It was an upbeat week for the economy and an eventful one for the financial markets. 2013 ended with major stock indexes at or near record highs, and 2014 opened with positive reports on manufacturing and construction spending.
Earlier today, Finance Minister Mathias Cormann tweeted that the “MYEFO update was Labor’s last Budget”. The MYEFO was the Mid Year Economic and Fiscal Outlook released in December, some three and a half months after the election.
He appears to have been serious, I don’t think anyone hacked his account and it was not an April fools joke.
Like a fire fighter refusing to put out a fire because he didn’t start it, Cormann’s comment and view of the budget is very disturbing from a couple of angles.
Regardless of who’s budget it is, the Coalition is in government thanks to a thumping win in the election four months ago having campaigned heavily on a platform of reducing government debt and running budget surpluses. It has to make the decisions on spending and taxing if it is to establish economic policy credibility. There is near universal agreement that a path to budget surplus is a reasonably important macroeconomic policy objective over the next couple of years, depending on the economic growth momentum from overseas and domestically. If the economy records decent growth, a budget surplus is desirable if not essential.
Bitching and scratching over the background to the budget and not how to get towards a surplus shows a dreadfully misguided layering of priorities from the new Finance Minister.
Another issue with Cormann’s tweet is that the Coalition has been in office four months now and the sum total of policy changes it has taken to date has added to the budget deficit through a ramping up in spending and the abolition of some taxes. In other words, the Coalition is over 10% of the way through its term and is adding to the budget deficit not cutting it.
The MYEFO document Cormann refers to (that has his name on the cover) has a simple line in table 3.4 which confirms that “effect of policy decisions” between the Pre-Election Fiscal Outlook and the MYEFO totalled $13.7 billion. See the MYEFO here http://www.budget.gov.au/2013-14/content/myefo/download/2013_14_MYEFO.pdf
These policy decisions by the Abbott government and obviously not Labor include the outlay of money to the RBA, the abolition of the carbon price and the mining tax and some additional infrastructure spending.
In passing, I would note also that some of the wider budget deficit between PEFO and MYEFO was due to a downgrade in world economic activity, something that I suspect even Cormann can’t sheet home to Labor. Between PEFO and MYEFO, Treasury cut the world GDP forecast for 2013 from 3% to 2.75%; for 2014 from 3.75% to 3.5% and for 2015 from 4% to 3.75%. These are important changes that have impacted on the budget position that the Coalition is now managing and have zero to do with the prior government.
For the sake of Australia’s economy, now into its 23rd year without a recession, let’s hope Cormann snaps out of his Opposition rhetoric and does something useful on the policy front to ensure the economy remains in sound AAA shape for years to come.
After months of speculation about the timing, the U.S. Federal Reserve this week announced a plan to slow its monthly purchases of mortgage and Treasury bonds from $85 billion to $75 billion, starting in January. The Fed also committed to keeping short-term interest rates near zero.
As is normal at this time if the year, economists are pretty much compelled to outline their main themes for the economy and markets in the year ahead.
I am not different so here we go.
1. Economic Growth
The economy is accelerating into the end of 2013 and with very easy monetary policy, a competitive Australian dollar, more favourable conditions in the global economy and fiscal policy moving to neutral, GDP growth is poised to accelerate to around 3.5% by the end of 2014. It might even be strong than that as the world economy grows at an above trend pace. While every Joe, Glenn and Martin know that mining investment will be a significant drag of GDP, a pick up in household consumption, a housing construction boom and solid export gains will swamp the mining downturn.
2. Labour market
With the economy on a clear upswing, jobs growth is likely to follow to a strong phase, of course allowing for the usual 6 to 9 months lag. In the neat term, the unemployment rate is likely to nudge 6% before it starts to tick lower from around the June quarter. Around 225,000 jobs are likely to be created in 2014 which will see the unemployment rate around 5.25% at the end of the year.
