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Investment Enews
November 2017

Will our economy continue to grow?

Remember the days when a bank account paid 5% per year? Remember when 8% p.a. was a prudent, responsible target for a conservative investor? If so, you may be one of the many investors who finds the current condition of the global economy to be profoundly disappointing. A world that had grown accustomed to strong, dynamic growth, year after year, now appears to be at risk of perpetual stagnation. For over a decade, economic growth rates have been low, even negative in many developed nations. Wages growth has stalled, leaving living standards becalmed. Inflation – once the bete noir of economies across the world – now looks more like a comforting old friend, chipping away at indebtedness and pointing to healthy consumer demand. And interest rates! What has happened to them? Will they ever rise again?

In this edition of Investment Enews, we take a look at a world plagued by low interest rates and searching for the next source of economic growth.

Interest rates – a generational decline

First, it is worth recalling the profound challenge presented to investors by ever decreasing interest rates. As the graph below shows, the Reserve Bank’s Official Cash Rate has plummeted across a full generation. From record highs in the late 1980s and early 1990s, we now see interest rates at unprecedented lows.

The challenge this presents for investors is obvious. In a low interest rate environment, the yields from cash and fixed interest investments are – with a few notable exceptions, such as our own portfolios – barely above inflation. Accordingly, global stock markets have surged, triggering fears of a bubble. Some prominent commentators predict disaster for these markets when the unconventional monetary policy experiments of the last decade are finally unwound.

So how can an investor – particularly a retail investor - respond? Risks are everywhere, but the biggest risk may ironically be arising from our greatest triumph – increasing life spans. As life expectancies inexorably increase, investors cannot afford to sit on the sidelines. The biggest risk of all may be the risk of being underinvested.

It’s easy for investors to feel overwhelmed by these forces. Yet the news is not all bad. Indeed, one could take quite a different view of Australian economic history. One such view was advanced in a recent speech by Reserve Bank Assistant Governor, Luci Ellis.

But the future might be brighter than it sometimes looks

Australia in 1958 was a very different place. Manufacturing accounted for around 25 per cent of output and 26 per cent of employment compared with 6 per cent and 7 per cent now. Living standards were lower. Real household disposable income per household was a little more than half the level it is now. The average household spent 20 per cent of its post-tax income on food consumed in the home, compared with 9 per cent now. And the basket of goods and services used to calculate real incomes did not then include overseas holidays, internet connections or the array of electronic goods that it does today.

Australia's economy was also organised very differently then. Almost all wages were set by a judicial process. High tariff and other barriers restricted manufactured imports. Agricultural production was protected and managed through marketing boards and other government agencies. The financial sector was highly regulated and restricted in the kinds of business it could do.

But by 1977 – perhaps because of these structures - Australia was a poorly performing, inward-looking economy. Economic growth and living standards were lagging other industrialised economies. Inflation remained higher as well. Productivity growth seemed lacklustre and there was a general sense that the Australian economy was not ‘world class’.

‘Protection all round’ was far from a progressive system. It encouraged rent-seeking. The wage-setting system didn't just support a basic ‘living wage’. For most of its existence, it enforced lower pay rates on women and excluded them from many occupations. By protecting Australian industry from imports, it created a mindset that local firms would never be able to compete. The idea that our industries could export abroad was barely considered.

Over time, the Australian economy was liberalised. This took decades. Some of the reforms, including the tariff cuts in the 1970s, might have been motivated by other concerns. But they had the same effect as if they'd been cut as a deliberate liberalisation measure: they spurred domestic firms to respond. The floating of the exchange rate in 1983 was particularly important. For a commodity-exporting country like Australia, subject to global economic fluctuations, a floating exchange rate is the best absorber of external economic shocks ever invented. And so it was that in the 1980s, the floating exchange rate absorbed the shock of our economy's increasing openness. Over the two years to January 1987, the Australian dollar depreciated by around a third on a trade-weighted basis.

These policies constrained real wages. But depreciation made it easier for domestic firms to compete with imports and become exporters. Manufactured exports roughly quadrupled their share of real GDP over the subsequent decade and a half (Graph 1). And despite the boom in resource exports and the gloomy rhetoric that often surrounds Australian manufacturing, that share hasn't fallen much since then.

The Australian economy of the 21st century is structured very differently. But there are a number of parallels. Back then, Australia was said to ride on the sheep's back. Together, wool and wheat were close to half of Australia's goods exports in the 1960s. Agriculture accounted for more than 40 per cent of business investment. Indeed, almost all of that agricultural investment was ‘cultivated biological products’, which is mainly livestock but includes vineyards and orchards. But, even then, agricultural employment was only 11 per cent of the total. And the vast majority of Australians, then as now, lived in the biggest cities, far removed from agricultural activity.

