Australian & New Zealand Weekly

Week beginning 7 July 2008

• US Fed: rate cuts off the table but hikes unlikely before late 2009
• Australia: housing finance, consumer sentiment, jobs previewed
• New Zealand: labour market data looming as critical
• Bank of England to stay on hold but case for more rate cuts building
• US: Bernanke testifying to house panel
• Key economic & financial forecasts.

US Fed View - Theory Versus Practice

Markets are jumping the gun in pricing an imminent return to rate hikes in the US. While the Fed's inflation concerns rule out additional cuts, they are unlikely to prompt it to raise rates in the face of a patently weak domestic economy. Concerns about rising inflation expectations also need to be tempered; many may see sound theoretical reasons for the Fed to respond, but the practical reality is that weak demand and structural labour market changes will see few of these price and wage expectations realised.

The US economy continues to face significant headwinds with clear downside risks to growth. In particular, once the tax rebate boost dissipates the consumer will buckle again. As such, we believe that although rate cuts may have been taken off the table, the case for a rate hike is unlikely to fully materialise until late 2009.

This is not how the market sees things. In the first half of June the market moved aggressively to price in a steep rate normalisation profile. It has backed off a bit since then but at 2.58% 2yr yields are still implying more than one rate hike this year and the OIS market is fully pricing two hikes of 25bps by the end of January 2009.

We think this is way too aggressive. Put simply, our case is that the Fed just does not raise rates in the face of rising unemployment (nb: the unemployment rate held at 5.5% in June, up from 5.0% in April).

But to put such a simple case leaves us open to accusations of ignoring the effects of rising energy prices and the associated rise in inflation expectations. The more hawkish analysts (and a few regional Fed presidents) argue that the Fed can't allow these expectations to become embedded in price setting behaviour. The cost of squeezing out a sustained rise in expectations would be a much deeper recession.

We believe there are solid grounds to think these risks are being overstated.

The first point is to return to the concept of the Phillips curve, which links inflation to changes in output - in this case we have charted the change in core CPI vs the change in non-farm payrolls. It reveals a wide scattering but with discernible discrete shifts over time. The curve has generally been horizontal except for the high inflation period of the late 1970s and 1980s. In particular the last decade has seen a very flat curve at historically low levels. Low inflation has been inelastic to changes in employment growth. So even if we had very tight labour markets, which we don't, core inflation should not accelerate alarmingly.

That is all very well, the hawks may say, but what about expectations? Surely, just as the curve shifted north in the high inflation environment of the 1970s and 1980s, it can do so again in the late 2000s. They would argue that even if you accept that the Phillips curve is horizontal, rising inflation expectations can shift the curve up as those expectations become embedded in behaviour. Thus you get higher inflation outcomes at a given rate of unemployment.

Certainly expectations are on the move. The most recent University of Michigan (UoM) Consumer Sentiment survey revealed median 1 year out inflation expectations of a little more than 5%, the highest since early 1982. Even 5 year expectations, which tend to be more stable, have jumped to 3.4%, the highest since 1994.

On a theoretical level we accept that a level shift in the Phillips curve is possible. But to argue that on a practical level, there must be a credible mechanism through which expectations are realised. In the past, higher inflation expectations primarily flowed through to actual prices via labour attaining wage rises that made expectations self-fulfilling. Collectivised and highly unionised wage bargaining in turn saw sectoral wage increases spread throughout the labour market irrespective of productivity performances.

The landscape is very different now. US labour markets are less unionised than they were 30+ years ago. Accordingly, wage outcomes are more closely tied to the exigencies of market supply and demand.

And right now conditions point to subdued wage outcomes. The labour market has softened and the unemployment rate is rising. Since the mid 1980s, a rising unemployment rate has been associated with disinflationary pressures on hourly earnings. Even if the labour market was to tighten, it can take up to two years for this to result in higher wage inflation.

We can't see how labour will be able to push up wages on a “cost of living” argument. And it appears that consumers don't think they will be able to either. In the UoM survey, both the income and expected financial position indices have undershot price expectations: leaving their ratios at their lowest levels since the late 1970s. In addition, job security is down (the UoM index falls as the number expecting unemployment to rise increases) to the lowest level since 1990.

