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David Bassanese
Expert
+ About David Bassanese

David Bassanese is one of Australia’s leading economic and financial market analysts, who has authored several investment books and works in a number of advisory roles.

David is Chief Economist at BetaShares, which involves providing economic and investment portfolio advice to both retail and institutional investors. David is also an economic advisor to the National Institute for Economic and Industry Research.

Prior to these roles, David was Economics Commentator with The Australian Financial Review, where is regular “Bassanese” column appeared three times per week, as well as monthly in Smart Investor Magazine.

David’s analysis and commentaries cover local and international economic trends, interest rates, the exchange rate, and share market analysis.

Prior to becoming a Fairfax business columnist in 2003, David spent several years in financial markets as a senior economist and interest rate strategist at Bankers Trust and Macquarie Bank. David started his career at the Federal Treasury in Canberra, after which he spent several years as a research economist at the Organisation for Economic Cooperation and Development in Paris, France.

David has authored two e-books: The Australian ETF Guide: cheap and easy investment strategies using exchange traded funds (ETFs), and The Australian Investor’s Guide to Asset Allocation.

David has a first class honours degree in Economics from the University of Adelaide, and a Master in Public Policy from the J.F Kennedy School of Government at Harvard University.

Downbeat consumers are the main economic risk

Wednesday, May 24, 2017

By David Bassanese

It seems not a day goes by these days without another alarmist headline in our major financial press warning of a Sydney or Melbourne house price collapse and the possible threat to the financial stability of the banking sector.

To my mind, however, the main risk to the Australian economy at present is not the direct threat to house prices or the banks, but rather, what these ongoing warnings are doing to the psyche of Australian consumers.

As it stands, measures of consumer confidence have already taken a tumble in recent months. The Westpac/Melbourne Institute index of consumer confidence dropped 1.1% in May, to be at a below average level, as consumers seemed to find little to cheer about in the Federal Budget.

That’s despite the big spending promises of Treasurer Scott Morrison with regard to health, education and infrastructure. If confirmed in the June confidence report, the lack of a budget bounce will be a big disappointment to Prime Minister Malcolm Turnbull.

Source: Westpac Economics, Melbourne Institute

Why are consumers so downbeat? You only need to look at their expectations with regard to the housing sector. According to the Westpac report, the ‘time to buy a dwelling” index slumped by 6.5% in May, to be at its lowest point since 2008 - when house prices were already weak and the Reserve Bank was pushing up interest rates prior to the financial crisis.

Ominously, for both the RBA’s and the Government's bullish forecasts for economic growth this year, retail sales have slowed to a crawl. Sales dropped 0.1% in March after a 0.2% decline in February. Annual growth is barely beating inflation, and is at its weakness pace in four years.

Not only are several high profile global hedge funds still banging the drum insisting local house prices are grossly overvalued and the banks are financially vulnerable, we got local analysts and headline seeking media outlets jumping on the bandwagon.  

Against this background, we’ve also already got banks raising mortgage rates without the RBA lifting a finger, and being cajoled by APRA to effectively cut back investor lending. The latest Federal Budget also cut back some important investor housing depreciation tax incentives and tightened up on foreign property purchases.  

All up, there is a lot of pressure being brought to bear on the housing market, and I’d be surprised if we don’t see a deeper cracks appearing in the strong markets of Sydney and Melbourne sometime soon.

Of course, a timely moderation in these hot markets is welcome. But I fear we may be imposing too many country-wide constraints too quickly in what is still a largely State-level problem.  

What’s more, I continue to maintain fears of a major housing crash in such a supply-constrained and booming city such as Sydney – much less the rest of the country - are way overblown. And while there are no doubt pockets of mortgage stress scattered across the country, barring a major surge in inflation, interest rates and unemployment (i.e. a 1970s style stagflationary environment), any likely rise in mortgage defaults won’t be material enough to give our major banks anything other than a glancing blow.   

Meanwhile, the greater concern is the toll all this unrelenting outpouring of dire warnings will have on the most important sector of the economy – namely household spending. Given weak income growth and high unemployment, households are already under a lot of pressure – and we’re at risk of adding yet another straw to an already vulnerable back.

In this regard, it’s worth recalling what RBA Governor, Phil Lowe, indicated in a recent speech. According to Lowe, “traditional financial stability concern[s]” regarding the banks “is not what lies behind the Reserve Bank's recent focus on household debt and housing prices in Australia.”

Rather, “the issue we have focused on is the possibility of future sharp cuts in household spending because of stretched balance sheets.”  

