Commentary | 27 December 2016

Australia's economy in 2017: Bad news for jobs but no recession

John Edwards wrties in the Australian Financial Review on the prospects for the Australian economy in 2017. Photo: Getty Images/Brett Hemmings

John Edwards wrties in the Australian Financial Review on the prospects for the Australian economy in 2017. Photo: Getty Images/Brett Hemmings

What with Trump, Brexit and so forth, 2016 did not go to plan. Undaunted, we will try again for 2017.

Let's start with the US.

Though it hasn't been as spectacular, the current economic expansion in the US is already the fourth longest since the end of World War II. If it continues through 2017, as I expect, it will be the third longest post-war expansion and closing in on the second longest. Output growth has been modest but persistent. After the lows of 2015, US inflation is drifting up. At 4.6 per cent unemployment is right back to where it was prior to the financial crisis. According to recent IMF figuring, the US is already producing a bit above its potential.

It follows the US Federal Reserve will extend its December rate rise with more increases in short-term interest rates through 2017. It follows, too, that the bond sell-off will continue. Until they are confident the sell off is over, many investors will be light on bonds, which helps shares.

How might the Trump administration affect this trajectory? Stock markets are pricing in a repeat of the Reagan administration of the 1980s, when share prices more than doubled. Output and employment growth picked up, inflation stayed low and bond yields began a long rally that went right through to the middle of the year.

In this respect markets are wrong. When Reagan came to office in January 1981 US monetary policy was very tight. Chairman Paul Volcker's Federal Reserve was dramatically increasing the overnight rate. Spurred by the Iranian revolution, oil prices had hit an all time high. In Reagan's inaugural year US unemployment was 7.5 per cent, and rising towards a peak of 10.5 per cent the following year. In the second year of Reagan's first term US output shrank nearly 2 per cent. In 1981 a big fiscal stimulus was appropriate, and Reagan produced it with big tax cuts and a vast increase in defence spending.

Different circumstances

Those are not the only differences between then and now. In 1981 US gross federal debt was less than one third of US GDP.  America could afford a debt increase. Today gross federal debt is three times higher compared with GDP. In 1981, US stock prices were not much higher than they had been two decades earlier, and the US was only just beginning a low inflation era after a decade of both rising inflation and rising unemployment. The price earnings ratio for the S&P index in 1981 was 10. After the doubling of US share prices in the last seven years the price earnings ratio for the S&P is now more than 25.

Trump may or may not get Congress to agree to his promised big cuts in company and personal taxes, but if he does the probable result will be a big increase in US federal debt, not much additional growth in an economy already close to capacity, a somewhat faster increase in wages and prices than otherwise, and a blowout in imports (including from China and Mexico). The share market might well continue to move up, but with the price earnings ratio already well above the average of the last half century shares can't go much further without an increasing risk of nasty correction.

If US short-term rates and bond yields continue to head up, as I expect, so will the US dollar. That probably means the Australian dollar will either stay where it is against the US dollar, despite higher commodity prices, or it will continue to drift down towards US70¢. The Reserve Bank of Australia will breath a sigh of relief.

The US market outlook is thus pleasing for share investors, but becoming risky. Emerging market shares might be expected to benefit. The US dollar MSCI emerging market index gained through 2016 but even so it is well below the peaks reached in earlier years.

Growth to remain slow

It is possible China's authorities could lose control of financial stability but they have the means prevent it and every incentive to use them if necessary. China's real economic problems are remarkably like those of Europe, America and Japan – coping with the decline of some industries while encouraging the more rapid growth of others. Growth will continue to slow, but for the next few years we should expect it to remain over 6 per cent. For its part while Europe faces a difficult year of political uncertainty, overall output growth has picked up and will likely remain above 1 per cent through 2017.

As for the Australian economy, I doubt we will see even a technical recession let alone a real one. But growth may well be too slow to reduce underemployment and perhaps to stop the unemployment rate increasing. The average four quarter rate of GDP growth over the last four years has been 2.5 per cent. It's a reasonable bet that will continue through 2017. Even this modest outcome requires that exports and household consumption continue to increase at roughly the average rates of the last four years (6 per cent and 2.5 per cent, respectively).

Because the home construction boom seems to have peaked in late 2016, sustaining 2.5 per cent GDP growth through 2017 also requires that business investment stops falling. We might have expected by now to see some evidence of an upswing in non-mining business investment. So far, we haven't. In the third quarter real business investment excluding mining was still below where it was eight years ago. It has been in trend decline in the last four years. The best that can be said of business investment is that the decline in mining investment has gone so far and so fast that further falls in 2017 won't have much impact on GDP growth. In any case mining investment is close to the floor necessary to meet the depreciation of the existing capital stock in the sector.In the absence of an upswing in non-mining business investment, overall GDP growth of 2.5 per cent through the year is as good as it is likely to get and even that depends on continued export growth.

Room for fiscal stimulus

Because of the weakness of private investment there is room for a big fiscal stimulus through additional government funded infrastructure investment. To my mind there is now a good economic case for government to commit to achieving a budget surplus on recurrent spending, freeing it to borrow to fund a bigger infrastructure program. An additional $8 billion a year would be less than 0.5 per cent of GDP, and well within current economic capacity. If the projects were selected and administered by an independent board, there could be some confidence the money would not be wasted. However, troubled by the budget deficit blowout revealed in the December Mid-Year Economic and Fiscal Outlook, by the scepticism of ratings agencies and the opposition of Treasury, the Turnbull government is unlikely to do it.

Through 2017, the issue will be jobs. The most recent numbers have been reasonably good but even so from December 2015 to November 2016 the total increase in jobs was barely above 80,000 and the number of full time jobs in Australia fell by nearly 50,000. In November 2016 the total monthly hours worked was below the peak reached 22 months earlier. Only a fall in the number of people seeking work and a big rise in part time work prevented headline unemployment looking a lot worse. If GDP growth through 2017 is no higher than 2.5 per cent and rising output per worker accounts for one percentage point of that (as it has on average over the last four years), unemployment will probably start to slowly drift up.

Will the RBA cut again? Perhaps it will, though only very reluctantly, only if jobs growth deteriorates – and even then with no conviction another cut would change much. Though RBA will be anxious about jobs it is also uneasy about the big increase in household debt, as RBA governor Phil Lowe told a recent CEDA dinner. The RBA will hope President Trump and the US Federal Reserve do most of the work for them.

All up, an OK sort of year for the Australian economy, but not one that will cheer the Prime Minister, Treasurer, or job seekers.