National Australia Bank chief economist Alan Oster and Goldman Sachs chief economist Tim Toohey tell Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz:
The Reserve Bank seems to have started to step back from the idea of the smooth transition from mining investments as a main economic driver, while political will to support the transition is lacking.
Alan Kohler: Gentlemen, thanks for joining us.
Alan Oster: Thank you.
Tim Toohey: Thank you.
AK: Well look, Tim, perhaps we’ll start with you. The market is off and running, as we speak, there's been ten days in a row of rises. I can’t even remember when I’ve seen ten consecutive gains. That’s unbelievable really. So, the question I guess is, is the market right? I suppose it’s always right in the short term, but is it right to be so positive?
TT: Well, I think what the market is doing is compressing risk premium – its the idea that things are not as bad as the way that people perceive things may have worked out at the very end of last year. So, I think we’d all accept there have been marginal increases in the growth view formally from the economics world and the earnings are actually still uniformly still basically in negative momentum.
AK: But it’s a reduction in risk premium…
TT: Perceived risk.
AK: …perceived risk, that’s taking place.
TT: Correct. There are two things. There’s that and there’s also what that has brought about: money shifting through asset classes back into equities. Now I think just about every strategist on the planet articulated that equities would probably be the most favourable asset class in 2013. I think we've all probably been surprised by the strength of the rally to date. But I think what is also pretty clear is that it’s not necessarily all coming from bonds. It’s largely coming from cash. I mean the fund flow into bonds has actually just been almost as strong as what we’re seeing into equities.
So, you know, the bond market is taking a bit of a different view. Equity markets like to think they get it right on the way up in terms of recoveries and they’re certainly placing their chips on that at the moment. I guess what we’re just a little bit cautious on, from our local perspective, is that of course the earnings have to follow and support the rally at some point and the data just hasn’t been supporting that.
AK: And Alan, that comes down to growth – both here and globally. Is growth beginning to surprise on the upside now?
AO: It probably is in China and it’s probably not anywhere else.
AK: Including Australia?
AO: I think Australia is going to surprise on the downside just to some extent. I think what’s happened is in a lot of ways is that people were really worried about Europe blowing up. They were really worried about the fiscal cliff. They were really worried that China was going to have a hard landing. You take those things away, at least temporarily for the US one, then you basically say 'well hang on the world’s not as bad as I factored in, so let’s move somewhere else'.
The only issue that I sort of have is when we actually get the hard data for the back end of last year, I think people are going to be really surprised. You have clearly got negative growth in Europe. You’ve already had negative growth in the UK. The Japanese have changed the government and have got a big stimulus package, not lifted because the economy did really well. So, the only one that’s really doing well is China and you’re starting to see things a little bit better through Asia. So, we’ve sort of got our growth numbers are about 3.3. The long-term average is about 3.8, 3.9. And as we go forward we think 3.9 next year. But I think really it’s more a case of 'the risk that I was worried about is maybe not there, so maybe I’ve got too much in cash and I’ll move it somewhere else temporarily'.
RG: When you have a market rise of this magnitude and you have interest rates falling – I’m talking about Australia now, the way they have fallen here – it usually takes a year, eighteen months before you see a big rise or a response in the business and consumer activity. I wonder if both of you are looking at the current situation and saying 'well that’s where it is now', whereas the market is looking at something much further ahead, and it was still vaguely self-fulfilling.
TT: I’d probably answer that in two ways. One is that we’re actually quite constructive on what happens to markets going forward, so we’re not actually that negative. We do think that as a non-mining economy you get some traction. The market will continue to factor that in. In every incremental positive news point that you get we’ll support that.
But the core point is that we’ve been trying to ease policy of broader financial conditions since November of the prior year. We got a little bit of traction into the back end of last year in terms of broader financial conditions starting to loosen up and that’s obviously supportive, but is it enough to offset what’s come in in terms of the mining drag that we know is there – the fiscal drag that’s clearly in place at the moment?
And I think, as what Alan was alluding to, since the start of December every data point with the exception of building approvals has come in below expectations and it’s been a really, really dry period weatherwise. Normally when it’s dry, you get positive data surprises. So, the data is probably worse than it actually looks. So I think Alan’s right. I mean, Q4 GDP could be something more like 2.5 per cent year-on-year. So, that’s quite a slowdown from where we were only two quarters before.
AO: We are quite worried that we think the economy has hit a really soft patch. Now, we’re not saying it’s going backwards, but we’re saying it’s really weak. So, you know, you look at the data, we’re just saying the data’s weak.
