WEEKEND ECONOMIST: Non-mining malaise

The latest Westpac-ACCI survey of industrial trends clearly shows that Australia's non-mining economy is struggling. This fact, combined with a weak labour market, leaves plenty of room for another rate cut.

In the March quarter, the Westpac–ACCI actual composite edged lower to 47.4. The index has now been in the sub-50 contractionary zone for a year, averaging 48.1 during that time. That is well below the year to March 2011 average of 54.3, but is still well above the low levels seen in the midst of the global financial crisis. The sub-50 readings for the actual composite over the past year have pointed towards weak conditions in the sector and, more broadly, a deceleration in domestic demand growth – a trend that has also been evident in the national accounts data.

Domestic demand growth was weak in the fourth quarter (Q4) of 2011, rising by only 0.2 per cent – the slowest pace of growth since Q2 2009. Taking a broader perspective, although Australian growth outcomes have been better than most other advanced nations, Australian growth has still been stuck at a sub-trend pace for four years.

Given the persistent weakness in the actual composite, it is not surprising that the net capacity utilisation indicator remained well below 'normal' at – 21 per cent in Q1 2012. Indeed, this indicator suggests that the manufacturing sector has been working below its 'normal' level of capacity utilisation for almost four years.

In contrast to the actual Composite, the expected composite rose in the March quarter to 51.6, a level consistent with expectations of modest expansion. In the past six months, the expected composite has retraced a third of the 15 point decline that occurred over the six months to September 2011.

Despite improving in the quarter, manufacturers remain pessimistic about the future: a net 11 per cent of respondents expect the general business situation to deteriorate in the next six months; that is well below the average level of the two years to March 2011 (the previous peak) of 19 per cent, the decade average of minus two per cent and the full history average of two per cent.

Looking at the overall economy, mining investment is expected to continue to provide strong support for growth in 2012 and beyond, but the non-mining sector is weak and in need of further stimulus. We expect economic growth to maintain a sub-trend pace over the first half of 2012 before easier monetary conditions provide a boost to conditions. Labour market conditions will be key to the outlook for the economy and the Reserve Bank of Australia's (RBA) policy stance.

On the employment front, the labour market composite improved a little in the March quarter, rising from –8.5 per cent to –7.0 per cent. The level of this index is consistent with annual employment growth of less than one per cent over the next six months. Also, the proportion of respondents reporting labour as "harder to get" in net terms was unchanged at minus four per cent. Both of these metrics are consistent with our expectation that the labour market will remain weak, resulting in an increase in the unemployment rate to around 5.7 per cent in the next three to six months.

Consistent with the soft labour market conditions, net wage growth expectations edged down in Q1 2012: Five per cent of respondents now expect their firm's next wage deal will produce a smaller annual wage rise than the previous deal. The last three net balance prints for this measure are a stark contrast to the outcomes of the prior 18 months which averaged 10 per cent. The Westpac–ACCI measure is pointing to a material softening in the ABS' Wage Price Index in the next six months.

Profit expectations again firmed modestly in Q1 2012, with a net 4 per cent of respondents now expecting their firm's profitability to improve over the coming year. It is apparent that firms have been less optimistic about their profitability over the past year than has historically been the case. Arguably this is a function of the strong Australian dollar and healthy wage growth. It is interesting to note that as manufacturers' wage expectations have softened in the past six months, profitability expectations have improved.

However, it is clear that manufacturers face additional cost pressures. In Q1 2012, the average unit costs net balance remained elevated at 20 per cent in Q1 2012. Manufacturers expect unit cost pressures to persist in Q2 2012.

Manufacturers are facing additional pressures owing to a lack of pricing power. On balance, average selling prices were reported to have declined further in Q1 2012 by four per cent of respondents. Average selling prices are expected to gain a reprieve in Q2, with a net one per cent of respondents expecting an increase in prices. This expectation is principally a function of less respondents expecting further declines in selling prices.

All told, the current environment is not one that is conducive to a robust improvement in manufacturers' profitability, even though wage pressures seem to be abating. Turning to investment, manufacturers' plans for plant and equipment investment in the next 12 months were little changed in Q1 2012, with a net six per cent of respondents planning to reduce their spending on equipment. Spending plans for buildings firmed modestly, but remained negative: a net 10 per cent of respondents expect to reduce building investment in the year ahead.

This is the fourth consecutive negative net balance for buildings and the third for equipment, highlighting an entrenched unwillingness amongst manufacturers to expand their operations.

The actual composite has also had a good fit with economy-wide plant and equipment investment. In this cycle, the recovery in business equipment investment lagged the actual composite, but the deterioration in the index over the past year has not been followed by a deceleration in equipment investment growth. This is not that surprising when one recognises that it is the mining sector that is driving the current surge in business investment. The 2011 CAPEX data highlights the importance of the mining sector: in Q4, mining CAPEX spending was up 78 per cent over the year; in contrast, nonmining CAPEX was up 3.3 per cent for the year.

In sum, this survey has again emphasised the weak state of the non-mining economy. Indeed, whereas international measures of manufacturing activity, for example the manufacturing ISM, picked up in Q1 2012, our Westpac–ACCI actual composite deteriorated further. Clearly the strong Australian dollar is having a material impact on Australian manufacturers and, more broadly, the non-mining economy. With activity lacklustre and the labour market weakening, there is a very real need for looser financial conditions. We expect the RBA will respond by easing policy, beginning in May or June.

Elliot Clarke is a Westpac economist.

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