Australian Economy At A Crossroads

This story features DOWNER EDI LIMITED, and other companies. For more info SHARE ANALYSIS: DOW

-Aussie dollar key to better balance
-Improved global growth prospects
-Transition occurring but needs help
-Coming boom in export growth?
 

By Eva Brocklehurst

Several economists from the major brokers now see a turning point in Australia's economic outlook. There is a nascent improvement in business and consumer confidence, asset prices are rising and the global economy is supportive. The trajectory of the Australian dollar remains the cornerstone to better balanced economic growth.

CIMB thinks a soft pace will continue in the short term but the economy is close to turning and by the end of the year could be on a much firmer footing. There are factors which hold back the economy in the medium term. Financial conditions remain supportive but it would help the medium-term outlook if the currency was weaker. The housing market is improving but consumer spending is still patchy. The labour market is soft but productivity growth is improving. CIMB expects GDP to grow 3.0% in 2014 and 3.4% in 2015. Citi has greater confidence that the growth pace will pick up next year. The broker's GDP forecast is 3.1% for 2014.

UBS expects real GDP growth of 3.3% in 2014, reflecting an upbeat forecast for net exports. Moreover, GDP could record growth near 5% real in 2015/16. Despite the strength in such a headline, were it to occur, lower commodity prices and high offshore ownership of Australia's listed miners suggest this sort of growth will have a much more muted impact on domestic activity. While higher export volumes will keep the trade accounts in check they're not expected to be a panacea for the budget. They also don't affect the broker's view that the outlook for inflation and RBA cash rates is much lower than in the past.

Citi thinks the August cash rate cut has "turned on the light" for credit appetite and householders are no longer viewing putting money in the bank as more attractive than investing in real estate. House prices in Sydney and Melbourne are responding to lower interest rates but overall credit growth is still soft. CIMB expects inflation to average 2.2% in 2014 and 2.7% in 2015 and this provides the room for the Reserve Bank to ease policy further if the labour market needs support. The broker continues to expect the RBA to ease policy once more before year-end taking the target cash rate to 2.25%.

Should the Australian dollar remain stubbornly high Citi thinks the RBA will be prepared to cut the cash rate further, particularly as the inflation outlook is favourable. The scope to cut would be compromised if house prices continued to accelerate and precipitated a surge in leverage. Citi expects no change in the cash rate, with the next move being up, but not until the third quarter next year.

CIMB thinks proper rebalancing of the economy will not occur unless the Australian dollar is below current levels. The broker forecasts the currency to be around US89c at year end and US88c at the end of 2014, but acknowledges downside risks to these forecasts. More policy support cannot deliver better growth by itself for sectors such as tourism, manufacturing and education services and, to some extent, retailing. Citi thinks the currency has already partly eased financial pressures on businesses. Citi’s Trade Finance Index showed exporters are forecasting a 5.3% rise in volumes next quarter. Last quarter the forecast was for a 3.4% decline in volumes. Stronger signs in China have seen the Australian currency rebound from its lows. The broker concludes that, ultimately, a lower Australian dollar will be needed to help re-balance the economy so it would not be good if the Aussie rose further. Despite this the current level is not overvalued when considered against key commodity price levels, in Citi's estimates.

Growth prospects have picked up in the major economies, particularly in the US, Japan, and China, but also, importantly, in Europe. CIMB thinks that, without continued improvement in the world’s major economies, the election-driven bounce in Australian business confidence would fade. Cit also notes the world's economy has turned more positive. In particular, the Federal Reserve appears confident enough about US growth to consider tapering quantitative easing, and fears about a hard landing in China have ebbed.

BA-Merrill Lynch, while acknowledging business confidence has risen after the election, is also sceptical it will be sustained. Confidence, nonetheless, has likely affected the near-term performance of stocks. The broker has fished out those stocks that outperformed or underperformed in the past when business confidence rose for consecutive months. In those periods, those identified as outperformers were in transport, retail and resources. So, in stock terms, the broker includes Toll Holdings ((TOL)), Leighton Holdings ((LEI)), Downer EDI ((DOW)), SEEK ((SEK)), Bank of Queensland ((BOQ)), Commonwealth Bank ((CBA)), Westpac ((WBC)), Fortescue Metals ((FMG)), BHP Billiton ((BHP)), WorleyParsons ((WOR)) and Woodside Petroleum ((WPL)).

For sectors exposed to the domestic economy, the rise in business confidence reflected expectations of improving volumes and/or margins. The outperformance of energy and materials suggests that part of the reason business confidence rose on previous occasions was an improvement in the global economy. Which ones underperformed? Healthcare, AREITs and utilities underperformed and since rising business confidence was accompanied by a "risk on" strategy it did not surprise the broker that defensive sectors underperformed.

Looking at the mining capex boom, UBS notes this added 1.5 percentage points to growth each year over the past couple of years. The sector's huge demand for economic inputs has crowded out activity in other sectors, in the broker's view, where activity has also been hampered by the high Australian dollar. With the recent fall in commodity prices, and passing through of a number of LNG projects, the peak in capex is nigh. The broker calls for Australia to move back towards more domestically-led growth to avoid a period of weak activity and rising unemployment. There is some upside in the scenario for exports, driven by faster rural growth on the back of accelerating Chinese demand as well as faster manufactured export growth because of the enhanced competitiveness from a lower Australian dollar.

Okay. There are some tentative signs this transition is occurring, helped by a lower cash rate and the recent fall in the currency. It's just that a moderate recovery in housing, worth about 0.25 percentage points to annual GDP growth, is unlikely to be enough, in UBS' view. A successful transition lies in lifting non-mining jobs and capex growth, stabilising the labour market and economy-wide demand. This is likely to mean Australia's domestic economy runs below trend for a while yet.

On the upside, UBS argues forecasters are underestimating the likely benefit to the top line from a coming boom in export growth. Based on the forecast boost to export capacity, UBS expects export volumes to rise 5.25% per year from 2013-20 and faster in the earlier years, by 7% from now up to 2016 which is well below the historical average of 5%. Given the potential for weaker capital imports, and a lower Australian dollar, UBS expects import volumes to rise just 3.5% per year from 2013-20, with even slower growth of 2.25% from now until end 2016, well below the historical average growth of 6%.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms