It’s a new financial year and investors are looking ahead to what the year might bring. Part 1 of this week’s View, published on Wednesday, presented a positive take on world markets, earnings, economics and politics. Part 2 today presents a positive take on Australia consistent with the glass-half-full tone of the current forecasts and commentary. We encourage readers always to form their own view of the outlook independent of the media’s daily screaming fearful and negative headlines. One of your author’s learnings from 2016-17 was to remain conscious of the disconnect between negative media headlines and reality, ignore the headlines and form his own view based on experience and facts. The media’s tendency to spin news and data using negative, cynical and sceptical language reflects only an imperative to sell subscriptions, clicks and page views – and, perhaps, our cynical era. Had you believed everything the media told you over the last year you would have sold everything and never invested again. The reality was the S&P/ASX 200 index rose 14% last year including dividends, there was no recession, no bank or housing crash either, unemployment was stable, and banks held their dividends as did most large companies. For ASX investors last year was actually better than average (at the index level). We think annual returns on the ASX will average 7-9% pa, not last year’s 14%.
We begin our discussion of Australia with the downtrend in the unemployment rate over the last two years, an important development with positive implications for banks and consumer-facing companies. This was consistent with earlier uptrends in job advertisements, a leading indicator. The first chart below shows the moderate lead ANZ’s job ads series has to the ABS’s measure of the unemployment rate. Recent growth in job ads as a percentage of the labour force predicts further employment growth.
 

Figure 1. Job advertisements as measured by ANZ vs. unemployment rate
Sources: ABS, ANZ, Fairfax Media
The ABS measure of job vacancies predicts further employment growth especially in the public sector. Public infrastructure spending, public administration, health care and aged care are all growth sectors in Australia.
 

Figure 2. Job vacancies
Source: ABS
Despite all the headlines about Australia being a “part-time nation” and the “death of full-time employment”, trend full-time employment has now grown 2% over eight consecutive months (prefer the trend data over the volatile seasonally adjusted and original data). This is respectable, as total employment normally grows 2% over a whole year. Part-time employment continues to grow every month, a socially welcome development after 20 years of complaints from new parents returning to the workforce they could not find enough part-time work. The proportion of the population in work, the unemployment rate and the participation rate are all steady over the last year. This is not the tight labour market workers want, and many people still want more hours than they can get (underemployment) but it is not recessionary. June data are due on 20 July.
 

Figure 3. Labour force status, trend data
Source: ABS, catalogue 6202.0
In Australia, most employment and employment growth is in the services sector, which contributes 67% of GDP. Manufacturing accounts for 6% of GDP. Together these sectors provide nearly three quarters of economic activity, so it is encouraging to note their consistent expansion over the last year according to two purchasing manager indexes compiled by the Commonwealth Bank. PMI data are more useful than sentiment surveys because they convey what is actually happening in the economy. Note the CBA series are only one year old so their long-term predictive power is not yet known. They are interesting but should be interpreted carefully.
In the two charts below the readings above 50 in June indicate solid levels of activity. Gains in manufacturing are being driven by increased output and new orders, a buildup of work outstanding and continued demand from Asia. Manufacturers are confident production will increase over the next year. The rate of new orders is starting to lift the rate of purchasing cost inflation, a new trend which should support the CPI over the year ahead.

Figure 4. Australian manufacturing purchasing managers’ index
Source: CBA
The services sector firms surveyed reported similar levels of improvement and optimism in June, when the services PMI strengthened to 57.0 from 54.8 in May. Note this measure of services sector activity does not include the struggling retail sector. The services sector reported improved marketing, greater demand, backlogs of work and – crucially – skills shortages starting to push up wage input costs in June. While the rate of input cost inflation in the services sector is the lowest since the CBA survey started in May 2016, it clearly is the services sector which eventually will lift national wages growth from current historic lows. The current very benign inflationary environment will not last forever and the Reserve Bank will welcome early signs of some upwards pressure on wages. It wants to normalise monetary policy, by raising the cash rate to neutral levels, to create room to cut the rate again in response to any negative shock but first it needs to see less excess capacity in the labour market.
Of course workers and consumers also welcome any better news on employment, unemployment and wages. Recent upside surprises in retail trade seem to reflect ongoing stability in the labour market and outweigh consumers’ concern about higher retail electricity prices. The ANZ-Roy Morgan weekly index of consumer confidence is at its highest since April and the proportion of consumers citing the wisest place to save as repaying debt or holding deposits fell in the June quarter. This measure is closely correlated with retail sales growth.
 

