April 09 National Newsletter   Signs of Hope   Written by Tony Pearson, Futureconomics

 

The world is in the deepest economic downturn since WW2. The IMF estimates that global growth will decline by up to 1% in 2009, the first backward step in over 6 decades. Developed nations such as the US, Europe, UK and Japan are in deep recession, with an estimated aggregate contraction this year of around 3.5%. There had been some hope that the emerging economies such as China, India, Latin America and Eastern Europe would “decouple” from the developed country downturn and maintain solid growth through stronger domestic demand, but it is now clear that that hope was misplaced. Growth of the emerging economies is expected to more than halve in 2009, to a very soft 1.5%.

The global economic downturn will be protracted. While the low point will likely be reached this year, recovery is expected to be insipid, and will be dependent on the degree of “traction” achieved by the various government and supranational measures of financial support and economic stimulus. It is likely to take a couple of years before growth returns to its long run sustainable path.

Australia has not been immune from these global developments and it is now clear that the economy is in recession, even if the official data on growth do not yet show it. Household spending, which makes up around 55% of the total economy, has eased, as wealth has been eroded by falls in asset prices, and as fears have increased about the security of employment. It is not that households do not have income to spend – in fact aggregate growth in household disposable income (after deducting tax and interest payments) has accelerated since September last year on the back of Federal government handouts and the rapid reduction in interest rates by the Reserve Bank. Nevertheless, households have mostly used the extra income to consolidate their balance sheets, opting to increase savings rather than to spend.

Businesses have responded by reducing costs, through some labour shedding and reduced hiring, and through a marked rundown in inventories. Somewhat surprisingly, investment by businesses on equipment and on structures has remained strong up to the end of 2008 (which are the latest available figures) although a sharp slowdown is expected through 2009. Profitability of non-financial businesses has also remained solid to date, with most of the profit erosion being centred on the financial sector. Again though, the non-financial sector is expected to suffer erosion of profits through 2009 as demand remains weak and as export prices, particularly commodities, fall sharply.

While this presents a sombre outlook, it is not all bad news. Governments and supra national bodies such as the IMF and World Bank have responded, and continue to respond, to this crisis. Their efforts can broadly be divided into four areas. The first set of measures has been aimed at stabilising the banking system and kick starting the flow of credit to businesses and households. These have included injections of liquidity by central banks, the extension of government guarantees to bank borrowings, injections of capital (with some offshore institutions being nationalised), and the purchase of “toxic” (unsaleable) assets. The second set of measures has been designed to support economic activity, and has included measures to support household incomes (handouts and tax cuts), and increased government spending on infrastructure. The third step has been dramatic reductions in interest rates by central banks. And the fourth area has been direct support to a small number of governments from the supranational organisations.

These measures are beginning to work, with some global and Australian leading indicators suggesting a turning point may already have been reached. Share markets showed a pleasing lift in March, as investors became more confident that governments and supranationals would be successful in stabilising financial markets, restarting the flow of credit to the private sector, and supporting economic activity. Leading indicators of Chinese industrial production have improved in response to the large government spending programs. And in Australia there are signs that demand for housing and other personal finance is now lifting in response to lower interest rates. That does not mean the crisis is over – economic activity will deteriorate further both abroad and in Australia in 2009 because it will take time for these support measures to have their full effect. Also, there is more work to be done in all these areas. Nevertheless, there is now hope that the authorities understand the nature of the problems and are on the right track in resolving the issues.

Australia is better placed than most countries to weather this storm. It entered the downturn from a position where growth was well above its long run potential. The banking system is not beset with the toxic asset problems of many developed country peers, and remains stable, comfortably capitalised, profitable and well run. Our authorities are well placed to provide financial and economic support, with the Federal government having no net debt at the start of the crisis, giving it an enormous capacity to lift spending, and with the Reserve Bank having plenty of potential to reduce interest rates, even from here. And the fall in the A$ helps the competitiveness of our exports and helps to preserve the A$ income of exporters.

Some industries will perform relatively well through these troubled times. Businesses directly linked into the government sector, including utilities, health and education, support services and defence are likely to be somewhat insulated from the downturn. The dwelling construction sector may already be responding to lower interest rates and the enhanced first home buyers grants, and is expected to show solid growth from mid 2009. And without trying to be twee, insolvency and business re-engineering services should be experiencing boom times!

In contrast, there are other sectors which will bear the full brunt of the downturn. The mining industry has already suffered lower spot prices and will experience significant reductions in contract prices and in export volumes in 2009, impacting negatively on profits, investment and employment. Manufacturing is struggling in response to weak domestic demand and reduced export orders. Automotive vehicle and parts manufacturers are having a particularly tough time. The finance sector is feeling the pressure of reduced demand for credit and rising bad debts, and a tougher funding environment, although it needs to be stressed again that the Australian banks are much better placed than their offshore competitors. Non residential construction will ease as business investment is reduced. Retail is in for a couple of years of subdued growth as households continue to devote more of their income to saving rather than spending. And the tourism sector will continue to feel the pain of reduced international inflows and a tightening of the belt by domestic households.

One topic close to the hearts of many Australians is the prognosis for house prices. A number of countries have experienced marked declines in residential prices as this global financial and economic crisis has unfolded. Some measures show US prices are down 30% from their mid 2006 peak (S&P Case Schiller 10 cities); UK house prices were down around 18% over the year to March 2009 (Halifax); and New Zealand house prices were down nearly 7% over the year to the September quarter 2008 (RBNZ). Prices in Australia have also been impacted, although much less severely, with prices in aggregate across the capital cities falling by 3% over the year to the December quarter 2008. There have been some doomsayers predicting much greater falls in prospect for Australia, although there are grounds for believing the downside will be limited. Demand for housing finance for owner occupation is lifting in response to lower interest rates and the enhanced first home buyers grants, with anecdotal feedback suggesting prices at the lower end of the market are already responding. Also, Australia does not have an oversupply of dwellings as do some markets such as the US. Rather, most indicators suggest Australia is chronically short of dwellings, with the “demand overhang” likely to be supportive of prices.

Overall it is clear that Australia will not be able to escape the fallout from the global financial crisis and the accompanying shock to the global economy. Growth in domestic economic activity is likely to be below trend for a couple of years. But it is not all bad news. Some industry sectors will perform relatively well. And there are already signs both offshore and in Australia that the very significant support measures taken by the authorities are beginning to have the desired effect. Within the dark clouds there are signs of hope.

 

Tony Pearson
Managing Director
Futurenomics
April 2009