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Economics
The recession we don’t have to have
July 24, 2008
Clifford Bennett, Chief Economist, Sonray Capital Markets

The Australian dollar looks set to strike toward Parity to the US dollar over the next 1-3 weeks, despite the increasing likelihood of the "recession we do not have to have".

Sonray was the first to highlight the potential for the "recession we do not have to have" in Australia toward year-end in a report published January 14th (attached). At the time new car sales were at record highs, but we noted the risk of Australia following a similar path to that of the US, that being vulnerability in property prices and our non-consensus view that retail sales could be soft in H1.

The RBA has, contrary to its own pronouncements, not been successful in slowing the economy and containing inflation, but rather unsuccessful in understanding the nature of the current bout of inflation, and has inadvertently tipped domestic demand on a downward course that risks a "recession we did not have to have". As the Fed had done in 2006, the RBA in 2008 remained pre-occupied with a vanilla take on inflation data, instead of recognizing the danger of the already apparent property price weakness in some eastern suburbs, as well as the absurdity of attempting to contain global oil and food price pressures with a blunt domestic instrument.

So where are we now? The domestic economy is already well into a significant downturn which could intensify into a domestic demand recession, as this year’s unnecessary RBA hikes continue to flow through the economy for another six to twelve months. This interest rate pressure on consumers, coming as it does on top of high petrol and food prices, declining equity market wealth and declining home equity wealth, will now be compounded with difficult to get credit, all of which may see the Australian economy stall quite suddenly in Q3 and Q4. The RBA may have in 2008 engineered an irrecoverable stall, leading to a hard landing.

It has been my contention for some time that the RBA can at this point in the global economic cycle only choose between, high inflation and strong growth, or, high inflation and weak growth. In other words at this time domestic instruments cannot impact inflation, domestic monetary policy can only impact demand, but that demand will not influence the inflation outcome because the inflation outcome Australia will experience is a function of global pricing pressures, not domestic demand pressures. So all the RBA has done is add to the economic pain of the consumer, and when a consumer society stops spending, the downturn can be severe.

As the first to foresee that the RBA would be cutting rates at year end, even though it itself does not realise so, we maintain that view. In summary, the domestic demand slow down will be more severe than current consensus expectations, and is an unnecessary product of RBA errors.

A recession is still very much on the cards for the US, and our central scenario there remains stagnant growth throughout 2008, and into the first three quarters of 2009. Most commentators now agree with our long held view that the US economy will begin to recover 6-12 months after property prices stabilise. The most likely scenario is that US property prices will have run their course to the downside by the end of this year. The US will continue to see consumers cutting back, high oil prices as their currency continues to fall, and extremely difficult credit conditions. The US will however at the end of 2009, worst case early 2010, begin to turn around, as long as the Fed can stop itself from hiking due to inflationary pressures that are beyond its control.

The Australian economy as suggested in January is at greater risk of "the recession we do not have to have" than most commentators are currently contemplating. Certainly exports will remain very strong, as fast as we can get the stuff on boats, but domestic demand is vulnerable to the current malaise of forces against it. These include high petrol prices, high food prices, the start of a potentially US style continued and intensified fall in property values, and equity market wealth has already been significantly eroded, but perhaps most damaging of all has been the unjustified increase in interest rates by the Reserve Bank this year. The outlook for Q3 and Q4 is not great in domestic demand terms. The fabulous strength of the export sector will moderate the coming down-turn, and should see Australian GDP picking back up toward trend levels around 3.5% by mid 2009. The outlook would however begin to match the dire view of the US, if the RBA were foolish enough to hike again. As we suggested earlier today, it is quite likely that today’s inflation data was the peak in the cycle, and the RBA will stay on hold until a softening domestic economy in Q3 Q4 encourages them to cut rates by December.

Now back to Equity markets.

At this morning’s in-house meeting I suggested that if the ASXSP200 recovered 5150 that would tend to suggest the already bullish feeling about the market was correct, for the first time in a while in a sustainable fashion. Given the high just seen, I am going to add a touch of salt and suggest we use 5,175 as our magical resumption of bull markets indicator. The Dow Jones rallied hard in the last hour yesterday, so the opening today will be interesting to see if that last hour rally can truly be maintained. The equivalent of ASXSP200 5,175, in the Dow Jones is 12,010. So for the moment then it is possible we are only having a good run in the midst of a still bear market. I do believe however that the next 1-2 days trading may well confirm the trend direction for months to come. If this is a bull market developing right now, then the Dow Jones should be able to maintain itself above 11,110, and the ASXSP200 above 4,920. So there is room for a pullback, but if the Dow opens firmly tonight, the rally is likely to continue.

