The ‘terms of trade’ is back as a major talking point. For many investors, the mere mention of this piece of economic jargon causes eyes to glaze over. But the Reserve Bank has cited a renewed increase in the terms of trade as justification for lifting rates again – contributing to the most aggressive rate hiking cycle since 1994. So what is it again? The terms of trade compares the prices we receive for our exports to the prices we pay for imports. Export prices are rising – particularly coal and iron ore. In fact, miners are likely to be successful in negotiating a near doubling of iron ore prices. Thermal coal prices are poised to lift by 40% with coking coal prices to lift by 55%.
And at the same time that export prices are rising, the strong Australian dollar is serving to restrain prices of imported goods. That gives consumers and businesses extra purchasing power – the ability to pay less for imported goods or buy more at the same price.
Put the two together and it is conceivable that our terms of trade will actually return to the record highs set in 2008. This means more dollars will be flowing into the local economy together with increased purchasing power. CommSec estimates that the 2008 terms of trade boom contributed an extra $24 billion (2% of GDP) through higher export prices alone. And over the five years to 2008, Federal Treasury believes that Australia’s GDP was lifted by around 9% or around $100 billion.
Over the coming year export earnings from coal and iron ore alone are likely to jump by around $40 billion, replicating the gains recorded in 2008/09. And while not all of this will flow through the economy (foreign shareholders in BHP Billiton and Rio Tinto will also gain) certainly Australian businesses, workers, shareholders and governments will be key beneficiaries.
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The Federal Government would have to be ecstatic about the boost to government coffers from higher coal and iron ore prices and the terms of trade more broadly. The government had expected the terms of trade to fall by almost 10% this financial year, but at this stage the decline looks more like 3.5%. And the projected 3.5% lift in the terms of trade in 2010/11 now looks like being closer to a 13% increase.
The Government estimated that the 2008 terms of trade boom lifted tax revenues by $33 billion in the 2008/09 year alone. It now seems that we are headed for a near repeat of that windfall gain. If the Government also withdrew the tax cut that will largely benefit high tax earners from July, the budget bottom line would look even better. Certainly it’s hard to justify cutting taxes at a time when other stimulus measures are being withdrawn, especially given that the key challenge is to return the budget accounts to surplus.
The week ahead
Relatively quiet times on the home front, but there is much more for investors to monitor abroad in the coming week. At home, data on housing finance is released on Monday with Reserve Bank data on credit and debit card lending issued the same day. On Tuesday, the latest commercial, personal and lease finance lending data is released together with the NAB business survey. And consumer sentiment data is issued on Wednesday.
Overall weak readings are expected, boosting the case for the Reserve Bank to take a pause in its rate-hiking cycle. Certainly housing finance has fallen sharply from peak levels, with owner-occupier loans sliding over the past four months. And we expect that the weakness extended into February with new loans down another 4%.
The most recent electronic card statistics reveal that Aussie consumers prefer to use their own cash (debit cards) to make purchases in preference to putting them on credit. In addition, Aussie consumers are increasingly shunning automated teller machines (ATMs), preferring to get cash out when shopping at retailers. So there will be plenty of interest to determine whether the ‘new conservatism’ continued into February.
Consumer confidence probably eased in the latest month – not just in response to the latest rate hike, but also the expectations of further rate hikes in coming months. However the Roy Morgan weekly confidence rating has been holding at historically high levels, so any drop in confidence is from lofty levels.
And there will be more than the usual amount of interest in the latest figures on business and personal lending. In February total lending fell by almost 3% with weakness in all components. Unless businesses and consumers become confident to borrow again then the economic recovery will start to lose momentum.
In contrast to Australia, it’s a literal data-fest in the US in the coming week. On Monday the monthly budget figures are released while trade data is issued on Tuesday. On Wednesday, consumer prices, retail sales and the Federal Reserve Beige Book are all released. Industrial production, the influential Philadelphia Fed index and weekly jobless claims data are all slated for release on Thursday. And then on Friday, housing starts and consumer sentiment are scheduled.
The main interest will be in the ‘activity’ indicators – especially retail sales, production and housing starts. And overall, investors should be encouraged if the results print in line with consensus forecasts. Retail spending is tipped to have lifted by 0.8% in March with non-auto sales up 0.4%. Production has been the driving factor of the economic recovery and that is expected to have continued in March with a 0.4% rise tipped. And housing starts probably rose by 2.5% in March although new permits may have softened modestly.
The other indicators to keep a watch on are the Federal Reserve Beige Book and consumer sentiment. The Beige Book is a useful summary about how the broader economy is tracking while consumer sentiment is a leading indicator of spending intentions.
On Thursday China will release its monthly batch of indicators. Given that China is our major trading partner and export destination, and given its importance to global growth more broadly, the data is of prime importance.
The US profit reporting season for the first (March) quarter gets underway in the coming week with Alcoa reporting earnings on Monday. Also worth watching over the week is Intel (Tuesday) with JP Morgan Chase on Wednesday, Charles Schwab, Advanced Micro and Google on Thursday and Bank of America and General Electric on Friday. Altogether 50 companies are slated to release earnings over the week.
Overall S&P 500 companies are expected to post a 38% lift in earnings per share compared with the weak result of a year ago with revenues up 6% (ex financials up 12%) and non-financial earnings up 27%. Given that the US sharemarket has posted solid gains over recent months investors will want their optimism validated, not deflated, so soft guidance statements will no doubt be punished.
Interest rates, currencies & commodities
The Reserve Bank has just delivered its most aggressive tightening cycle since 1994 and there are few signs that it is done with lifting rates. But the Bank has repeatedly said that the main aim – at least in the short-term – is to get rates back to ‘normal’. And by ‘normal’, the Reserve Bank means the average rate for the variable mortgage rate over the past decade or 15 years. Over the past decade the mortgage rate has averaged 7.24% while the 15-year average is 7.47%. So arguably the Bank is only one rate hike away from ‘normality’.
It is too early to say whether the Reserve Bank is set to pause for a month or two in its rate hiking cycle, but we would argue that it would be a useful strategy. Arguably the Reserve Bank went too far, too fast in lifting rates to decade highs in mid-2008 and it would want to avoid repeating the same mistake.
Certainly higher coal and iron ore prices will be pumping cash into the economy, but for the vast majority of home buyers and small businesses that means little. States like Western Australia and Queensland are the prime beneficiaries of the increase in resources sector activity and income and the Reserve Bank may have to think of new tools to stifle inflationary pressures in the ‘two speed economy’.
Craig James is chief economist at CommSec.