I’m not sure why this a surprise to anyone but, hey, if you’re going to use a “zero change assumption” in your forecasting then by definition it’s going to, from Bill Evans:
The Minutes of the monetary policy meeting of the Reserve Bank Board for November provided no significant surprises.
Probably the most significant change in the Minutes was around the growth outlook for the Asian region: “Growth in Asia had slowed by more than had earlier been expected”. This covered both China and other countries in the Asian region. However the Board has not changed its view on the terms of trade: “outlook for Australia’s terms of trade was little changed”.
Nevertheless, uncertainty was emphasised given that upside risks were centred around possible prospects for (unpredictable) high cost Chinese producers cutting production. On the downside, there is a clear downgrade to the likely demand conditions, with no signs of a pick-up in construction activity and steel production falling by 3% through the year.
On balance, risks to the outlook for bulk commodities and therefore the terms of trade must therefore be to the downside.
Of course we have recently seen a disturbing fall in the iron ore price, coming down by 18% over the last month to its lowest weekly average since the boom began.
The question arises as to whether our current forecast, and that of the Reserve Bank, that 2016 will be a relatively benign year for Australia’s terms of trade will come under scrutiny.
Recall that the 10% falls in the terms of trade which we saw in both 2014 and (likely) 2015 were associated with particularly weak growth in nominal income, leading to considerable pressure on household disposable income and spending. In both 2014 and 2015, nominal income growth is set to register around 2.0%. Only a (modest) fall in the savings rate has allowed household spending growth to hold in at a cautious 2.5%.(real).
The Reserve Bank’s forecast of 3% real GDP growth in 2016 (up from 2.25% in 2015) is dependent on a lift in the growth pace of household expenditure to 3-3.5%. That is expected to be supported by ongoing employment growth and further falls in the savings rate with a lift in nominal income growth (back to around 4.5%) associated with a more steady environment for the terms of trade.
But how might a severe collapse in the iron ore price affect those calculations?
The key metric will be changes in Australia’s export prices in USD terms.
However because of its sharp falls in recent years the iron ore price is no longer as significant to Australia’s terms of trade.
Current approximate weightings in Australia’s export price Index are: iron ore (20%); coal (12%); other resources (19%): services (20%); agriculture (14%); manufacturing (11%); and other non- resources (4%).
In 2013 the iron ore price averaged USD136/t; USD97/t in 2014; and USD56/t in 2015 (current estimate). Consequently on a year 20 November 2015 average basis the iron ore price fell by 28% in 2014 and 42% in 2015. Our current estimate for the average fall in the iron ore price in 2016 is around 10%. However if the iron ore price averaged, say, around USD35/t in 2016 it would have fallen by about 35% in 2016.
On a through the year basis, a 35% fall in the iron ore price (assuming a USD45/te starting point) would see the iron ore price printing around USD30/t by year’s end.
Consider the perspective of a USD30/t iron ore price. Between 1999 and March 2005 the iron ore price ranged between USD15–25/t. From the second half of 2005 the price started to lift quickly reaching USD40/t by year’s end. With the volume demand for iron ore vastly stronger now, the issue for markets will be whether supply has sufficiently adjusted to fully offset the demand lift over the last 10 years to return prices to those insipid levels. We doubt it.
However if iron ore was to fall to USD30/t how would that affect our export prices ?
Presumably, in a world of a 35% fall in the iron ore price other commodity prices would also be weaker. However it is reasonable to assume such weakness would be less than the fall in the (more volatile) iron ore price.
For example, on a year average basis: base metals were steady in 2014 before falling by 18% in 2015; oil fell 8% in 2014 and 44% in 2015; coking coal fell by 21% in 2014 and by 14% in 2015; thermal coal fell by 13% in 2014 and 19% in 2015; while rural commodities fell by 12% in 2014 and 12 % in 2015.
On the other hand the services and manufacturing components of the export price basket will move in line with Australian inflation and global manufacturing prices (adjusted for any exchange rate movement).
Consider a scenario where iron ore prices fell a further 35%; other resource and rural prices fell by 10%; while services and manufacturing prices lifted by 2.5%.
On current weightings that would see a fall in the USD export price index through the year of around 10% – implying a third consecutive year when the terms of trade were to fall by around 10%. (Export prices will be impacted by any move in the AUD against the USD, as so too will prices of imports.)
Of course, another year of a further 10% fall in the terms of trade would mean another 2.0% nominal increase in national income placing the Reserve Bank’s 3% growth forecast for real GDP growth in extreme danger and opening up the possibility of rate cuts.
Our current forecasts are more in line with the Reserve Bank’s “steady” view around the terms of trade outlook but the risks are apparent.
That, Mr Evans, is the base case.
