Slack in the economy

The spare capacity in the Australian labour market currently is pretty clear – the lowest year-on-year wage growth since records began 17 years ago, shows how challenging the current environment really is.

Sydney Opera House
Source: Bloomberg

Wage dynamics reveal the weakness is across the labour landscape - public to private, mining to non-mining; the pain is being felt across the board. The implication from the numbers is that many working Australians have actually experienced negative real wage growth since June last year.

This is why policy makers now have a real challenge in engineering some form of recovery – confidence and spending is sliding and will be further impacted as consumers tighten their belts.

The other issue here is that wage growth that is being created is causing bracket creeping. That means the increase in wages is actually being eroded immediately by tax, as workers cross over tax brackets. This provides no additional benefit in terms of disposable income. In fact, in some cases it is actually worse than not receiving a pay increase – all this is further strain. An engineered recovery is becoming even tougher for policy makers, given not a single sector in the Australian economy will have wage growth above 3% in the next quarter.

Here in lies the dilemma for Glenn Stevens and those in Martin Place - give assistance to the struggling employment market at the risk of further driving the frothiness in the housing market, or leave things as is and watch the slow burn to lower confidence, lower consumption and lower investment.

The next piece of the rates puzzle comes into play today - the release of the private capital expenditure numbers. The survey is an 18-month forecast of CAPEX expectations from private firms here in Australia. It will be the first time we will see investment intentions for 2015-16 and will show if the steady decline in investment spending will indeed continue into FY17, where is was forecast growth would pick up.

Expectations are for real CAPEX to have declined 4.5% in the fourth quarter with the overall expenditure at $150 billion in 2014-15. 2015-16 is expected to see CAPEX falling to $107 billion, as the sharp downturn in mining investment bites and the non-mining space sees significant slack.

The Non-mining space will be key to today’s figures - expenditure needs to be at or above $55 billion in 2015-16, which would point to about 6% growth year-on-year. This would suggest the translation from the mining space to the non-mining space is taking place, albeit sluggishly.

Below $55 billion in non-mining and the slack in the economy will continue to widen, as the sharp decline in mining would create a hole that would need to be filled and that is likely to lead to further monetary assistance.

This is why Tuesday’s meeting remains a live event, although the interbank market believes there is only a 39% chance of a 25 basis point cut to the cash rate next week. Weak figures from the CAPEX read today will likely see that figure ramping up. However, it may only reach 50%.

Rates never move in single moves. There is normally two or three in a rates cycle - the likelihood of a 2% cash rate by the end of May, is near enough to 100% according to the markets. Will they follow their own advice and move early as there is no time to waste?

The other interesting situation here is the AUD/USD which has popped back above 79 cents as the USD corrects. Make no mistake, the majority of this move is USD related as the weak data from the past two weeks here in Australia has largely been ignored in the pair on USD weakness. However, the short term outlook is for it to continue to push higher. Be aware the top of the down channel at 79.6 is a very strong resistance level.

Forcing the market higher

The interesting situation currently is the slack in the economy is being completely ignored by the ASX 200. A new seven year closing high last night is four points from the May 19 2008 peak. From here, the next closing high is January 15 2008 at 5960. The strength in the market is two-fold: dips in yield stocks are being snapped up on any weakness and the oversold material space is seeing solid support on the back of results that show the underlying businesses are weathering the collapse in commodities.

I see another reason for the market’s strength. Cash instruments from banks and other institutions have been cut by 40 basis points in the past three weeks, after the 25 basis point cut from the RBA in early February.

This means term deposit rates are now sub 3% and are within 50 basis points of the trimmed mean inflation read. Plus tax needs to be collected on these TD yields – this is more than enough of an incentive to shift funds out of cash and into equities.

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