Saturday, 25 June 2016 08:26

Brexit stage right - what it means for Australia

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Ben Wellings, Monash University

Britain’s decision to leave the European Union has opened a fundamental crack in the western world. Australia’s relationship with the United Kingdom is grounded in the UK’s relationship with the EU.

Given Australia’s strong and enduring ties with the UK and the EU, the shockwaves from this epoch-defining event will be felt in Australia soon enough. Most immediately, the impending Australia-EU Free-Trade Agreement becomes more complicated and at the same time less attractive.

What will happen to trade ties?

The importance of Australia’s relationship with the EU tends to get under-reported in all the excitement about China. We might ascribe such a view to an Australian gold rush mentality. Nevertheless, Australia’s trading ties to the EU are deep and strong.

Such ties looked set to get stronger. In November 2015 an agreement to begin negotiations in 2017 on a free-trade deal was announced at the G20 summit in Turkey. Trade Minister Steven Ciobo said in April 2016 that an Australia-EU free trade agreement:

… would further fuel this important trade and investment relationship.

When considered as a bloc, the EU consistently shows up as one of Australia’s main trading partners. Consider the statistics below:

  • in 2014 the EU was Australia’s largest source of foreign investment and second-largest trading partner, although the European Commission placed it third after China and Japan in 2015;

  • in 2014, the EU’s foreign direct investment in Australia was valued at A$169.6 billion and Australian foreign direct investment in the EU was valued at $83.5 billion. Total two-way merchandise and services trade between Australia and the EU was worth $83.9 billion; and

  • the EU is Australia’s largest services export market, valued at nearly $10 billion in 2014. Services account for 19.7% of Australia’s total trade in goods and services, and will be an important component of any future free trade agreement.

This is all well and good. But when not considered as a bloc, 48% of Australia’s exports in services to the EU were via the UK; of the $169 billion in EU foreign direct investment, 51% came from the UK; and of Australia’s foreign direct investment into the EU, 66% went to the UK.

You get the picture.

The UK was Australia’s eighth-largest export market for 2014; it represented 37.4% of Australia’s total exports to the EU. As Austrade noted:

No other EU country featured in Australia’s top 15 export markets.

In short, the EU is not as attractive to Australia without Britain in it.

Beyond trade numbers

But the Australia-EU-UK relationship cannot be reduced to numbers alone. It also rests on values shared between like-minded powers.

Brexit represents the further fracturing of the West at a moment when that already weakening political identity is in relative decline compared to other regions of the world, notably Asia (or more specifically China).

EU-Australia relations rest on shared concerns such as the fight against terrorism advanced through police collaboration and the sharing of passenger name records. The EU and Australia also collaborated to mitigate climate change at the Paris climate summit. And they work for further trade liberalisation in the World Trade Organisation – but don’t mention agriculture.

Without the UK, these shared political tasks become harder.

Clearly, Australia-UK relations rest on a special historical relationship. However, it has seen efforts at reinvigoration, as British governments buckled under the pressure of the Eurosceptics among the Conservatives.

David Cameron addresses the Australian parliament in 2014.

Beyond everyday trade, historical links have been reinforced through the centenary of the first world war and the UK-Australia commemorative diplomacy that has come with this four-year-long event.

Cultural ties are most regularly and publicly affirmed through sporting rivalries such as netball, rugby and most notably cricket. Expect these ties to be reinforced as the UK seeks trade agreements and political support from its “traditional allies”.

For those with British passports, there will be a two-year period of grace as the UK negotiates its exit. After that, it will be quicker to get into the UK at Heathrow, but this might be small consolation for the loss of a major point of access to the EU.

The vote to leave is a major turning point in Europe’s history. It marks a significant crack in a unified concept of “the West”. It is not in Australia’s interests.

It’s time for Australia to make new friends in Europe.

The Conversation

Ben Wellings, Lecturer in Politics and International Relations, Monash University

This article was originally published on The Conversation. Read the original article.

Richard L. Gruner, University of Western Australia

Woolworths is ditching its Select private label range. It intends to launch a new brand for a more focused range of products that promises more bang for the buck. The move comes after Woolworths decided in March to axe its Homebrand label as part of its strategy to compete with Aldi.

The move makes sense, but will likely do little to restore consumer trust and sales growth.

Management guru Michael Porter has long argued that products need a clear positioning in consumers’ minds as either special and expensive or convenient and cheap. Woolworths Select was neither, stuck somewhere in the middle. This positioning was confusing for customers.

But will fixing this problem make a difference, and perhaps even keep growing Teutonic supermarket force Aldi at bay?

Unlikely. After all, similar efforts are only baby steps towards what truly distinguishes growing companies: the ability to make consumers' lives simpler. Think of Uber, Netflix, Amazon, but also Aldi. That’s the common denominator.

And yet, research shows that most companies keep confusing the gobbledegook out of us. A lot has been written about how consumers get more than they want, and how more product choice often makes us less happy.

But consumer confusion extends to other tactics too, like pricing and discounting. Shoppers increasingly ask questions such as: why are some products almost always on special (while others never are)? Do half-price offers mean that we usually pay twice as much as we should?

