Since late February I have spent four of the last five weeks offshore visiting customers and government officials.
The first trip was to North America (two weeks) and the second was to Asia (two weeks; six countries).
The view in North America was overwhelmingly for a US economy that would register 3 per cent plus growth in the final three quarters of 2014. The key justification for that view was the strong state of US corporate balance sheets. Another common view at that time (probably since revised) was that the Australian dollar was likely to trade down to the "low 80s". There was also a high degree of scepticism around the state of the Chinese economy, with quite a few people seeing similarities between the Chinese shadow banking system and the build up to the Lehman financial crisis in 2008.
Some of the more thoughtful analysts gave more attention to weak household income growth – a key issue from my perspective. Indeed unless "corporate America" uses its strong balance sheet to boost employment; household income growth and investment, the sustained lift in growth that is expected to stem from strong corporate balance sheets will prove to be ephemeral. History has not been kind in that regard. To date, strong corporate balance sheets have been leveraged into share buy backs; acquisitions and offshore investment. To be sure the US "energy revolution" has led to solid increases in investment in some energy intensive industries such as chemicals, but the aggregate data does not point to a lift in business investment of the scale that would be expected to be associated with strong corporate balance sheets.
Real consumption per capita has been growing at a faster pace that real income per capita, which has averaged below 1.0 per cent per year over the past two years. This has been accommodated by a fall in the household savings rate to levels from which it is unlikely to fall much further. In short the expected lift in the growth momentum of the US economy will hinge on income growth. In that regard the evidence is not convincing; it seems likely that US consumer spending will lose some momentum through 2014. That said, a surprise lift in household income growth would significantly improve prospects for US growth. We expect that employment and income dynamics are currently dominating the thinking of the Federal Reserve. Issues around "financial stability" are likely to be less important for policy – after all, a key aim of the quantitative easing policy has been to encourage more risk taking. If the income and spending profiles for the US evolve as we expect, then the Fed will strongly consider pausing the tapering process in the summer or early fall.
Readers will be aware that following my return from the US we decided to revise our long held call for more rate cuts in Australia in the second half of 2014. While the obvious lift in dwelling approvals and the associated building boost was a factor, the key reason was evidence that the pace of consumer spending had lifted and that the household savings rate, which had held at 30 year high of around 10 per cent, had moderated. Evidence around consumers' savings decisions; and an improved outlook for jobs growth, as indicated by the business surveys, pointed to a more constructive outlook for consumer spending going forward. Similar issues to the US with household income growth being heavily constrained by weak wages and employment growth are also apparent in Australia.
However, improving business conditions in surveys; a clear wealth effect from rising house prices, which is likely to boost spending and lower the savings rate, and evidence from the Westpac–Melbourne Institute Index of Consumer Sentiment that households are becoming less risk averse all point to a more constructive environment for consumer spending. In contrast to the US, Australia has adequate scope for its high savings rate to accommodate stronger consumer spending despite constrained income growth. However, this environment is unlikely to be conducive to rate hikes earlier than in the second half of 2015. Through 2014 we expect weak income growth, with an associated rising unemployment rate; soft wages growth and benign inflation.
With this revised view on the interest rate outlook I embarked on a busy two weeks in Asia.
Issues in Asia were more focused around the Australian dollar and commodities. Discussions in China emphasised that the economy was facing a more "difficult" year than 2013. However, concerns around the shadow banking system were significantly underplayed, with the dominant role in shadow banking of off balance sheet vehicles of banks largely financing local government and major government infrastructure projects being emphasised by the authorities. The plan to rebalance the economy towards consumption has been accepted, but the "values" of the authorities being "control" and "stability" emphasise that any threat to those "values" would soon be dealt with by direct policy intervention – most likely a reversion to "old style" stimulus policies albeit at a much more modest pace than in 2009.
The overall conclusion is that China's growth will decelerate but a damaging financial crisis or any uncontrolled sharp growth deterioration can be ruled out. We feel that, eventually, this "difficult” and “decelerating" China story will weigh on the Australian dollar, although until it does, there are obvious upside risks for the currency relative to our forecasts in the short term. We retain our December 2014 target of 88¢.
Bill Evans is Westpac chief economist.