Tuesday 06 February 2018 by Craig Swanger Opinion

US takes off but Australia not expected to follow

Guest contributor, Craig Swanger contrasts the domestic economy with the US on interest rates, growth and inflation expectations

underemployment

Australia’s latest CPI figures still show very weak inflation. Underlying inflation was up only 1.8%pa in 2017. It excludes volatile petrol and food prices, and is the key figure the RBA considers when looking at interest rates. Worse still, if we remove the impacts of artificially created inflation from government excises on petrol and tobacco, inflation is just 1.5%pa. 

Australia’s inflation has been weak since 2015. This has certainly been driven by weak wage growth and while less certain, the impact of digital price competition.  

Contrast between Australia and the US is growing

The picture in the United States is quite different.  The US economy was recovering strongly from 2014 and has now received an enormous boost from the Trump Tax Plan.  Repatriation of corporate cash being sheltered in lower tax environments, and lower tax rates for corporates and the upper income levels, have all lead to a boost in confidence at the very least.  It would be reasonable to assume that much of this confidence will lead to increased spending and investment, and that certainly has been the evidence in recent weeks.  

The charts below highlight the very different trajectories of the two economies.  Inflation in the US has been around 0.5% lower than in Australia for more than 30 years. This is reflected in the two countries CPI targets: Australia’s target range is from 2.0% - 3.0%, averaging 2.5%pa; the US target is 2.0%pa.  

But in late 2015, Australian inflation fell while the US started to see an increase from its post-GFC low points.  This cannot be explained by the costs of goods since we import most goods and with the falling AUD around that time, if anything, the price of goods should have been going up.  Nor can it be explained by petrol prices that are excluded from “Underlying Inflation”.  

Australia’s anaemic wage growth to blame

The explanation comes from wage growth.  As we’ve forecasted for several years now, wage growth in Australia has continued to fall.  The last data out in September 2017 showed the strongest rise for three years, but just for the one quarter, which was purely because of the rise in the minimum wage mandated by Fair Work Australia from 1 July 2017. 

One quarter does not tell us anything useful.  Figure 2 uses rolling two year data to take out these short term noises.  The picture is a sobering reality check on the true state of the demand for labour in Australia compared to the US.  

Both countries are celebrating low unemployment.  But wage growth habitually uncovers the flaws in the unemployment rate, namely that it doesn’t measure how much employment is demanded by employers.  It only measures how many people can’t find one hour of work per week.  Wage growth is the result of demand growing faster than supply causing competition for increasingly scarce labour.  If every person in the labour force could only find one hour of work each week, the unemployment rate would be 0%, yet there would be so much surplus supply of labour that wage growth would collapse. 

Falling unemployment does not necessitate rising wages.  Falling “underemployment” on the other hand will push up wages.  And at the end of 2017, Australia still had very high underemployment at 14.3%, stuck at the same level for three years, hence the very weak wage growth.  By contrast, underemployment in the US is back to the same level it was at the peak of the pre-GFC economic boom and still falling sharply.  

Consumer spending and household debt

Australian consumer spending remains very weak.  There were signs of a pickup in retail spending in November, but this was more thanks to heavy discounting on the Black Friday sales weekend, which brought forward spending that normally happens in December.  Because prices were so discounted, sales might have been higher but profits were lower. 

Consumer spending makes up 60% of the demand in the Australian economy.  This means that it is critical for domestic economic growth that is excluding exports - for wage growth, for inflation, and therefore for future interest rates and equities returns.  This type of increase in spending, which results in lower earnings, does very little for business investment or willingness to increase wages. 

The consumer spending challenge for the Australian economy is only going to get worse if interest rates do rise.  Australian household debt is at record levels.  Due to high debt and low wage growth, discretionary income is under severe pressure, evidenced by the falling level of household savings. 

Worse still, inflation for essential items like health, housing, utilities and education are rising at a much faster pace (2.6%pa) than discretionary items like clothing, furniture and electronics (1.0%pa). So, discretionary spending is being severely squeezed from both ends.  

The “Amazon Effect”

The digital economy continues to put downward pressure on inflation.  While the US inflation is now rising, it is only after some fairly extraordinary employment growth and economic stimulus.  Inflation for goods mostly purchased online such as technology, clothing and entertainment have all been falling for several years now.  As predicted in our article on the Amazon Inflation Index last year, the digital economy will continue to hold inflation down for as long as the level of online shopping rises, which will be at least another 10 to 15 years yet. 

In Australia, the Amazon Effect has barely begun. Australia’s level of online shopping is still around two years behind that in the US.  Amazon and Alibaba, the world’s largest two online retailers, only reached Australia in a meaningful way last year.  As these online retailers start to change Australian consumer behaviours, domestic retailers will suffer lower and lower margins, putting retail sector employment under pressure. On the bright side, this pressure will see lower prices on a large range of goods that we have always paid more for compared to the rest of the world.  

Conclusion and investment implications

Inflation in the US has without doubt started its long awaited rise.  It is more muted than one would expect when employment growth is so high, but it has clearly moved higher in the past two years.  With employment growth continuing at strong levels, underemployment at pre-recession lows and GDP growth expected to be very strong in the current period, there is little doubt that the US Federal Reserve will be increasing rates in 2018. And while the Fed will watch the reaction of the real economy and financial markets, it will likely increase rates by 75bps this year. 

On the other hand, Australia’s inflation looks anaemic.  For the first time in more than 20 years, our inflation has fallen below that of the US for an extended period.  No doubt caused by wage growth, our fallen inflation underlies the truth about Australia’s domestic economy. 

Excluding exports, we are running out of fuel for growth in the domestic economy.  The RBA cannot increase rates without putting even more pressure on the weakest part of the economy – the household sector.  Ironically, now that housing prices are weakening, households will be even more sensitive to rising rates. 

The only proactive plan for the Australian economy is to leave rates on hold. Let increasing rates in the US and to a lesser extent, in Europe, push down the Australian dollar, and allow a lower dollar improve the prospects for the tourism, education and other exportable service sectors, along with agriculture and mining investment.  With all of those sectors by a lower dollar, wages may start to move again, and only then can the RBA consider raising rates.

Until that time, Australian dollar longer term bonds may still rise in yield with other global bond yields, but they shouldn’t rise.  However, we have seen several times in the past that global bond traders push all yields higher when markets are moving quickly (as they are now), and then in the wash up, the fundamentals of the underlying economies realign weaker countries, like Australia at the moment – down again.  And as we predicted in 2016, this will likely very soon result in Australian 10 year bond yields falling below US 10 year yields, a rare and ominous sign for the Australian economy.


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