Macro Letter – No 11 – 09-05-2014
Canada – Australia – New Zealand – Commodities vs Housing
- Commodity prices continue to decline due to slowing Chinese growth
- Rising real estate prices in Canada, Australia and New Zealand ignore commodity demand
- What does this mean for their stock, bond and currency markets?
Since the initial recovery in 2010 the price of Iron Ore and Coking Coal has declined due to lower demand from China. Australian Coking Coal hit a six year low in April. This downturn in demand has also been evident in the price of Copper and other industrial metals. Last year grain prices also tumbled adding to the pressure on commodity exporting countries: although prices for New Zealand’s Dairy Products remained firm.
Since Australia and New Zealand have similar major trading partners, and are geographically close when compared to Canada, they tend to be considered together whilst Canada is grouped with other NAFTA countries. I want to review these three countries together. To begin I’ve constructed a table which highlights some of the similarities and differences between these “commodity” countries.
|Country||Main Exports||Export Markets|
|Canada||Oil, Wood Products, Chemicals||USA (73%) EU (5%) UK (4%)|
|Australia||Coal, Iron, Wheat, Aluminium||China (30%) Japan (19%) S. Korea (8%)|
|New Zealand||Dairy Products, Meat, Wool||Australia (21%) China (15%) USA (9%) Japan (7%)|
During the decline in commodity prices the currency markets have reflected these dynamics quite accurately. The CAD and AUD have been steadily falling vs the US$ – although these trends may be starting to reverse. The NZD by contrast has continued to appreciate not only against the US$ but also against its “commodity cousins”.
The chart below shows the NZD Trade-weighted index up to mid 2013 – it has continued to appreciate since then.
The AUD Trade-weighted index chart is updated to the beginning of 2014 – it continued to weaken until last month.
The third chart is of the CAD effective exchange rate – it also shows foreign capital flows.
Source: Business in Canada
Plus ça change, plus c’est la même chose
The currency markets reflect Canada and Australia’s reaction to the weakness of Chinese demand, the rising NZD points to other factors. Before I delve into the real estate market I thought the table below might be useful, it looks at a number of economic indicators across the three countries. In many respects these economies are quite similar.
|Country||GDP||Unemploy||CPI||Current A/C||Budget||Base Rate||10 yr||Debt/GDP|
New Zealand is delivering the strongest GDP growth with the highest real interest rates, but all three countries are suffering from twin budget and current account deficits. Considering the weakness of commodity markets and their reliance on those export markets it is clear that other factors are driving growth.
A quick review of the central bank policy reports reveals another common theme – real estate.
Inflation in Canada remains low. Core inflation is expected to stay well below 2 per cent this year due to the effects of economic slack and heightened retail competition, and these effects will persist until early 2016. Total CPI inflation is forecast to be closer to 2 per cent over the coming quarters and remain close to target thereafter.
The global economic expansion is expected to strengthen over the next three years, as headwinds that have been restraining activity dissipate.
In Canada, the fundamental determinants of growth and inflation continue to strengthen gradually, as anticipated.
The Bank continues to expect Canada’s real GDP growth to average about 2 1/2 per cent in 2014 and 2015 before easing to around the 2 per cent growth rate of the economy’s potential in 2016.
No mention of concern about an overheated real estate market in the highlights, however later in the summary they do state: –
Recent developments are in line with the Bank’s expectation of a soft landing in the housing market and stabilizing debt-to-income ratios for households. Still, household imbalances remain elevated and would pose a significant risk should economic conditions deteriorate.
Perhaps the BoC don’t believe it’s their job to reign in the housing market. The Canadian government has imposed several rule changes to curtail the allure of property but, whilst price rises have slowed the correction has yet to materialise. March 2014 house prices were unchanged for the first time in 15 years – it’s too early to predict the top just yet.
The Economist picked up on real estate earlier this month. They pointed out that Canadian household debt has increased from 76% of GDP in Q3 2007 to 93% in Q3 2013. On their measure Canadian property is 76% above its long-term average and on a rent to income basis, 31% overvalued.