Ironically, that has left the RBA a delicate balancing act. One the one hand, it has tried to warn households not to ramp up debt a lot further out of fear of weaker consumer spending later. But in doing so – together with the unrelenting barrage of negativity from other quarters -  the RBA increasingly faces the risk of bringing on the severe curtailment of consumer spending that it was trying to avoid in the first place.

We are at risk of talking ourselves into a more serious than required downturn.

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Forget the rhetoric - how does the Budget fare on policy?

Wednesday, May 10, 2017

By David Bassanese

At face value, the latest Turnbull Federal Budget represents a breathtakingly shameless shift in political principal – toward the centre - in a bid by the Prime Minister to finally call the bluff of right-wing rivals in his own party and co-opt the policies of his left-wing rivals over in the Labor Opposition.

After all, having once declared Australia did not have a revenue problem, Treasurer Scott Morrison has now announced new tax measures amounting to $20 billion over the four-year forward estimates.

He has also embraced the big spending packages in health and education it once derided and Labor had championed.

So much for the politics, but what about the public policy merits of the Budget? To my mind, they are not that bad, though the idealist in me would have preferred a more fairer and efficient targeting of the extra money being thrown into health and education.  

Cutting through all the rhetoric, however, it’s worth noting there was effectively no new net recurrent spending announced in the Budget. The Government has effectively raised $20 billion in new taxes over the next four years – through the higher Medicare levy and the new slug on banks – plus gained a fortuitous $8 billion reduction in net-spending over this period due to “parameter changes” such as through lower-than-expected spending on disability payments and private health insurance rebates. 

This $28 billion in turn, has allowed the Government to effectively give up on expecting the extra net $14 billion in “zombie” saving measures long stalled in the Senate, plus reduce expected Budget deficits over the next four years by $11 billion – even while also having to reduce expected revenues by $3 billion due to an expected shift in the composition of national income growth from more highly taxed wage income to lower taxed mining sector profits.  

Seen this way, all the new spending on health and education is fully funded by cuts elsewhere – such as slugging universities, reduced family tax benefits and (of course) yet another purge of alleged welfare cheats. Note also, seen in this way, it’s simply not true the increase in the Medicare levy is being used to fully fund the NDIS – as should be apparent from the fact the Budget was still projected to return to surplus with the NDIS even before this Budget.

Contrary to some wild claims, moreover, it’s also not true the Budget is puffed up by wildly optimistic forecasts. The Government’s growth forecasts are not materially different from those in the mid-year review last December, and in fact, a touch conservative compared to those released by the Reserve Bank last week. As for the “technical assumption” of above-trend growth in the following 5-year projection period – so as to reduce lingering spare capacity in the labour market – this has been assumed for several Budget rounds now. That’s as good a guess as any and is nothing new. 

All up, the net improvement in the Budget outlook - despite some new spending and conservative economic forecasts - suggests the AAA credit rating should not be put at risk. 

As for specific recurrent measures, I’d regard the housing affordability package as useful at the margin (such as encouraging the supply of cheaper rental properties) - but most other token measures - such as small saving incentives for first home buyers - won’t materially affect housing costs either way for most Australians. 

Last but not least is the Government’s extra $14 billion for new infrastructure projects over the next few years – such as the second Sydney airport and Brisbane-Melbourne Inland rail line - and its new focus on distinguishing capital versus recurrent spending. As I’ve long advocated such an approach, there are few complaints from me, especially if it allows the Government to take a more creative and pro-active approach in getting worthwhile infrastructure projects off the ground.

Through various means, the Government is now helping to generate around $75 billion in road and rail projects over the next decade, and is responsible for around $50 billion in capital spending at the State and Federal level next financial year.  

Indeed, with the mining boom over and the housing boom soon to end, public infrastructure might be an important growth support in the next few years, especially if the Australian dollar remains uncomfortably high. Of course, the usual provisos apply – in that we can only hope these projects pass rigorous cost-benefit tests and are not just directed at marginal electorates. 

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Australia has 3 distinct housing challenges

Thursday, April 27, 2017

By David Bassanese

A lot has been written about the Australian property market in recent months, but depending on where you live, the headlines are likely to have been entirely different. Indeed, Australia has in fact three distinct housing challenges in different parts of the country and no single policy instrument – from changes to interest rates or taxation policies – can hope to fix them all.

The good news for Australian investors in general, however, is that the disparate challenges facing the housing sector are, in some senses, offsetting – some states are very weak, while others are very strong. Collectively, that means the national housing sector is neither an overheated bubble destined to crash, or is already so cyclically depressed it is undercutting employment growth and household wealth.  

In further good news - for investors in bank stocks at least - the challenges in the housing sector, while tough for certain regions and households, don’t appear to pose undue financial stability risks for our major banks due to their high regional diversification.

So what are these problems, and why are banks so well placed?