There are some tentative signs that inflation is less benign that was the case a year ago. The surge in asset prices (housing and shares) is underscoring a huge gain in wealth which in addition to higher spending spilling over to consumer prices. The lower Australian dollar is adding some stimulus to the economy which is also likely to see inflation edge up into the upper half of the RBA’s 2 to 3% target band. Headline inflation to hit 3% by end 2014, but underlying inflation will lift to around 2.75%.
4. Monetary policy
The RBA will be hiking interest rates during 2014, perhaps aggressively. The growth, labour market and inflation dynamics suggest the current 2.5% official cash rate is too low. The best bet for now is to expect the RBA to snug and tap interest rates up by around 25 basis points each quarter in 2014 with the cash rate ending 2014 at 3.5%.
5. Fiscal policy
By the time the government brings down the MYEFO for 2014-15 in the final months of 2014, there will be a clear trajectory to budget surplus for 2016-17 and beyond, largely because the budget’s automatic stabilisers will be super-charging revenue but also as some of the money shuffling from the government pays back the current out-years from the smoke and mirror budgeting that will see the 2013-14 deficit hit something close to $50 billion. In net terms, the government is unlikely to do much to deliver a structural fiscal policy tightening. Most savings measures announced to date have been fully offset to a ramp up of spending elsewhere. The infrastructure spending program is likely to be captured in the budget figuring which will mean the path to surplus will be not much different to that proposed by the previous government.
6. House prices
Having risen a solid 10% or so in 2013, house price growth is likely to taper somewhat in 2014. A rise of less than 5% for the year is more likely as tighter monetary policy, a rebound in supply and some tapering of pent up demand works to take some house price heat out of the market. Indeed, if the RBA hikes a little more than I expect, house prices my be dead flat in the second half of 2014.
7. The Australian dollar
The AUD is ending 2013 about 15% lower than the peak reached during the first half of 2013. There is a very hearty debate being driven by the RBA about fair value for the currency with the RBA judging that the AUD is overvalued. This assessment has some substance although with a lift in the global economy, strong domestic activity and probably wider interest rate differentials are all AUD supportive. The recent fall in the AUD has seen a lot of international investors lighten what were very overweight positions. They and others may be tempted to reenter the AUD market, especially when interest rates rise. All up, it is a scenario where the AUD could easily lift through 95 US cents or regain parity during 2014. Range for the year, 84 US cents to 97 US cents with more time in a 90 to 95 range, especially in the second half of 2014.
The favourable growth and earning story is likely to be offset by monetary policy tightening not only in Australia, but in the US and some other major countries around the world. The ASX200 is likely to record a decent gain and should hit 5,750 points during the year although it is likely to be biased nearer 5,500 over the latter part of 2014. The risk to this forecast is to the high side – the more positive conditions spark a more solid increase in the ASX200 to above 6,000. In other words, buying stocks now, around 5,150 points is a good trade.
9. Bond yields
The bear market for bonds that unfolded in 2013 is likely to continue into 2014. The 10 year government bond is likely to break above 5% with the rate hikes skewing short end yields even higher, meaning a flatter yield curve. The higher inflation rate that is likely to be printed over 2014 will be critical in driving yields higher, as will a reallocation of cash to stocks and away from bonds.
There will be a plethora of political matters that will be important in 2014. There will be, in no particular order, the by election for Kevin Rudd’s old seat of Griffith, the new Senate election for Western Australian and then the State elections in South Australia, Tasmania and Victoria. All will be interesting but largely irrelevant for those looking for clues for implications for Federal politics given the next Federal election will not be held until the end of 2016.
I will, as always, revist these calls during 2014.
Happy new year.
PIMCO’s most recent update on the Australian Economy :-
- In 2013, real growth in business investment in Australia outside the mining sector slowed to almost zero, in part due to the high exchange rate.
- While some sectors of the economy such as housing appear to be improving, we continue to expect sub-trend growth in 2014 due to the subdued outlook for business investment.
- The RBA will most likely have to keep interest rates low for an extended period to ease the transition away from mining-assisted growth and encourage a weaker exchange rate.
