26 years and no recession – what might go wrong

Wed, 28 Feb 2018  |  

This article first appeared on the FIIG website at this link: https://thewire.fiig.com.au/article/commentary/opinion/2018/02/25/26-years-and-no-recession-what-might-go-wrong 

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26 years and no recession – what might go wrong

 Australians should be justifiably proud of the fact that the last recession in Australia ended in the June quarter 1991, over 26 years ago. This means around half the current workforce has never had to deal with the pain and suffering – both financial and emotional – that a recession delivers.

While the economy is hardly on fire at the moment, it is pretty safe to say there is no material threat of a recession. Indeed, there are few identifiable issues that can be seen as genuine triggers for what some are suggesting is a long overdue recession.

As 2018 kicks off, business investment is rapidly recovering from the mining sector imposed slump and public sector spending is strong. These items alone will provide a foundation for the economy for the next year or two, also supported by the export sector, which should perform well following steady growth in the global economy. Despite moderate growth in household spending due to weak wages growth and high levels of household debt, it is still expanding and adding to bottom line GDP. In other words, it is not falling and offsetting the positive news in business investment and public spending.

For a recession to emerge as a material threat, household consumption has to fall, or business investment and public infrastructure spending has to reverse sharply, neither of which are currently on the radar.

Forecasting a recession is easy

Forecasting recessions is easy and many people seem to make a living out of it.

Such forecasts are usually designed to grab headlines, but most times they are unhelpful as well as being wide of the mark. There is a favourite saying amongst sensible economists that the economist extremists have forecast eight of the last two recessions. This means that recessions are indeed rare and when one is close to unfolding, they are sometimes headed off by policy makers who react to the looming economic storm by adjusting policy.

Witness the response from the RBA and government when the global financial crisis was unfolding in 2008 and 2009.

To be sure - Australia will have a recession one day, but it will not be soon. Nonetheless, identifying the likely causes of that next recession is useful if for no other reason than to set the framework against one occurring. It is a bit like getting the tyres and brakes on a car checked – not that you’re likely to crash, but to reduce the risks, check the wear and tear on the tyres and the brake pads.

There are a few issues that might contribute to the next recession when it eventually comes along:

Housing

Australians are highly exposed to housing. This is because they have unprecedented debt levels used in large part to buy a house to live in. Add to that are the negative gearing tax laws that have created a market distortion that encourages large scale borrowing by individuals to buy an investment property.

While interest rates and the unemployment rate are low, and house prices are not falling, most householders will have little trouble meeting their debt servicing obligations. In saying this, the RBA continues to highlight that the level of bad debts and loan arrears – household financial stress in other words – is hovering near historical lows.

The RBA also implied that this high debt exposure and acute sensitivity to interest rate changes means that any monetary policy tightening cycle will be moderate and protracted. So, an extreme monetary tightening episode, which would risk a housing slump, is very unlikely. Significant interest rate rises would only occur if the economy is strong. More problematic is the threat to housing from higher unemployment. After all, it is hard to maintain mortgage payments if you don’t have a job.

The low-ish 5.5 per cent unemployment rate is some way from signalling a risk to housing. But if, for whatever reason, the unemployment rate was to edge up to 6.5 per cent or more, the risks of a severe housing downturn would increase.
Related to this is the basic issue of supply and demand. Like all other markets, housing is subject to the basic laws of demand driven predominantly from population growth, and supply driven by new construction.

This is a more ‘live’ risk in the scenario of a severe housing decline. If new supply is created by strong building activity and if immigration was to weaken, which would undermine housing demand, prices would then fall. We know that the level of new dwelling construction has been tracking at near record highs and much of this new supply has been absorbed by the additional population, which is still growing rapidly. Cuts to immigration would increase the risk of a decline in housing.

China

As a market for close to 30 per cent of Australia’s exports, China is vital to our economy. There is no doubt that an important part of the current “26 years and no recession” aspect of the Australian economy is due to the huge growth in Chinese demand for our exports, both in terms of the volumes purchased and the price paid. Suffice to say, any serious disruption to the Chinese economy would be felt quite starkly in Australia, risking a recession.

While China at the moment has some policy challenges with an investment overhang and high levels of debt for many state owned enterprises, the expansion continues. The internal risks to Chinese growth are being addressed with policy reform by the authorities in a careful and measured way. Only if these policies fail will Chinese economic conditions deteriorate to a point that undermines the Australian economy.

Proof that the Chinese economy is negotiating these challenges is the solid level of commodity prices, especially for iron ore, coal and copper. Prices would be materially lower if the Chinese economy was experiencing weaker activity. The risks to the Chinese economy therefore appear linked to geopolitical issues that are impossible to fully anticipate. One issue is perhaps an elevated trade war with the US that could emerge while President Trump remains in office. Upheaval in North Korea is another? But this is mere speculation.

