regions run current account surpluses which probably gives them greater scope to take rates down without causing a massive fall in their currencies (chart 5). In Australia, it may not be possible to cut the cash rate below 0.75% because the current account deficit has been sizeable in the past as a share of GDP and must be funded (note that the current account deficit would blow out if there was a negative commodity price shock). As a result, there may only be a few rate cut ‘bullets’ left if we are right. The RBA will hope that if/when the next shock arrives the cash rate is a fair bit higher than it is today to allow them scope to cut and provide stimulus to the economy. But while the cash rate sits at 1.5% the economy is more vulnerable than usual to a shock.

The limited capacity to stimulate the economy further via rate cuts means that the ability of household leverage to increase further is also hamstrung. As interest rates have come down over the past 30 years the stock of household debt relative to income has risen (chart 6). That is because households have been able to borrow more for a given level of income. As a result, Australia has
the second most indebted household sector in the world.


In previous downturns rate cuts both encouraged and made it possible for households to increase debt relative to income. That debt initially went into higher dwelling prices, but ultimately the new credit created found its way into consumption. But with very little capacity to take interest rates lower and with the household sector already very stretched, the consumer is not going to absorb the next economic shock by borrowing through it.

Fiscal policy: There is some scope to stimulate the economy via fiscal policy if/when a negative shock arrives. In fact, the Government’s balance sheet looks in a much better condition than most other advanced countries when assessed on a debt to GDP basis. But we should not get too carried away because Australia has a structural deficit which means debt to GDP will rise quite quickly if/when the next negative shock arrives. From here, any downturn in the economy would almost certainly see the Government’s triple A credit rating stripped. While there is some conjecture over the precise implications of losing the triple A, its loss would certainly carry some weight from a symbolic perspective given it’s been the proud boast of successive Treasurers.

A commodity price shock

From an external perspective, a commodity price shock carries the greatest risk to the Australian economy. Australia continues to be heavily reliant on commodities for its resource revenue (chart 7). And a huge chunk of our exports go to China (chart 8). As such, the biggest threat to commodity prices is a slowdown in China that would lead to lower investment growth (or possibly a fall in investment). Such a slowdown could occur it if the Chinese authorities accept a lower level of output growth for the sake of financial stability given the rapid build-up of corporate debt. It could also happen if a greater emphasis is placed on delivering growth through services rather than investment. And it could of course come via a China hard landing (a Trump-led lift in tariffs in the US, for example, could be the trigger). In any event, commodity prices get hit and that would have implications for the Australian economy.


A sizeable fall in commodity prices would pull Australia’s terms-of-trade substantially lower. Roughly speaking, a 40% fall in commodity prices would see Australia’s terms-of-trade fall by 30% (chart 9). This is an illustrative example, but it is also represents a plausible outcome if there was a material slowdown in investment growth in China. In such a scenario the AUD could fall to the low-mid US 50 cent mark (chart 10).


A terms-of-trade shock would weigh on income across the economy more broadly given the strong correlation between commodity prices and nominal GDP (chart 11). In addition, Government revenue would be hit because of the relationship between the terms-of-trade and the tax take. Finally, unemployment would rise. While a lower AUD would provide some support to the economy, the limited capacity of monetary policy to absorb a commodity price shock from here would see the unemployment rate rise faster than would otherwise have been the case.

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).


We consider a policy mistake to be a risk because the RBA has been overly bullish on wages and the consumer over the past five years (charts 14 & 15).


The apparent bias in their forecasts towards a lift in wages and consumer spending means there is a risk that they hike too early if/when wages growth starts to rise.

Here we note that the RBA puts the neutral cash rate at 3.5% which is 200bpts above current settings (this is higher than our estimate of 3.0%). This means that on their own numbers, the RBA would be tightening to 3.5% if it thought the economy was on a sustained path to full employment and inflation at the mid-point of their target band. That to us looks too aggressive and therefore
there is a risk that the central bank hikes too early or too quickly.