The BoC summary also ignores a dichotomy within Canada. Since the crisis of 2008 the populous manufacturing heartlands, Ontario and Quebec (60% of Canada’s population) have seen little economic recovery. The commodity exporting Western states, by contrast, have rebounded – although they are now slowing in response to weaker Chinese demand. Government energy policy remains focussed on supplying the Chinese and Japanese markets with Oil and LNG. China has also been a major investor in Canadian energy companies both directly and indirectly. Since 2007 China is estimated to have invested C$119bln in this sector according to a recent Jamestown Foundation report.
A sustained US economic recovery may insure that Canadian economic growth becomes more balanced over the next couple of years – after all, 73% of Canadian exports are to the US – however, the Canadian government has a gaping budget deficit to plug. In 2008 they were in surplus – they hope to balance the books once more by 2015/2016. This may be a tall order; at the provincial level Ontario has the largest debt of any Canadian state and a debt to GDP ratio of 37.5% – the outstanding amount, C$267.5bln, is significantly larger than the debt of California. Quebec, not to be eclipsed, boasts the largest debt to GDP ratio at 49%, although its total is lower. The Fraser Institute forecast that this will rise to 57% of GDP by 2022/2023 if they continue with their current policies.
Canadian real estate prices are also a concern for the international markets since six Canadian financial institutions dominate the domestic mortgage market. They have combined financial assets equivalent to five times Canada’s GDP – unlike the US Canada has a “Too big to bail” problem.
Recent indicators for the global economy suggested that activity in Australia’s major trading partners in the early part of 2014 had expanded at around its average pace…
…In China, data for the first few months of 2014 had suggested a continuation of the easing in economic growth that had started in the latter part of 2013…The targets for inflation and money growth in China were also unchanged for 2014.
Recent data for the United States were consistent with further moderate growth in the economy…
In Japan, domestic demand growth had remained strong, with activity picking up prior to the consumption tax increase at the beginning of April…In the rest of east Asia, growth had continued at around the average of the past decade, while economic conditions in India remained subdued…
Global commodity prices had declined since the previous Board meeting. The spot price for iron ore had been volatile over recent weeks, while steel prices in China had declined and spot prices for coking and thermal coal were well below current contract levels. The fall in the price of steel in China over recent weeks was consistent with a softening in demand. At the same time, the supply of steel appeared to have been constrained by a tightening in credit conditions reflecting the Chinese authorities’ concerns about pollution. Base metals prices had also declined, though rural commodity prices were a little higher.
Domestic Economic Conditions
Members began their discussion of the domestic economy with the labour market, which remained weak despite a strong rise in employment in February and an upward revision to employment in January…Meanwhile, a range of indicators of labour demand suggested a modest improvement in prospects for employment, although the unemployment rate was still expected to edge higher for a time.
The national accounts, which had been released the day after the March Board meeting, reported that average earnings growth over the year to the December quarter 2013 had remained subdued. With measured growth in labour productivity around the average rate of the past two decades, nominal unit labour costs were unchanged over 2013.
Members recalled that the national accounts reported that GDP rose by 0.8 per cent in the December quarter and by 2.8 per cent over the year, which was a little stronger than had been expected. In the quarter, there had been further strong growth of resource exports, while growth in consumption and dwelling investment picked up a little and business investment declined. Public demand had made a surprisingly strong contribution to growth, but planned fiscal consolidation at state and federal levels was likely to weigh on public demand for some time…
Retail sales had increased by 1.2 per cent in January, continuing the pick-up in momentum that began in mid 2013. The Bank’s liaison with firms suggested that, more recently, retail sales growth may have eased from this strong rate. Motor vehicle sales declined further in February, as had measures of consumer confidence over recent months, but the latter were still around their long-run averages.
Housing market conditions remained strong, with housing prices rising in March to be 10½ per cent higher over the year on a nationwide basis. Members noted that dwelling investment had increased moderately in the December quarter, with a pick-up in renovation activity, and that the high level of dwelling approvals in recent months foreshadowed a strong expansion in dwelling investment…
Business investment fell in the December quarter, driven by a large decline in machinery and equipment investment and falls in engineering and non-residential building construction. While much of the decline appeared to have been driven by mining investment, non-mining business investment was also estimated to have declined in the quarter. More recently, non-residential building approvals had increased in January and, in trend terms, were at their highest level since 2008, with increases evident across a range of categories, including the office, industrial and ‘other commercial’ sectors…
Conditions were not sufficiently robust to prompt a change in monetary policy. Perhaps this is because the markets are focussed on next week’s deficit busting budget. What is clear is that manufacturing continues to struggle. According to a report from the Boston Consulting Group, Australia has the highest manufacturing cost of the top 25 largest exporting nations. This poor performance is reinforced by a report from the Productivity Commission pointing to a -0.8% fall in Multi-Factor Productivity (MFP).
