Australian & New Zealand Weekly

Week beginning 28 September 2009

• Global Financial System Facing Challenges.
• Australia: RBA Governor Stevens & Treasury Secretary Henry to appear at Senate enquiry into fiscal stimulus Monday.
• Australian data focus: key retail sales data for August released; also dwelling approvals & private credit growth.
• New Zealand data: building consents, business & employment confidence due.
• US data: busy week includes house prices, consumer confidence, Chicago PMI, core PCE deflator, manufacturing ISM, pending home sales, construction spend, auto sales, factor orders, employment report & plenty of Fedspeak.
• Key economic & financial forecasts.

Global Financial System Facing Challenges

In a very quiet week the most important development was the release of the Reserve Bank of Australia's Financial Stability Review. Not surprisingly the assessment of the health of the Australian banking system was glowing.

The banks' growth since the last recession has concentrated on mortgages. Whereas in the last recession mortgages represented around 30% of balance sheet assets they are now between 50% and 60%. According to the Review the quality of the banks' mortgage loan books is robust, with only 1% of borrowers having an LVR larger than 90%. Non performing loans represent only 0.6% of the mortgage books.

Business loans have deteriorated faster with non performers at 3.5% of business loans up from 1% a year ago but still well below the 6% which banks experienced in the last recession. The Bank pointed out that businesses had been able to raise substantial equity in 2009. Non financial and real estate companies raised a record $63 bn of new equity in 2009 which has allowed a reduction in gearing of non resource companies from 95% in December 2008 to around 82% in June 2009. In addition large corporates have issued around $23 bn (around 3% of the stock of business credit) of corporate bonds (mainly offshore) since the beginning of 2009. With business credit growth slowing from 17.1% in the year to June 2008 to 0.8% in the year to June 2009 this increased reliance on the global capital markets has offset only very marginally the picture in Australia of collapsing business credit (annualised growth rate of business credit over the last 6 months has been minus 6.5%).

From an interest rate perspective the RBA's assertion that rates are at inappropriate emergency levels cannot be supported by the business credit aggregates. The key driver must be the 42% rise in owner occupiers' mortgage finance approvals although the Bank does note that there has been a disconnect in this rate cycle with property investors, with the value of new loans to property investors up by only around 5% from the lows. With First Home Buyers pulling back and banks being increasingly challenged by continuing wide funding spreads in the global markets there must be some considerable risk to the sustainability of the current mortgage boom. New finance approvals fell by 2% in July and our industry data suggests a further fall in August.

With credit pressures possibly easing, the policy focus may switch to inflation. The next CPI will be released on October 21. We currently expect a 0.8% print for the September quarter underlying inflation. That would see annual underlying fall from 3.8% to 3.5% but still well short of the Bank's current forecast for 2009 of 3.25%. A read of around 0.5% would be required in the December quarter to deliver the 3.25% forecast - a substantial drop down from the 1.2%; 0.7%; 1.1%; 0/8%; 0.8% (forecast) prints of previous quarters. It would also jeopardise the 2% forecast for underlying inflation in 2010. A decision by the Bank to revise up its inflation forecast could be sufficient justification for raising rates in November. However, as discussed previously, we think the uncertainty about the employment and consumer spending momentum will be enough to see the Bank delaying until 2010.

Global Financial System

The second area of interest in the Review was the Bank's take on the state of the global financial system. The chart below sets out the estimates which the IMF produced in April for the extent of losses to entities lending to US borrowers. The IMF estimated that losses would eventually reach USD 2.7 tr up from the October estimate of USD 1.45 tr. That increase, rationally, took into account the much sharper than previously (October) expected rise in the unemployment rate and the sharper contraction in GDP growth. Losses on residential mortgages were estimated to have doubled and, in particular, losses to consumers were revised up sharply. Now, these estimates were made at probably the low point of confidence in the economic cycle so there is probably some scope for a better outlook. However we really do not know yet.

The RBA points out that losses on securities slowed from USD 215 bn in 2008 H2 to USD 60 bn in 2009 H1. The bulk of the remaining losses are held in the "hold to maturity" loan books of the lending entities. As the RBA notes, "favourable accounting treatment has also played a role in reducing write downs". That upward trend in the loan writedowns is confirmed in the Review with large global banks setting aside provisions of USD 142 bn for the first half of 2009 - a 70% increase on the first half of 2008.

I believe this dynamic is only in its early stages - banks progressively writing down "hold to maturity loan losses"; shrinking capital; constraining credit to delever as well as limit the need for new capital. While the IMF estimates may now prove to be too pessimistic the general theme of accounting changes allowing the banks to avoid the sharp writedowns on "hold to maturity loans" which we saw with securities held on balance sheet the pressure from the bad debt cycle in the US has years to run.

