Forecasters currently hold widely differing views about the Australian dollar in 2022. Westpac stands on the positive side of the fence. But there are unusually significant risks, in addition to ongoing uncertainties around COVID, including commodity prices; energy shocks; stagflation; China’s policies around property and energy; central banks; and vaccination success rates; before we start to think about the unknown unknowns.
In the latest survey of Market Economists in the Australian Financial Review (October 4) we saw an unusually wide distribution of forecasts for the AUD by June next year.
The median forecast was USD 0.74 whereas the range (excluding some extreme numbers) went between USD0.68 and USD 0.83.
Westpac’s forecast is significantly above the median at USD0.77. The survey does not extend beyond June next year so we are unable to test the “popularity” of our view that AUD will extend its gains into 2023 , reaching USD0.80.
The explanation for such a wide range is that there are strong cases to be made on both sides.
Commodity prices are already at levels (despite the more than halving of iron ore prices from the recent peak) which point to a significantly undervalued AUD.
Fair value models which are mainly driven by commodity prices put the AUD in the “high 80’s” or even “the 90’s”.
High valuations have held up as the collapse in the iron ore price has been offset by the surge in energy prices – LNG and thermal coal.
And it is starting to dawn on markets that these elevated energy prices may be with us for a lot longer than previously expected.
A mismatch between a surge in demand as the world bounced out of lock downs and limited energy supplies , partly as the world has been pivoting away from fossil fuels to the less flexible renewables, has seen surging coal and LNG prices.
Investors are reluctant to commit long term funds to fossil fuels to boost supply, as is usually the case when prices of any commodity surge, pointing to these prices holding for longer than was first expected.
The whole energy story should therefore be a solid positive for the AUD.
But there are risks that energy prices could go too far setting a basis for global stagflation. Fears of a repeat of the “lost decade” in the 70’s weigh very heavily on ” risk on”currencies like the AUD and support the safe haven currencies, principally the USD.
Stagflation occurs when high inflation is accompanied by a stagnation in the economy.
It can result when the economy faces a supply shock such as the rapid increase in the price of oil that we saw in the 1970’s (when inflation hit double digits and the unemployment rate got to 10%).
Prices rise at the same time as economic growth slows because production is more costly and less profitable.
As discussed, energy prices have surged – crude prices have doubled over the last 12 months in the US; high coal and gas prices are causing energy disruptions to factories in China as energy suppliers struggle with high costs and centralised controlled pricing to users.
Markets are talking more openly about stagflation in 2022 (especially in the UK with its current energy shortages).
But there are a number of factors that will avert such a disaster (The arguments centre on Australia, but are relevant for the other developed economies.)
Firstly, demand is set to surge rather than stagnate as economies emerge from lockdown. And that demand will be centred on the service sectors that are not energy intensive.
Rising growth will boost the demand for labour which will lower the unemployment rate and support wages growth.
The surge in demand will be driven by the household sector which has accumulated high savings that are now available for spending while higher wages growth will support income growth.
A lift in productivity would be helpful by lifting income growth without pressuring prices although that effect is likely to be limited.
The other necessary condition, along with stagnating demand, which is associated with stagflation is high inflationary expectations.
In such an environment, workers feel that they can make excessive claims on employers and employers feel they can agree to those claims because they have significant pricing power. But that psychology which dominated in the 70’s is highly unlikely to re-emerge given the ongoing attitude of employers towards containing costs and the survey evidence that inflationary expectations amongst workers and households are low (after 30 years of low inflation).
The other potential shock to inflation is disrupted supply chains. COVID and China’s energy crisis are exacerbating supply concerns at a time when demand is lifting.
But, once again, the major source of rising demand is likely to be in services where supply chain disruptions are less important. To be sure, Westpac expects that inflation will return to the RBA’s target of 2.5% by the end of 2022 about two years before the RBA expects it to occur which partly reflects some supply disruptions and higher wages (including some restrictions to labour supply) but not an uncontrollable surge in inflation.
