Month: May 2013

Confidence – boom or bust for Australia?

An interesting dynamic has been playing out in the Australian economy over the last 18 months. Business confidence has been falling, yet it appeared that consumers were becoming more optimistic. I wasn’t sure what to make of this.

When I studied economics we analysed national income, the balance of payments and learnt about the relationship between income, inflation, employment and the money supply. Essentially, we learnt about how the economy ‘really works’. We didn’t ignore the role of consumers or business though. My economics text made mention of the ‘animal spirits’ as one determinant of the business cycle. For the most part though, we didn’t spend much time covering that dark side of economics – how human behaviour and emotions drive decision making and how that in turn moves the economy – our animal spirits.

Enter behavioural economics (which is not a recent thing) to offer an alternative view on how the economy works. The book “Animal Spirits” (Shiller, Akerlof 2009) offers this description of the ‘animal spirits’;

“It refers to our peculiar relationship with ambiguity or uncertainty. Sometimes we are paralyzed by it. Yet at other times it refreshes and energizes us, overcoming our fears and indecision.”

Underlying our animal spirits is the concept of confidence. The dictionary definition of confidence is ‘trust’ or ‘belief’. Some economic theory is based on how consumers & business make rational decisions by engaging in rational behaviour – gathering data and making decisions on the balance of probability. Again, Shiller & Akerlof go further;

“But there is more to the notion of confidence. The very meaning of trust is that we go beyond the rational. Indeed, the truly trusting person often discards or discounts certain information. She may not even process the information that is available to her rationally; even if she has processed it rationally, she still may not act on it rationally. She acts according to what she trusts to be true.”

“In good times, people trust. They know instinctively that they will be successful. They suspend their suspicions.”

Translation – in good times, people spend. There is perceived certainty and we act with vigour. In bad times, or even just uncertain times, business and consumers tend to withdraw. The mere threat of uncertain conditions in the future is enough to put a dampener on major spending decisions. Clearly one decision has an expansionary impact on the economy, the other, a contractionary impact. This school of thought says that it is the change in the animal spirits that drives changes in behaviour and the kinds of decisions we make.

It’s not just the concept of confidence that informs our animal spirits. In their book, Akerlof & Shiller also outline corruption, fairness, the money illusion and stories as the other determinants of our animal spirits. It’s easy to think that one event, such as an interest rate cut or a budget announcement can change or shift the outlook of an entire economy. These single events can add to or subtract from the social mood, but our animal spirits will be informed by a broader range of influences. Unfortunately, this is still an emerging way of thinking about the economy and there is only a broad measure of ‘confidence’ that is tracked in the mainstream, which is what I will look at in this post.

So if confidence is a fundamental driver of the ‘animal spirits’ of decision making, what do we make of the current disparity in movement between consumer and business confidence and what does it mean for the Australian economy?

Business confidence has been falling

The NAB monthly business survey looks at current business conditions and business confidence. All measures of the business survey have been grinding lower since 2010. Capacity utilization, business conditions and business confidence continue to deteriorate, albeit not to the same extent as during the GFC. So far, this has been a slow grind down rather than a dramatic drop based on outright ‘fear’.

Source: RBA

This is not a sign of boom times for Australian business.

The latest NAB report shows little indication of any near term improvement in business activity – employment conditions, forward orders and capacity utilization were all weaker from already subdued levels.

Whilst there was an improvement in trading conditions and profitability for the month, it came at the expense of employment;

Source: NAB

The overall trend downwards is unmistakable and the components of business conditions have moved into negative territory and continue to edge closer to GFC levels.