1. Post-mining boom cyclical correction

The first and earliest problem is the deep post-mining boom cyclical correction being felt in our once booming mining regions, especially in cities such as Perth. Both house and apartment prices in Perth got ridiculously expensive during the boom and also led to a building glut. The consequence is now falling property prices and abandoned projects.  

Sadly, the solution for Perth is straight forward – the market just needs to continue doing its job of clearing excess supply and inflated prices though price cuts and the mothballing of more late-to-the-party construction projects. The high debt position of vulnerable households and investors facing either unemployment and/or negative home equity is also being resolved – through foreclosures and some increase in bank loan write-offs. If there’s any good news in Perth, it’s that – according to the minutes of the latest Reserve Bank policy meeting, “there were signs that [Perth property] prices may be stabilising.” 

2. Hot property markets: Sydney and Melbourne

At the opposite end of the cyclical spectrum are the hot property markets of Sydney and Melbourne – which have been the main beneficiaries of the post-mining boom re-direction of national economy activity. Whether we have yet reached a bubble psychology among property buyers in these cities is still debatable – especially as measure of home loan affordability, thanks to low interest rates, remains far from extreme. 

Either way, the gradual tightening in lending standards and higher interest rates faced by investors and those seeking interest-only loans could well start to correct buyer enthusiasm in these cities in the coming months. If not, regulators may well need to consider more regionally-specific buyer restraints (as tested in New Zealand and Canada) which is a better targeted response than a nation-wide lift in interest rates or a crack down on negative gearing.

3. Inner-city high rise apartment developments

The third issue is the surge in inner-city high rise apartment development in Melbourne, and to a greater degree, Brisbane. Brisbane apartment prices have already started to fall and declines may well be ahead for Melbourne as an influx of new supply hits the market. Helping Melbourne at least, however, is that population growth has been relatively strong and rental vacancy rates remains quite low. Either way, as in Perth, the market will likely deal with these supply excesses though price declines, some foreclosures, and mothballed developments. That said, RBA analysis suggests only around 2% of outstanding bank housing loans cover the inner-city Melbourne and Brisbane markets - so barring a huge spike in default rates, bank losses are likely to be relatively well contained.

As for the hysteria over national household debt in general, it’s also worth noting (based admittedly old 2014 data) around 75% of households had a debt-to-income ratio of less than 200%, with 30% of households having no household debt whatsoever. And most of the nation’s highly indebted households tend to have the highest level of income and wealth. 

All up, the regionally diverse nature of Australia’s housing challenges, and the regionally diversified operations of our major banks, suggest a major national housing boom or bust – or systemic risk to our banks - is likely to be avoided for the foreseeable future. Of course, that’s not to deny certain region and certain households won’t face challenges – for which more targeted policy responses are required. 

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How will the Budget tackle housing affordability?

Wednesday, April 12, 2017

By David Bassanese

Under pressure to be seen to be doing something, it now seems likely that the upcoming Federal Budget will contain a detailed range of measures to deal with Australia’s alleged “housing affordability crisis”.

Of course, not wanting to be seen to follow Labor Party policy, Treasurer Scott Morrison will likely eschew significant changes to the capital gains tax regime or negative gearing.

To my mind, that’s just as well - as I seriously doubt these long entrenched tax measures have contributed much to the escalation in prices in the hot markets of Sydney and Melbourne in the past few years.

If tax and investors were the only problem, property prices would be taking off across the country – and they clearly aren’t.

That said, that’s not to deny the fact that there are some simmering problems in the housing sector. But in dealing with these problems, we need to ensure we don’t make matters worse rather than better. 

The first rule of public policy should be: do no harm.

In that regard, as most sensible economists have been quick to point out, anything that merely enables households – especially budding first home buyers – to simply bid more at property auctions is a cruel con on those that the Federal Government purports it most wants to help. In supply-constrained markets such as Sydney especially, all demand side subsidies would do is enslave buyers within even larger debts at the expense of the lucky pre-existing owners that would sell into an even stronger market. 

For Scott Morrison, one clear test will be whether he avoids the temptation to allow first home buyers to dip into their superannuation to save a deposit on a home.

Although some on this backbench are clamouring for such a policy, it is simply horribly flawed in design - and opens up a potential pandora’s box of politically popular pet projects that we could next waste superannuation on. 

If the Government truly wants to tinker with superannuation in the name of housing affordability, a far better policy would be to reconsider the ability of self managed super funds to borrow with abandon and splash out on investment properties.

The newly installed loophole over recent years that has allowed SMSFs to borrow to fund property acquisitions – providing the loans are non-recourse – has arguably had a greater effect in boosting investor demand for property in recent years than the much longer standing capital gains and negative gearing provisions.  

