PORTFOLIO POINT: The real economic picture shows Australia’s macro-economic policy settings are positioning the economy for solid growth over the next 12-18 months.
On Friday I suggested that investors stay out of the domestic stockmarket for a bit until this country sorts itself out.
At the very least there doesn’t appear to be a lot of urgency for those looking to make a domestic portfolio change, or those considering an underweight cash position. We’re going through another bout of needless pessimism, and until that subsides a bit I think there are better opportunities on equities elsewhere. Another way of thinking about it is that after the hard run we’ve had here, and given the current domestic mood, I’m less concerned about missing any renewed upswing in the Aussie market than I am in global markets. Australia will most likely lag again (assuming the fiscal cliff comes to nothing).
So I want to take a longer-term view this week and address one of the key concerns in the domestic market. This is the idea that domestic macro-economic policy settings are not that stimulatory despite recent rate cuts, nor supportive of earnings growth. Table 1 is the key.
You’ve probably read the stories, but there are fears about the size of Australia’s fiscal contraction in 2012-13. Table 1 shows that on paper, it’s one of the largest around with a ‘locked in’ contraction of about 3% of GDP in that year. That is, private demand would have to rise by 3% just for Australian GDP to record no growth in fiscal 2012-13. That’s now! Only if the US goes over the cliff would you see a larger contraction of 3.3%.
Unfortunately, this idea gained significant traction following last week’s GDP figures. They showed public demand fell by 2% in the quarter, which is the largest fall since the GFC. Both public consumption and investment fell, although the fall in investment was particularly sharp, down some 8%. So far this all fits in with the idea of a significant fiscal contraction underway.
This isn’t the case though. First up, that fall in public spending was largely driven by one-offs – or lumpy, volatile items. Defence spending in particular dropped 50% in the quarter, and without that public demand would only be off 0.7% for the quarter instead of the 2% reported. GDP itself would have been a strong 0.8% for the quarter instead of the 0.5% recorded. This, by the way, is one of many reasons why I have argued that underlying GDP is probably still running above trend as we know that defence spending isn’t being cut at all. So this is just an issue of expenditure timing.
The bigger issue more broadly is that government budgets at both the national and state level reveal that spending actually isn’t being cut. At best, spending will be held steady in the 2012-13 year, of which we are half-way through, before accelerating quite sharply in the second half of 2013 for the 2013-14 fiscal year ( 5% at this stage).
Is the fact that spending is being held steady over the remainder of this year a problem? No, and there are two reason for this.
Firstly, unlike the GFC there is no void to fill. During the GFC private demand fell, and public spending had to offset it. In contrast, private demand is incredibly strong in Australia now, rising by an average 1.5% per quarter (or 6% annualised) over the last two years – when the cash rate was 125 basis points to 175bp higher! Half of this is private consumption – the rest investment. Quite frankly the economy doesn’t need increased public demand expenditure with private demand so strong, and realistically a prudent government would not be increasing spending. They would be cutting and already be in surplus given the strength of private demand.
Secondly, and perhaps more to the point, it’s highly unlikely that government spending will end up being this constrained anyway – and there are two key points in this regard.
Consider that on a cash basis, the government expects to cut spending by $7 billion over the next year. If it succeeds in doing this it will be the first time in the modern economic era that it has been done. Quite frankly, I don’t think that’s really going to happen, especially in an election year. Whatever your politics the reality is this government has a tough task ahead of it to stay in power, which makes it highly unlikely it will conduct unpopular spending cuts. I mean it hasn’t done it to date has it, so why would it start now?
In any case, on an accruals basis, the government isn’t even forecasting a reduction in spending for the year. It forecasts it to rise 0.5%. For interest, a cut in expenses on this basis has only been achieved once since 1997 and that was in 1998-99 when the accruals basis was introduced, so I’m sure there were some measurement issues there.
The last thing we need to consider is spending estimates nearly always overshoot. Take a look at the chart below – it shows that in recent times at least, spending has always come in higher than initially projected.
Each line in the chart represents a fiscal year. So the chart covers fiscal year 2001-02 to fiscal year 2011-12. The bottom axis shows the relevant budget estimates. So, for the latest fiscal year of 2011-12 (the top black solid line), there are five estimates, the first of which was made in the 2008-09 budget and the final 2012 outcome. The thing to note is that each line is higher than the next and that each line is upward sloping. This tells us two things at a glance – that each year spending is more than the previous one and also that spending estimates for any one year get progressively higher in each budget.
That is, except in the current fiscal year of 2012-13. Estimates have been generally flat from the first estimate. The chart above shows why this is unlikely to be achieved – especially with the terms of trade now falling.
It’s in that sense that the 3% cash rate can’t be said to be offsetting the contractionary influence of fiscal policy. Fiscal policy isn’t contractionary, and it is highly likely as I have shown above that spending estimates for this next year represent a significant undershoot.
Consequently, readers need not worry about how accommodative policy settings are. Despite what you may read, and while I may disagree with the need, the fact is policy is extraordinarily accommodative and this will support GDP and earnings growth over the medium term.
Take a look at chart 3 above. It is often stated that the cash rate at 3% is not that stimulatory because banks haven’t passed on rate cuts in full. Consequently it is argued that bank lending rates are only a little below the average and so not that stimulatory. This is not true. Excluding the GFC (as an extreme event) you have to go back to the late 1960s to see variable or fixed home lending rates as low.
This is critical as our monetary policy transmission mechanism is not impaired through either housing investment excess or heavily indebted consumers. As I have demonstrated previously, confidence is the only problem in our market. There are no structural issues impeding monetary policy.
As an aside, it’s not really even the case that the strong Australian dollar is hurting growth too much. Its impact is overstated. I mean, think about it. A strong currency doesn’t dampen consumer spending (almost two-thirds of the economy). If anything, it actually acts to increase it as imports become cheaper. Don’t forget that we import the majority of consumer goods items that we consume. Similarly, a strong currency doesn’t negatively impact business investment or housing construction. In fact, according to tourism experts, it is not even the primary factor that influences people to travel abroad. Consumer wealth and cheap flights, or competition in the airline space, is a much bigger factor here. The truth is the contractionary influence of the exchange rate is very minor for a country like Australia. The biggest impact is that it’s dampening inflation. Take that away and we are in big trouble.
So you can see that, despite claims to the contrary, macro-economic policy is actually very stimulatory, providing significant ongoing support to earnings growth over the next 12-18 months.