Thursday, 9 April 2015

Macro Trends April 2015: Forecasts, Rationales, Effects

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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