WEEKEND ECONOMIST: Stuck in third gear

Australia is facing a challenging 18 months, with a mining investment peak, rising unemployment and worse-than-expected world growth set to keep monetary policy frozen.

I am meeting with international investors over the next two weeks. The report below summarises our key discussion points on the Australian economy and markets.

Growth in the Australian economy is likely to slow through 2013 and 2014. We expect average growth to slow from 3.6 per cent in 2012 to 2.5 per cent and 2.3 per cent in 2013 and 2014 respectively. The key theme will be the inability of private demand to respond sufficiently to low interest rates so as to adequately fill the gap in demand created by the sudden slowdown in mining expenditure over the course of 2013 and 2014.

Mining expenditure is likely to peak in late 2013 to early 2014, with mining spending swinging from a major contributor to growth in 2012 to a drag in 2014.

The expectation from the authorities is that non-mining investment and household spending will respond to lower interest rates and accelerate to fill the void. Some evidence has been building, with consumer confidence rising by 6 per cent since October; however, business confidence has been flat. Investment, employment intentions and house prices appear to have stabilised, but manufacturing, in particular, remains weak. Households are concerned about job security. A recent pullback in equity markets, associated with European developments around Cyprus and the surprise slowdown in China’s growth rate have unnerved consumers around the global economy.

Businesses are responding to soft demand, with plans to improve efficiency and limit expansion plans. With 2013 being an election year, both households and business are being impacted by political uncertainty. Indeed, political issues have dampened confidence; that is unlikely to pass until well beyond election day (September 14) as businesses, in particular, scrutinise the policies of the winner.

Fiscal policy stands as a significant headwind to a more robust response by the economy to low interest rates. In previous easing cycles, fiscal policy has supplemented monetary policy; this is particularly true of the housing market, with direct subsidies to first home buyers. In this cycle, FHB subsidies have been reduced or restructured in major states and FHBs have failed to respond. Investors and upgraders are being required to "carry" the recovery. To date, an encouraging response from investors has been limited to NSW, with diverse regional conditions highlighting considerable difficulties in engineering a nationwide boost to property activity.

House prices have shown some evidence of responding to near record low rates but, to date, the evidence is patchy. House price expectations have recently been boosted, although new entrants to the market are already being discouraged by affordability and concerns around rising rates.

Australia's unemployment rate has edged up slightly, despite near record low interest rates. Signals around the February and March jobs reports were confusing with 74,000 jobs added in February, but 36,100 jobs lost in March. For us, the key message was in the unemployment which remained steady in February, but jumped from 5.4 per cent to 5.6 per cent in March. Lead indicators point to ongoing labour market weakness in 2013. The unemployment rate is likely to exceed 6 per cent by early in 2014, and the employment to population ratio is likely to fall further.

Under these circumstances, the output gap will widen and inflation pressures are likely to ease. Efficiency gains by firms, limited demand pressures, and an Australian dollar which remains elevated will contain inflation pressures. To date, it appears that both parties are insisting on maintaining tight fiscal policy, placing unnecessary fiscal pressure on the states who are responsible for the bulk of the much needed infrastructure boost, and the provision of most public services.

In 2012, job losses in the government sector have been considerable, being exceeded only by losses in the construction sector. Recent price action has the market forecasting that there will be one more rate cut of 25 basis points by August 2013. We expect a further rate cut in June, and an extended period of rate stability. We cannot see a rate hike in 2013 or 2014.

That view is consistent with our growth outlook. With inflation pressures contained and growth forecast to be below potential, there is a respectable case for this expected policy support. Whether a second round of rate cuts begins in 2014 will be determined by the state of the global economy. Our view is that the risk outlook favours 'disappointment' for the globe in the 2013 second half and 2014. The IMF is forecasting world growth in 2014 of 4 per cent, up from our forecast of 3.2 per cent. This boost is based on expectations of solid momentum in China, European stability, and a lift in the pace of underling private demand growth in the US. The reality is likely to be less encouraging, with China's growth plateauing in response to policy restraint, Europe remaining in recession for another year, and US growth being contained in the 1-2 per cent range as excessive sovereign and household debt constrain confidence.

In Europe and the US, governments will overreact to high sovereign debt and banks will continue to restrict the availability of credit. Accordingly, while our central forecast is for one more rate cut to be followed by a long period of rate stability, there are genuine risks favouring a renewed easing cycle in 2014. Australian government bonds are likely to outperform other markets, while Australian semi-government bonds should improve their relative attractiveness to both supra-nationals and Commonwealth bonds.

Under this scenario, we look for a marked downshift in global commodity prices around the second half of 2013 and into 2014. Slowing global demand and increased supply, which has been responding to rising demand in the first half of 2013, will dictate this downshift.

We expect that the Australian dollar, after reaching around $US1.04 by mid year will be on a down trend through the remainder of this year and into 2014 ($US1.01 by December this year, and $US0.97 by June 2014). Narrowing rate differentials, softening commodity prices, and elevated global risk will be headwinds for the Australian dollar. However, ongoing QE policies in the US through this year and next, complemented by aggressive balance sheet expansion by the Bank of Japan and (in time) the ECB will continue to keep the Australian dollar overvalued when compared to 'normal' relationships with interest rates, commodity prices and the current account deficit.

Bill Evans is Westpac's chief economist.


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