Australia in 2018: Risks and Issues · 2019-08-10 · Australia in 2018: Risks and Issues The...

Australia in 2018: Risks and IssuesThe outlook for the Australian economy, interest rates and currency in the year ahead, as well as what the global PMI surveys are indicating about prospects for the manufacturing and services sectors.

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Michael Blythe is the Chief Economist and Managing Director of Economics at the Commonwealth Bank. His extensive experience as an economist reflects more than thirty years working in economic policy and financial-market-related areas.

Michael’s role encompasses monitoring, analysing and forecasting trends in the Australian economy and financial markets. In addition, he prepares a wide range of research material on matters of current interest. In his capacity as the CBA’s Chief Economist, he is a regular conference presenter and media commentator on major economic developments and themes. Michael and

his team have consistently ranked in the top three for macroeconomic analysis advice in various industry polls.

Michael works in the Institutional Banking & Markets division of the Commonwealth Bank. This division is responsible for managing the Group’s relationships with major corporate, institutional and government clients and providing a full range of capital raising, transactional and risk management products and services.

After graduating in economics from the University of Sydney in 1982, he spent a total of 13 years in various roles within the Economic Group of the Reserve Bank of Australia.

This included a stint at the International Monetary Fund in 1988. He was the RBA’s Senior Economist from 1991-95. Key features of these roles involved the provision of economic analysis and policy advice.

Michael joined the Commonwealth Bank in late 1995.

This report from pages 4-23 is an abridged version of “Australia in 2018: risks and issues” written by Commonwealth Bank Chief Economist, Michael Blythe, and published on 17 January 2018. The full document can be found on https://www.commbank.com.au/content/dam/commbank/corporate/research/publications/economics/economic-issues/australia/2018/180118-Risks_Issues.pdf

https://www.commbank.com.au/content/dam/commbank/corporate/research/publications/economics/economic-issues/australia/2018/180118-Risks_Issues.pdf







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ContentsOverview

Global backdrop

Global commodity prices

Australia’s commodity boom-bust

Australia’s growth guaranteed

Residential construction

Non-mining capex

Households are a macroeconomic risk

Inflation, interest rates and the Australian dollar

Global risks and issues

Commonwealth Bank Purchasing Managers’ Index

Global PMI comparisons

Australia PMI

Key contacts

4

6

8

10

12

14

16

18

20

22

24

28

32

36

Overview Australia’s growth guaranteed Global risks and issues Commonwealth Bank PMI Key contacts

Australia in 2018: Risks and Issues

Contents

4

OverviewGlobal growth was better than expected in 2017 with global forecasters spending the year revising up their projections. Australia notched up 26 years of economic growth, overtaking the Netherlands as the economy with the longest expansion. Around the world growth was sufficiently strong to push down unemployment but not enough to generate inflationary pressures. This, coupled with surprising resilience in commodity prices, enabled markets and economies to ride out numerous geopolitical shocks.

In 2018 the Australian economy will benefit from a supportive global backdrop and domestic economic and policy parameters that favour growth. The headwinds from the unwinding of the commodity boom are behind us and a fair proportion of the growth story appears locked in. Unemployment should fall further while inflation lifts modestly. The main downside risks revolve around slower residential construction, business capex uncertainties and the interaction of high household debt and weak income growth.

• Most economic outcomes in 2017 were better than forecast, unlike the past five years.

• Prospects for both the global and Australian economy are encouraging.

• It is becoming easier for Australia to grow and a significant part of the prospective growth story looks locked in.

• As the economy moves closer to ‘normal’, policy settings will need to normalise.

Key predictions:


Australia’s growth guaranteed Global risks and issues Commonwealth Bank PMI Key contactsContents Overview

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The domestic issues and risks mainly relate to the consumer while the global ones remain the fluid geopolitical backdrop. The main points, discussed in more detail in the following pages, are:

• A synchronised global upturn is underway. Rising trade, capex and jobs indicate the upturn is sustainable, with the skew in growth towards Asia and industrial production favouring Australia.

• Commodity prices may retreat a little in 2018 but risks are to the upside. Over the medium-term, a shift in policy direction in India and China’s Belt & Road initiative point to some upside risks to commodity prices.

• The end of the commodity bust makes it easier for Australia to grow. Higher commodity prices are again boosting incomes and the drag on spending and jobs from falling mining capex is almost complete.

• Some of Australia’s growth appears locked in from the resource export payoff, the infrastructure boom and Asia’s income expansion.

• Demographic and regional dynamics should limit the downturn in residential construction.

• The long-awaited lift in non-mining capex is underway. Fundamentals are favourable but businesses need to adjust their hurdle rates and ‘animal spirits’ must lift.

• Household debt, and the housing market underlying it, looks more of a macroeconomic risk than a financial stability risk. The persistence of high debt, weak incomes and other pressures is changing household behaviour in a way that weighs on consumer spending.

• The economy will near the RBA’s definition of “normal” in 2018. A rate rise is likely by year-end.

• 2018 will see its fair share of geopolitical and financial risks.

Key Commonwealth Bank forecasts for 2018

Real GDP %ch

Headline CPI %ch

Underlying CPI %ch

Unemployment rate %

Wage Price Index %ch

Terms-of- Trade %ch

Current A/c deficit

2.9% 2.3% 2.1% 5.3% 2.4% -5.7% $39.1bn

“ Australia has seen 26 years of economic growth, overtaking the Netherlands as the economy with the longest expansion.”

Source: CBA



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A favourable global backdropThe global economy is evolving in a way that will assist Australia’s economic story, albeit risks remain.

