WEEKEND ECONOMIST: Confidence trick?

The 191st Westpac–ACCI Survey of Industrial Trends was closed in the week ending June 12, amidst a backdrop of encouraging 'green shoots' of a global recovery, relative resilience in the Australian economy with significant fiscal policy support, improved housing indicators and a reduction in the perceived difficulty of obtaining finance.
The Actual Composite Index rose 3.9 points to 38.3 points, partially reversing a 6.9 point fall previously, but remains well below 50 consistent with contracting activity in the second quarter of 2009. It also remained at a level not consistently seen since the 1990-91 recession, below its decade average (52.3) for the fourth consecutive quarter, and was broadly in line with predictions in the prior survey's Expected Composite Index.

The less-bleak economic backdrop saw some improvement in expectations, driving the Expected Composite Index 12.3 points higher to 47.6 (highest since the third quarter of 2008). However this level remains consistent with a further (albeit milder) contraction in the third quarter of this year, below its decade average (52.8). General business sentiment surged 57 points (greatest improvement since 1975) to -4 (highest since the fourth quarter of 2007).

Labour demand indicators improved moderately, but remained consistent with a sharp slowing in jobs growth through the second half of 2009 and a rise in the unemployment rate eventually beyond 8 per cent. The Labour Market Composite net balance rose 8 points to –25, historically consistent with –1.5 per cent annual jobs growth. Perceptions of labour market tightness rose slightly, but only to their second lowest level since the first quarter of 1992.

Surprisingly, credit conditions eased, although the proportion seeing finance as a constraint remained at a 34-year high. However, an overwhelming majority continue to rate insufficient orders as the most significant constraint.

With improved business expectations, investment plans firmed somewhat, but remained historically weak, still consistent with falling investment through the year ahead. Selling prices continued to fall and unit cost pressures are easing, but pressure on profit margins remained strong.

This survey is consistent with other surveys on business conditions we have seen recently both for Australia and the US. The Actual Composite Index, which provides a guide to the respondent's assessment of current business conditions, has improved from the depths of the March quarter but is still firmly in the "contractionary" territory. In turn, investment intentions and capacity utilisation have improved somewhat but still point to a heavy load of excess capacity.

The broader measure of Confidence (outlook for the general business situation) has improved dramatically but we are a little suspicious that it may be exaggerating the improvement. Respondents are probably only recognising that things are unlikely to get any worse than in the March quarter rather than declaring a robust future.

We have always preferred the Composite Index to the "General Business situation” measure as a guide to the improvement in conditions. This ‘gradual improvement' theme is also apparent with the Labour Market Composite which has improved somewhat but is still pointing to a sharp slowing in the labour market and associated deterioration in the unemployment rate. Consistent with that is the measure of labour availability, which has improved a little but is still
the second lowest measure since 1992.

Both prices and costs are expected to fall. Contrary to the commonly quoted inflation scare the greater risk is deflation as excess capacity and rising unemployment both domestically and offshore contain any inflation pressures.

Westpac is surprised by current market pricing which is pointing to rate increases of around 150 basis points by end 2010. It is far more likely that rates can fall further rather than rise in the current environment.

Bill Evans is chief economist at Westpac.