Is This What The Bottom Of The Curve Looks Like, and Could The Donald Make It Worse? / by Adam Howard

Welcome back to another instalment of The Update!!

I’m not sure how to start. 

Some sort of bad pun about Donald Trump winning the US Presidential Election?  A loose reference about Australia heading into recession?   An angry comment about the politicians denying we are heading into recession?

How about all three...

Donald J Trump, the Master of The Art of the Deal, will be the next President of the United States of America.

Australia is displaying all the hallmarks of an economy headed for recession, and Scott Morrison, our esteemed Treasurer, is denying this fact.

Before I bang on about the potential impacts of these facts, let’s have a look at their origins.

Trump first.  Now, I’m not sure what everyone thinks about the soon to be erstwhile President Obama…and this isn’t going to be a political essay, but one thing is for sure; he was great at giving a speech.

One of my favourite annual Obama speeches is the White Correspondent’s Dinner (WHCD), a light-hearted, slightly comedic event which has been criticised over the years as a display of the overly cosy relationship between the White House press corps and the sitting President and administration.

In the lead up to the 2012 Presidential election Obama gave a speech at the WHCD with DJ Trump in attendance…and tore him apart in front of a room full of journalists.  Have a look at this link:

Now we know Trump is going to be President, and in retrospect you can almost see the inception of the idea to run for President as he sat in that room of smug insiders while they made fun and laughed at him.  Brutal.

So, his run at the top job was a way of exacting revenge.  Probably not the best motive for wanting to lead….

Now, our economy.

For years, most notably during the Global Financial Crisis (GFC) and the years immediately following, we have listened to politicians talk proudly about the strength of the Australian economy; it’s immunity from the global malaise; a tilting of Australia towards Asia; a new normal.

And this was true for a while.

But where did this growth start? 

Like all growth phases it started from a low base, with Paul Keating’s “recession we had to have” in 1990-91.

And it was a long one, lasting over 2 decades.

It reached its peak in 2006, with the establishment of the Australian Future Fund, now run by ex-Treasurer Peter Costello, initially funded through continued Federal Government budget surpluses and sale proceeds from the privatisation of Telstra.

The period since 2006 has really been an exercise in trying to wring the last few drops of growth out of an increasingly reluctant economy. 

We happened to be very lucky that Chinese demand for our iron ore and base metals began to increase in the early 2000s, so that by 2006-2008 our economy was propped up by the activity created by infrastructure projects catering to this increased demand.

If it wasn’t then it would have ended with a resounding bang as the GFC took out most western liberal democratic economies.

Now, spiking demand like that was always going to be short term, which is what we saw, with the peak occurring in 2011, and since then we have seen Western Australia and Queensland move from being the engine rooms to being the turkeys of the national economy; the millstones around the neck of the Federal Treasurer. 

So, now our respected talking heads are all talking about if Australia is, why Australia is or is not, when Australia will be in and how long Australia will be in a recession.

So, there you have the origins.

What about the current situation?  Our economy first.

Here are the current rankings from CommBank’s State of the States from best to worst, with a link to the full report included:

  1. New South Wales

  2. Victoria

  3. Australian Capital Territory

  4. Northern Territory

  5. South Australia

  6. Queensland

  7. Tasmania

  8. Western Australia

https://www.commsec.com.au/stateofstates

 

The above rankings are based on the following eight economic indicators.

  1. Economic growth (7th)

  2. Unemployment (8th)

  3. Retail Spending (4th)

  4. Business Investment (7th)

  5. Population Growth (5th)

  6. Housing Finance (7th)

  7. Construction Work (7th)

  8. Dwelling Starts (6th)

Now, I will continue to delude myself by thinking this is an important national newsletter I am writing here, but for those of you with a Western Australian focus, I have included WA’s ranking in parentheses above.

Unpleasant reading, huh??

So, let’s work on whether we are in a recession already. 

A recession is generally defined as a fall in GDP in two successive quarters, so by any definition Australia IS NOT in a recession.  We have had a fall in GDP in 1 quarter so far; the September quarter showing a contraction of 0.6%.  Here is the link to the graph:

http://www.tradingeconomics.com/australia/gdp-growth

 

The question is, will we enter a recession?

Personally, I think the more important question is “Does it matter?”

Before you call me a heartless bastard, hear me out.

Whether Australia is in a recession or not is just a story in a paper or included in a news report until it directly affects you, and then it becomes real.

And as I always say, it’s dangerous to talk about “the market” or “the economy” without some context.

The national economy is an enormous creature; organic, dynamic, multi-faceted, with each State or Territory’s only slightly less so.

Whether we are technically in a recession or not is purely a matter of definition. 

I can report, from what I see and am told when out talking to people around Perth, that financially things have been more difficult over the past 12 months than previously, with the following just some of the anecdotal evidence I have found over the past 9 months:

  • Trading businesses reporting revenues down by about 20% year on year;

  • Employees negotiating reductions in pay of up to 10%;

  • Business owners returning to front line positions and replacing paid employees;

  • Investment properties being sold by financially secure people simply to reduce debt load;

  • Almost all new home loans being put on Principal and Interest repayments, and household spending sacrifices being made to do so; and

  • An almost total absence of investment property purchases.

