A deep dive into the Director Sentiment Index

Director sentiment slides again.

There were no major official Australian data releases this week, but we did get the results of the AICD’s latest Director Sentiment Index (DSI), which showed that directors have again grown more pessimistic about the state of the economy. Last Friday, data showed quarterly economic growth in China slowing to a six per cent annual pace, its slowest rate in about three decades.

This week’s readings include Treasury’s take on Australia’s economic outlook,[1]a defence of our export profile, the risks to the regional economy, the possibility of ‘peak car’, consumer-led violence, the economics of helicopter drops and Doing Business 2020.

What I’ve been following in Australia . . .

What happened:

The DSI for the second half of 2019 shows that directors are increasingly concerned by both the domestic and international economic outlook.[2]The overall index has moved further into negative territory, falling from minus 16.9 in the first half of this year to minus 21.2 in the second to deliver the weakest reading since the second half of 2016.

Roughly 49 per cent of respondents thought that the health of the Australian economy at the time of the survey was weak or very weak, compared to just 11 per cent who judged it to be strong (the remaining 40 per cent thought the economy was ‘OK’). And those numbers became more pessimistic when directors were asked about their assessment for the next 12 months, with the share of respondents judging the economy likely to be weak rising to 59 per cent, the share thinking that it will be strong falling to eight per cent, and the share opting for ‘OK’ dropping to 33 per cent.

Directors have also become significantly more negative in terms of the outlook for the international economy, with all global economies and regions covered by the survey now in negative territory in terms of the net balance between those who foresee a strong economy less those who expect a weak one. Respondents are most upbeat about Asia in general (with a net balance of minus seven), although they are slightly less upbeat about China in particular (a net balance of -12). Conditions in the United States are now expected to be appreciably weaker than at the time of the previous survey (a net balance of -26, down from minus six in the H1:2019 DSI) and respondents have become even more pessimistic about the outlook for the European economies (a net balance of -65, down from -55). These findings are consistent with the IMF’s view that the world economy is now in a synchronised slowdown.

That relative pessimism about the economic outlook is also reflected in directors’ views on likely trends in Australia’s major economic indicators over the next 12 months, with more directors thinking that the expected rate of inflation, the value of the dollar, the level of the RBA’s cash rate, and the pace of wage growth will be lower than higher, while more think the unemployment rate will increase than decrease.

The message is also consistent across states and territories, with respondents in all cases downgrading their assessment of the health of their region over the next 12 months relative to their views in H1:2019. All states and territories are now in negative territory in terms of their net balance score, with respondents most gloomy in Queensland and South Australia.

In an interesting contrast to their views on overall economic conditions, directors are relatively more optimistic regarding the growth outlook of their primary directorship company. For the coming year to June 2020, 43 per cent of respondents think their business will expand compared to just 20 per cent who think it will weaken and 37 per cent who think conditions will remain stable. (Although note that net balance score of 23 is up only slightly from the 22 reported in the H1:2019 DSI and other than that outcome, is the weakest result since the second half of 2015.) Over the coming year, more directors think their business will increase investment levels, staffing, exports, outsourcing and wages than decrease them, although for all categories the most common expectation was for stability.

There’s also a difference between directors’ overall confidence in the business outlook and the outlook for their sector over the next 12 months: in the case of the former, pessimists slightly outnumber optimists (a net balance score of minus five) while in the case of the latter, the reverse holds (with a net balance score of eight).

The leading source of director concern is the global economic uncertainty epidemic, with directors nominating this as the main economic challenge facing Australian business, and with the share of respondents nominating this factor up sharply to 37 per cent from 27 per cent in the previous DSI. That’s followed in directors’ list of worries by low productivity growth (23 per cent), China’s outlook (21 per cent), climate change (21 per cent) and excessive regulation or ‘red tape’ (20 per cent). In contrast, directors overall are relatively sanguine about the availability of credit (eight per cent), industrial relations (seven per cent), labour shortages (seven per cent) and the value of the dollar (six per cent). Issues such as the level of government debt (three per cent), Brexit (two per cent) and the budget (one per cent) have fallen to the bottom of the rankings.

The rate of growth in labour productivity has been sliding since 2011-12, slowing to a crawl (just 0.3 per cent) in 2017-18 and then contracting by 0.1 per cent in 2018-19. No surprise then, that directors nominated low productivity growth as the second most critical economic challenge facing business. The top three measures directors think could help lift Australia’s national productivity performance are a reduced focus on short-termism (chosen by 39 per cent of respondents), more infrastructure spending (33 per cent) and a greater focus on fostering innovation (30 per cent). In this context, directors are also concerned about the level of ‘red tape’ they need to manage.

