In this week’s minutes the RBA highlighted again the significant degree of uncertainty clouding the economic outlook. And we do not expect much clarity will emerge until we are at least some way through the still significant decline in resources sector investment that we believe is to come. The RBA notes that the current outlook is clouded as there are “…number of forces working in different directions”. We agree, but find the forces weighing on growth are more compelling than those supporting it. Therefore ahead of June quarter GDP figures, released in the first week of September, we reaffirm our forecast for sub-trend economic growth to persist for the remainder of this year and throughout 2015. As a consequence of our growth forecast the unemployment rate will continue to rise and remain elevated. And this would leave the RBA on hold for what we believe will be an unprecedented period of time (we would note here that the adjustment from the largest investment cycle in Australia’s history is also unprecedented).
Current forecasts – the state of play…
Our current GDP growth forecasts for 2014 and 2015 are 2¾% and 2½% respectively. This puts us at the bottom of consensus forecasts for both years. And as a consequence we also have an unemployment rate forecast at the top of the consensus range.
We had entered the year with weaker GDP growth forecasts for 2014 but were, like others, taken by surprise by the strong contribution from net exports to growth in the March quarter national accounts. This has resulted in the market as a whole lifting its 2014 GDP growth forecasts. But we still look for growth to remain below trend from the remainder of the year. Indeed June quarter GDP figures will be a reality check. The key driver of GDP growth over recent quarters has been net exports, accounting for 2.7% of the 3.5% through the year growth rate. This will contributor will be sorely absent in the June quarter, indeed net exports are expected to detract around ¾pp from growth based on the monthly data. Retail sales will also detract slightly from growth also based on data to hand. So ahead of further partial data released over the next fortnight (which has the potential to alter our forecast) we currently anticipate quarterly growth of between 0-¼%qoq.
The lack of net exports this quarter raises an interest point around GDP forecast generally over the coming year or two. The market looks for around 2.8% GDP growth in 2015, just below trend, and the RBA’s central forecast is for a return to trend growth in 2015-16. But we continue to highlight the implications of these forecasts – that is very weak domestic demand growth.
This is because the Commonwealth Treasury’s forecast for net exports to contribute 1% and 1¼% to GDP growth in 2014-15 and 2015-16, market forecasts are similar and we assume so are the RBA’s. This suggests that if GDP forecasts come in as expected then domestic demand growth in the economy will be limited (or more exactly gross national expenditure, i.e. domestic demand and inventories).
Indeed on the RBA’s central forecast this implies growth of 1½% in 2014-15 and 2% in 2015-16 – compared with average annual growth of just over 4% over the last 30 years. This is well below what is required to push the unemployment rate lower or indeed even keep it stable. Our own growth forecasts are slightly weaker than this and is why we have the unemployment rate rising further than most others in the market at 6½%. This is higher than the Treasury’s forecasts and likely those of the RBA as well.
Resources boom itself is working in opposite directions
The over-arching theme of our growth forecast is one of transition. We are now very much in the third and final stage of the resources boom – exports – and this is the payoff for years of investment. This last stage is no doubt adding to growth and will be doing so for some time.
However, the first two stages are still in decline and will be for some time yet. The price increases that spurred the investment cycle in the first place are still receding, weighing on the terms of trade and nominal growth. The investment cycle has also peaked and is declining weighing on real growth. These first two stages of the cycle are weighing on the domestic economy and employment. The third is adding to real growth via the external sector. We do not believe enough rebalancing will take place in the domestic economy, to offset the dampening effects of the early stages of the mining investment cycle. This is despite accommodative monetary policy encouraging it. Therefore growth will be mired below trend this year and next.
Factors to the good are not great…
The lack of rebalancing in economic growth has clearly frustrated the RBA. And even though it continues to see signs that the ‘normal’ stimulatory effects of this policy stance emerging, few are overly compelling as yet. And none seem strong enough or certain enough in terms of timing to offset the downward pressures on growth that are inevitable.
The most certain positive factor to emerge as rate were lowered has been dwelling investment. This is as expected given its strong cyclical relationship with interest rates. However, even though we expect that this sector will add solidly to growth in coming quarters this may not last. Indeed in our view the peak in this cycle will likely come in late 2014 or at best early 2015. This is an assertion we made last week (see Residential construction cycle to fall short). And the implication is that dwelling investment should not be counted on to significantly offset the decline in resources sector that will gather momentum in 2015. Indeed it may even detract from quarterly growth in the second half of the year. And due to this employment growth in this key sector could also stagnate.
