Weekend Economist: Pessimism pervades

The Westpac Melbourne Institute Index of Consumer Sentiment rose by 1.9 per cent in November from 94.8 in October to 96.6 in November. The Index is 12.5 per cent below its level of a year ago and 3.6 per cent below its level before the lead up period to the Commonwealth budget in May. In fact, we have now seen nine consecutive months where pessimists have outnumbered optimists. That is the longest run of pessimists outnumbering optimists since the Global Financial Crisis and before that the recession of the early 1990s.

The modest increase in the Index may be attributed to more positive news on the financial markets. The Australian share index has lifted by an impressive 5 per cent since the last survey, while the Australian dollar has stabilised following its 7 per cent plunge in September. The Reserve Bank's decision to hold rates steady came as no surprise with households generally comfortable that low interest rates are likely to persist for some time. Households will not have been impressed by the confusing news around the official employment reports. Following major data revisions from the Australian Bureau of Statistics the unemployment rate was revised up from 6.0 per cent to 6.2 per cent. Previous assessments that the unemployment rate may have stabilised around 6 per cent have now had to be reconsidered.

That disappointment is likely to have impacted the Westpac – Melbourne Institute Unemployment Expectations Index. The Index increased by 2.7 per cent in November (a higher print indicates that respondents are more pessimistic about the labour market). That result is particularly disappointing given that it followed a promising fall of 3.9 per cent in October. This Index is now 5.5 per cent above its level of a year ago and 17.2 per cent above its level of three years ago when the Reserve Bank started its most recent cycle of rate cuts.

This slow recovery in the Index is disappointing for our economic forecasts. We expect GDP growth to hold in 2015 at 3.2 per cent and lift to 3.5 per cent in 2016. That will be driven by a lift in household spending. In particular we are looking for consumer spending to lift from the 2 per cent annualised pace that printed in 2014 H1 to 2.8 per cent in 2014 H2 and 3.4 per cent in 2015.

Recall that in 2013 H2 consumer spending had lifted its growth pace from 2 per cent (annualised) in 2013 H1 to 3 per cent in 2013 H2.The slowdown in 2014 H1 coincided with a fall in the average print on Consumer Sentiment from 107 in 2013 H2 to 98 in 2014 H1. Much of that slowdown can be attributed to a sharp adverse response to the May Commonwealth budget including during the lead up period where consumers were unnerved by media talk of a fiscal crisis and the need for a tough budget.

Although the improvement has been slow the index has recovered from its post budget low by 4 per cent and we expect further improvement over the course of next year. The government has indicated that there will be a need to revise up the forecast budget deficit in the government's MYEFO statement. (Currently the forecast budget deficits are $29.8bn in 2014/15 falling to $17.1bn but they are based on an iron ore price of around $US100 per tonne by end 2014 whereas the current spot is around $US75 and Westpac's forecast by year's end is $US80.) 

Some commentators have speculated that the deficit forecast will have to be revised up to around $37bn in 2014/15 and $25bn in 2015/16. However, the government has indicated that it will not introduce additional savings measures to offset that slippage. That approach is likely to bolster confidence as the government seeks to restore some growth momentum.

In particular we are relying on the wealth effect to boost consumer spending. Australians' wealth has been boosted by $1.6trn over the last 3 years – mainly in superannuation and housing. There appears to be a reasonable link between rising house prices and consumer spending. The states with the fastest growth in consumer spending are also the ones with the fastest rising house prices. With the Reserve Bank not set to raise rates until the September quarter of next year and house prices likely to maintain solid upward momentum the wealth effect is likely to provide an important boost to overall consumer spending growth.

The survey has also highlighted the ongoing concern which households have with jobs. Our research shows a key jobs growth relationship that indicates household spending (consumption and residential housing investment) leads employment growth by 6 months. The expected lift in spending momentum is set to boost employment which in turn will lower the unemployment rate and signal improving job prospects to households.

We expect the unemployment rate to peak at 6.3 per cent by early 2015; reach 5.9 per cent by end 2015; and 5.2 per cent by end 2016. The wealth driven boost to consumer spending will be important in this regard.

Bill Evans is a chief economist at Westpac