Spare capacity has also been rising (deteriorating) and is very close to those levels recorded in the GFC. The decline in this measure has appeared to level off, if not improve somewhat, over the last 4 months;-

Source: NAB

Overall, business conditions remain difficult. A recent report by Dun & Bradstreet shows businesses coming under cash flow pressure with average business payment times rising during 2013;

“Business cash flow has slowed this year, placing further strain on a range of industries already experiencing low confidence because of weak trading activity and high operating costs.” (Source: D&B 22/05/13)

There was one thing that really jumped out in this latest NAB report and that was the dramatic decline in mining confidence;

Business Confidence by Industry (net balance) 3mth moving avg

Source: NAB

I highlight this because it is an important area of the economy. Essentially, there is rising pessimism and uncertainty regarding our biggest export industry. Declines in commodity prices (coupled with a persistently high $A), lower mining profits, uncertainty regarding future demand as a result of lower than expected growth in US, China & Europe and the impact of the transition from the investment phase to the export phase of the mining boom are having an impact on mining confidence.

It appears that we are starting to see falling mining equipment sales and profit downgrades from mining services providers as well:

  • Transfield announcing a profit downgrade and job cuts due to; “ongoing uncertainty in commodity markets resulting in delay and deferment of a range of resources infrastructure projects” (Source: AFR 21/05/13)
  • “Mining services contractors (Coffey, UGL & Worely Parsons) cut earnings guidance and announced plans to cut jobs amid project delays and cancellations” (Source: MacroBusiness 21/05/13)

This is important because mining has been a key component of business investment & capex growth, with growth in mining investment forecast to taper off this financial year:

Source: RBA

I’d also argue that mining has been an important driver of employment, retail sales and house price growth over recent years. When you dig into these numbers from the Australian Bureau of Statistics (ABS), you start to realise just how much Western Australia (as a proxy for mining generally) contributes to the growth in these indicators.

The Reserve Bank of Australia (RBA) is optimistically forecasting that other sectors will ‘step in’ to fill the gap left by mining investment. One such area is Liquefied Natural Gas (LNG). Not three days after the RBA released this forecast did Woodside cancel its $36b Browse LNG project in Australia (in order to develop the project in Canada and compete with Australia instead). Uncertainty has been created about the future size of LNG exports (and new projects in Australia) as Russia and the US announce plans to enter the North Asian market. Overall, there has been $149b in mining projects cancelled in the last year.

Are these the ‘optimistic’ conditions where business will be spending to expand? Not likely. You are already seeing non-mining capex flatten out and employment conditions weaken in an attempt to control costs & maintain profitability.

The question is how could consumer confidence be improving under these conditions? What happens to business conditions when, or if, consumer confidence falls? We might not have to wait long for that answer…

Consumer confidence back in negative territory

When I started writing this post the Westpac Melbourne Institute Consumer Sentiment Index for May had not yet been released. As of April 2013, the trend upwards in consumer confidence was still broadly intact, despite being slightly lower in the month of April. The Roy Morgan data though, showed consumer confidence moving lower. I was going to write about how long it would take before consumer sentiment started to falter, especially on the back of continued difficult business trading conditions, leading to further cuts in employment (as we saw above). Well, the May numbers are out and the results were poor. The consumer sentiment index moved back into negative territory, dropping -7.3 pts to 97.6, only just above the reading for the same month last year (95.28). Anything below 100 represents more pessimists over optimists.

The index is based on a survey of over 1,200 Australian households, which reflect consumers’ evaluations of their household financial situation over the past year and the coming year, anticipated economic conditions over the coming year and the next five years, and buying conditions for major household items.

Source: Westpac, Melbourne Institute May 2013

The truth is that we will need to see how this plays out over the next several months in order to ascertain whether it is a major trend change.

I’d like to look at the trend leading up to the May 2013 data because it will help to understand what has been driving the shifts in consumer sentiment.

In late 2008/early 2009, the drop in consumer sentiment during the on-set of the GFC shows just how fearful consumers had become and it was showing up in lower consumer spending. The government moved quickly to ‘restore confidence’ through stimulus payments and a doubling of the First Home Buyers (FHB) grant. It’s interesting just how quickly consumer confidence bounced back – not quite to all-time highs (which was in January 2005 at 127.67), but close. Recall that the messages in the press were all about how Australia avoided the worst of the GFC. But ever since that rebound, sentiment started drifting off until the pessimists outnumbered the optimists again (early 2011). Up until this point, business & consumer confidence had been moving in a similar direction. From August 2011, the two start to move in opposite directions.

