Commodities and Trump a game changer: HSBC's Paul Bloxham
GUEST OBSERVER
For the past five years, the Australian economic story has been about rebalancing growth away from being driven by mining investment at the end of the commodity prices ‘super-cycle’.
Between 2011 and early 2016 a 60 percent fall in commodity prices weighed on tax revenues, corporate profits, and wages growth.
Mining investment also fell from 9 percent of GDP in 2013 to around 4 percent of GDP currently.
The main factors offsetting the drag have been falling interest rates – which supported local disposable incomes and asset prices – and a lower AUD – which improved the competitiveness of the non-mining sectors, like tourism and education exports. A housing boom and rising services exports have supported growth.
Three key factors are now changing the story. First, the mining investment decline is almost done, with only a couple more quarters to run. Second, commodity prices have lifted, in some cases significantly. Third, the election of Donald Trump and the expectation of faster US growth and inflation means that more Fed rate hikes are now expected, which has strengthened the USD, conversely weakening the AUD.
The first two elements have been in train for some time and have helped to underpin our view that the RBA is unlikely to cut its cash rate below 1.50%. However, the stronger-than-expected lift in bulk commodity prices combined with the now faster- than-previously expected lift in US rates (HSBC’s view is now for a Fed Funds rate at 1.375% by mid-2018), mean that we now expect the RBA to lift its cash rate in 2018.
Although local inflation is currently below the RBA’s 2-3% target and wages growth is sluggish, we expect both to gradually lift from here. Supporting this, we see the rise in commodity prices as likely to support national incomes, tax revenues and corporate profits and to flow through to wages growth. Non-mining business investment is also already showing signs of rising and, on the labour market, it is worth keeping in mind that these indicators tend to lag the cycle, rather than lead it.
Previous concerns that any increase in the cash rate by the RBA might put upward pressure on the AUD are less of a concern if the Fed is hiking.
Commodity prices have risen; some quite significantly
Commodity prices appear to be past the trough, with the price of Australia’s commodity export basket having risen by 40% in USD (30% in AUD terms) since the beginning of the year (Chart 1). In particular, Chinese policy measures have supported the iron ore price and sharply lifted coal prices (Chart 2) (for more on this see Commodity Economics Comment: Watching the coal price spike,
27 September 2016). Although we do not expect coal and iron ore prices to stay at current high levels, we do see them holding well above previous lows. For example, the Q4 coking coal export contract price was US200 a tonne, up from US92 a tonne in Q3.
The election of Donald Trump has also supported the outlook for global infrastructure investment and lifted base metal prices. In our view, Trump’s election has also increased the risk that the Chinese authorities boost infrastructure investment in the face of downside risks to exports (see Commodity Economics Comment: Trump and hard Commodities, 16 November 2016).
From the RBA’s perspective, the lift in commodity prices should support growth in export values, which should lift income growth (see Downunder Digest: Australia’s strong export outlook, 29 September 2016). Importantly, there is also a strong positive correlation between commodity prices and local nominal GDP growth (Chart 3). For the RBA, more income should support corporate profits and tax revenues and, if history is a good guide, some of this will feed through to wages growth. There is a strong positive correlation between commodity prices and unit labour costs (Chart 4) (for more on this see Downunder Digest: Commodity prices and inflation, 12 October 2016).
The drag from falling mining investment is also set to wane in the coming quarters. Mining investment has already fallen from a peak of around $25bn a quarter to its current rate of AUD10bn (Chart 5). The RBA has recently noted that the fall in mining investment is around 80% done. We expect that mining investment will stop being a drag on GDP from mid-2017.
The expected levelling out in mining investment is expected to occur at around the same time that housing construction starts to become a drag on GDP growth (Chart 6). Importantly, the swing in mining investment is expected to be far larger than the drag from falling apartment building. In addition, although we expect that there may be a modest shake-out in the Brisbane and Melbourne apartment markets, we do not see a national housing price decline (for more on this see Downunder Digest: Australia’s many housing markets in 2017, 25 November 2016).