The final pieces of data that points to Western Australia being in a long recession are the technical numbers.

There is another number that’s useful here which is called State Final Demand (SFD), which is GDP after you remove imports and exports.  Useful in our case because of the size of our resource exports and the fact very little if any of the dollars paid for those exports flow to Western Australian households.

Western Australian SFD has been on a downward trend since the end of 2012 and has shrunk for 5 consecutive quarters to the end of the September 2016 quarter.

In layman’s terms this means the businesses and people of Western Australia have been spending increasingly less on everything for the past 15 months to 30 September 2016.

But the ridiculous thing is, because Western Australia’s GDP hasn’t gone backwards for 2 quarters you can’t call it a recession.

So, if it looks like a recession, smells like a recession and feels like a recession, then it’s a recession, right?

Not to our elected officials who clearly have an incentive to say we are not in a recession, as that would imply responsibility for the status quo….but we all know what’s what, don’t we?

Now, from a banking perspective these economic conditions are obviously not good.  Not for you and I; never mind that.  For the poor ol’ banks.

Too much risk out there: falling income, rising living costs, falling property values.  Scary.

Makes it hard to find credit worthy customers, even in a time where interest rates are at record lows.

But that’s just WA. 

On the East Coast, particularly in Sydney and Melbourne, there is wild speculation in the property markets.  Irrational exuberance has taken hold with property values rising by close to if not well into double figure percentages over the past 12 months.

The banks, and everyone else mildly interested, keep asking “Is that a bubble?”

Once again, our elected officials talk down the alarmists.  Of course, it isn’t a bubble.  The banks will only lend responsibly.  The regulators have got this under control.

Then the regulators agree.  Yes everyone, we got this.  It’s OK. 

But then the regulators knock the banks around telling them, you guys haven’t lent responsibly.  You’re not allowing for actual living expenses.  You’re not verifying applicant income well enough.  No more interest only loans.  Limit your balance sheet growth.

And the banks oblige and change their policies, making credit harder to come by, and maybe, just maybe, making a bad situation worse.

This is where we lurch back to our boy, Donald J Trump, the incumbent President of the United States of America.  His election had an immediate impact on the global cost of money, which is already affecting the rates our banks charge.

Here’s how it works.

Trump got elected on the back of some substantial campaign promises around infrastructure spending…about US $12 Trillion in promises to be precise.

That means the US Federal Government needs to borrow more to pay for that, which means it needs to sell US Treasuries; bonds that are always in demand. 

The thought of more Treasuries on the market pushed the rate payable on a 10-year Treasury up by about 0.55% the day after Trump was elected.

And the rate payable on a 10-year Treasury is one the key variables that influences the global cost of money as it is regarded as a risk-free rate.

As that rate increases, so do the rates on all other forms of bonds, and our banks fund a lot of their loan books through selling bonds, so the cost of their money just increased and guess who they passed that cost onto??  That’s right.  You and me.

It’s already happened with fixed rates across the board increasing by up to 0.60%, and is also flowing into variable rates.

An increase in rates also makes it harder to obtain credit, as it means the cost of the debt being sought is higher, requiring more income to service.

Now, all the above might amount to nothing, but it’s got people in high places worried.  Here’s why.

We already have the two resource states, WA and Queensland, performing poorly, and those economies had been supporting the national economy.

The New South Welsh and Victorian economies are leading the way, but have a heavy focus on home lending, property investment and residential construction, which is all semi-speculative activity.

The property markets in NSW and Vic need to slow down, but not collapse, so tightening bank policies help there, but to add higher rates to the mix might be dangerous, leading to what is euphemistically called a hard landing for the economy.

WA and Queensland need some help.  Lower rates mean more disposable income that could be spent in the local economy.  Higher rates mean less access to credit, more mortgage distress, more asset sales.

So, our elected officials and bureaucrats are scratching their heads, wondering what to do.  Damned if you do and damned if you don’t, really.

So, what’s next?  What happens?

Here’s what I think.

Rates rise and the unbridled enthusiasm for property in Victoria and New South Wales slowly quietens down. 

Australia has a soft, if even noticeable, recession according to the numbers and definition of a recession.

Middle and lower class Australians continue to struggle for the foreseeable future, and by that, I mean at least 5 years.

Struggle in the sense that income levels will continue to stagnate, living expenses must reduce in real terms as discretionary spending is reduced, and mortgages are paid down.

There will be no policy change that miraculously prevents this from happening.  No change to the tax laws that will create more jobs and bring about more growth.  Don’t believe Malcom or Bill.

I am not a right or left wing theorist, but I agree with Joe Stiglitz (ex World Bank Chief Economist) and Bernie Sanders (ex Democratic Presidential Nomination contender) that the middle class is the engine of any liberal, democratic capitalist economy, and for growth to return the middle class needs to either earn more (wages growth) or owe less (repay debt), and achieving either takes time…at least more time than your average resource boom takes.