Weekend Economist: Conditional confidence

The uneven nature of economic growth and volatile investment spending pose serious questions for emerging economic optimism.

The Australian economy grew at a below trend pace in 2013. Growth is expected to remain below trend in 2014, with the economy navigating a period of transition as the mining boom moves from the jobs intensive investment phase to the production phase. There is evidence that the broader economy is gaining strength, albeit off a soft starting position, particularly in housing as well as consumer spending. That said, there is considerable uncertainty surrounding this transition, compounded by a number of persistent headwinds impacting the Australian economy.

To recap recent developments, gross domestic product growth was 3.8 per cent in the year to June quarter 2012, a strong and above trend outcome centred on a surge in mining investment. As mining investment began to crest from the second half of 2012 overall economic growth slowed to a low of 2.1 per cent in the year to March quarter 2013. In 2013, household demand rebounded somewhat and GDP growth recovered to 2.8 per cent for the full year. We anticipate a similar outcome for 2014, forecasting 2.7 per cent growth, improving to 3.2 per cent in the four quarters to December 2015 (or 3.0 per cent in year average terms for 2015).

The Reserve Bank in their February statement on monetary policy was also of the view that growth in 2014 is likely to be below trend. Year ended GDP growth is forecast to be 2.75 per cent (2.25 per cent-to-3.25 per cent) in December 2014, improving to 3.5 per cent (3.0 per cent-to-4.0 per cent) in December 2015.

Record low and falling interest rates in 2013 ignited a strong upswing in the housing sector. House prices have increased at a double digit pace, a trend that has extended into early 2014. RP Data-Riskmark reports that after a flat February, house prices rose 2.3 per cent in the month of March to be up 3.5 per cent in the quarter and 10.6 per cent over the past year. A strong upswing in dwelling construction is unfolding, with private approvals over the six months to February running at a 200,000 annualised pace, up from 140,000 early in 2012, a rise of more than 40 per cent. Looking ahead, we anticipate the emergence in coming months of a levelling out of lead indicators of the housing sector, notably housing finance. Interest rates have been unchanged now for eight months and sentiment towards housing has moderated, with views on whether now is a “good time to buy a dwelling” retreating to below average readings as the recent run-up in prices has reduced purchasing power.

Consumer spending gained momentum in 2013, off a low base, as households responded to low and falling interest rates, rising household wealth and a Federal election feel good factor. Consumption increased by 0.8 per cent in the December quarter, lifting annual growth to 2.6 per cent up from 1.5 per cent at the start of the year. Momentum appears to have extended into the March quarter, as discussed below. Although, for the near-term outlook, we note that the optimism of late last year has given way to a more cautious mood. The Westpac-MI Consumer Sentiment index was back at 99.5 in March, down from 110 in November, on renewed concerns about the economy and jobs. This caution suggests households may be reluctant to lower their saving ratio in the near-term and hence spending will be constrained by income growth, which will in turn be largely determined by conditions in the labour market. We expect consumer spending growth of 3.0 per cent in 2014, in line with the pace over the second half of 2013.

A striking feature of labour market trends of late was the extent of weakness over the second half of 2013, with employment contracting, declining by 0.1 per cent. That result appears to be an under- shoot with policy uncertainty surrounding the September federal election contributing to a hiring freeze. We assess that the labour market has reached a turning point, with lead indicators pointing to an end of the hiring freeze. But equally, the risk is that employment growth is lacklustre in 2014 and that unemployment grinds higher, from 6.0 per cent currently to around 6.5 per cent. We see a number of headwinds impacting Australia, forces that will weigh on job creation.

Key exogenous forces at play are; a sharp downturn in mining investment; sub-trend public demand growth as governments focus on budget repair; a slowing of our number one trading partner, China; a resulting decline in the terms of trade, adversely impacting national income; and a still relatively high Australian dollar, which is driving significant structural change in trade exposed sectors.

Mining investment, at the height of the boom, directly added 2.5ppts to annual GDP growth in mid-2012. That turned around to be a direct subtraction of about 0.8 percentage points during 2013. A drag of a similar magnitude is in prospect in 2014, with the downturn to extend out to 2017 and 2018. Non-mining investment ended 2013 on a weak note, as business awaited greater certainty on public policy and more evidence of improved domestic conditions. With household demand on a firmer footing, relative to early 2013, we assess that non-mining investment is at or past its low. Although, the initial response is likely to be modest, more so than is typically the case at turning points given persistent powerful headwinds.

Dividends from the mining investment are beginning to flow. Resource exports are set to perform well in 2014 and 2015, building on strong gains in 2013 associated with expanding capacity in the sector as new projections begin operation. Total exports of goods and services added 1.4 percentage points to GDP growth in 2013. We anticipate a repeat of that in 2014, with an improvement to a 1.8 percentage points contribution in 2015.

Turning to focus on conditions in the March quarter 2014 in more detail, we expect GDP growth to print at 0.7 per cent, following a 0.8 per cent increase in the December quarter. That would see annual growth tick higher to 2.9 per cent from 2.8 per cent. Consumer spending and exports are likely to be key growth supports as was the case in late 2013.

Retail turnover increased by only 0.2 per cent in February, but that was on the back of a 1.2 per cent rise in January. For the March quarter, retail sales growth is looking likely to be around 2.0 per cent in nominal terms and close to 1.0 per cent in real terms, which would be a repeat of the December quarter outcome. International trade data surprised to the high side in February, with a trade surplus of $1.2 billion. In the first quarter to date, the trade surplus totals $2.6bn. That is a sharp improvement from a deficit of $181 million in the fourth quarter and from a deficit of $3.3bn in the third. Export volumes are outpacing imports, as resource exports expand and given patchy domestic demand, in part reflecting the downturn in mining investment. Net exports will be supportive of GDP growth in the first quarter, extending a trend evident throughout 2013.

Taken together, retail sales and international trade prints suggest risks to our first quarter GDP forecast are tilted to the high side, absent significant surprises in the month of March. Although we caution that getting a firm fix on first quarter GDP is difficult at this stage, in part due to the uneven nature of growth at present and the uncertainties surrounding volatile investment spending. In the December quarter the investment numbers provided a number of surprises: new dwelling construction was disappointingly flat, business investment slumped, down 3.4 per cent and public investment rebounded, up 4.6 per cent.

Andrew Hanlan is senior economist with Westpac.

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