Confidence Draining Away

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By Greg Peel

The survey to compile the Westpac-Melbourne Institute index of Australian consumer confidence for May was conducted just after the release of the federal budget. More importantly, it also followed the latest RBA rate hike. The result was a 7% fall in the index to108 from April's reading of 116.

While the result indicated the response to the budget was more negative than positive, Westpac chief economist Bill Evans suggests it was the rate hike, and the subsequent rise in the standard variable mortgage rate (SVR) from 7.15% to 7.40%, which really caused the damage.

Evans believes we have now reached the tipping point in the rate rise cycle. We may have had six hikes in total from the RBA's “emergency” trough of 3% on the cash rate all the way to 4.5% today, but the initial hikes were all about an Australian economy that was surprising all and sundry by not collapsing as originally assumed post-GFC. Indeed, the Chinese influence has meant Australia's economic response to the GFC has been merely the briefest of stumbles followed by a rapid return to what the RBA determines to be “trend” growth.

And to that end, the minutes of the RBA's May monetary policy meeting, released yesterday, note that borrowing rates in Australia have now returned to their decade-long “average”. Given the return to average corresponded with Australia's surprising economic turnaround, it is no surprise Australian consumers were buoyant and thus “confident” even as the cash rate rose. The rate hikes were seen as reflecting good news rather than bad. But as we have now approached average, that gloss has given way to simple economic reality.

Evans notes that the last time the RBA was returning rates to average, following the brief 2002-03 recession, confidence lasted all the way to March 2005. But in that month the SVR rose from 7.05% to 7.30% and confidence turned – falling 15.5% according to the Westpac-MI index that month. It then fell an average of 8.5% each month thereafter as seven more rate hikes followed.

This month's result suggests that pattern may be about to repeat. Notably, the period 2004-08 coincided with the last resource sector “boom” in which iron ore and coal prices were jumping significantly. At that stage it became apparent that Australia's economy had become distinctly “two-speed” – commodity prices were driving up the GDP and thus interest rates, but the benefits were felt only in the mining states of WA and Queensland and not in the most populated states of the south east. NSW was as good as in a recession, yet the cost of a mortgage kept rising and rising (as did the cost of petrol).

We are back in that same two-speed rut once more. The last two rate hikes have been specifically linked to the rise in coal and iron ore prices, but the RBA noted with relish in its May minutes that retail spending and new home loan demand were now weak. On that basis, the RBA saw its hikes as working as planned, such that the response of the humble consumer to pull back on purchases and commitments was acting as a welcome offset to inflationary mining profits.

Whether or not this pattern will continue to play out is now completely dependent on Europe. The RBA's opinion is that the impact of Greek problems on Australia would only ever be “small”, but the RBA meeting was held before the more recent disintegration of European markets and the announced E720bn euro stabilisation fund. Simple logic would recognise that Europe is China's biggest export customer and hence Chinese manufacturing will now be impacted by the inevitable European recesssion. This means less demand from China for Australia's commodities, which may even mean lower prices ahead for coal and iron ore as well as base metals. Note that BHP Billiton ((BHP)) recently won a decade-long battle to bust apart the incumbent annual contract pricing model, which was heralded at the time as the greatest achievement since someone first found silver at Broken Hill. Contract pricing will now be settled on a quarter by quarter basis.

Will BHP's win now come back to bite the miners on the backside? Australia managed to avoid recession in FY09 because bulk commodities were still being sold at inflated annual contract prices which were settled prior to the GFC and carried through to the March quarter of 2009. The next settlement saw a big price drop through to March 2010, and then another jump back to record levels. If 2010 prices were fixed for the year, then Messers Rudd and Swan could well be forgiven for basing a budget on strong commodity prices. But now that prices will be settled quarterly, what happens if the next price is lower? And then lower again?

A similar confidence index is conducted each month in Germany to assess the sentiment of investors and financial market participants. It is hardly surprising the ZEW index has been trending down through 2010 as the Greek problem has unfolded, but it did see a bounce in April following the announcement of the EU-IMF Greek rescue package that month. Yet brief relief has given way to contagion fears once more, and the May index released last night showed a larger than expected fall to 45.8 from 53.0 in April.

If there is one saving grace for the world's biggest exporter of manufactured goods, it is that a weak euro makes German products cheaper and more attractive to importers. But given those export receipts will now have to be funnelled into the new pan-eurozone rescue fund, there's little to be confident about.

Across the Atlantic, the world's biggest consumer of manufactured imports is struggling to remain confident as well. Recent US economic data have been quite strong, but the cloud which has drifted across from Europe has stymied enthusiasm. Last week's fortnightly Michigan University measure of US consumer confidence rose from 72.2 in the second half of April to 73.3 in May. That might seem pleasing, but it fell short of economist expectations and short of the recent 73.5 peak recorded in March.

In other words, it looks like confidence in the sector which delivers 75-80% of US GDP may be topping out as well. Europe is clearly not helping, but nor did the April increase in US unemployment from 9.7% to 9.9% assist confidence either. The unemployment rate had fallen to 9.7% in March from 9.9% in February.

There is also a small matter of mortgage resets hangings over the US economy at present which doesn't get a lot of press.

At the peak of the US subprime mortgage binge, two newly-created styles of mortgage stood out. One was the NINJA loan (no income, no jobs or assets) and the other was the adjustable rate mortgage (ARM). In 2005, mortgage creators started selling ARMs to NINJAs. Typically, an ARM offered a “honeymoon” mortgage rate of 2-3% for a period of anything from 18 months to three years before “resetting” to a higher rate. That higher rate could be as much as 12-13%.

Remember “jingle mail”? Laws in the US allow a mortgage holder who cannot meet interest payments to simply walk away from the house in question and post the keys to the bank. This meant a NINJA could live in a nice house for maybe three years at a mere 2-3% mortgage rate and then simply move out come reset time. NINJAs never worried about credit ratings – they never had one in the first place.

So when did the subprime crisis start to emerge in the US? Around mid-2007, which happens to be 18 months after the first wave of ARMs were sold. But despite the fact US house prices started to tip over in 2006, ARMs were still being sold right up to mid-2007. You do the maths.

The last, and biggest, wave of ARMs are due to reset around about now.

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