The end of the big rise?

Non-residential construction is likely to be one of the few bright spots in the Australian economy over the next five years.

PORTFOLIO POINT: Australia is facing two major headwinds – a shift to deleveraging and a weakening in our terms of trade – over the medium term. Both will have significant implications for the sharemarket and Australian dollar.

Australia’s superb macro performance over the past two decades has been assisted by two major tailwinds: rising leverage and rising export prices. Both trends seem set to reverse. The prospective shift to falling leverage – particularly by households – and a turn in the terms of trade (export prices relative to import prices) will have important implications for investors. These changes will likely reduce Australia’s resilience to external shock, are important adverse structural shifts for sectors of the equity market, point to significantly lower nominal profits growth and will likely see the currency weaken over the medium term.

Australia has been the best-performing developed economy through the past two decades. This stellar performance went hand-in-hand with – and, more importantly, was assisted by – a tremendous increase in domestic leverage, particularly by households (Exhibit 1). Economies in a leveraging phase tend to be resilient: there’s a tailwind of asset price appreciation, monetary policy is very effective (because of the willingness to borrow), and sentiment is strong. The rise in leverage also had sector-specific benefits, notably for housing construction, finance and retail. A second, massive structural support came into play over the past decade: the rise and rise of commodity prices, which pushed Australia’s terms of trade to all-time highs (Exhibit 2).

These two great trends seem set to go into reverse. Household leverage has flat-lined over the past four years, and we expect it to fall. The terms of trade fell in the December 2011 quarter. This may not mark the start of a steady decline, but it likewise seems clear that the great rise in the terms of trade will soon be over.

A shift to deleveraging and weaker terms of trade will have important economic and market implications. It will likely reduce macro-economic resilience to external shocks, reduce trend nominal GDP growth, and with it earnings, lower the AUD over time, and puts a cloud over several parts of the equity market.

What will change

In this note, we put rough numbers around the possible trend change in household leverage and the terms of trade. These trends will change: if a trend is unsustainable – and both of these are – then it will not be sustained. But our numbers are part guesswork: being precise about the turn in a trend that has lasted one decade (rising terms of trade) or two decades (rising household leverage) is folly. The more important point is to look at the implications of these trends reversing, rather than to precisely forecast when that may happen.

We’ve looked at a five-year horizon (to end 2016); we’re confident that the changes we talk about will be apparent over that period. Exhibit 3 shows our forecast for household leverage (debt as a percentage of household disposable income). The rate of decline is slower than the rate of ascent. More to the point, it does not imply debt repayment: as we’ll discuss, we assume benign deleveraging, accomplished by borrowing lagging income growth. In contrast, the current deleveraging cycle in the US household sector is largely due to outright debt reduction (much of it, of course, due to default).

Exhibit 4 shows our forecast for the terms of trade (the ratio of export prices to import prices). The level of the terms of trade forecast for end-2016 is higher than at any period in Australia’s history, aside from the current level, and spikes seen in 1950 and 1925. In other words, the forecasts imply that in five years, the terms of trade will be very high by historical standards. The decline in Exhibit 4 is based on the view that export prices will fall by around 4.5% per year, relative to import prices. It is the relative shift between export and import prices that drives the terms of trade. We assume that that 4.5% relative shift reflects flat import prices and a 4.5% fall in export prices.

Commodity prices drive the swings in aggregate export prices. The expected decline in commodity prices does not rely on pessimistic forecasts for commodity demand. The key is the supply response. Over a long time horizon, it’s likely that commodity prices will revert to marginal cost – which, in turn, is now well below current spot prices. The gap between spot prices and marginal cost has created the supply-side investment boom now underway in Australia (and elsewhere). The supply response implies higher export volumes, but also weaker prices. Exhibit 5 shows our export volume forecasts. We expect mining export volumes to rise by 13.5% per year.

The mix of higher volume growth and falling prices points to lower growth in nominal export earnings. We’ll discuss the implications of this below, but as a cross-check our forecasts are broadly in line with recent forecasts from the Bureau of Resource and Energy Economics (the Resources and Energy Quarterly, March 2012). The Bureau forecasts that Australia’s nominal resource exports will rise at an annual average pace of 5.3% over the five years to FY2017 (June year-end). We forecast growth of 6.2% over the five years to calendar 2016.

This is not a note to set out the fine points in our macro scenario. We have assumed near-trend real GDP growth, and an unemployment rate in a 5-6% band, throughout the forecasts. That’s enough to outline some of the likely trend changes caused by a shift to household deleveraging and weakening terms of trade.

