Australia’s Economic Machine
Today I am going to head down under to beautiful Australia.
As always, I look at each Economy through “transaction-based” approach, which basically means at the bottom of everything, an economy is just someone selling something and someone buying something. That is it.
As in all posts, I will look at 3 main factors to determine how the Economic Machine is working:
(1) Productivity Growth
(2) The Long Term Debt Cycle
(3) The Short Term Debt Cycle.
Let’s get started!
1. Productivity
Australia is largely a services economy, however , much of its success is based on agriculture and mineral resources.
To begin our analysis we first look at Australia current Annual GDP Growth Rate, which expanded at 0.30% in the third quarter of 2014.
For the past 60 years Australia has seen an average GDP growth rate of around 0.88%, with an all time high of only 4.5% or so, and an all time low of around -2% or so. So, the cyclical swings are not very drastic in this economy, and I think we can rest assured that even in GDP growth slides, it won’t slide far and will typically retain growth shortly.
One of my key views is that movements in GDP growth are typically due to expansions or contractions in credit. So, to really understand where productivity is going you have to examine the debt cycles.
Recessions/depressions don’t occur because a drop in Productivity, as many economists think. They occur because a drop in demand, and that is largely due to a drop in credit creation.
Additionally, the most important thing to keep in mind is that debt can’t grow forever, because eventually people can no longer afford to service the debt. The debt-service payments grow faster than incomes, and you have defaults. That is how we get cycles.
Lets look at the Long Term Debt cycle to clear up the picture a bit.
2. The Long Term Debt Cycle
Long Term debt cycles typically occur over a period of 50–75 years, and are a result of debts rising faster incomes, until you get to a point where people/countries can no longer afford to service their debts, usually because interest rates are low and can’t go any lower.
We look at the Long Term Debt Cycle because the availability of credit(debt) expands spending beyond income levels. And one person’s spending is another person’s income. So, an increase in credit, increases spending, which increases income levels, which increases spending, which increases demand, which increases production, and as production increases so should income levels.
The above events are what cause the long term debt cycle.
This cycle churns and churns, and the bubble inflates and inflates, and everyone is happy. But this cannot go on forever. Eventually debts grow faster than incomes, and debt service payments become too high and people/countries can’t afford to service that debt. That is when the entire thing comes crashing down, and everything works in reverse.
Knowing where a country is in this process, and where it is likely headed, will give you insights as to how certain assets will perform.
To begin, the below chart shows the Government Debt to GDP in Australia at 20.48% of GDP, which is very low and seems to be trending down. This suggests that the government may continue to reduce its spending, and that is not good for economic growth.
Now, the above chart details debt relative to GDP, but it is more precise to look at the debt service payments, and not high debt levels, because it is the service of the debt that we should concern ourselves with. As long as countries/companies/people can afford to service their debt, the party can continue. The party ends when the debt service payments grow to more than we can borrow.
I would like to examine data on Debt Service Payment levels as a % of income, but I could not find any reliable data for Australia on that.
One could consider Interest Rates in Australia, which are currently at 2.50%, and has been holding at that level for the last year or so.
With rates at this level, central bankers have some room to lower rates to increase growth in credit, which ultimately spurs growth in the overall economy.
As seen in the below chart, Money Supply (M0) in Australia have steadily rising for the last few decades and I see nothing to suggest it stopping any time soon.
With an increase in the money supply you will typically see an increase in purchases, increased incomes, increased demand, and fast economic growth. The only worry of this increase in spending and demand is of course inflation.
Currently, the inflation rate in Australia is 2.30%, which is a healthy level. Inflation has been trending down lately, which but not so far as to bring about deflationary worries.
As well, one can look at the Sovereign Bond yields to get an expectation of inflation in a market. The 10Y decreased to 2.71% in January from 2.81 percent in December of 2014.
The yield on government debt indicates expectations on inflation and debt repayment. Inflation is typically seen as the primary killer of bond portfolios, as higher inflation typically drives interest rates up, and bond prices down. The rate on the 10Y has plummeted for the last few decades, as investor put their money in safety. This low rate would also seem to suggest that the market does not expect inflation to be a problem in the foreseeable future.
Keep in mind the drop in oil prices, and Australia is a net oil importer, so that is going to help consumers as well, as they have more money to spend in their pockets, which rises spending and overall demand, and may push up economic growth.
However, debt problems typically occur because financial assets are bought at high prices with credit. Let’s look at Australian Stock market to get a general picture of where financial assets are currently.
As you can clearly see, Australian Stock Market experienced a very cyclical boom and bust around 2008, just like the rest of the world, and since then has seen some reinflation of asset values. This may be near a high or at a high in the short term cycle, so I would look out for a reversal at these levels in stocks in 2015–2016.