Australians will remember 2013 in part for the fall of some of our national corporate icons. The Ford Falcon and Holden Commodore are unlikely to be produced domestically going forward, and Qantas has unsuccessfully sought subsidies from the Federal government. Due to elevated cost structures and a high exchange rate, Australia Inc. is increasingly unable to compete in a fiercely competitive global market.
High on the Reserve Bank of Australia’s (RBA) Christmas wish-list this year will be a lower exchange rate and a business community more willing to loosen its purse strings in 2014. Unfortunately, the first wish will likely need to be granted before the second can be realized. We expect the RBA will need to keep policy accommodative over the cyclical horizon and 2014 will be a critical transition year for the Australian economy.
Over the year through September 2013, real growth in business investment outside the mining sector slowed to almost zero (0.5% to be precise, as shown in Figure 1). Why has Australia Inc. invested so little into its businesses this year? As RBA Deputy Governor Philip Lowe commented in a speech in late October, the lack of business investment in recent years is actually a global phenomenon across the developed world.
Although hard to quantify, this “investment drought,” as Lowe described it, has likely been influenced by a lingering risk aversion after the financial crisis as well as the political uncertainty that has been common in many developed countries over the past few years. But in Australia another variable has also been restraining non-mining capital expenditure, and that is the elevated exchange rate.
As Figure 1 shows, changes in the real trade-weighted exchange rate have historically led changes in non-mining business investment. As the real exchange rate appreciates, domestic products and services become less competitive relative to foreign goods and services, both at home and abroad. And of course, the reverse is true when the real exchange rate depreciates.
Another important point that Figure 1 illustrates is that exchange-rate movements impact the real economy with long lags. Historically, it has taken two years or so for the transition mechanism between the exchange rate and the real economy to work, meaning the full impact of this year’s currency depreciation is unlikely to be felt before 2015.
Critically, it is the real exchange rate that matters when determining global competitiveness (that is, the nominal exchange rate adjusted for inflation differentials between countries). The real exchange rate can appreciate (and domestic companies become less competitive) either because the nominal exchange rate rises, or because the price of domestic goods and services rises faster than world prices while the nominal exchange rate remains unchanged. Take Holden as an example. An Australian-made Holden Commodore can become expensive relative to an imported Volkswagen Golf either because Australian input prices (e.g., wages, parts, etc.) are higher than global input prices, or because the nominal exchange rate rises, making imported VWs cheaper.
Viewed through this lens, it is unsurprising that Australian businesses have been hesitant to invest: They have felt increasingly uncompetitive. Twenty-two years without a recession has generally meant that prices in Australia have continued to rise, while in other countries economic downturns have resulted in periods of price adjustment. One way of illustrating this is Figure 2, which shows headline consumer prices for five developed countries starting after the last recession in Australia in 1991. Amplifying this growing price disadvantage over recent years has been the very strong nominal exchange rate.
Following the RBA’s policy meeting in December, RBA Governor Glenn Stevens noted, “A lower level of the exchange rate is likely to be needed to achieve balanced growth in the economy.” We agree. The critical variable will be how Australia Inc. responds. Because of the historical lag between changes in the exchange rate and changes in business investment as well as the subdued capital expenditure responses in recent business surveys, we remain cautious heading into 2014. We also expect that structural change will continue to affect the composition of growth in the Australian economy. (Please see the Viewpoint, “Dutch Disease Lite in Australia’s Economy,” April 2012.)
2013 was a challenging year for both policymakers and Australia Inc. While there have certainly been signs that some sectors of the economy such as housing are improving, we continue to expect sub-trend growth over the coming year due to the subdued outlook for business investment. To ease the transition away from mining-assisted growth and encourage a weaker exchange rate, the RBA will most likely have to keep policy accommodative via low interest rates for an extended period. So how do we think investors should be positioned heading into 2014?
- Own Australian duration at the front end of the yield curve.With anchored domestic monetary policy and the US Federal Reserve likely to reduce its purchases of US Treasury bonds (potentially putting upward pressure on global long-term yields), the probability of the domestic yield curve flattening significantly is low. At the same time, due to the shape of the yield curve, the three-to-five-year maturity sector provides the highest expected return per unit of duration.