A synchronised upturn is underway for the first time since 2006. It is pushing global growth above trend for the first time since 2011. Advanced economies and China drove the lift in global growth in 2017 as domestic demand strengthened. The improvement is spilling over into emerging market economies, lifting global growth further in 2018.

Rising global trade, capex and jobs point to a sustainable upturn: world trade looks set to expand at better than 4%pa over the next few years, above the 3%pa average of the previous five years; the OECD estimates show that global capex is running at

the top end of the range of the past five years; and the 1% fall in the unemployment rate in advanced economies during 2015-2107 is exceptional and supports consumer spending.

The global inflation cycle may be turning up given China is now ‘exporting’ inflation to the rest of the world; the output gap evident in advanced economies since 2009 will close in 2018; 70% of advanced economies have unemployment rates at or below full employment on OECD estimates; and oil prices are higher. While global inflation rates will likely remain low, some upside risks may start to emerge in 2018.

A synchronised, sustained upturn with some shift to upside inflation risks no

longer requires extreme monetary policy settings. Interest rate normalisation will continue, albeit only slowly and cautiously so policy interest rates will remain low by historical standards. Add in a small amount of fiscal stimulus and the global policy mix remains supportive.

The global growth skew favours Asia and commodities and therefore Australia. For example, the lift in semiconductor sales favours the many countries in Asia that are exposed to the global IT cycle and global trade more broadly. Likewise, strong growth in global industrial production bodes well for global commodity demand and major suppliers like Australia.



7

0

25

50

75

2004 2007 2010 2013 2016 2019

% of total

Accelerating

GLOBAL GROWTH MOMENTUM(number of countries...)

Fore-casts

Contracting

Slowing

Accelerating

Source: IMF/CBA

Fore-casts

Contracting

Slowing

% oftotal

-14%

-7%

0%

7%

-14%

-7%

0%

7%

Mar-06 Mar-09 Mar-12 Mar-15 Mar-18

OECD GROSS FIXED CAPEX(annual % change)

Source: OECD

-10%

-5%

0%

5%

10%

-24%

-12%

0%

12%

24%

Jan-08 Jan-10 Jan-12 Jan-14 Jan-16 Jan-18

ChinaPPI goods

manufacturing(rhs)

INFLATION INDICATORS(annual % change)

Source: CBP World Trade Monitor/CEIC

Adv economyimport prices

(lhs)

-14%

-7%

0%

7%

-14%

-7%

0%

7%

Jan-01 Jan-06 Jan-11 Jan-16

14%14%

GLOBAL INDUSTRIAL PRODUCTION(annual % change)

Source: Bloomberg

Global growth momentum (number of countries...)

Inflation indicators (annual % change)

Global industrial production (annual % change)

OECD gross fixed CAPEX (annual % charge)



8

Good near-term prospects for global commodity pricesWhile the longer-term metrics favour lower commodity prices, shorter-run dynamics are pushing in both directions.

China is the key to demand, accounting for 45-60% of global consumption of the major commodities (only 20% is for China’s own consumption). The numerous factors currently playing out mean Chinese growth and therefore commodity demand may surprise

on the high side, as they did in 2017. The Commonwealth Bank China Tracker was pointing higher at end-2017.

The reluctance of miners to invest means the supply side of the commodity equation could also be price-friendly in 2018. Gross margins remain relatively low by historical standards. The early period of low prices forced supply rationalisation and this will continue in 2018 as

China focuses on environmental compliance, safety and cutting overcapacity. This may see suppliers of high quality, low cost commodities pick up market share.

Commodity forecasts typically assume prices settle around some sort of real long-term average. This is reasonable assuming no ‘new’ China drives a repeat of the 2007-11 price spike.

8%

-10%

-5%

0%

5%

10%

-8%

-4%

0%

4%

Jan-06 Jan-09 Jan-12 Jan-15 Jan-18

CBA CHINA TRACKER(momentum - change in annual growth rate)

CBA China Tracker momentum

(adv 5 months, rhs)

GDPmomentum

(lhs) Source: CBA/CEIC

0

12

25

37

3

5

7

9

2003 2006 2009 2012 2015 2018

MINING INDICATORS

% %

Grossmargin

(adv 2 years)(rhs)

Source: CBA Commodities

Capex/total assest

(lhs)

Commonwealth Bank China tracker (momentum - change in annual growth rate)

Mining indicators



9

100

200

300

400

100

200

300

400

Sep-04 Sep-07 Sep-10 Sep-13 Sep-16 Sep-19

IndexIndex

2005/06averageSource: CBA

CBA COMMODITY PRICE INDEX

CBA(f)

60

85

110

135

60

85

110

135

Jan-15 Sep-15 May-16 Jan-17 Sep-17 May-18

USDbn

USDbn

Newly signed

contracted project

Completedcontracted

project

BELT & ROAD INITIATIVE(rolling annual contract value)

Source: CEIC

The commodity supercycle is dead. We are holding to our medium-term assumptions that the base for commodity prices is around 2005/06 levels. These are well below 2011 peaks but 125% above pre-boom norms.

But it is worth watching India. It has the same population and urbanisation trends and infrastructure needs as China. If India industrialises in a similar

way to China over the next 20 years it would be a bigger consumer of minerals than China is now. The Make In India policy will help. Regulatory reforms are also making it easier for India to grow.

China’s Belt & Road Initiative is another positive driver for commodity prices in the medium-term. The plan to improve connectivity across Eurasia via a Silk Road Economic Belt and a Maritime

Silk Road will require considerable investment in infrastructure, much of which is commodity intensive. There’s also President Trump’s proposed US$1 trillion infrastructure program.

