Rates, GDP To Fall

Sydney, Aug 29, 2008 (ABN Newswire) - Interest rates will fall by 0.25% to 7% for the cash rate at 2.30 pm next Tuesday and by the close of business, the National Australia and ANZ Banks will have followed suit.

They have promised to follow any RBA cut as quickly as possible.

A quarter of a per cent drop in rates is now more likely after the better than expected capital spending figures for the June quarter and the year to June (which included significant upward revisions in spending in both the December and March quarters).

So will it be time to go shopping? David Jones and other retailers would love us to, but there are still too many imponderables out there. Caution is the watch word, and besides the rate cut is well and truly been priced into the market.

We still have business inventory figures to go and the June quarter balance of payments which both provide us with an idea of how much contribution (if any) business inventories and trade could make to growth.

On balance, trade should be a small positive given the sharp rise in export income from higher oil, gas, coal and iron ore prices that have already produced two months of trade surplus in the quarter.

And business inventories could be a touch higher than expected because of the slowdown in retailing and consumption which has happened a bit quicker than expected. But these are the two imponderables that make it hard to forecast.

Some economists say that the gross domestic product could be flat to up 0.4% in the quarter, which would represent a slowdown on the higher rate in the March quarter when GDP rose 0.6% from the December quarter for an annual rate of 3.6%.

But that's exactly what the RBA has been engineering.

But interest rates will fall Tuesday in what will be followed later in the year by a second cut of 0.25%; or if the RBA decided on a first up 0.50% cut, there wouldn't be a further cut until the first quarter of 2009.

The bank bill market has 30, 90 and 180 day bills all trading under the cash rate of 7.25%, and there's a 35% chance of a cut of 0.50%.

The RBA still has to balance growth with inflation which it expects will hit an annual 5% rate this quarter and possibly in the December quarter, although pressures do seem to be easing with the drop in oil and petrol prices.

But higher rents and building costs are still big drivers of inflation in the economy.

In the US second quarter growth was revised upwards to 3.3% annual from 1.9% because of a surge in exports and a plunge in imports: without the trade figures, the economy barely grew, and expectations are for a very sharp fall this quarter as reality sinks home.

But in Australia, yesterday's June quarter and 2007-08 capital spending figures from the Australian Bureau of Statistics provided a real positive surprise.

Economists had been expecting a rise of around 2% in seasonally adjusted terms in the quarter, but it came in at 5.7% and the March fall was revised to a 1% increase.

The ABS said there are now signs of a noticeable expansion of downstream processing investment from the mining boom.

However, a couple of economists say the figures don't sit with business confidence surveys and business borrowing, which are both declining.

The ABS's figures show that new capital spending hit a record $86.4 billion in the year to June, and the third estimate of capex for the current financial year has risen 26.2% to just under $100 billion at a massive $99.758 billion, which looks like rising further as the year wears on, despite some signs of deferred investment.

The ABS said this morning that the "seventh and final estimate for 2007-08 for total capital expenditure is $86,404 million. 

"This is the highest seventh estimate on record and has shown an increase of 11.4% from the final estimate for 2006-07.

"There has been growth in both asset classes, particularly building which rose 17.4% while equipment rose 6.6%. The seventh estimate is 1.6% below the sixth estimate. A 1.3% rise in equipment was offset by a 4.7% fall in the building asset class.

"The third estimate for 2008-09 is a series high at $99,758 million which is 26.2% higher than the same measure for 2007-08.

"The third estimate reflects some deferral of planned 2007-08 spending and reveals some spread of investment intentions into downstream industries connected to mining.

"Both asset classes have shown substantial growth when compared to the third estimate of the previous year with building rising 29.5% and equipment rising 22.5%.

"The third estimate is also 14.5% stronger than the second estimate for 2008-09. Building has risen 15.1% and equipment 14.0% between the second and third estimates."

The June quarter itself saw a rebound from the surprise dip in the March quarter (which was revised up anyway by the ABS with new spending found and re-allocated) to show a 1% growth instead of a 2.6% fall.

The ABS said that total new capital expenditure rose a seasonally adjusted estimate rose 5.7% in the June quarter. 

Economists had been looking for a 2% rise, so the news is encouraging and means that economic growth will be a bit better than some analysts had thought.

"Equipment, plant and machinery rose a large 8% in seasonally adjusted terms, but the seasonally adjusted estimate for spending on buildings eased half a per cent in the quarter," the ABS said.

Plant and machinery spending accounts for some 8% of GDP, according to Macquarie Bank interest rate strategist, Rory Robertson. 

He says it means the economy grew bit quicker in the second quarter than thought.