The biennial IMF Fiscal monitor – published last month – placed Australia at the top of the list of developed countries with the fastest deteriorating economies relative to forecast. They focussed on the government budget deficit – currently the third largest of all developed nations, behind Japan and Norway. They urged the Australian government to take draconian measures to bring Debt to GDP ratio down toward 70% by 2020.
There has been much discussion of potential changes to the tax treatment of mortgages which could puncture the buy to let market, where “negative gearing” has been prevalent. The RBA acknowledged that housing construction is now “Strong” vs “Solid” at its March meeting. The Australian Bureau of Statistics – Trends in Household Debt was released this month showing household debt is at the highest level in real term for 25 years. The Household debt to Income ratio is currently the highest in the developed world at 180%, though Canada isn’t far behind at 165%.
Before you rush to sell your second home down-under it is worth noting that on the basis of Mortgage Interest to Income Australian property is not that expensive. The current ratio is 7% down from 12% in 2008 – although still above the 50 year average of 5%, it reflects today’s benign inflation and lower interest rate environment.
Longer term commodities are still a major source of economic growth, but Australia is ranked 79 in terms of Economic Complexity, with New Zealand at 48 and Canada at 41. All three countries have falling productivity; Australia’s average is -1.3, New Zealand -1.2 and Canada -1.1. In the shorter term, it seems that real estate is the main driver of growth and that growth is based on leveraged household debt.
The Reserve Bank today increased the OCR by 25 basis points to 2.75 percent.
New Zealand’s economic expansion has considerable momentum, and growth is becoming more broad-based.
GDP is estimated to have grown by 3.3 percent in the year to March…
Prices for New Zealand’s export commodities remain very high, and especially for dairy. Domestically, the extended period of low interest rates and continued strong growth in construction sector activity have supported recovery. A rapid increase in net immigration over the past 18 months has also boosted housing and consumer demand. Confidence is very high among consumers and businesses, and hiring and investment intentions continue to increase.
Growth in demand has been absorbing spare capacity, and inflationary pressures are becoming apparent, especially in the non-tradables sector. In the tradables sector, weak import price inflation and the high exchange rate have held down inflation. The high exchange rate remains a headwind to the tradables sector. The Bank does not believe the current level of the exchange rate is sustainable in the long run.
There has been some moderation in the housing market. Restrictions on high loan-to-value ratio mortgage lending are starting to ease pressure, and rising interest rates will have a further moderating influence. However, the increase in net immigration flows will remain an offsetting influence.
While headline inflation has been moderate, inflationary pressures are increasing and are expected to continue doing so over the next two years. In this environment it is important that inflation expectations remain contained. To achieve this it is necessary to raise interest rates towards a level at which they are no longer adding to demand. The Bank is commencing this adjustment today. The speed and extent to which the OCR will be raised will depend on economic data and our continuing assessment of emerging inflationary pressures.
By increasing the OCR as needed to keep future average inflation near the 2 percent target mid-point, the Bank is seeking to ensure that the economic expansion can be sustained.
I have always been impressed by the hawkish credentials of the RBNZ, governor Graeme Wheeler is taking a proactive approach to potential inflationary pressure. However, since these minutes were published the RBNZ has announced that it will intervene on the foreign exchanges to stem any excessive rise in the value of the NZD. The New Zealand currency is near to a 40 year high. Rather than keeping interest rates artificially low to reduce the attraction of NZD as a destination for foreign capital flows, they have chosen to intervene. Governor Wheeler identifies four economics risks which might presage a reversal in NZD strength: –
- Weakening of US growth
- Fall in dairy prices
- Fall in Chinese growth
- Increase in financial market volatility leading to a “Risk-Off” environment
The RBNZ has also been courageous in articulating another problem with the current New Zealand policy mix in relation to the “High Immigration Policy”. Board member, Michael Reddel’s working paper – The long-term level “misalignment” of the exchange rate – discusses this subject, it observes that immigration does not guarantee rising living standards for everyone. He goes on to suggest that “Capital Deepening” from immigration has failed to show up improved MFP. The undesirable side-effects of the policy, however, can be seen in rising land and property prices due to finite supply and increased demand from immigrants, together with foreign capital inflows which have supported the NZD. This has led to a reduction in real incomes and an increase in real interest rates.