Belt & Road initiative (rolling annual contract value)

Commonwealth Bank commodity price index



10

Australia’s commodity boom-bust is overThe unwinding of the commodity boom was a significant drag on, and downside risk to, Australia’s economy over the 2011-17 period.

The ‘income recession’ from falling commodity prices is over. The income recession was a major growth risk. During the down phase falling commodity prices extracted income equivalent to 1.1% of GDP pa on average. Businesses responded to profit pressures by cutting back on labour and capex, governments cut spending to offset revenue shortfalls and slower wage growth hurt household spending.

Swings in commodity prices drive the swings in the terms-of-trade and nominal GDP (or income). The return of nominal GDP

growth to 2010/11 rates has boosted company profits and government revenues. The improved fiscal backdrop means tax cuts are on the table for discussion. Cutting income taxes is one way to transfer part of the benefit of the recovery in incomes to households.

The recovery in incomes shores up Australia’s AAA rating via smaller budget deficits and a smaller current account deficit. The ratings agencies should be noting that the Commonwealth position is improving. The current account deficit also improved to around 1.8% of GDP in 2017, well below normal outcomes of 4% of GDP. This lowers Australia’s exposure to global funding markets.

Falling mining capex weighed on spending and jobs. The mining capex share of GDP is back around normal levels. In fact, there is some scope for mining capex to lift from here.

About 50,000 mining jobs have been lost compared with our assumption of 90,000 job losses. Recent readings in our jobs proxy show a lift in employment and leading indicators are moving higher so the labour market fallout is less than expected. The commodity downturn is largely complete. Taking out a significant negative means it is getting easier for Australia’s economy to grow.

10



11

The commodity boom-bust (start = 100)

Mining CAPEX relative to normal (rolling annual % of GDP)

Commodities & vacancies (Nov 2013 = 100, monthly)

Underlying budget balance (outcome vs forecast)

0

200

400

0

200

400

2002/03 2006/07 2010/11 2014/15 2018/19

IndexIndex

Commodityprices

(RBA USD index)

THE COMMODITY BOOM-BUST(start=100)

Miningcapex

Source: RBA/ABS/CBA

-4

-3

-2

-1

0

1

2

-4

-3

-2

-1

0

1

2

1995/96 2000/01 2005/06 2010/11 2015/16

% ofGDP

% ofGDP

Budget outcome worse than expected

Budget outcome better than expected

UNDERLYING BUDGET BALANCE(outcome vs forecast)

Source: CommonwealthBudget Papers

-1%

0%

1%

2%

3%

4%

-1%

0%

1%

2%

3%

4%

Sep-05 Sep-08 Sep-11 Sep-14 Sep-17

Metals

Coal

Oil &gas

MINING CAPEX RELATIVE TO NORMAL(rolling annual % of GDP)

Source: CBA calculations

Other

25

49

73

97

121

40

60

80

100

120

Nov-13 Nov-14 Nov-15 Nov-16 Nov-17

RBA AUD Bulk Commodity

Price Index(lhs)

DFP ResouceVacancies

Index (rhs)Source: DFP Recruitment/RBA

COMMODITIES & VACANCIES(Nov 2013=100, monthly)



12

Australia’s growth guaranteedMany of the key economic drivers for 2018 and beyond are locked in so a fair proportion of the growth story is ‘guaranteed’.

Australia will become the largest global exporter of LNG in 2018/19, with rising resource exports contributing ~½% to GDP growth each year for the next two years. The LNG has already been sold. Exports will also boost the trade

balance by $0.65bn per month between 2017 and 2019, boost government revenues and influence Australia’s terms-of-trade (and A$).

The rise in infrastructure spending will contribute ~½% to GDP growth for the next two years. The GDP outcome is guaranteed since it comes from multi-year projects that have started. There is potential for the infrastructure boom to be

prolonged given some projects are set up as commercial operations. There could be a stream of assets for sale, with the sale proceeds recycled into new infrastructure.

There is plenty of investor appetite for long-life assets, particularly transport. Also, a survey of the infrastructure industry, including investors, highlights the importance of the right policy backdrop.

Bulk commodities (contribution to GDP growth)

Infrastructure challenges* (change between 2016 and 2017 surveys)

-0.5

0.0

0.5

-0.5

0.0

0.5

02/03 06/07 10/11 14/15 18/19

%pts%pts

Ironore

Oil &gas

Coal

BULK COMMODITIES(contribution to GDP growth)

Source: CBA/ABS/DIST

CBA(f)

-15 0 15 30

Political risk

Cost of bidding

Getting value

Competition forassets

Sovereign risk

Taxation

Complexity ofbidding

* % of survey respondents

INFRASTRUCTURE CHALLENGES*(change between 2016 and 2017 surveys)

Source: IPA


Global risks and issues Commonwealth Bank PMI Key contactsContents Overview Australia’s growth guaranteed

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There is also a need to look beyond asset recycling when funding infrastructure spending. Debt financing makes sense when interest rates are low and it effectively spreads the cost across users over time.

Asia’s solid population growth and rising incomes are generating a spending wave that is reshaping the region and the

global economy. Australia has benefited from the early stages of Asia’s income progression via the commodity-intensive nature of spending. More is to come as Asian incomes rise further.

The main benefits reside in the services economy. The rise in education and tourism spending will contribute ½ to ¾% to GDP growth pa for the next two years.

Growth in Australian industry sectors exposed to Asian income growth ran at 3.5%pa over the past two years. That compares with overall GDP growth that averaged 2.3%pa over the same period.

