Unhappy new year in store?

PORTFOLIO POINT: If the global economy turns down, as feared, Australia might not be able to weather it as it did during the GFC.

The big uncertainty for 2012 is how hard global events will knock Australia, and whether the policy response will be as effective as 2008-09. Our macro team’s base case is for a soft landing in Asia and no global recession. That points to another uneven year for the Australian economy, and moderate returns to investors. If something worse unfolds – and that’s our bias – then expect aggressive rate cuts and outright losses for equity investors. The question in that scenario is whether the policy response can again prevent global crisis interacting with domestic structural problems to push Australia into recession.

Global pressures are already affecting Australia

Commodity prices are rolling over, pointing to a significant fall in export growth (Exhibit 1). In turn, that will affect mining-related profits, and public sector revenue. Likewise, the stress in the global financial system is affecting funding costs, and raising concerns about Australian financial institutions (Exhibit 2). For now, however, conditions are far better than in 2008. If recession is limited to Europe as global growth has a soft landing, then we expect a year of near-trend Australian growth with modest RBA rate cuts, a small decline in the Australian dollar and moderate returns to equity investors.

If downside global risks unfold, then the effectiveness of the domestic policy response will be critical. Policy was very effective in 2008-09: Australia saved itself, it wasn’t China. The two recent rate cuts show that the RBA will be pre-emptive and aggressive. Moreover, mining-related investment looks solid, and households have a saving buffer. However, fiscal policy is more constrained, and Australia is entering this slowdown with consumers more cautious, house prices falling, and business sentiment weak. It’s too soon to make a strong call on what would happen under this scenario, but it may be harder for Australia to dodge a second global bullet than it was the first.

If not for the rest of the world '¦

The domestic economy looks to be just where the RBA wants it: growth running at around trend, with inflation now in the middle of its target band and expected to stay there for the foreseeable future. If global growth remains reasonable then next year could be, in an economic sense, unchallenging. The key feature of the domestic economy is likely to remain the uneven expansion. The resource expansion is set to continue.

Through 2003-08 the key to the boom was the rise and rise of commodity prices. The key to the second leg of the boom is the likely rise and rise of mining-related investment spending. The investment pipeline is bulging: Exhibit 3 shows the value of engineering work done each quarter, and work yet to be done on projects already commenced.

Behind this already-impressive workload is a wall of additional yet-to-commence projects. This has several implications: First, it suggests that Australia’s growth is not overly dependent on short-term swings in China. These projects are being developed on the back of a 20–30 year assessment of the commodity outlook. They will not stop even if China falls into recession. Only a major shock would empty the pipeline.

Second, the robustness of the investment outlook is a pillar of the RBA’s policy outlook. With mining and mining-related sectors providing an outsized contribution to growth, the RBA has aimed to cap growth in the rest of the economy at a sub-trend pace. That is the only way to maintain aggregate growth at a pace consistent with its medium-term inflation target. The RBA does not have the tools to level out disparate growth between sectors (Exhibit 4).

Third, if global growth does slow – as seems likely – then commodity prices would almost certainly fall. The post-2009 rise has already hit a clear inflection point (Exhibit 1). But the first-round effect of weaker commodity prices is limited to lowering miners’ profits and widening the budget deficit. We would not expect a cyclical setback in commodity prices to have a material impact on mining-related investment spending. Lower commodity prices would also go hand-in-hand with a weaker Australian dollar, providing a partially offsetting stimulus.

Our macro team’s base case for global growth is for moderate slowdown, albeit with recession in Europe. It is also likely that bank deleveraging in the developed world will tighten global credit conditions. But this is a long way from a 2008-09 outcome.

Under this base case, expect another year of near-trend domestic growth. Growth will remain uneven. The unevenness in activity is now being translated into uneven labour market – where the private non-mining sector is starting to fire (Exhibit 5) – and uneven profits. The macro measure of non-mining profits is falling (Exhibit 6). Profits in the non-mining sector are now no higher than they were in 2003.

Under this base case we expect modest further RBA rate cuts (perhaps 50–75 basis points), a manageable decline in the Australian dollar (to US90¢) and moderate equity market returns – although the domestic market performance will be guided by returns in major comparable markets.

The downside risk

Global risks are skewed down. Indeed, the recent three-month decline in the OECD’s leading indicator is already deeper than any prior decline that was followed by a soft landing (Exhibit 7). The downside risk effectively comes with two levels of severity.

The vanilla downside is that there is a broad developed-world recession. The cause would be tight credit conditions caused by bank deleveraging and broad-based fiscal tightening. In this setting Asian growth would be weaker than forecast, but a hard landing in China could still be avoided. The tail risk is disorderly sovereign and banking default in Europe. If this eventuates then global recession is likely, and we would expect an Australian recession. We’ll focus on the vanilla bear case.

We see this as a material risk – perhaps a 30–40% chance. The issue in this setting would be whether Australia could repeat the successful policy response of 2008-09 that saw the economy escape what was a global recession.

