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A rise in Australia’s terms of trade should lead to a rise in investment.

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Justin Still

Justin Still

The very modest gains in share prices at a time when other developed markets have generally been rising faster reflect the difficulty the local economy has faced in breaking out of its post-mining slump.

Although there are some promising signs that business conditions are finally taking a turn for the better, consumer sentiment remains weak, and the equity market may continue to be side-lined by ongoing sub-par growth until clearer signs emerge. 

This week we therefore take a look at Australia’s terms of trade and what an improving ratio means for corporate investment decisions and whether this is the circuit breaker needed to spur a rebound in earnings growth. 

Terms of trade is calculated by dividing the price of a country’s exports by its imports.

When a country’s terms of trade are improving (i.e. export prices increasing at a great rate than import prices) it means that for every unit of exports sold the country can purchase more units of imported goods. 

Between 2001 and 2012 Australia’s terms of trade increased by 90 per cent.

The terms of trade then fell 18pc from its peak through to mid-2014.

In Australia import prices commonly move in a relatively stable way.

Export prices on the other hand move in big swings brought about by big swings in commodity prices. 

Every month the Reserve Bank of Australia publishes its index of commodity prices.

In United States dollar terms, the RBA index of US$ commodities peaked at an index level of 246.5 in July 2011.

From that time, the commodity price index fell to a low of 90.8 by the beginning of 2016, (and the terms of trade fell) leading to a fall in investment and a slowdown in jobs growth. 

From this point in time commodity prices have started to rise again, which means that Australia’s terms of trade has also started to rise.

By July 2017 the RBA’s index of commodity prices in US$ terms had risen to 122.4.

A rise in Australia’s terms of trade should lead to a rise in investment.

A rise in investment should lead to a rise in employment growth, which in turn should see a rise in GDP growth, which is what we need to see to push company earnings (and the Australian stock market) higher. 

At this stage though the market continues to lack direction.

With corporate outlook statements erring on the side of caution, investors have not been willing to extrapolate this growth beyond FY17.

It seems this will be the case until we see further evidence of growth in the Australian economy. 

  • Justin Still, Investment Adviser (Authorised Representative: 000279726), Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410 
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