So, consumers are clearly pessimistic on wages rising by enough to meet higher prices. Thus households expect a decline in real income, suggesting that any rise in prices will see a hit to real spending. Credit may be accessed at the margin, but falling house prices and tighter lending standards suggest consumer loans will not be abundantly available.

Labour costs may remain in check but firms are still facing a significant cost pressures as rising global prices for energy, raw commodities and even capital lift their overall cost structure. Firms, where possible, will pass on those rises. Unlike previous cycles, slower growth in the US and a widening of its output will not generate a significant disinflationary impulse to global prices. As such, these price pressures will continue even as the US slides further into recession.

However, the weak starting point of domestic demand, the limited pricing power in labour and product markets and the additional demand dampening effects of price increases will dominate the inflation outlook medium term. Indeed a period of high inflation outcomes presents a greater threat to real spending than to a sustained lift in core inflation.

Australia: Data Wrap

May credit

• Credit increased by 0.6% in May. That represents an improvement from an increase of just 0.4% in April which was the weakest monthly result since mid-2001.
• Even so, there has been a substantial slowing in the trend pace of credit growth. This reflects the combined impact of higher interest rates and unsettled financial markets.
• Business credit strengthened in May, increasing by 0.6%. That follows the surprisingly anaemic 0.1% rise in April. Also, the February result was revised higher. These outcomes are more consistent with our view of current conditions
• Housing credit growth moderated over the last three months, as higher interest rates impacted. Softness is set to continue in the near term given weakness in new lending.

Jun TD-MI inflation gauge

• The inflation gauge rose 0.5% in June (0.49% to two decimals) following a 0.3% rise previously (0.31% to two decimals). The main sources of higher prices cited were petrol and rents. Partially offsetting price falls were seen in fruit and vegetables, and audio, visual and computing equipment. With a relatively lower 0.19%mth result from June 2007 dropping out, annual growth in the gauge rose to 4.8%yr from 4.5%, a new high for the more than 5½ year history of this series.
• With the June rise slightly higher than that seen three months prior in March (0.44%), 3mth growth edged up to 1.29% from 1.24% previously. The mid-month of the quarter read for the gauge has the better correlation with the quarterly headline CPI pace. In may that was 1.24%, above Q1's mid-month pace of 1.15%. The recent 3mth pace also remains consistent with another high headline CPI in Q2, similar to Q1's 1.3%qtr.
• After three months of narrowing, price pressures broadened in June. Prices rose in a net balance of 17 items, up from a net 12 previously, the highest breadth since February.
• While price pressures remain strong according to the inflation gauge, the detail provides some hope for a deceleration in the quarterly core inflation pace. Excluding petrol, the gauge rose just 0.1% in June after rising 0.2% in May and 0.4% in April and March. Also, the trimmed mean of the inflation gauge rose just 0.3% in June (vs 0.5% prev) the lowest rise since February.

RBA policy announcement

• The Reserve Bank Board decided to leave interest rates unchanged, as widely expected. However, there were several changes to the accompanying statement.
• International financial conditions were seen as more difficult, the Bank noting credit concerns had resurfaced in the past month.
• Domestically, the Bank noted that the recent flow of information has given additional support to its assessment of moderating demand growth. Along with household spending and credit growth, the soft May jobs numbers (employment down 19.7k) were also included as "tentative signs of an easing in labour market conditions".
• On inflation, short term pressures are seen as somewhat stronger with the Bank warning that "the CPI will be further boosted in coming quarters by the recent rises in global oil prices", which are also adding to global inflationary risks. However, high oil costs are also seen as contributing to demand restraint.
• Most importantly, while the Bank sees the outlook for inflation as uncertain and oil prices as driving higher results over the immediate short term, inflation is still expected to decline over the medium term "provided demand continues to evolve as expected". The implication is that the Bank will look through any fuel-driven spike in the CPI in coming quarters if demand continues to soften.
• The key medium term uncertainty remains whether the slowdown in domestic demand will be sustained given the sharp positive terms of trade shock flowing through in 2008.
• Our call remains that interest rates will be on hold for a prolonged period of time. Equally, we still see the risks to rates as being skewed to the high side given the extent of ongoing inflation pressures and given the positive terms of trade boost. Looking forward, the minutes of the July meeting will be released on July 15 with the Q2 CPI data released on July 23.

