May 12, 2014

Iron ore drags down terms of trade for gloomier economic outlook

The outlook for Australia's iron ore producers is dour. That drags down our terms of trade, and suggests Joe Hockey's gloomy economic forecasts can be believed.

For some time now, Treasurer Joe Hockey has taken flak for his Mid-Year Economic and Fiscal Outlook and its dour forecasts for Australian growth and the budget outcomes. These criticisms have been very premature and generally analytically inadequate. Present indications suggest Hockey's MYEFO was close to the mark and, moreover, that any upgrade to forecasts would leave the federal government hostage to increasingly hostile fortunes. Over the weekend the Department of Finance released its monthly tracking of the government's cash flow, and it showed the budget deficit is ahead of its projections. Unemployment is at 5.8% versus the 6% expected for the June quarter, and the economy is probably slightly ahead of the 2.5% growth forecast as well. Nominal GDP is at 4.8%, ahead of 3.5%. But composition matters, and the net result is a deficit only about by about $1 billion (or 3%) ahead of projections after five months. As the Finance assessment said:
"The underlying cash balance for the year to 31 March 2014 was a deficit of $34,783 million, compared to the Mid-Year Economic and Fiscal Outlook (MYEFO) profile deficit of $35,814 million. The difference of $1,031 million relates to lower than expected cash payments partially offset by lower than expected cash receipts, excluding net Future Fund earnings."
Hardly a bonanza -- nor is it a victory for Hockey's critics, given it's far closer than the forecasts promulgated in the final years of the previous government. Moreover, Treasury forecasts under Hockey should remain dour. A range of indicators suggest very strongly that the cyclical economic rebound we've enjoyed is as good as it's going to get in the next 18 months. The housing market surge is likely to continue but at a diminishing rate; consumer confidence has crashed to a post-GFC low; and the business investment cliff still lies ahead, with its modest offset in housing construction. But behind it all is one other measure than is declining fast is going to get worse before it gets better: the terms of trade. The ToT is the ratio of export prices to import prices, and it determines income flows in the economy. For instance, if it rises, we have more pricing power to buy more stuff in the world. If it falls, we have the reverse. Right now it is tumbling. On balance that will mean lower nominal growth than now in the period ahead, lower corporate tax receipts, a lower sharemarket, lower capital gains and lower household spending.
"Blood will flow through the gullies of the Pilbara, and the effects on wider confidence will be material via superannuation accounts."
The MYEFO forecast 5% falls in the ToT for this year and for next, but we are well ahead of that schedule already. Indeed, we will meet those projections in the next few months alone as coal and iron ore spot price declines register in longer term contracts. Most troubling is the outlook for iron ore, which makes up roughly one-third of the export side of the ToT. If it were only to hold its current level at $102.70 it would still be 24% down from last year, a hit of 8% to the ToT. Coking and thermal coal are also down heavily, taking the falls to about 10% on the year with a few minor offsets in gold and wheat. That's manageable. But the problem is that the iron ore price is on the verge of the same magnitude of falls again. After years of aggressive investment, the Pilbara cartel of Rio Tinto, BHP and Fortescue have ramped up production capacity spectacularly just as China seeks to rebalance away from building (and steel) as its primary growth driver. Goldman Sachs is now forecasting an average iron ore price of $80 next year, and that implies downside spikes well into the $60 range during inventory cycles. It estimates the direct impact on the budget to be around $7 billion to the end of 2015, despite rising volumes. But the implications are wider. An iron ore price oscillating around $80 represents an existential crisis for emerging Pilbara miners. The big producers, Rio and BHP, will be fine in the long run even if their share prices still fall heavily. But Fortescue Metals is regarded by markets to have a break-even point somewhere between $75 and $80, and given its still huge debt load it will face the fight of its life. The many juniors that have flourished in the market will face wipe-out. Blood will flow through the gullies of the Pilbara, and the effects on wider confidence will be material via superannuation accounts. That will also flow on to the budget via lower confidence and spending. Raising growth forecasts now will give Hockey and the Coalition a false sense of security regarding the cuts they can make versus projected revenues that will never arrive. In short, it would repeat the mistake of former treasurer Wayne Swan. It is much better for both the government and the economy to go with conservative forecasts that can be met given the increasingly inclement outlook and if we do go better then fiscal stability is something that the public can rely upon as we manage our way across the business investment gulf through 2017.

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One thought on “Iron ore drags down terms of trade for gloomier economic outlook

  1. stephen Matthews

    says David:
    Blood will flow through the gullies of the Pilbara

    Please ignore this fatalastic Hanrahan who enjoys high office at Macro Economics .
    He’s been down on the Aussie iron ore industry for the past 3 years .
    he’s been wrong everytime.

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