A change in immigration policy

Australia’s population growth rate is significantly higher than most other OECD countries. Australia’s population grew by a strong 1.6% (i.e. 373k) in 2016. Net overseas migration accounted for 56% of that increase (chart 16).


A strong population growth rate boosts the potential growth rate of the economy (not output per person, however) as well as puts upward pressure on dwelling prices through stronger demand for housing. It also, over time, alters the industry composition of the economy (chart 17).

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.

ASX 200 tests support at 5900

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.

Wage Index

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.

Wage Index

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).

ASX 200

* Target calculation: 5950 + ( 5950 – 5650 ) = 6250

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.

ASX 300 Banks

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.

ASX 300 Metals and Mining

GDP slow growth as stocks power on

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.

Nominal GDP

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.

Real GDP

The S&P 500 powers on, climbing to a new high of 2581, while rising Twiggs Money Flow signals buying pressure.

S&P 500

Retracement of the Nasdaq 100 successfully tested its new support level at 6000, confirming a fresh advance.

Nasdaq 100

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.

Fedex

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.

~ Jesse Livermore

Australian growth faces headwinds but the index has other ideas

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.

ASX 200

Miners are advancing, with the ASX 300 Metals & Mining Index breaking resistance at 3300.

ASX 300 Metals & Mining Index

The ASX 300 Banks Index is headed for a test of 8800. Upward breakout would complete a bullish outlook for the ASX 200.

ASX 300 Banks Index

Australia: Economy needs more support

Low corporate bond spreads (BBB-Treasury) indicate the absence of financial stress.

Corporate Bond Spread

Australian wage growth is also low, but declining.

Wage Index

And shrinking currency growth suggests the economy needs even more support than the large recent spend on public infrastructure.

Currency Growth

It’s a bull market

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%.

Hourly Wage Growth

Currency in circulation, growing at a healthy annual rate of 7.3%, shows the Fed stance remains supportive.

Currency in Circulation

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.

Employee Compensation & Corporate Profits Relative to Net Value Added

The rising Freight Services Index indicates that economic activity is strong.

Freight Services Index

While a low corporate bond spread — lowest investment-grade (Baa) minus the equivalent Treasury yield — indicates the absence of stress in financial markets.

Corporate Bond Spreads

What more can I say: It’s a bull market.

What does falling job growth indicate?

Job growth fell to 156,000 for August, from a high of 210,000 in June, according to the latest BLS stats.

Job growth

Unemployment ticked up from 4.3% to 4.4% for August.

Unemployment

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.

S&P 500 with Twiggs Volatility

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.

Philadelphia Fed Leading Index

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*.

S&P 500

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.

Nasdaq 100

Target 6000 + ( 6000 – 5750 ) = 6250

The bull market remains on track for further gains.

ASX 200 Narrow Line

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.

ASX 200

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.

Monthly Hours Worked - Seasonally Adjusted

Iron ore continues its extended bear market rally, suggesting that the next correction is likely to find support above the primary level at 53.

Iron Ore

ASX 300 Metals & Mining is also likely to find support above 2750. Respect of support at 3000 would signal a strong up-trend.

ASX 300 Metals & Mining

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.

ASX 300 Banks

Nasdaq and S&P500 meet resistance

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.

Unemployment below the long-term natural rate

Source: St Louis Fed, BLS

But hourly wage rates are growing at a modest pace, easing pressure on the Fed to raise interest rates.

Hourly Wage 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.

Hourly Wage Rates

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%.

Real GDP compared to Nonfarm Payroll * Average Weekly Hours

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.

Nasdaq 100

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.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500

Bob Doll: Lack of  infrastructure stimulus might benefit stocks

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.

Unemployment v. LT Natural Rate

Source: Weekly Investment Commentary from Bob Doll | Nuveen

Australia: Job gains

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%.

Monthly Hours Worked

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.