AK: Sure. It loses confidence. It builds business confidence data. This week showed a big spike.
AO: Yeah. It was really good. And what was interesting about it is that it was everywhere. So, you know, it was the biggest increase in a month since September 2011, but it still got you back to levels of confidence that are below average. It’s just that you were in the worst numbers. But what really worried me about the survey – and I know there’s been a lot of spin about, you know, the big jump in confidence – but what really worried me was not only is the actual data for now looking awful, but the forward orders – you know, capital expenditure plans, demand for credit – is the lowest we’ve ever had in that survey. And you’re sitting in a bank, what you see is you don’t see anybody going out and borrowing as a result of the cutting rates.
People are still nervous, so it will take time. And going back to your original question, monetary policy lags are always twelve to eighteen months and I think they’re probably longer now because until you convince people that things are okay, they’re not going to go out and borrow. In fact, you look at business creditors, they're probably negative over the last twelve months and certainly negative in the last few months. Credit cards are going backwards and we think Christmas was bad. So, I don’t see any stimulus at all coming out of what they’ve already done.
Stephen Bartholomeusz: To go back to the markets for a minute, Tim referred to this continuing flow of funds into bonds. There’s been a lot of talk about there being a bubble in bonds, a credit bubble, which might end when the QE3 or whatever it is program in the States finally looks like it’s going to end. How likely is it is there to be an absolute implosion and what would be the flow-on effects be for us, if any?
TT: Well, I think the absolute implosion would have to come on the back of two things: the end of QE and much higher inflation expectations. And not just in parts of Asia – which is more likely where we’ll see inflation, by the way, and it’s probably one thing that could dampen this enthusiasm the market actually has at the moment.
But just bear in mind what you’re actually saying. I mean we’ve got a situation where it’s more likely than not that Europe actually continues to provide additional quantitative easing. The world has come to the realisation that the Bank of Japan is a bit of a game changer. You know, the extent of the monetary easing that they’re going to implement on the world this year is still unclear, but everyone’s ratcheting higher their expectations and even in the US it’s more of a gradual tapering of what is a very large program.
So, the idea that we have still rampant excess capacity in the developed world, still weak growth forecasts as well as actions in the developed world tells us that we’re probably not going to see too much of the inflation breakout in the developed world. So we’re not that concerned that there’s going to be a fundamental re-evaluation of where how bonds can break out dramatically to the upside. But yes, we think it’s going to be the worst of the asset classes to be involved, you know, in the next twelve to eighteen months as people gradually rotate out.
So to get the cataclysmic bubble type effect, I think you’d need to see, as I say, much higher inflation and, you know, much sooner into QE. It's not impossible, so certainly we don’t want to be doubling the bet on the market.
AK: But particularly their bond markets and stock markets. They do tend to move in jumps. I mean, like in 1994 when the bond market did crash, it seemed to come from nowhere.
TT: Correct. But what's the order of magnitude? Are we talking, US Treasuries going into 3.5 per cent or what are we talking? I mean, you know, we do think it will definitely happen and build its own momentum, but again if we’re looking at very sluggish growth, until we see a much more positive catalyst there, I think you probably can’t get too negative.
SB: So, if you have sustained loose monetary policy in most of the major developed economies and you have unconventional measures being used, that flows through into currencies as well.
SB: So, does that mean that we, looking forward for the foreseeable future, are going to have a hard currency because everyone else is trying to soften theirs?
TT: Well, this is the additional complication for monetary policy, right? I mean if you’re sitting there at the Reserve Bank and you’re saying 'look data’s been weak and we know it’s weak', you know that there is a limited timeframe for when investment rolls down and you’ve seen the Bank of Japan move to this new framework, you would be nervous about the currency going up into a weakening economy.
And I think that would be fairly unconventional for the Reserve Bank to work in anticipation of a currency movement, but at the same time, we’ll just have to start to factoring it into our thinking. I mean the worst thing we could do is actually implement policy, think we’ve got some traction coming through.
You know, basically the equity market being a little bit higher, it’s not transforming through into business conditions, – orders, investment, employment. In fact, the employment indicators have softened dramatically. Just look at the number of people filing for Newstart applications at the moment. It’s starting to break out, which is a pretty good real measure. Tt’s got of persistence in it, that series. So, the economy is actually weaker. One thing you could do is say 'okay the equity market’s higher, fantastic that means we’ve done enough'. I think that’s one of the biggest mistakes you could make.
AK: What do you think is going to happen to rates?