Figure 5. Australian retail trade
Source: ABS
Meanwhile, capital city housing markets are cooling but not crashing and mortgage lending growth is tracking sideways over 6%. Both trends support bank balance sheets and earnings, though bank earnings growth will remain slow.
 

Figure 6. Capital city house prices and bank lending growth by sector
Sources: Shawandpartners, Core Logic, RBA
Due to the lack of stock of detached dwellings in Sydney and Melbourne, population growth and shortages of vacant land for new dwellings, we predict these markets will remain healthy. Units and apartments are already a different story with heavy falls in the prices of lower-quality new units in oversupplied postcodes and price appreciation for units in popular, well-located suburbs with building constraints and land shortages.
There is much speculation about whether the widening distribution of dwelling price outcomes will make consumers feel less wealthy and cut spending. We would point out most houses outside mining and depressed regions are still appreciating or holding their market values, so most homeowners haven’t lost wealth yet. It will depend on whether consumers need ongoing property price appreciation to justify current spending levels or are satisfied with steady house prices.
The households under perhaps the most pressure are those living off fixed interest investments. Real interest rates on term deposits would be negative in many cases:
 

Figure 7. Real cash rate
Sources: Fairfax Media, Bloomberg
This is because inflation is stirring but term deposit rates have fallen:
 

Figure 8. Term deposit rates
Source: Canstar
Last week the Canadian, European, UK and US central banks all hinted or guided to gradual normalisation of their various monetary policy instruments. Markets have moved quickly to price this in:
 

Figure 9. Probability of a rate hike compared with two weeks ago
Sources: Fairfax Media, National Australia Bank, Bloomberg
Despite the selloff on global equity markets this unfortunately caused on 30 June, the last day of our financial year, the growing confidence of central banks to normalise monetary policy from extremely accommodative post-GFC settings is welcome. The worst thing central banks can do is keep policy too loose for too long because this creates dangerous asset price bubbles and incentives for aggressive financial product design and selling – which causes the next crisis. Excessively low US interest rates in the first half of last decade were thus a leading cause of the GFC.
But after this week’s monetary policy meeting, it is clear Australia’s Reserve Bank is still some way from raising the cash rate here. Speculation the RBA would pivot to the new moderately hawkish tone of other central banks was disappointed and the Australian dollar fell in response to the statement from the meeting:
 

Figure 10. Statement after July 2017 Reserve Bank monetary policy meeting (Click image to enlarge)
Sources: RBA, StocksInValue
In the above statement the RBA specifies the parameters which have to improve for it to shift to a tightening bias: GDP growth, non-mining investment, consumption growth, real wages, debt-servicing ability, employment growth, unemployment and inflation. The need for A$ depreciation is also clear. However much the RBA would like to plan to raise its cash rate, one main reason it didn’t say so this week is the need to avoid currency appreciation. The recent appreciation of the A$ against the currencies of trading partners is unwelcome:
 

Figure 11. A$ trade-weighted index
Sources: RBA, ABS, Thomson Reuters, WM/Reuters
Australia’s key bulk commodity export prices remain volatile week to week and difficult to predict. In iron ore the end of long-term contract pricing has made prices more variable and often a function of the marginal prices on individual ship cargoes. The safest way to invest in large-cap resource stocks is to buy periods of deep pessimism but buyable windows are likely to be short given the improving world economy and China’s recent guidance for ongoing GDP expansion at recent rates. We like BHP closer to $20 and RIO below $60.
 

Figure 12. Key Australian bulk commodity export prices
Source: RBA, ABS, Bloomberg, HIS
There has been much gloomy commentary forecasting a sharp slowdown in GDP growth now apartment construction has peaked. In fact total construction activity is rising despite the decline in apartment development. House building (detached houses), engineering and commercial construction have driven the fifth straight month of expansion in the construction sector.
 

Figure 13. Performance of Construction Index, all subsectors
Sources: Trading Economics, Australian Industry Group, Housing Industry Association
2016-17 ended with BHP under attack from activist investor Elliott Associates for its haphazard expansion into US shale oil, amongst other matters. This will remain one of the major investing sagas of 2017-18, especially if new BHP chair Ken Mackenzie agrees to divest the US shale assets during any new period of optimism about long-term oil prices. For the moment BHP admits its mistakes but is standing its ground:
 

Figure 14. BHP’s strategy in US shale (Click image to enlarge)
Source: BHP
 
Clime Asset Management owns BHP for and on behalf of various mandates for which it acts as investment manager.