WEEKEND ECONOMIST: Watching for recovery

The first sectors to emerge from the recession will be cyclical spending including housing and motor vehicles. But the depth of the financial crisis will delay the normal recovery time for these industries.

I am visiting our European and United Kingdom customers over the next two weeks. Set out below is the message I will be giving them about the Australian economy:

The Australian economy is now in recession. Westpac's forecasts are close to the Reserve Bank's and the Government's. We expect that the economy will contract in each of the first three quarters of 2009 to be followed by a particularly anaemic recovery beginning in the December quarter. Growth of around 0.2 per cent is expected for the December quarter with the first half of 2010 showing only a 1.5 per cent annual pace. Westpac, the RBA and the Government expect growth in the second half of 2010 to improve to a still below trend 3 per cent annualised pace.

That growth pace will put no pressure on resources with ample spare capacity being accumulated as the unemployment rate increases from the current 5.5 per cent to near 9 per cent by end 2010. We expect that under such a benign recovery environment there will be scope for the monetary authorities to cut rates by a further 1 per cent while there will be no pressure to raise rates until 2011.

With markets priced for flat rates in 2009 and rate hikes totalling around 100 basis points in 2010 from early 2010 there is scope for fixed rates to fall and some downward pressure on the Australian Dollar. That pressure will be supported by the expected market disappointment at the pace of the global recovery as the slow recovery in the global financial system constrains the capacity of economic agents to finance any increase in demand that may result from the aggressive fiscal and monetary stimuluses.

Australia's economic environment over the course of 2009 will be marked by falling business investment and a contraction in jobs. Businesses tend to respond to a slowdown to the growth pace of their sales and profits with a lag of around six-to-12 months. Consumer spending was particularly weak throughout 2008 and despite aggressive rate cuts and Government handouts is expected to remain very weak in 2009. In fact, we estimate that the Government is expecting three consecutive quarters of contracting consumer spending in 2009.

However, the big jolt will be in business investment and employment. Collapsing confidence, limited credit availability, and weak sales and profits will see businesses cutting right back on investment and employment plans. The slowdown will initially be concentrated in non-residential construction and equipment. Approval data points to a sharp run-off in mining investment in 2010. Jobs growth typically lags spending by six-to-12 months and while we
expect the most severe period of job losses to be over the next 12 months the unemployment rate is unlikely to peak until well into 2011.

The first sectors to emerge from the recession will be cyclical spending including housing and motor vehicles. Those folks who are currently sharply building their savings with the prospect of losing their jobs will gradually relax that behaviour as they become increasingly confident about job security if they "survive the danger period". However, the financial crisis will delay the normal recovery time for these sectors as credit for multi-unit developments and motor vehicles remains tight.

Australia's capital markets are set to take on a very different character as private sector demand for credit contracts and the supply of Government bonds explodes. Australia's supply of Commonwealth Government bonds is expected to increase from around $50 billion to near $200 billion by 2012 while the supply of semi-government securities is expected to increase from around $100 billion to $200 billion over the same period. However, Australia's prospects of returning to budget surpluses by 2015 are reasonable. That would allow for the volume of net debt to peak at around 14 per cent of GDP compared to 80 per cent with doubtful prospects for stability in the majors.

Nevertheless, yield curves are likely to steepen as central banks deal with the immediate concerns of avoiding deeper recessions and keep short rates low while markets look towards a burgeoning bond supply. We do not expect central banks to see the need to start raising rates before 2011 when they will make aggressive moves to return to neutral (rates up around 3 per cent in both Australia and US). That will see an appropriately sharp bear flattening of the global curves.

The timing of Australia's return to pre-recession levels of activity is expected to be midway between that which would be expected for a typical commodity price/interest rate/fiscal policy driven recession and a full blown financial crisis style recession. It is true that Australia's banking system is sound but there are other aspects to a financial crisis which are affecting Australia. These primarily relate to Australia's over reliance on foreign capital through the direct involvement in the domestic economy of foreign banks and the banks' excessive funding reliance on foreign capital markets.

Restrictions on the supply of new credit and a sharp rise in funding costs are both constraining economic activity through reduced availability of credit and sharply higher funding costs. The strong balance sheets of the domestic banks and the predominant floating rate nature of the Australian mortgage market have allowed an efficient pass through of aggressive easing in monetary policy to private sector borrowing rates. That has substantially improved the potential cash of borrowers while aggressive fiscal stimulus has supported that position.

Not surprisingly, households have sharply increased their savings to improve balance sheet quality in expectation of rising unemployment. Large rate cuts have also substantially improved the affordability of housing. Improvements in affordability in the US and the UK have mainly come from price reductions. A strong loop back effect on the Australian economy from tumbling house prices to confidence; wealth; jobs and financial stability remains a risk but we expect that affordability has now improved sufficiently to sustain house price stability.

We are sceptical about the outlook for commodities. The recent 30 per cent rise in base metal prices should not be seen as the beginning of a strong cyclical up swing. This move, in our opinion, reflects a recovery from the excessive pessimism earlier in the year when markets feared the nationalisation of the US banking system and questioned China's capacity to engineer a recovery. That Chinese recovery is now underway through a boom in infrastructure investment. With exports contracting rapidly and mixed evidence of a recovery in property markets the challenge for China will be to broaden the recovery from the public to the private sector. Certainly, the spending multipliers of infrastructure investment are low. The spectacular growth in bank lending must also be tested for its degree of penetration into the private sector with concerns that the low-risk state owned enterprises are dominating the supply of credit.

However, China cannot engineer a sustained recovery in commodities on its own. Our view is that because the recovery in the developed economies will be slow and patchy, prospects of a sustained upswing in commodity prices in the near term are limited.

Bill Evans is chief economist at Westpac Banking Corporation.

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