The pace of improvement in markets is likely to create a wide gap between market expectations and the capacity of an economy constrained by a slowly unfolding bad debt story to deliver on those expectations.

Australia: Data Wrap

RBA Financial Stability Review

• The Report highlights that conditions in the global financial system have improved significantly over the last half year. While markets remain under a degree of stress, extreme risk aversion has dissipated. The Australian financial system has, throughout the crisis period, remained resilient.
• The Australian banks have - in aggregate - experienced only a modest decline in profitability. The banks are well capitalised and have strengthened their balance sheets further with significant new equity raisings during the past year. The recent decline in bank profits has been mainly because of a rise in provisioning charges, reflecting a rise in banks’ non-performing assets. The ratio of these to total on-balance sheet assets stood at around 1.5% as at June 2009, compared to 0.7% a year earlier. This is around 0.8% above its average of the past decade, but still well below the early 1990s peak of over 6%.
• Household financial conditions continued on a path of improvement. The significant decline in net worth through 2008 is being reversed - the RBA estimates that more than half of the peak-to-trough contraction has now been clawed back (including all of the small decline in house prices). Meanwhile, policy easing has been a major cushion, maintaining growth in real disposable income in the face of declining labour income.
• The Report noted improved consumer sentiment had seen some winding back in the very conservative financial attitudes apparent earlier in the year.
• The good underlying condition of household balance sheets continues to be apparent from loan performance. Although up from their lows, non-performing housing loan ratios remain historically and internationally low.
• Arrears on credit cards remain steady. Property repossession applications and backruptcy data also suggest the number of households experiencing extreme financial difficulties remains low.
• Most businesses entered the crisis period with sound balance sheets after a long period of economic expansion. Even so, many businesses have strengthened their balance sheets, by taking advantage of the recovery in equity markets to raise additional equity. Debt reduction - with business credit declining - has also been evident.
• The Report notes that some borrowers are facing tighter credit conditions and rising borrowing costs, as banks review risk margins as lending facilities are renewed. For some sectors, particularly related to property, this is acting as a break on economic activity in the near term.
• The report highlights that a distinguishing feature of the current episode is the success of equity raisings. The amount raised in the first half of 2009 was equivalent to around 6% of GDP, more than double the average of the last 15 years.
• Conditions in wholesale credit markets have eased. Large nonfinancial corporations have issued around $23bn in corporate bonds so far in 2009, compared with only around $2bn in the second half of 2008.
• On the international architecture, the Bank acknowledges the need for a convergence of prudential and accounting standards, but argues for the maintenance of flexibility at the national level.

Round-up of local data released last week

New Zealand: Week ahead & Data Wrap

Here comes the sun

What a week. A whopping improvement in the current account deficit, a big upward revision to the dairy payout, an official - if tenuous - end to the recession, a huge leap in consumer confidence: no wonder the NZD was on a flyer.

The current account balance staged a spectacular improvement in the June quarter. The annual deficit narrowed sharply to 5.9% of GDP, from a revised 8.1% in the year to March (was 8.4%). The goods balance (s.a.) was again in surplus despite the higher NZD: strong dairy export volumes were a saving grace. Import prices fell, and import volumes were down 22% from their peak a year earlier - a stark illustration of the impact of the recession on demand. Services recorded a smaller deficit than in recent quarters, thanks to a bumper ski season and fewer overseas trips by New Zealanders. The investment income deficit narrowed sharply, partly thanks to the BNZ’s $661 tax bill, which reduced the deficit by some 0.4% of GDP in itself. But even allowing for this, income outflows were very soft as profits of overseas-owned firms took a substantial hit in Q2, a product of the drawn-out recession.

We expect the annual deficit to fall below 5% by year-end as last year's spike in world oil prices continues to drop out of the equation. However, the import bill is likely to rise again as demand recovers through next year.

In even bigger news, Fonterra revised its forecast dairy payout for this season from $4.55 to $5.10/kg of milksolids - even assuming a NZD near US$0.70. This lifts farmer revenue by over $750m, the equivalent of 0.4% of GDP, and follows strong gains in USD dairy prices: up 56% in two months at Fonterra’s global auctions. We suspect the payout estimate includes a view that world prices will hold on to most of their recent gains as the world economy recovers. There are some supply-side positives too: US milk production is expected to keep contracting well into next year.