Asian income growth proxy (Australian GDP exposed to Asian income growth)

Emerging and developing Asia

55

73

92

2.0

2.6

3.2

1990 1994 1998 2002 2006 2010 2014 2018

%Bn

Population(lhs)

EMERGING & DEVELOPING ASIA

GDP per capita as a share of

the global total(rhs)

Source: World Bank/IMF/CBA

-3

0

3

6

-3

0

3

6


ASIAN INCOME GROWTH PROXY(Australian GDP exposed to Asian income growth)%pa

%pa

Source: ABS/CBA



14

Will residential construction be a drag on growth? The consensus forecast has dwelling starts dropping from 2015’s record 240,000 to 191,000 in 2018. The typical residential construction downturn cuts GDP growth by around 1 percentage point.

There are reasons why the top for this cycle will be more extended and that the downturn may be milder than expected. The residential construction pipeline is at record highs; the pipeline is heavily skewed towards higher density dwellings; and the average completion time for apartments is six quarters versus two quarters for a new house.

Strong demographics could limit the fall. As at mid-2017 (latest data) population growth was running at 388,000 pa

versus 360,000 a year earlier. Current estimates of underlying housing demand of around 185,000-190,000 may be short of the mark. Despite the record construction boom, the construction: population ratio is below average levels. Plus sharply slower dwelling turnover limits the ability to satisfy demand from existing stock.

Sydney and Melbourne will also support construction. They now account for 50% of national population growth (typically 38%). And their residential vacancy rates (Sydney 2.0% and Melbourne 2.1%) are below the national average of 2.6%. Leading indicators like building approvals and new construction lending are trending up again. Lending to buy residential blocks of land is growing solidly.

Furthermore, the renovation share of activity is unusually low with leading indicators pointing up. Both renovation lending and building approvals are trending higher. A rise in renovation activity would be consistent with the lift in house prices and housing wealth over the past few years.

Our construction forecasts are based on another successful construction rotation – this time to infrastructure and other non-residential construction. Given the multiplier impact on spending and jobs from these areas, we forecast the construction rotation will add 1¼ percentage points to GDP growth and create 62,000 new jobs over the next two years.



15

Work in the pipeline (residential)

Commonwealth Bank residential construction forecasts

Construction multipliers

Dwelling supply (new construction as % of population growth)

0

1

2

3

0

1

2

3

Sep-03 Sep-07 Sep-11 Sep-15

WORK IN THE PIPELINE(residential)

Houses

Higherdensity

dwellings

% ofGDP

% ofGDP

Total

Alts & adds

Source: ABS

0

40

80

120

0

40

80

120


% %

DWELLING SUPPLY(new construction as % of population growth)

Average

Source: ABS/CBA

Table 6: CBA residential construction forecasts

2016 2017 2018Commencements:

HousesMedium-high density Total (inc public)

11 6k1 14k234k

112k 99k

214k

1 10k89k

203k

GDP contribution from new construction 0.4% -0.1 % -0.1%

GDP contribution from alterations & additions 0.0% -0.1% 0.1 %

Table 7: Construction multipliers

Gross value added (per extra $1 of

construction spend)

Employment (extra jobs per $1mn spent)

Residential 1.34 7.2

Non-residential 1.34 5.9

Engineering 1.41 4.5 Source: CBA estimates



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The turn in non-mining capex appears to have finally arrived It may well be that the lengthy list of positive fundamentals that has characterised the capex backdrop for the past two years is finally bearing fruit. If so, it is long overdue.

However, there is some concern that capex is being dragged from reluctant businesses. The education and tourism booms are forcing education- and tourism-

related construction. The skew in jobs growth towards services requires more offices and the infrastructure boom will require the private sector to tool up. But reasons for caution remain.

Hurdle rates used to evaluate projects are still too high. Surveys show that most businesses have hurdle rates of 10-16%. This looks unrealistically high in a low

inflation, low yield and low return environment. Instead companies prefer to return ‘excess’ capital via buybacks and dividends. Additionally, animal spirits remain fragile as is evident from the fall back in new business formation. The lift in new ABN registrations in early 2017 has receded.

Reasons include the rise in perceived political and sovereign risk and the

Non-res building approvals (rolling annual total)

Business hurdle rates (for investment decisions, % of firms)

2

4

6

8

2

4

6

8

Jul-13 Jul-14 Jul-15 Jul-16 Jul-17

$bn$bnOffices

NON-RES BUILDING APPROVALS(rolling annual total)

Retail

Entertainment, recreation &

accomodation

Education

Health &aged care

Industrial

Source: ABS0

10

20

30

40

0

10

20

30

40

0<7 7<10 10<13 13<16 ≥ 16

BUSINESS HURDLE RATES(for investment decisions, % of firms)

Source: Deloitte CFO Survey/RBA

% %

Hurdle rates (%)



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rancorous debate about company taxes. Businesses are also worried by the energy price shock associated with higher electricity and gas prices. This is the major concern identified by Australian businesses in the World Economic Forum’s Executive Opinion Survey. Mining, manufacturing and some service areas are most exposed to higher energy costs.

Some respondents to Commonwealth Bank Purchasing Manager’s Index surveys reports that capacity constraints are holding back output. The backlog of work is at elevated levels and delivery times are lengthening. Reluctance by businesses to lift capex would limit our ability to participate in the global upturn and put upward pressure on labour costs and input/output prices.