At best, discounts have become meaningless. While discounts were used successfully in the past to move excess merchandise, they have become ubiquitous and permanent, providing little incentive to respond. It’s a bit like the guy in the audience of a stadium that stands up to see more: it’s an effective tactic so long as not everyone else is standing up too.

Another major concern that emerges is product claims and packaging; for example, most consumers do not know the difference between “Product of Australia” and “Made in Australia”.

Also, products claiming to be “natural”, “real”, or “healthy” are usually hiding behind meaningless terms, undefined in labelling law and merely meant to persuade rather than inform people. The result is ever more confusion.

So what should brands do to simplify the consumer experience? Ironically, the answer to this question is not simple. It takes an awful lot of work to make things less confusing. An app that you visit once in a while and find easy to navigate may be the result of years of painstaking work, with many difficult decisions made behind the scenes about what should go where, and just as importantly, what to leave out.

Companies should start making every aspect of their product offerings simpler. Consumers do not appreciate clutter; they appreciate everything being transparent, clean and easy.

Marketers should understand that consumers rarely inherently care about brands. In some countries, only about 5% of brands would truly be missed. Whether consumers order an Uber ride, or buy a carton of milk, they often want to invest the least amount of effort and time in making the right decision.

Overloading consumers’ already saturated brains with all kinds of marketing tactics, including dynamic pricing and even heavy discounts can backfire or fall flat. This was clear when consumers showed a lack of interest in even 90% discounted product at Dick Smith’s closing down sale.

Instead, every decision brands make should be guided by a desire to help customers feel confident about their choices. Fortunately, we can learn from a handful of companies that have long understood the principle of simplicity in driving customer satisfaction.

Aldi’s success, for example, is often attributed to its simple business model of providing consistently low and transparent prices for a reduced range of high quality products.

No discounts, no confusing ads, no loyalty cards, no bullshit.

The Conversation

Richard L. Gruner, Asst Professor, University of Western Australia

This article was originally published on The Conversation. Read the original article.

John Lingard, Newcastle University

British dairy farmers are once again protesting over the low prices on offer for their milk. They worry that too many producers are going bust, and that long-term milk supplies are at risk.

Supermarkets are usually cast as the villains in this piece and this time it is no different. Farming unions are meeting Morrisons to ask for a fairer deal – and protesters in Stafford even took two cows into an Asda branch to help make their point.

However it is too simplistic to blame the supermarkets – the real problem is global. Too much low-value milk is being produced around the world.

Too much milk …

Over the past decade, UK milk production averaged 14 billion litres per year, of which around 500m litres are exported. Just 139m litres are imported. Milk made in the UK tends to stay in the UK.

What happens to that 14 billion litres? Defra

Nonetheless the number of dairy farmers continues to decline, from 40,000 at the start of the 1990s to 14,159 in 2013. This is alarming to some, but it shouldn’t be. For long-term security of milk supplies, it doesn’t really matter how many dairy farmers pack up production. The cows often move to another farm and it is easy enough to step up production through more intensive feeding and selective breeding.

After all, even though the total number of cows in the UK has halved since the 1970s, production has remained steady thanks to the fact average yields have doubled. Farmers are literally squeezing more out of each cow.

… that no one wants

Half of domestic milk production has to be diverted from the more lucrative liquid market into cheese, yoghurt, ice cream, butter and other manufactured products.

This is partly because people drink a lot less milk these days; from five pints per week in the 1960s to around three pints today. Consumption is down 8.1% in the past ten years alone. Any industry would struggle in such circumstances.

This supply and demand problem is replicated across the world – and there is currently a massive oversupply of manufactured milk products on world markets due largely to increased production in China, India, Brazil and New Zealand (where they are dealing with similar issues).

Got milk? gwire, CC BY

This surplus, combined with a collapse in global demand especially in China, has depressed prices. A Russian import ban in retaliation for EU action over Ukraine has also hit prices. Russia used to buy 27% of the EU’s cheese exports and 19% of its butter.

The Global Dairy Trade auction, the industry’s main dairy commodities index, hit a 13-year low in August 2015. The GDT has now lost 64% of its value since a record high in February 2014.

What this means for your local farmer

The amount paid to farmers – the UK’s farm gate price – has declined sharply since early 2014 to just 23.66p per litre. When it costs farmers around 30p to produce each litre, it’s easy to see why they are annoyed.

The major milk processors have to balance their operations across the various markets they sell in and, as a consequence, pay dairy farmers an average price. Farmers will not get, and should not expect to get, the supermarket price for liquid milk. Some supermarkets – Tesco, Marks & Spencer, Sainsbury’s and Waitrose – have agreed direct contracts with dairy farmers that allow them to recover their production costs, but these only involve a small number of farms.

Retail supermarket prices for liquid milk are much higher than farm gate, at typically 55-60p per pint (£1.30 or so per litre), but there is no evidence that milk is being used as a “loss leader”. Four pints for 89p at Asda is probably as low as they can get, but the price spread is understandable, appropriate and market-justified; we can’t just hold supermarkets alone responsible. If there is a villain in this piece, it is the world market.

