WEEKEND ECONOMIST: Nothing in reserve
Slowing mining investment and the line ball decision to hold rates last month, coupled with deteriorating business confidence and an underperforming manufacturing and services pick up, points to a rate cut.
The dominant theme that is likely to push the board into deciding to cut will be the perceived need to stimulate domestic demand to ensure that the non-mining sectors of the economy go someway to "filling the gap” in Australia’s growth profile which will appear as the mining investment boom slows down.
We expect that the bank’s assessment of the contribution from mining investment to Australia’s economic growth is broadly in line with our own estimates. It is likely to contribute 2.4 percentage points togrowth in 2012; 0.6 percentage points in 2013; and subtract 1.4 percentage point’s in 2014 as the level of mining investment falls in 2014.
From the perspective of GDP, the achievement of 3 per cent GDP growth in 2014 will be assisted by a turnaround in the contribution to growth from net exports from a drag of 0.25 percentage points in 2013 to a contribution of 0.5 percentage points in 2014 as imports of mining equipment slow and some projects begin production. (However we only expect growth in gas exports to increase by 5 per cent in 2014 with the big lift of around 50 per cent occurring in 2015 as most projects begin production.)
The forecasts indicate a solid recovery in non-mining business investment. Contribution to growth in 2012 is expected to be -0.6 percentage points with that swinging to 0.3 percentage points in 2013 and 1 percentage point in 2014.
In addition the consumer spending/housing sectors are expected to increase their contributions to growth from 1.9 percentage points in 2012 to 2.0 percentage points and 2.2 percentage points in 2013 and 2014, respectively. We assess that the lift in the contribution from the consumer/housing sectors will be constrained by a number of factors.
Firstly, we do not expect to see a reduction in the savings rate.
That will restrict consumer spending growth to the pace of growth of household incomes. In turn, employment growth is expected to remain subdued while wages growth is slowing. Lower interest rates will assist income growth at the margin but short of a most unlikely fiscal stimulus it is hard to see any substantial boost to household income growth.
We believe we have seen the early signs of an uplift in the housing sector through both prices and construction. But credit availability will be impacted by the banks’ funding challenges and the absence of substantial foreign lending or disintermediated debt.
That outlook highlights the importance of the forecast lift in non-mining business investment. Deteriorating business confidence is a particularly disappointing signal in that regard. Achievement of a "respectable” growth rate in 2014 of around 3 per cent (RBA’s current forecast) is expected to require a 1.6 percentage point turnaround in the contribution of non-mining business investment between 2012 and 2014. That compares with a 0.2 percentage point boost from the consumer/housing component.
Support for this rebalancing of business investment was not encouraging from the capex survey results, published on November 29.
There was strong growth in equipment investment in the September quarter, up 6.2 per cent. That was mainly driven by a 5.5 per cent jump in services investment in the quarter (up from -4 per cent in the second quarter).
However capex plans indicate that the services sector does not expect to build on that promising lift in the third quarter. We estimate that services sector capex plans for 2012-13 were downgraded to a decline of 3 per cent, down from a small rise of 1 per cent in the June estimate.
The story around mining and manufacturing is consistent for both the September quarter actuals and the 2012-13 plans.
Manufacturing investment contracted by 3.8 per cent in the second quarter and fell 9.7 per cent in the third quarter while 2012-13 plans were revised down to -17 per cent from -13 per cent (in June).
Mining investment increased by 2.8 per cent in the September quarter, moderating from a 10 per cent increase in the June quarter while 2012-13 investment plans were scaled back from growth of 33 per cent in June to 18 per cent in the September report. The survey took place in October/November – after the iron ore price had recovered from its August (second half), September (first half) lows. It would be risky to dismiss this mining signal as an overreaction to the August/September "panic” in the resources sector.
The overall picture from the capex release is that mining is slowing more rapidly than expected and that services/manufacturing is not positioning to fill the gap. Lower rates are needed to stimulate demand and accelerate this process.
Of course, we expected that the board would embrace this style of argument in November but were disappointed when it appears that it opted for more information around the cumulative impact of the 150 basis points of cuts which had already been implemented.
Discussion around the board’s so called dilemma is that the consumer is responding to lower rates but business is not. That should not be surprising since business will generally be guided by their assessment of expected sales which, in turn, will be largely driven by the confidence of their markets – the household sector.
A recognition lag is entirely reasonable. However, the risk for the outlook for the Australian economy is around the likely relative turnaround in household and business investment.
Recall, we expect that with mining investment (after adjusting for net exports) impacting a growth "turnaround” of around 3 percentage points between 2012 and 2014 that "gap” will be mainly filled by"consumer/housing” (around 0.4 percentage points) and business investment (around 1.6 percentage points).
Consumer/housing will be important to send a positive signal to business which will respond with a lag. The impact of consumer/housing will be limited due to consumers’ likely desire to maintain a savings rate around 10 per cent and funding constraints on banks.
Businesses are not constrained in that way with gearing levels low and their much lower reliance on bank funding.
There are considerable risks around this "smooth transition” scenario. Firstly, households may remain tentative, particularly given that they are still extremely cautious around their job security. Secondly, businesses may be unnerved by external factors – the ongoing high Australian dollar; and shocks to the global economy.
For our part those risks emphasise the need for further stimulus particularly given that interest rates are still only around 70 basis points below neutral. Positive signals from households are important for restoring business confidence. Imagine the profile for GDP growth in 2014 if business’ contribution did not turnaround. Growth of less than 2 per cent in 2014 would almost certainly be assured – policy would then need to be eased aggressively and the opportunity fora smooth transition from mining to non-mining investment would be lost.
On a final note, readers of this piece might be convinced that a rate cut next week is a very high probability. We hope that is so, although there is definitely a prevailing view in the market that the board is very reluctant to move given how far rates have come down. We find that interpretation inconsistent with the decision to include the following statement in the minutes of the last meeting: "members considered that further easing may be appropriate in the period ahead”. Choosing such direct language seems inconsistent with a board that has become reluctant to move. We expect that support around the board table for further moves is strong and that will be shown next Tuesday.
Bill Evans is Westpac's chief economist.