By Gerard Minack, founder of Minack Advisors
Australia’s once in a century commodity boom is (unsurprisingly) reversing. There is a serious risk – say, a 40% chance – that Australia has a recession in 2015. Recession would become my base case if leading indicators of employment deteriorate. Under almost any scenario the outlook is for a lower A$, lower interest rates and under-performing equities. If there is a recession expect sharp outright losses in equities, notably banks, and significant falls in house prices.
The past decade saw a once-in-a-century boom in Australia’s commodity prices and mining investment. It was completely predicable that the twin booms would not last, even if it was not easy to say exactly when they would peak, or how fast they would reverse. The terms of trade (ratio of export prices to import prices) are now falling fast. They remain well above long-run averages, so further declines are likely (Exhibit 1).
Mining investment is also now falling (Exhibit 2).
The two major direct beneficiaries of the boom were the mining/construction sectors and governments, State and Federal.
The Federal government enjoyed a remarkable fiscal magic pudding. Exhibit 3 shows the cost of policy changes in successive Federal budgets, and revisions to the budget balance due primarily to changed economic forecasts.
Through the 2000s new policy measures costing 1%-plus of GDP were introduced each year, but were more than offset by economic revisions. The result was a run of headline budget surpluses, despite significant discretionary loosening of fiscal policy. Note that these numbers capture only the impact on the current year budget. Many of the new policy measures had a long-tail: the costs – either in terms of revenue foregone or committed spending – increase over time. The mis-match between a front-end loaded revenue boom and back-end loaded spending measures and tax cuts is now apparent.
The magic pudding is gone. Economic revisions are now worsening the forecast budget balance by around 1½% of GDP per year, matching the size of the beneficial revisions in the prior cycle. The cumulative downgrades are less than the aggregate upgrades that went before, suggesting more downgrades to come.
Real GDP did not measure the boom. GDP averaged around 3½% through the last cycle, lower than in the 1990s cycle. Just as real GDP did not capture the boom, real GDP will not capture the bust.
The measures that did capture the boom were national income (which adjusts GDP for the impact on real income of terms of trade changes) or real domestic demand. Exhibit 4 shows that real domestic demand persistently grew 1-2% faster than real GDP through the last cycle. The important forward looking point is that as the boom recedes, domestic demand will run persistently below GDP for an extended period.
Real domestic demand increased by just 1% over the year to the September 2014 quarter. Growth was lop-sided: demand increased by 4¾% in New South Wales, and fell elsewhere (Exhibit 5).
Domestic demand, not real GDP, is the key growth measure for domestic business. Domestic corporate sales growth has fallen by two-thirds: from 15% nominal growth through the last cycle to 5% now (Exhibit 6).
These trends – domestic demand weakness, sluggish corporate sales, demand declines in mining-driven states – are likely to persist for some time. Three factors will likely worsen next year: already-announced job losses in domestic car makers start; the mining-related investment decline is likely to accelerate; and the residential investment cycle is likely to contribute less to growth (Exhibit 7).
While these factors will work to slow already-weak demand and employment growth, the hoped-for offsets remain elusive. Business investment outside mining remains tepid, and the A$, while down against the US$, remains relatively high on a trade weighted basis. In combination, this points to a reasonably high risk – say, around 40% – of recession in 2015.
The main reason I do not yet have recession as a base case is that leading indicators of employment appear reasonable (Exhibit 8). If the employment leading indicators turn lower, then the risk of recession would commensurately increase.
What seems clear is that under most scenarios the A$ keeps weakening, domestic equities under-perform global equities, and the RBA will ease policy. Within the domestic equity market, safe yield plays and beneficiaries of A$ weakness – both areas that have done well this year – will continue to be relatively strong. If recession eventuates, then the most of these trends will become more pronounced, with the additional likelihood of declines in bank shares and domestic house prices.