So what made consumer sentiment turn upward in Aug 2011? Here is the data on a shorter time period from June 2011 until May 2013;


From a low of 89 in August 2011, sentiment had moved up to 97 by October 2011. At first I thought it had to be interest rate reductions. But the first interest rate cut in this current cycle of cuts didn’t occur until November 2011. Was it as simple as the promise of rate cuts? It was after all the period of time when the RBA shifted its policy stance from contractionary to expansionary.

I mentioned earlier that I doubted that one event alone would turn the tide. What else was happening during 2011?

  • Employment growth was starting to slow – it had been growing by between 200k and 300k.
  • House prices were drifting off again after the FHB-fuelled rebound. The September 2011 qtr recorded the second highest post GFC fall in % terms (ABS) – but that wouldn’t have been known until October or November when that data was released. This could have in fact spurred confidence in some sectors (investors) – real estate prices coming down, together with the RBA making noise about rate cuts. Remember that our real estate market didn’t ‘crash’ during the GFC, so the ‘story’ of our economy about how real estate is always a winning trade was still in place.
  • Retail sale growth was low, but wasn’t getting worse.
  • Mining was peaking – the iron ore price was only just off its peak, at around $170/t.
  • $A remained strong – the full brunt of that was only just starting to be felt by business. I recall some media interpretation of a strong $A as a sign of strength of our economy (that others had faith in our economy).
  • Globally, the Euro crisis started to rear its ugly head and that only got worse into the latter part of 2011.
  • QE2 had ended mid 2011 and the US stock market was reacting negatively. The Aussie stock market had already started to turn down as well.

Despite the lack-lustre news, consumer confidence started to improve from September 2011. Note that none of the points above address what the social mood was at that time in Australia.

After a pull-back in early 2012, confidence continued to improve, unlike business confidence. Consumers had become more positive about their financial situation. This appeared to manifest itself in retail sales growth, growth in housing finance (albeit low), growth in personal credit (now back up to zero %) and a savings rate that remained at 10% of GDP (spending rather than increasing savings).

But this ‘improvement’ in confidence did not translate into improvement in business performance or confidence, as you might expect. That is because I think this level of consumer confidence was (is) shaky at best.

This is the first reason why;-

Source: RBA

Households still hold high amounts of debt. This could be a source of nervousness in a real estate market that is no longer powering upwards as it had been for so many years. But as interest rates decline, household finances look a little better. There is no crisis, just caution and maybe a little bit of hope.

The second reason why I think confidence was/is shaky at best is that, as I mentioned earlier, WA was a key driver in the improvement across most metrics of the economy post GFC. A high rate of growth in employment, retail sales or housing prices could easily be tracked back to WA (or mining). In most other states (Vic, QLD, TAS & SA), I would argue that consumers were (are) in fact quite uncertain. Maybe we’ve hit a tipping point now that mining has come off the boil;-

Source: RBA

The unemployment rate has been trending higher in most states for a while now – Vic, QLD, TAS & SA. The unemployment (& employment) situation in NSW has not been as bad. But the situation in WA has turned – unemployment is rising and employment growth is slowing.

The Roy Morgan consumer confidence report claims that consumer sentiment started to move lower post the federal budget in May. That could have tipped the scales as well – consumers received less as a result of that budget. The message was all about tightening. This is against the backdrop of an election whereby both parties are talking austerity for the federal budget. I don’t want get into a discussion about the federal election in this post, but I will say that I doubt it will add to a sense of hope or optimism in Australia (the outcome is a foregone conclusion right?). There is a bumper sticker making its way around that seems to sum up the election quite well:

“Voting for Tony Abbott because you hate Julia Gillard is like eating shit because you hate spinach”

So what are the implications if consumer confidence continues to decline?