May retail sales

• Retail sales surprised on the upside in May posting a 0.7% rise against expectations of a 0.1% gain. This was the strongest monthly increase since November 2007.
• Also surprising was the pattern of sales by category which showed gains in many 'discretionary' segments that had seen significant declines in previous months.
• The May retail bounce stands in stark contrast to other indicators that suggest consumers are still coming under considerable pressure. Rising prices probably played a part in the result, implying weaker growth in underlying sales volumes. However, we also suspect the bounce is partly a 'relief' rebound: May was the first month since December that consumers weren't slugged with a mortgage interest rate rise, official or market-led. As such, sales growth is unlikely to be sustained at these rates for long, especially given the latest run-up in fuel prices.

May dwelling approvals

• Dwelling approvals fell 6.5% in May more than unwinding a 5.4% rise in April. Most of the April-May shift was due to a spike in apartment approvals.
• Private sector house approvals fell 1.2% in May after a 1.2% rise in April. This large, stable segment provides the best guide to the underlying trend in approvals. Its current trend declines of 6.5%yr annualised point to a downturn but not a particularly severe one (approvals regularly go up or down 15%+ in a cycle).
• The state breakdown continues to show a widespread weakening with the one exception of SA where trend approvals are running at a 25yr high. The other large states have now all seen trend declines of the order of 7 to 9% since the start of the year.
• The value of renovation approvals also dropped sharply in May, falling 10.2% after a 7.3% rise in April. The value of non residential building approvals is also trending lower at 1.1%mth, but remains extremely volatile month to month.
• Overall, the decline in dwelling approvals since the start of the year continues to unfold in an orderly manner. Indeed, the measured pace of the downturn to date, especially compared to finance approvals for established dwellings, suggests that an acute shortage of housing is providing more support to construction than broader market activity.

May trade balance

• The trade deficit was slightly higher than expected in May at $965mn (consensus $950mn), but the bigger news was the revision of the April position to a surplus of $12mn from a deficit of $957mn, the first trade surplus since March 2002. This stemmed from a revision to the value of iron ore exports, with the ABS adjusting for the anticipated price increase from the new contract prices recently negotiated. This adjustment lifted the price gain from March to April to 61% from 16%, and the ABS applied a +$725mn trend-break to metal ores and mineral exports and associated aggregates in April.
• Even with the April export gain revised up to 10.1% from 5.8%, total exports managed a further 1.5% rise in May. Rural exports surprised with a 2.2% rise despite weaker prices. Non-rural and other exports rose 1.6% after a revised 14.4% jump previously (was 7.4%). The upshot of this was that even after the trend-break boost to April exports, trend growth in May for total exports was a strong 1.8%mth, and for non-rural exports higher still at 2.1%mth.
• Even though imports bounced back with a 6.0% jump (consumer goods up 7.8% led by cars, intermediate goods up 9.9% led by fuels) after a 1.9% fall previously, trend growth continues to slow, particularly for consumer and capital goods, consistent with the slowing in domestic demand apparent through 2008.

Round-up of local data released last week

New Zealand: The Week ahead & Economic Wrap

Jobs in the balance

There were some bright spots in this week's data, if you take them in context. But as the market contemplates the timing and extent of the Reserve Bank's next easing cycle, conditions in the labour market loom as one of the biggest risk factors.

Building consents fell 45% in May, a near-complete unwind of the sharp spike in April (the result of developers rushing to beat an increase in consent application fees from 1 May). Excluding the volatile apartment component, residential consents have resumed their downward trend. However, non-residential consents reported a small increase in trend value relative to April, with low vacancy rates in the major cities encouraging office building.

Monday's business confidence survey also showed the commercial construction sector more confident about its own prospects.

Elsewhere though, firm's beliefs about their own prospects remained at recessionary levels, though increased confidence about interest rate cuts later this year provided some comfort. Not surprisingly, inflation expectations crept higher again, and pricing intentions rose to their highest level since December 2000 - a time when the New Zealand dollar was languishing at all-time lows, not at the upper end of its cycle.

The Westpac McDermott Miller employment confidence index fell 8 points to 120.8 in the June quarter, the biggest quarterly decline since the survey began in 2004. The shocking employment outturn in the first quarter of this year (29,000 jobs were shed according to Statistics New Zealand), high profile job losses announced through April and May, and continued pessimism amongst the business community, are just a few of the factors that are likely to have weighed on employment confidence this quarter. Nevertheless, at current levels, employment confidence remains in optimistic territory.