The ABS said that the March quarter 2008 estimate for capital expenditure has been revised upwards $563 million or 2.9% in original terms. December quarter figures were also revised upwards by a similar amount.

A solid rebound in capital spending should mean fears for a larger than expected slowdown in second quarter economic growth will be averted.

Figures out Wednesday on new construction work done, thanks to a 6% drop in engineering work done in the quarter, suggested that the construction, engineering and building sectors would be making a flat contribution to second quarter growth. 

But total construction work done was still up nearly 6% year on year in the June quarter, will make a substantial overall contribution.

The ABS said that projections for capex growth out into the current financial year suggested that there was a strong build up still under way to where spending would total around $30 billion a quarter.

"Renewed strength in the trend series for total capital expenditure, including upwards revisions for March support the anticipated movement of projections towards the $30,000m expenditure per quarter level by the end of the 2008-09 financial year," the ABS said.

Driving this is an upturn expected in buildings, according to the ABS:

"The projections for the building asset class are very strong for the coming twelve months and are the main driver behind the strength displayed in the projection for total Capex. 

"The projections anticipate an upturn in the pace of growth in the building series in the year ahead. "

Manufacturing will be weak; mining will be strong, as will investment in machinery and plant.

In a note to clients earlier in the week economists at Merrill Lynch expressed caution about the 2009 outlook.

"The initial phase of rate cuts will only be designed to loosen the brakes on the economy."Lower rates will help mitigate downside risks to the economy next year, but fundamental forces suggest growth will remain below trend in 2009, including;

"Still restrictive financial conditions: even allowing for our forecast of 100bp of easing to 6.25% by June next year, monetary conditions will remain on the restrictive side of neutral. Policy works with a lag and financial conditions are adjusting from their tightest level since the late 1980's."

We have already seen a growing number of companies, especially in the property and financial sectors, plus some in building and building supplies, express their own caution about the next year: they termed it a "lack of visibility"

Wattyl, Boral, Stockland, GPT are just some that come to mind.

In contrast the likes of retailers JB Hi-Fi and even little Noni-B, which had a poor 2008, see earnings growth and have been confident enough to say so in their outlook statements. David Jones is expecting flat growth in this year, but earnings growth much faster and even Woolies sees sales growth in the 'high single digits' and earnings growth of up to 12%.

Merrill Lynch continued: "Income and balance sheet constraints on the household sector.

"We do not expect a strong rebound in household spending through 2009. Household incomes will be constrained by weaker employment and real income growth.

"The household debt servicing ratio is at a record level, as is the change in the ratio over the past 12 month (see chart below). Debt servicing will show little improvement during the initial phase of rate cuts because income growth will also be slowing.

"Real asset prices are falling at the steepest pace since the early 1990's recession, eroding household net worth

"Weaker global growth, with ML forecasting below trend growth of 3.4% in 2009, down from a forecast 3.9% in 2008 and 4.8% in 2007. Demand growth is slowing substantially in the developed world. In developing economies, inflationary pressures (and tighter policy settings), together with weaker developed world demand, is moderating growth.

Goldman Sachs JBWere: said that 2008 is shaping up as the worst year for returns from listed property, Australian shares, alternative assets and residential property since comparable data became available in the mid-1980s. Not even in the depths of the early 1990s recession or the 1987 crash did wealth destruction occur on terms of this breadth and depth.

The Australian equity market is overshooting domestic economic fundamentals and is now discounting a recession of an order of magnitude similar to the early-1990s.

However, our forecast of a solid recovery in equity returns in 2009 is based on;

1. An oversold starting position. History suggests a strong recovery in the year following a negative return from equities (15% average nominal return since 1885, 28% since 1985).

2. Consensus has now largely adopted our macro views for growth and inflation and hence we believe that market expectations have been reset, and indeed the market now appears to be factoring in a more bearish outcome than we think is likely.

3. Interest rate easing cycles in the past have generated an average return of 13% 6 months after the commencement of an easing cycle and we believe the Federal government will begin to put in place a highly stimulatory Budget in 2009.

4. Based on our review of relative risk aversion, equities stack up as the cheapest relative to other asset classes.

5. The rally in Australian fixed interest markets is drawing to conclusion and Australian bonds are now fairly valued based on our views on growth and inflation.

Based on our current top-down GDP estimates, a flat or slightly negative EPS growth outcome for the Australian market can be expected for the 2008-09 year. In contrast the equity market appears to be pricing in a much harder landing than we think likely, suggesting a 15% EPS decline on a discounted 12-month-forward PER multiple of around 11-12 times.

In other words, we believe the equity market has now overshot relative to our economic forecasts.


 

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