With too much supply and not enough demand, farmers have two options. Those near big cities can opt out of the globalised milk market through establishing farmer co-operatives to supply just the local area where they can possibly charge higher prices. Or they can seek high-value, niche markets such as yoghurts, farm-produced ice cream and organic milk.

One other way of dealing with supply-demand imbalances would be to bring back dairy quotas, at least at lower levels. The EU introduced quotas in 1984 to control milk production and eradicate butter mountains but they were abolished in April this year.

The problem currently facing the British dairy industry is that it is easy to produce milk in the UK’s green, wet and pleasant land, but it is very difficult to find profitable markets for 14 billion litres of the stuff. Until dairy farmers resolve this overproduction dilemma, many will continue to go out of business.

Uneconomic dairy farms, like uneconomic coal mines, must close down and the adjustment process is harsh and painful for farmers and miners alike. In today’s highly globalised world a more humane outcome is unlikely.

The Conversation

John Lingard, Associate, Centre for Rural Economy, Newcastle University

This article was originally published on The Conversation. Read the original article.

Bruce Muirhead, University of Waterloo

The Australian government’s intervention in the dairy crisis by offering concessional loans to struggling farmers has prompted suggestions that other types of regulation - such as a dairy floor price - might be needed.

The dairy industry was deregulated more than a decade ago; perhaps it’s time Australia looked to other countries for models to fix the system.

The current situation facing the Australian dairy industry is the same the world over. The European Union and the United States come to mind, as milk supply outweighs demand. But they provide assistance to their dairy farmers through subsidies or other support that helps to keep them viable.

Canada does not compete internationally in the dairy sector as it maintains a supply management system introduced in the early 1970s. Dairy is not subsidised, as government provides no support, and the price paid to farmers is negotiated among stakeholders.

When I explained this Canadian supply management model to Victoria dairy farmers, as part of my research earlier this year, they rejected the idea. However the current situation may cause some of them to reconsider this position.

While the Canadian model works for Canadian farmers, a supply managed system would be more difficult for those in Australia given that about 40% of Victorian dairy is exported and exports don’t happen with supply management. But Australia’s share of the global market is decreasing over time, despite the best efforts of Australian dairy organisations and farmers, and the number of farms continues to decline. Perhaps Australia will end up with a system resembling a supply managed one through market mechanisms.

I interviewed a total of 45 farmers and dairy stakeholders in Australia during February and March of this year, nearly half in Queensland and the remainder in Victoria and Tasmania. I was interested in how the Australian dairy model works, especially as it is cited by the business press in Canada as one that we should adopt given their dislike of Canada’s regulated system.

What is the supply management model? Briefly, it matches domestic demand with domestic supply and exports are non-existent. The system is based on quotas - for example a kilogram of milk solid costs C$25,000 in the province of Ontario where I live, and it represents about one cow’s worth of production. Producers need at least 50kg of milk solids to run a decently remunerative operation.

Stakeholders representing producers, consumers, processors, the restaurant association and others meet annually to determine price, not government. Included in this is a profit guarantee for farmers that allows them to make long-term decisions and maintain a middle class lifestyle while milking on average about 70 cows. It also means they are immune to this latest global crisis, and to future ones.

And if supermarkets decide to use milk as a loss leader, it is the deep-pocketed supermarket that takes the hit, not the farmer. The price paid to the latter is guaranteed by negotiation, which creates stability.

Clearly, this is not how it operates in Australia where the supermarkets, according to one Queensland dairy producer, “must bruise the farmers to give them a loss leader.” Nor is the price consumers pay for milk in Ontario out of line with that charged by Coles and Woolworths, the real regulators of Australian dairy. Southern Ontarians pay the equivalent of the infamous A$1.00 per litre – A$4.00 for Canada’s four litre container, and have done so for years.

I found in my research that Victoria’s dairy farmers are in favour of privatisation and deregulation. They talked a lot about efficiency and how they are among the world’s more efficient farmers, and Canadians must surely not be, given their system.

Perhaps this is true if efficiency is measured by getting the greatest amount of milk for the least input. But Australian dairy farmers fall behind by other parameters.

Ontario dairy farmers, for example, employ robotic technology at a much greater rate than their Victorian counterparts. New dairy barns are being put up all over the province and a majority of them install robots to do their milking. Ontario now has hundreds of farms using milking robots.

The situation in Victoria could well come to that of New Zealand’s, where cows may be culled and the survivor’s rations severely cut back, as farmers are unable to feed supplements in such an adverse economic climate.

In an interview, as part of my research, one New Zealand dairy farmer told me he was into “starvation mode” for his cows because of cost. He was feeding them with grass only and when that ran out, there was nothing else. He was certainly running an efficient farm, but at a significant cost to his own mental health and to that of his cows’ wellbeing and ability to provide milk.

One Victorian farmer told me that even before the announcement of cuts to the milk solids price, he and his colleagues “farmed at the margins". When prices are robust, so are farmer’s livelihoods, but when they collapse, as they always do in a commodity situation, so do their livelihoods.

This results in another vicious cycle of dairy farmers quitting the industry which leads to further instability. As another interviewee told me, following the cut:

“We will wait and see and hang on for dear life.”

Might the future of Victorian dairy be Queensland, where farmers suffered much of what their Victoria counterparts are now experiencing more than a decade ago after deregulation, and dairy is now a niche industry?