- Position for a weaker exchange rate.Stopping short of physical intervention, the RBA has clearly stepped up its verbal assault on the Australian dollar in recent months. As the exchange rate is such an important variable in determining the competitiveness of Australia Inc. and therefore how smoothly Australia rebalances its growth engines next year, we expect this RBA rhetoric to continue. Two other factors should also be working in the RBA’s favour to achieve a lower exchange rate over the cyclical horizon:
- The increase in iron ore supply will likely exert downward pressure on iron ore prices and therefore Australia’s terms of trade. Our credit team is expecting the increase in iron ore supply from the four largest producers (Vale, Rio Tinto, BHP and Fortescue) over the next two years to exceed the incremental increase in demand from China over the same period. Given that China represents approximately half of all global iron ore demand, this supply/demand imbalance should exert downward pressure on Australia’s terms of trade.
- Foreign capital inflows that have kept upward pressure on the exchange rate over recent years are likely moderate going forward. Foreign direct investment into the mining sector will likely subside as the resource-project pipeline continues to taper next year. Additionally, despite a spike in the third quarter of 2013, foreign purchases of Australian government bonds have generally been much less aggressive.
UPDATED: Reflecting ABC story that the cumulative budget deficits will be $120 billion over the four years from 2013-14 to 2016-17.
It is possible to boil down tomorrow’s MYEFO to a couple of simple points to see just how the budget deficit widening that will be reported has come about.
The starting point for MYEFO comparisons are, of course, the last Treasury estimates of the fiscal position which were published in August in the PEFO. That fiscal position was for total cumulative net budget deficits of $54.6 billion over the four years of the forward estimates from 2013-14 to 2016-17.
The key point almost always overlooked in the so-called ‘blame-game’ narrative is that there can only be two reasons for changes in these budget numbers:
- Policy decisions taken by the government of the day.
- Changes to the economic forecasts or the so-called parameters that are the foundation of estimates of government spending and revenue.
There can be no other factors that have changed the budget bottom line between PEFO and MYEFO.
I’ll repeat for emphasis – there can be no other factors other than policy decisions and changes to economic parameters that can influence budget bottom line estimates in the MYEFO results.
According to the ABC, it looks like the aggregate budget balance for the four years from 2013-14 to 2016-17 will be a deficit of approximately $120 billion, some $65 billion more than was estimated at the time of PEFO.
This $65 billion budget blow out can be due to only two things, government policy decisions and changes in economic parameters.
The good news is that Treasury have always published the dollar value of these components. I assume it will again tomorrow.
These two numbers should be the key big picture take on MYEFO:
- how much of the budget blow out was because of decisions like spending $8.8 billion on the RBA, abolishing the carbon price and changes in education funding, to take a few on that side, and
- how much is due to Treasury changing its view on economic conditions, especially GDP growth, inflation, employment and wages?
On the second point, the chatter is that Treasury has taken the lower bound of the consensus forecasts for the economy and that this is adding a few tens of billions to the aggregate deficit. This is sheer dumb luck and has been a factor driving budget changes for decades.
The other number – the change in the budget balance due to policy changes – will be the more interesting. What decisions has the Abbott government taken to change the budget balance? Has its decisions added to or reduced the budget deficit?
It is that simple and there is, or should be, no blame game. Just facts.
Financial Times article written by Tracey Alloway
A brief summary:-
It’s a bit difficult to work out what the underlying state of the global economy or its country constituents actually is right now. The true or underlying picture is being somewhat obscured by the vast amounts of cash the central banks are flooding into the system with the resultant low interest rates pushing investors up the yield/risk curve.
The Deutsche Bank recently noted that the current economic expansion in the US economy has lasted 54 months by the end of the year. The average expansion since 1854 has been 39 months by the bank’s calculations. This means the current expansion is now the seventh longest of the 34 expansionary economic cycles to have occurred over the past one and a half centuries.