When directors were asked to nominate the top five issues they felt that the Australian federal government should address in the short term[3], the energy policy-climate change nexus was front of mind, with energy policy right at the top (52 per cent), followed by climate change (44 per cent). The top five was rounded out by infrastructure (43 per cent), taxation reform (38 per cent) and productivity growth (34 per cent).

When the outlook is extended to the long term, the top two priorities remain the same although the order flips, with the top five comprising: climate change (50 per cent), energy policy (40 per cent), infrastructure (39 per cent), ageing population (34 per cent) and taxation reform (31 per cent).

Infrastructure spending is a critical area where directors continue to see scope for greater government activity in both the short and long term. Despite recent increases in public infrastructure spending, more than seventy per cent of respondents judge that the current level of spending is still too low, with 42 per cent saying that spending is a little low and 32 per cent saying that it is far too low. The top three priorities for infrastructure investment[4] identified by respondents are water supply (nominated by 53 per cent of respondents and up markedly from 40 per cent in the first half of 2019), renewable energy sources and regional infrastructure.

Taxation reform is another top five policy priority for directors. Here, 71 per cent of respondents think that the level of personal taxation is too high (with 46 per cent judging it to be somewhat high and 25 per cent opting for far too high) and 54 per cent of respondents think that corporate tax levels are too high (44 percent saying somewhat high and ten per cent saying far too high). When asked about the relative priorities for reform in the context of any future comprehensive review of the current taxation system, directors’ top three choices are personal income tax (56 per cent), state-based taxes such as payroll tax (50 per cent) and company tax (46 per cent).

Directors also remain unimpressed with the quality of the public policy debate here in Australia, with 45 per cent assessing it as poor and 33 per cent as very poor.

Finally, the DSI also included a new question on investment. Australia’s new private business investment as a share of GDP fell to just 11.7 per cent in the second quarter of this year, its lowest level this century, prompting discussion of what it would take to get businesses investing again. According to respondents, the single most important factor that would contribute to an increase in capital expenditure would be an improvement in the economic outlook (nominated by 64 per cent of respondents). Other key factors would be an improvement in Australian economic policy certainty (47 per cent) and an enhanced focus on long-term returns (38 per cent), followed by additional public investment in infrastructure (29 per cent). There has been some discussion of the case for government policy directly targeting the incentive to invest, and 29 per cent of respondents said that the provision of investment incentives such as accelerated depreciation would encourage their business to increase investment levels over the coming year, slightly ahead of the share of respondents nominating lower company tax rates (25 per cent).

Why it matters:

To provide some context for the results, it’s worth noting that at the start of the survey period, the RBA had already delivered two consecutive 25bp rate cuts (in June and July), and while the central bank had opted to leave rates unchanged at its 3 September meeting, markets were confidently predicting a third rate cut before year-end (duly delivered at the October meeting). So even with those rate cuts baked in, survey respondents still saw the economy weaker in 12 months’ time. That suggests both that directors overall are sceptical about the ability of recent interest rate cuts to deliver an improved economic outlook and that they are yet to see convincing evidence of the RBA’s ‘gentle turning point’ but are instead concerned that economic conditions could deteriorate further from here.

With the Treasurer announcing on 19 September that the federal budget had effectively returned to balance in 2018-19 for the first time since 2007-08 (technically, the 2018-19 underlying cash balance was just in deficit, but only to the tune of $690 million, which as a share of GDP is equivalent to zero per cent), the federal budget and government debt are now ranked relatively low in terms of directors’ priorities for government policy. With conventional monetary policy apparently struggling to gain traction, that suggests scope for additional fiscal support for the economy, possibly in the form of increased / accelerated infrastructure investment4 along with lower personal tax rates (in the case of the latter, perhaps by bringing forward the already legislated[5] stage two tax cuts). Such a package would be in line with directors’ priorities and would be aimed at both supporting growth and improving productivity.

. . . and what I’ve been following in the global economy

What happened:

Data released last Friday by the National Bureau of Statistics (NBS) showed growth in China’s economy slowed to a six per cent annual rate in the third quarter of this year.

Why it matters:

With China serving alongside the United States as one of the two main engines of the world economy, Chinese economic weakness has been a key factor weighing on global activity this year. And, of course, China has a major influence on the Australian economy – according to the latest DSI (described above), China’s economic outlook is seen by directors as the third most important economic challenge currently facing the economy.

In this context, the Q3 growth result came in only a little below the consensus forecast of a 6.1 per cent print and that continued what has been a steady downward slide in Chinese economic growth since the global financial crisis. This result was also the lowest recorded growth rate since the NBS started releasing quarterly data in 1992 and the weakest in annual terms since the post-Tiananmen slump, which saw the economy expand by less than four per cent.

