The Australian Economy the Housing Market Update

The Australian Economy – March 2014.

On March 17 Westpac revised its forecast for the RBA cash rate, eschewing  (keeping away from, avoiding) any more rate cuts in the cycle and predicting that the next move will be up by the second half of 2015.

The world economy slowed in 2013 from growth of 3.2% in 2012 (5.2% in 2010; 4% in 2011) to 2.9% in 2013.

Westpac expects a modest lift in growth in 2014 to 3.2% although the International Monetary Fund is more upbeat, expecting 3.7%. The US economy is likely to remain "stuck" around a below trend rate of 2.2 % despite a reduced drag from fiscal (Government) policy.

Westpac also expects a renewed slowing in housing and business investment as businesses remain cautious and continue to focus on cost cutting and productivity gains.

Evidence also suggests that Europe is likely to barely emerge out of a two year recession. China will be comfortable with growth in the 7–7.5% range as it works through excessive credit growth and makes some gestures towards restructuring the economy to encourage consumer spending.

Westpac predicts growth in Australia in 2014 (2.7%) and 2015 (3.2%). That growth forecast for 2015 is predicated on interest rates remaining steady until the second half of 2015 when the Reserve Bank will be expected to begin the process of returning the record low cash rate to more normal levels.

They expect the cash rate to rise by 50bps in the second half of 2015. Unusually for this stage of the cycle there are a number of significant headwinds facing the Australian economy. Firstly, we have seen a peaking of mining investment expenditure. The boom has been dominated by six large LNG projects all of which have run significantly over budget prompting investors to eschew any major new projects.

Fortunately, growth (as opposed to employment) will be cushioned by a substantial lift in net exports. Whereas in 2015/16, compared with 2011/12, the mining investment cycle will subtract around 1.5ppts from growth the boost to export growth will add around 1ppt to GDP growth. Nevertheless, particularly from the perspective of the labour market, it will be important for growth to rebalance towards non mining investment; consumer spending and residential construction.

In this regard the picture is very mixed and somewhat uncertain.

Westpac confirms that Businesses is still showing considerable resistance to expansion, either through investment or employment. The last six months of 2013 were the weakest from the perspective of jobs growth since the early 1990's. Although we have seen a solid lift in jobs growth in the first few months of 2014 there is not enough evidence that points to continued jobs growth.

They also confirm that the dominant business strategy has been to protect profits by increasing work hours and constraining wages. Wages growth is the slowest in 20 years. Demand for labour has, to date, not responded to record low interest rates apart from in the residential housing market where progress has been heavily regionalized.

Recently we have seen a marked lift in assessed business conditions and employment intentions. If these tentative results are accurately signaling a solid lift in employment and investment then prospects for above trend growth in Australia will improve. The combination of this lift; some upward revisions to the consumer spending profile and the lift in employment in the first few months of 2014 have prompted Westpac  to revise their interest rate forecast from a further two rate cuts in the second half of 2014 to steady rates over that period.

The lift in business confidence is likely reflecting more buoyant economic conditions in 2013 Q4 when consumer confidence peaked at 110. Since then, consumer sentiment has lost 10% with households becoming concerned about prospects for rising interest rates and further tightening in fiscal policy at a time when labour market conditions had weakened sharply. Anxiety around job prospects and security has intensified in recent months.

A further threat to consumer spending will be the likely rise in the unemployment rate through 2014. Despite lacklustre jobs growth and strong population growth, the unemployment rate has only increased by around 0.4% over the last year as the participation rate has declined markedly. Interest rates are at 50 year lows but do not appear to be boosting business investment and spending in the broader economy. The Reserve Bank has become nervous around the prospect of further cutting rates for fear of sparking an excessive lift to house prices.

Westpac anticipates that house price gains and new lending growth will slow through 2014. Melbourne and Perth housing markets are likely to cool, given high starting points, while markets in SA and Tasmania will be contained by some ongoing structural challenges faced by those economies.

The Reserve Bank has shown a high degree of sensitivity to the recent boost in inflation in the December quarter – eschewing its policy to "talk down" the dollar with a subsequent lift in the AUD to USD 0.90 from USD 0.865.

Bill Evans from Westpac expects these inflation concerns are overstated. He states that the dominant influence on inflation is likely to be the soft wages environment, although the Bank is expecting that the pass through to inflation from the weaker AUD in 2013 will extend into the March quarter resulting in a 0.8% read on core inflation. That outcome would severely unnerve markets.

With rates on hold through 2014 any further fall in the AUD can be expected to result from ongoing weakness in the terms of trade. We expect the terms of trade to fall by 6% in 2014 with associated falls in the AUD to USD 0.88 by year's end. Despite downside risks to Chinese and emerging markets' growth supply constraints are likely to limit the extent of any price falls of iron ore and coal prices. Further out, rising interest rates and sharply improving trade position are likely to boost the AUD back into the high USD 0.90's.

Source: Bill Evans, Chief Economist, Westpac.

ARTICLES TO READ

There are also two very interesting articles from Tim Toohey at Goldman Sachs and Stephen Walters at JP Morgan on the interest rate and economic climate.  Please see both below.

From Tim Toohey at Goldman Sachs:

Today's speech reinforced that the RBA has set quite a high hurdle for further policy easing, suggesting that the RBA cannot be expected to 「fine tune」 the recovery, particularly in regard to non-mining investment.

Governor Stevens' effort to downplay the stronger 4Q 2013 CPI, inflation pressures more broadly and the February job report reinforces our view that there is little prospect of rates being raised anytime soon.  Overall, we share the Governor's view that there are promising signs of recovery.  The Governor acknowledged that we are likely to see a 「boom」 in new dwelling construction, consumption to grow broadly in line with income and some delay in non-mining investment to rise to fill the gap left by declining mining investment. 