AO: We’ve got three cuts issued and the reason for that is we think you’ve got a very soft economy. Unemployment will start to go up. I don’t see the currency coming down any time soon because there are so many European central banks who don’t want to hold pure euro. And they’re bigger than us. And on the currency the other thing I think is important is I don’t think the currency is radically out of line.
But we’ve got models that are similar to the Reserve Bank and they say $US101 plus or minus five, okay, but you’re at the top end of the range. You’re going to stay there, but people no longer believe it’s going to eighty cents. So, what you do is you close down your business, you become an importer or you just give up.
And so, I think they’re really important factors and I don’t think monetary policy helps you that much, so our view would be sometime in the next couple of months they have to do a cut, then they’ll sit back and say we’ve done enough, but unemployment pushing up around 5.6, 5.7 towards 6 will mean they’d have to come in and do it again. Because I just don’t really see fiscal policy being loosened to help.
Robert Gottliebsen: Do you agree with that?
TT: Yeah. I think it’s one of those strange events over the last fifteen years where Alan and I are on exactly the same page.
RG: Never happened.
TT: No, I don’t think it actually has. So, I mean I know it’s in a very unpopular call at the moment and I think a lot of people believe that most of the Reserve Bank are actually on holiday, but we’re still of the view they will cut in February. And that’s in the face of, you know, very strong 'risk on' sentiment. Again it’s more that they have a pretty strong view of, you know, this foot race between getting non-mining up and when mining tips over, what are the associated weights that you’re putting on those two factors?
And I think the point that I would make is the consensus view of growth of around about two and three quarters actually would imply non-mining growth getting up to, you know, basically from 0.6 per cent year-on-year at the moment, the way we calculate it, to over 4 per cent real growth by the end of the year. When you think about that, that’s a pretty strong recovery that you’ve actually got baked in implicit or explicit in that consensus forecast and, you know, where we’re sitting at the moment the signs of life that we can see at the moment just aren’t big enough to generate that type of momentum into this calendar year.
AO: Yeah. And when we look at breaking up our surveys we see that okay, mining is now back to net balance about zero and that was back to trend, but it was plus thirty not long ago and what we’re still seeing and particularly in thermal coal is, you know, there are large chunks of Australian thermal coal that we export we’re currently exporting at a loss and so that has a ramification.
Just because the iron ore price has gone back up is not going to fire up a hell of a lot more investment. In fact, you’re going to see more cutting and we look at things like mining services which is really strong. And you might be a really good operator, but if you’re operating and providing services to a mine that’s about to go bust, you’ve got a problem.
And then we look at construction and we think construction of new houses is at the worst level since the GST came in in 2000. So, there are some seriously bad parts of the Australian economy. Now, again there are some seriously good parts; health and services, et cetera. But net, you know, we get quite nervous about what we’re seeing when we don’t see any stimulus coming through.
RG: Let’s go forward a year or two. How serious will the fall in mining construction be to this country?
AO: If you’re talking about GDP, practically nothing because what you’re doing is you’re going from an investment phase to an export phase, okay. But the problem you’ve got is that roughly four people to build a mine, one person to run it and in LNG it’s more like eight to one, so you get a situation where from GDP it’s going to look really good. It’s going to look like three. Domestic demand is going to look like one. And that’s going to push for us unemployment up to around six.
TT: Yeah. We’ve got a slightly different view on that. The way that we do it is that we model out all the individual projects and we’ve done this for a long period of time – and what’s very clear to us is that there’s no smooth handover from investment peaking to output to exports. It obviously comes in. You know, for things like coal and iron ore it’s a bit more of a linear transformation. The rate of growth and export volumes that the companies are expecting, the analysts are expecting and indeed we as economists are expecting is fairly linear, so there’s no huge step change.
The big step change comes with LNG, in that LNG exports only start ramping up from the back up of calendar 2015. There’s this 18-month handover that is bumpy and I think the Reserve Bank has started to step back from the idea of the smooth transition.
AK: So, you think the transition’s going to be messier?
TT: Well, it just needs support. Obviously in any other normal environment you’d probably be expecting different arms of policy to be working with a pretty clear objective to try and fill a hole. I think the Reserve Bank now sees the hole. I’m not sure that, given the political environment we have, there is a burning need or desire to find a way to put an appropriate level of projects in place at the right time. I think we’ll end up getting there, but whether it actually is going to be implemented at the right time – which is pretty much now; you’d want to be starting to implement these projects now – is going to be really interesting.
RG: Can I suggest the possibility of a second hole? And that is the enormous increase in energy, gas and oil, being produced in the US and in the Middle East by Iraq. Leaving aside whether the US exports its LNG or not, just put that aside and just say 'hey there’s a huge rise in energy production'. Is that likely, do you think to lower, the prices of LNG and coal?