A key question now is how Beijing responds to the ongoing loss of momentum. The official growth target is for real GDP growth to be between six and 6.5 per cent this year, and with year to date growth now running at 6.2 per cent, the economy looks to be heading to the bottom of that target band. To date, the authorities have been focused on juggling two competing priorities: on the one hand, they want to make sure that growth hits the official targets, but on the other, they have been keen to deliver higher quality, more sustainable growth, including by reducing the economy’s reliance on debt- and investment-fuelled growth. The trade conflict with the United States has further complicated what was already a tricky balancing act, and officials have shown signs in recent months of re-prioritising ‘growth maintenance’. That seems to have seen Beijing return to an old policy favourite, infrastructure investment: on one estimate, Beijing has more than doubled the value of large-scale infrastructure projects it has approved so far this year compared with the same period last year.

What I’ve been reading: articles and essays

Treasury Secretary Steven Kennedy’s opening statement to Senate Estimates. Kennedy’s view is that recent weakness in the economy has been driven by several temporary factors, including the downturn in the housing market and the drought.
Adam Triggs of the ANU’s Asian Bureau of Economic Research disagrees with claims that Australian exports are ‘too dumb and too China-dependent’.

Unfortunately, there’s no text available for this one, but here is RBA governor Philip Lowe talking about Australia’s experience to the IMF.

Also from the IMF, the Fund has published its latest regional economic outlook for Asia and the Pacific. The key message is that although the region remains the fastest-growing part of the world economy, contributing more than two-thirds of global growth, ‘near-term prospects have deteriorated noticeably since [April 2019] . . . with risks skewed to the downside.’

Greg Ip in the WSJ asks if ‘peak car’ is holding back the world economy, as the global auto market shrinks.

Two interesting pieces from VoxEU on shifting national economic fortunes. Schivardi and Schmitz look at the relationship between the IT revolution and weak productivity growth in southern Europe, arguing that poor management efficiency meant that the IT revolution exacerbated an already present performance gap with northern Europe. And Willem Thorbecke asks why Japan lost its comparative advantage in producing electronic parts and components.

The New Yorker profiles Gabriel Zucman, the economist who helped invent Democratic Presidential candidate Elizabeth Warren’s proposed wealth tax. For a rather more combative view on the wealth tax debate, try watching this video from the Peterson Institute.
John Lanchester takes a sometimes disturbing look at the digital economy and China, arguing that ‘China is about to become something new: An AI-powered techno-totalitarian state’.

Tyler Cowen notes the prevalence of ‘large and often violent demonstrations’ across the world in 2019 and suggests that one common feature is the relative rise of consumer-led protests, often with (high) prices as the common theme. Related, John Authers on the worrying message from the violence in Chile.

The Economist examines ‘creative carbon accounting’ and the challenge posed to national emission targets by the case of carbon emissions that are created by products that are consumed within a given nation’s borders but produced outside them.

Another one to listen to: David Beckworth interviews Frances Coppola on the economics of helicopter drops and her book on ‘The case for people’s quantitative easing’.

The World Bank has published its latest Doing Business report which ranks 190 economies on their ease of doing business. According to the 2020 rankings, New Zealand holds the top spot, with Singapore, Hong Kong SAR, Denmark and South Korea rounding out the top five. Australia is in 14th place, up from 18 in last year’s assessment.

1. The DSI for H2:2019 reports the views of 1,489 AICD members who were polled between 12 September and 26 September 2019. ↩

2. The DSI for H2:2019 reports the views of 1,489 AICD members who were polled between 12 September and 26 September 2019. ↩

3. The short term is defined in the survey as the next three years and the long term as the next ten to twenty years. ↩

4. Although see the comments from Treasury’s Steven Kennedy in the readings section below. ↩

5. The government’s three-stage tax plan passed the Senate in July this year. The first stage delivered immediate tax relief through an increased in the low and middle income tax offset (LMITO). The second stage is scheduled to deliver additional tax cuts in 2022-23, which will see (1) an increase in the low income tax offset (LITO), (2) the expiry of the LMITO, and (3) an increase in the top band of the 19 per cent income tax bracket. The third stage arrives in 2024-25 and will see the 32.5 per cent marginal tax rate reduced to 30 per cent. These changes build on earlier tax reforms which included the abolition of the 37 per cent tax band from 2024-25. That means that from July 2024 Australia’s income tax system will have only three tax rates, with an estimated 94 per cent of taxpayers facing a marginal rate of 30 per cent or less. ↩