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We have witnessed the brutal ending of a commodity cycle in the last 18 months; we will potentially never see iron ore at 100 plus US dollars a tonne again, let alone 150 plus (it’s now hovering around 50 dollars a tonne). Steel and industrial intensive growth is slowing in China, and now associated commodities find themselves back at 2005 levels.

 

Chart 1: Year on Year per cent Chinese GDP growth

With all the negativity toward global demand priced into ‘growth’ commodities (iron ore and copper are the key ones), it’s little wonder we’ve seen a small bounce off the lowest prices. 

The Australian economy has high commodity price sensitivity – we find ourselves now in the midst of a sharp transition away from a more than decade-long commodity price bonanza. The wealth effect from the boom years is significant, with property the standout asset class. The unemployment rate has managed to only tick up marginally in the last twelve months, despite significant job losses within mining and related industries. The RBA has slashed interest rates to historic lows to cushion the impact, the currency is re-pricing assisting the transition.

Pay Rise Lately?

One of the symptoms of this transition is wages growth. Growing incomes help confidence, spending and ultimately jobs. But wages growth in Australia is sluggish – and this is a key factor in a very subdued inflation picture. Sluggish wages growth batters confidence, stops marginal spending, and slowly grinds jobs growth to a halt. The jobs market may still be ticking along, holding the unemployment rate from ratcheting higher, but wages growth drives momentum. We are experiencing a post boom slow burn, as opposed to wholesale job losses.

 

Chart 2: Year-on-Year per cent Australian Wage Growth 

Those two charts look awfully similar. It’s no coincidence.

The Australian economy is sensitive to the fortunes of the housing market, and a small tick up in the unemployment rate will be a trigger. Incomes are not growing to support ongoing house price appreciation.

 

Chart: Domain Group 

We are seeing early signs of a weakening after an incredibly strong period. The Aussie banks are particularly vulnerable to a housing market correction.

The price action of Banks vs Commodities in 2015 is opening up a great thematic trade in Australia, with both large components of the ASX.

CBA and WBC are the two with the larger mortgage exposure, and NAB has a large investor lending exposure. A 5-10% correction in house prices could be enough to see the banks sold down significantly, and the AUD is likely to follow. Consumer confidence would be negatively affected and the RBA would consider cutting again.

However it’s no sure thing that the banks are in for tough times. Holding commodity prices constant, if the housing market keeps performing and Australia’s transition to lower commodity prices is smooth, the banks will do relatively well. This will see the RBA likely on hold through 2016 and AUD hold above 70 US cents (subject to Federal Reserve policy).

Please note: All information is the author’s opinion and cannot be used as any form of financial advice.