The tight labour market has been one of the key pillars of the New Zealand economy in recent years, providing critical support to the consumer as interest rates have risen, the housing market has toppled over, and the cost of living has ballooned. The survey suggests that employment has now become vulnerable to the economic downturn. However, at this stage most survey respondents believe the current weakness will be largely reflected in reduced job opportunities, rather than lower earnings. If this situation persists, then the Reserve Bank may be faced with a bigger inflation problem than they currently anticipate.

The NZIER's Quarterly Survey of Business Opinion on Tuesday will provide further clues on the balance of risks between inflation and growth. This survey is arguably the most important release ahead of the OCR review on 24 July - certainly the greatest source of uncertainty for our near-term outlook. While the CPI the following week will be ugly, there is far less scope for surprises (and past inflation outturns have only a small bearing on the Reserve Bank's forecasts).

Business confidence and activity indicators took a sharp dive in the March quarter, and we expect them to signal that Q2 GDP was even worse than Q1. The Reserve Bank's June forecasts assumed 0.2% growth in Q2, and more recently Governor Bollard commented that he expects it to be “roughly flat”, so a contraction in Q2 would represent a downside risk to their outlook. The labour market indicators - difficulty finding skilled and unskilled workers, and overtime worked - eased substantially in the last survey, though they remained at historically high levels. Another sharp fall would indicate a looming increase in unemployment, though not necessarily to the extent that the Reserve Bank is projecting.

Strong pricing and inflation indicators are likely to temper any market reaction to weak activity measures. Recent surveys have suggested that firms not only intend to pass on cost increases, but have been able to do so; the last QSBO survey showed that the percentage of firms increasing their prices in the previous three months was the highest since 1987.

We may also receive the REINZ's June house sales figures by next week. Figures for the Auckland region published by Barfoot and Thompson earlier this week pointed to a small rebound in sales, in what is typically one of the slowest months of the year. Fixed mortgage rates were reduced by as much as 50bp over May and June, which looks to have lent support to an otherwise moribund market. But with a sharp contraction in sales in the year to date and a large backlog of unsold homes, prices will remain under pressure. We continue to expect price declines to reach an 8% annual pace, although there will be monthly ups and downs around that trend.

Round-up of local data released last week

Data previews

Aus July Westpac-MI Consumer Sentiment

July 9, Last: 84.7

• The Westpac-MI Consumer Sentiment Index fell by 5.6% in June from 89.8 in May to 84.7 in June, the lowest read since December 1992. Although interest rates were unchanged in the month, a sharp rise in fuel prices knocked sentiment further into negative territory.
• The July survey is in the field from June 30 to July 6. Factors that are likely to influence sentiment include: interest rates again staying on hold in July but more equity market declines (the ASX down 8.1% since the previous survey), higher fuel prices (up another 3.9% from the previous survey date to over $1.62/litre nationwide), and continued weakness in economic data including tentative signs of softening in labour markets.

Westpac-MI Consumer Sentiment Index

Aus May housing finance

Jul 9, Last: -2.5%, WBC f/c: -4.0%

Mkt f/c:-2.0%, Range: -5.0% to flat

• We're forecasting owner-occupied housing loan numbers to decline by a further 4% in May. Indeed, some indications are that risks to this are skewed to the downside.
• Housing finance has fallen sharply as sharply higher interest rates bite. New loan numbers to owner occupiers plunged 17.3% over the three months to April. That decline is now as great as that over late 2003/early 2004.
• While the RBA was on hold in April and May, the 1.4% rise in variable mortgage rates since last August continued to impact.
• The burden in this cycle is being felt most in the established housing market, with lending down 19.4%. Finance for the construction of new dwellings has experienced a more moderate decline, falling by 6% so far.

