WEEKEND ECONOMIST: Consumed by Europe

The Westpac Melbourne Institute index of consumer sentiment increased by 0.3 per cent in June. That was another disappointing result. It follows a second consecutive cut in the official cash rate by the Reserve Bank. Sentiment has risen only 1.1 per cent from its April level and remains 1.7 per cent below the level recorded in October last year despite a 125 basis point reduction in the cash rate that has brought the average standard variable mortgage rate down by nearly 1 per cent.

Clearly other factors are dominating rates in the minds of consumers – those factors are concerns about the domestic economy and international conditions.

The June survey included additional questions on ‘news' categories recalled and whether news was assessed to be favourable or unfavourable. The results show negative news around the economy and international conditions dominated.

By far the highest recall was on news about ‘economic conditions' (67.1 per cent of respondents) and ‘international conditions' (40.4 per cent). The recall level on economic news was the highest since 2009 and roughly double that of news items on ‘interest rates' (31.8 per cent) and ‘budget and taxation' (34.7 per cent). The recall on ‘international conditions' was second only to the record high registered in December last year. Consumers continued to view news on both ‘economic' and ‘international' conditions as very unfavourable with the latter seen deteriorating sharply since March.

Over this last week I have been visiting customers in Europe and the UK. My disturbing impression, to date, has been that meetings have not imbued me with any comfort that there is a clear logical plan for European stability. There seems to be no real consensus around whether Greece will leave the euro; what might be the necessary policy initiatives required to keep Greece in the euro; whether Greece matters or the debate has moved on to Spain and Italy; any hard evidence on the flight of retail deposits from Spanish and Italian banks; and, most importantly, the state of the debate in Germany. The realists accept that the trade-off for Germany is whether it is prepared to underwrite fiscal consolidation including eurobonds and a substantial inflation boost or whether it is accepting of the alternative that would involve a break-up of the euro and a huge loss of competitiveness through a sharp appreciation of the new deutschmark. In that regard, I will be visiting Germany next week and might get a better appreciation of this definitive issue.

In short, I have not seen anything yet to sway my view that Europe is likely to be a series of rolling band-aid bail outs and crises while the Germans contemplate their options. Of course that situation cannot go on indefinitely as the combination of austerity, credit restrictions, social unrest, and low confidence will deepen Europe's growth woes.

From the perspective of Australia's households their confidence levels, which are impacted by European news, are likely to fluctuate depending on whether we are in a crisis or bail out phase. The sentiment index of 'news heard on international issues' deteriorated from a low of 33.1 in March after the €2 trillion bailout by the ECB to an extreme low of 20.0 as speculation around a Greek exit builds.

Across the five sub-indexes of consumer sentiment, two improved and three deteriorated. Lower interest rates saw a solid rise in the sub-index tracking responses on ‘family finances versus a year ago', up 4.6 per cent after a 17 per cent rebound in May, and the sub-index ‘time to buy a major household item', up 7.5 per cent. However, June saw a significant deterioration in the sub-index tracking consumers' forward views on their family finances, down 7.7 per cent. Remarkably, this sub-index is now lower than July 2008, its low point during that GFC period. The sub-index tracking views on the ‘economic outlook over the next five years' fell 3.8 per cent.

Responses to questions on ‘time to buy a dwelling' and ‘time to buy a car' both showed an improvement in June, with these indexes rising 8.2 per cent and 7.5 per cent respectively. Lower interest rates and lower prices are clearly improving affordability and buyer sentiment on both fronts, although buyers will tend to be reluctant to follow through on purchases while there are concerns about the economic outlook and job security.

In that regard The Westpac-Melbourne Institute unemployment expectations index deteriorated further in June, continuing a trend which emerged during the first half of 2011.

The Index rose by 3.2 per cent in June and jumped 18 per cent over the last year, indicating that households have become increasingly worried about the labour market. The Index is now at 151, up 39 per cent from the level prevailing at the start of 2011. An Index reading around 151 is relatively high by historical experience. It is on a par with the peak during the synchronised global downturn of 2001. The index is well below the peak during the 2008-09 period.

Of course these confidence results seem at odds with the extraordinary boost to consumer spending which printed in the national accounts for the March quarter of 2012. Consumption was up by 1.6 per cent in the quarter. There are a number of factors which qualify our assessment of the relevance of this result. Firstly, the largest boost came from food where prices actually fell during the quarter, thereby providing a temporary boost to real spending power. Also, there may be measurements issues, with prices understated and volumes overstated. There was also a curious 2.5 per cent jump in nominal wage income (10 per cent annualised) which seems unusual given flat employment, an increase in the wage price index of only 1 per cent in the quarter, and a reduction in hours worked. Our view, partially supported by a contraction in nominal retail for April, is that this boost is unlikely to be sustained and with three soft prints for sentiment since that March quarter splurge a marked slowdown in spending can be expected in the June quarter.

The Reserve Bank board next meets on July 3. On May 31 Westpac revised down its forecast for the low point of the official cash rate in this cycle from 3.25 per cent to 2.75 per cent. That was in response to a further deterioration in the global economic outlook and our assessment that confidence in the domestic outlook had continued to soften despite further rate cuts. Evidence from the June survey confirms the fragility of confidence and the critical role played by the global economic situation in impacting confidence.

Our interest rate view includes a likely further cut at the meeting in July. However, with the surprisingly strong GDP print for the March quarter, the board may choose to delay the next move until after the next inflation report due out on July 25. That decision will be heavily dependent on global developments over the next three weeks. At this stage we are comfortable in maintaining the July call while emphasising that the case for an eventual cash rate of 2.75 per cent remains robust.

Bill Evans is Westpac's chief economist.