|Summary: The Australian economy is now highly reliant on the prices of both iron ore and coal to generate above-average economic growth. While iron ore producers have lifted production, lower prices and a strong dollar mean our trade position or the earnings of major commodity exporters won’t improve anytime soon.|
|Key take-out: The $A needs to depreciate to offset the sharp decline in export revenues flowing from the significant fall in iron ore prices. If Australia’s trade account continues to track in the red, it will be a strong indication that our resource company earnings are struggling to improve.|
|Key beneficiaries: General investors. Category: Economics and Investment Strategy.|
The surging trade account surplus ($2.96 billion) reported in the March quarter created a false impression of both the strength of the Australian economy and our external trade position.
In retrospect, it is clear that the March trade surplus was a direct result of the sharp decline in the importation of capital goods that had been flowing into Australia during the resource development boom. The culmination of this capital cycle is still some two years away (2016-17) and, at that point, resource investment will revert back to its historic average of 2% of gross domestic product (GDP).
Remember that it peaked at 7% of GDP in 2012. The slide in new resource investment has commenced, and so the Australian economy is now highly reliant on the prices of both iron ore and coal to generate above-average economic growth.
Given the above, the June month trade deficit at $1.6 billion and the restatement of the May deficit to $2 billion should send alarm bells ringing in both Treasury and the Reserve Bank of Australia (RBA). The June quarter trade deficit is estimated at $4.8 billion, which, when annualised, represents a disturbing 1.5% of GDP. Figure 1 shows the Australian trade account has slipped substantially back into the red.
I reiterate my recent comments that the $A needs to depreciate to offset the sharp decline in export revenues flowing from the significant fall in iron ore prices. Readers should note that the RBA index of export prices, weighted by volumes, shows that prices have declined by 15% in 2014. These negative trends are exemplified by the observation of burgeoning volumes and a lift in exports to China of 10%.
Despite the dramatic lift in volumes the total $A export revenue on the trade account lifted by just 0.9% in 2013-14 compared to the previous year. On the other side of the trade ledger, the value of imports rose by 4.8%.
In coming weeks we will receive critical financial analyses from the major mining companies when they produce six month operating results and outline their expectations for the coming year. At this point, it seems clear that while the big iron ore exporters will report volume growth of about 10%, this will be offset by price declines with no relief from the exchange rate. While operating costs continue to be cut, it seems that the substantive part of those cost gains has now been achieved.
Therefore, while it is positive that Australian iron ore producers can and will lift production, it will be a rather fruitless exercise for shareholders if this does not translate into higher revenue and profits. Unfortunately, given where the $A sits at present, it seems that neither Australia’s trade position nor the earnings of major commodity exporters will improve anytime soon.
I suggest that readers need to keep an eye on Australia’s monthly trade account. If it continues to track in the red, it will be a strong indication that Australia’s resource company earnings are struggling to improve.
That will invariably lead to lower share prices, because current market consensus earnings for 2014-15 seem way too bullish. Weaker resource share prices in the face of a strong $A suggest to me that the Australian sharemarket is stuck at its current 5,500 index level.
John Abernethy is the Chief Investment Officer at Clime Asset Management. Clime offer excellent performing growth and income portfolios through its individually managed accounts service. To find out more, or to request a review of your share portfolio, call Clime on 1300 788 568 or visit www.clime.com.au.