Economy shrinks: Wake-up call for Australia

• Economy contracts: The economy contracted by 0.5 per cent in the September quarter after an upwardly-revised 0.6 per cent increase in the June quarter (previously up 0.5 per cent). The Aussie dollar fell half a cent in response. It was the first contraction in the economy for 5½ years. Annual economic growth slowed from 3.1 per cent to 1.8 per cent.

• Contribution to growth: The biggest contribution to growth came from household consumption ( 0.3 percentage points) followed by inventories ( 0.1pp). The biggest drag on growth was public investment (down 0.5pp) followed by net exports (down 0.2pp) and dwelling investment, ownership transfer costs and commercial construction (all down 0.1pp).

• Income: Real gross national income rose by 0.9 per cent in the September quarter to be up 3.2 per cent on the year. In nominal terms GDP lifted 0.5 per cent in the quarter and rose by 3.0 per cent over the year.

• Productivity: Gross value added per hours worked in the market sector fell by 0.8 per cent in the September quarter after rising by 1.7 per cent in the June quarter. Annual growth was 0.7 per cent.

• Industry sectors: Eleven of the 19 industry sectors expanded in the September quarter. The strongest sector was Agriculture, forestry and fishing, up 7.5 per cent and adding 0.2 percentage points (pp) to growth. Finance and insurance services added 0.1pp. The Construction sector fell by 3.6 per cent in the quarter (-0.3pp). Mining, “Other services” and Rental, hiring and real estate services all took 0.1pp off growth.

What does it all mean?

This will turn out to be just a blip on the radar screen, but a very important blip. Many Australians have become complacent. And that includes businesses and politicians. The only way the economy can grow is by Australians spending, investing and employing. Australians didn't do this in the September quarter. Still, there was also seasonality involved in the weak result. The Reserve Bank has been intimating for some time, monetary policy is reaching its limits. Infrastructure spending may prove useful in coming quarters in providing fresh momentum to the economy.

In the September quarter the economy was hit by a perfect storm. Not only was there the reaction to the UK ‘Brexit' vote, there was also the Federal election and then there was the uncertainty about the US elections. And clearly, when there is a lot of uncertainty around, consumers and businesses tend to delay decisions to spend, invest and employ. A big fall in public investment also accounted for the bulk of the contraction of activity in the quarter. Wet weather didn't help, causing a big drop in construction.

While spending measures of the economy were weak in the September quarter, income measures were actually quite strong. And the farm sector was also strong in the quarter and should also be a key contributor to growth in coming quarters. For those who may have forgotten after 25 years of consistent economic growth, a ‘technical recession' involves two consecutive quarters of contraction in the economy. We don't believe there are grounds for another quarter of contraction. And indeed it would be amazing if there was some variant of ‘recession' with a jobless rate of 5.6 per cent.

The Reserve Bank is always looking ahead and so must we. The outlook for the economy remains bright with record home building, a record winter crop, unemployment at 3½-year lows and super-low interest rates. Already the data for the December quarter has been more upbeat including retail spending and job ads.

The Reserve Bank warned yesterday that annual economic growth would slow before it picked up in 2017. That is our expectation also. The economy should grow near its ‘potential' rate of 3 per cent in 2017. We continue to believe that interest rates will remain on hold in coming months. But no one will be thinking of rate hikes any time soon.

What do the figures show?

National Accounts:

Economic Growth: The economy contracted by 0.5 per cent in the September quarter after an upwardly-revised 0.6 per cent increase in the June quarter (previously up 0.5 per cent). The Aussie dollar fell half a cent in response. It was the first contraction of the economy for 5½ years.

The economy has grown by 1.8 per cent over the past year, down from 3.1 per cent growth in the year to June. Growth has averaged 2.7 per cent over the decade and averaged 3.0 per cent over the last 15 years.

The non-farm economy fell by 0.6 per cent in the September quarter after a rising by 0.7 per cent in the March quarter. Annual growth stands at 1.8 per cent.

Farm GDP rose by 8.0 per cent in the September quarter after falling by 0.3 per cent in the June quarter. Farm GDP rose by 2.3 per cent over the year.

At current prices, GDP rose by 0.5 per cent in the June quarter to be up 3.0 per cent on the year. The annual growth rate is still well below the decade average of 6.2 per cent. Over the year to September 2016, the Australian economy was valued at $1,666 billion.

Growth drivers: The biggest contribution to growth came from household consumption ( 0.3 percentage points) followed by inventories ( 0.1pp). The biggest drag on growth was public investment (-0.5pp) followed by net exports (-0.2pp) and dwelling investment, ownership transfer costs and commercial construction (all -0.1pp).

