Is the Australian economy improving? Have we been too busy ‘talking it down’ to notice the turnaround taking place? Last week a few economic releases came out that, on the surface at least, pointed to Australia’s economy being a lot stronger than many people initially thought.
So in today’s Daily Reckoning, we’re going to tackle these questions.
Firstly, the data. Building approvals surged 6.8% in January (all data quoted here is seasonally adjusted). GDP grew faster than expected in the three months to December at 0.8%, or 3.2% annualised. Retail sales for January were strong, rising 1.2% for the month (and up 6.4% over the year) while our trade surplus for January came in at a whopping $1.4 billion — well ahead of expectations. Oh, and a measure of services sector activity also surged during January.
This torrent of good news has completely overshadowed the steady stream of weaker data and news on job losses you’ve seen in the preceding months. And make no mistake; there is some good news in there.
But you have to put some of these data points in context to come up with a clearer picture of what’s really going on.
From our analytical perspective, most of the strength you’re seeing in the data is the result of the RBA’s interest rate cuts over 2012 and 2013. This inflationary impulse is strong, but it’s not sustainable.
Interest rates always work with a lag effect. Lower rates initially boost asset markets and you’ve seen the equity and Australian property market do well over the past 12-18 months. Then you get the second round effects, like an increase in retail sales and services sector activity. We think that’s what you’re seeing now. But we’re not convinced there’s a lot of juice left in the tank.
Take the building approvals data, for example. The chart below shows approvals approaching cyclical highs. And it’s been driven by high density (apartment) approvals, not housing, which adds less overall value to the construction process.
Interest rates have worked their magic here but with the last of the RBA’s significant rate cuts coming in August 2013, and before that in May 2013, the benefits of lower rates have mostly flowed through the system.
RBA boss Glenn Stevens spoke to the House of Reps in Canberra on Friday and reckons dwelling investment will continue to pick up. Maybe he’s right. Approvals certainly have some momentum and there’s probably a few months of gains left to flow through. But our guess is that by the second half of the year, you’ll see a slowdown as the inflationary pig moves through the python.
And then the hungry thing will want more…
But this latest batch of data has many calling for higher interest rates. A good guide to market expectations is the three month bank bill swap rate, and it’s currently sitting around 2.65%. Given the official cash rate is 2.5%, the market is leaning towards the next move being up, but it’s not certain when, so there’s a bit of fence sitting.
We reckon the RBA is quite happy to do nothing here and await further data. The Australian dollar is back above 90 cents and Stevens doesn’t appear too concerned about the recent strength. He doesn’t like it, but isn’t talking it down too much. He’s probably happy for it to have a breather around here for a few months as the inflationary impact of a sharply weaker dollar in the second half of 2013 took the RBA by surprise.
Another reason to sit — we’re going to see an unprecedented drop off in business investment in 2015 which will detract from growth. Higher exports will make up for that but the effect on GDP will be misleading. GDP is a measure of the economy’s production. So if BHP and RIO produce more iron ore, Aussie GDP gets a boost. That’s despite a portion of the earnings and dividends from the increased production flowing to foreign investors via foreign ownership of these (and other) companies.
Meanwhile, the drop in business investment will hurt jobs much more than the pick-up in production will benefit them. And there’s always the risk of iron ore not quite being as beneficial for Australia as it has been in the past. That’s because of China’s rebalancing and massive overcapacity in the steel industry. Check this out from Reuters:
‘BEIJING, Mar 6 (Reuters) – Chinese steel output, which hit 779 million tonnes last year, is now close to its peak, with the market weakening and the government now determined to tackle a capacity glut responsible for mounting debts and heavy pollution, executives said.
‘Big miners like Rio Tinto , BHP Billiton and Vale have banked on continued growth in steel demand from China, which buys around two-thirds of the world’s seaborne iron ore to feed a steel sector responsible for nearly half of the world’s total output.
‘But the steel industry has borne the brunt of an economic slowdown as well as a concerted effort to tackle smog, and Zhang Wuzong, delegate at the National People’s Congress (NPC) and chairman of private steelmaker Shandong Shiheng Special Steel said there was no room for further expansion.
‘”You can basically say that Chinese steel output has reached a peak,” he told Reuters.’
Peak steel production in China and rising iron ore production in Australia and around the world can only mean lower iron ore prices and a lower terms of trade…which in turns means lower national income for Australia. (Even though such effects won’t show up in the headline GDP figures, it will feel like we’re in a very weak growth environment).
So we’re still facing headwinds. Raising interest rates now would stall house price growth, slow down credit creation, dwelling construction and consumption. What low interest rates giveth, higher interest rates taketh away.
Weighting all this up we think the RBA will want to keep its foot to the floor for a little longer to try and ‘rebalance’ the economy away from mining investment and towards anything else it can get. And it’s only getting it right now with the help of zero real interest rates.
If you think our economy is a healthy one, think again. All this ‘growth’ is coming from the benefits of the lowest real interest rates in decades (apart from the GFC) as shown in the chart below. And we need these low rates because the household sector has that much debt that it needs constant injections of easy money to keep up the spending and the borrowing.
That’s why the chart shows a multi-decade secular downtrend in real rates. Our maladjusted economy can no longer handle a prolonged increased in real rates. We’ve got too much debt, and can’t service it at higher rates leading to a slowdown.
Don’t tell the economics profession that though. It’s all good…the recent data says so. Well, yes it does, we suppose. If you’re only looking to the next quarter, it is all good.
Looking beyond that, we say things aren’t quite so rosy. Give it a few months, and it’s likely the conversation about Australia’s economy will change again.