Aiding and abetting this unhealthy development is the fact that encouraging SMSFs to buy properties does not constitute “financial advice”, enabling a cottage industry to develop among property spruikers and accountants.

The result is a multitude of small and insufficiently diversified property-based SMSFs around the country, all partly subsidised by the generous superannuation concessions provided by tax payers.

Other housing related measures rumoured to be in the budget seem more sensible – like encouraging greater social housing, and taxing newly built properties left vacant by foreign investors.

As regards foreign purchasers, I’d also like to see a much tougher crackdown on illegal purchases of established properties by those that purport to be residents but really aren’t. What we don’t want to see is local property prices inflated by global money laundering and/or the simple desire of rich people in risky countries to park their money in safe havens like Australia.

Allowing pensioners to sell their homes without risking their pensions might also free up some under-utilised properties for sale, but we could then be left with an even more uncomfortable policy whereby some with millions in freely available non-housing assets are still claiming social welfare. All this raises the vexed issue of whether the generous exemptions for the family home in the pension assets test still make a lot of sense.

A final point to note is that the allure of property, given the capital gains tax concessions and negative gearing benefits, has only been enhanced in recent years as fiscal drag pushes more Australians into higher marginal tax brackets. It’s symptomatic of the fact the whole tax system is creaking under the strains of gross distortions and root and branch reform is desperately needed.

Sadly, however, we seem destined to get more tinkering around the edges – whereby new distortions are introduced to counter some of the unintended consequences of older distortions. 

The only ones smiling through all of this is the nation’s tax accountants – as greater complexity and loopholes keeps them in high demand.

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Banks lift mortgage rates without widespread criticism. Why?

Friday, March 31, 2017

By David Bassanese

The recent decision by Australia’s major banks to unilaterally lift mortgage interest rates has not been met by the usual wailing from our politicians. 

Indeed, it’s hard to believe that banks have been able to get away with lifting rates on investor property loans by a full 25 basis points without widespread national condemnation of their greed. Banks have even lifted rates on owner-occupier loans, especially those provided on interest-only repayment terms. 

Of course, the big difference this time is that the rate rises appear to have the tacit blessing of officials.

Indeed, given that both the Reserve Bank and the Australian Prudential Regulation Authority (APRA) want to slow investor activity in the housing market, any crimping in demand due to bank rate rises would be welcome. Banks probably figure that they might as well jack up rates to slow demand (in the process helping their profit margins), rather than have the RBA jack up overall funding costs and/or have APRA force them into non-price forms of credit rationing. 

For bank shareholders this is good news – allowing banks to slow housing demand through a widening in net-interest margins is probably the best-case outcome they could hope for. In turn, this could help bolster bank return on equity (ROE) and limit the risk of a cut in dividends and/or further capital raisings.

More broadly, moreover, recent research from the RBA suggests banks still arguably offer good value – in that implied risks premiums embedded into their share prices have perhaps excessively widened since the financial crisis.

As noted by RBA economist David Norman*, bank return on equity had averaged around 15% over the past five years, though recently dropped to just over 10% largely because of capital raisings (reduced leveraged) to meet higher capital standards as set by APRA. 

 

Here’s the bad news: according to Norman “it is unlikely that ROE will return to the levels that major banks and their investors had become accustomed to without the banks taking additional risk or achieving substantial productivity gains.”

Theory suggests, however, that banks should be rewarded by reduced leverage through a decline in their “cost of equity”, which can be broadly tracked by changes in bank price-to-earnings valuations i.e. to the extent reduced leverage results in reduced risk, it should be reflected in a lift in bank valuations, all else constant. But this has not happened – cost of equity has remained broadly unchanged at around 12%, which is even more striking given the decline in government bond yields over this period. Back in the late 1990s, by contrast, bank cost of equity decline notably (i.e. bank valuations rose) as interest rates declined.  

 

By contrast, Norman estimates the “implied equity risk premia” for banks has risen by almost three percentage points since the financial crisis.

This is also evident from the fact that bank valuations relative to the market have dropped in recent years. What’s more, as local banks have boosted their capital ratios by more global banks in recent years, it has resulted in a partial reduction in the premium of local bank return on equity and price to book valuations over global banks. 

 

Why? Ironically, although improved bank capital adequacy should reassure investors about bank safety, the lingering risks of further capital raisings appear to have generated counter-veiling upward pressure on their “risk premium” – and hence the effective cost of equity – facing banks. 

All up, this suggest that to the extent fears of further capital raisings ease, it could lead to a belated reduction in bank cost of equity – and hence relative valuations. And improved valuations seem even more likely if banks are able to at least partially restore return on equity through fatter net-interest margins.  

