The long grinding cycle becomes an epic tale


It has been six months since I last wrote on Macquarie’s strategy research theme the ‘long grinding cycle’ (LGC), and what might have been a short story is now looking more like a multi-chaptered nonfiction novel.

To re-cap, we defined the LGC as a longer economic cycle characterised by low inflation (with the risk of deflation), weak demand growth and for Australia a re-alignment of its economic cycle from its traditional peers (in particular the United States).1

Sound familiar?

Let’s take a look at what characterised the past six months. Consumer confidence remains flat, although we have seen some sporadic improvements in retail activity. House prices, mainly in Sydney and Melbourne, are rising, and combined with a rising stock market in the first four months of 2015 this has provided something of a ‘wealth effect’. A Federal Budget more palatable to the public has also helped.

However, it’s a different story for business confidence as reflected in business investment – or more to the point, lack of investment. Capital expenditure is now 20% lower than where it was 12 months ago, and this is the crucial missing element for our economy’s growth outlook.

The mystery is, why is this so? Over the past 12 months the Reserve Bank of Australia (RBA) has cut official the interest rate by a combined total of 0.5%, to 2%, which Macquarie predicted in January.

The Australian dollar has depreciated against the US dollar by 20%, 3% against the Euro and 7% against the Japanese Yen. As these are our trading partners, that’s certainly helping our exporters by making them more competitive and helping to re-balance the economy. Meanwhile, the oil price is 45% below where it was 12 months ago, with benefits to both industry and households.

All these elements should be providing cost benefits to business and reflecting in stable, if not improving, profits.

However, our economy is still transitioning from a reliance on the mining investment boom for growth to a broader range of economic activity. The RBA continues to note this at its monthly monetary policy setting meeting referring to the need for a weaker currency to re-balance our economy.

The latest GDP reading shows our economy is growing at 2.3%. The make up of this growth is interesting, as 1.3% is still largely mining related, so consumer, business and government activity account for the balance of 1%.

The Greek debt crisis makes for interesting daily news, however the reality is Australia has very little direct exposure to Greece, either financial or in trade.
Macquarie is of the view that the European Union (EU) is also in a much stronger position to handle this crisis. To put it in perspective, the total foreign debt exposure by European banks to Greece is 45 billion Euros. It’s certainly a large number, but not compared with the total market capitalisation of European banks which is 1.3 trillion Euros.

The recent fall in the Chinese stock markets however could be of greater concern and relevance.

Keeping some perspective, the Chinese share markets, notably the Shanghai Composite and the Shenzhen Composite, had rallied 150% in the past 12 months. It’s certainly not sustainable and a correction was inevitable. However the pace of the 30% fall has been a surprise.

Macquarie analysts believe there will be little impact on the Chinese economy, and therefore Australia, as the share markets are still in their infancy and do not reflect the broader Chinese economy. They also lack deep linkages – for example, these share markets provide just 2% of total capital sourced. It is estimated less than 8% of the adult population own shares, compared with developed world benchmarks of 20% to 35%.

Lastly, Chinese households are very good savers. They hold high levels of cash and the fall in the stock markets will not be have a significantly negative impact on wealth effect – especially given those participating would also have benefitted from the 150% rise.

China is in a prolonged period of structural reform, and we believe authorities will aim for stable growth of around 7% over this period of change.

And so the LGC continues. We may see a further 0.25% official interest rate cut in November this year to 1.75% if the Australian economy’s activity remains subdued, and a further depreciation in the Australian dollar would also be helpful.

In terms of forecasts, it’s certainly a mixed picture – and I believe we are only half way through this story.

Source: Macquarie