Another reasonable month for the share market

One reason why markets again did well was the absence of negative news from (most of) the rest of the world. In particular, nothing bad happened in Europe, and the Spanish and Italian long-bond rates continued to fall, by about half a percentage point over the course of the month to date, thus driving down the borrowing costs for those two beleaguered nations.

In Australia, on the other hand, there were some interesting developments. As I suggested four weeks ago, the RBA passed up the chance to cut the cash rate further. One reason I gave why this might happen was a belief that we may need further cuts more when the mining investment boom ends. “The end of the boom” story gained a lot more currency over the month. BHP Billiton confirmed the mothballing of its Olympic Dam extension project the Resources Minister, Martin Ferguson, pronounced the boom over (later backtracking from these remarks) and the Reserve Bank, in its Statement on Monetary Policy, suggested that mining investment would peak in 2013-14, a year that begins just 10 months from now.

Here is some of what we know. The earnings (both current and prospective) of the resource sector have fallen significantly, although digging stuff out of the ground remains very profitable. The decline in earnings primarily reflects falls in commodity prices, with the prices of iron ore and coking coal both off by about one-third from their peaks. These declines primarily reflect a plateauing in steel production in China, and speculation that production may fall in the future. Commodity prices remain high relative to historical levels, so mining remains profitable.

It should not be a surprise that commodity prices have fallen from their peak it happens eventually in every boom. When commodity prices rise sharply, supply and demand both tend to respond, and users look for substitutes or alternative sources of supply. The real surprise on this occasion is that it has taken so long for this to happen. In past episodes, the decline in prices has been precipitous far sharper than the consensus view on this occasion.

Mining investment is very strong and will get stronger. It constitutes about 4% of GDP, which is an all-time high share, and is higher than in any other developed country in the world. Almost no matter what, this share will continue to increase. There is a massive pipeline of projects, of varying degrees of commitment. Some of these would have been planned on the assumption of higher prices than now prevail, and hence are vulnerable to postponement or cancellation. But it is difficult to see this happening widely and quickly enough to prevent further substantial growth in capital spending for some time to come. There will, incidentally, be no single peak in mining investment while spending associated with coal and iron ore projects could turn fairly quickly, spending on LNG projects will continue to grow for several years.

The slackening of the mining boom has several implications for Australia. First, as I wrote two months ago, the increase in our terms of trade in recent years provided a handy offset to a decline in productivity growth. On a per capita basis, incomes in Australia were more than $6000 higher in 2011 that they would have been if the terms of trade had not risen in the previous decade. Going forward, we won’t have that bonus rising living standards are going to require that we work harder or smarter!

Second, when mining investment does eventually stop going up, Australia will lose the source of more than a quarter of its growth. Either this will have to be replaced by something else (resource exports and investment elsewhere in the economy are the obvious candidates), or we will experience a significant slowdown.

Third, and least important, the wafer-thin Budget surplus projected for 2012/13 almost certainly won’t happen. The Budget is extremely sensitive to commodity prices, and not just because of the resource rent tax. Failure to deliver the surplus is of no economic consequence.

Fourth, the end of the resource boom almost certainly will take care of one of Australia’s other “problems” right now, the continued strong exchange rate. The currency has risen by 8 cents in the past seven weeks, standing at 1.043 US dollars at time of writing.

The Strong Australian Dollar. Will it Ever Fall?

In early-August, the Reserve Bank noted that the strong currency was probably having more effect on some areas of the economy than it thought likely earlier. Why is it so strong?

We keep coming up with reasons for the strong dollar, and the reasons keep faltering while the currency does not. We were told the currency was held up by strong commodity prices they fell away but the currency did not. Then it was the fact that interest rates were so much higher in Australia than elsewhere, thus attracting capital. We cut rates and thus narrowed this differential but the currency remained robust. The explanation du jour is continued foreign buying of Australian assets, particularly long-term Government bonds. With a long-term rate of 3.25%, Australian government bonds are the highest-returning AAA-rated securities in the world, so it’s no surprise they are attractive to foreigners. The share of Commonwealth government securities held by offshore interests has doubled in the past 10 years, and now stands close to 80%.

Sooner or later, this share will stop going up, and then a source of support for the $A will be removed. Everything points to a lower dollar eventually but, to be honest, I have had that view for more than two years and it is yet to pan out.

The question has been raised as to whether the Reserve Bank is likely to intervene to drive the currency down. It has intervened in the past on a few occasions, always to hold the currency up. That is, it has sold foreign currencies and bought the Australian dollar. Such intervention has usually been profitable, with the Reserve Bank subsequently replenishing its holding of foreign exchange at a lower price. Selling the Australian dollar to drive it down may work, but it’s not a one-way bet.

Right now, the Swiss monetary authorities are intervening to hold the Swiss franc down, with some success. Why can’t we follow their example?

There are some very good reasons not to do so. First, the Swiss can’t cut interest rates to weaken the currency since their cash rate is already zero. We can. Second, Switzerland is currently experiencing deflation, so a bit of inflation as a result of a lower-than-otherwise franc would actually be desirable. And third, the Swiss national bank has massively expanded its balance sheet to accommodate its purchases of foreign exchange (including, ironically, the $A), to an extent that we simply wouldn’t (and shouldn’t) contemplate in Australia. As Governor Stevens said in his semi-annual testimony to the House of Representatives Standing Committee on Economics, Switzerland’s foreign exchange reserves total about 70% of one year’s GDP. This figure is less than 4% in Australia. Undertaking intervention on anything approaching the scale used in Switzerland would expose the Australian taxpayer to massive risk.

If the Reserve Bank really does want a significantly lower dollar, then the first thing for it to do would be simply to cut interest rates further. The fact that it hasn’t done so in the past two months suggests that, while some sectors are clearly being hurt by the currency, the Bank judges the current level of rates to be “correct” for the state of the economy as a whole. This may, of course, change in the future.

Incidentally, while I claim no great expertise in being able to forecast the currency, I can perhaps give you a short-term outlook. My wife and I are travelling overseas this coming Monday (27 August). The last time that we ventured offshore, the currency dropped by 14 cents in three and a half weeks. If that happens again, don’t say that I didn’t warn you.

The Bottom Line

In early-July I somewhat reluctantly cut my end-year forecast for the ASX200 from 4700 to 4500. There is no further change this month.

Chris Caton
Chief Economist

The views expressed in this article are the author’s alone. They should not be otherwise attributed.