Australia: Slower Growth in 2008

Expect a significant slowdown in Australian domestic growth next year. There are two reasons to be confident that growth will slow:

First, policy makers — particularly the RBA — want growth to slow. After five years of stellar activity, turbo-charged by the global boom in resources, Australia has hit capacity constraints. To sustain growth at the recent pace would see a material lift in inflation, anathema to an inflation-focused central bank. Consequently, the uncertainty in our forecast is not whether domestic demand will slow, but whether the RBA has already tightened policy enough to achieve that slowdown. If it hasn't, then it will tighten more, until growth does slow.

Second, global growth seems set to slow. Morgan Stanley economists have downgraded growth forecasts for Europe, the UK, Japan and the US. Our US team is now forecasting a recession in 2008.

The prospect of a global slowdown will open up a second avenue of global weakness to Australia. The first was the global credit crunch: bank funding costs have increased, non-bank mortgage lenders are in difficulty, and corporate funding (particularly of speculative deals) has been restricted. Now there will be a second impact: weaker commodity prices.

Admittedly, the near-term outlook for commodity prices is mixed. Our mining analyst, Craig Campbell, notes that the annual contract negotiations for bulk commodities are still likely to see large price increases. However, spot prices for base metals, which are already falling, are likely to weaken further next year. This also raises the prospect of bulk prices falling in 2009. The bigger-picture point, however, is this: after five years of perpetual upgrade to commodity prices, next year is more likely to be one of downgrade.

This matters. The most important factor in the mining boom has been the lift in export earnings, which has almost solely been due to rising prices. Our forecasts incorporate significant growth in volumes. But if prices fall — which is not our forecast for 2008, but it is for 2009 — then the benefit of rising volumes will be neutralized.

We have revised our economic forecasts in light of the September quarter GDP report and our team's new US forecasts. We have not made substantial changes to 2008 as we had already incorporated a significant slowdown in domestic demand. But we have reduced our 2009 forecasts, with average GDP now at 3.0%, down from 3.7% for 2008e.

Domestic markets are not pricing in the slowdown we expect next year, nor the change in global conditions. The Australian equity market is trading at the top of its usual valuation band and at a significant premium to both the US and global equity markets. Moreover, these valuations are based on earnings that look optimistic to us.

I continue to have major concerns about the medium-term outlook for Australia. This is not necessarily an issue for 2008, barring an unexpected setback to employment. But the bigger-picture point is that Australia’s private sector remains a constant borrower and highly leveraged. The most eloquent measure of this problem is that with the highest terms of trade in 50 years, Australia continues to run a current account deficit — a measure of national dis-saving — of almost 6% of GDP. This is against the backdrop of an economy with unprecedented leverage.

The major reason for this borrowing is household-sector borrowing. Although the household saving rate has turned positive, the broader net saving series remains in deficit (the saving rate includes several non-cash items, such as 'income' from owner-occupied rent, and depreciation on owner-occupied housing). This suggests that the household sector would be very vulnerable to job losses — as would lenders, who would presumably see a major uplift in delinquencies and defaults.

The key catalyst is job losses, and that doesn't seem in prospect for next year. However, unless you think the economic cycle has been banished, there will be job losses at some stage. Our view is that 2009 is a period of high risk if global growth falls short of current circumspect forecasts.

For investors, 2009 is over the horizon. But the markets would start to price in the downside if warning signs of financial distress become apparent next year. That, for now, is not our base case. However, it suggests that the risks around our already cautious outlook for 2008 are to the downside.

Of course, very few households directly hold foreign debt. The middle man is Australia's financial system. Australia's banks have seen a material change in their funding mix over the past decade. Deposits now support far less of their loan book, and the residual is increasingly funding overseas.

In my view, this introduces substantial system risk. Australia's banks can now have a material funding squeeze — either in terms of price or quantity — if global capital markets lose their appetite for Australian bank debt.

By Gerard Minack Sydney
Morgan Stanley
December 17, 2007