March 10, 2005
NOW that the dust has had time to settle, let's have another look at the national accounts figures released last week, think about how we can interpret the Reserve Bank's decision to raise interest rates in the face of "weak growth", and look at consequences for property.
Economic growth was weak in the second half of 2004. Let me clarify. GDP growth, ie production growth, was weak last year.
But domestic demand and domestic expenditure (GNE) growth remained strong, albeit a little lower than the very strong levels of the preceding two years. What happened?
Domestic demand did slow from around 6 per cent to around 4 per cent during the course of the year as we saw the first impact of the housing downturn on work done in the housing market come through. We saw a stock rundown (probably unintended) in the second half of the year affect GNE. But there were positives, too.
Government expenditure (consumption and capital) was strong and, most importantly, we saw the first signs of acceleration in business investment in plant and equipment. That's important.
Let me digress for a second. We at BIS Shrapnel have for a long time been arguing that business investment has been inadequate. In aggregate terms, business investment appeared strong, boosted by some extremely solid sectors, the minerals and secondary processing boom, for example. It was only when you looked at the industry level that the inadequacy became apparent.
It was easy to see why it happened. The last eight years have seen numerous negative shocks to the Australian economy. The Asian crisis of 1998 was followed by the "tech wreck" post-2000, the domestic downturn in 2001 and, just as we recovered from that, we ran into the impact of world recession, drought and SARS in 2003.
Over all this time, the logic of most Australian businesses, driven by investment markets through boards and through the ranks, has fluctuated between cost cutting and cost containment, from a focus on survival to emphasis on short-term profits.
It worked for a while, with strong growth in profitability (through cost cutting, but little new investment). But now we have to pay the piper.
What we're seeing now are the consequences of the short-term focus on profits, of inadequate investment both in the private and public sectors and of inadequate planning.
Capacity constraints, infrastructure bottlenecks, and the blowout in imports and the current account deficit are the result of a corporate logic driven by investors, analysts, boards and management to improve efficiency and maximise this year's profit and share price. Sound familiar?
As a result, business Australia is tight as a drum.
We're lean and mean and efficient. We've extracted almost all of the profitability increases available from reducing costs. We can't increase production without increasing labour and we're running into capacity constraints.
Productivity growth has fallen to virtually zero. And we haven't invested enough to allow for growth. Meanwhile, demand is strong.
Moreover, all this is happening at a time when we're running into skilled-labour shortages.
Now that bottlenecks and capacity constraints are becoming apparent, companies are making a seachange in logic, switching from cost containment to investment for growth, both by increasing the productivity of labour and by expanding capacity.
That's the only way for them to underwrite growth in both output and profitability over the next few years.
This switch in corporate logic has already begun. It was evident in the latest CAPEX and national accounts data. Interestingly, small business started before large business. But we're now seeing the beginning of a surge in investment that will last several years and, fortuitously, it's all happening at a time that the high (actually, overvalued) Australian dollar has made that capital expenditure cheap.
The problem is that it will take time for new capacity to come on stream. We should feel the benefits of labour-saving investment first. But I digress.
If demand is so strong, how come production is so weak? There are several answers:
- Capacity constraints are limiting our ability to produce to meet demand.
- The overvalued dollar is not only affecting our competitiveness in manufactured exports, but more importantly is affecting our competitiveness against imports.
- The combination of strong demand, capacity constraints and an overvalued dollar has seen increasing import penetration and several years of extremely strong import growth. And import growth will stay strong since most of our business equipment is imported.
- Meanwhile, exports have been constrained by the same factors. Strong demand for and prices of minerals and metals has been constrained by capacity. Investment started two years ago but those projects are only now starting to come on stream. The problem is compounded by capacity constraints in transport, materials handling, port and shipping infrastructure necessary to get product to its final destination. Exports, still weak, will rise substantially through the course of this year and next.
- Add to that the rundown in stocks in the second half of last year, which should be reversed this year.
The upshot is that there's a significant negative external contribution and a major gap between expenditure and production.
The blowout in the current account deficit, usually conveniently ignored, is a symptom of this and a serious long-term problem for Australia, albeit a sleeper at the moment.
The import problem won't get any better this year. While demand is strong, there will continue to be leakage of demand into imports. The Australian dollar doesn't look like falling any time soon to improve competitiveness. And investment will take time to flow through into production.
But the export situation will improve as new capacity comes on stream this year and next and the stock rundown should turn around.
So, over the course of this year, we should see a reduction in the gap between expenditure and production. The expenditure side will soften a little, but production will improve and growth will be sustained.
Meanwhile, despite the slowing of GDP in the second half of 2004, we've seen a surge in job creation. Employment grew by 3 per cent in the year to January 2005 and that will boost household income.
We're not afraid of losing our jobs or going broke. So we'll keep spending what we earn, perhaps a little more slowly than in the last few boom years for retail sales, but still growing strongly.
It is against this background that we must interpret the Reserve Bank's decision to raise interest rates. They already knew what the growth figures would be when they made their decision. To some this was an anomaly. Why increase interest rates if growth is weak?
What it does show is the seriousness with which the Reserve views the threat of inflation, particularly in an environment of strong demand in the face of capacity constraints and skilled-labour shortages.
That's the story we've been telling for a long time now. (In fact, we're thinking of suing the Reserve for stealing our line). And I must say if I were in the Reserve's shoes and was worried about inflationary pressures, I'd try to cut back demand early in the hope of avoiding the need for a more significant rise in interest rates later on. And that's what I think they've done.
Sure there is as yet no sign of inflation. And thanks to the federal Government for pointing that out. But these are precisely the conditions in which inflationary pressures can emerge.
I still think demand inflationary pressure will come through, taking CPI inflation to levels unacceptable to the Reserve during 2006 and forcing a significant tightening. But if it's to be avoided, the Reserve is doing the right thing.
So, what does this mean for property markets?
Firstly, we're not going to see a collapse in the economy this year. We can live with these higher interest rates. Interest rates are still low.
And the emergence of capacity constraints will be felt in the property industry, too, as the supply of space dries up, leading to rising rents and new construction. Meanwhile, we'll see a phase of investment in new warehousing technologies, increasing the demand for and development of industrial property.
Business investment will boost property demand in the commercial and industrial sectors.
Meanwhile retail sales growth should be sustained, albeit at a lower rate than the extraordinary levels of the last few years - around 7 per cent per annum real compared to my rule of thumb 2.5 per cent. We're not worried about losing our jobs and we're not really tightening our belts yet.
The strength of retail margins will flow through to retail rents over coming years. Retail property is OK. On the other hand, residential property is not going to recover quickly.
This is the time when business-related property will be strong.
Frank Gelber is chief economist at BIS Shrapnel
Reference: The Australian.
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