8 big issues for the Australian economy in 2014 [Rented article of Craig James is chief economist at CommSec.]

The Australian economy struggled to get out of third gear over much of 2013. But we are hopeful that the economy will finally find fourth gear over the 2014 year.

The main culprit holding back the economy in 2013 was the election. Businesses and consumers simply weren’t prepared to ramp up spending, investment and employment until the election was out of the road. But the economy was also in the transition phase with mining investment topping out while home construction and mining exports were just starting to find their feet.

There were also the budget problems in the US with enforced spending cuts serving to slow economic growth. And China struggled to get past issues in the financial system. But by the end of 2013, growth had picked up in the US and China, and it was looking more promising in Europe.

In line with other forecasters such as the International Monetary Fund, we expect that global economic growth will return to near ”normal” around 3.5 per cent in 2014. One of the main risks is central bank tapering or the winding back of stimulus. Take too long to taper and you risk higher inflation. And if you taper too early you may risk de-railing the economic recovery.

In Australia, we expect that home building and mining exports will pick up the baton from mining construction in 2014 to drive economic growth. And with the election out of the road, home prices rising and a better tone in evidence in the global economy, we expect that consumers will open their wallets a little wider while businesses should respond by lifting hiring and investment. Unemployment could prove reasonably stable with upside risks earlier in 2014 giving way to downside risks as 2014 progresses.

One of the main risks domestically is that the Federal Government is too aggressive in tightening budget spending, rather than relying on stronger economic growth to boost government revenues and thus reduce the size of the budget deficit.

If fiscal or budget policy is too tight, the Reserve Bank may provide some offset by cutting interest rates.

But while there is the risk that the Reserve Bank will cut rates one more time in the first half of 2014, in the second half of 2014 the risk will shift to higher interest rates as economic growth returns to normal.

Turning to the Aussie dollar, over 2013 the currency tracked a US17.5 cent range. For 2014, our currency strategists warn about similar volatility and expect a similar range (to 2013) and should see mid-0.9000s and low 0.8000s trade.

The US ‘taper’

There have been numerous column inches devoted to the US ‘taper’, that is the winding back of monetary stimulus or the ‘tapering’ of bond purchases. Everyone is agreed that the Federal Reserve needs to pull back stimulus at some point; the hard part is in working out when is the ‘right’ time to do it.

As the Reserve Bank Governor counsels, the ‘taper’ will lead to short term volatility on financial markets but the longer-term implications are more positive. Sharemarket investors may fret that the days of cheap money (free money?) are coming to an end, but if the Federal Reserve is toying with the idea of taking the foot off the throttle – even just modestly – that signifies that the economy is doing better. And in a better-performing economy, spending grows and businesses invest and hire staff, and that clearly is positive for revenue and profits

Inflation or deflation?

In many parts of the so-called ‘advanced’ world, interest rates are at or near zero. And in the US, Japan and the UK, central banks have gone further to stimulate economies, buying securities from financial institutions in exchange for cash (quantitative easing). But despite all their efforts, inflation rates in many parts of the western world are lower now than a year ago. One exception is Japan where Prime Minister Abe is determined to get the economy going and end the period of deflation so-called Abenomics. And he has achieved some success with consumer prices up 1.1 per cent on a year ago after falling by 0.4 per cent in 2012.

With more money circulating and chasing fewer goods, the assumption is that inflation will follow. To date, it hasn’t really happened.

If inflation starts creeping higher, it’s a positive development, not negative. It means that economic growth is returning. But it also means that central banks need to be vigilant and make sure that a little inflation doesn’t become a lot, necessitating sharply higher interest rates that could actually choke off economic recoveries.

Housing boom or just a ‘normal’ recovery?

Some commentators are looking at the Sydney housing market and concluding that a boom is underway. And the perception is that, as sure as night follows day, if there is a boom, clearly there follows that there will be a bust.

But interestingly the Reserve Bank isn’t worried about a housing boom – not yet anyhow. Still, it is warning investors not to pay over the top and to realise that property prices can go up as well as go down.

It will also be important to watch trends like the number of people in each home. If household size

continues to increase, then the extra supply could actually lead to a marked softening of home prices.

The rebalancing of China

The new Chinese leadership wants the country to more closely emulate western industrialised nations where household spending plays a greater role in driving economic growth. For instance in the latest national accounts in Australia, household consumption accounted for 55 per cent of the economy (GDP or gross domestic product). In China, the available 2012 data indicated that household spending accounted for almost 36 per cent of the economy with the government sector at 13.5 per cent of GDP; investment at 48 per cent of GDP and net exports at almost 3 per cent of GDP.