RBA rate hikes bite - as they did in 2003

Aus Jun employment chg

Jul 10, Last: -19.7k, WBC f/c: 25k

Mkt f/c: 10k, Range: -10k to 25k

• After 18 months of consecutive gains (a record run) employment fell 19.7k in May. Trend growth continued to slow, but it is far from collapsing. Monthly trend growth remains positive at 10.5k and annual trend growth of 2.53%yr remains above labour force growth.
• Our preferred leading indicators of labour demand continue to imply only a gradual slowing in jobs growth to 2%yr in 2008H2. Job ads have topped out, but are yet to enter any downtrend of significance. Our latest Westpac-ACCI labour market composite also implies jobs resilience over H2. Consumers' unemployment expectations imply risks of a faster slowing, but we feel this survey is currently tainted with a high degree of pessimism. We expect a 25k rebound in June jobs, which would see trend growth continue to slow gradually to 2.41%yr.

Aust jobs growth: rebound likely in June

Aus Jun unemployment rate

Jul 10, Last: 4.3%, WBC f/c: 4.3%

Mkt f/c: 4.3%, Range: 4.2% to 4.5%

• Despite the first fall in employment in 19 months in May, an accompanying pullback in the participation rate to 65.2% from a record high of 65.5% fully offset, leaving the unemployment rate steady at 4.3%. While the unemployment rate is above its February 4.0% low, the trend rate has only marginally risen from a low of 4.13% in March to 4.17% in May.
• With the pullback in the participation rate in May taking it below trend, continued strong cost of living pressures on households and a solid jobs rebound expected for June, we expect the participation rate to rebound in June to 65.4%. This would drive stronger labour supply growth than last month, and offset the forecast jobs rebound to leave the unemployment rate unchanged at 4.3% for the third consecutive month.

Unemployment and participation rates

NZ Q2 NZIER business confidence

Jul 8, Last: -64%

• The QSBO is the most important data point between now and the July OCR review. We think business confidence and activity indicators will give a clear indication that Q2 GDP was even worse than Q1, representing a downside surprise to the RBNZ.
• Difficulty finding labour (skilled and unskilled) is an excellent leading indicator for the labour market. A big fall would indicate a looming increase in unemployment.
• We expect pricing and inflation indicators to be extremely strong, following on from rising pricing intentions in the NBNZ monthly survey. Very strong inflation indicators will temper any market reaction to weak activity indicators, further highlighting the RBNZ's quandary.

QSBO capacity utilisation

NZ Jun REINZ house prices

Jul 10-16, Last: -1.4% yr

• Real Estate Institute housing data for the month of June will be released some time in the week starting 7 July.
• Lower fixed rates through May and June look to have provided some stimulus to the recent uninspiring market. However, overall we expect the activity data to remain very weak, with sales still around 40% lower than a year ago.
• The median price remained unchanged at $345k in May. However, the downward pressure remains intense given the sharp contraction in sales year to date. As such, we expect June prices to have pushed lower.

UK July Bank of England decision: on hold

Jul 10, Last: 5.0%, WBC f/c: 5.0%

• The BoE cut rates for the third time since Dec in April. But with the Bank forecasting inflation to rise to 4% in coming months, and community inflation expectations rising, easing remains off the agenda for the time being. Indeed there was some discussion of a possible rate hike at the June policy meeting.
• However the probability of a recession in coming quarters has risen. In particular, housing is in dire straights: prices are down 6% yr; new mortgage approvals are down 63% yr; mortgage equity withdrawal is down £8.5bn (2.3% of GDP) over the past year); construction is at its lowest since the early 1990s.
• As the economic slowdown intensifies, BoE policy committee members will form the view that, on a two year perspective, inflation will risk falling below the 2% target. Hence we expect the next policy move to be a rate cut, before year-end.

BoE official interest rates

US May trade deficit to widen

Jul 11 , Last: -$60.9bn, WBC f/c: -$62.5bn

• The trade deficit widened by $4.9bn in April, due entirely to oil, which added $5bn to the import bill. That meant imports jumped 4.5%, overwhelming a decent 3.3% jump in exports.
• Import prices rose 2.3% in May, led by fuel. So while we expect import volumes to be constrained by weak domestic demand, the price effect means imports should post a further 2% gain.
• Business surveys suggest that exports growth has remained solid, consistent with the competitive US$ and solid US trading partner growth in LatAm, Asia and the Middle East. May orders data were not that impressive, although Boeing's foreign sales were higher. Export prices rose only 0.3% in May. We expect a 2% rise in total exports.
• Gains of around 2% for both imports and exports would deliver a $62.5bn deficit in May.

US trade balance

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Disclaimer

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