Mining: How deep is the hole?

Chart 1 shows that mining as a percentage of GDP is at record highs, although it has started to drop off. The rise in mining has resulted not only in mining capex rising as a percentage of GDP spending, but also that total capital spending has been boosted. We know that a sizeable decline in mining investment is approaching, with capex falling. However, the end of the investment phase of the mining boom is going to be partially offset by the increase in net exports as capital imports fall and exports grow, helping to support GDP growth as the production phase begins.

Nevertheless, the transition will entail jobs losses as fewer workers are required for the production phase. In addition, there will be an income shock for those transitioning away from mining since wages will be lower as non-mining jobs tend to pay less.

Exchange rate and interest rate sensitive sectors which have been hurt by the high Australian dollar and relatively high interest rates (such as housing, overseas education, and tourism) need to recover to help offset the drop in mining investment and they must grow to keep unemployment down. Low interest rates are currently helping housing and consumption but we also need a lower Australian dollar for tourism and education.

How does iron ore factor into the story?

The supply of iron ore has lagged the surge in demand for steelmaking in China, which has led to a quadrupling of its price over the past decade. While supply from India and Brazil has continued to lag, seaborne supply from Australia has increased due to production increases by BHP Billiton, Rio Tinto and, more recently, by Fortescue Metals.

Over the past five years, a lack of overseas iron ore supply to Chinese steel mills has meant that steel producers supplemented it with high cost, low quality domestic iron ore. This pushed up the iron ore price, which in turn gave strength to the AUD.

At the start of 2014, the market expected iron ore prices to fall, as has recently been seen, due to the removal of a large portion of this Chinese domestic supply. In addition, the iron ore market should transition from being in a deficit position to a mild surplus due to increased supply, largely from the lower cost producers in Australia, which will also help to subdue prices.

If iron ore prices drop, isn’t it bad news for the AUD?

Not necessarily. Although prices may fall slightly, the increase in volumes that Australia supplies to China should help to prop up the AUD, which in the past had been driven to some extent by the iron ore price (see chart 2). However, we can also note from the chart that the iron price started falling in September 2011 but this had little effect on the AUD.

Will iron ore exports help Australia’s current account position?

Australia has historically experienced current account deficits as the norm. Moving the budget from a deficit to a current account surplus will require, among other things, a shift to a trade surplus. There should be a significant rise in resource export volumes as the mining boom transitions from the investment to the production stage.

Despite the drop in iron ore prices, export values are increasing due to these greater volumes.  This is expected to continue since Australian iron ore is a low cost, high quality product and is replacing current production of high cost, low quality products in other major export markets. As a result, iron ore now represents nearly 30% of Australian total exports measured by value (see chart 3).

This added around 0.5% to December quarter 2013 GDP growth as the balance of trade went from a deficit to a surplus. The trade account has been largely in surplus from 2008-2012 due to the impact of higher terms of trade. Although the terms of trade remain high, they have fallen from the peak reached in 2012. However, the trade account has not returned to a deficit, like it did in 2009, because capital imports have fallen and volumes of iron ore exports have increased.

Will a current account surplus be positive for the AUD?

The trade account is likely to remain in surplus as the volume of iron ore exports accelerates. Additionally, this increase is currently offsetting the fall in the iron ore price so we should see the AUD more stable going forward. This impact from iron ore should be compounded as the liquid natural gas (LNG) projects are completed and proceed to the production phase, which should further underpin the currency.

What does this mean for the Australian bonds and the cash rate?

Australian government bonds are currently experiencing sustained low yields due in part to the current economic environment and offshore buying. 10-year bond yields are now sitting at around what we view as the new neutral rate of 4.00%, but 3-year yields remain much lower. In our view, we should expect lower rates for longer, which may keep a lid on yield rises. With the recent budget announcement of a reduction in bond issuance, there may also be a small positive effect on our bond market due to reduced supply.

In our view, the Reserve Bank of Australia (RBA)  is at the end of its easing cycle and our base case is that the RBA will keep rates on hold at 2.50% for some time to allow historically low rates to help the economy rebalance and that the next move in rates will be upwards.

However, the timing of rate hikes will not be as early as in previous easing cycles over the past two decades as the present shock to the economy, with the mining boom shifting from the investment to the production stage, requires low interest rates to help smooth the economy’s transition.

The drag on growth this year and next year from the budget is unlikely to be that great due to the government’s back loading of cuts, but it won’t help a fragile economy that is in the process of transitioning from the mining boom. Infrastructure spending will take a few years to come through and announced job cuts won’t help the unemployment rate.

If the budget measures negatively affect consumer sentiment for a prolonged period, then this could also be a drag on economic growth, as could any strength that it gives to the AUD.  All this is likely to keep the RBA on hold for at least this year and perhaps now for longer than previously expected.

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Disclaimer: This document was prepared and issued by Tyndall Investment Management Limited ABN 99 003 376 252 AFSL No: 237563 (“Tyndall AM”). Tyndall AM is part of the Nikko AM group. The information contained in this document is of a general nature only and does not constitute personal advice. Nor does it constitute an offer of any financial product. It is for the use of researchers, licensed financial advisers and their authorised representatives. It does not take into account the objectives, financial situation or needs of any individual.  The information in this document has been prepared from what is considered to be reliable information but the accuracy and integrity of the information is not guaranteed by the Company. Figures, charts and other data, including statistics, in these materials are current as of the date of publication unless stated otherwise. In addition, opinions expressed in these materials are as of the date of publication unless stated otherwise. The graphs, figures, etc., contained in these materials contain either past or backdated data, and make no promise of future investment returns etc. Past performance is not a reliable indicator of future performance.

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