If consumer spending grows at a faster rate, then Chinese consumers are more likely to feel that they are benefitting from the expansion of the economy. And in terms of social stability, that is an important factor. Further, there is concern that some provinces may be over-investing in the cities, and those concerns are more likely to be dispelled if growth of retail sales exceeds that of production or fixed asset investment.

The reshaping of Australia

Since 2008 the Australian economy has grown by 14.3 per cent. Of that growth, Mining has contributed 3.2 percentage points (pp) of which iron ore alone has added 2.3pp. But not far behind is Health Care (1.7pp), Professional services (1.6pp) and Construction (1.4pp).

At the other end of the scale, Manufacturing has sliced 0.4pp off growth, while Arts, Agriculture, Transport, Education and Utilities all added nothing to Australia¡¦s economic growth.

So it is clear that Australia has been riding on the back of iron ore (as opposed to riding the sheep back in the 1950s). In the coming year Mining will pull back, but there is plenty of scope for other sectors to grow. In the equivalent five year period before 2008, from 2002-2007, the economy grew 19.8 per cent with Finance (3.1pp), Construction (2.6pp) and Health Care (1.4pp) the main contributors to growth.

The drivers of the Australian economy regularly change and indeed they will again over coming years as the mining construction boom fades and mining exports take over. But clearly other sectors will pick up the slack, with Construction – in particular home construction – the most likely candidate.

Aussie dollar to slip or slump?

Over the past 40 calendar years the Aussie dollar has, on average, tracked a range of US13.7 cents a year or 17.1 per cent. Since the dollar floated the range has been US14.3 cents a year or 18.8 per cent. And over 2013 so far the range has been US17.5 cents or 16.9 per cent. In short, the Aussie dollar is volatile and 2013 has been a year of above-average volatility.

Over 2014 our currency strategists expect a similar trading range, with the Aussie likely holding from the low US80s to the mid US90s. Certainly the Reserve Bank Governor has recently indicated that he thought the Australian dollar should be closer to US85 cents, rather than near US90 cents currently.

Much will depend on the recovery path of the US economy and the extent of tapering undertaken by the Federal Reserve.

Will new conservatism continue?

The conservatism of Australian consumers has been one of the big trends of the past five years. Aussies are saving, not spending. They are more likely to leave money in the bank rather than put money to work elsewhere (although more recently investors have become keen on property again).

Consumers will also shop around for bargains. And it hasn¡¦t just been inherent fiscal conservatism but the internet that has driven this tendency together with a relative firm currency. The internet has allowed consumers to do product comparisons and undertake online shopping – not just in Australia and overseas. Of course the high Aussie dollar has opened the world to shoppers, keeping downward pressure on retail prices and margins here in Australia

If the conservatism continues, then this will mean a continuation or more thoughtful spending and reduced debt levels, meaning that inflation remains under control and interest rates stay lower for longer. Retailers will need to keep costs down, together with margins and they will have to compete harder to improve customer service to lift revenues. Because simply, global competition is here to stay, even if the Aussie dollar eases further.

A new glory era for interest rates?

Over 2013, the cash rate has averaged 2.75 per cent. – the lowest calendar year average since 1959. So while people can debate whether rates are at record lows or not, there is no debate about the last time period that rates have been this low – it was 54 years ago, back in 1959.

If inflation remains under control, there is no fundamental need to lift interest rates markedly. But certainly cash rates are close to zero in many western nations, so it is hoped that rates can rise to at least modest nominal levels to give central banks a degree of flexibility in the future, rather than being forced to rely on the new tools like quantitative easing.

Currently the consensus is that the US federal funds rate won¡¦t rise until perhaps 2015. But longer-term rates are tipped to rise across western nations by between 60-70 basis points over 2014 as global economic growth lifts closer to longer-term averages of around 3.5 per cent. The hard part for central banks will be to get the timing right for lifting policy rates.

Main Problems of UK Economy,What are the main problems of the UK current economy situation?

1. Unemployment
2. Low economic growth
3. Government borrowing
4. External Factors

The main problem facing the UK economy at the present time is persistently high unemployment and stagnant economic growth.

The latest graph for economic growth shows the UK in a double dip recession. There are signs that the UK may recover soon, but since 2008 growth has been way below the long run trend rate of growth, leading to a significant loss in potential output.

Low economic growth adversely affects many different economic problems:

• Demand deficient unemployment. The sharp rise in unemployment since 2008 is due to the slowdown in economic growth.
• Fall in real wages. Stagnant economic growth has contributed to a fall in real wages and lower living standards.
• Increased burden of debt / GDP. With falling GDP, it becomes much more difficult for the government to reduce the burden of government debt to GDP. Despite austerity measures, the debt to GDP ratio is forecast to keep rising.

Unemployment

Unemployment is close to double figures (8.5%) – 2.5 million. The official figures also hide some disguised unemployment, (such as enforced part-time work / early retirement) but, unemployment is still a significant problem.

