The Recession That Is Long Overdue

This story features NATIONAL AUSTRALIA BANK LIMITED, and other companies. For more info SHARE ANALYSIS: NAB

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, Editor FNArena

Amidst reigning uncertainties regarding Europe and the US economy, the Australian share market has started to outperform its international peers. How's that for a change?

Investors should look no further for an explanation as both international and domestic investors are warming to the prospects of an interest rate cut by the Reserve Bank of Australia later this year. Officially, the RBA is still in tightening bias and a clear majority of economists and other market experts and commentators remains of the view the RBA is not done yet with lifting the official cash rate, but behind the curtains of daily headlines and market commentary the balance is shifting with more and more experts stepping away from this view.

Such a move makes all the more sense as globally forecasts for economic growth this year and next are being scaled back, leaving the Australian economy vulnerable to further loss in momentum.

UBS economists in Australia, who are still "positive" about the Australian economy and about RBA policy, now acknowledge their view is increasingly under threat. UBS's Global Macro Team has started to look into downside scenarios for the global economy. The local economists admit if any of such scenarios turns into reality, their forecasts for GDP growth in Australia this year will be reduced to below trend. This in turn will pull the RBA from tightening bias into cutting official interest rates.

However, the most convincing argument was put forward by market strategist Tim Rocks and his team at BA-Merrill Lynch. The team has been collecting newspaper articles about staff cuts and jobs losses in Australia since early June. The results are simply staggering. Rocks and Co reported on Monday they have tallied no less than 7,000 announced job losses and, most importantly, they don't think most of these jobs losses have already been reflected in the official (un)employent numbers yet. Readers are hereby reminded it was only a few weeks ago the official unemployment rate in Australia deteriorated against the ruling market expectation from 4.9% to 5.1%, effectively wiping out all gains booked since the start of 2011.

Economists at ANZ Bank have been pointing out for months they believe their monthly jobs ads survey peaked in March this year and the deterioration recorded since then appears consistent with RBA rate cuts in the past. However, if the research done by Tim Rocks and his team at BA-ML proves accurate, the unemployment rate in Australia is not simply going to rise in the months ahead; it is going to rise at fast pace. There should be little doubt this will trigger policy responses, not only from the RBA but likely also from the Gillard government in Canberra.

It is easy to see why "bad" news from the domestic jobs front is likely to turn out a positive for the Australian economy and for the share market. History shows retail operations are very sensitive to a change in sentiment, but above all, highly leveraged to policy stimuli such as hand outs, lower taxes and falling interest rates. The same applies to gaming companies (oh irony!). Lower interest rates and improved sentiment should also boost property prices and overall activity in the property and development sector. Banks are traditionally amongst the beneficiaries too. Note also resources companies have proved this reporting season the strong AUD really is hurting their cost levels and margins.

The newspaper jobs research has convinced Rocks and Co the RBA will start cutting interest rates, probably in November. Hence why BA-ML is now advising its clientele to start positioning for a switch in the official interest rate outlook. The stockbroker advises banks and low end consumer stocks will be the main beneficiaries from the switch. BA-ML has a preference for National Australia Bank ((NAB)) and Westpac ((WBC)) and suggests  investors should consider owning stocks such as Wesfarmers ((WES)), Woolworths ((WOW)), Asciano ((AIO)), Toll Holdings ((TOL)), Westfield Retail ((WRT)), CFS Retail Trust ((CFX)), Tatts ((TTS)) and Tabcorp Holding ((TAH)).

The stockbroker observes most of these stocks also offer defensive earnings, a reasonable dividend yield plus attractive valuations.

Ten days ago, market strategists at Goldman Sachs made a similar recommendation to their clients after the stockbroker switched its view towards a RBA rate cut in September, to be followed up with a second cut before year-end. Looking back into history, Goldman Sachs found the main "victim" of RBA rate cuts has always been the Australian dollar.

Similar to BA-ML, Goldman Sachs stated retailers always turn out to be the main beneficiaries, as do building materials, banks and A-REITs. Often media companies are also mentioned, but Goldman Sachs's research found the performance of media companies tends to disappoint.

Stocks most leveraged to the end of RBA rate hikes, soon to be replaced with rate cuts instead, include, according to GS, David Jones ((DJS)), Myer ((MYR)), JB Hi-Fi ((JBH)) and Wesfarmers ((WES)) among the retailers, OneSteel ((OST)), Boral ((BLD)) and CSR ((CSR)) among building materials suppliers and Toll Holdings and Qantas ((QAN)) in the transport sector.

