When will the next rate rise come?

While headline news regarding the economy has been bleak, December quarter GDP showed the economy is not collapsing and lower interest rates & the lower $A do seem to be boosting forward indicators for the economy.

February seemed full of bad news in Australia with layoffs coming from various companies including Toyota, Alcoa and Qantas, unemployment rising to 6% and very poor business investment intentions. And yet, the share market rose 4.2% last month and has had two good years and December quarter GDP growth even perked up a bit. So is the outlook as bad as the headlines suggest or has the share market got it right? In part the share market has taken comfort from earnings results released in February so we will start there.

Profits tuning up

After two years of falls, the December half profits needed to start to turn up in order to meet market expectations for a circa 13% uplift in profits this financial year, making February an effectively make or break reporting season. In the event, the profit cycle has turned up right on cue, albeit led by the large miners and the banks, and so market expectations look to be on track.

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Overall results were solid:

• 50% of companies exceeded expectations (compared to a norm of 43%);
• 66% of companies saw their profits rise from a year ago, with strong results from miners and banks seeing overall earnings rise nearly 15% over the year to the December half, with a near 40% gain for miners. This compares to a 0.5% fall over the year to the June half;
• 64% of companies have increased their dividends from a year ago and only 13% have cut them. A year ago only 53% were boosting dividends. Aggregate dividends rose nearly 14% over the year to the December half; and
• 56% of companies have seen their share price outperform the day they released results.

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Key themes included:

• a continued focus on cost control, but also a 7% rise in revenue, versus less than 2% revenue growth over the year to the June half. Industrials saw sales growth of 5%;
• help from a lower $A, which boosted the value of foreign earnings & makes Australian firms more competitive;
• a massive turnaround for resources stocks leaving them on track for circa 40% earnings growth this financial year;
• signs of life in cyclicals like housing related stocks (Boral, Stockland) and retailers (JB HiFi, Harvey Norman);
• continuing strong results from the banks; and of course
• strong dividend growth, which is usually a sign companies are confident about the outlook.
• consensus earnings expectations for 2013-14 rose slightly through the reporting season with earnings now expected to gain 15%, led by 40% from resources. This is expected to
• slow to 7% in 2014-15 with resources slowing and non-resources picking up. A key driver of whether this will be delivered will be whether the economy picks up.

Growth still soft, but signs of improvement

Since the June quarter 2012 Australian economic growth has been poor, averaging around a 2.5% annualised pace. This is well below the level necessary to absorb workforce entrants and hence unemployment has risen from 5% to 6%.

A recent spate of layoff announcements is only adding to fears, not helped by the rapidly deflating mining investment boom. This is also highlighted by the latest ABS survey of investment intentions with a conventional interpretation of investment intentions that adjusts for the average gap between actual and expected investment pointing to an 11% contraction in investment next financial year. An alternative approach based on comparing the estimate of investment for the next financial year to the corresponding estimate made a year earlier points to a 17% fall – worse than seen in the early 1990s recession.

This has all led to a sense of gloom about Australia. However, the time to be really gloomy was two years ago – when the RBA was stubbornly slow to cut interest rates. Now interest rates are at generational lows and the $A is down more than 20%. And household wealth is up. Importantly, the normal play out from falling interest rates is unfolding:

• house prices have risen solidly over the last year;
• auction clearances holding at 80% in Sydney and 72% in Melbourne despite bad news in February is a good sign;
• record building approvals will see rising housing construction this year. Building approvals at their strongest since 2002;
• consumer and business confidence are trending up particularly the latter;
• the lower $A should start to boost demand for local goods and services, eg US tourists to Australia seem to be rising again;

Lower interest rates, rising wealth levels and rising housing construction is likely to drive a pick-up in retail sales. In fact retail sales growth did pick up last year. Eventually this is likely to help non-mining investment. What’s more December quarter GDP saw an uptick in GDP growth to 0.8% quarter on quarter and 2.8% year on year, but more importantly it showed growth is far from collapsing and that other sectors of the economy – notably consumption, housing and trade – are helping the economy grow despite falling investment. But what about the weak jobs and investment outlook news?

The jobs headlines lately have certainly been bleak but: the labour market always lags the economic cycle; the announced job losses (totalling less than 20,000 across the car makers, Alcoa, Qantas, etc) are small relative to actual change between first estimates the National Australia Bank’s business survey are all stabilising or pointing up. While mining investment is falling off a cliff,  the broader investment outlook may not be as leak as suggested by recent data. First, the approach of comparing estimates exaggerated the weakness this financial year initially pointing to a 9% decline, which now looks like coming in flat.

Secondly, investment intentions in industries outside of mining are starting to improve. In fact, the NAB business survey’s investment intentions index has actually started to rise. Thirdly, the impact on overall economic growth of the slump in mining investment will be partly offset by a slump in imports of mining equipment. This is already occurring.

Retail sales and trade data

Growing at a much stronger than expected 1.2% in January, retail sales marked their ninth consecutive increase. What’s more the gains were broad based with particularly good gains for department stores unlike the December result which was heavily dependent on higher food prices. Retail sales are now up 6.2% on where they were a year ago, which is the fastest rate of annual increase since November 2009. It’s looking increasingly that, thanks to a combination of lower interest rates and rising wealth levels and a modest improvement in consumer confidence, retail sales are at last throwing off the malaise they have been in since 2010. While the pace of growth may settle back towards 5% this year, the environment for retailers has clearly improved.

The trade surplus came in $1.4bn in January with exports up strongly and imports down. This was way above market expectations for a $100 million surplus and is the biggest surplus since August 2011 which is a pretty good outcome given the fall in our export prices which has occurred since then. The huge increase in the trade surplus likely involves a bit of noise (eg the $425m rise in non-monetary gold exports) but the improving trend since 2012 is clearly evident. The silver lining to the end of the mining investment boom is clearly becoming evident. Not only is it boosting resource exports as new projects start producing but falling mining investment is helping drive a decline in imports of mining related equipment (capital goods imports fell 9% in January).

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Conclusion

The latest retail sales and trade data coming on the heels of stronger than expected GDP growth in the December quarter last year add to evidence that other sectors of the economy are starting to fill the gap left by the slump in mining investment. There is no need for the RBA to cut interest rates again. Rather the debate will start to shift to when the first rate hike will come, which we have pencilled in for later this year.

Dr Shane Oliver is head of Investment Strategy and Chief Economist at AMP Capital.