Mining leaves a gaping hole

We have already endured the first phase of the downturn in mining as commodity prices have dragged down corporate profits and government revenues. This has led to weakness in both labour markets and household income as miners and governments have cut spending.

The second phase of the mining downturn is starting now and will extend well into next year as mining-related construction activity peaks before winding down as projects complete. The investment phase of the mining boom has seen capital spending in this sector surge from 1% of GDP a decade ago to 6% of GDP currently (Fig 1).

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Over the next two years, business investment which is fully one-fifth of the economy will fall by almost 20% as construction of these projects finishes. This will be a significant drag on growth.

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The dividends of this investment via higher export volumes will provide some relief. Unfortunately much of this will be lost in the short term as commodity prices move lower again with the terms of trade normalising. The real benefit of this expansion will not come through until 2016, when Australia becomes the world’s largest LNG exporter.

While there is little doubt around the scale of contraction in construction activity, there is considerable debate regarding the uplift in other sectors of the economy that have been subdued through the mining boom. As financial conditions continue to ease, activity in manufacturing, housing and tourism should improve.

I am less sanguine than most on the outlook for the economy given the historic experience with the economy slipping into recession in each previous cycle. We had the gold rush in the 1890s, the wool booms in the 1920s and during the Korean War, energy shocks in the 1970s – and all of these episodes ended badly for the economy (Fig 3).

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While I am not expecting a recession this time, given the economy is far broader and more open than it was in prior periods, I fear activity will be well below trend in the medium term.

A further softening in the terms of trade and construction activity are a given. The unknowns to consider are:

• the uplift in household sector spending as financial conditions ease, even as unemployment edges higher;
• the recovery in non-mining investment, which has been weak for some time;
• and policy response from a new government as it seeks to fill the gap left by mining.

In the first phase of the downturn, company profits and government revenues fall and miners and the public sector tighten their belts. The secondary effects are felt through the economy as employment growth stalls and unemployment starts to rise, as seen in Fig 4.

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Given the household sector’s size and relevance to the economy, it is the only hope for bridging the gap left by mining. In spite of record low interest rates and higher household wealth, a strong uplift in spending is considered unlikely given ongoing deleveraging trends and rising unemployment. (See Fig 5).

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There is little the new government can do either to compensate for the pending collapse in investment despite its grandiose infrastructure rhetoric. The public sector is more likely to be a drag on growth given ongoing fiscal revenue pressures and the coalition’s fiscal consolidation plan.

In a perfect world, the economy would rebalance without suffering a downturn. However, mining investment has tapered a lot earlier than expected as commodity prices have fallen and project economics have deteriorated with rising costs. The new government, on the other hand, which will look for countercyclical measures to buttress the economy, is a long way from being “shovel ready”, with most projects in the early planning phase. Thus, we are left with this gaping hole in 2014.

Despite the deterioration in public finances since the GFC, federal debt is amongst the lowest in the OECD, as shown in Fig 6. We certainly have the capacity to fund a much larger public infrastructure program. However, the government is a long way from being ready and a suitable private sector funding model needs to be reconsidered given failures in recent years.

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Even if the new government was ready, it would hardly matter, as private engineering construction is more than six times the size of its public sector equivalent. While we can get some comfort from the tepid recovery occurring in the residential building industry, engineering construction is as big as housing and non-residential-building combined. The scale of the downturn in mining construction will overwhelm any recovery occurring elsewhere.

Higher export volumes will eventually offset the decline in investment activity in the longer term, particularly as LNG shipments start flowing from 2016. In the near term however, higher iron ore volumes will be nullified by lower prices as the market becomes oversupplied. Moreover, while export volumes add to GDP – the income benefit to the economy is diluted as profits are repatriated to owners offshore.

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While I am not expecting a disaster, the economy will continue to perform below trend, as the non-mining sector has in recent years. This will be reflected in softer profit growth from the listed sector.

The sharemarket has rallied strongly over the last 18 months, even in the absence of profit growth, and now looks fully valued. I need to see profits rise to justify the strong move in shares. Given my weak economic outlook, I cannot see this happening and, on that basis, retain cautious portfolio settings.

That is not to say the sharemarket cannot move higher, because in all likelihood it will as the liquidity driven reflation cycle continues unabated. But beware because, in so doing, shares are becoming more expensive and risks are building.

Justin Braitling is a principal of Watermark Funds Management at www.wfunds.com.au.