AO: If you look at the LNGs – the long-term contracts they’ve signed apparently – they’ve actually got a price in there. The problem you’re going to have is you’ve got a contract price there and you’ve got an actual spot price there. At some stage there’s going to be some sort of issue. The other thing I’d say is that the thing you were worried about is already here in thermal coal.
RG: Oh, yes. That’s true.
AO: Okay. So...
RG: Or maybe it could get worse.
AO: And it’s going to continue to be like that. So I think we export something like seven hundred million tonnes of coal, thermal coal and at least a hundred million of that is basically making a loss at present.
TT: I’d make the distinction between – this might be a classic economist comment – but between what it’ll mean for GDP, economic growth as we measure it, and what it will mean for national income. And the two are very different things under that environment. On the ore environment where the price collapse, you know, that all happened… the impact actually on measured GDP because it was the output, and the output is what will occur regardless. That volume will arrive regardless. But from a national income perspective obviously if you get this breakage between the oil linkage and LNG prices...
RG: You mean tax revenue, don’t you?
RG: That means in the ultimate.
TT: Well, I mean without doubt that’s why the governments dearly wanted these projects. I mean if you actually looked at the economic benefit of them, as Alan said, of the big seven LNG projects, there are about 78,000 jobs that we could get. In total mining we can only find about – this is from the company announcements – we could only find about 35,000 to 38,000 in the LNG sector during the construction phase and we could only identify about 3,000 during the operational phase. So these projects are probably the least employment intensive projects on the face of the earth. So it’s not about job creation. It’s not necessarily about participating in the revenue. It’s about tax.
AK: And meanwhile the manufacturing reconstruction or restructure is taking place now. That’s not for the future. It’s actually happening now. How do you see that playing out?
TT: Well, it’s interesting. We’ve had these debates a number of times about, you know, a currency at a certain level will decimate manufacturing. I think what we’ve tended to find in history is it’s the rate of change in the currency that will decimate manufacturing; whether they have time to adapt, whether they have time to change their processes, put in capital deployment that can make them efficient in different measures. So, what worries me is that we still have this gulf in terms of expectations of the manufacturing sector, about what their place in the world is going to be, and a lack of certainty around, you know, where the currency could ultimately go to on QE. I think that makes it very, very hard for them to invest and to employ.
AO: Yeah. My view of the manufacturing is similar, but I think you do need to know that, you know, twenty odd years ago they were 20 per cent of the economy; today they’re 7-8 per cent of the economy and the same sort of thing in the labour market. So, to some extent it’s already happened. I think what you’ve got to do in manufacturing is you’ve got to basically reorientate yourself into services including mining services or into something that’s smart. And I always, you know, if you’re just trying to compete with China on labour costs, give it away. You’re not going to win. So, you just need to be smarter in the way you’re doing it. But we’re about half the size, in terms of manufacturing of our economy, than most economies, so we’ve already had it.
TT: I think we’re already seeing though the rise in China labour costs and we’re seeing ample stories on this – I’m sure you guys have even picked up on the theme as well – that many large manufacturing processors have moved back to the US. You know, I think the issue for Australia perhaps is that it’s perceived that our weight rates are so fixed that you’re never really going to get that adjustment unless it comes via the exchange rate rather than through the nominal economy.
AK: It’s also true that the renminbi has been rising versus the US dollar – a little bit, not hugely, but I suppose there’s got to be potential for the renminbi to break out even more. I mean it’s more than twenty per cent of our trade weighted index.
AO: The Chinese are not going to have a PB step jump because it will cause them problems in exactly the area we’re talking about. But I think what’s really happened in some ways is that what you might call the really low cost of manufacturing has already gone from China and it’s back into Vietnam and places like that. You know, Australia’s looking up – whether it's China or wherever, it doesn’t matter, they still can’t compete. So, they’ve got to sort of add value. But I’m not that negative in terms of manufacturing. It’s just that I don’t see it as getting up and employing huge amounts of people.
And then you have less in the mining sector and you have less income going through. People are very conservative. You know, credit card spends and everything else. I just don’t think people are going to give up again. And that’s one of the problems I have with monetary policy. The idea that you’re going to cut rates by 25 or 50 basis points and people everywhere are going to go out and give up again, I just don’t believe it.
SB: One of the few , maybe the only, positive notes that’ve been struck here so far have been the reference earlier on to China and the rekindling of their growth rate, fundamentally through stimulus and the infrastructure spending. How sustainable is that and what happens if it isn’t sustained?