What's in store for the Australian economy in 2009?

18.08.08

A difficult question.

The ‘R’ Word (Recession) has been tossed around the media recently, primarily because the current economic data suggests that things are slowing down and they are slowing down fast.

However, things have been pretty good for the Australian economy over the last 15 years. The last recession in Australia is a distant memory, profit growth has been solid for years and until recently; inflation and interest rates were generally benign.

Some economists earlier this year became concerned that the RBA (Reserve Bank of Australia) was going too far in raising the interest rates, and that excessive rises in the interest rates would increase the chances of a ‘landing’ that was harder than necessary.

What do we know?

1. Australia has seen a major tightening in financial conditions over the last year;
2. The RBA has increased the official cash rate by 1.00% to 7.25% over the last year;
3. Bank lending rates have risen by an additional 0.5% to 0.6% reflecting an increase in the cost of funds due to the global credit crunch. As a result, the standard variable mortgage rate has increased from 8.05% a year ago to just over 9.60%. This 20% increase means that a family with a A$250,000 mortgage is now paying about an extra $75 a week in interest payments;
4. The credit crunch has slowed the amount of credit available to lend. This is set to worsen as provisioning for bad debts cuts into the lending ability of banks;
5. Shares have had a 30% top to bottom fall, reducing wealth levels and confidence and boosting the cost of equity capital;
6. House prices have started to top out and fall, further cutting into wealth levels and confidence
7. The surge in petrol prices has added about A$20 a week to a typical family’s weekly petrol bill;
8. Consumer and business confidence have fallen back to recessionary levels;
9. Retail sales volumes have fallen at an annualised rate of 1.8% so far this year after rising 5.6% last year;
10. Housing and relating indicators are uniformly weak with falling building approvals and housing finance commitments, weekend auction clearance rates running about 20-30 percentage points lower than a year ago and generally falling house prices;
11. While the pipeline of investment projects yet to complete is huge, new projects are starting to slow down;
12. Private sector credit growth has slowed dramatically and housing credit is growing at its slowest pace in over 21 years;
13. Softening job vacancies, business hiring plans and job growth indicate the labour market is slowing.

But will we have a Recession?

Again, a very difficult question. Given all these variables discussed above, it is likely that we will see a further deterioration in growth in 2009.

But it is not all bad news. Australia is in better shape than many other countries. The strength in the terms of trade is providing a boost to national income. Moreover, rural production is likely to be boosted this year, there is a huge pipeline of investment projects, an undersupply of housing and our budget surplus and high level of interest rates means there is plenty of scope to ease policy if need be.

This all suggests that while the risk of recession is now significant (around 40%), it is still likely we’ll avoid it, but with growth slowing to 1% to 2% over the next year.

What does this mean for investors in shares?

Sharp economic downturns are bad for shares for the simple reason that they are bad for profits and investor confidence. However, the Australian share market has arguably already priced in the possibility of economic recession. The market is now trading well below fair value. The market’s forward PE is now just 11 times and a 30% slump in profits is required to bring it back to its ten year average of 15.2 times. As such there is a good buffer already prices into shares and we remain of the view that they are good value from a longer term perspective, though earnings will need to be reviewed carefully prior to stock selection.

It is likely however that the news flow over the next few months will remain poor – with more earnings downgrades, more bank provisioning for bad debts and more bad global news. The ‘ride’ is likely to remain rough at least until the end of the calendar year.