Commonwealth Bank manufacturing PMI (price pressure indicators)

Industry: electric & gas usage (% of intermediate costs)

0 5 10 15

MiningSugar & confectionary

BeerTCF

PaperPrinting

Basic chemicalsCleaning compounds

Nat rubber productsGlass

CeramicsMetal & metal prod

Retail tradeAccomodation

Food & bev servicesRental & hiring

Public administration

INDUSTRY: ELECTRICITY & GAS USE(% of intermediate costs)

%

All industryaverage: 3.1%

Manufacturingaverage

Source: CBA40

45

50

55

60

40

45

50

55

60

May-16 Nov-16 May-17 Nov-17 May-18

IndexIndex

Suppliersdelivery times

Backlogsof work

CBA MANUFACTURING PMI (price pressure indicators)

Source: IHS Markit/CBA

Inputprices



18

Stretched household balance sheets and weak income growth are a macroeconomic riskHouseholds are major sources of risk to financial stability (via high levels of household debt and the housing market underlying that debt) and the macroeconomy (pressures on consumer spending).

The trigger to turn financial stability risk into reality isn’t there. The usual triggers are rising unemployment and rising interest rates. The other potential trigger is the housing market. High price to income ratios are often cited. However, the rising valuations are concentrated in Sydney and Melbourne, the capital cities with the strongest demographics. Most of the new supply is also going to those cities.

Nevertheless, the housing market is cooling and price growth

will continue to slow. Low affordability, regulatory action, higher mortgage rates, weakening price expectations, tighter lending standards and higher stamp duty for foreign buyers are dampening demand. Excluding genuine recessions, house price downturns have been small and short-lived. Commonwealth Bank borrowers have lifted repayment rates and built up sizeable balances in offset accounts.

There is some cyclical relief coming, such as the improving labour market lowering job security fears. But the biggest cyclical boost would be an end to the extended period of weak income growth. Policy makers can influence income via interest rates, taxes and social welfare payments. So any increase in

household spending power is dependent on a lift in wages growth.

Unusually weak wages growth is a common global theme. One driver is increased competition in product and labour markets, making employers reluctant to grant wage rises and workers reluctant to pursue them. Australia’s high level of underemployment and the resultant labour market slack is further dampening wages.

The correct economic and policy backdrop would see jobs growth continue, labour market slack fall and wages respond. There is a degree of urgency building. At the very least, it seems we should be thinking about wages policy as well as the more traditional monetary and fiscal policies.

18



19

Housing cycle triggers

Wages & debt Wages & underemployment

Australia: dwelling price drops (% decline from peak)

0

5

10

15

0

3

6

9

Jul-78 Jul-85 Jul-92 Jul-99 Jul-06 Jul-13

%%

Recessions-Slowdowns

HOUSING CYCLE TRIGGERS

Unemployment(lhs)

Mortgagerate(rhs)

Source: RBA/ABS

-8 -6 -4 -2 0

1981

1986

1989

1994

2004

2010

Price cyclepeak in,,,

AUSTRALIA: DWELLING PRICE DROPS(% decline from peak)

7 months

Source: CoreLogic/CBA

10months

21months

7 months

13months

% change

19months

0

2

4

6

0

50

100

150

Mar-98 Mar-02 Mar-06 Mar-10 Mar-14 Jan-00

%pa%

Household debt(% of GDP)

(lhs)

WagePriceIndex(rhs)

WAGES & DEBT

Source: IIF/ABS

6

7

8

9

101

2

3

4

5

Mar-04 Mar-08 Mar-12 Mar-16

% pa

WAGES & UNDEREMPLOYMENT

Private sector wages

(lhs)

Underemployment rate

(inverse, rhs)

%

Source: ABS



20

Will inflation matter in 2018?The economy will move closer to the Reserve Bank of Australia’s definition of normal in 2018. A rate rise is likely by year-end.

Commonwealth Bank expects inflation rates to move a little higher in 2018 reflecting: a modest acceleration in labour costs; further narrowing in the output gap; higher energy costs and administered prices; and some offset from lower

tradables prices on A$ strength. While higher, CPI inflation will only be running in the bottom half of the RBA’s target band at year-end.

Inflation risks seem tilted to the upside. Our PMI surveys indicate supply and demand issues are affecting input and output costs. Higher energy prices are boosting business input costs with a risk they filter through the pricing

chain. Conversely, new CPI weights will likely help restrain inflation. Competitive pressures will continue but we suspect much of the price adjustment for Amazon’s entry to the Australian market is already in place.

The last interest rate change in Australia was in August 2016. We expect a modest tightening cycle will start at end-2018.

Consumer prices (annual % change)

Commonwealth Bank Services PMI (price indicators)

0

2

4

0

2

4

Sep-98 Sep-02 Sep-06 Sep-10 Sep-14

CONSUMER PRICES(annual % change)

% %

Headlineinflation

(exc GST)

Underlyinginflation

Source: ABS

45

50

55

60

45

50

55

60

May-16 Nov-16 May-17 Nov-17 May-18

IndexIndex

Expansion

COMMONWEALTH BANK SERVICES PMI(price indicators)

Source: IHS Markit/CBA

Contraction

Inputprices

Pricescharged



21

By the end of 2017 the RBA’s focus had clearly shifted towards a normalising economy.

Benchmarking the current economy against the RBA’s expectations of ‘normal’ parameters shows activity is approaching normal but inflation indicators are still some way off. One indicator to watch is underemployment, given

its importance to the direction of wages and prices. The RBA will also be influenced by the increased sensitivity of households to changing interest rates.

We put the cash rate peak at 2.5% and don’t expect to get there until early 2020. We suspect the RBA is “comfortable’ with the AUD in a USD0.70-0.75 range. Our forecasts have the AUD above the

RBA’s comfort zone in 2018. This should mean that the RBA will prefer to lag any global tightening cycles. The hope is to take the benefit in a currency that was lower than otherwise would be the case.