Ongoing deterioration for unemployment in Australia was equally the prediction that supported a change in interest view at Goldmans, though it has to be noted, BA-ML's updated views are far more dire.

Economists at Citi have yet to join those anticipating rate cuts, but Citi strategists equally have been toying with the idea. Last week, Citi nominated JB Hi-Fi, Harvey Norman ((HVN)), APN News & Media ((APN)), Ten Network ((TEN)), the ASX ((ASX)) and Stockland ((SGP)) as likely major beneficiaries, as well as healthcare stocks ResMed ((RMD)) and CSL ((CSL)) on anticipated downward pressure on the Australian dollar.

Let us return to the latest piece of research conducted by BA-ML as the suggestions made by Rocks and his team will no doubt confound many who are today still expecting that resources companies and their capex intentions for the years ahead will keep a firm lid on unemployment in Australia. Firstly, BA-ML makes the observation that official statistics seem to be lagging what's really going on in everyday Australia. But also that those previous mentioned 7,000 acts of jobs cuts could potentially translate into up to 100,000 jobs losses in the months ahead.

If true, this will lift the unemployment rate to 6% by March next year – a long way from the 4.5% most economists were projecting for 2012 as recent as only a few weeks ago. Reasons BA-ML: even if only half of these numbers show up in the statistics, this would still translate into a jump in unemployment of 0.5%, still "an irresistible case for a rate cut".

In this Rocks and Co are correct. In fact, while mainstream media and market commentators in Australia tend to focus on the official GDP calculations to determine whether an economy is in recession, or not, more experienced economists have been arguing for a while a much more accurate signal is whether there is significant deterioration in the labour market. After all, the end all and be all of every economy is its ability to create and retain jobs. Would a jump in the official unemployment rate from 4.9% to 5.5% and beyond represent such a "significant deterioration"?

I think the answer is affirmative. As such, and in line with my personal analyses since earlier this year, I think Australia is finally going to have the recession it badly needs to fix whatever is not right, and what hasn't been right for too long. On more traditional metrics such as quarterly GDP numbers, there may not be a "recession" on the horizon for Australia, but when it comes to what really matters -jobs, jobs and jobs- I think Australia is (finally) having the recession it has to have – less than twenty years after the famous Keating recession.

Three important observations support the view in favour of RBA rate hikes. Prior to the switch to reduced interest rates in 2008 the official unemployment rate had only deteriorated by 0.2%. Earlier, in 2000, the deterioration was 0.3%. Granted, the unemployment rate today suggests a much tighter labour market, but then we already recorded 0.2% deterioration, with further losses likely.

Secondly, "mining" only created 35,000 new jobs in the year to May (representing 2% of total). The largest suppliers of jobs in Australia remain healthcare and retail trade (both good for 11% of total each), followed by construction (9%), manufacturing (9%) and education (8%). With companies such as Qantas and BlueScope announcing 1000 jobs losses each this reporting season, it seems practically impossible that extra jobs at LNG projects, in the Pilbara and at engineering and mining construction services will pick up the slack. Note the demise of the Colorado clothing chain also claimed more than 1000 jobs losses, while the new government in NSW is intent on cutting 390 government payroll positions (to name but a few additional examples).

Thirdly, BA-ML correctly points out history shows a direct correlation between reduced sentiment and jobs losses. Reports the stockbroker: a 30 point drop in the consumer sentiment index typically causes 30,000 job losses over a year and a sharp fall in building approvals could cause another 40,000 losses. Conclusion (according to BA-ML): "We are on track for a 6% unemployment rate by March of next year."

My knee-jerk response is: we probably won't get there because of policy interventions by the RBA and the Gillard government. This will be a good thing for the share market.

On a similarly positive note, analysts at GaveKal observe oil prices remain in decline and they have come down a lot from levels earlier in the year. Reports GaveKal: liquidity squeezes typically end when oil prices weaken, releasing a lot of liquidity unto the markets, which in turn allows other financial assets to find their footing.

"Hopefully, this time will prove no different".

Here are some of my previous writings on changing dynamics for the Australian labour market:

– Change Is Coming To Australia (Aug 3, 2011)

– Weak Labour Market Data, A New Trend? (29 June, 2011)

(This story was written on Monday 22nd August, 2011. It was sent out in the form of an email to paying subscribers on that day.)

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