As Jim Reid, the well-respected Deutsche strategist, points out, the US appears to have “just about escaped [a correction] due to extraordinary monetary and fiscal stimulus”.
Until the stimulus’s are tapered back its hard to know what the health of the worlds economies is really like.
To read the full article click here
Market Economics – Stephen Koukoulas Blog
A year ago, I outlined my top 10 economic and policy issues for 2013 in my Business Spectator column, which can be seen here.
With 2013 all but over, the bank manager and key clients are well satisfied.
Those Top 10 calls for 2013 from Business Spectator are reproduced in full below and I have a short comment following each one.
In the next day or so, I will outline a similar top 10 for 2014. If it is as successful as this year, it may well be a bath in Billecart Salmon this time next year.
From Business Spectator:
The top 10 big issues for 2013
1. GDP growth
GDP growth is likely to muddle near 2.5 per cent early in 2013 before easier monetary policy and a more positive tone from the global economy boosts activity through the course of the year. A solid pick up in housing construction and a lift in household consumption will be significant contributors to the growth pick up, and will take up some of the slack from a less robust mining sector. With accommodative monetary policy in place, the cash flow for the household sector and business will be growth positive. Government demand will continue to act as a dampening influence on economic activity, moderated in part by the decision of the government to allow the automatic stabilisers to support activity. By end 2013, GDP growth is likely to be around 3.5 per cent.
[Comment: GDP growth was 2.3% in the year to the September quarter and looks like holding 2.75% when the December quarter data are released next year. I may have been a quarter premature with my call for stronger GDP growth. Components panning out as expected.]
Inflation (RBA underlying) will be skewed towards the bottom of the RBA’s 2 to 3 per cent target as the lagged effect of softer growth through 2012 impacts on prices. The persistently high Australian dollar will further dampen import price pressures, at least for the first half of 2013. Another dampening influence on inflation is the moderate wage increases and solid growth in productivity. By end 2013, the moderation in inflation may be dissipating and the market and RBA may legitimately be factoring in inflation risks in 2014.
[Pretty much spot on. Inflation is locked in the lower portion of the 2 to 3% band, but the September quarter was high. With the December quarter CPI next month, the annualised run rate for the second half of 2013 is likely to be near 3%.]
The unemployment rate will be five-point something every month during 2013. And while it might edge up in the first half of the year as the economic expansion unfolds a little below trend, it should end 2013 near where it is now, that is 5.2 per cent. The forward indicators for jobs point to the unemployment rate moving higher in the near term and it would be no surprise to see an off month with unemployment hitting 5.7 or 5.8 per cent. But as economic growth picks up through the year, the unemployment will fall back lower to around 5.2 per cent.
[See comment on GDP but the unemployment rate has basically been in a 5 ¼ to 5 ¾% range all year. It just has not started to tick down yet but it probably will as growth accelerates.]
4. House prices
House prices have been weak for two years. Stretched affordability has finally been catching up to house prices and to the extent there ever was a bubble, it has been deflating in an orderly manner. The fundamental drivers of house prices are increasingly positive. Strong population growth is underpinning long run demand, while low interest rates, low unemployment and rising real wages are likely to underscore housing demand and therefore prices. After the weakness of the last two years, it would be no surprise to see house prices rise 10 per cent this year.
[Again, spot on, with house prices surprising just about everyone else with gains of 10% locked in for the year.]
5. Monetary policy
Monetary policy will remain accommodative through 2013. The RBA is likely to cut interest rates in the first part of the year as it catches up to the slowing growth and low inflation dynamics prevailing at the moment. The official cash rate is likely to bottom out at 2.5 per cent during the June quarter with ongoing low inflation driving the reasons for the easings. Rates are likely to remain on hold over the second half of 2013, but it would be no surprise to see financial markets starting to price in the risk of a monetary policy tightening as the year draws to a close.
[Again, close to perfect, with the only variance a month or two out on the date of the rate cut to a historical low of 2.5%. According to a Bloomberg survey in early January 2013, there were only four other forecasters out of 29 expecting the cash rate to end 2013 at 2.5%.]