A number of domestic factors are different now compared to 2008. On the positive side, private sector financial indicators are in better shape: the non-financial sector is healthy, banks have reduced their dependence on wholesale funding, and the household sector saving rate is much higher.

On the negative side, it seems that any fiscal policy response will be much more constrained. Likewise, confidence indicators are much lower now than they were entering the 2008 crisis. Employment is weaker. House prices are falling – but, in our view, remain significantly overvalued.

It’s clear is that the burden of the policy response would, in this scenario, fall squarely on the RBA. The November-December rate cuts show that the bank stands ready to be pre-emptive and aggressive. With the RBA taking a lead role, it seems likely that the cash rate target could go lower in 2012 than it did in 2009 in this scenario. The 2009 low was 3%; the target is now 4.25%. Rate markets are now pricing in a 3% cash rate target next year (Exhibit 8). If this 30–40% bear scenario eventuates then we think rates could fall below 3%.

Such a rate move would provide a powerful cash flow benefit for the Australian household sector. Exhibit 9 shows household disposable income growth. Policy changes – lower rates and cash benefits from the federal government – provided huge support in 2009, peaking at a 9.8 percentage point contribution over the year to June 2009. Roughly half of that came from the federal government, the other half was the gross benefit of RBA rate cuts. (The gross benefit reflects the reduced interest payments on household debt. This is partly offset by lower interest income received by households. The offset is approximately half.)

Fiscal policy would likely be less aggressive and less pre-emptive than in 2008-09. On current forecasts – which would certainly be wrong under the bear scenario – the budget will return to surplus in 2012-13 (Exhibit 10). This implies some discretionary tightening, but most of the improvement is due to the presumed improvement in the macro environment. The prospect of less fiscal response to any downturn implies a greater monetary response, in our view.

The sharp decline in the Australian dollar was the third factor that helped Australia in 2008-09. It would presumably repeat in a global downturn. While the dollar has been supported by foreigners buying the high yield and high credit ratings of domestic debt, the big moves in the currency continue to be driven by commodity prices (Exhibit 11). A global recession would see commodity prices fall sharply, and we would expect to see the dollar around US80¢ in this scenario.

Will the policy response work?

Australia dodged the global bullet in 2008-09 – largely, in our view, because of the aggressive domestic policy response. We are not as confident that if there were to be a second sharp global slowdown – which, to be fair, may not be as severe as 2008-09 – Australia would be as successful responding. There are a few issues that may mute the policy response:

First, as noted above the policy response will be more lopsided, depending more on monetary policy and exchange rate changes. These arms of policy arms are subject to lags, unlike the fiscal cash drops that had a near-instantaneous effect in 2008.

Second, it’s not clear the monetary policy will be as effective as in 2008-09. For sure, the monetary lever is much more powerful in Australia than many other developed economies. Not only does the RBA have room to cut, but the transmission mechanism to household mortgage debt – which accounts for 90% of total household debt – is very fast. Monetary policy will have lost none of its effectiveness in terms of improving household sector cash flow.

But we’re less sure about second round effects. In particular, the willingness of households to spend (rather than save) that cash windfall, and whether falling rates will again lead to higher house prices, and the associated positive wealth effects.

There’s growing evidence that there has been an important change in household sector attitudes. The household saving rate has risen sharply, and that has gone hand-in-hand with survey evidence of greater financial prudence (Exhibit 12).

Likewise, the growth in borrowing for housing is now at an all-time low (series starts 1977 – see Exhibit 13). While the 2009 recovery in house prices was also helped by the federal government’s increased grant for first-home buyers, it’s noticeable that credit growth accelerated to its lowest cycle peak in 30 years.

The caution may be reinforced by two other points. First, confidence levels are far lower now than they were entering the last downturn. Second, there are clear signs that segments of the housing market are under severe pressure. The holiday home market seems, in our view, set to give way. This is a relatively illiquid part of the market, but we expect to see prices halve from their recent peak. It also seems likely that the decline in top-end metropolitan markets will accelerate, partly because of the structural decline in finance sector employment and remuneration. The combination of greater consumer caution and clear pockets of weakness in the residential market may crimp the prospect of rate reductions triggering the sort of broad-based house price gains that helped the domestic economy in 2009.

The upside risk here, of course, is that policy does prove to be as effective as in 2008-09. We acknowledge that that is a risk, not least because the RBA will be willing to keep cutting until it sees clear follow-through.

Ultimately, however, the key to avoiding broad-based house price losses in 2009 was that Australia avoided broad-based job losses. So perhaps the key forward-looking question is whether employers will be as willing to hold on to staff in a second global downturn. Statistically, the labour market resilience was one “benefit” of poor productivity (Exhibit 14). But the trend decline in productivity suggests that there is scope for labour cutting in a downturn.

None of this will be an issue if the global economy has a soft landing, which remains our global team’s base case. But it’s clear the risks of something worse are quite high. If that downside does eventuate, then we are not as confident that Australia will be able to dodge the global bullet a second time.

Gerard Minack is head of global developed market strategy at Morgan Stanley.