*Returns on equity, cost of equity and the implications for banks, RBA Bulletin march Quarter 2017

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The case for making some people worse off

Wednesday, March 15, 2017

By David Bassanese

Today, I’d like to indulge in what’s generally called 'political ethics' – and more specifically, focus on one of the blights of public policy-making these days, namely the inability to put forward a policy that makes at least one section of the community worse off.  

At face value, the “no-disadvantage test” seems imminently fair: if a section of the community is to be made worse off by a policy, they should at least be compensated in some way. It’s this apparent inability to properly compensate everyone affected by a policy change that has hampered a broadening in the ramshackle goods and services tax, not to mention the recent outcry over penalty rate changes. 

Yet, from an economist’s perspective, many policies that make certain members of the community worse off could still be justified (even arguably ethically), provided the benefits to the many more than offset the costs to the few. This is what’s known as utilitarianism – whereby the aim of most public policies is to maximise overall social welfare or “utility” based on a careful cost-benefit analysis across the winners and losers. If a lower corporate tax rate and/or lower penalty rates boosted overall economic growth by enough, wouldn’t this make up for the fact it made some people worse off?

Even before we consider the ethics of this - there is of course, the political hurdles. By their nature, policies that benefit many at the cost of a few are very hard to implement, because the benefits are spread so thinly that the support offered to politicians by the winners won’t be anywhere near as intense as the opposition mounted by the concentrated group of losers. Cue intensive lobbying campaigns and expensive television propaganda!

But, even assuming politicians had the courage to implement such policies, it still begs the question: is it fair or ethical? 

I’d argue that in most cases – in which largely financial considerations rather than fundamental human rights like life and liberty are at stake – then such cost-benefit calculations are inherently fair. The reason being is that Governments are charged with deciding on a whole raft of policies that benefit the overall community – and the costs and benefits of each individual policy will benefit each of us in different ways. In some cases, we’ll be among the minority of losers from a certain change, and in other cases, we’ll be among the majority that achieve small (and often hardly perceptible) benefits. In our representative democracy, we effectively consent to the luck of the draw in each case – provided these decision are made purely on non-discriminatory cost-benefit grounds. On average, we should all end up better than if nothing ever changed. 

Of course, I can hear the complaints already. What about policies that benefit the rich over the poor? Again, some policies – such as cutting corporate tax while raising the GST – might, in the first instance, do exactly that. But again, some others – such as progressive income taxation - will do the opposite. It’s a case of checks and balances – and we can’t allow us to get into a position whereby any policy which specifically hurts the poor is automatically ruled out. To do otherwise risks making the economy – and the overall plight of the poor – even worse.

Indeed, to the extent the net balance of policies – and the distribution of income and wealth more generally – still leaves less for the poor than we would like, that’s exactly where broader redistributive policies kick in. Conceptions of justice should apply at the broader level – making sure everyone has basic equality of opportunity and liberty and some share in partly lucky spoils of those better off in society. It’s not necessary – and ultimately harmful to the least well off - to grind reform to a halt by insisting each and every policy make no-one worse off, especially the poor. 

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RBA wary of bubbly property markets

Wednesday, March 01, 2017

By David Bassanese

The upshot of recent commentary from the Reserve Bank of Australia is pretty clear: our new suite of so-called “macro-prudential” controls to contain risks in the housing sector have failed miserably. 

It’s such a problem that the RBA is now loath to cut interest rates again, even at the risk of entrenching uncomfortably low inflation, lest it lead to a further build-up of household borrowing and frothy house prices in Sydney and Melbourne. 

Reserve Bank Governor, Philip Lowe, could not have been clearer. In a speech last week, he noted the RBA is now more carefully balancing the risks “from having inflation low for a longer period against the risks from attempting to increase inflation more quickly, which would partly occur through encouraging more borrowing.”

As Lowe conceded, “if inflation is low for a long period of time, it is certainly possible that inflation expectations adjust, making it harder to achieve the [inflation] objective.”  

In this regard, the fact that underlying inflation has dropped to below the RBA’s 2 to 3% target band, and does not look like lifting back into the band within a year or so, should be a cause for concern, as should be the fact that annual wage growth has dropped to historic lows of less than 2%.

Yet, Lowe downplayed such a risk, claiming “at the moment though, I don't see a particularly high risk of [low inflation expectations] in Australia. The recent lift in headline inflation is helpful here and most measures of inflation expectations are within the range seen over recent decades.”

This marks a big departure from the RBA’s inflation concerns last year – when it cut rates twice in the face of the first initial decline in inflation to below its target band. Now, however, the bank is more concerned with “continuing rises in indebtedness, partly as a result of low interest rates, [which] increase the fragility of household balance sheets.”