As one Queensland interviewee emphatically instructed me about Canada’s model:

“Don’t give away [the] regulated system!”

Now is the time for Victoria to consider the advice of this farmer and introduce more regulation.

The Conversation

Bruce Muirhead, Professor of History and the Associate Vice President, External Research , University of Waterloo

This article was originally published on The Conversation. Read the original article.

Friday, 29 April 2016 15:39

2016 Federal Budget - A Preview

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Westpac expects the underlying budget deficit for 2016/17 which will be announced by the Federal Government on Budget night, May 3, will be $29bn. That is a near $5bn upgrade from the Government's December forecast, published in the Mid-Year Economic and Fiscal Outlook (MYEFO). Across the four years to 2018/19, the improvement is $17bn.

The economic environment is somewhat more favourable than anticipated. Real output growth has surprised to the high side in 2015/16. Commodity prices have also surprised, bouncing off historic lows, driving an upgrade of the terms of trade forecasts. In 2016/17 the terms of trade is set to swing from a major negative for national income to a small positive. Partially offsetting this: the currency has moved up from its lows; and general inflation pressures have weakened.

On the Government's forecasts for real GDP growth we expect just the one change, a 0.25% upgrade for 2015/16. That yields a profile of: 3.0%, 2.75%, 3.0% and 3.0%. The forecast for nominal GDP growth is upgraded by 0.25% in both 2015/16 and 2016/17 but downgraded by 0.25% in 2017/18, giving a profile of: 3.0%, 4.75%, 4.75% and 5.25%.

The iron ore price is expected to be revised higher from US$39/t fob in MYEFO to US$50/t (fob) for 2016/17 and US$46/t (fob) beyond that. This adds an estimated $7.8bn over the 3 years to 2018/19.

The budget impact from the improved economic backdrop, together with prospects for the 2015/16 deficit to be $1bn smaller than expected on lower expenditures, is $4.5bn in 2016/17 and $3bn a year thereafter, we estimate.

We anticipate that the balance of new policy measures, including the drawing down of the contingency reserve, as occurred in the May 2015 Budget, will be neutral for the budget in 2016/17 and improve the budget position by $2bn in 2017/18, increasing to a $5bn contribution in 2018/19.

The 2016 Budget is to focus on competition, innovation, investment and infrastructure. There will be tax cuts to boost investment and activity, as occurred in the 2015 Budget, funded by revenue integrity measures. A new infrastructure delivery agency is to be created, with private sector involvement. Any potential impact of the new infrastructure agency on government borrowing is unclear and has not been incorporated in our figuring.

The budget returns to balance in 2019/20, which now rolls into the four year forward estimate period. That is one year earlier than expected in MYEFO.

Net debt peaks at 17.9% of GDP in 2017/18, which is below the 18.5% peak forecast in MYEFO. In dollar terms, net debt climbs to $330bn in 2018/19, some $17bn below that in MYEFO.

 

 

Bill Evans

Westpac Economics

 

 

Thursday, 31 March 2016 07:43

$AUD likely to resume downtrend

Written by

Introduction

After hitting an almost seven year low of $US0.6827 in January the Australian dollar has rebounded by 12% or so hitting a high of $US0.7680. The rebound begs the question as to what is driving it and more fundamentally whether the 38% decline from its 2011 high against the US dollar has now run its course. This note looks at the main issues and what it means for investors.

Why the rebound?

A classic aspect of investing is to be wary of the crowd. When investor sentiment and positioning in an asset reaches extremes it often takes only a slight change in the news to drive a big reversal in the asset’s price. And so it is with the Australian dollar. After its large fall to below $US0.70 big speculative short (or underweight) positions had built up. This coincided with a lot of talk about a “big short” in Australian property, banks and the $A. This can be seen in the next chart.

Source: Bloomberg, AMP Capital

And then over the last month or so the news for the Australian dollar has turned more positive with commodity prices bouncing back (from their recent lows oil is up 50%, copper is up 15% and iron ore is up 45%), the Fed sounding more dovish and delaying rate hikes which has pushed the $US down generally and Australian economic growth holding up well. The combination of a more dovish Fed and better Australian data has seen a widening in expected interest rate differentials between Australia and the US, which makes it relatively more attractive to park money in Australia. So with more positive news on Australian export earnings and the relative interest rate in favour of Australia, speculators and traders have closed their short positions and the Australian dollar has rebounded.

More broadly the rebound in the $A has been part of a return to favour by growth assets since January/February that has seen shares, commodities, corporate debt and growth sensitive currencies rebound as worries about a global recession receded. This is often referred to as “risk on”.

Will the rebound in the $A be sustained?

In the very short term the $A could still go higher yet as long positions in it are still not extreme and the Fed’s new found dovishness could linger. A rise to $US0.80 is possible. However, it’s premature to say that the $A has seen its lows and the trend is now up. In fact my view remains that the trend is still down. First, just as the long term upswing in the value of the $A from $US0.48 in 2001 saw multiple setbacks, including a 39% plunge in 2008, on its way to the 2011 high of $US1.10 the secular down trend that started in 2011 is likely to have several reversals too. There will always be short term/cyclical swings.