Another key indicator is how much the Government is spending, as the Government is one of the most important aspects of the economy. If the government is increasing its spending, that will increase demand, increased demand leads to increased incomes, which leads to more spending, and eventually an increase in prices. But, as we saw above, inflation is not a problem at the moment.
As seen above, Government spending in Australia has been steadily increasing for the last 50 years, and doesn’t show any signs of stopping in 2015.
Now, the top of the long term debt cycle occurs when 1) debt service payments are high and/or 2) monetary policy doesn’t spur credit growth.
With Debt to GDP high and interest rates low, I don’t think debt service payments are a problem in Australia, which would seem to suggest we are no where near the top of the long term debt cycle.
Let’s look at the Short Term Debt Cycle to better understand this economy.
3. The Short Term Debt Cycle
Short term debt cycles occur when you have 1) spending growing faster than 2) the capacity to produce, which then leads to 3) increases in prices (inflation), and that continues until 4) spending is slowed by tightening monetary policy, and that is when a recession happens.
Recessions typically arise from a contraction in private sector debt growth, which is typically the results of central banks tightening (increasing rates) to stave off inflation. If we work that backwards we see that increasing inflation will drive central banks to tighten, which will slow private sector debt growth and bring about a recession.
So, to begin, we want to examine the growth rate in Consumer Spending (money and credit) and Government spending, and see if total spending is growing faster than the growth rate of the capacity to produce.
Below is a chart showing Consumer Spending, which increased for the last 15 years or so. I wonder when this will peak??
Below is a chart on Consumer Credit data. As you can seen, Consumer Credit has been growing for the last 15 years as well. A clear cycle is shown in this chart. Now, the more credit growth, the more overall spending you will see, which will prop up incomes, increase demand and the economy grows, until people can no longer afford to service their debt.
The above two charts are worrisome to me, because credit growth can’t go on forever.
Wage growth in Australia has seen steady growth over the last 15 years, which is good for economic growth because as wages increase, so will spending, and one person’s spending is another’s income, so you see more spending, and more income growth, which pushes economic growth even higher.
As well, when discussing the short term debt cycle, we have to examine whether total spending is growing faster than the growth rate of the capacity to produce, because that leads to inflation, until spending is curtailed by tighten monetary policy, which brings about a recession.
To examine production capacity we look at Industrial Production, which increased 4.63% in 2nd quarter of 2014 (the most recent data available).
But as you can see Production seems to be hovering around the peak here in the short term cycle, and I would not be surprised by a downward trend coming in 2015.
It is also important to think about what drives Industrial Production, because that same driver will likely drive the Services sector as well. And that driver is of course Demand. But what drives demand? Incomes drive demand somewhat. But when people want more than they can afford, they leverage up. So credit growth really drives demand. That is why credit creation is so very important to the overall movement of the economy.
To get back to our Short Term Debt Cycle analysis, if spending is growing faster than production we will see price increases, or inflation, which is the killer of economic prosperity. At 4.63% growth in Industrial Production spending could be growing faster than that, but I’m not entirely sure.
I would also like to look at Capacity Utilization here, and in the below chart we can see that Australia is slowly pulling out of a bottom and is currently running at a Capacity Utilization of 80.48%.
This level is healthy, but on the cusp, and means that there is little slack in the economy, or barely any room to increase production without having to incur additional costs such as building new factories or plants. Levels of around 82%-85% usually indicate inflation is likely coming.
You can also see the cycle peaking around 2008, and that we appear to be slowing climbing out of the following recession still. When CU is high or rising, that usually means that demands is growing, and when CU is falling that typically means demand is falling.
This chart is a positive to me, because if teh trend looks to be for CU to continue to grow, that typically means demand has strengthened, which is obviously good for economic growth.
Lets pull it all together.
Conclusion:
When we take all the above information and charts into consideration, I think that Australia is in Late Part of the “Recession Phase” — Typically, this is evidenced by:
- central bank eases monetary policy
- inflation concerns subside
- recession concerns grow
- interest rates decline
- lower interest rates cause stock prices to RISE (even though the economy hasn’t yet turned up)
- commodity prices and inflation-hedge assets (oil, natural gas, gold) continue to be weak.
- the lower interest rates and higher stock prices set the stage for the expansion part of the cycle to begin all over again, and we go round and round.
I think Australia if you have some guts, this might be a great time to jump into Australia, as they slowly pull themselves out of the bottom, and begin growing again.
But I could be wrong.
Originally published at theeconomicmachine.tumblr.com.
