Decoding mixed signals

With economists predicting an upturn after a downturn, David Potts examines the distinctly ambiguous messages the economy is sending.

With economists predicting an upturn after a downturn, David Potts examines the distinctly ambiguous messages the economy is sending.

It's not where the economy is at that drives markets but where they think it's going. The trouble is economists are forecasting an upturn before any telling evidence has come to light that we've reached the bottom yet.

That the economy has been slowing down in the past six months is indisputable. Even Treasury and the Reserve Bank concede it's growing "below trend". Trend is 3 per cent to 3.25 per cent, and the 2.5 per cent annual rate recorded in the March quarter isn't enough to prevent unemployment rising.

But the true picture is bleaker. A better idea of what's going on, or rather isn't, is the per capita figure. The increase in immigration that Australia has experienced over the past year will naturally boost demand, which will produce some domestically generated economic growth.

Gross domestic product (GDP) per head is growing at a sickly 0.4 per cent annualised rate, down from the not-much-better 0.5 per cent in the previous quarter.

Most economists are forecasting a weak 2013 and a better 2014. How can they know? The slowdown is the easy part: falling commodity prices caused by weaker demand from China, plus the budget's fiscal contraction. Though the government isn't in a bull's roar of a surplus, the halving of the deficit (after taking into account the time-shifting fiddles between financial years perfected by the departed Wayne Swan) is still contractionary.

It's impossible to tell in advance just when growth will bottom out because that'll depend on households loosening the purse strings. They must do so at some point, but it depends on when they decide to take advantage of low interest rates and rising incomes. They may wait until after the election so they can suss out how tough the next budget will be. Rising petrol and power prices will probably make them think twice, too.

A recent survey in BusinessDay of prominent economists shows they expect GDP to grow 2.35 per cent (0.4 percentage points less than the budget forecast, by the way) this financial year, rising to 2.75 per cent in 2014-15.

That may be an educated guess but it makes sense because Australia will be producing a lot more iron ore, coal and natural gas as the gigantic investments from the mining boom start to come on stream.

So, there'll be an export boom by volumes all right. But that's only half the story. The question is what prices it will fetch since mines in other countries will be starting at the same time, posing the potential problem of a supply glut.

It also seems housing investment is picking up, as you'd expect from falling interest rates. What took builders so long? A housing recovery is Treasury's great white hope in taking up the slack from the end of the mining investment boom.

Business investment has been forecast to fall 12 per cent this year and 20 per cent in 2014 in a survey by ratings agency Standard & Poor's. This would be much worse than the downturn after the global financial crisis.

That puts the economy at a crossroads. It can take the housing recovery freeway, or backtrack into a slump.

It will all depend on the dollar. Though its fall from grace has been sudden, it will take some time to work its way through the economy. A US10¢ fall in the dollar has the same impact as a 1 percentage-point cut in rates, according to AMP Capital's chief economist Shane Oliver.

In barely two months the dollar has dropped US10¢, so there are four rate cuts about to course through the economy.

Jobs

The job market has been a puzzle in this economic slowdown.

If it didn't do what it was supposed to before, it's hard to guess where it'll go from here. The unemployment rate hasn't climbed as much as the weaker economic growth suggested it might, even allowing for older workers leaving the workforce altogether. More representative is the unemployment rate for full-time workers, because lately the growth in new jobs has been mostly for part-timers. It's at 6 per cent, up from 5.2 per cent a year ago.

Just as telling is that the number of hours being worked is falling.

But if anything will be good for jobs it's a drop in the dollar, except that by lifting costs it will tend to makes things worse before they get better.

Petrol prices have already soared and food prices can't be far behind. This decline in household disposable income is likely to curtail spending for a while.

Shares

Even before the profit-reporting season started, there were earnings downgrades.

"I expect some more negative results due to reduced investor and consumer confidence," Mark Newman, chief investment officer at K2 Asset Management, says.

But mining has probably seen the worst of the downgrades thanks to the drop in the dollar.

"The trick is when to come back into resources. There won't be many more negative surprises. When it moves up it will be quick. The risk for investors is being negative for too long," Newman says.

Meanwhile, the sharemarket is still coming to grips with the prospect of the liquidity pump in the US closing down as its economy picks up, and slower growth in China.

The world's sharemarkets have been underwritten by the US central bank's money printing.

While designed to buoy Wall Street - at which it has proven to be spectacularly successful - and restore confidence among American households, this liquidity has spilt over into commodity prices and other sharemarkets as the US dollar has fallen in value.

At the same time Japan has embarked on an even bigger money-printing program relative to the size of its economy, making it the boldest version of so-called quantitative easing yet.

So, while the markets are being artificially pumped up by central banks, at some point there should be a positive impact on the US and Japanese economies.

This is already the case in the US.

The question is whether a stronger-growing US will provide enough oomph to global growth to outweigh the drag from sucking out funds from other sharemarkets such as ours.

Then there's China.

Its growth rate has officially slowed to its target of 7.5 per cent. But there could be more than meets the eye. In what may have been a slip of the tongue, China's finance minister said the growth goal this year would be 7 per cent, which was later corrected on the official website to 7.5 per cent.

He'd earlier said that 6.5 per cent wouldn't be "a big problem".

Based on the annualised results in the past two quarters - taking each and multiplying it by four - China's economy is in fact growing by somewhere between 6.6 per cent and 6.9 per cent.

While slower Chinese growth would lower commodity prices, the dollar could also be expected to drop.

It won't be just about exporters doing better than importers such as retailers. The strong dollar, by keeping prices at bay and in some cases even reducing them, lifted real incomes, which in turn helped job-creating services industries.

But it also permanently boosted the amount households were saving, James White, economic and markets research analyst at Colonial First State Global Asset Management, says.

"Australians have undergone the largest natural de-leveraging [of debt] of any developed economy in the past five years. The high savings rate has also led to a structural decline in credit growth. Clearly, real and nominal growth must be lower. It seems to me that growth of 2.5 per cent is all we can expect of the economy," he says.

That's well below the 3.5 per cent we've become used to.

With lower economic growth in prospect, has the market run too far?

"Overall, the market is at fair value already. Half our recommendations are to hold," says Andrew Doherty, head of equities at analysts Morningstar, which follows 230 stocks.

"The total return should be in the mid to high single digits over the next few years," Doherty adds.

Property

If low interest rates are going to help anything straight away, it would have to be property. And indeed, home prices have risen about 5 per cent in Sydney and a bit less than that in Melbourne in the past year. Investors are returning to the market in a big way - loan approvals are increasing at an annual rate of 25 per cent, admittedly from a low base.

But first-home buyers are proving to be more reticent, perhaps spooked by fears of rising unemployment.

High rents are even better than cheap finance, which after all is tax deductible for landlords.

Yields before costs are approaching 5 per cent in Sydney and are just over 4 per cent in Melbourne. This is thanks to a prolonged lull in new home construction and more young people continuing to rent rather than buy.

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