AUD/USD exchange rateCash rate & labour market slack

5.5

6.6

7.7

8.81.0

3.3

5.7

8.0

Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Jan-17

% %

Underemploymentrate

(inverse, rhs)

RBA cash rate(lhs)

CASH RATE & LABOUR MARKET SLACK

Source: ABS/RBA

0.60

0.75

0.90

1.05

1.20

0.60

0.75

0.90

1.05

1.20

Jul-05 Jul-08 Jul-11 Jul-14 Jul-17

USDUSD

Average to 2007

RBA "comfort zone"(USD0.70-0.75)

THE AUD

PRESIDENTIAL APPROVAL RATING

Source: CEIC



22

Global risks and issuesThe supportive global economic backdrop is susceptible to the many downside risks in play. Recent years have showed.

Risks in the US include President Trump imposing trade restrictions and continuing tensions with North Korea and Iran. Upside risks include a lift in infrastructure spending and fiscal policy moving in an expansionary direction.

There is a strong vein of global disillusionment that lies behind many geopolitical events, demonstrating that income growth, and how it is distributed, matters. Potential flashpoints in 2018 include NAFTA talks, ongoing Brexit negotiations plus elections in Russia, Italy, Mexico, Brazil and Venezuela plus US mid-

term elections and possibly an Egyptian presidential election. Italy is the one to watch. Italy’s attachment to the EU is open to debate yet little risk is priced into financial markets.

More generally, financial markets have very little allowance for risk. That is despite the composition of global debt which reached a record 318% of GDP in 2017. In particular non-financial corporate debt in emerging markets is a concern: much is denominated in USD; will be refinanced at a time of higher USD interest rates and potentially stronger USD; and credit metrics are soft.

China’s high and rising levels of debt, and the proportion coming from the shadow banking system, are long-running

concerns. While Chinese authorities have exceptional firepower to bring into play if necessary, China stands out for its large credit-to-GDP gap (gap between actual credit ratios and trend), an early indicator of banking crises or severe distress.

The global backdrop favours rising interest rates, especially in the US, but still low inflation rates mean only modest increases. Australian longer-term interest rates will follow the US higher, again the rise should be limited. Near term more stimulatory fiscal policy may favour the USD but other central banks are likely to start lifting rates hence most major currencies will likely strengthen against the USD in 2018.


Commonwealth Bank PMI Key contactsContents Overview Australia’s growth guaranteed Global risks and issues

23

Italy: Geopolitical risk

Credit-to-GDP gap Australian markets

Global debt (% of GDP)

0

13

25

38

0

150

300

450

Jul-12 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17

ITALY: GEOPOLITICAL RISK Basis

pts%

Italian 10-yr bond spread

to Bunds(lhs)

Source: Eurobarometer/Bloomberg

% who see Italy as better off outside the EU

(rhs)

50

75

100

50

75

100

Mar-99 Mar-03 Mar-07 Mar-11 Mar-15

%%

GLOBAL DEBT(% of GDP)

Source: IIF

Mature marketgovernment

debt

Emerging market non-financialcorporates

-30 -15 0 15 30

ArgentinaAustralia

BrazilCanada

ChinaIndia

IndonesiaIsrael

JapanNZ

NorwayRussia

S ArabiaSingapore

S AfricaSwitz

ThailandTurkey

UKUSEU

CREDIT-TO-GDP GAP

Source: BIS

0.00

0.30

0.60

0.90

1.20

0

2

4

6

8


% USD

CBA(f)

Cash rate(lhs)

10-yrbonds(lhs)

AUSTRALIAN MARKETS

AUD(rhs)

Source: Bloomberg/CBA


Commonwealth Bank PMI Key contactsContents Overview Australia’s growth guaranteed Global risks and issues

Commonwealth Bank Purchasing Managers’ Index

PMI surveys have become highly-valued economic indicators in all major economies of the world, providing a timely alternative data set to official economic statistics.

Key features of the PMI surveys include:

Timeliness: the PMI is available well ahead of comparable official data such as GDP, employment and inflation: data are released right at the start of each month referring to the month just past.

Wide coverage: the PMI surveys were the first data to cover the increasingly important services sector, filling a void in analysts’ knowledge of major economies.

Internationally comparable: an identical methodology is used to produce and calculate the PMI in over 40 countries, generating a unique data set that can be easily used for international comparisons and regional aggregation, including unique global sector data.

Accuracy: the surveys have an unparalleled track record of providing early signals for policymakers, businesses and investors on changing economic trends. The PMI data were the first to indicate the severity of the impact of the global financial crisis on the real economy and have since become the most closely-watched, market-moving economic indicators in the world.

24

In 2017 Commonwealth Bank announced its partnership with IHS Markit to publish the new Purchasing Managers’ Index (PMI) surveys for Australia. The PMI series produced by IHS Markit is one of the most closely-watched signals of business activity. Central banks, financial markets and business decision-makers around the world value the surveys as timely and often unique indicators of economic trends. The indexes are based on monthly surveys of more than 27,000 companies in more than 40 countries, representing 87% of global GDP.


Key contactsContents Overview Australia’s growth guaranteed Global risks and issues Commonwealth Bank PMI

25

IHS Markit began producing PMI data in 1992, gradually extending coverage to some 40 countries. Australian PMI data were added in 2016, sponsored by Commonwealth Bank. Over 27,000 companies now contribute to the monthly surveys, including over 850 in Australia, providing factual information on metrics such as output, order books, employment and prices.

PMI coverage40+ Countries covered

27, 000 + Companies surveyed every month

87% Global GDP

25

Current coverageRecent expansion





26

A strong global PMI reading for December 2017 rounded off the best annual performance since 2014. Moreover, December saw improved inflows of new business and the largest rise in employment for a decade, suggesting that business started 2018 on the front foot. The survey data also show that the developed world is continuing to enjoy an improved share of the upturn relative to emerging markets. However, 2017 as a whole was the best year since 2012 for the emerging markets, highlighting how the global economic upturn is becoming more broad-based.