Why the change in sentiment? The obvious rebound in the Sydney and Melbourne property markets following last year’s rate cuts clearly didn’t please the Bank – particularly after it partly justified the case for rate cuts on the view that prices were moderating in these cities earlier last year, as well as growth in investor lending, thanks to some extent the APRA imposed “macro-prudential” tightening in lending standards.  

With hindsight, the Bank now fears it helped throw petrol on a wild bonfire that had thankfully already started to simmer down. As seen in the chart below, annual growth in investor lending bottomed in August last year, and has been accelerating ever since. 

 

Another more recent ground for caution is the mid-2016 slowdown in consumer spending, which seems to suggest households have reached the limit on the degree to which they want to run down their savings further to keep spending in the face of still quite muted income gains. The Bank is loath to risk pumping up household leverage even further, given the risk of a severe reckoning later.

Fair enough: but it does beg the question – why didn’t our “macro-prudential” tightening in lending conditions do more to contain our hot property markets even in the face of lower interest rates? The balancing act clearly failed. 

One problem appears to be that investor buying – which is the main driver of higher house prices – is not as credit driven as seemed apparent. After all, the latest credit figures from the RBA show that annual growth in investor housing credit, while accelerating again, has so far only lifted to back to 6.7% by January, which is still comfortably below APRA’s 10% desired cap.  

Maybe the cap needs to be lowered? 

The other, less well documented problem, is the extent of foreign (largely Chinese) buying in our major cities. The law states that buying of established properties needs to be by residents, or at least temporary residents, with the latter required to sell their properties when they leave. But how well these laws are enforced is hotly debated!

Given the tentatively encouraging signs of growth in the economy, the fact the RBA is less inclined to react to stubbornly low inflation by cutting rates anytime soon is, as yet, no great tragedy. But the inability of macro-prudential controls to contain recent property excess is clearly constraining the Bank’s options. 

With unemployment high and inflation low, the economy can, and should, be able to growth faster than it is at present. Lower interest rates would help, if only we did not need to worry about the bubbly Sydney and Melbourne markets. It means other still weak property markets across the country can’t benefit from a further lowering in rates, and it has left the $A higher than it would otherwise be. It’s also likely to mean share market performance, while reasonable thanks to recent gains in commodity prices, will lag that of our international peers. 

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Positive signs for economy: forget rate cuts in 2017?

Wednesday, February 15, 2017

By David Bassanese

Despite the shenanigans in Canberra, corporate Australia seems to be getting on with the job.

After I suggested just last week that the economy may be experiencing its own version of the “Trump bump”, we got more positive signs on the outlook in the past week. Business sentiment has gone through the roof, and the RBA has backed up its recent optimistic statements on the economy with a detailed justification of its views in the latest quarterly Statement on Monetary Policy. 

Of course, it’s important not to get too carried away, but parts of the economy appear to be stirring. The hope is that this will eventually translate into stronger corporate earnings, especially in the non-mining sectors. That said, if the economy is really picking up, we can forget about rate cuts this year, and there’s even a chance of rate hike by Melbourne Cup day. Under such a scenario, the $A could also conceivably re-test US80c, especially if coal and iron ore prices also defiantly remain firm.

Last Friday in its statement, the RBA doubled down on its optimistic outlook for the economy by dismissing the negative September quarter GDP result as largely reflecting “temporary factors”. Bad weather delayed some high-rise residential construction projects, and ever-volatile public investment saw fit to decline in the quarter. More seriously, consumer spending was also soft in the quarter, but already retail sales volumes, at least, did bounce back nicely in the December quarter.

That said, even allowing for a reasonable bounce back in growth last quarter, the RBA concedes growth through 2016 was likely only around 2%. But this disappointment has done nothing to shake the RBA’s faith that growth will lift to a 3% pace in 2017.

Why the optimism? For starters, business surveys suggest the decline in mining investment is close to bottoming out, meaning it will be less of a drag on growth. What’s more, LNG exports volumes are slated to pick up nicely, contributing an extra 0.5% to growth both this year and next year.  

Critically, however, the RBA is also counting on residential construction staying at a relatively high level despite the clear downtrend in new home building approvals that is now evident. Its confidence is based on the fact that much of the lift in home approvals in this cycle has been for high-rise apartment blocks, which take around three times longer (a year and half) to build than more traditional stand-alone homes – meaning there’s a lot more work still in the pipeline than is usual when building approvals start to turn down. Most of this work is slated to take place in Sydney, Melbourne and Brisbane. 