Unemployment is such a pressing economic problem because:

• Increases relative poverty in the UK. (Unemployment benefits are substantially lower than average wages).
• Unemployment is particularly stressful, causing alienation and reduced living standards.
• Social division. Fortunately, unemployment hasn’t increased to southern European levels. But, the experience of southern Europe shows how society can start to fragment under mass unemployment.
• Budgetary cost. Persistently high unemployment adds to the budget deficit. The government have to spend more on benefits, and they receive lower taxes. If unemployment falls, it will be much easier to tackle the budget deficit.
• more on unemployment

Government Debt

In the short term, government debt is less pressing than the government have claimed. Since 2010, they have given indication that reducing debt levels are the most pressing economic problem. Because of debt, the government have pursued austerity leading to lower growth. I feel the government unnecessarily panicked over debt. Nevertheless, long term spending commitments and long-term debt forecasts are a problem. With an ageing population and perhaps lower growth rates, it could be difficult to finance long-term spending commitments from current tax levels. Debt is a long-term problem rather than short-term.

More on UK debt

4. External Factors

Many of the UK problems are due to domestic factors: low spending, low investment, negative output gap. However, because the UK relies on trade with other countries, especially Europe, external factors are a potential problem. The continued recession and economic uncertainty in the Eurozone is having an adverse impact on UK confidence and UK exports. The concern is that if the Eurozone recession continues to deepen, it could have a large drag on the UK economy – making UK recovery difficult. On the plus side, the US economy shows more promising signs.

Lesser Economic Problems

Inflation

Inflation is currently a relatively minor problem because it has fallen to be within the government’s target. However, with rising energy prices, it could resume its upward trend in the coming months. This cost-push inflation is a problem because with low nominal wage growth, many could see a fall in living standards (causing an increase in fuel poverty). Also, savers may be adversely affected because interest rates are low. more on inflation

Current account deficit

The deterioration in the UK current account is a cause for some concern because it is occurring in a recession. Usually a recession leads to lower imports and an improvement in the current account. This deterioration in the current account suggests the UK could have declining international competitiveness, though it may also be a temporary situation related to Eurozone crisis. More oncurrent account deficit

Lack of Infrastructure Investment

The recession has seen a fall in public sector investment. This threatens long-term productivity issues, such as transport bottlenecks.

As well as infrastructure problems, there are also concerns over other supply side problems, such as inflexible labour markets and lack of vocational skills.

Poor Labour Productivity growth

Some of this poor labour productivity growth can be attributed to the recession. But, if this trend of low productivity growth continues, it will harm the capacity for long-term economic growth.

THE FINANCIAL CRISIS OF 2015

Oliver Wyman Group has released a very interesting piece about the potential for a future financial crisis (thanks to the FT).  They make the case that the next great financial crisis will occur around 2015 and will be the result of a massive bubble in commodity markets that results in widespread economic collapse and sovereign defaults.

I’ve described in recent reports how the financialization of the USA is helping to drive commodity prices higher (see here for more) and generate economic instability.   This, combined with the other two major structural imbalances in the global economy (China’s flawed economic policy and the inherently flawed single currency system in Europe) are creating an environment that is ripe for disequilibrium and turmoil.  The potential for bubbles is not only likely, but now appears like a near certainty.

Wyman describes how the bubble will form in commodities and ultimately collapse:

“Based on favorable demographic trends and continued liberalization, the growth story for emerging markets was accepted by almost everyone. However, much of the economic activity in these markets was buoyed by cheap money being pumped into the system by Western central banks. Commodities prices had acted as a sponge to soak up the excess global money supply, and commodities-rich emerging economies such as Brazil and Russia were the main beneficiaries.

High commodities prices created strong incentives for these emerging economies to launch expensive development projects to dig more commodities out of the ground, creating a massive oversupply of  commodities relative to the demand coming from the real economy. In the same way that over-valued property prices in the US had allowed people to go on debt-fueled spending sprees, the governments of  commodities-rich economies started spending beyond their means.  They fell into the familiar trap of borrowing from foreign investors to finance huge development projects justified by unrealistic valuations. Western banks built up large and concentrated loan exposures in these new and exciting growth markets.

The banking M&A market was turned on its head. Banks pursuing high growth strategies, particularly those focussed on lending to the booming commodities-rich economies, started to attract high market valuations and shareholder praise. In the second half of 2012 some of these banks made successful bids for some of the leading European players that had been cut down to a digestible size by the new anti-“too big to fail” regulations. The market was, once again, rewarding the riskiest strategies. Stakeholders and commentators began pressing risk-averse banks to mimic their bolder rivals.