The metals & mining sector recorded the weakest growth of all 23 detailed industries covered by the global PMI in 2017, albeit with the rate of expansion gathering some momentum toward the end of the year. Asian metals & mining have lagged behind the global average, however, moving back into contraction in both October and December.

50 54 58 62 66

Other Financials

Banks

Media

Healthcare Services

Real Estate

Insurance

Commercial & Prof. Services

Industrial Services

Transportation

Software & Services

Pharmaceuticals & Biotech.

Beverages

Beverages & Food

Food

Technology Equipment

Tourism & Recreation

Constructional Materials

Household & Personal Use Products

Metals & Mining

Basics Material Resources

Industrial Goods

Automobiles & Parts

Chemicals

Machinery & Equipment

Paper & Forest Products

General Industrials

Global PMI: sectors ranked by output growth in 2017



27

Global PMI

-3.5%

-2.5%

-1.5%

-0.5%

0.5%

1.5%

2.5%

3.5%

4.5%

5.5%

35

40

45

50

55

60

65

2000 2004 2008 2012 2016

GDPPMI Output Index

Global GDP annual % changeJP Morgan Global PMI

Developed v emerging markets

40

35

‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 ‘13 ‘14 ‘15 ‘16 ‘17

45

50

55

60

Developed world

Emerging markets

PMI Output/Business Activity Index

Focus on metals & mining

35

40

45

50

55

60

65

2009 2010 2011 2012 2013 2014 2015 2016 2017

Global Asia


28

The recent PMI survey data have brought encouraging news of the global upturn becoming more broad-based among the world’s largest economies. While the star performer of 2017 was the Eurozone, where a strong December reading completed the best year since 2006, the UK, US and Japan all also reported solid − albeit comparatively more modest − rates of

expansion. In the emerging markets, markedly improved performances were seen in both China and India at the end of 2017. But Brazil slipped back into decline.

Having exceeded the global average almost continually from mid-2016 through to August 2017, the composite Commonwealth Bank PMI for Australia fell below the global average

in September and October before perking up again to hit a five-month high at the end of the year. Slower growth in Asia generally had been a contributory factor to the weakened pace of expansion in Australia. A subsequent pick-up of regional and global trade in December helped to lift the performance of the Australian economy, especially in manufacturing.

35

40

45

50

55

60

2015 2016 2017

Global

Developed world

Emerging markets

Australia


Global trends and Australia Major developed markets

35

40

45

50

55

60

2015 2016 2017

UK

Eurozone

US

Japan


Global PMI comparisons

PMI indicators of economic growth



29

Major emerging markets

35

40

45

50

55

60

2015 2016 2017


China

India

Brazil

Russia



30

The PMI indicated that worldwide manufacturing gained growth momentum throughout the second half of 2017, with output, employment and new orders rising at increased rates towards the end of the year. All showed the largest monthly gains since early-2011 in December.

Over 2017 as a whole, the fastest rates of expansion were seen in Austria, Germany and the Netherlands, topping a leader board in which the first seven places were all held by European nations.

The fastest growing manufacturing economy outside of Europe has been found in Australia, followed by Canada. The relatively strong performance of Australia is perhaps all the more surprising given the lacklustre growth of manufacturing seen across much of Asia. Asian countries held seven of the bottom nine places in the rankings.





31

Global manufacturing rankings, 2017

48 50 52 54 56 58 60

MalaysiaS KoreaThailand

IndonesiaBrazil

GreeceChina

MyanmarIndia

MexicoRussia

VietnamTurkeyJapan

PhilippinesUS

PolandTaiwan

SpainCanadaFrance

AustraliaIreland

UKItaly

Czech Rep.Netherlands

GermanyAustria

Asia ex-Japan & ChinaAsia

Eurozone

Emerging marketsDeveloped world

WORLD

Manufacturing PMI, 50 = no change on prior month (2017 full year average)

Historical Manufacturing PMI data

30

35

40

45

50

55

60

Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17

US

Japan

China

Eurozone

Asia (ex. CN&JP)

Australia

Manufacturing PMI

32

The Commonwealth Bank PMI showed Australian economic growth fuelled equally by manufacturing and services in the first half of 2017, but the former outperformed to lead the upswing towards the end of the year. The strongest manufacturing sector in 2017 was consumer goods.

The all-important investment goods sector (including plant and machinery) lagged behind, though saw a promising looking upswing towards the end of the year. It was likewise the consumer that provided the main impetus to the service sector through much of 2017.

Australia PMI45

50

55

60

65

2016 2017

Composite (all sectors)

Manufacturing

Services


Expanding

Contracting

Output

Manufacturing sector output

40

50

45

60

55

70

65

2016 2017

Consumer goods

Intermediate goods

Investment goods


Rising

Falling

Service sector output

40

50

60

70

65

55

45

2016 2017

Consumer services

Transport, Information & Communication

Finance, Real Estate & Business Services


Rising

Falling



33



34

New orders

48

50

52

54

56

58

60

2016 2017


Manufacturing

Services

Goods exports


Expanding

Contracting

Employment

48

50

52

54

56

2016 2017


Manufacturing

Services

PMI Employment Index

Expanding

Contracting

Backlogs of work

47

50

53

56

59

2016 2017

Composite (of all sectors)

Manufacturing

Services

PMI Backlogs of Work Index

Expanding

Contracting

Resurgent exports provided a major thrust to the Australian manufacturing sector at the end of 2017, helping drive faster growth of order books.

