What the economists are missing

Don’t listen to economists who predict dark times ahead.

Summary: Some economists are predicting dark times for the Australian economy, but they are attributing an importance to the terms of trade that it doesn’t have. Although headline GDP growth is slightly below trend, there is good reason to believe the figures are wrong. Other indicators such as jobs growth and building approvals are also strong.

Key take-out: Growth is above trend and accelerating, although a fall in confidence poses a danger to continued above trend growth.

Key beneficiaries: General investors. Category: Economy.

One of the biggest questions going into 2015 concerns the performance or health of the Australian economy. The Fairfax press is celebrating the apparent success of Professor Ross Garnaut in predicting dark times for the Australian economy – indeed, some economists think Australia is already in an “income recession”. The Reserve Bank of Australia for its part has dismissed the idea that the country is in an income recession and for good reason. We’re not.

As I’ve noted before, the mistake I think Garnaut and his followers make, is that they attribute an importance to the terms of trade that it doesn’t have. On his view, the ratio of export prices to import prices (the terms of trade) is the sole determinant of economic growth. That is, price relativities determine growth. It should be noted however, that such a view has no theoretical or empirical support in mainstream economics – it is quite simply baseless and cannot be taken seriously. He’s not the only economics professor making outlandish claims I might add. Larry Summers (a professor of economics at Harvard University) was equally alarmist when he resurrected the idea of “secular stagnation”. Instead we find that the US economy is booming.

There is a debate as to just how robust the Australian economy is, however, which is an important question. If the Australian economy is below trend now, following 225 basis points worth of interest rate cuts over three years and given the strength of our major trading partners, then there is a huge problem: It would suggest that monetary policy is ineffective and that the economy may slip into a downturn in 2015. Remember, the economy was growing at a well above trend pace before the easing cycle began. This has clear investment implications – underweight Aussie equities and overweight cash etc.

In my opinion, I think the weight of evidence argues against below trend growth. Certainly there is evidence to suggest it is. Most notably headline GDP is growing at a 2.7% annual rate on the latest figures – which is below trend. Barely though.

Yet I’ve good reason to believe those headline figures are wrong. At a basic level, this reflects the problems the Australian Bureau of Statistics is having in seasonally adjusting data. You can see that most visibly with the dramas they’ve had on the jobs numbers. But you can also see it when looking at the growth figures. Whether this is due to budget cuts or other measurement problems I don’t know, but it is there.

Recall that economic growth is taken as the average of three measures – expenditure, incomes and production. The expenditure and incomes measures are actually growing at trend to above trend rates on the original, unadjusted figures. The apparent weakness in the Australian economy is solely due to soft production. That by itself isn’t unusual – the three measures often differ. What is unusual and what leads me to dismiss the production numbers is the driver of the supposed weakness: The weakness in production is largely due to a fall in public spending and construction.

Here’s the thing though – we know public spending isn’t falling. Neither party has been able to rein in spending which is why the budget is still in deficit. We know this as fact. Neither is construction falling. Indeed other data from the ABS show construction growth is strong. When we adjust for these obvious errors, the production side of the accounts rises to trend, and all of a sudden headline GDP is back at trend or above.

That’s not the only reason why I think the economy is growing at a healthy rate though.

Jobs growth has surged over 2014. On the latest figures – to November – 170,000 jobs were created (original figures), which is the strongest annual result in four years. The monthly gain was the strongest November gain in 12 years. Moreover, the unemployment rate has been steady at 6% for about six months. I realise we need to take these numbers with a good dose of salt, but the numbers were showing this even before the ABS started having problems, and these are not results that reflect a weakening or sub-trend economy.

Nor is the surge in building approvals and housing construction. On current approvals, the implied level of housing starts is at a record high. Construction will be strong for the next few months (at least) on those figures. Elsewhere we see signs of recovery. Credit growth is on the up and the strongest in about five years. Consumer spending is also on the road to recovery – growth rates up sharply in 2014.

For mine, growth is above trend and accelerating, although it fair to say it’s not all peaches and cream. Confidence has deteriorated and is a clear and present danger to continued above trend growth in 2015. Recall that mining is likely to slow sharply this year and it will detract from economic growth. If consumer spending or housing construction slows, then growth will likely fall to below trend rates. Yet whether we get above or below trend growth has nothing to do with the terms of trade – and everything to do with the consumer – and investors should watch that space.