The Australian economy – more help will be needed

Introduction

The Australian economy remains in a difficult period as the mining boom unwinds. Non-mining activity has bounced back but is far from strong enough to offset the headwinds coming from the mining downturn. This note looks at the outlook for growth, interest rates, profits and what it means for investors.

Growth remains poor

June quarter growth was anaemic at just 0.2% quarter on quarter or 2% year on year.

Microsoft Word - SS_The Australian economy still soft.docx

Source: ABS, AMP Capital

Were it not for a strong surge in public spending and a (likely temporary) bounce in investment in WA, June quarter growth would likely have been negative as consumer spending was soft, housing investment fell, underlying business investment was soft and net exports and inventories cut 0.6% points and 0.2% points from growth respectively.

Growth outlook

The growth detraction from net exports and inventories seen in the June quarter is payback for positive March quarter contributions and unlikely to be repeated in the current quarter, allowing growth to bounce back a bit to around 0.5% quarter on quarter, which is the average of the last two quarters.

However, this will not alter the tough position Australian now finds itself in. Mining investment, having risen from around 2% of GDP to 6%, is now falling back rapidly as large projects complete. This is detracting around 1 percentage point from growth per annum. To offset this we need to see growth in other parts of the economy pick up. We have seen housing and consumer spending springing back to life and improvement in tourism and higher education. However, non-mining investment remains disappointing.

The latest business investment (capex) plans from the ABS point to more weakness ahead. Comparing the third estimate of investment for 2015-16 with that a year earlier for 2014-15 points to a 23% fall in business investment this financial year.

Microsoft Word - SS_The Australian economy still soft.docx

Source: ABS, AMP Capital

While slumping mining investment is no surprise what is concerning is that the outlook for non-mining investment remains weak pointing to a 7.5% decline this financial year. More broadly, several other factors seem to be playing a role in sub-par growth in the economy, including: steeper than expected falls in commodity prices that continue to cut into national income growth (nominal GDP growth was just 1.6% year on year through last year); the ongoing threat of more budget austerity; household reluctance to take on more debt; delays in the fall in the $A (just over a year ago it was still around $US0.95); and subdued levels of confidence.

But there are several reasons not to get too negative.

  • Borrowing rates are at generational lows. Australians owe the banks $1.2 trillion more than the banks owe them, so the household sector is a net beneficiary of low rates.
  • The fall in the $A is a big positive for manufacturing, tourism, higher education, services, farming and mining.
  • Petrol prices aren’t as low as they should be, but are down from their highs last year, delivering savings to households.
  • The household savings rate remains relatively high at 8.8% and has scope to drift down supporting spending.
  • Australia managed the boom a bit better than it has in the past when booms led to inflation or trade deficit blow-outs or both and all sectors of the economy boomed together and so went bust together. This time there was no major buildup of imbalances in the economy and sectors suppressed by the mining boom are bouncing back.
  • Reflecting this, real state final demand is up 3.3% year on year on NSW & 3% in Victoria, while it’s down 1.8% in WA.
  • Most Australians don’t get paid export prices so hand wringing over the “national income recession” is overdone.

This should mean the risk of a recession remains relatively low and there is no reason to get overly gloomy on Australia. Rather growth is likely to continue to remain sub-par at around 2% as the negatives and positives balance out.

More RBA rate cuts and the $A heading to $US0.60

However, with the mining downturn having at least another two years to run the prospect of another few years of growth running well below potential is not appealing. While potential growth in the Australian economy may have slowed to around 2.75% thanks to slowing productivity and population growth, actual growth is running well below this at around 2%. This means spare capacity in the economy will continue to build, with a rising trend in unemployment and downwards pressure on inflation. What’s more, housing construction which has helped the economy looks to be at or close to peaking. Against this backdrop the economy is likely to need more help.

First, the combination of an extended period of below potential growth, a rising trend in unemployment and weak inflation is likely to ultimately drive the RBA to cut interest rates again. A slowing in Sydney and Melbourne home price growth (as APRA measures bite) should make it easier for the RBA to do this. The November RBA meeting is the next one to watch, failing that then expect a move early next year. While in an ideal world it would be good to see more of focus on economic reforms to drive stronger growth, the political reality means that this will be hard to achieve any time soon.

Second, the $A looks headed to around $US0.60. The primary driver is the ongoing secular bear market in commodity prices but the likelihood of a further narrowing in the interest rate differential versus the US adds to the case. This will be a typical overshoot in the value of the $A, but it’s necessary to help drive increased demand in non-mining industries like tourism and manufacturing and in turn help drive up non-mining investment.

Profits disappointing, but good outside resources

The recently completed profit reporting season was a good reflection of the state of the economy. 2014-15 profits were weak overall with June half results being a little disappointing. 43% of companies beat expectations and 59% saw their profits rise from a year ago which is okay, but it’s well down on what we saw in the last few reporting seasons.