Hiring meanwhile remained robust, linked to efforts to ameliorate stretched capacity amid robust demand. Employment across both monitored sectors showed solid growth in the closing months of 2017.

Backlogs of uncompleted orders showed one of the largest rises in the history of the survey in December, notably in manufacturing, underscoring the need for firms to build capacity to meet stronger than anticipated demand.



Costs

47

50

53

56

59

62

2016 2017


Manufacturing

Services

PMI Input Prices Index

Rising

Falling

Selling prices

46

50

48

52

54

58

56

2016 2017


Manufacturing

Services

PMI Output Prices Index

Rising

Falling

Supply chains & prices

52

54

56

58

6040

42

44

46

48

502016 2017

Supplier delivery times

Input prices, goods

PMI Delivery Times Index PMI Prices Index

Slower deliveries(more delays) usuallymean higher prices

The Commonwealth Bank survey data also indicated a further rise in input costs, with solid rates of increase recorded across the economy. Higher import costs and greater labour expenses were reported.

In the manufacturing sector, supply chain constraints were seen as a factor behind price hikes, suggesting a shortage of capacity as demand exceeded supply for certain key inputs.

Seeking to protect margins, Australian companies raised average prices charged for goods and services at the steepest rate in the survey’s history during December.

35



36


Client Risk Solutions

Telephone Email Address

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Research


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Key contactsInstitutional Banking and Markets provides relationship management and product capability for the Bank’s major corporate, government and institutional clients. We offer a range of solutions to our clients, ranging from core transactional banking to debt, equity and financial markets risk management products and services.

The Markets division is responsible for the Trading and Sales activities in financial markets encompassing all Foreign Exchange, Commodities, Fixed Income and Interest Rate products.

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Contents Overview Australia’s growth guaranteed Global risks and issues Commonwealth Bank PMI Key contacts

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Fixed Income & Rates Telephone Email Address

Adam Donaldson Head of Fixed Income & Rates Research +612 9118 1095 [email protected] Scott Rundell Chief Credit Strategist +612 9303 1577 [email protected] Philip Brown Senior Fixed Income Strategist +613 9675 7522 [email protected] Jarrod Kerr Senior Interest Rate Strategist +612 9303 1766 [email protected] Tally Dewan Senior Securitisation Strategist +612 9118 1105 [email protected] Kevin Xie Fixed Income Quantitative Strategist +612 9280 8058 [email protected] Chris Walter Senior Credit Strategist +612 9118 1126 [email protected]

Foreign Exchange & International Economics Telephone Email Address

Richard Grace Chief Currency Strategist & Head of International Economics +612 9117 0080 [email protected] Elias Haddad Senior Currency Strategist +612 9118 1107 [email protected] Peter Kinsella Senior Currency and Rates Strategist +44 207 710 5603 [email protected] Joseph Capurso Senior Currency Strategist +612 9118 1106 [email protected] Andy Ji Asian Currency Strategist +65 6349 7056 [email protected]

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Sales

Institutional Telephone Corporate Telephone

Syd FX +612 9117 0190 NSW +612 9117 0377 +612 9117 0341 VIC +612 9675 7737 Fixed Income +612 9117 0020 SA/NT +618 8463 9011 Japan Desk +612 9117 0025 WA +618 9215 8201 Melb +613 9675 6815 QLD +617 3015 4525 +613 9675 7495 NZ +64 9375 5738 +613 9675 6618 Metals Desk +612 9117 0069 +613 9675 7757 Agri Desk 1800 633 957 Lon FX +44 20 7329 6266 Debt & Derivatives +44 20 7329 6444 Credit +44 20 7329 6609 HK +852 2844 7539 Sing +65 6349 7074 NY +1212 336 7750

IHS Markit


Joe Hayes Economist +44 1491 461 006 [email protected] Bernard Aw Principal Economist +65 6922 4226 [email protected] Joann Chin Marketing and Communications +65 6439 6027 [email protected]


Contents Overview Australia’s growth guaranteed Global risks and issues Commonwealth Bank PMI Key contacts

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IHS Markit Disclaimer (pages 24-35)

About Commonwealth Bank Manufacturing PMI® and the Purchasing Managers’ IndexTM Report. The Commonwealth Bank has commissioned IHS Markit to conduct research and provide insights for this edition of the Commonwealth Bank Manufacturing PMI through the Purchasing Managers’ Index Report. The Commonwealth Bank Manufacturing PMI is based on data compiled from monthly replies to questionnaires sent to a representative panel of purchasing executives in over 400 private sector manufacturing firms in Australia. The panel is stratified by GDP and company workforce size. The manufacturing sector is divided into the following nine broad categories: Food & Drink, Textiles & Clothing, Wood & Paper, Chemicals, Plastics & Rubber, Metals & Metal Products, Electronic & Electrical Equipment, Machinery & Equipment, Transport Equipment and Other Manufacturing.

About PMI® by IHS Markit. The intellectual property rights to the Commonwealth Bank Manufacturing PMI® provided herein are owned by or licensed to IHS Markit. Any unauthorised use, including but not limited to copying, distributing, transmitting or otherwise of any data appearing is not permitted without IHS Markit’s prior consent. IHS Markit shall not have any liability, duty or obligation for or relating to the content or information (“data”) contained herein, any errors, inaccuracies, omissions or delays in the data, or for any actions taken in reliance thereon. In no event shall IHS Markit be liable for any special, incidental, or consequential damages, arising out of the use of the data. Purchasing Managers’ IndexTM and PMI® are either registered trade marks of Markit Economics Limited or licensed to Markit Economics Limited. Commonwealth Bank use the above marks under license. IHS Markit is a registered trademark of IHS Markit Ltd.

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