Wednesday brought more good news in the form of the Q2 GDP release. Meagre 0.1% economic growth is hardly spectacular, but still, it is the first positive figure since the final quarter of 2007. The substantial interest rate cuts over the past year, expansionary fiscal policy, and a strong increase in net migration have all given general support to economic activity. But still, the positives only just outweighed the negatives. On the plus side, we saw a strong increase in real estate and business services as lower interest rates and net migration boosted house sales. Maari oil helped boost mining activity, and exceptionally cold weather saw electricity demand rise strongly. Surprisingly, direct government spending made a negative growth contribution. Instead, expansionary fiscal policy showed up elsewhere, with infrastructure investment dampening the decline in the construction sector and the April tax cut helping lift consumer spending/retail trade by 0.4%.

However, there were still plenty of negatives, with large contractions in construction, manufacturing, wholesale trade, and transport and storage. The recovery, if we can call 0.1% growth that, is clearly not widespread. But perhaps the most encouraging aspect of the data is that the detail points to more growth to come. A truly massive inventory unwind is a case in point. Production will need to lift to replenish depleted stockpiles, especially now consumer spending is rising again. We have therefore nudged up our estimate for Q3 growth from 0.2% to 0.4%.

To top it off, consumer confidence rocketed higher in the September quarter, lifting 14 points. The Index now stands at the highest level in four years and well above average. Consumers, regardless of age, income group, gender, or region, are convinced that good times are on their way. All survey components recorded increases, but the dominant influences were a sharp turnaround in the short-term economic outlook, and consumers' assessment of their financial position in a year's time hitting a 7-year high. Other questions paint a more sobering picture: a net 21.9% of respondents still say they are worse off financially than a year ago; a relatively small proportion believe it is a good time to buy a major appliance; and the majority would still save or pay down debt with a cash windfall. The temptation is therefore to downplay the implications for consumer spending in the face of high household debt, tighter credit, and rising unemployment. But history tells us that when confidence rises, spending follows. There is no compelling reason to think that this time will be any different.

All this happy news will have the RBNZ seriously questioning whether they can really hold off until late 2010 to lift the OCR from its extreme lows. But the degree of economic slack means an interest rate hike is not imminent - perhaps mid-2010 or a touch earlier. Finally, the August merchandise trade balance was considerably weaker than expected thanks to a drop in exports, perhaps reflecting dairy stocks now running low.

The coming week provides a well-earned breather, with relatively minor releases. Building consents (Tuesday) are likely to rise, with residential showing a bounce-back from particularly weak apartment consents in August. Monthly business confidence (Wed) has been on a roll lately and will hopefully stay fairly robust - though steadily tightening monetary conditions are a headwind. Employment confidence is also released on Wednesday.

Round-up of local data released last week

Data Previews

Aus Aug private credit

Sep 30, Last: 0.2%, WBC f/c: 0.2%

Mkt f/c: 0.2%, Range: 0.1% to 0.4%

• Total credit expanded by 0.2% in July. That was a slight improvement upon the previous five months, when credit was either stagnate or increased by 0.1%, with declines in business offsetting a modest upward trend in housing.
• We're forecasting another rise of 0.2%, judging that monthly credit growth is at or nearing a turning point.
• Housing credit growth, which was 0.6% in July, has stepped up from the low of mid-2008. Low interest rates and government incentives have triggered a surge in new lending, although the impact has been tempered by existing mortgage holders paying down debt more aggressively.
• Business credit may be beginning to decline at a slower rate, contracting by 0.3% in July. Business confidence is up, but firms are still focussed on strengthening their balance sheets.

Aus Aug retail trade

Sep 30, Last: -1.0% (sa, trend series suspended), WBC f/c: 0.2%

Mkt f/c: 0.5%, Range: -0.5% to 0.8%

• Retail sales fell 1.0% in July after a 0.8% decline in June. The falls need to be read in the context of three strong months prior to this (+2.4% in March, +0.8% in April and +1.2% in May), with the overall pattern reflecting the substantial boost from the Govt's second round of fiscal stimulus payments.
• We expect the fall-back from this boost to continue in August - an effective drag on monthly growth of about -0.2ppts compared to about -0.5ppts in July. However, the record surge in the Westpac-Melbourne Insitute Consumer Sentiment Index between May and September points to an underlying improvement in spending (though the survey detail suggests consumers remain cautious about their finances). Overall we are forecasting a 0.2% rise in August sales, implying a pick-to a 4%+ underlying annual sales pace (long run average is 5.7%yr).