Overall global view remains a mature consumer economy called the USA has exhausted itself with the bursting of the debt bubble, and while tarnished, the rest-of-the-world will continue to grow quite strongly despite the US doldrums.

Expect Oil to consolidate, perhaps for several months which would really surprise everyone, in a US$120 to US$140 range. Gold is expected to remain highly sort after on dips, as we are seeing they can be significant. Nevertheless the outlook is very positive for Gold. If correct about rest-of-world economic strength, Gold will remain in high demand. If wrong and we have a serious global slow-down, Gold will be like never before the ultimate safe haven. The US dollar has a further 10% to fall over the next twelve months, and could even have a momentary spike of around 15% lower.

The key point today is that Equity markets may now have fully priced in the still to come further decay of the US economy, and this is why they are beginning to rally so sharply.

The currency implications will be surprisingly negligible.The Australian dollar will continue to be driven by global pricing pressures. We have long argued the US would experience below consensus stagnant growth through 2008 and 2009, while the rest-of-the-world, though momentarily moderated, will continue to grow quite strongly through this period. The financial markets result will primarily be a still much lower US dollar, and continued higher Gold and Oil prices. Commodity prices in general will resume their up-trend, albeit with significant volatility.

For the Australian dollar the prognosis then is unchanged, our door-step-of-Asia commodity producer status, alongside rising commodity prices due to continued strong global demand, coupled with high interest rate yields, maintain the fundamental price pressure for the currency to move toward US$1.01 by year end, with US$1.08 likely in 2009, and perhaps even US$1.12 in 2010. This will be despite the domestic slow down. Both the Australian dollar and the domestic economy will be being driven by the same impulse, un-necessarily high RBA rate settings.

Even with an expected 25 point rate cut in Q4, and again in Q1, Australia will maintain a very attractive yield by global standards. Toward year end is also when global data will increasingly confirm that the rest of the world is continuing to grow strongly, despite US stagnation. This combination of factors will continue to see the Australian dollar highly sort after by global fund managers.

Short term, there is only slight risk of a further pull back toward .9650 .9625. The far more likely scenario is continued broad based US dollar weakness acting as a catalyst for fresh buying of this high yield commodity producer. Expect a few days consolidation .9700 to .9800, but the dominant and immediate risk remains very much to the upside.

Parity to the US dollar may only be 1 to 3 weeks away.

Australian Consumer Prices rose by 1.5% in Q2, above expectations of 1.3%, and pushing the year on year rate to 4.5%.

This is a very firm number, and certainly means the RBA will not be cutting rates until December or perhaps Q1 2009.

The RBA will not be raising rates either, as this number was expected to be high, and fully reflects higher petrol prices. Given the current retreat in Oil prices, which I expect will see Oil now consolidate for perhaps a few months in the US$120 to US$140 area, this CPI number today may in fact be the peak in this inflation cycle for Australia.

The RBA would be well advised to maintain current settings, and in fact recently has perhaps shown some signs of recognizing the potential for a severe domestic demand slow down. It is simply impossible to ignore falling equity and home wealth alongside increasing credit cost and what will remain high, but perhaps not higher, petrol prices. While the export sector will continue to boom, the Australian consumer remains badly in need of some TLC.

Equity market implications of a continuing neutral to hawkish stance by the RBA are not severe. Equity markets in general appear to be looking for excuses to buy, rather than the last few months of looking for excuses to stay sidelined. With regard to the RBA most investors recognize that lower oil prices should stay the RBA’s hand until the severity of the domestic demand slow down is clearer.

Currency implications are some initial buying pressure, but again that excitement could abate quickly as participants recognize the RBA will remain on hold. The big picture range for the AUD at the moment is .9649 .9790, with immediate consolidation and a lot of energy building in this .9675 .9735 range.

Clifford Bennett, Chief Economist, Sonray Capital Markets.

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