Of course, this longer-than-usual lag between home building approvals and actual construction leaves us with two risks down the track: some current plans might still be mothballed if conditions change, and there’s a greater risk of an eventual supply-demand mismatch (most likely over supply) later. But for now at least, new supply is being absorbed reasonably well in the hot markets of Sydney and Melbourne, though new apartment prices have already started to decline in the less buoyant market of Brisbane.

Elsewhere in the economy, the RBA is also counting on household spending remaining reasonably steady, and the long-awaited recovery in non-mining investment finally gathers steam just as the home building boom eventually fades. Even public infrastructure projects are contributing to growth.

The great immediate test of this optimism will be the labour market.

Reflecting improved economic growth this year, the RBA is counting on some lift in employment growth in coming months after moderation through 2016 - and it expects the unemployment rate to “edge lower” over the next year or so. But while continued gains in job ads and a firming in corporate hiring intentions points in this direction, the RBA did note these lead indicators have proven overly optimistic on the labour market over the past year. 

Of course, whether the RBA is right or not remains to be seen. But this week’s National Australian Business survey for January certainly counts in its favour. The NAB’s measure of business conditions shot up from +10 to +16 last month – or equal to levels seen in the pre-financial crisis boom period. While conditions in the consumer and business service sectors remain steady at a high level, driving the improvement in recent months has been decent recoveries in the mining, manufacturing, transport and wholesale sectors. To my mind, that suggests rising commodity prices and the cranking up in export volumes are making conditions at least “less bad” in these still relatively soft sectors. 

Of course, we might still worry about what may happen when the housing sector eventually turns down if non-mining investment remains missing in action. But then again, one of lessons of recent years is that our remarkably resilient economy in recent decades has always seemed to find a growth driver to latch onto.

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Is Australia starting to enjoy the Trump bump?

Wednesday, February 08, 2017

By David Bassanese

Is Australia already starting to enjoy the “Trump bump”? A smattering of positive economic data in recent weeks and an upbeat outlook from the Reserve Bank suggests the economy could well shake off the impact of the impending slide in home building fairly well. If so, it would be a great relief to Canberra and the RBA and suggests the share market could well post another year of positive returns, thanks to a belated lift in corporate earnings.

We’ll see of course, but to my mind, the tentatively improving outlook suggests simply persistent low inflation won’t be sufficient to goad the RBA into cutting interest rates further this year – especially with the Sydney housing market still red hot. What will also be necessary are clear signs that the labour market is deteriorating, as would be evident with the unemployment rate piercing through the 6% level again.

So why all the positivity? Perhaps the single best timely indicator on the economy is the National Australia Bank’s monthly business survey. The latest survey covering the month of December revealed an encouraging rebound in economy-wide business conditions, after having been on the slide since mid-2016. 

The improvement was fairly broad-based across sectors, with gains in transport and wholesaling particularly impressive. The NAB economists – who have been calling two RBA rate cuts this year – tried to look for the weak spots, noting that conditions in the retailing sector remained poor. But even in retailing, the latest survey showed a strong lift in forward orders during the month. As an indicator of consumer spending, moreover, the NAB survey could be given as a misleading read or at least reflect lags, as we know retail sales volumes rebounded by a solid 0.9% in the December quarter, after close to flat reading in the June and September quarters.

What appears to be particularly hurting retailers is not sales so much (though new foreign entrants and online retailers remains an intensifying threat), but the sheer lack of pricing power. According to the official retail sales survey, retail prices rose a meagre 0.3% in the December quarter, and only 1.3% over 2016. It’s little wonder underlying consumer price inflation remains so low.

It’s just a hunch, but perhaps one of the reasons for the relative strength in transport and wholesaling as reported by the NAB is the rapid growth in online retailing – we’re buying online and having stuff delivered to our homes or offices rather than venturing into shops. The solid gain in resource export volumes is another factor supporting transport.

Otherwise, the strongest sectors in the NAB survey are in finance, property and business services, along with recreation and personal services. Again, another reason for the ailing traditional retailing sector is that we are buying more “experiences”, through services such as massages, travel and eating out, rather than clothing, take-home food or household goods.

The other clear positive percolating through the economy is the amazingly persistent strength in coal and iron ore prices. While they’ve come off their boil in recent weeks, they remain at high levels – and the outlook has improved from the despair of early 2016, thanks to signs that China has no choice but to continue pump-priming housing and infrastructure activity to keep the economy ticking over, while also cutting back on excess capacity in its own high cost and highly polluting coal and iron ore industries. 