Non-mining business investment is rising modestly
Recent revisions by the statistics bureau to the annual national accounts numbers show that non-mining business investment has been on a modest upward trend for the past couple of years (Chart 7). The NAB business survey has also shown a more promising outlook for non- mining business investment recently (Chart 8). Looking into 2017 and 2018, we expect non- mining business investment to continue to lift, supported particularly by ongoing Asian demand for Australia’s services exports, including tourism and education.
The labour market still has spare capacity, but it also lags
The key challenge to our view is that spare capacity in the labour market has continued to weigh on wages growth, which, in turn, is weighing on domestic inflation. Although the unemployment rate has been edging lower over the past 18 months, the recent fall has been largely due to declining labour market participation. At the same time, the ‘underemployment’ rate has not been declining recently.
Spare capacity in the labour market has been one of the factors weighing on wages, with growth in the wage price index falling to a new record low in Q3 2016 of 1.9% y-o-y (Chart 10). Importantly, however, the slowdown in wages growth also reflects the response of the economy to the fall in commodity prices. As we showed in chart 4, unit labour costs are correlated with commodity prices. In addition, there are other measures, such as the national accounts measure of wages, which is already showing a modest lift in wages. At a more fundamental level, it is worth keeping in mind that the labour market, and particularly wages, tend to lag the cycle. In short, the recent commodity price rise is yet to have its effect on the labour market.
Inflation should lift as the ‘rebalancing act’ ends
Our central case is that underlying inflation is likely to lift next year and head back to the RBA’s 2-3% target band over time (Chart 11). As we see underlying inflation climbing only slowly, we doubt a cash rate rise will be needed in 2017 but now think that hikes in 2018 are likely.
Fed hikes mean AUD may be kept at bay
Another factor that has changed the story for Australia has been developments in the US. The election of Donald Trump has driven the expectation that US policymakers will deliver fiscal stimulus in 2017 and that this is likely to put upward pressure on inflation. This has shifted markets expectation for the Federal Reserve, with more hikes now priced in. Our Chief US Economist, Kevin Logan, has revised up his GDP forecasts for 2017 to 2.3% (from 2.1%) and for 2018 to 2.7% (from 2.2%) on the expectation of greater fiscal stimulus. Our Chief US Economist now expects the Federal Reserve to lift its policy rate to 1.25-1.50% by mid-2018 (see US Economic Outlook: Higher GDP forecasts; more Fed tightening, 21 November).
The expectations of faster US growth and inflation and more Fed rate hikes than previously thought, have seen the USD strengthen recently. For Australia this has meant that the AUD has held broadly steady despite the lift in commodity prices. A stronger USD is good news for Australia as it supports the competitiveness of the traded sectors, particularly services exports, such as tourism and education. As Chart 1 showed, because the lift in USD commodity prices has not been matched by a rising AUD, the AUD value of Australia’s commodity index has risen sharply in recent months, boosting local incomes.
RBA on hold for 2017 and may be hiking in 2018
As we expect the transition from mining investment to non-mining led growth still has a few more quarters to run and inflation is currently below the RBA’s 2-3% target band, any upward movement in the cash rate seems unlikely any time soon. By the same token, the RBA has made it clear that it has little appetite for further rate cuts.
Governor Phil Lowe noted in a recent speech that it is ‘unlikely to be in the public interest, given current projections for the economy, to encourage a noticeable rise in household indebtedness, even if doing so might encourage slightly faster consumption growth in the short term’. The recent revival in investor interest in the housing market, albeit modest, is likely to also dissuade the RBA from cutting its cash rate further in the short run, even if inflation is lower than the central bank would like (Chart 12).
For the RBA, 2018 is a long time away and there would be little (if any) discussion about likely policy settings that far out. The uncertainties are huge. Interestingly, though, given that the RBA now assumes the market path for the cash rate in its forecasts, the central bank will now also need to consider what hikes in 2018 would mean, given that the market is (just barely) pricing them in.
PAUL BLOXHAM IS CHIEF ECONOMIST (AUSTRALIA AND NEW ZEALAND) FOR HSBC.