Overall profits fell around 2% over the last financial year and guidance for the current financial year was cautious.
However, several points are worth noting:

  • The fall in profits owes to a 35% slump in resources profits.
  • The rest of the market saw profits rise around 7.5% driven in particular by general industrials, building materials, retail and health care stocks.
  • Profits for industrials ex financials rose 11.5%, and are now up four years in a row. See the next chart.
  • Revenue growth remains subdued but is being helped by the lower $A with strength in companies connected to home building and NSW.
  • Dividend growth remains solid at 4% in 2014-15 with 57% of companies raising dividends.

Microsoft Word - SS_The Australian economy still soft.docx
Source: UBS, AMP Capital

Consensus earnings growth expectations for 2015-16 remain soft at around 4%, driven by industrials ex financials with profit growth of 8.5% more than offsetting another 6% expected decline in resources profits. Low interest rates and the falling $A should help industrial profits.

Are high dividend payouts to blame for weak capex?

A common view is that companies are not investing because shareholders are demanding high dividends. This may be playing a role but it’s likely to be minor. Contrary to popular perception the dividend payout ratio (ie dividends relative to earnings) is not significantly out of line with its historic norm. For industrials the payout ratio at around 70% is around where it was prior to the GFC. It’s mainly resources stocks that have boosted payouts to around 70% from around 30-40% prior to the GFC) and it’s hard to argue they should ramp up investment after having over invested!

Microsoft Word - SS_The Australian economy still soft.docx

Source: Bloomberg, Global Financial Data, RBA, AMP Capital

The real reasons for the lack of investment by non-mining companies is likely to be post GFC caution, wariness after getting smashed through the mining boom by the high $A, high interest rates and high labour costs (just four years ago now) and too high hurdle rates for a low inflation world.

Implications for investors

First, bank term deposit rates are likely remain low or fall even further. The search for decent income flows has further to run.

Second, the $A is likely to continue to fall. So continue to favour unhedged over hedged global shares.

Third, Australian economic growth is likely to disappoint relative to expectations for the US and Europe, suggesting a case to maintain a greater exposure to traditional global shares even though we expect Australian shares to end the year much higher than they are now.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

China drives market volatility

financial-markets

Investors around the globe are catching their breath after one of the most turbulent day’s trading in many years.

The Chinese share market fell by more than 8.5%, as measured by the Shanghai Composite Index, marking its largest single-day descent since 2007. The US stock market also saw its biggest sell-off in four years with the S&P 500 and Nasdaq both in correction territory, down 10% on recent peaks.

Market falls around the world appear to reflect a combination of factors that are contributing to negative sentiment among investors. More notably for Chinese shares, despite the volatility experienced over the past few weeks, those who have been invested in the market for the past year have still generated positive returns of approximately +70%.

Are we heading into another major financial crisis?

Our current analysis suggests that the negative sentiment we have seen in the last few days is not out of the ordinary, with occasional sharp market sell offs during bull markets.

Following the share market fall in 1987, as well as the Global Financial Crisis, share markets took time to build firm bases and entered periods of protracted volatility before then commencing clear rising trends. It’s likely that this is what we are now experiencing with China.

While the recent market downturn has been sizeable, it’s not among the worst in market history. Financial markets in the west have been booming for the past six years at a time when global macro divergences have intensified. Recovery from the last recession has been patchy and weak by historical standards, but that has not prevented a bull market in equities.

For all the talk of ‘Black Monday’ in China, this was more of a correction in western markets, with 12-month market gains of around +70% even despite the sell-off this week.

What impact does this have on AMP Capital’s long term view?

Globally, while volatility is likely to remain high and a further correction is possible, we see little risk of a recession or bear market in global shares at this point in time.

What we have is a sharp adjustment of market sentiment and extreme fear without a real change in the underlying economic backdrop.

We also expect the Chinese government will support economic growth through strong monetary policy easing and other measures which, in turn, should help support growth in China and the broader emerging markets.

We will continue to watch and monitor the market, and will make necessary changes to our portfolios as the situation evolves.

Do you see any opportunities?

Going through August-September, we expect to see continued volatility. Historically, the September quarter is one of the weakest quarters of the year so we will not necessarily be putting all money to work at the moment but if we see further dips over the next few weeks, we will take advantage of these buying opportunities.

In terms of our views on asset allocation, we currently see the share market correction in China as a buying opportunity. While there has been a significant readjustment in valuations, the earnings backdrop for Chinese companies remains good.

We remain confident there will also be aggressive support from central banks to stem any negative impact to economic fundamentals.

About the Author
Nader Naeimi is Head of Dynamic Asset Allocation 
With over 18 years’ experience in Australia’s financial markets, including 15 years as part of AMP Capital’s Investment Strategy and Economics team, Nader’s responsibilities include analysis of key economic and market factors influencing global markets.

Important note:While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.
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