Bloxo puts the commodities bull case

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Paul Bloxham of HSBC recently released a very good piece of research arguing that the global economy had made a structural shift towards emerging markets growth that would continue a powerful surge in infrastructure growth and support high prices for commodities for decades.

I agreed with his note but disagreed with its conclusion, that this would be enough to keep Australian commodity prices at stratospheric levels. After all, iron ore could be at $60 and still be very high in relative terms.

Today Bloxo is out with a new note arguing that the current commodity price weakness is cyclical:

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The debate about whether Australia’s mining boom is over, or not, has ratcheted up in recent weeks. We remain of the view that the mining boom’s death is ‘greatly exaggerated’. In the end, though, much depends on the commodity price outlook. On this, we think the high level of commodity prices in recent years is mostly structural, with the recent dip cyclical, much as our view on China is that the recent slowdown is more cyclical than structural. Real commodity prices at well above their late 20th century levels are expected to continue to support Australia’s growth prospects.

Rising commodity prices have boosted the Australian economy for most of the past decade and are a key reason why it escaped the worst of the global financial crisis. Without the rise in commodity prices, Australia’s experience would have been very different. Much like the rest of the developed world, Australian’s have been deleveraging in recent years: they have increased their saving and have become more cautious borrowers. Business credit was falling until recently. The credit to GDP ratio has fallen for the past four years. But thanks to rising commodity prices, income growth has still been strong.

As such, Australia’s economy is 9% larger than it was four years ago. By comparison, the US is only 2% larger and the euro area economy is 2% smaller, even with extraordinary policy settings. Why has Australia outperformed? China is 45% larger and commodity prices, at their late 2011 peak, were 50% higher than in mid-2009 in AUD. Since then commodity prices have fallen by 13% in AUD.

Rising commodity prices were a key driver of income growth. The high level of commodity prices has also motivated large capacity expansions in the resources sector to get underway. As commodity prices decline, the free kick to income growth will become a thing of the past. But this does not mean the mining story is over – far from it.

Indeed, much of the mining investment is in long term projects that will take a few more years to complete. The current projects underway are valued at $260 billion (18% of GDP). Mining investment will still be a rising share of the economy in 2013. Plus, the big kick to exports is yet to come. LNG exports don’t really ramp up until 2015. The lift in exports expected over the coming four years by the official resource bureau is expected to contribute a similar amount to GDP volume growth as investment has in the past four years (see ‘Reports of the mining boom’s death greatly exaggerated’, 26 July 2012).

Much has been made of the recent shelving of longer term mining expansions, including Olympic dam in South Australia. Importantly, though, these projects were never actually part of our, or officials, forecasts. For forecasting purposes, they were treated as being on the shelf. So recent announcements just shelve projects that were already on the shelf! In fact, over the past three months more projects have gained final approval, not less.

Besides, another key concern about the Australian economy has been the ‘two speed’ economy. What some have been calling ‘Dutch disease’, though we have refuted this and instead think of it as necessary structural change in the face of unprecedented shifts in the composition of global growth (see ‘Does Australia have a resources curse’, 18 August 2011). Nonetheless, slower growth in the mining sector, at some point, will allow for some growth rebalancing. The mining sector has crowded out other activity. Given the economy is currently operating at around full capacity there was no other way for the mining expansion to happen without boosting inflation. Lower interest rates will help this rebalancing to occur. A lower AUD would also help support the traded-exposed sectors, and with commodity prices off their peaks, we continue to expect some further downward pressure on the AUD.

Of course, if commodity prices were to fall sharply further from here, then times will get tougher for Australia. This is the big worry. Unfortunately, forecasting commodity prices is notoriously difficult. However, our work on this suggests that big declines in commodity prices seem unlikely (see ‘Commodities and the global economy’, 8 August 2012).

In our view is that the unusual period for commodity prices was the very low level in the 1980s and 1990s. With emerging economies now driving global growth, and these economies requiring commodities to grow, we think commodity prices will stay well above the levels reached in the late 20th century. The RBA agrees. Indeed, the RBA is still forecasting Australia’s terms of trade (the ratio of export prices to import prices) to stay above the ‘then record peak’ reached in 2008.

Supporting our view on commodity prices is our view on China. As our Chief China economist, Qu Hongbin, has recently noted, the current slowdown in China is cyclical not structural (see ‘Slowdown more cyclical than structural’, 28 August 2012). The slowdown has been a result of tight Chinese policy settings last year and the developed world slowdown. Trend growth in China is still over 9% for the coming three years, in our view, and Chinese growth is expected to head in that direction later this year.

This is the central case. Of course there are risks. If commodity prices do fall more than expected, this would no doubt weaken Australia’s growth prospects. Income growth would fall by more, which would weaken mining company profits (although the extent of AUD decline would also be important). The decline seen in commodity prices so far is already calling into question the government’s budget surplus projections (we have long been sceptics on this, see ‘Budget Surplus, reality or rhetoric?’, 7 May 2012). It seems unlikely to us that the government would introduce further discretionary fiscal tightening to stick to its surplus plans at all costs, but given it has become a political imperative it is possible.

For the nominal economy, a sharper fall in commodity prices would make times tougher. Though the extent to which the AUD followed commodity prices down would be very important. We still believe that a sharper fall in commodity prices would see a lower AUD, though the RBA has recently noted a risk that it doesn’t due to safe haven flows. It also seems clear to us that the RBA would be unlikely to intervene, given recent commentary (a point we have made before).

For the real economy, much of the mining investment is baked in, resource exports would still pick up and some eventual slowdown in mining sector growth will leave some room for other parts of the economy to expand.

The shelving of projects that might have happened later in the decade can actually be thought of as a positive thing, as it will help to prevent an oversupply problem – and thus a commodity price collapse – later in the decade.

Much depends in the commodity price outlook. There are reasons to remain upbeat though. We expect commodity prices to stay structurally high. Much of the mining investment boom is ‘baked in’ and the kick to resource exports is yet to come. An eventual slowdown in mining sector growth will also leave room for the expansion of the other sectors of the Australian economy which have been crowded out in recent years.

Fair enough I suppose but this is starting to feel pretty defensive. Although I agree a short term bounce will come and that China can grow at 9%, this is not longer a good idea. To me, the debate over China’s imbalances has been won by Michael Pettis and the cost of keeping growth at that kind of level will not only outweigh the benefits, it will risk a much more serious correction (and commodity crash).

Seeing the glass half-full like this risks emptying it altogether.

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120830 Australian Economics Comment – It’s All About Commodity Prices

About the author
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal. He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.