Commentators tend to treat the here and now as though it will last forever. Accordingly, the weight of current opinion sways in the breeze, buffeted by each piece of good or bad news, usually biased towards reflecting the latest piece of news. Now, after a run of good news, there is a mood of optimism in the economy. The same people who, only a few months ago, were sweating on the second quarter of negative growth so that they could call a (technical) recession are now waxing lyrical on the resilience of the Australian economy in the face of world recession.
BIS Shrapnel’s forecasts have gone from standing out at the beginning of the year as the most optimistic to being close to the most pessimistic – without the forecasts actually changing. What recession? Now the talk is all about the rebound, of the strength of the Australian economy, the end to the investment downturn, the strength of consumption expenditure and the problems of an over-strong economy. “When will we see the next round of interest rate rises? Can we afford to continue with the fiscal stimulus associated with infrastructure spending? Will it overstimulate the economy? And what about the deficit?” This optimism is premature. Certainly, we’ve seen positive growth through the first half of the year. But my forecast is that growth will relapse, remaining flat for the rest of this year and next before a strong rebound in the economy in 2011. Let’s take stock for a second. Why did we see all that positive news in the first half of the year?
My answer is that most of it was due to government stimulus. The stimulus packages were intended to cushion the economy against the impact of the downturn, to prevent a more severe recession. They were successful. But the current tendency is to look at the strength that they engendered as being due to a rebound in the economy rather than an expenditure boost. That makes a huge difference. An expenditure boost will relapse once the boost has finished. People treated the household handouts as a windfall to be spent. And they were. That’s what caused the rebound in consumption expenditure in the first half of the year. Household disposable income grew extremely strongly over the last financial year.
It was boosted at first by strong employment and wages growth. (Was it only 18 months ago that the primary policy concern was demand-inflationary pressure caused by capacity and labour constraints?) Then, as the Reserve Bank responded to a slowing economy by reducing interest rates, the reduced interest costs went straight to the mortgage belt. But, with confidence collapsing under the weight of the world financial crisis, compounded by fear of unemployment, little of this was spent. Most households maintained their mortgage payments so that the interest rate reductions went towards reducing the term of the loan. Households went into precautionary saving mode – despite near record growth in real household disposable income, household spending stalled. But the handouts were different. While some may have been saved, most was spent.
The problem is, of course, that once the additional income from the handouts is no longer there, income will fall back, affecting expenditure. Household disposable income is likely to fall in real terms this year as employment falls and wages growth weakens. Even with the recovery in confidence, we think private consumption expenditure will remain relatively flat. Business investment picked up in the June quarter, leading many commentators to interpret that as the beginning of an upswing after a shallow downturn. Indeed, I saw several misinterpretations of the ABS figures for private new capital expenditure expectations supporting this view. Would that it were so! The CAPEX expectations figures have been deteriorating rather than improving. Business is still in cost-cutting, cash-saving mode, with falling profits and a severe credit squeeze affecting their ability to invest. Equipment investment picked up strongly in the June quarter after a fall in the March quarter. But that was mainly due to a pull forward in spending resulting from the Government’s tax deductions for business spending on plant and equipment. That will leave a big hole after the tax deductions end.
We think equipment investment will fall by 10 per cent this financial year, and that could prove conservative. Private engineering construction is still growing. But that’s being held up as we complete the last round of projects. The prospect is for a substantial decline over the next two years. Even with some projects, including Gorgon, being brought forward, we’re looking at a fall of one third in work done on minerals investment over the next two years. Private engineering construction will fall by 20 per cent over the next two years. Commercial building has already begun to decline, hit hard by the impact of the credit squeeze on property and affected by the weakening of demand. That will continue. All in all we’re looking at a 15 per cent decline in business investment over the next 18 months. It’s not all negative. The Government’s infrastructure investment program will add substantially to investment.
In addition to the schools program, there is a strong boost from health-related investment waiting in the wings to boost the building side. And government infrastructure spending will provide a significant boost. Meanwhile, residential building remains weak. But a recovery in residential property has already begun. And that will initiate a phase of construction building strength through next calendar year and beyond. Strong government expenditure will only partially offset the fall in private investment this financial year. But recovery in residential construction will take over as a driving force of investment in 2010/11. I don’t want to be the bearer of bad tidings, but we have to be realistic about this. The current wave of optimism is being viewed through rose-tinted glasses. As the government stimulus ends, expenditure will stall or fall. Far from recovering quickly, investment will fall this year, constraining growth in the economy.
Private consumption expenditure will be constrained by falls in real household disposable income. The upshot is that BIS Shrapnel is forecasting real GDP growth of 0.9 per cent this financial year, with weak employment growth and the unemployment rate heading towards 7.5 per cent or higher. In that environment I don’t expect significant rises in interest rates until the second half of 2010. But once they start, they’ll rise significantly. Nor should we cut government infrastructure investment spending prematurely. We can use the infrastructure and we need the boost to the economy. Once the construction cycles turn positive in 2011, there will be time enough for governments to refocus on their deficits. The next 18 months will be tough, with weak investment constraining growth. But we expect a strong rebound beginning in 2011 as rolling investment cycles underwrite growth.