The narrative driving the global commodities bubble assumed a continuation of the increasing demand from China, which had become the largest commodities importer in the world. Any rumors of a slowing Chinese economy sent tremors through global markets. Much now depended on continued demand growth in China and continued appreciation of commodities prices.”

The bubble bursts
Western central banks pumping cheap money into the financial system was seen by many as having the dual purposes of kick-starting Western economies and pressing China to appreciate its currency. Strict capital controls initially enabled the Chinese authorities to resist pressure on their currency. Yet the dramatic rises in commodities prices resulting from loose Western monetary policies eventually caused rampant inflation in China. China was forced to raise interest rates and appreciate its currency to bring inflation under control. The Western central banks had been granted their wish of an appreciating Chinese currency but with the unwanted side effect of a slowing Chinese economy and the reduction in global demand that came with it.

Once the Chinese economy began to slow, investors quickly realized that the demand for commodities was unsustainable. Combined with the massive oversupply that had built up during the boom, this led to a collapse of commodities prices. Having borrowed to finance expensive development projects, the commodities-rich countries in Latin America and Africa and some of the world’s leading mining companies were suddenly the focus of a new debt crisis. In the same way that the sub-prime crisis led to a plethora of half-completed real estate development projects in the US, Ireland and Spain, the commodities crisis of 2013 left many expensive commodity exploration projects unfinished.

Western banks and insurers did not escape the consequences of the commodities crisis. Some, such as the Spanish banks, had built up direct exposure by financing Latin American development projects. Others, such as US insurers, had amassed indirect exposures through investments in infrastructure funds and bank debt. Inflation pressure in the US and UK during the commodities boom had forced the Bank of England and Fed to push through a series of interest rate hikes that forced many Western debtors that had been holding on since the subprime crisis, to finally to default on their debts. With growth in both developed and emerging markets suppressed, the world once again fell into recession.”

Of course, this scenario is already largely playing out in real-time.  We are seeing investors drive up the prices of commodities as the global economy recovers and speculators look for the next big boom.  Wyman elaborates:

“However, it is already apparent that increasing commodities prices are also creating inflationary pressure in China, which is exacerbated by China holding its currency artificially low by effectively pegging it to the  US dollar. This makes commodities look like an attractive hedge against inflation for Chinese investors. The loose monetary policy in developed markets is similarly making commodities look attractive for Western investors. This “commodities rush” is demonstrated in the right-hand chart below, which shows the asset allocations of European and Asian investors. A recent investor survey by Barclays also found that 76% of investors predicted an even bigger inflow into commodities in 2011.”

Ultimately, they conclude that the imploding commodity bubble will lead to another financial crisis and sovereign defaults.  Their “base case” scenario involves mostly European nations experiencing defaults.  This looks not only likely, but probable.  It is likely that the periphery of Europe will remain mired in recession for several years as austerity measures put downward pressure on their economies and the Euro governments fail to enact a true fix to the flawed single currency system. Persistent weakness in Greece and Ireland will cause continual political turmoil and ultimately the scenes of Egypt would not be surprising throughout many parts of Europe as citizens demand real change.  The Euro would likely remain the primary European currency, however, several periphery nations would reconsider their involvement.

Now, where I disagree with the Wyman analysis is in their “worst case” scenario.  Any regular reader knows that it is highly flawed analysis to conclude that the USA could potentially default on its obligations – all of which are denominated in the currency in which it alone has monopoly supply of.  This simple point eludes even some of the brightest minds in economics today.  A default of the USA is impossible.  The only form of default could come through hyperinflation.  Considering the deflationary collapse that would likely result during the Wyman “worst case” scenario I think it’s likely that we would once again see the USA become the global safehaven and the USD would not collapse, but surge as it did in 2008.  Still, the economic impacts would be deeply negative for the entire global economy though a collapse of the USA is not on the table.

We continue to see increasing disequilibrium in the global economy.  The flaws in the Euro, China’s misguided economic policy and the endless financialization of the USA are the three primary factors contributing to what is unavoidable future calamity.  It’s clear that none of these countries are interested in any sort of near-term pain that would be required to fix these structural imbalances so it’s not a stretch to assume that we will continue the boom/bust cycle that has become a trademark of the last 25 years of global economic growth.  The commodity bubble will merely be a symptom of these imbalances.

Wyman concludes that this event could be several years away, however, I fear that this event could easily occur sooner than 2015.  We remain in one continuing balance sheet recession with rippling waves that could cause these imbalances to resurface sooner than anyone believes.  The resulting impacts will be broad and have the potential to forever change the way we approach future economic growth and the way governments intervene in markets.  I would expect the Bernanke Fed to be in the middle of the ensuing storm.  Such a crisis would likely result in wide ranging policy changes that will finally clear the imbalances of the credit crisis and create a foundation for truly sustainable economic prosperity.