Past six months...
In Australia, the fall in commodity prices and the terms of trade that started in 2011 continued through the first half of this year. The exchange rate finally responded to this softening in March, with the broad TWI falling around 6½% since then (Chart 1). Apart from falling commodity prices, other factors pushing down the A$ appear to have been US$ appreciation, concerns about the outlook for China, and a reduction in the cash rate in May.
Export revenues have been boosted by still strong prices for bulk commodities – coal and iron ore. Service exports softened a bit in March and April, but rose 2½% on a year before. Exports of manufactures have continued to struggle (Chart 2).
The resource investment boom that has done so much to propel economic growth over the last few years moved closer to its peak, according to both the Reserve Bank and BREE. Capital spending in the resource sector remains extraordinarily strong by historical standards, and will probably stay that way for the next year, but may soon begin to decrease.
Overseas, world economic growth looks as if it accelerated modestly out of the soft patch it fell into late last year. Growth strengthened in the US, Japan, and the rest of Asia. The euro area remains in recession, but the rate of GDP contraction seems to be diminishing. China’s growth, however, disappointed, slowing from an 8% annualised rate in the December quarter to just 6.4% in the March quarter. There are signs of only a mild pick-up in the June quarter.
Despite the signs of acceleration, it looks as if 2013 as a whole will be year of slower expansion than 2012.
Notice that commodity prices fell even as the world economy picked up speed. This seems to be due to a combination of increased production on the supply side and substitution and conservation on the demand side – all three of which have been induced by previous high prices.
The US economy produced two pleasant surprises. First, it didn't plunge over a fiscal cliff. A pick-up in private demand prevented this from happening, even though across-the-board federal spending cuts (the ‘sequester’) imposed a large fiscal drag on growth. Second, predictions of a slide into fiscal insolvency faded following the release of projections by the Congressional Budget Office suggesting that economic recovery would shrink the federal government to 5.3% of GDP this fiscal year and 2.4% by 2015. (True, budgets are projected to increase later in the coming decade, because of population ageing, rising health care and health insurance costs, and growing interest payments on federal debt. But the increase is a slow one and seems containable through a range of feasible cost containment measures.)
Another euro area country succumbed to crisis and required a bail-out: Cyprus. Because the bail-out actually involved a bail-in of uninsured depositors, concerns arose that depositors could flee banks in other crisis-prone peripheral countries. But this hasn't happened so far.
For all the inability of peripheral euro countries to outgrow their debts, markets have become less anxious about a full-blown crisis erupting – involving sovereign debt default, banking collapse and even euro area exit. And the reason is, the European Central Bank has said it is willing to act as a lender of last resort to banks and governments facing sudden funding stops.
The sharp turn towards fiscal and monetary stimulus under 'Abenomcs' gave a strong boost to Japanese GDP by weakening the yen, directly injecting spending into the economy, and buoying consumer and business sentiment.
Emerging economies were a mixed bag. Latin America and Asia outside of Japan and China appear to have slowed in the March quarter, though there are some signs of speed-up in the current quarter. March quarter growth actually turned negative in Taiwan and Thailand, and virtually stalled in Hong Kong, Singapore and Malaysia. The Middle East & North Africa were held back by regional tensions and euro area weakness. Emerging Europe slowly accelerated from a near standstill in the December quarter.
In financial markets, the provision of ample liquidity under quantitative easing programs by the US Federal Reserve, Bank of England and Bank of Japan, along with the European Central Bank’s Outright Monetary Transaction (OMT) program of sovereign bond purchases on the eurozone periphery, led to a strong rally in share and bond prices, including high-yield ('junk') bonds and emerging market debt, as well as to a marked depreciation in the yen.
Next six months...
The peaking of the Australian resource investment boom, the slowdown of China, and ‘QE taper' are likely to be prominent concerns over the next six months, and indeed into 2014.
Significant ‘rebalancing’ is likely to take place within the Australian economy as resource investment starts to fall. Markets have grown somewhat anxious that there won't be a smooth ‘baton pass’ from resource investment to other forms of domestic spending and resource exports, leaving the economy exposed to a sharp downturn. Based on overnight indexed swaps, they are pricing in a further 25 basis points of cash rate cuts by the Reserve Bank before the end of the year to cushion the downturn, and the Bank itself, at its June monetary policy meeting, said that 'the inflation outlook as currently assessed might provide some scope for further easing, should that be required’.
Further A$ depreciation may also be in store. Both the Reserve Bank and the Commonwealth Treasury foresee further falls in the terms of trade, as the international supply of iron ore and coal increases and prices come down. The Reserve Bank thought last month that ‘It was possible that the exchange rate would depreciate further over time as the terms of trade declined’. Further A$ depreciation should help to offset some of the financial impact of lower commodity prices on miners and could boost the prospects of non-resource exporters.
The transition from the investment boom to the subsequent export boom should start to become evident. As we noted last month, iron ore exports are forecast [in the 2013-14 Commonwealth Budget] to increase by more than 40% over the next three years, with total volumes reaching double their 2008-09 level in 2014-15. Coal export volumes are also expected to rise strongly – 35% over the next three years. Australia is also expected to become the world’s largest LNG exporter by the end of the decade.
Not only does the Chinese economy appear to be settling into a slower 7-8% growth groove, because of structural factors like a decline in the working age population, slowing rural-urban migration and declining investment; it is also vulnerable to a sharper cyclical slowdown because of a credit boom it has undergone since 2009. This has created a legacy of poorly performing investments financed by loans from local government finance companies and shadow banks that could turn sour once credit growth slows. A credit squeeze currently being implemented by the central bank to rein in such excessive lending creates precisely this ‘hard landing’ risk.
There is also a risk of financial volatility from tapering of the US Federal Reserve’s quantitative easing. The Fed indicated in mid June that it could begin such a taper or scaling back of its asset purchases by year-end if unemployment falls in line with its forecasts. When the tapering starts, there is likely to be a significant decline in asset prices worldwide, and in emerging market assets in particular. Indeed, the anticipation of taper has already begun to induce such volatility.
Roger Donnelly, Chief Economist
Ben Ford, Senior Economist
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