Second, the recent rally looks a bit like the 9% short covering rally that occurred in early 2014. After falling through parity in 2013 the $A hit a low of $US0.8660 in January 2014 by which time large short positions had been built up. These were then closed as the RBA saw it prudent to opt for an extended “period of stability” in interest rates and commodity prices bounced higher which pushed the $A up and left it stuck around $US0.94 for five months. Once short positions had reversed, commodity prices resumed their downswing and it looked like the RBA would have to cut rates again the $A resumed its downswing.

Third, fundamental drivers still point south for the $A:

  • Commodity prices - while the worst is probably behind us, commodity prices likely remain in a long term, or secular downswing thanks to a surge in supply after record investment in resources for everything from coal and iron ore to gas and slower global demand growth. As can be seen in the next chart raw material prices trace out roughly 10 year long term upswings followed by 10 to 20 year long term bear markets. This long term cycle largely reflects the long lags in supply adjustments.

    Source: Global Financial Data, Bloomberg, AMP Capital

    Plunging prices for commodities have resulted in a collapse in Australian export prices and hence our terms of trade and this weighs on the value of the $A. This is highlighted by the iron ore price which at the start of last decade was below $US20/tonne rising to over $US180/tonne in 2011 and is now running around $US55/tonne.
  • Interest rates – the interest rate differential in favour of Australia is likely to continue to narrow, making it relatively less attractive to park money in Australia as part of the so-called “carry trade”. While Fed hikes have paused recently in response to global growth worries, they are likely to resume at some point this year in line with the so-called “dot plot” of Fed officials interest rate expectations pointing to two 0.25% hikes this year.

    Meanwhile, although it’s a close call we remain of the view that the RBA will cut interest rates again in the months ahead: as mining investment continues to unwind; the contribution to growth from the housing sector via building activity and wealth effects starts to slow over the year ahead making it critical that $A sensitive sectors like tourism and education are able to fill the gap; to offset possible further out of cycle bank interest rate hikes; and as inflation remains at the low end of the target range. The strengthening $A also adds to the case for another rate cut.

A final critical driver of the Australian dollar is the US dollar itself – but it has become more ambiguous. The ascent of the US dollar from 2011 was a strong additional drag on the $A both directly and via its impact on commodity prices. However, it also added to concerns about the emerging world (as a rising $US makes it harder to service US dollar denominated loans raising the risk of some sort of financial crisis) and as a rising $US constrains US economic growth, doing part of the Fed’s job for it. Consequently, the sharp upwards pressure on the value of the $US may have run its course. But with the Fed still gradually tightening a sharp fall in the $US is unlikely either. Rather it’s likely to track sideways.

Source: Bloomberg, AMP Capital

$A likely to resume its downswing

So while the big picture outlook for the $US has turned neutral, the combination of soft commodity prices and the relative interest rate differential between Australia and the US set to narrow point to a resumption of the downtrend in the $A in the months ahead. How far it may fall is impossible to tell. One guide is via what is called purchasing power parity (PPP), according to which exchange rates should equilibrate the price of a basket of goods and services across countries. The next chart shows the $A/$US rate against where it would be if the rate had moved to equilibrate relative consumer price levels between the US and Australia since 1900.

Source: RBA, ABS, AMP Capital

Right now the $A is around fair value on this measure of $US0.75. But it can be seen from the chart that the $A rarely stays at the purchasing power parity level for long and is pushed to extremes above and below. Right now the commodity down cycle is likely to push the $A to overshoot fair value on the downside. In a way this could be seen as making up for the damage done to the economy during the period above parity. This is likely to take the $A towards $US0.60 on a 12 month horizon.

Implications for investors

There are a several implications for investors. First, the likely resumption of the downtrend in the $A highlights the case for Australian based investors to maintain a decent exposure to offshore assets that are not hedged back to Australian dollars (ie remain exposed to foreign currencies). Put simply, a declining $A boosts the value of an investment in offshore assets denominated in foreign currency one for one. This has been seen over the past five years to February where the fall in the value of the $A turned a 7.1% pa return from global shares measured in local currencies into a 12.9% pa return for Australian investors when measured in Australian dollars.

Second, having an exposure to foreign currency provides a useful hedge for Australian based investors in case we are wrong and the global growth outlook deteriorates significantly. The $A invariably falls (and foreign currencies rise) in response to weaker global growth.

Finally, the fall in the value of the $A to levels that offset or more than offset Australia’s relatively high cost levels is very positive for sectors that compete internationally including manufacturing, tourism, higher education, agriculture & miners. This in turn should continue to help the economy weather the mining downturn and is in turn positive for the Australian share market. Roughly speaking each 10% fall in the value of the $A boosts company earnings by 3%.

 

Shane Oliver

AMP Chief Economist

To modify Benjamin Franklin, it seems that in Australia nothing can be said to be certain, except death, taxes and endless debate about property prices. Why is it so unaffordable? Are foreigners to blame? Is it a good investment? Is negative gearing the problem? Are property prices about to crash?