Clearly the slack in investment and employment needs to be taken up in other non-mining sectors of the economy – where growth has been stubbornly soft despite the RBA’s best efforts. Yet this is where most of the “uncertainties” in the outlook lie. The RBA are convinced that lowering interest rates further will not prompt a change of behaviour in this sector. It highlights that ‘animal sprits’ need to stir in the sector for and any growth momentum to build. To date businesses have remained sidelined awaiting improved conditions before changing behaviour, preferring to be reactive rather than proactive. And further there is a distinct absence of risk-taking that was more prevalent before the Global financial crisis. A shift in behaviours that is further compounded by the negative effects of the higher A$ and domestic wages burdens that have eroded domestic competitiveness.
Consequently we don’t expect conditions to improve materially over the next 12-18 months and this will keep non-mining investment and employment growth subdued. This is despite the recent rise in business confidence that may indeed suggest that animal spirits are stirring. We are unconvinced as this stage that this rise in sentiment will be maintained. And we would note that that the positive sentiment that came with the change in government may still wane. This is as it becomes increasingly clear that that the new government cannot get fiscal or reform measures passed through the Senate. And will not likely get a mandate to reform work place relations in particular that could lead to improvements in productivity that the business sector and the desperately economy needs.
The one unmitigated positive, in terms of real GDP growth, is the ongoing expansion of resources exports. There may be some slowing in the growth of bulk commodity exports over the coming few years. However, those in LNG come online in a rush to see net exports contribute strongly to GDP for some time to come. The downside here is that the production phase of the resources boom has significantly less benefits for the domestic economy in terms of employment and incomes.
…and those to the bad could get ugly
In contrast the uncertainty that characterises the upsides, we see that there is quite a bit of certainty around the factors weighing on economic growth. First and foremost is the decline in the resources investment cycle is occurring and is of magnitude to significantly impact the economy – it is just a matter of when.
Secondly, the terms of trade are declining and will continue to do so. The effects of the former are more readily observed when it comes to GDP growth.
Resources sector investment peaked at around 7% of GDP and it will come down to around 1½-2% over the next few years. This alone is a significant challenge to growth. However, the latter, despite being more difficult to isolate in its direct impact on GDP growth, should be no less concerning.
The rise of the terms of trade provided around half of the growth in per capita incomes in Australia in the decade to 2011 at which point it peaked at an historical high. This masked what was relatively poor productivity growth. But since 2011 lower commodity prices have pushed the terms of trade 20% lower and there is likely more to come. This has seen gross national income growth per capita decline in 2012-13 by 0.8%, the first such decline since 2009-10 and before that the early 1990s recession. This decline occurred despite strong growth in the productivity of labour.
This is likely to be a new paradigm of softer income growth that will characterise coming years. It is uncontroversial to expect further falls it in the terms of trade.
Yet we would be less assured that productivity growth can be sustained at the current level – at least not without cost.
Productivity growth that supported GNI growth throughout 1991-2003 was characterised by improving labour market conditions. That is both solid employment growth and a falling unemployment rate. Recent productivity growth has been driven by relatively soft employment growth and a rising unemployment rate. This has been in an environment where workplace reforms have not favoured businesses so they have improved productivity the only way they know how (with the impasse in the Senate this seems likely to continue). Further in 2013 we have seen a reversal in labour inputs due soft employment growth and the participation rate falling. That latter we would also expect to continue as the population ages over the medium term.
The Treasury summed up this situation over a longer time frame, to 2025, in May’s Federal budget where it noted that its analysis indicated that “…annual labour productivity growth would need to increase to around 3 per cent per year to counteract the effects of population ageing and a falling terms of trade. This is well in excess of what has been achieved in the past 50 years, and more than double what was achieved in the past decade.”
Therefore weaker income growth will characterise the medium term and we think will be most prevalent in coming years as the terms of trade adjust. This will weigh on growth as significantly as the more visible decline in the investment cycle.
Low growth means low rates
In our view weaker income and soft real growth will mean that the RBA will leave rates on hold for an extended period. And when it does tighten policy it will do so very tentatively. We expect that the factors outlined above combined with the high indebtedness of households mean that the ‘neutral’ rate of monetary policy is now significantly lower than it has been historically.
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