WEEKEND ECONOMIST: Contractionary tide

The past week has been an important week for the policy outlook.

We have received updates for consumer confidence, the domestic labour market and business conditions. Furthermore, the global landscape has taken on a decidedly more uncertain hue.

On consumer sentiment, July saw basically no change in overall confidence among households. With the index at 102.1, optimists still slightly outnumber pessimists, but confidence remains 7.6 per cent below its March 2013 peak.

The survey detail point to powerful ‘cross-currents’ beneath the stable headline result.

The components of the index tracking views on family finances fell sharply in July. In particular, assessments of ‘family finances versus a year ago’ fell 5.6 per cent to be back near recent lows.

In contrast, views on the outlook for the economy improved, with the sub-index tracking consumers’ expectations for economic conditions over the next five years surging 9.2 per cent to well above-average levels for the last two years.

Of similar concern was a downgrade in ‘time to buy’ views. All ‘time to buy’ indexes are still at high levels, but notable declines in ‘time to buy a dwelling’ and ‘time to buy a car’ (-8.4 per cent and -10.3 per cent respectively) clearly point to a degree of fragility in sentiment.

Pinpointing the exact drivers of these shifts is difficult.

It may reflect clearer signs of an upturn in parts of the local economy, the housing sector in particular.

The sharp fall in the Australian dollar may also have played a part – this would ordinarily be a negative for sentiment, but the decline may be viewed differently given the currency’s high starting point and the impact this has had on the ‘trade-exposed’ economy.

Political developments may well have been a factor as well, with Kevin Rudd replacing Julia Gillard as prime minister in dramatic fashion in the week before the survey.

Unemployment expectations also remained at an elevated level in July, the 3.6 per cent decline only partly offsetting the cumulative 13.5 per cent rise seen over the three months to June.

The trend level of the index is now 22 per cent higher than its long-run average, pointing to a weak outlook for full-time employment and total hours worked.

By state, the largest deterioration has occurred in the mining regions. Western Australia is now equal with Queensland in being the most pessimistic state on the labour market.

Given the entrenched caution over the labour market, it was not surprising to see the unemployment rate rise to 5.73 per cent in June, up almost 0.2 percentage points from May. Driving the increase was a 34,100 rise in the labour force, only partly offset by 10,300 new jobs.

The mix of jobs was also weak, with a 14,800 rise in part-time jobs obscuring the loss of 4400 full-time jobs.

Sample roll issues continue to create volatility, but there is a clear modest uptrend in unemployment. There is little reason to suspect a marked change in employment prospects and/or investment activity in the foreseeable future; rather, the risks remain to the downside for activity and employment.

According to the NAB survey, June saw business conditions and capacity utilisation slump to the weakest readings since 2009: business conditions fell four points to -8, well below its historic average of zero; and capacity utilisation weakened to 79.3 in the month, continuing a downward trend apparent since first quarter 2012. Confidence ticked a touch higher in the month, but it remains below trend.

Forward orders continue to point to a poor out-turn, with the index at -5 in June. In June, business conditions fell sharply in mining, manufacturing, retail and wholesale; they also trended lower in recreation and personal.

In contrast, finance, property and business experienced a bounce following a run of disappointing monthly reads. By state, business conditions were negative and weakened across the four largest states. Clearly there is a strong, broad-based case for further policy accommodation to support domestic demand. Before concluding, we must make mention of the global economic developments of the past week.

Firstly, the IMF has revised down its global growth forecasts, bringing them more into line with our own, and giving the Reserve Bank easing bias further support. That said, as is to be expected, the IMF remains more optimistic for 2014, anticipating an end to Europe's recession and a strengthening in US growth.

Our expectation is that this view will prove too optimistic. In Europe, S&P’s downgrade of Italy’s credit rating to BBB (the second lowest investment grade rating) with a negative outlook has added to the growing unease over the region’s financial and political stability.

Political uncertainty in Portugal and Spain has also (unsurprisingly) come back to the forefront of market participants minds. Conditions in both nations are bleak; this is also the case in Greece and Cyprus. We believe activity is likely to continue to contract in 2014 and that there are many downside risks.

In recent days, the focus has clearly been on the US. Following the release of the June FOMC minutes, market participants briefly pounced on the comment that "about half" of the 19 participants would like to end assets purchases altogether by the end of the year – clearly a hawkish view.

However, the reality is that this count included all 12 of the regional Fed governors (who are typically hawks), seven of whom are non-voters in any given year.

Taking a broader look at the FOMC minutes, it left much open to interpretation, with "several" of the 12 voting members believing a reduction in asset purchases would soon be warranted, but "many" members wanting to see further improvement in the labour market before acting, and "some" also wanting to see confirmation of the expected acceleration in growth.

Since the June meeting, we’ve had a stronger than expected June payrolls report, but second quarter GDP (due in late July) is shaping up to be even softer than the first quarter's subdued 1.8 per cent annualised pace.

As such, it is far from clear that a majority of members will be over the line by the September meeting – something the market seems to be treating as a done deal.

Indeed, based on Bernanke’s dovish comments in his post-speech Q&A on Wednesday, a tapering of Fed purchases in the foreseeable future seems anything but likely.

All else equal, the chief consequence of such an outcome would be greater support for the Australian dollar – as was the case in the immediate aftermath of said comments.

The Reserve Bank board next meets on August 6. The case for a further 25 basis point cut in the cash rate has clearly been made on the activity front. All we now wait for is comfort that inflationary pressures remain benign. The trend apparent in the Melbourne Institute’s consumer inflation expectations survey and our forecast for the second quarter CPI (due July 24) is consistent with this notion, paving the way for an August cut.

We continue to expect two further follow up moves, the first in the December quarter, the second early in the new year, taking the cash rate to 2 per cent.

Elliot Clarke is an economist at Westpac.