Wednesday, May 22nd, 2019
Walking to work is great and healthy for a 60-year-old. But it does mean that I spend my 20-minute trek talking to myself – inside my head.
So, following the Federal election and a week where the US-China trade negotiation nearly collapsed (again) – I want to share a conversation with myself.
I have asked myself questions, many of which that I think or feel that you are asking.
Let’s get started.
Welcome me and I thank myself for the invitation.
Q. John – You have opined that the US-China trade negotiation would be settled because both sides had so much to lose from a trade dislocation or a trade war. What has gone wrong?
My answer – It’s clearly a complicated negotiation and it is made more complicated by President Trump’s desire to achieve too much too quickly. The deficit cannot be wiped quickly and can only be rectified over a decade by creating the pathway and maintaining the agreed course.
The trade deficit for the US (or trade surplus for China) is approximately US$400 billion. It seems to me that this cannot be rectified quickly and indeed a trade deal should focus on that which is achievable and logical.
Logically it will involve the US steadily replacing imports that currently flow from China, with local production (replacement) and China increasing its imports from the US in specific areas where there is competitive, price or quality advantage.
It is these opportunities that should be focussed on first. Thus, the US should gain greater access for energy, food and services exports to China. Concurrently China – possibly through capital investment – agrees to allow a transfer of production to the US mainland. It is this second part that is most difficult to structure because the US cannot simply create the productive means, inside a production line, that currently are sourced from China.
The pathway should have an agreed target (timeline) whereby the US trade deficit is progressively reduced. A good plan would be to increase US exports to China by say $10 to $20 billion per year whilst Chinese exports to the US reduce by a similar amount. Thus, over ten years the deficit could be reduced and possibly eliminated.
There is a problem with my view. The respective negotiators have different time constraints created by their electoral or administrative cycles. Trump has an election next year and may be granted another 4 years (total 5.5 years). The Chinese Administration (led by Xi Jinping) has no time constraint over its governance of China. The pressure is thus on Trump to deliver quickly and he must acknowledge that he has limited capacity to lock in future US Administrations. China knows that Trump does not have bi-partisan, business or market support for tariff walls.
The US election cycle came into focus last week when Trump suggested that China was slowing negotiations to potentially allow them to deal with a Democratic Party President in 2021. Whether that is actually true or not, it does show that Trump needs to negotiate a deal that is clearly in the US national interest as well as being one that is also good for China.
Q. John – the equity markets have been a rollercoaster for the last 18 months and the recent trade dislocation created a downward shift. Where to from now?
My answer – The short term is too hard to predict. The current trade blow up – in complete contrast to the negotiating harmony of a few weeks back – simply confirms my point.
It seems to me that markets (and these includes bond markets) have an elevated (arguably excessive) level of short term capital that directs daily price movements. That is the result of sustained QE and the compression of cash rates by Central Banks.
I am observing that markets are sending very strong messages to governments and administrations to set policy that supports risk markets. We saw this when equity and bond markets forced the US Federal Reserve to change strategy in January. I suspect that markets will force Trump to deal with China and not lift tariff walls. The risk of inflation in the US caused by the tariff wall is real and the US cannot risk a pickup in inflation above 2%. Further, a reduction in trade to China would slow economic activity in both the US and across the world.
I don’t know where markets are going in the short term, but I do know that quality companies who fund their own growth will do well over a period. I also suspect that bond markets (whilst currently elevated) will bounce around inside yield bands. Government bonds currently offer very poor returns forcing yield investors to look elsewhere for decent returns.
Q. John – The RBA has held rates steady again in the May meeting. What’s the outlook here?
I maintain that the RBA does not need to do anything with interest rates at present. They are at historically low levels (in both actual and in real terms) and are supporting the economy.
Further, there is no evidence (see Japan) that extremely low interest rates will generate economic activity. Indeed, the evidence suggests the opposite occurs (across the Eurozone) where lower interest rates stifle investment.
There is the current election campaign being waged with a raft of fiscal expenditure promises being made with the promise of a budget surplus being maintained. I have a view that neither political party understands the interaction of fiscal and monetary policy. This makes it difficult for the RBA and they must wait to see what the next Government sets as its fiscal policy before they can respond.
Given that Australia is growing at a low rate (RBA forecast now below 2% in real terms) it is extraordinary that both alternative governments are fixated on creating and maintaining a surplus independent of what the economy is doing and what is needed.
The creation of a surplus (outside changes to franking or negative gearing) is created by 3 main factors that are not admitted by either side. First, there is a tax bracket creep that is entrapping middle-income earners to higher taxes. Second, there is the maintenance of elevated iron ore prices that is driving budget revenues and third is the decline in bond yields. Australia has nearly $90 billion of maturing debt in the next two years that will be reset at 2% lower costs saving nearly $2 billion per annum in interest a year from FY21.
It is a confusing environment for the RBA to navigate. Australia has high employment levels but with low wages growth and low inflation. We have relatively high export prices (particularly iron ore) with a large trade surplus but with a weakening currency. An improving capital account with a surge in long term savings flowing from superannuation that is generating foreign income flows. Maintenance of strong levels of inbound tourism from China that is supporting the local services economy.
Whilst there are identifiable issues and risks for the Australian economy, we must remember that there always are! They are not elevated world risks compared to any previous period. Our biggest risk is self-induced. The inflated residential property market and household debt levels. This problem was created by runaway credit creation both prior to and since the GFC.
What should the RBA and the next government do? In my opinion, rather than propping up property prices by handouts or cutting interest rates, there should be an absolute focus on reducing or at least stabilising the cost of living in Australia.
Whilst the child care assistance program proposed by the ALP fails to address the seemingly poor regulation in that industry, it does acknowledge that cost pressures are rampant across the economy. All levels of government should act to keep down the cost of living and refrain from putting up charges or fees. If that requires the Commonwealth to provide short term assistance to each level of government then so be it. Cutting interest rates is not the solution but a focus on keeping the cost of living down is. More so in a period of stagnant wages as households pay down debt. Further a focus on infrastructure development – fast-tracked – should be a priority across the nation.
Therefore, the bi-partisan desire to create budget surpluses seems very ill-conceived at present. A small deficit of 1% of GDP seems much more logical at this point in the cycle. If that was the policy then the RBA would not need to cut interest rates. Monetary and fiscal policy would be in harmony.
Having made that point I am not confident that the RBA will have the fortitude to maintain rates at current levels. The lack of coordination between fiscal and monetary policy leads me to that view.
Originally published Wednesday 15th May 2019.