So the key will be strong demand from households which will also be supported by accommodative fiscal policy as the Federal government moves into election mode accompanied by increasing price pressures but not explosive increases.
In short we do not see stagflation as a significant risk, either domestically or globally.
Another development that would derail the AUD would be a sustained downturn in China. The plight of property developers Evergrande and Fantasia (with more firms seen at risk) is raising the familiar concern about the overexposure of the Chinese economy to the property market.
Markets are focusing on the risk of contagion to more property developers but the government seems most likely to use its extraordinary resources to ring fence Evergrande; engineer an orderly distribution of its assets; restructure its liabilities and avert a damaging contagion. Agreed, the risk is probably not on the supply side which the government can manage but on the demand side as buyers reassess the attractiveness and risks of property investment. That caution may mean a reset in the market, particularly with respect to speculators.
The sheer importance of the property market in China makes it likely that, in time, the government’s support on the supply side will eventually revive demand. As we have seen in previous cycles, severe disruption to the overall economy has been avoided.
Our overriding theme is that while the Chinese government will embrace reform in both the property and energy markets its principal objective will continue to be stability and harmony and will be very careful to avoid “unintended consequences” of its reform agenda.
Having made that point it is still true that failure of the Chinese government to maintain stability would be a significant red flag for the AUD.
After considering two of the factors that might be encouraging the AUD pessimists it is probably time to raise a few positives.
Latest data on vaccinations point to NSW (71.1%) and Victoria (66.2%) already ahead of the US (63.9%) in terms of at least a single vaccination as a percentage of the total population. Indeed at 65.7% Australia, overall, is ahead of the US.
While momentum in Australia is sustained, it is reasonable to expect that the nation could reach 90% double vaccination (adults over 16) by near the end of 2021. Australia’s world leading management of COVID in 2020 was one factor behind the surge in AUD to near USD0.80 by early 2021.
As Australia lagged behind in the vaccination stakes through 2021 we saw the AUD reach a low of USD 0.71 in August. But since then ,the vaccination rate has surged and the AUD has at least stabilised despite the emergence of China’s property issues; energy related risks to global growth; the halving of the iron ore price and the severe contraction in the economy in the September quarter.
Now Australia is poised to emerge from the lock down of its two major cities while vaccination rates continue to point to be near world leading coverage – and well ahead of the US where a hard core 20% of the population appears to be implacably opposed to vaccination. It is not unreasonable to anticipate that Australia with its very low proportion ( less than 10%) of the adult population opposed to vaccination coupled with its growing access to vaccines will be a world leader in the “vaccine stakes” in 2022.
And then we have the central banks.
The FOMC appears to be ready to begin tapering its $120 billion monthly asset purchases with the aim to end the program by mid 2022. But that process will be calibrated by the success in achieving the FOMC’s inflation/full employment targets. We expect these targets to be met by December next year. There is also scope to see the country achieve an 80% full adult vaccination objective over that period boosting growth prospects.
On the other hand we do not see the RBA being too far behind the FOMC. The RBA’s QE program is likely to be completed by August at the latest with the inflation and employment targets forecast to be met nearly two years before the RBA’s current guidance – effectively neutralising any advantage that the FOMC might accord the USD.
But most importantly our solid expected performance of the AUD will rely on global growth and a settling of global risk concerns. A tapering of the FOMC will reflect growth success rather than weighing on growth and remember that tapering is not tightening – that only comes when the balance sheet is scaled back which is unlikely until well into the tightening cycle.
We expect that the world’s energy constraint will have eased although the supply response will be much more sluggish than in previous cycles.
And don’t underestimate the boost to global confidence as the world steadily increases its vaccine coverage.
As is always the case the list we have covered-commodity prices; energy; stagflation; China property; vaccinations; central banks – will not be exhaustive either in terms of current knowns or future “unknowns” and it is easy to see why we forecasters have such a range of possible outcomes.
For now, Westpac’s “list” still favours a stronger AUD while recognising those downside risks- both known and unknown.
