Oliver's Insights

KEY POINTS:

• The recent surge in petrol prices and another rise in interest rates had led to renewed concerns about the outlook for the Australian economy.
• However, although these factors are negative they are more than offset by big tax cuts and increased family benefits in the latest budget and the ongoing boost to national income from high commodity prices.
• Overall, we see the Australian economy continuing to record solid (3% or just above) economic growth with benign inflation. We see interest rates remaining on hold, but the risks are on the upside.
• The budget is unambiguously positive for the stockmarket, both in terms of its stimulus to the economy and the potential boost it provides to inflows to the stockmarket via superannuation.

A year ago there was much concern that the Australian economy had hit the wall, with the economy running up against capacity constraints threatening a further trade deficit blowout, a wages breakout and inflation. At the same time, many worried that as the earlier drivers of strong growth faded, namely the housing and related consumer boom, growth might slow sharply. Then later last year there was concern that higher petrol prices would also threaten the Australian economy. In the event, it has come through very well:

• Housing construction has had the mildest of downturns.

• Consumer spending has slowed from levels two years ago but certainly has not collapsed. Consumers appeared to get used to progressively higher petrol prices through last year.

• Meanwhile, business investment surged, powered along by strong profits, high capacity utilisation and the mining boom.

The main disappointment of the past year has been the failure of a decent pickup in export volumes to occur, to take advantage of high commodity prices. But in many ways the constrained mining supply response is partly why commodity prices remain so high and it takes a while to ramp up mining production after years of understandable under-investment.

More importantly, though all the predictions of doom did not materialise '” house prices did not crash, households did not spontaneously decide to stop spending under the weight of high debt levels, higher petrol prices have not led to an inflation breakout, and there has not been a generalised wages breakout in response to skill shortages.

So overall economic growth has slowed from a few years ago, but it has certainly not collapsed.

THE OUTLOOK

Looking forward, we do not see things changing that much. Certainly the latest rise in petrol prices and interest rates are negative for household spending and may act as a dampener in the months ahead, but these are more than offset by the tax cuts and family benefits in the budget.

Roughly speaking:

• An average household uses 45 litres of petrol a week, so the 30¢ a litre rise in the petrol price over the past year will cost them an extra $13 a week.

• The recent rise in interest rates will cost a household with a $200,000 mortgage an extra $10 a week in interest payments.

• However, a dual income family on $80,000 a week with two kids will see their weekly disposable income boosted by $29 a week from July 1 thanks to the budget. A single income family on $80,000 will get an extra $39 a week. (Estimates vary depending on the number of dependants, etc.)

So in net terms, the budget is giving more spending power back to consumers than the petrol and interest rate increases took away. That said, it is hard to see consumers going on a spending spree. Higher petrol prices seem to have a bigger psychological impact on people than most other factors that affect their spending power. The housing market (excepting Perth and Darwin), is still pretty flat and talk of further interest rate increases will linger for a while yet. And the proposed superannuation changes will also help to encourage savings (via superannuation). So part of the budget’s boost may be saved or used to pay down debt (as was the case after last year’s budget). Overall, we see consumer spending growing about 3% over the next year or so.

Still soft building approvals suggest housing construction will remain flattish over the next year. However, business investment is likely to remain robust as its main drivers in recent times '” high levels of profit and capacity utilisation and the mining boom '” remain in place.

There is likely to be a modest pick-up in export volumes though, as recent mining sector investment starts to pay off. Overall, we see economic growth of about 3–3.5% over the next year, which is in line with the Government’s forecasts. This is consistent with trend growth for the Australian economy and is also in line with what leading indicators of growth are suggesting. The chart below shows the National Australia Bank business survey’s measure of business confidence and the Westpac Leading Index. Both are running around their average levels for the last 15 years, a period over which economic growth has averaged 3.4% a year.

Perhaps more importantly there are none of the usual warning signs of an impending end to the economic expansion that is now into its 15th year:

• Underlying inflation measures remain benign. There has been little flow-on from high petrol prices to generalised price inflation. As the Treasury points out, the inflation rate excluding auto fuel is about 2% year on year. Retail price inflation was running at just 0.2% quarter on quarter, or 1.9% year on year in the March quarter. In contrast to the 1970s oil supply shocks, increased domestic and international competition is serving to ensure that price inflation remains moderate.

• Similarly, there is still little evidence of a generalised wages breakout and this is likely to remain the case, with employment growth having cooled down.

• There are few indications that the global commodity boom will end soon. Demand for commodities is remaining strong with little sign that China’s growth rate is about to slow significantly, low inflation suggests there is little threat to solid global growth generally and the resources supply response remains muted.

• Finally, while household debt levels remain a risk there is little evidence that it is causing major debt servicing problems and the Reserve Bank of Australia’s “softly softly” approach to raising interest rates provides confidence that rates will not go up too far too fast and trigger major problems for households.

So in the absence of a major shock '” such as a human flu pandemic or a war in the Middle East '” there is little reason to be negative on the Australian economic outlook.

So what about interest rates?

Our view remains that the RBA is now on hold, with last week’s interest rate move likely to deal with the bank’s earlier perceived risks to inflation and underlying inflation measures likely to remain benign anyway. Certainly the 2006-07 budget provides a significant fiscal easing. This is estimated to about 0.4% of GDP (based on the fall in the size of the projected budget surplus relative to GDP between 2005-06 and 2006-07). (Some have referred to a stimulus equal to 1.2% of GDP based on the policy easing in 2006-07 but this ignores the fact that in the absence of such easing the budget would have had a contractionary effect on the economy equal to 0.8% of GDP). The RBA is likely to focus on the fact that the budget still projects a big surplus, indicating it is taking more out of the economy than it is putting back in and part of the tax cuts/family benefits will be put towards increasing saving/reducing debt. However, if rates are going to go anywhere there is still more risk that they will rise than fall.

STOCKMARKET IMPLICATIONS

We continue to see the relatively stable outlook for Australian growth, inflation and interest rates as supportive of the local stockmarket. Certainly, the budget has to be seen as positive for retailers, with it more than unwinding the negative impact of petrol and interest rates on household spending power. Other beneficiaries from the budget include construction companies, wealth managers (as the superannuation changes will act to boost saving via super) and child care providers. Our view remains that the broad outlook for Australian shares remains positive. Valuations are still OK, profit growth is likely to remain robust, with recent earnings upgrades certainly pointing in this direction, and the demand/supply balance for shares remains very positive.

In terms of the later, the budget adds to confidence that the Future Fund will be well over $30 billion by year’s end; $18 billion has already been allocated to it, and with the 2005-06 budget surplus likely to be at least $15 billion the fund should be at least $33 billion by year’s end. If only 30% of this is allocated to Australian shares, this will provide another $10 billion in demand for them. Similarly, if the super reforms encourage a 10% increase in super inflows this will result in another $2 billion a year (and rising) in demand for local shares.

CONCLUDING COMMENTS

It’s often easier to find the negatives in things, but over the Past 15 years many things have gone right for the Australian economy and it is worth being reminded of these. They include low inflation, the elimination of Commonwealth net debt, 15 years of continuous growth, and a return to unemployment rates last seen in the 1970s. It should also be noted that even before recent moves on taxes, Australia was a low taxing country. Sure, Australia faces problems, as do all countries, but there is a lot that has been going right for the “lucky country”. And this was the case even before the mining boom got under way.