Worries about a property crash have been common since early last decade. In 2004, The Economist magazine described Australia as “America’s ugly sister” thanks in part to a “borrowing binge” and soaring property prices which had seen it become “another hotbed of irrational exuberance”. At the same time the OECD estimated Australian house prices were 51.8% overvalued. Since the GFC, predictions of an imminent property crash have become more common with talk that a property crash will also crash the banks and the economy.

Our view since around 2003 has been that overvaluation and high levels of household debt leave the housing market vulnerable. As such it could be seen as Australia’s Achilles heel. However, in the absence of a trigger it’s been hard to see a property crash as a base case. Not much has really changed. This note takes a look at the key issues and what it means for investors.

Overvalued, over loved and over indebted

The two basic problems with Australian housing are that it is expensive and household debt is high. Overvaluation is evident in numerous indicators:

  • According to the 2016 Demographia Housing Affordability Survey the median multiple of house prices in cities over 1 million people to household income is 6.4 times in Australia versus 3.7 in the US and 4.6 in the UK. In Sydney it’s 12.2 times and Melbourne is 9.7 times.
  • The ratios of house prices to incomes and rents are at the high end of OECD countries and have been since 2003.
  • Real house prices have been above trend since 2003.

Source: ABS, AMP Capital

The shift to overvaluation more than a decade ago went hand in hand with a surge in the ratio of household debt to income, which took Australia’s debt to income ratio from the low end of OECD countries to now being around the top.

Source: ABS, RBA, AMP Capital

Overvaluation and high household debt are central elements of claims that Australian house prices will crash. These concerns get magnified whenever there is a cyclical surge in prices as we have seen recently in Sydney and Melbourne.

But a crash seems elusive

However, given the regularity with which crash calls for Australian property have been made over the last decade and their failure to eventuate, it’s clear it’s not as simple as it looks.

First, the main reason for the persistent "overvaluation" of Australian home prices relative to other countries is constrained supply. Until recently Australia had a chronic under supply of over 100,000 dwellings, as can be seen in the next chart that tracks housing completions versus underlying demand. Completions are at record levels but they are just catching up with the undersupply of prior years.

Source: ABS, AMP Capital

Consistent with this, vacancy rates while rising are below past cycle highs. In fact, in Sydney they are still quite low.

Source: Real Estate Institute of Australia, AMP Capital

Secondly, Australia has not seen anything like the deterioration in lending standards other countries saw prior to the GFC. There has been no growth in so-called low doc and sub-prime loans which were central to the US housing crisis. In fact in recent years there has been a decline in low doc loans and a reduction in loans with high loan to valuation ratios. See the next chart. And much of the increase in debt has gone to older, wealthier Australians, who are better able to service their loans.

Source: APRA, AMP Capital

Third, and related to this, there are no significant signs of mortgage stress. Debt interest payments relative to income are low thanks to low interest rates. See the next chart.

Source: RBA, AMP Capital

By contrast in the US prior to the GFC interest rates were starting to rise. Yet in Australia bad debts and arrears are low. While new loan sizes have increased, Australians seem focussed on cutting their debt once they get it.

Finally, while some seem to think that because property prices in mining towns like Karatha are now crashing this is a sign that other cities will follow. This is non-sensensical. Property prices in mining towns surged thanks to a population influx that flowed from the mining boom. This is now reversing. Perth and Darwin are also being affected by this but to a less degree. By contrast the surge in property prices in cities like Sydney and Melbourne that occurred into early last decade predated the mining boom and their latest gains largely occurred because the end of the mining boom allowed lower interest rates.

The current state of play

Our assessment is that the boom in Sydney and Melbourne is slowing thanks in large part to APRA’s measures to slow lending to property investors. However, house price growth is likely to remain positive this year. Price growth is likely to remain negative in Perth and Darwin as the mining boom continues to unwind. Hobart & Adelaide are likely to see continued moderate property growth, but Brisbane may pick up a bit. Nationwide price falls are unlikely until the RBA starts to raise interest rates and this is unlikely before 2017. And then in the absence of a recession or rapid interest rate hikes price falls are more likely to be 5-10% as was seen in the 2009 and 2011 down cycles rather than anything worse.

Source: CoreLogic RP Data, AMP Capital

What to watch for a property crash?

To see a property crash – say a 20% average fall or more – we probably need to see one or more of the following:

  • A recession – much higher unemployment could clearly cause debt servicing problems. At this stage a recession looks unlikely though.
  • A surge in interest rates – but the RBA is not stupid; it knows households are now more sensitive to higher rates.
  • Property oversupply – this is a risk but would require the current construction boom to continue for several years.

Implications for investors

There are several implications for investors:

  • While housing has a long term role to play in investment portfolios it is looking somewhat less attractive as a medium term investment. It is expensive, offers very low income (rental) yields compared to all other assets except bank deposits and Government bonds and it’s vulnerable to possible changes to taxation arrangements around property.
  • There are pockets of value, eg in regional areas. You just have to look for them.
  • As Australians already have a high exposure to residential property (directly and via bank shares and property trusts), there is a case to maintain a decent exposure to say unhedged global shares because it could provide an offset if it turns out I am wrong and the Australian property market does have a crash.

 

Elizabeth Savage, University of Technology Sydney

Health Minister Sussan Ley today announced private health insurance premiums will increase by an average of 5.6% from April. This amounts to the average family paying about $300 more a year for an average policy.