The New Zealand government has established a housing affordability target of four time income – this being the long-run average. The current level in Auckland is seven times.
It is worth noting that Australia has similar policies on immigration and similar problems with housing affordability. The foreign buyers are often Chinese – as the Chinese real estate bubble implodes, one has to wonder how long this will continue.
Real Estate, Currency, Bonds or Stocks
The real estate markets in Canada, Australia and New Zealand are all at or near all time highs, their levels of household debt are similarly extended. Given the illiquid nature of real estate as an asset class now is not the time to buy. The trend is still upward, but when markets reverse those with poor liquidity “gap” lower; the risks in real estate look asymmetric, now is a good time to reallocate to more liquid assets.
I’ve already reviewed the relative merits of the three currencies but, to reiterate, I continue to favour NZD over CAD and, because Canada has a more balanced economy in terms of export markets and economic complexity, I favour CAD over AUD – although CAD/AUD is not a compelling trade in itself.
Canadian 10 yr bonds made their highs in July 2012 yielding 1.56%, by September 2013 they had followed US Treasuries lower to yield 2.83%. Now at 2.4% they are in a neutral range.
By contrast the TSX Index has made new highs this month. Momentum is slowing but the trend remains firmly in tact – remain long but be tentative if establishing new positions. The BoC are not expecting a dramatic increase in growth in 2015/2016 – thereafter they expect growth to slow towards 2%.
Australian 10 yr bonds also hit their highs in July 2012 at 2.68%. In line with the weakness of US Treasuries they declined until yields reached 4.50% in December 2013. Since then they have rallied to 3.83%. The beginning of an up trend is in place, supported by expectations of an extended period of unchanged policy from the RBA. The Australian governments decision to freeze fuel taxes last month means they have an additional A$5bln shortfall in income – the fiscal tightening required to balance the budget is likely to stay the RBAs hand for some time to come – of the three countries, this is my favoured bond market.
With fiscal tightening on the cards it was surprising to see the ASX Index making new highs in April. The momentum is stronger than in Canada and the trend is quite clear. Once the terms of the budget are announced next week it may be easier to consider establishing new longs; I would prefer to see the market make new highs by way of confirmation; if Canberra bites the bullet, Australian stocks might bite the dust.
New Zealand 10 yr bonds made their highs in May 2013 at 3.17%, by December 2013 they had fallen to 4.88%. In line with most other bond markets they have rallied this year to a current yield of 4.31%. The recovery looks weak and the recent interest rate hike by the RBNZ, together with their more up-beat assessment of potential growth and inflation, makes NZ bonds the least attractive of the three bond markets. The three markets have almost identical yield curve shapes (1.30/1.35 bp positive) but, starting with structurally higher rates, I believe the New Zealand curve should be steeper at this stage in the cycle. I’ve tried to trade the Kiwi yield curve in the past and been burnt by the pro-active policies of the RBNZ – please don’t regard this as a recommendation.
The NZ 50 Index, along with the Canadian and Australian indices, has made new highs in the past month. The momentum is stronger than in the TSX or ASX, which is justified by the fundamental assessment of the RBNZ. The negative impact of a strengthening currency should be tempered by RBNZ intervention. This will also encourage capital flows into stocks, since the “carry trade” is capped. RBNZ tightening in expectation of inflation is likely to encourage liquidation of bond holdings, again favouring stocks.
The only cloud on an otherwise rosy horizon is the liquidity risk associated with New Zealand markets in general. In the latest survey of GDP growth by The World Bank, Canada was ranked 11th,Australia 12th whilst New Zealand came in at 55th. As RBNZ governor Wheeler pointed out, one of the risks to the New Zealand economy is a reversal of foreign capital flows if financial market volatility increases. Barring a return of the “Risk-Off” trade, I favour New Zealand Equities; hedged, but only if you really need to, by a short position in New Zealand bonds.