Monthly Hours Worked

US Retail & Light Vehicle Sales slow

Retail sales growth (excluding motor vehicles and parts) slowed to 2.4% over the 12 months to June 2017.

Retail Sales ex Motor Vehicles & Parts

Source: St Louis Fed & US Bureau of the Census

Seasonally adjusted light vehicle sales are also slowing.

Light Vehicle Sales

Source: St Louis Fed & BEA

Seasonally adjusted private housing starts and new building permits are starting to lose momentum.

Housing Starts & Permits

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.

Manufacturing Durable Goods Orders ex Defense & Aircraft

Source: St Louis Fed & US Bureau of the Census

Cement and concrete production continues to trend upwards.

Cement & Concrete Production

Source: US Fed

And estimated weekly hours worked (total nonfarm payroll * average weekly hours) is growing steadily.

Estimated Weekly Hours Worked

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.

Fedex

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.

S&P 500

Target: 2400 + ( 2400 – 2300 ) = 2500

The stock market remains an exceptionally efficient mechanism for the transfer of wealth from the impatient to the patient.

~ Warren Buffett

Australia faces headwinds

Australian wage rate growth, on the other hand, is declining. is in a worse position, with a dramatic fall in investment following the mining boom.

Australia: Wage Price Index

Source: RBA & ABS

As is inflation.

Australia: Inflation

Source: RBA & ABS

Growth in Household Disposable Income and Consumption.

Australia: Household Income and Consumption

Source: RBA & ABS

And Banks return on shareholders equity.

Australia: Banks Return on Equity

Source: RBA & APRA

But not Housing.

Australia: Banks Return on Equity

Source: RBA, ABS, APM, CoreLogic & Residex

At least not yet.

Falling house prices would complete the feedback loop, shrinking household incomes, consumption and banks ROE.

US adds 222 thousand jobs

From the Wall Street Journal:

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…..

Job Gains

Source: St Louis Fed & BLS

Forecast GDP for the current quarter — total payrolls * hours worked — is rising, showing an improving economy.

Real GDP Forecast

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.

US Corporate Profits and Employee Compensation as percentage of Value Added

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.

Hourly Wage Rate Growth

Source: St Louis Fed & BLS

Which should mean further growth ahead.

Investment the key to growth

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.

S&P 500

source: Westpac

There are three factors that may influence this:

  1. 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.
  2. Low growth in personal consumption, especially of non-durable goods and of services, would discourage further capital investment.

US Net Debt & Equity Issuance

  1. 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.

US Net Debt & Equity Issuance

source: Westpac

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.

US Net Capital Formation

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

Australia is in a worse position, with a dramatic fall in investment following the mining boom.

Australia: Business Investment

source: RBA

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.

Australia: Components of Business Investment

source: RBA

You’ve got to prime the pump…. You’ve got to put something in before you can get anything out.

~ Zig Ziglar

Westpac Leading Index counters jobs surge

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….

Read more at Westpac.

Australia: Jobs surge

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.

Australia Jobs and Unemployment

Seasonally adjusted hours worked also jumped, reflecting an annual increase of 2.3%.

Australia Hours Worked and Real GDP

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.

~ Aristotle

Steady growth in US hours worked

Growth of total hours worked, calculated as Total Nonfarm Payroll multiplied by Average Hours worked, improved to 1.575% for the 12 months to May 2017.

Total Hours Worked

And the April 2017 Leading Index, produced the Philadelphia Fed, is tracking at a healthy 1.64%. Decline below 1.0% is often an early warning of a slow-down; below 0.5% is more urgent.

Hourly Wage Rate Growth and Core CPI

Dow Jones Industrial Average continues to advance. Rising troughs on Twiggs Money Flow signal long-term buying pressure.

Dow Jones Industrial Average

Dow Jones Transportation Average is slower, headed for a test of resistance at 9500. But recent breakout of Fedex above $200 is an encouraging sign and the index is likely to follow.

Dow Jones Transportation Average

We are in stage III of a bull market, but this can last for several years.