In recent years, resource exports accounted for around half of Australian exports. That figure is likely to increase a little as new liquefied natural gas (LNG) capacity comes on line. During the recent resource investment boom, mining investment exceeded non-mining investment for a period. But, even if you added in workers in sectors such as construction and professional services who were doing work on mining projects, mining-related employment is just a fraction of the workforce. That was true even at the peak of the mining investment boom. So, again, the vast majority of Australians' economic lives are relatively unconnected to the biggest exporting sector.

The past decade or so also isn't the first time Australia has seen a surge and reversal in the terms of trade, either. The Korean War induced a boom–bust cycle in wool prices. Later, there was a surge in mineral commodity prices. This induced a boom in resource investment, though not as large or long-lived as the one we have just been through. Then, as recently, Australia needed to manage the consequences of that.

Then, as now, there were concerns that the economy would suffer from ‘Dutch Disease’, where a higher exchange rate renders the manufacturing sector uncompetitive and industrial capacity atrophies. Often it wasn't appreciated that if much of the investment equipment is imported, the exchange rate doesn't appreciate as much. Yes, other sectors, including manufacturing, will find it harder to compete with imports when the exchange rate is high. But that isn't a permanent state of affairs.

Then, as now, there were concerns that our prosperity might be based on too narrow a foundation. Even around the turn of this century, foreign investors argued that Australia was an ‘old economy’. We should stop digging things out of the ground, they said, and start building microchip factories. Of course, this would have meant stopping the export of commodities in order to start the export of different commodities. And considering the relative price movements of iron ore versus microchips since then, we are better off for not having taken that path.

So there are many similarities between the resources boom of the early 1980s and now. But there were also important differences. This time around, the role of foreign investment in funding that boom has been less controversial. The labour market has probably adapted to the shock more quickly, too. We see this in the interstate migration figures. Perhaps more importantly, the high wages on offer in the booming sector weren't automatically flowed through to the rest of the labour force through a centralised system. So the cost base of the economy didn't shift as much. And this time around, the Australian dollar has floated freely and done much of the work to adjust to the shock. A floating exchange rate regime has several advantages in the face of a terms of trade and investment boom. As the exchange rate appreciated, the benefits of the income shock coming from the higher terms of trade were more evenly shared. Rather than the income boost going solely to the resource industry, lower import prices raised the real incomes of all Australians. If instead we'd had a fixed exchange rate, we would have had a balance of payments surplus. That would have represented a large monetary stimulus. And we know from the wool boom during the Korean War what the result of that would have been: significant inflation, and not much to show for it afterwards.

As the mining investment boom turned down, and became a drag on growth, the question was often asked: ‘Where is the growth going to come from?’ Commentators started speaking of a growth ‘handover’: if mining investment wasn't going to provide our growth, something else needed to. And for a while, particular non-mining sectors did seem to pick up, to become in turn the new ‘engine of growth’.

First to do so was residential construction. It added much less to growth than the mining investment boom did, at least directly (Graph 2). Even at its peak, it was only adding around ½ percentage point to annual GDP growth. Compare that with the mining investment boom, which added roughly 1–2 percentage points to growth in each of 2011 and 2012, for example, even after netting out the high import content in resource investment. This sector is not where we will find an ‘engine of growth’ to pull us all along.

The newest so-called ‘engine of growth’ is public infrastructure. Like high-density residential construction, infrastructure projects serve as a good replacement for mining investment projects in a ‘growth handover’: the human skills needed for both types of work are very similar. And spillovers to the rest of the economy are probably even stronger than for housing.

There is a problem with this ‘handover’ idea. First, all of the sectors identified as new ‘engines’ of growth produce long-lived stocks of things: mines, buildings, bridges and railways. You can produce above-average amounts of these things for a while, but you can end up with an excess you don't really need if the boom continues for too long. This is the problem with any kind of construction-related boom. The stock-flow dynamics really matter. None of these sectors should be thought of as sustaining growth indefinitely.

Second, in searching for a replacement for the mining investment boom, too often people forget that it gave way to a mining exports boom. That boom is now happening, and for LNG it still has a bit longer to run. We anticipate that resource exports will add about a cumulative 1.2 percentage points to GDP over the next two years. Resource exports now account for around half of Australia's export revenue, and that will remain broadly true even if commodity prices fall a bit from here.