Whatever the factors that are driving the Chinese economy, it would be wise for Australian investors and policy makers to pay close attention to economic and political trends in China, just in case something goes wrong.

Policy error

Recessions can be triggered by policy errors. For example, the RBA hiking interest rates too much, the government implements a confidence sapping tax measure or does something to damage the budget and sovereign credit rating.
It has happened before. Like other risks, it appears that the pragmatism and common sense approach of those pulling the policy levers, make a policy mistake driven recession very unlikely. The RBA will not over extend interest rates to levels likely to induce a recession as it keeps an eagle eye on inflation, house prices, household debt, the Australian dollar and the business environment. To be sure, the RBA could be slow to recognise an emerging problem, but as we saw in the lead up to the global financial crisis, it slashed interest rates to protect the economy when the economy looked to be stalling.

Treasury understood the lessons of the fiscal stimulus measures implemented during the GFC. Its success helped to keep Australia out of recession. If it did look like a recession was looming, Treasury would search for some fiscal stimulus to warn off that prospect.

A black swan

In economics, ‘black swans’ are events that no one can realistically anticipate. They are a surprise that has significant effects on the economy and financial markets. They are often linked to a commodity price shock or a policy change that has unintended consequences, pushing markets into free fall. They can be a geopolitical event such as a major conflict, a climate event or even societal unrest.

By their nature, it is impossible to anticipate one of these coming along and driving the next recession.

Recessions impact financial markets

The market effects of a recession are well established. Falling GDP, sharply rising unemployment and usually disinflation pressures tend to crunch business profits, increase bad debt and defaults, threaten bank failures and usually see a tightening in credit. As a result, interest rates and share prices fall and foreign exchange markets show extreme volatility.

Never say never, but not now

Australia will one day have another recession, but it won’t be in the next year or two. There is too much upside in the outlook for business investment, public sector spending and exports to contemplate a severe downturn. While weak wages growth will dampen consumer spending for another year or two, it is not going to go into reverse and offset the stronger points in the economy.

House prices however, do remain a threat to the economy. But with demographics helping to support any oversupply and possible structural weakness in prices, there is the added advantage that the RBA can ride to the rescue if the price falls threaten the big picture view of the economy - its impact appears moderate.

So, get set for 27, 28 and maybe even 29 years and no recession for Australia. Be warned though, some economists will try to scare the daylights out of people suggesting one is just around the corner.

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Don’t fall for the spin - Scott Morrison’s budget surplus is no certainty

Thu, 06 Dec 2018

This article first appeared on the Yahoo Finance web site at this link: https://au.finance.yahoo.com/news/dont-fall-spin-scott-morrisons-budget-surplus-no-certainty-224422761.html 

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Don’t fall for the spin - Scott Morrison’s budget surplus is no certainty

Prime Minister Scott Morrison could yet be guilty of prematurely declaring that his government will deliver a budget surplus in 2018-19.

Sure, tax revenue is growing at a rapid pace and the government is underspending on a range of government services, but there are still seven long months to go between now and the end of the financial year that might yet blow up the surplus commitment.

PM Morrison’s ‘return to surplus’ boast is based, it appears, on hard data for the first four months of the 2018-19 financial year on revenue and spending information from the Department of Finance. These numbers do look strong, at least in terms of the budget numbers and if the trends on revenue and spending continue, the budget will probably be in surplus. Treasury will be factoring in ongoing economic growth, no increase in the unemployment rate and buoyant iron ore and coal prices over the remainder of the financial year. These forecasts and hence the budget bottom line are subject to a good deal of uncertainty, as they are every year.

If, as is distinctly possible, the economy stalls in the March and June quarters 2019, commodity prices continue to weaken and if there are some unexpected increases in government spending, the current erroneous forecasts for revenue and spending could leave the budget in deficit.

Change of view on monetary policy

Wed, 05 Dec 2018

In the wake of the September quarter national accounts, and with accumulating information on house prices, dwelling investment, the global economy and spare capacity in the labour market, I have revised my outlook for official interest rates.

For some time, I have been expecting the RBA to cut the official cash rate to 1.0 per cent, a forecast that has been wrong (clearly) given its decision to leave rates steady right through 2018.

That said, it has been a highly profitable call with the market pricing interest rate hikes when the call was made which has yielded a decent return as time has passed.

My updated profile for RBA rates is:

May 2019 – 25bp cut to 1.25%
August 2019 – 25bp cut to 1.00%
November 2019 – 25bp cut to 0.75%

The risk is for rates to 0.5% in very late 2019 or in 2020

It will be driven by:

  • Underlying inflation remaining below 2%
  • GDP growth around 0.25 to 0.5% per quarter in 2019
  • Annual wages growth stuck at 2.5% or less
  • Global growth slowing towards 3%
  • Labour market under-utilisation around 13 to 13.5%

There are likely to be other influences, but these are the main ones.

AUD, as a result, looks set to drop to 0.6000 – 0.6500 range.