The Problem in the US and the Thaw in China

Right now, most parts of the Australian economy are going gangbusters. Those companies that are able to overcome labour shortages and higher costs are going to record strong profit growth and that will underpin the local share market.

But, as we saw with Woolworths, there will be surprises on the downside.

Treasurer Josh Frydenberg in his mid-year statement is bubbling over with joy because he will be able to take a strong economy and prosperity for many Australians to the election. It’s good news for markets.

Clearly the most obvious threat is the Omicron version of COVID-19. Australia's already high vaccination rates mean that it is likely that we will embrace booster shots on a massive scale so reducing the local impact. Other parts of the world might have deeper problems.

But today I want to raise two concerns that will become big issues in 2022.

We all watch US President Biden on television. It is clear that the US President is not well and is having lapses in memory. My medical friends say it is possible that he has some form of early dementia. Less well publicised in Australia is that the US Vice-President Kamala Harris is in fine health but not performing well. There is clearly a leadership problem in the US.

Whenever a great power appears to show weakness at the top, military adventures by its opponents are likely to increase. And so we have Russian troops massing on the borders of the Ukraine and an increasingly militant Iran.

Closer to home, China is sending jets on a regular basis over the Taiwan skies. These are events that present dangers to the markets.

But, economically, probably the biggest danger is the fact that real interest rates in the US are now hitting minus five per cent. The official rates are close to zero and the inflation rate is at least 5 per cent and arguably higher. Negative interest rates at that level represent an enormous unsustainable stimulation.

The Federal Reserve will cut back its bond buying but at some time in 2022 the US will need reduce the high negative interest rates. It is possible that the US inflation rate will decline but it doesn’t look likely, especially as energy prices are being underpinned by the lack of capital to develop new reserves.

Australia has negative interest rates but nothing like the level of the US. The great danger is that the US Federal Reserve will be forced in 2022 to move interest rates closer to neutral which will involve some steep rises in interest rates which will reduce markets around the world. Clearly Wall Street believes that won’t happen and inflation will be reduced.

In Australia, any rise in US rates will cause Australian banks to increase the home loan rates because they source part of the money in the US. They will probably wait until after the election to take action. The Reserve Bank will delay raising our interest rates for as long as possible. It is hoping that wages — its main criteria — will not explode. Any increase of more than 2.5 per cent in mortgage rates will have a severe impact given our high mortgage debt.

In this environment, the dollar is vulnerable.

The optimistic share markets might be right but there is a level of danger we have not seen before.

On the good news side, I was greatly encouraged by the fact that our businesspeople are meeting with Chinese businesspeople. I simply don’t believe that would have been possible six months ago. Obviously the business sectors of the two nations have a great many things they can do together. The discussions this week were preliminary but at least it is a start.

Six months ago, there was very little respect for Australia in China because we had made a series of very bad defence decisions and seemed to have no willingness to address our defence mess. The appointment of Peter Dutton as defence minister means that we have tackled two of the equipment mistakes – the submarine and helicopters — and we will no doubt tackle the frigates. And as part of that submarine cancellation, we have put together the AUKUS alliance and we have been showing a lot more leadership in the region.

While China might be very unhappy at our actions suddenly there is respect because we are showing strength and not buckling under the Chinese pressure as we were expected to do by Beijing.

Unless Taiwan becomes a war zone, I think it is likely that during 2022 there will be further thaws in the chilly relations with China.

The very high prices that we saw in 2021 for iron ore and other minerals has caused all minerals producers to look closely at likely forward demand. BHP believes that the demand for nickel will increase fourfold in the decades ahead and is planning to increase its production and looking for takeover opportunities. But it also expects copper and iron ore to double in demand in coming decades.

Copper is easy to understand because of its key role in electrification. Demand for steel is going to be boosted by the enormous investment required in decarbonising. That means that China is still going to need Australian iron ore in big quantities even though China will also foster increases in production in other countries or locally in China. Australia iron ore producers will want to work with China on the use of hydrogen and other means to reduce the carbon emissions in steel making.

These situations underline that our mineral exports are not simply going to disappear in a reduced carbon environment. Moreover, because the world is cutting back on carbon-related energy investment, prices for oil, gas and coal are likely to stay high for an extended period because demand is not going to suddenly slump but supply will tend to decrease, along with lower investment.

I think in 2022 and certainly 2023 we will start to see energy funds develop for those that are prepared to invest in carbon either in terms of equity or loans. These energy securities will offer high returns and will reward those that are prepared to invest in carbon. Already a large number of US citizens are protesting to banks for restriction on carbon loans. The obvious reaction is to mobilize capital via different means.

We are going to see an increase in the number of American companies coming out here and given our likely lower Australian dollar it is going to make it a lot more attractive for Australian technology and other companies to export.