Third, it was also often forgotten that the rest of the economy had been squeezed to make way for the mining investment boom (Graph 4). Sectors such as tourism and manufacturing were affected by the exchange rate appreciation. Since the beginning of 2014, though, the Australian dollar has on average been 18 per cent below the peaks it reached in 2013, on a trade-weighted basis. The squeeze naturally reversed itself when the investment boom ended. So part of the answer to the question ‘where is the growth going to come from?’ is ‘all the industries that had been growing more slowly than usual during the boom’.

The ‘engine of growth’ mindset also seems to divide industries into the worthy and the unworthy. Only ‘good growth’, we are told, is truly sustainable. Much of the recent growth in employment has been in household services such as health and education, which leads some to dismiss it as ‘bad growth’. Are people presuming that it's all driven by the public sector and therefore somehow artificial? Or is it that they think jobs in service industries are all low-skill, low-wage jobs and therefore bad jobs?

The literature in fact shows that growth in health and education can indeed be ‘good growth’ – sustainable growth. Both sectors contribute to stronger performance in other sectors. Better health outcomes are good for their own sake; they improve people's welfare. In addition, they improve productivity of individual workers and make it less likely that careers will be cut short (and retirement income will fall short) because of ill-health. Similarly, better education is not only good for its own sake – it builds human capital, the better skills we all need to be more productive.

Where will the Growth Really Come From?

It is hard to go past the ‘three Ps’: population, participation and productivity. Australia's population is growing faster than in almost any other OECD economy.

Of course, just adding more people and growing the economy to keep pace wouldn't boost our living standards. But there are two reasons why we should not assume that this is all that happens. Firstly, the average education level of newly arrived Australians is actually higher than that of existing residents, precisely because they are younger. So Australia's migration program is structured in a way that, in principle at least, it can grow the economy while raising average living standards.

Secondly, increasing economic scale is not neutral. There is more to it than just getting bigger. Bigger, denser cities are more productive. Perhaps more importantly, larger population centres allow more variety in the goods and services produced. As Adam Smith said in relation to a porter, “A village is by much too narrow a sphere for him; even an ordinary market town is scarce large enough to afford him constant occupation.

Participation can and has been increasing average incomes and living standards. The increase has been concentrated amongst women and older workers. (Graph 6). Older workers have increased their participation in the workforce as the trend to earlier retirement has abated. Mixed in with this is a cohort effect related to the increasing participation of women more generally. Each generation of women participates in the labour force at a greater rate than the previous generation of women did at the same age.

In the end, though, lifting participation is a once-off adjustment. Once someone enters the workforce, they can't enter it a second time without leaving first. Greater participation raises the level of living standards but it isn't an engine of ongoing growth. We must also remember that the objective is not that everyone must be in paid employment. Many people are outside the labour force for good reasons, for example because they are in full-time education, caring for children or other relatives, or doing volunteer work by choice.

Productivity is arguably the most important of three Ps and also the hardest to measure. The average productivity of firms in an economy depends on three things:

  • How quickly the leading firms in that country adopt the technology and match the productivity levels of the globally leading firms in that industry.
  • How large the leading firms are in the national economy.
  • How quickly the laggard firms can catch up, once the national leading firms have adopted a particular technology.

Australia is normally seen as being a relatively fast adopter of technology. But there are some aspects where we seem to lag. One is R&D expenditure (Graph 7). While this isn't greatly below the average of industrialised countries and many similar countries get by perfectly well doing much less, it has been declining in importance lately. Some other indicators also suggest that Australian firms have in recent years been less likely to adopt innovative technologies than their peers abroad. For example, while small firms are holding their own, large firms in Australia are less likely to use cloud computing services than large firms in many other countries. This wasn't always the case: a decade and a half ago, Australian firms were towards the front of the curve in adopting the e-commerce technologies that were new at the time. A lot depends on whether the workforce has the skills to use these new technologies, but at heart, technology adoption is a business decision.

So what does it all mean?

Well, according to Assistant Governor Ellis, protection hurts more than it helps and it leaves a legacy of disbelief in our own competitiveness. We don’t have to find a new ‘engine of growth’ for the economy. Instead, we should focus on trying new things and ‘gradually getting a bit better at what we do’.

In this light, things do not seem so gloomy at all. Investors need to carefully check whether their return targets are realistic. A risk-free 8% p.a. is unlikely to present itself when official rates are at 1.50%. And in our view it is still likely to be some time before there are significant upwards movements in rates. More moderate, sustainable returns should be the order of the day, so that capital can be preserved. But the future of the Australian economy in this Asian 21st century looks full of potential. We are making progress on each of the ‘3 Ps’ and – with a business by business commitment to increasing productivity through innovation – we can ensure that Australia’s growth story continues.

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