This post
refers to our forecasts and justifications for six economic variables which are
central to investing strategies, and reflected in future valuations. These
variables include the economy, GDP
growth, the exchange rate, RBA cash
rate, unemployment rate, 10 year bond yield and inflation rate for
Australia. Investors should remember that the share market tends to factor in
perceived and forecasted economic strengthening before it happens, but less
likely to acknowledge economic weakening.
Economy: short term decline over 2015,
medium term growth due to depreciation
The economy
is experiencing below trend growth, rising unemployment and a weak fiscal budget.
This is mainly from drops in commodity prices, lack of reforms and instability
in the political environment, with cuts to public investment, low business
confidence and hence slow credit growth, and falling capex in mining sectors. Generally,
the Australian economy needs to transition from a focus on mining capital
expenditure and high commodity prices towards non mining sector, property
investment and consumption, with stronger government spending on infrastructure.
The main
risks to the economy are derived from the exchange rate, trade weighted index-
including iron ore export prices, employment growth, consumer confidence and
the timing of both fed and state infrastructure investment. The RBA cash rate seems
to be mainly affecting the housing market. Consumption and investment are less
interest sensitive relative to previous cyclical downturns, which plays a role
in the RBA setting the cash rate to its lowest since the 1960s. Therefore I
believe the RBA’s stimulus is missing the big picture of strengthening the
economy’s structural and cyclical weaknesses.
Declining
growth over 2015 is likely however with the depreciation of the Australian
dollar to a forecasted 70-75c mark, it should accelerate growth in the medium
term, especially with regards to export competitiveness. The RBA is likely to use its policies to
target the currency.
GDP growth: 2.4% over 2015 and into
early 2016 from end of mining growth and absence of investment
We forecast GDP to grow at 2.4% over the
remainder of 2015 and early 2016. GDP growth was 2.5% over 2014 to the December
quarter, the second consecutive quarterly contraction. Gross domestic income also
declined 0.2% due to falling terms of trade. Factors driving the slowdowns include
inventory declines and lack of both public and private investment, which
outweighed growth in consumption and net exports. Constrained wage growth meant
reduction in savings to increase consumption. Flat commodity prices and the
delay in transitioning towards non mining private investments due to lack of
business confidence means this underlying trend is set to continue. Mainly
industrial and commercial services would benefit from this GDP growth given the
fed government follows through with infrastructure spending. The financial
sector is being stimulated through low bad debts expenses and increased
productivity, so the GDP growth will help lending growth which is currently
slowed down by low consumer and business confidence related to job security.
Exchange rate: depreciate to 70-75c
due to rate hikes in US and terms of trade decline
Current
depreciation is partially due to the termination of quantitative easing in the
US this year, which slows down the carry trade from US dollar denominated
capital markets to Australia. Carry trade refers to where investors borrow
money at a lower interest rate economy, converting it to a currency in a higher
interest rate country and investing it in the highest rated bonds of that
country. Decline in the terms of trade and general unfavorable growth outlook
will also play a role in depreciation. Nevertheless the depreciation will be at
a lesser extent compared to the Euro and the Yen. Quantitative easing in Europe
and Japan is causing capital to flow towards higher yielding Aussie bonds.
There is also still support for the Australian dollar from Chinese investors,
emphasising on our economy’s wealth profile.
The energy
and transportation sector are most affected by the $A depreciation. Depreciation
increases the $A value of offshore earnings and revenue denominated in $US,
though also increases costs for importers where their cost base depends greatly
on the overseas value chain.
RBA cash rate: drop to 2% in the next
few months to promote depreciation
The current
rate sits at 2.25% though we forecast a cut to 2% in the next few months. Due
to the lack of fiscal stimulus and structural policy inertia, the RBA must step
up to drive the depreciation of the Australian dollar whilst improving
employment and economic growth. The depreciation of the Australian dollar has
been trending for some time however it must fall further according to a trade
weighted perspective against the US dollar. This depreciation would trigger
inflation and GDP growth which reduces the need to maintain such a historically
low cash rate. Industrials, consumer goods, financial and real estate sector
are likely to benefit. Households who have recently been exhibiting low
propensity to consume will increase their consumption. This is also the result
of stimulatory interest rates which ensures low mortgage rates, with wealth
generated from the property price boom. Multiplier effects flow through to all
sectors. A cyclical trajectory forms as unemployment reduces, increasing
earnings for real estate investment trusts.
Unemployment rate: increase to 6.5% due
to discouraged jobseekers, subdued GDP growth and lack of new jobs being
created by the economy
The current
rate of unemployment is 6.3%, unemployment refers to those who have not worked
for more than a month as a proportion of the labor force. We forecast this rate
to increase 0.2% to 6.5%. Whilst in January unemployment rose 0.3% and the 6.3%
in Feb and March was a decline of 0.1%, we expect employment growth to stay
weak parallel to the weak GDP expectations. Participation rate which followed a
declining trend line in 2014 is still being limited by discouraged jobseekers,
implying the real problem is being masked by statistically measured
unemployment. The economy is not creating enough new vacancies to absorb the
number of new entrants into the labor market, plus a strong GDP of 3% pa is
needed to support stronger employment rates. Unemployment would affect all
sectors especially consumer discretionary, as the marginal propensity to spend
is boosted when consumers have job security.
10 year bond yield: increase to 2.65%
from QE in Japan and Europe
This yield
represents the benchmark risk free rate for investor decisions. It is currently
2.48% and we forecast it to increase to 2.65%. Internationally, bond yields are
being slowed by quantitative easing policies from slow economic growth, as
evident in Japan and Europe. This results in capital outflow towards more
attractive bonds (Australia) which will trap such countries in a cycle to lower
their yields further. This will improve
our financial sector as low interest rates make bank equity more appealing due
to dividend yields and earnings growth will accumulate through low lending
rates.
Inflation Rate: increase to 2.5% over
2015 and 3% in 2016 from depreciation and tradeables
The current
rate sits at 1.7% though 12 month forecast is an increase to 2.5%. Headline
inflation fell to 1.7% from 2.3% in the last quarter of 2014. Falling petrol
prices sustain inflation from other areas which is why our inflation forecast still
remains well below 3%. Meanwhile underlying inflation, derived from volatility
movements in commodities such as fuel, was 2.3%, driven by non-tradeables. Tradeables
prices should rise in the next few months and converge with the strong pricing trend
of non-tradeables due to depreciation of the Australian dollar. The
depreciation is not only against the US dollar, the $A is expected to
depreciate against the Chinese Yuan, increasing prices of imports from China,
further generating inflationary pressures. In 2016 we therefore forecast a 3%
inflation rate. Such inflation has both positive and negative impacts on
consumer staples and discretionary- inflation allows cost increases to be
easily passed onto consumers to maintain margins though expenditure is reduced.
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