One final comment: we believe that our scenario is relatively benign. We are forecasting a steady, but moderate, decline in the terms of trade. We are forecasting slow household sector deleveraging, against a backdrop of near-full employment. In our view the risks around these assumptions are slanted to the downside, particularly given downside risks to global growth and financial conditions. As we will argue, the benign change in these trends will darken the outlook for several variables important to investors. Clearly, if the downside risks eventuate, the outlook would become commensurately more difficult.

Now we discuss the implications of the prospective change in household leverage and the terms of trade.

1. Lower real domestic income

Real GDP is often used to measure an economy’s real income. This is not always the best measure. A rise in the terms of trade reflects price changes (export prices relative to import prices) and does not directly affect real GDP. But a rise in the terms of trade does boost real income: it means that a lower volume of exports is required to buy a given volume of imports. Australia has to export fewer tonnes of coking coal to buy an imported BMW now than a decade ago. Real gross domestic income (GDI) adjusts GDP to capture the real income effect of a change in the terms of trade.

The first impact of declining terms of trade is that, all else equal, gross domestic income growth will be lower. How much lower depends on whether the stronger export volume growth can offset the declining (relative) price of exports. We doubt that it will. We assume 13.5% volume growth in mining exports, versus a 4.5% fall in terms of trade. This implies a significant deceleration in nominal mining export growth: to 6.25% annual average growth over the five years to 2016, from 15.75% growth over the five years to 2011. This slowdown in export growth implies that annual average growth in real gross domestic income slows to 2.75% over the five years to 2016, down from 4.5% growth over the 2004-11 period (Exhibit 6).

As an aside, on an all-else-equal basis, it would require annual average growth of mining export volumes of 25% to offset the income effect of the decline in the terms of trade. (Of course, all else would likely not be equal – such a rapid supply expansion would likely lead to weaker commodity prices, hence weaker terms of trade, than we assume.) It is critical to remember that GDI is the key measure of national spending power. For sure, the rise in export volumes leads to faster real GDP growth going forward – on our numbers, averaging 3.5% versus 3% over 2004-11. But the key point is that real income growth will be lower over the forecast period despite GDP growth being higher. This is the flip-side of the past decade, when real gross domestic income growth was significantly faster than the reasonable, but not exceptional, GDP growth (3% over the past decade).

2. Lower nominal GDP growth

The change in the terms of trade likewise suggests that trend growth in nominal GDP will be lower, even though real GDP growth will be higher (Exhibit 7). There are a couple of points to note about this: First, remember the important difference between inflation in the things a country consumes and inflation in the things it produces. The RBA has done a good job controlling the former (focusing on the basket of goods and services consumed by the household sector), while the price of things produced by Australia has risen much faster. At the economy-wide level, the difference between the inflation rate in what we produce versus the inflation rate in what is consumed is captured by the terms of trade. Consequently, the RBA may keep consumer-level inflation in its target range, but the decline in the inflation of Australia’s export prices means that GDP-level inflation will trend at a much lower pace going ahead.

Second, while real GDP is often the focus of policy makers and analysts, nominal GDP matters more for many important variables. The most obvious for investors is earnings growth.

3. Lower earnings growth

The non-financial corporate sector’s profit share of GDP is now near all-time highs. We expect a moderate decline, partly on the back of falling commodity prices (Exhibit 8). The non-financial profit share of GDP forecast for 2016 is the highest on record, aside from the levels seen over the past three years.

But the combination of this moderate fall in profit share with the lower trend growth in nominal GDP has a significant effect on the outlook for trend earnings growth in nominal terms (Exhibit 9). The macro measure of profits (which, to be fair, does not exactly correspond to listed-sector profits) is expected to grow by 3.75% per year over the forecast period, down from 9.75% average growth over the past decade. In short, we expect trend profit growth to more than halve from the average of the past decade.

4. Sharply lower credit growth

By definition, a period of rising leverage means that credit growth is faster than GDP (or income) growth. Conversely, falling leverage implies credit growth lower than GDP growth. This trend change will occur against a backdrop of significantly lower nominal GDP growth. This combination – deleveraging with lower nominal GDP growth – points to a marked fall in credit growth.

Exhibit 10 shows the effect on household debt growth. Debt has grown at an annual average rate of 10.75% over the past decade; our forecasts imply growth of just 1% ahead. (Note that this is the change in the stock of household debt. Gross new lending will be higher, but offset by debt repayment.)

The link between loan growth and profit growth in the financial sector is not always tight (Exhibit 11). However, the sharp deceleration in lending will, in our view, lead to lower trend earnings growth for the sector.

