A different downturn
While the debate over whether or not we are entering a recession rages, previous downturns have been marked by double digit declines in business investment and residential property. This time around that is most unlikely.
I assess that the 'two negative consecutive quarters of GDP growth' is unreliable since it can be distorted particularly by short term fiscal 'packages' to offset recessionary forces. For instance it has now been pronounced by the NBER that the US entered recession around Q4 2007 when growth contracted by 0.7 per cent. However growth rebounded by 0.9 per cent in Q1 2008 and 2.8 per cent in Q2 2008. That 'recovery' was the direct result of a short term fiscal stimulus package which mainly impacted in Q2. Similar 'distortions' are very likely for Australia as the $10.7 billion (1 per cent of GDP) fiscal stimulus package boosts spending in Q4 2008 and Q1 2009.
I think a more reliable approach is to smooth out short term fluctuations and declare a recession if GDP contracts on a year over year basis.
Using that definition we can assert that Australia has experienced three recessions since 1965. The first came in the mid 1970s when growth contracted by 1.2 per cent in the year to the December quarter of 1974 and continued into the March quarter 1975 when it contracted by 1.1 per cent through the year. The next recession occurred in the early 1980s when GDP contracted by 1.1 per cent in the year to the September quarter of 1982 and year on year growth remained negative until the June quarter 1983. Finally, in the early 1990s, GDP contracted by 1.4 per cent in the year to the March quarter 1991 and negative year on year growth persisted for another three quarters.
These recessions were associated with alarming increases in the unemployment rate. In the 1970s recession the unemployment rate increased from 1.6 per cent to 5.4 per cent peaking in December 1975. In the 1980's the unemployment rate increased from 5.4 per cent to 10.4 per cent peaking in September 1983 while it increased from 5.6 per cent to 10.8 per cent in the early 1990s peaking in July 1992.
Clearly the response of the labour market to a contraction in GDP will depend on the extent and depth of the contraction but history tells us that Australia's recessions have been fairly brutal for the labour market.
Westpac is not forecasting a year on year contraction in GDP but we are predicting three consecutive years of very soft growth. For 2008 we are expecting growth of 2.1 per cent; 1.9 per cent in 2009 and 2.8 per cent in 2010. Australia has seen brief slowdowns in the past. For example, growth in the year to December 2000 was 'only' 1.5 per cent but it rebounded in 2001 to register 4.1 per cent. Growth in the year to December 1977 was only 0.3 per cent but recovered in 1978 to register 3.8 per cent. We have not seen a period comparable to our current forecasts where the economy avoids recession but remains well below trend for an extended period.
For the three years of soft growth we are expecting consumer spending growth of 2.5 per cent (2008); 1.3 per cent (2009) and 2.4 per cent (2010). For growth in business investment we expect 7.5 per cent (2008); –4.2 per cent (2009) and 1 per cent (2010). For residential dwelling investment we expect -2.7 per cent (2008); 7.5 per cent (2009); and 9.3 per cent (2010).
All of the recessions have been characterised by spectacular double digit contractions in residential building construction and business investment. Consumer spending has been much less volatile particularly reflecting the stable services components although sales of motor vehicles have been volatile.
For 2009 Westpac is expecting a very different profile for residential investment to the recession profiles. Unlike in the recession periods when growth rates in residential construction in the preceding years have generally averaged double digits, over the last three years residential construction growth has been close to zero in each year. Unlike in the lead up to recession years new housing is chronically undersupplied despite a surge in underlying demand associated with sharp increases in immigration.
We estimate that the shortages in the housing market in Australia have reached around 140,000 dwellings – almost a full year's production. While Westpac's forecast of a solid recovery in dwelling investment in 2009 may prove to be over optimistic there seems little chance that the style of collapse in residential investment that we have seen in recessions will occur in 2009 or 2010.
The current period of soft growth in Australia has been characterised by excessively weak consumer spending – not at the contraction levels we saw in the last two recessions but at a growth pace which is half trend. With the unemployment rate near record lows through most of 2008 the slowdown in consumer spending has been mainly the result of two key factors. Firstly, the excessively high mortgage rates which prevailed for the first three quarters of 2008 and secondly the negative wealth and confidence effects which have stemmed directly from the global financial crisis.
The Reserve Bank has moved swiftly to ease interest rates. Debt servicing ratios have fallen 3ppts in the space of just three months. Westpac expects the RBA to target another 1.5ppt fall in this ratio (RBA cash rate down to 2.75 per cent) by the June quarter. This interest rate flexibility has been enhanced by the record collapse in inflationary expectations as registered by the results associated with the Westpac Consumer Sentiment survey.
The Westpac Consumer Sentiment Index has increased 12.2 per cent in the last two months to be 3.3 per cent above the average of 2008. Other aspects of the December Consumer Sentiment read are encouraging. The 'Time to buy a major household item' index has increased by 42 per cent in the last two months while the 'Time buy a dwelling' index has reached its highest level since the housing boom of 2002.
Of course, the Commonwealth government has engineered the biggest fiscal stimulus (1.7 per cent of GDP) since 1991 and directly targeted households with high propensities to spend. The unemployment rate is set to rise but without a recession is unlikely to exceed a 'manageable' 6.5 per cent by end 2010. Understandably, households remain concerned about job security. The measure from the Consumer Sentiment survey has reached record levels and supports our view that the labour market will continue to weaken. However our growth forecasts indicate that the unemployment rate is unlikely to go much above 6.5 per cent.
The area of huge uncertainty is undoubtedly business investment. If business investment was to contract by 20 per cent in 2009 and a further 20 per cent in 2010 (comparable with the recession years) then growth in both 2009 and 2010 would slow to only 0.5 per cent – the impact of such a collapse in investment on other spending/employment could conceivably be greater than we have assumed thereby pushing the economy into recession.
Evidence on the outlook for business investment is not clear. Certainly some business confidence surveys are painting a grim picture. Whereas the ABS's Capex survey is indicating a positive outlook at least until June next year. Even using recession style realisation ratios points there is growth in business investment through to June.
Huge uncertainty surrounds the impact of the credit crisis on business investment. For example, our research indicates that there are around $50 billion in syndicated loan facilities maturing in 2009 and $27 billion is owed to foreign banks.
Typically, these banks will want to return capital to their domestic markets. Domestic banks are unlikely to have the risk appetite or capital capacity to fully replace the foreigners. Corporate deleveraging will likely be required for those borrowers. However, the Reserve Bank's latest Financial Stability Review indicates that most corporates have been remarkably disciplined through the last ten years of strong domestic growth. While there has been an explosion of debt levels for those companies in the 90th percentile of gearing the median level of gearing has been stable since 1998.
An unprecedented (including during recession periods) collapse in business investment associated with the credit crisis would deliver the recession which is so popularly anticipated but, at this stage, Westpac does not expect the style of collapse in business investment that would be required to generate a recession.
Bill Evans is chief economist at Westpac