Aus Aug dwelling approvals

Sep 30, Last: 7.7%, WBC f/c: 2.5%

Mkt f/c: 2.5%, Range: -2.0% to 5.0%

• Dwelling approvals are still playing catch-up with other indicators showing a sharp improvement in housing activity. Approvals rose another 7.7% in July after a 9.9% jump in June, but were still up 'only' up 27.7% from their low compared to 60%+ gains for housing finance approvals for construction.
• The under-performance is partly due to developer financing problems which has seen apartment approvals particularly weak (and volatile). However we suspect it is more a case of delayed response. First Home Buyers require a signed contract to be eligible for Govt bonus payments and would have had more urgency in securing finance than building approval.
• We are forecasting August approvals to show a solid 2.5% rise led by a strengthening upturn in private houses.

NZ Aug building consents s.a.

Sep 29, Last: +5%, WBC f/c: +12%

• Total dwelling consents bounced back in July, despite a very weak outturn for the volatile apartment component (only 55 apartment consents were issued versus 133 consents in June).
• We expect some payback from the weak apartment figures in August, while the upward trend in ex-apartments should continue.
• Non-residential consents picked up in July, but remained relatively weak compared to a year ago. Recent surveys of investment intentions suggest further small gains in August.

NZ Q3 employment confidence index

Sep 30, Last: 96.1

• Employment confidence lifted off record lows in the second quarter, but remained in pessimistic territory.
• The recent run of positive economic news and the further sharp gain in consumer confidence are expected to provide support to employment confidence.
• Improved employment confidence in combination with the more buoyant mood of the consumer would certainly bode well for the emerging economic recovery.

NZ Sep NBNZ business confidence

Sep 30, Last: 34.2

• General business confidence posted strong gains in August to be at its highest level in 10 years. Further gains are expected in September following the results of other surveys. The BNZ business survey rose again in September and the manufacturing PMI joined the services PMI above 50.
• Agriculture was the only pessimistic sector in August (some 44 points below overall confidence). Large increases in world milk powder prices and a chunky increase in Fonterra’s payout forecast is likely to see confidence in the agriculture and related sectors improve.
• More important than improving confidence is that it translates into more output and employment. We will be looking for further improvement in the indicators of own activity, employment and investment intentions as more evidence that the economy is on the road to recovery.

US Sep ISM factory report

Oct 1, Factory Last: 52.9, WBC f/c: 53.5

Since Q2, most US business surveys have shown varying degrees of improvement, as fears of economic Armageddon around the turn of the year were replaced by "normal" recession concerns. Since mid year, most regional surveys have risen above the neutral level, indicating factory sector expansion, and in Aug, the ISM factory index jumped from 48.9 to 52.9, its first >50 reading since Jan 2008.

Regional factory surveys already available for September were either unchanged (Richmond) or quite a bit stronger in the headline (NY and Philly), although their detail was less impressive, with orders and shipments slipping in some districts and jobs falling at a faster pace than in Aug.

Because the ISM factory headline is a composite of the activity detail, Sep's gain could be much less impressive than Aug's.

US Aug core PCE deflator - approaching all-time lows

Oct 1, Last: 0.1%, WBC f/c: 0.0%

• The core PCE deflator slowed from a "soft" 0.2% gain in June to 0.1% in July, pulling the annual rate of gain down to 1.4%, a pace last seen in late 2003 during that year's relatively shortlived bout of deflation concern.
• The core CPI also recorded 0.2% and 0.1% gains in June-July, followed by a very soft 0.1% in Aug (0.068% before rounding). That is a strong signal that the core PCE deflator could record a flat Aug result (as it tends to run a little slower than the CPI). If so, the annual core PCE deflator could slip to as low as 1.2% yr, which, apart from the one month drop to 1.1% yr immediately after the 9-11 terror attacks, would be the equal lowest recorded since the early 1960s.
• The report will include modest personal income growth of 0.2% but solid auto-driven personal spending growth of >1%.

US Sep non-farm payrolls to fall by 150k

Oct 2, Payrolls Last: -216k, WBC f/c: -150k

Oct 2, Unemployment Last: 9.7%, WBC f/c: 9.7%

• Payrolls fell by 216k in August, the smallest loss of jobs recorded in exactly a year, but the separate household survey found a loss of 392k jobs, the steepest since May, and that, combined with a small rise in the labour force, pushed the jobless rate up to a fresh cycle high of 9.7%, a rate last seen in 1982-83.
• With the economy likely expanding at a 2-3% pace in Q3, job shedding should further diminish, a view supported by falling initial jobless claims, and less weak job components in some business surveys. We forecast a 150k payrolls fall.
• We expect the household survey to show a small fall in the labour force as some unemployed stop the job search; if so the jobless rate should not rise further this month, but a 10% unemployment rate is still imminent.

Westpac Institutional Bank
http://www.westpac.com.au

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