Australia’s deepest fears looming larger
Weak retail sales in Australia speak to the biggest fear lurking over the Australian economy; that a high and rising debt load is starting to squeeze households, even before the RBA moves to tighten policy from record low interest rates. Australia is seeing positive signs for business and government capital expenditure, but if consumers retrench this may not be enough to rebalance the economy, or will at least stretch out the time before rates can normalise. In the meantime, a weaker exchange rate may be required to keep the economy on a sustainable path, and the nation’s growth and exchange rate are highly vulnerable to an external shock, such as lower commodity demand from China.
Feeding Australian’s deepest fears
Australian retail sales were much weaker than expected in August. This feeds straight into the biggest fear lurking over the Australian economy, frequently mentioned by the RBA and given consistently wide coverage in the media. High household leverage and a cooling housing market are dampening consumer demand.
On Monday, right on cue, the IMF annual Global Financial Report, released a special focus chapter on “Household Debt and Financial Stability,” picked up by the Australian Financial Review (Australian debt binge to drag on growth, jobs, IMF warns – AFR.com), speaking straight to greatest fears in Australia. If households in Australia are paying attention, they must feel like the walls closing in.
The AFR reported: “August’s fall [in retail sales] was the largest since March 2013, and the first back-to-back decline since November 2012. Not since late 2010 has there been a larger two-month slide.”
The AFR’s Jacob Greber, suggested that the recent speculation about the RBA bringing forward rate hikes, “joining the rest of the developed world,” may have dampened spending. Greber is channeling the worry that a high debt load has made Australian consumers hyper-sensitive to interest rate rises.
Household debt vs. recovering business and government investment
There are a number of positives helping underpin the Australian economic outlook. Non-mining business investment has shown a positive trend in the last year, and the downturn in mining investment is approaching its nadir. Government infrastructure spending is also on a strong growth path (Public GFCF +14.7%y/y in Q2). While mining investment tails off, exports have ramped up, supporting the Australian external balance.
However, private sector consumption, as in any developed economy, accounts for over half of GDP, and weak consumer spending would be a major drag on the overall outlook.
In fact, the question becomes: will stronger business and government spending boost employment and income growth sufficiently to sustain consumer spending growth, or will weak consumer spending drag down business confidence and weaken the overall economy?
In any case, a sluggish consumer response to stronger income growth will make the RBA more reticent to raise rates, especially if household debt loads make consumers much more sensitive to rate rises.
Australia’s strength is its flexible exchange rate
The IMF paper on household debt and financial stability highlights a number of positives for Australia in dealing with its debt load. Its sound financial banking regulatory environment and flexible exchange rate will help mitigate the adverse effects of high household debt. But of course, as an FX analyst, I have my eye on the currency effects. The mitigation arises from an exchange rate that falls to help support the economy that may suffer from weak consumer demand.
AUD more sensitive to retail trade than external trade
It is understandable that the AUD exchange rate has become more sensitive to retail sales data than is historically the case. It is now more responsive to retail sales than trade data. While retail sales were weak, Australia recorded a solid trade surplus of $A989m, above 850m expected, in August, and an upward revision to July from $A460m to 808m.
The stronger net exports reflect increasing volumes of iron ore and natural gas coming from the boost to capacity after the mining investment boom, stronger commodity prices in the last year, and strong growth in services exports (tourism and education), boosted by demand from Asia, in particular, China.
Australia’s goods trade balance was 0.7% of GDP in August, above -0.9% in New Zealand and -2.2% in Canada. Including services, Australia’s G+S balance was still 0.7% of GDP, New Zealand moves up to about +1.0% (with a services surplus of around a 1.9%), and Canada moves down further to around -3.4% (with a services deficit of around 1.2%).
Relatively weak consumer confidence
Weaker consumer spending is consistent with surveys of consumer confidence that are subdued in Australia relative to strong readings in many other developed economies.
All eyes on the Australian housing market
Weaker consumer confidence may be a reflection of the high debt levels in Australia, increasing concern that the housing market is over-priced, and diminishing potential for further capital gains.
Not helping is that Australia’s equity market is underperforming global markets, in part due to the perceptions that a slowing housing market and supervisory measures are weakening the outlook for banking stocks.
In any case, the wealth effect from rising house prices appears to be diminishing as households are more worried that prices are becoming unattainable for younger generations, and they appear much less inclined to withdraw the capital gain/equity in their homes to fund other spending (viewing their debt to income ratios as already stretched).
The state of the housing market has the potential to amplify the dampening impact of high household debt on consumer spending. The inclination to save will increase if house prices are perceived to be stagnant or falling.
The housing market has shown tentative signs of losing momentum. The national auction clearance rate has fallen from around 78% early in the year to around 70%. House prices still appear to be rising, but they have been more volatile this year. Gains have fallen to a 0.3% monthly rate in recent weeks, somewhat below the average monthly gain for this time of year over the last five years (0.5%).
In the last two months, the RBA has noted in their policy statements that “conditions are easing” in the Sydney housing market. It has noted all year that “a considerable additional supply of apartments is scheduled to come on stream over the next couple of years.”
The signs of easing in the housing market are still at best tentative, but the market is likely to be highly reactive to developing evidence of slowing.
Troubling declining impulse from still too high credit growth
The RBA has noted for months that APRA’s “supervisory measures” have generated some tightening in lending conditions, mainly for investors, via new limits on growth in interest only loans. In its policy statement this week, the RBA said, “growth in borrowing by investors has slowed a little recently.”
This might add to the signs of easing in the housing market. However, it is also the case that borrowing by owner-occupiers has accelerated somewhat this year, and overall household debt is still growing faster than incomes.
Overall housing-related credit growth is rising at a steady annual rate above 6. This compares with wages growth of under 2%. The compensation of employees in the national accounts rose 2.1%y/y in Q2.
The evidence of overall slowing in credit for housing is very tentative, and the national debt to income ratio is still rising from 194% in Q2. With mortgage interest rates at around record lows, households are still expanding their leverage. As such, it is not clear that APRA macro-prudential measures are having all that much effect.
Nevertheless, there is tentative evidenced that the housing market is slowing and consumer confidence is relatively weak even before credit growth has slowed, or the RBA begins lifting interest rates.
The RBA and APRA are only very gently leaning into the wind. We are yet to find out how sensitive households will be to rising interest rates, but the fear is high that households will retrench demand for consumption and housing rather abruptly, judging by already underwhelming consumer demand and tentative signs of slowing housing market.