It’s The RBA Against The Australian Consumer

This story features JB HI-FI LIMITED. For more info SHARE ANALYSIS: JBH

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

Last weekend one of the Sunday newspapers carried an interesting news story by shareholder activist Stephen Mayne, revealing the Australian Labor party is one of the richest political parties in the democratic world. Probably of more importance to your average Australian taxpayer is that Mayne also found that the two freshly elected politicians currently associated with the Federal Government’s future economic track record, prime minister Kevin Rudd and treasurer Wayne Swann, “have a fabulous record when it comes to financial management”.

Labor, Mayne revealed, does not only have a $10m margin loan with CommSec, but Rudd and Swann also had the investment nouse to buy shares in Commonwealth Bank and Suncorp-Metway, among other investments made, from the late eighties onwards. Mayne estimates that what started off with $16.4m from selling a radio station in Brisbane in 1986 is today an investment portfolio with assets worth between $700m and $1bn.

The picture painted by Mayne of two cunning investors who know how to make a buck and let it multiple, is one that stands in sharp contrast with the general view among professional investors in the financial circles of Sydney and Melbourne who believe that Australia decided last November to trade in its highly experienced, thoroughly-proven team of economic and political leaders, with a younger, yet inexperienced and largely unproven team of Labor politicians.

Some commentators have suggested the Labor election win is responsible for offshore investors withdrawing their funds from the Australian share market since November. As recent as last week an email was sent around in Sydney containing a chart of the All Ordinaries showing it had all gone downhill since the new government had leaped into power. (Regardless of your political view, but that is a bit rich).

The irony of this story is that those Labor sceptics will be hoping pretty soon they will be proven wrong as the Reserve Bank intends to squash inflation back inside the 2-3% range (from 3.4-3.8% last month). It can hardly be overemphasised but this is not going to be an easy or smooth process. Official interest rates have just been raised to 7%. With every extra step higher the chances of seriously disrupting the economic process in Australia will grow exponentially.

Already market experts are anticipating an uptick in credit card defaults, property foreclosures, corporate failures and personal bankruptcies. Despite some experts questioning whether the RBA is setting up Australia for the next recession, the central bank made it clear this week that official interest rates have only one way to go still: up.

TD Waterhouse economist Stephen Koukoulas believes Australia is being punished for the fact that inflation has been systematically underestimated over the past few years. In a sign that he believes the RBA currently finds itself behind the curve, Koukoulas believes Australians better prepare for interest rate hikes at each of the next two following RBA meetings, possibly followed by another one later in the year. This would take official interest rates in Australia to 7.75% at a time when interest rates in the US might drop as low as 2%.

Because of the sharp deceleration in the US economy, interest rates in most developed economies are expected to trend lower over the medium term. Not in Australia, however.

Even CommSec chief equities economist Craig James, usually among the dovish commentators in the market, now believes the RBA will hike at its next meeting in March, and possibly one more time after that, in May. This scenario, James suggests, can only be prevented through some unforeseen crisis, such as another shock from international finance institutions, or simply through a weaker local economy than is currently anticipated.

Investors and borrowers better not hope for the best, says James, because the odds are very much in favour of higher interest rates: “investors and borrowers need to plan for higher rates and budget accordingly”.

This sudden switch in the outlook for interest rates (most experts assumed 7% would be the peak in this cycle) is already having an impact on the local share market. Under normal circumstances, share prices for the likes of David Jones ((DJS)) and JB Hi-Fi ((JBH)) would have soared to new highs with released results better than market expectations and company management displaying full confidence for the year ahead. Instead investors are turning away from discretionary retailers fearing the RBA will take no prisoners in its vigorous battle with the inflation dragon. In other words: those companies have been riding the peak in consumer spending and as interest rates will rise further the only way seems down.

Economists at Macquarie put it as follows this week: with overall investments still strong, and expected to remain strong, and exports likely to rise (the Australian dollar should remain strong too) there is only one way the RBA will achieve its goal: consumer spending must accommodate most of the slowdown.

Here comes the scary part: in its Statement on Monetary Policy this week, the RBA lowered its nonfarm GDP growth forecasts to 2.75% by the end of 2008 and to 3% by the end of 2009.

In effect, says Macquarie, to achieve these goals “consumer spending must slow to its weakest pace since the early 1990s”. The economists believe this will be difficult given strong population growth, high employment and the promised income tax cuts. “This suggests that if the RBA is serious about pushing growth below trend, then interest rates may need to rise sharply further.”

For the record: Macquarie economists do not adhere to any doom and gloom scenarios for consumer spending in Australia for the year ahead – they believe the RBA is up against a still well-supported adversary. A view supported by Craig James, though the CommSec economist does point out that most supportive factors from the past years seem to have peaked and are now reversing. Macquarie does acknowledge, however, the risks for consumer spending are now skewed to the downside and potentially darker scenarios cannot be completely dismissed.

One of the reasons why Macquarie retains a positive view is because it believes inflation will subside and the RBA won’t have to lift interest rates as high as it currently believes it may have to. In case the RBA view proves to be the more correct one, Macquarie sees a “host of innocent bystanders” who will be caught out by interest rates rising much further, including the domestic housing market and a range of businesses with high gearing.

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