5. The housing bubble deflates

We think that the single most important reason for the escalation in house prices over the past two decades was the rising willingness and ability of households to increase leverage (Exhibit 12).

No single variable, aside from rising leverage, explains the breadth of the housing boom and its timing. The simple fact is that the big increase in house values, in both real terms and relative to income, occurred in the late 1990s/early 2000s. This pre-dates many of the 'reasons’ put forward to explain why Australian housing is so expensive by global standards. That list of reasons includes population growth, supply-side blockages, a peculiar Australian preference for houses, or the fact that our largest cities are coastal.

That leverage is the key driver of house prices is, in our view, supported by another simple fact: the end of rising household sector leverage has coincided with weaker house price performance. In inflation-adjusted terms, house prices now are no higher than in late 2007. Relative to income, prices are no higher now than 6-7 years ago. If, as many argue, the key to house prices was supply/demand factors, then house prices should have continued their sharp increase over the past 6-7 years. What explains softer house prices, in real terms and relative to income, is the end of the leverage boom. The forward-looking point is that falling household leverage will likely lead to falling house prices, at least relative to incomes. This is good news in a macro sense – it implies a gentle deflation of the housing bubble. But it also means that wealth effects will be a headwind, and housing will be a poor investment. Our best guess is that house prices will fall in real terms, but the macro scenario we are using here suggests that nominal prices are more likely to be flat for an extended period, rather than see sustained outright nominal price declines.

6. Household saving to stay high

Several factors have contributed to the lift in the household saving rate over the past four years: demographics (baby-boomers approaching retirement); a decline in wealth (relative to income); the end of the house price boom; and perhaps growing caution given the global crisis. Exhibit 13 shows how the rise in the saving rate has coincided with a more cautious investment view of households: a rise in the proportion of households that think the best thing to do with spare cash is to pay down debt, or deposit money with a bank, versus investing in housing or the equity market.

Most of the factors that have encouraged higher saving will remain intact for the foreseeable future. Consequently, we expect that the household saving rate will remain around 8-10% of disposable income (Exhibit 14). However, a steady saving rate implies that consumer spending will rise in line with income.

7. Lower nominal consumer spending

The combination of lower nominal GDP and income growth, and a relatively steady saving rate, implies that nominal consumer spending will grow more slowly than through the 2003-08 period (Exhibit 15).

Of course, the retail sector is already under some pressure. Some of the problems in retail are not directly connected to broad macro trends, rather they reflect idiosyncratic issues. One important change is not in the growth of overall consumer spending, but a shift in the mix. Exhibit 16 shows consumer spending split between 'discretionary’ and 'necessities’. The point is that not only is trend nominal spending growth lower, but there has been a significant shift away from spending on items provided by listed retailers.

We haven’t modelled this split between 'essential’ and 'discretionary’ consumer spending. Our hunch, however, is that much of the discretionary retail spending is linked to housing. Either in a direct sense (furnishing or renovating) or indirectly (rising house prices encourage more borrowing). Certainly there is a correlation between households’ willingness to borrow and retail sales volumes (Exhibit 17). If this link remains intact, then the prospect of lower borrowing suggests that 'discretionary’ consumer spending will continue to lag overall consumer spending.

8. A lower $A

The single most important influence on the $A has been commodity prices. That in turn means the currency is correlated with the terms of trade (Exhibit 18). The prospective decline in the terms of trade would likely also see the $A significantly lower on a trend basis.

9. Weaker equity performance

Many factors affect equity performance. Several of the changes that deleveraging and falling terms of trade will produce are likely to be adverse for equity performance. This is not the place to give a detailed rundown of the equity market outlook, but the obvious point is that the rise in the terms of trade corresponded with a material out-performance by Australian equities versus global equities (Exhibit 19). A decline in the terms of trade likely points to underperformance by Australian equities (in common currency terms).

10. The boom sector: Construction

The focus of this note is the turn in household leverage and the terms of trade. On the other hand, one sector will continue to boom, in our view: non-residential construction. Exhibit 20 shows our forecasts for non-residential construction as a share of GDP. We expect that construction will peak at over 9% of GDP, compared to a long-term average share of GDP of under 4%. At some stage, this will normalise. However, this is unlikely to be an issue for the next few years. This does underscore the point, however, that the principal way the mining boom will support GDP in the next few years is the investment side, not the export side. It also means that, on a medium-term view, Australia will face a third adjustment: to the rundown in the investment boom now underway.

*This is an edited version of a research note from Morgan Stanley.

Gerard Minack is head of global developed market strategy at Morgan Stanley.

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