While this is consistent with our previously published views, our forecasts embrace a faster decline in commodity prices, a nearer term decline in mining investment, ongoing subdued household income growth and intensifying fiscal headwinds.  Governor Stevens also acknowledged the AUD as one of a 「full panoply (array) of risks」, and with a ~+40bp post-speech rally to ~0.92, it has returned to the level seen last November when the Governor characterized it as 「uncomfortably high」. By mid-2014 we expect that financial conditions will tighten in a falling commodity environment, fiscal policy will be tighter post the May Budget and non-mining GDP growth will likely be insufficient to offset the drag from the mining related sectors. 

We continue to lean towards one further cut this cycle (-25bp in July), and a very gradual tightening cycle to be delayed to 2Q2015.

And Stephen Walters at JP Morgan:

Reserve Bank Governor Glenn Stevens today delivered a speech on the domestic and global outlook at an investment conference in Hong Kong (and later will be a panel discussant on unconventional policy). The Governor's speech covered familiar terrain, but he emphasized more than once that there is a 「very substantial」 degree of uncertainty around the outlook, an 「unavoidable」 fact that makes drawing firm conclusions unusually difficult.  The only explicit policy guidance came when he re-used the familiar phrase that a 「period of stability」 on interest rates is likely.

We suspected that Governor Stevens, who again pondered today why many local forecasters are so pessimistic, might drink from his familiar 「half-full」 glass today and indeed, there were flourishes of constructiveness around housing, in particular.  These however, were tempered by more sober references to uncertainty and risk.  The Governor, of course, did an exemplary job explaining the current thinking of the Bank - he always does.  The problem is that the current outlook is shrouded in so much uncertainty that drawing firm conclusions is fraught and, perhaps, even pointless until some of the doubts are resolved.

Interestingly, Stevens declined to give stubbornly-high AUD another kick lower, despite the Governor being offered the ideal opportunity in the Q&A session. There was, for example, no return to describing AUD as 「uncomfortably high」, a phrase officials had favoured as recently as December. Instead, the Governor repeated the mantra that a lower AUD would aid the rebalancing in the economy.

The lift in resource exports alone will not be sufficient to fill the growth gap left by falling investment in the resources sector, which will 「decline significantly」.

On inflation, it was interesting that Mr. Stevens hopes the recent CPI data 「conveyed at least some genuine information」. This sticks to the theme in official commentary that, although the latest print was unexpectedly high, the staff believes there possibly is loud statistical noise drowning out the signal. Later, Stevens repeated the thinking that inflation will be 「consistent with target」 from here, partly because of labour market weakness and benign wages growth. And, in answering a question, Stevens said he didn't see danger of a serious outbreak of inflation.

Mr. Stevens' discussion of global themes sounded all too familiar – lift in the US, improvement in Europe and policy tools working in Japan. He delivered an extended discussion of the outlook for China and the problems in the so-called shadow banking system, in particular, but didn't draw strong conclusions on how all this will play out. On balance, he sounded pretty constructive.

The RBA's public narrative seems not to have changed much at all since the easing bias was dumped back in February. Officials seem content with current policy settings and the level of AUD, for that matter, and seem happy that earlier policy easing is working, particularly in lifting prices and activity in the housing market. In fact, Mr. Stevens indicated after the speech that a 「boom」 in residential construction is on the way.

The rotation from mining investment as the main source of GDP growth (the 「handover」, according to Stevens, from a boom of 「truly epic proportions」) remains a work in progress, but officials seem confident there will be sufficient lift outside mining to fill the large growth gap. Indeed, there are 「promising signs」 in this regard. He sounded more cautious on the outlook for employment, though, and still expects the jobless rate to rise.

We are less sanguine, and still expect a policy ease later this year. AUD simply refuses to stay below 90 US cents (it touched a 3-month high today), despite the lower terms of trade, the jobless rate still looks likely to keep climbing as the non-mining economy only slowly fills the yawning gap left by the mining capex cliff, and the noises from Canberra still hint at a tough Budget in May.

We expect Treasurer Hockey to unleash a material fiscal drag on top of the tightening already announced, mainly on the expenditure side of the public accounts.

COMMON ECONOMIC TERMS.

Each month I will explain an important economic term to make your understanding of economic reports easier. We will start with two fundamental economic terms.

What is Monetary Policy?

• Monetary policy involves influencing the supply and demand for money through interest rates and other monetary tools.
• Monetary policy is usually conducted by the Central Bank, e.g. The Reserve Bank of Australia.
• The target of Monetary policy is to achieve low inflation (and usually promote economic growth)
• The main tool of monetary policy is changing interest rates. For example, if the Reserve Bank feel the economy is growing too quickly and inflation is increasing, then they will increase interest rates to reduce demand in the economy.
• In some circumstances, Central Banks may use other tools than just interest rates. For example, in the great recession 2008-12, Central Banks in UK and US pursued quantitative easing. This involved increasing the money supply to increase demand.

What is Fiscal Policy?

• Fiscal policy relates to the impact of government spending and tax on aggregate demand and the economy.
• Expansionary fiscal policy is an attempt to increase aggregate demand and will involve higher government spending and lower taxes. This expansionary fiscal policy will lead to a larger budget deficit.
• Deflationary fiscal policy is an attempt to reduce aggregate demand and will involve lower spending and higher taxes. This deflationary fiscal policy will help reduce a budget deficit.

The Main Difference between Fiscal and Monetary Policy

The main difference is that Monetary policy uses interest rates set by the Central Bank.  Fiscal policy involves changing government spending and taxes to influence the level of aggregate demand.