6. Australian dollar
The Australian dollar ends 2012 significantly over valued. It is a classic market overshoot based on strong global investor demand for Australia’s triple-A rated assets. Markets can be prone to overshoot but in time they inevitably revert to fair value. If the Australian dollar reverts to fair value during 2013 it is likely to be trading near US90 cents at some stage. That said, a free-fall in the dollar is unlikely because of the global economic improvement through the year and the possibility that commodity prices move higher as China and the US pick up. The trading range for the Australian dollar for 2013 should be US88 to US106 cents.
[Another near perfect forecast – the range for the year (with 2 weeks to go), has been US89 to US106 cents, embarrassingly accurate. Recall that when the forecast was made, the AUD was trading at US105 cents.]
7. Australian stock market
The Australian stock market is likely to continue to move higher aided by a move positive growth and profit outlook. A bearish year coming up for bonds will also likely see an asset allocation move to stocks. At some stage during 2013, the ASX200 will break above 5000 and could well trade at 5250 as the year progresses. A positive lead from global markets will be a positive driver with super stimulatory policy prevailing in the US, Europe, Japan and the UK.
[The ASX was strong, up until a few weeks ago. The ASX200 hit 5,400 and looks like ending around 5,100. I probably was a touch too bullish.]
8. Bond yields
Bond yields will stay low in the early part of 2013 aided by the policy actions of the US Fed, the European Central Bank and the Bank of England. As the economy accelerated and the market started to become a bit more concerned about inflation risks, bond yields should move higher. It is likely the 10-year government bond yield will exceed 4 per cent from the middle of the year.
[Again a good call with the 10 year yield currently around 4.3%, up over 100 basis points for the year. It has been good to be short.]
9. Australian election
The election should be held in October, around the 19th or 26th. While an Abbott-led coalition victory is more likely than not. That said, the fickle nature of the political environment, the unpopularity of Mr Abbott and a positive policy agenda from the Labor Party could easily see the election go either way. With economic management – including interest rates – usually an important influence in election outcomes, the Labor Party could win. It will be that versus the carbon and mining taxes and issues of trust that will be driven by the coalition in forming the election campaign issues. It is not yet clear whether the election would be market moving, other than if there was a coalition victory, but without control of the senate, there may be a year or so of policy stalemate as the senate blocked policies to remove the carbon and mining taxes.
[Election date wrong, winner correct, and issues wrong. The economy was not the focus of the campaign. My error. The election outcome has been market moving, although not in the way some would expect. Markets are increasingly taking a dim view of the economic credentials of the new government.]
10. Federal budget
In terms of policy, Treasury is obviously of the view that the budget will record a small deficit in 2012-13. That outlook is premised on a half year of sub-trend economic growth, ongoing softness in commodity prices and the terms of trade remaining weak. For the 2013-14 budget, the government will be incorporating the financial cost of implementing the Gonski education reforms and the roll out of the National Disability Insurance Scheme. When incorporating these policy changes in the budget on May 14, it will find the money to fund it. Expect to see a scaling back of the generous tax treatment of superannuation and more policies that limit benefit payments to high income earners.
[Nothing much either way here. The budget deficits are small, and aside from the unexpected policy decisions from the new government, a surplus was on track in the next couple of years.]
Andreas Utermann Global CIO provides Allianz’s 2014 market outlook, the key points are:
- Central Banks loose monetary policy (read quantitative easing) is set to continue and with it low interest rates
- Global economy should be boosted by a cyclical recovery against a background of moderate economic growth
- Currency wars (and possibly trade wars) are a big risk factor
- What appear to be less risky investments at the moment may end up getting chewed up by higher inflation in the longer term
- Dividends from equity will continue to be a key driver of the asset classes returns.
For the full article click here
An article on Morningstar ranks the vulnerability of various emerging market country index funds to a reduction in capital flows. With many investors buying the emerging markets story its certainly a relevant piece and suggests investors would be better not to lump all emerging markets together. A higher score indicates a more vulnerable economy.
Click here for the full article.