Judging by the RBA’s post-meeting Statement on Tuesday, the Bank still seems to see more blue skies than rain clouds ahead. For starters, it downplayed the negative September quarter GDP result suggesting it “largely reflected temporary factors” – which we know were factor like poor weather which hampered some construction projects and export shipments. The Bank then confidently expressed the view that its “central scenario remains for economic growth to be around 3 per cent over the next couple of years.”  As gleaned from various surveys, that’s still toward the top-end of the range of market-economist expectations (including my own), and suggest the RBA won’t revise down its growth outlook by much at all in this Friday’s Statement on Monetary Policy.

Given the RBA talks to an extensive range of business contacts on a regular basis, the fact it remains relatively upbeat on the economic outlook is encouraging. That said, while the RBA is not the worst economic forecaster in the country, even it is not infallible.

More generally, however, my sense is that the RBA may be getting a little more comfortable with below-target inflation, especially if it coincides with above trend growth (as it expects) and associated downward pressure on the unemployment rate. Indeed, provided low inflation does not reflect deficient demand – but rather “positive supply shocks” such as new entrants and productivity-enhancing technology shocks – it could actually be construed as an economic positive that enhancing real incomes.

All this suggest that a rate cut as early as May will also be a stretch – even if annual underlying inflation stays close to 1.5% in the March quarter report in late April – unless we also start to see the unemployment rate defying the RBA’s optimism and push back above 6%.

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Bond yields and China: the market's trump card?

Wednesday, February 01, 2017

By David Bassanese

Despite the various risk factors faced by the Australian equity market last year, it’s perhaps remarkable that it managed to produce a fairly decent outcome. In analysing the reasons, we can really focus on two factors: bond yields and China. Barring a spanner in the works from Donald Trump, the good news is that these factors may continue to keep the market ticking over fairly nicely this year also. 

The Australian equity market’s total return in 2016 was close to 12% - which is little above the broadly 10% return we might expect from the market over the long-run. Of this, the usually reliable grossed-up dividend return was around 5%. Stock prices provided the extra 7% return, the contribution to which were broadly split between higher (forward) earnings and a modest rise in the market’s price to forward earnings ratio.

Indeed, one of the surprises of 2016 was that the market’s elevated PE ratio managed to stay elevated – in fact it rose a little further, from 15.6 to 16.1, compared to a long-run average closer to 13.5. The lesson, however, was that super-low bond yields continued to justify a higher than average PE ratio. Indeed, local 10-year government bond yields actually eased back a little last year to end at 2.77%, which by my estimates had the equity market on a “fair-value” PE valuation given long-run bond-equity relationships. So those, myself included, that continued to fret about a “regression to the mean” in PE valuations did not have their fears validated by the market.

The other big story in 2016 was the resources sector, which defiantly rose from the ashes in the face of considerable investor scepticism. But this was not all hot air. As it turned out, China’s decision to support wavering growth by relaxing constraints on home building and unleash even more infrastructure projects actually saw its steel demand strengthen last year, following what appeared to be the start of steady annual falls in 2015. Add to that cuts in China's own iron ore and coal capacity, and the stage was set for a lift in its resource imports which led to surging commodity prices. Weather related supply setbacks in both Brazil and Australia added to the upside in prices.

The result of all this was a stunning 50% rebound in resource sector forward earnings over the year, which led to a modest 5% gain in overall market earnings despite continued sluggish performance in the non-mining sectors. Indeed, last year resources were a classic cyclical play – a good time to buy was when the sector’s PE ratio was elevated, in anticipation of a rebound in depressed earnings, which in fact, was more stunning than most anticipated. In turn, this has allow PE valuations in the sector to fall to more reasonably (though still a touch pricey) levels in recent months.

Where to from here? While I’m increasingly nervous about Donald Trump, I suspect his more erratic ways will be eventually kept in check by those around him. As for the economy, the key take-way from his plethora of executive orders last week was that he’s clearly decisive – and keen to live up to his promises – which bodes well for his pledge to slash taxes and boost infrastructure spending when he eventually focuses on this. 

Closer to home, while US bonds yields are likely to rise further this year, ours will likely rise by somewhat less – especially if the RBA cuts rates again as seems possible given persistently sub-2% underlying inflation. That, in turn, could keep the market’s PE ratio relatively elevated at around 15-16 times forward earnings.

Meanwhile, provided coal and iron ore prices don’t slump too far – which is a reasonable bet given China’s pledge to support growth and further rationalise its own resources industry – then further earnings upgrades could flow through in the resources sector. Indeed, even allowing for the natural tendency of bottom-up equity analysts to be overly optimistic on earnings expectations, I still see scope a further moderate 5% gain in overall market forward earnings this year, led by our miners. If the RBA cuts rates and the $A falls further, an overdue improvement in non-mining earnings could also emerge.

So Trump aside, key positives for the local market this year are the RBA’s lingering easing bias and China’s determination to keep its economy ticking over. 

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