Inflation: In terms of domestic price pressures, the household consumption implicit price deflator rose by 0.2 per cent in the September quarter after a 0.4 per cent increase in the June quarter. Annual growth stands at just 1.0 per cent. Real non-farm unit labour costs rose by 0.6 per cent in the September quarter after falling 1.2 per cent in the June quarter. Real non-farm unit labour costs fell by 0.6 per cent over the year.

Productivity: Gross value added per hours worked in the market sector fell by 0.8 per cent in the September quarter after rising by 1.7 per cent in the June quarter. Annual growth was 0.7 per cent. GDP per hour worked fell by 0.9 per cent in the quarter to be up 1.0 per cent over the year. And hours worked in the market sector rose by 0.5 per cent in the quarter to be up 0.5 per cent on the year.

States & Territories: The only data available is state final demand (more accurate data would include net exports but it is not available for all states and territories). In the September quarter growth was strongest in the Northern Territory (up 4.7 per cent) from NSW, Queensland and South Australia (all up 0.1 per cent). SFD fell most in Western Australia (down 3.8 per cent) from ACT (down 1.3 per cent), Victoria (down 0.4 per cent) and Tasmania (down 0.3 per cent).

The ACT had the fastest annual growth rate in the September quarter (up 6.4 per cent), followed by NSW (up 5.0 per cent), Victoria (up 2.5 per cent), South Australia (up 1.6 per cent), Northern Territory (up 1.5 per cent), Queensland (up 1.2 per cent) and Tasmania (up 1.1 per cent). Western Australia contracted by 9.5 per cent.

Consumer spending lifts. Household spending rose by 0.4 per cent in the September quarter to be up 2.5 per cent for the year. Only five of the 17 sectors recorded weaker spending in the quarter. Spending fell most in Purchase of vehicles (down by 3.8 per cent) and Food (down by 0.8 per cent). Spending rose most in Communications (up 2.7 per cent) and Hotels, cafes and restaurants (up 2.2 per cent).

Industry sectors: Eleven of the 19 industry sectors expanded in the September quarter. The strongest sector was Agriculture, forestry and fishing, up 7.5 per cent and adding 0.2 percentage points (pp) to growth. Finance and insurance services added 0.1pp. The Construction sector fell by 3.6 per cent in the quarter (-0.3pp). Mining, “Other services” and Rental, hiring and real estate services all took 0.1pp off growth.

Other points:

Profit share rises. In seasonally adjusted terms, the ratio of profits to total factor income rose from 24.2 per cent to 24.4 per cent in the September quarter. The wages share rose from 54.0 per cent to 54.5 per cent.

Household savings ratio falls. The household saving ratio fell from 6.7 per cent in seasonally adjusted terms in the June quarter to 6.3 per cent. In trend terms household saving was steady at 6.5 per cent in the September quarter.

Imports rose as a share of spending. The imports to sales ratio rose from 0.371 in the June quarter to 0.373 in the September quarter.

The inventory to sales ratio rose from 0.615 per cent in the June quarter to 0.625 per cent.

What is the importance of the economic data?

The quarterly National Income, Expenditure and Product release (national accounts) from the Bureau of Statistics is the most complete assessment of Australia's economic performance. Detailed estimates are provided on incomes (wages, profits), spending (such as household, dwelling investment and trade (exports and imports) and production (comparing industry performance). Other data includes household saving and the economic performance of States and Territories.

The main use of the national accounts figures is as a historical record of economic performance. The information has little forward-looking value for currency, interest rate or share markets.

What are the implications for interest rates and investors?

The national accounts data is backward looking. But the data is taken into account by the Reserve Bank, serving as a base for forecasts. The Reserve Bank uses six-month annualised growth figures to ascertain how the economy is travelling. Even assuming a 1 per cent lift in the December quarter, annual economic growth would be below Reserve Bank estimates of 3.0 per cent.

If the Reserve Bank is forced to revise down inflation forecasts as well as economic growth then it will put another rate cut on the table. But that remains to be seen – inflation still looks to have bottomed, especially with oil prices pushing higher. We – like the Reserve Bank – expect the economy to lift over 2017, so it is still too early to talk about rate cuts. And the question has to be asked – at current levels, do rate cuts still work to lift spending and investment?

Income measures posted solid growth over the September quarter. Real gross national income rose 3.2 per cent over the year with net national disposable income up by the same magnitude. So there is no shortage of income to drive spending and investment decisions.

Seasonality played a role in the September quarter. Usually spending grows by 0.9 per cent in real terms, but in September quarter 2016, the economy fell by 0.3 per cent in original terms – the first time this has happened in 34 years (since September 1982). So if activity was delayed, this could find its way into the December quarter numbers, leading to a far greater bounce in economic activity.

Craig James is the chief economist of CommSec.