This year’s increase is a little lower than increases of about 6% approved over the last two years.

The 2016 increases range from 3.8% for the Doctor’s Health Fund, to just under 9% for CUA health Fund. Increases for the largest funds, Medibank and BUPA, are just below the industry average. (Scroll to access the full list below).

Under the Private Health Insurance Act, the health minister must approve company requests for premium changes, unless she is satisfied that to do so would be contrary to the public interest.

After receiving the first round of applications, the minister requested on January 30 that health funds “resubmit lower applications for premium increases or provide any evidence of extenuating circumstances”. Twenty funds subsequently lowered their requests.

The minister’s request for funds to work with the health department to reduce premiums, while unusual, is not surprising. Since 1997, when the Howard government introduced the 30% health insurance premium rebate, the federal government is a significant stakeholder in the private health sector.

The annual cost of the premium rebate has grown markedly from about A$1 billion in 1998 to about A$6 billion currently.

In the 12 months to December 2015, the national regulator, the Australian Prudential Regulation Authority, reports that premium revenue increased by 6.9%, benefits paid by insurers by 6% and fund profits before tax by 7%.

Despite the small reduction in this year’s premium increase, the 2016 outcomes for the industry are unlikely to differ much from those of 2015.

What’s driving premium increases?

The major driver of premiums is the level of benefits paid to insured patients for hospital treatment and services covered by general insurance.

In 2015, total hospital benefits were A$13.58 billion, including A$2.13 billion for benefits to medical practitioners and A$1.95 billion for prostheses such as pacemakers, stents and artificial hips and knees.

Benefits for general cover (99% of which are for extras treatment such as dental, optical, chiropractic, natural therapies) totalled A$4.63 billion.

Hospital benefits have increased at a faster rate than extras. This is despite the share of the population with hospital cover remaining steady at around 46% to 47% over the past five years and very limited increase in the average age of the population with hospital cover.

Even though there has been a steady increase in the share of the population with general cover (from about 52% in 2010 to 56% in 2015) premium increases are being driven by hospital benefits, of which 14.4% are for prostheses.

Insurers could use higher benefits payments to justify premium increases if there was sufficient competition in the insurance sector to promote efficiency and lower costs of private treatment.

But the Australian industry is highly concentrated. The two largest insurers, Medibank and BUPA, have 56% of the market. This suggests that inefficiency is driving premium inflation, some of it arising from a poorly designed regulatory framework.

Benefits for prostheses

In 2015, insurers paid almost A$2 billion in hospital benefits for prostheses.

The insurance cost of prostheses was raised in a submission to the Harper Competition Policy Review from Applied Medical, a manufacturer of a clip applier used in laparoscopic surgery.

The submission argued that the minimum benefits set by the government regulator, the Prostheses Listing Authority, were far higher than both prices in comparable overseas countries and those paid by public sector hospitals in Australia:

Subject to the need to consult with stakeholders, there is sufficient power to implement reforms which would bring prostheses costs to the private health system down so that they would be comparable with prices paid in other countries – reducing prices by as much as 75%.

Applied Medical estimated that hospital benefits could be reduced by about A$600 million annually if excess benefits, currently shared between the manufacturer and the private hospitals, were eliminated.

The final report of the Harper Review, released in March 2015, recommended:

The regulation of prostheses should be examined to see if pricing and supply can be made more competitive, while maintaining the policy aims of the current prostheses arrangements.

Minister Ley has raised prostheses reform as a priority this year, noting that insurers pay $26,000 more for a pacemaker for a private patient than a public patient ($43,000 compared with $17,000).

What needs to be done?

According to an online government survey in November and December of 2015, the public is concerned about the affordability of health insurance and questions its value for money.

Despite premiums continuing to increase at a rate considerably above inflation, there is little evidence that people are responding by dropping their cover.

The Lifetime Health Policy, introduced the Howard government introduced in 2000, ensured that the penalties of doing so are too high if they wish to buy insurance at some time in the future. After the age of 31, the policy adds adds a 2% loading to the premium for every year of age over 30.

One way to keep premiums down is to address regulatory failures. Reforming the inflated prostheses benefits set by the government regulator and health minister in 2006 is in urgent need of attention.

Without such reforms, patients remain worse off, paying insurance premiums which increase every year. And the federal government is faced with an ever growing cost of the insurance rebate.

Another way is for government to rethink the incentives for insurers to pursue cost reductions by health providers that will lower insurance payouts and thereby lower premiums.

In the Australian system, insurers pay the providers agreed amounts and request approval from the minister for premium increases to cover increased benefit payouts. In other countries, insurers contract with specified health providers who compete both on quality and price for patients listed with the insurer.

Encouraging insurers to be more active could reduce premiums for consumers.

The Conversation

Elizabeth Savage, Professor of Health Economics, University of Technology Sydney

This article was originally published on The Conversation. Read the original article.

Michelle Grattan, University of Canberra

The government is set to secure reforms to the Senate voting system that will squeeze out “micro”-players.

Immediately after the changes were announced by Prime Minister Malcolm Turnbull and Special Minister of State Mathias Cormann, the Greens welcomed the move and called on the ALP to support it.

