Big economic trends you need to be aware of in 2015

Arrows on side of road pointing both ways

With incredibly loose monetary policy implemented around the world we are going through uncertain economic times. Nobody convincingly knows what will happen and over what timeframe. In the media we are dished up with a succession of short-term views on the currency, growth, and interest rates. None of which capture the big structural issues lurking ominously in the background.

Stepping above the day-to-day noise we face an ageing population and the need to repay huge levels of debt. As much as we try, neither will change with wishful thinking. Add to the mix a healthy dose of geopolitical instability, which wont get any easier with most developed countries facing tough economic choices. And then throw in high youth unemployment across Europe and no real wage growth in developed countries for over 20 years as we struggle to adjust our workforces to globalisation and technology.

Whilst we have some short-term growth prospects in New Zealand (ra ra) these bigger trends could bite us at any time. Our fixation with short-term news delivers a false sense of security. We’re quick to pick up on positive sentiment, “green shoots” and equally quick to ignore the risks that sit outside of our expectations. The bigger trends go unnoticed until its too late and we have some sort of calamitous event or market correction. Arguably our "Boom/Bust" cycle reflects out inability to adjust to gradual change, similar to how you can boil a frog in water because it doesn't notice the change in temperature.

Early in 2014, NZ Economists were forecasting that mortgage rates would hit 8.00% by the end of 2015. Rates would be fuelled by our rock-star economy, confidence, record commodity prices and full capacity leading to underlying inflation. All of this was based on short-term signals. There was little regard for 2014 being the peak of a commodity cycle, which has since fallen back by around 40%.

Inflation sits at 1.00% and it is now clear that interest rates will remain low. It's not rocket science that NZ only produces around 7.00% of global dairy output so high prices would encourage production elsewhere in the world like Uruguay and Brazil and that other countries like Australia would eventually negotiate free-trade agreements with China. Sure hindsight is easy, but this isn't hindsight as we've been talking about these risks for over 18 months now in "The Economic Risks that Lurk Beneath". The fundamental problems that caused the Global Financial Crisis still exist.

The GFC was primarily concerned with unrestrained lending practices, credit derivatives, and a lack of integrity across the financial system. It’s a trend that had been building since the early 1990s with debt-fuelled growth throughout the world. In December 1990 household debt sat at $21.5b. Twenty-four years later it sits at $211b, a compound annual growth rate of 10%. Much of that was driven by an ability to borrow more at lower interest rates, so servicing costs haven't increased that much. However, our debt-levels are such that we are close to saturation. Interest rates do not need to increase much to bring the economy to it's knees and that's one of the primary reasons you won't see rates go that high. They simply can't and that's not just a NZ phenomena.

Although not as bad as it was in 2008, we are still up to our eyeballs in debt and bankers haven’t miraculously become ethical. Global growth has stalled and countries are keeping interest rates low to compensate. In the absence of strong growth interest rates couldn't increase much before quickly draining any disposable income. What if, without sounding alarmist, the GFC is just the start? Governments and Reserve Banks cannot grow debt and print money indefinitely. With more and more of our income needed to service debt, and an ageing population, it’s hard to see where growth will come from. If there is no consumption growth, then we face over supply of consumer goods and deflation. Across most consumer goods we already have deflation driven by technological change, the speed of redundancy, and massive supply. Who’d have thought consumers could buy a 70-inch flat screen LED TV for less than $3,000 (12 months ago the same TV was $12,000. Ten years ago you'd have paid $12,000 for a 42 inch flat screen.)

Recently some key commodity prices have plunged – iron ore is down 50% and dairy (milk powder) is down 40%. Even oil and gas prices have recently tanked. Commodity price increased off the back of unprecedented demand, but those prices encouraged investment and gradually supply has caught up and even passed demand. This is one of the most basic economic principles that we seem to forget or ignore it in practice. The impact on our part of the world cannot be understated.

51% of Australia’s exports are made up of iron ore, coal, petroleum and natural gas. Iron ore has fallen from around USD130 per ton to USD66 per ton and will wipe out about $16b of income. Closer to home Fonterra has forecast a reduction in price for milk solids from $8.40/kg to $4.70/kg, wiping out $7b of income. The Australian dollar has slipped to 95 cents against the New Zealand dollar and dropped about 30% against the USD in the past 18 months. The drop against the USD will partially compensate for the fall in export earnings but at the same time imported goods will become more expensive and make it tough for retailers. For New Zealand we've suddenly become more expensive to one of our key export markets and a major market for tourism. The Queenstown ski holiday will be about 25% more expensive this year for Australians.

At the same time we have these negative macro trends, Asset markets are hitting new record highs. The NZX50 hit a record high of 5552 on the 23rd December. NZ shares have doubled since the height of the GFC in 2009. Offshore, the S&P also closed the year on a record high of 2,082 and if they’re not at record highs, then most stock exchanges around the world are near record highs.

Of course the same thing has occurred across property markets. Auckland is at record highs and house prices in major metropolitan areas are going equally nuts, from Sydney to London. The most ominous property bubble is China where houses are 30 times income compared to New Zealand at 9 times income. Iron prices are already falling. What happens when China’s property bubble goes pop like Japan’s did in the early 1990s? Asset markets are driven by surplus money buying up assets at higher prices and lower yields. There is too much money floating around and nowhere to invest it. Businesses have surplus capacity and face weaker demand and lower prices. All of this is a recipe for a massive market correction when it finally arrives. I once heard an Indian proverb about rivers that is a great analogy for printing money. I can't for the life of me find it, so here goes the JB version ...

When Man diverts rivers, the river responds up building up sediment and so the water level increases. Over time Man builds a higher riverbank, and yet more sediment forms. This repeats until the riverbank is too high and eventually collapses during a flood. Whereas once a flood was manageable it now destroys the entire valley.

.. and so it is that history repeats.