While the Greens said they would scrutinise the legislation, which was introduced in the House of Representatives immediately after the announcement, they have had extensive negotiations with the government. Support from the Greens is all that is needed to get the measures through the Senate.

The changes would bring in optional preferential voting “above the line”, replacing the present group voting tickets. Voters would be advised to number at least six boxes in order of choice. But their vote would still be valid if they numbered only one box.

At present, people just mark one box but have no control over their preferences. Complicated deals over preferences have meant the election of candidates on tiny votes.

Almost all voters vote above the line.

In relation to below-the-line voting, the government proposes to reduce the number of informal votes by increasing the number of mistakes allowed from three to five, as long as 90% of the voting paper is filled in correctly.

Group and individual voting tickets will be abolished.

A restriction will be introduced to prevent individuals holding relevant official positions in multiple parties.

The changes also allow parties, if they wish, to have their logos on the ballot paper, to reduce confusion. At the last election the Liberals complained that many of their voters thought the Liberal Democratic Party (LDP) was the Liberal Party. The LDP got senator David Leyonhjelm elected in NSW.

Turnbull said there had been much criticism of the last Senate election. People were astonished to see senators elected on very small votes. Under the reforms every Australian who voted in the Senate “will determine where their vote goes. And that’s democracy”, he said.

If there is a double dissolution all or almost all micro-players would be immediately out. A normal election would make it nearly impossible for new micro-players, but the several elected in 2013 would still have more than half of their term remaining.

Amid speculation about a double dissolution, Turnbull said “nothing has changed”. He was working on the assumption that the election would be held at the normal time – which was August, September or October.

Turnbull said the government did not have a view on who would be electoral winners out of the change. He pointed out that the reform was recommended unanimously by the Joint Standing Committee on Electoral Matters.

That committee will now scrutinise the legislation, which the government wants passed by the time parliament rises for the autumn recess in mid-March. It will take the Electoral Commission about three months to make the necessary changes, which means they could be ready for either a normal election or a July double dissolution.

Greens leader Richard Di Natale said the Greens had been putting forward legislation over 12 years for Senate voting reform that ended backroom preference deals and put power back into the hands of voters.

“The only people who support the current system are the faceless men and factional operators who can wield power and influence in back rooms,” he said.

Independent senator Nick Xenophon, who won almost two quotas at the last election, supports Senate voting reform.

Labor, despite supporting reforms on the parliamentary committee, has since become sharply divided. Some factional heavyweights strongly oppose them, believing they would work to the Coalition’s advantage. Opposition Leader Bill Shorten reserved Labor’s position.

Motoring Enthusiast Party Senator Ricky Muir, elected in 2013 on about 0.5% of the Victorian Senate vote, tweeted his disapproval of Turnbull’s move.

Michelle Grattan, Professorial Fellow, University of Canberra

This article was originally published on The Conversation. Read the original article.

Tuesday, 24 November 2015 10:21

Australian Growth - State by State

Written by

The Australian Bureau of Statistics have released the annual State Accounts.

The state accounts provide annual estimates of output growth by state, Gross State Product.  Quarterly estimates are not available.

The accounts for the 2014/2015 financial year confirm that a growth transtion is underway.  The mining states of the north west, Qld and WA are slowing, while the southern states, Victoria, SA and Tasmania are improving.

WA, despite a loss of momentum, still managed to top the growth charts in 2014/2015 at 3.5%, moderating from 5.6%.  The two largest states came in next, with Victoria at 2.5%, accelerating from 1%, and NSW at 2.4%, rounding up from 2.3%.  Next were SA at 1.6%, rebounding from a soft 0.8%, and Tasmania, also at 1.6%, extending its recovery from 1.3%.  Qld tumbled from 2nd place to 6th place, with output growth of only 0.5%, slowing from 2.8%.

The maturing of the mining investment boom, as construction work on major gas and iron ore projects are progressively completed, was central to the loss of momentum in WA and Qld.  Across the south-east conditions benefitted from the significant easing of monetary conditions - with record low interest rates and a sharply lower currency.

South Australia

SA's economy bounced back, expanding by 1.6%, following a sulggish 0.8% gain in 2013/2014.  As with NSW and Victoria, the key service sectors were the growth engine (particularly retail, hospitality and communications) adding 0.6%, up from only a 0.1% contribution in the previous year.  Health, finance and real estate added 0.9%, up from 0.6%, while conditions were mixed elsewhere.

The outcome for 2014/2015 of 1.6% was only a touch shy of the 1.75% expected by the state government, ahead of an anticiapated rise of 2% in 2015/2016.

Victoria

The Victorian economy experienced a significant rebound following a couple of disappointing years.  Gross State Product grew by 2.5%, up from 1.0%, an outocme close to the state's long run average of 2.7% and  a little above the state government forecast of 2.25%.  The government expects growth of 2.5% in 2015/2016.

As in NSW, the key service industries strengthened, addinng 0.7%, up from 0.4%.  In addition, it was a good year for both construction (0.5%) and finance (0.4%), as the housing sector responded strongly to low interest rates and an expanding population.

 

Source:  Westpac Economics 24th November 2015

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