  • Larger value purchases may be put off – real estate, cars, major renovations. This would have implications for credit growth (already at historical lows), house prices and construction etc.
  • Higher growth in the savings rate
  • Lower discretionary spending – resulting in further pressure on sales/income for business, placing continued pressure on margins and employment.
  • Paying down of debt – an alternative use of disposable income
  • Shift into less risky assets – taking money out of the stock market
  • A shift in social mood towards uncertainty, even greater fear about things such as employment stability. I would already argue that our business media headlines are starting to be tainted with some ‘doom and gloom’ (maybe it’s just what I read).

This all of course has a flow on effect into the broader economy.

Based on current business confidence levels, we are seeing business retreat. The last few years have seen difficult trading conditions, despite what appeared to be improving consumer confidence. For the most part, consumer optimists started to outweigh the pessimists. But the latest consumer confidence numbers (May 2013) show this trend reversing sharply – if this continues, (that is a big ‘if’) then another driver of spending and activity in the economy may retreat. This could have major implications for the economy, specifically housing, finance and discretionary spending.

Inflation in Australia – March 2013 Quarter

Last week the ABS released its quarterly CPI series for March 2013. Across various measures, inflation looks to be within the RBA’s range of 2-3%:-

Source: ABS 6401.06

The headline inflation figure (ALL Groups CPI) rose +0.4% (or +0.1% seasonally adjusted) quarter on quarter and +2.5% year on year. The RBA, in assessing its interest rate policy, looks mostly at the trimmed mean and the weighted median in order to understand ‘underlying’ price pressures;

  • Trimmed mean (15% of the smallest & largest price movements are removed) +0.3% quarter on quarter and +2.2% year on year.
  • Weighted media (price change at the 50% percentile by weight of the distribution of price changes) +0.5% quarter on quarter and +2.6% year on year.

Since mid-2008, the trend in the underlying inflation rate suggests that price pressures have been abating and we are appear to be moving more into the lower end of the RBA’s range (compared to where we were at the start of 2010).

Another way to look at the CPI series is to look at tradable v non-tradable items. This helps us to understand the extent to which price changes are attributable to domestic factors (changes in labour costs, productivity) or international factors such as exchange rate movements or changes in supply and demand in overseas markets.

  • Tradable component – items whose prices are largely determined on the world market (approx. 40% of CPI by weight). Items are classified as ‘tradable’ if imports or exports represent at least 10% of supply of an item.
  • Non-tradable component – the remaining categories (60% of CPI by weight).
  • The ‘total supply’ of an item is domestic production plus imports.

Source: ABS 6401.06

Price pressure in Australia appears to be driven by ‘non-tradable’ items. Over the last ten years, the non-tradable component of CPI has been running at an average growth of +3.8% – well above the RBA’s range. These are items in the CPI whose prices are largely attributable to domestic factors – so changes in labour, productivity, profits. Does this mean we are experiencing wage inflation? There are potentially factors other than wages driving these costs.

Delving into the detail of the non-tradables segment, its not the ‘labour-intensive’ categories contributing to price growth:-

Source: ABS 6401.11

The top four items (electricity, medical and hospital services, rents and new dwelling purchases by owner occupiers) account for 45% of the total non-tradable contribution to total CPI (of the last year). It’s very hard to see what might be driving these price changes without delving into each and every product/service category. Prices of two of the top four items (rents & housing) will be determined by returns or market prices. Electricity prices may have been impacted by carbon taxes (a one-off), although electricity prices have been rising since before then on the back on growing demand. My point is that labour prices may not be the driving force behind all of these price changes.

What is this data telling us about prices here in Australia? The average contribution of all other non-tradable categories (90%) is 1.5 index points each – this is not very high. If a household is exposed to each of these product or service categories, then the costs do add up. Most households would be experiencing the impact of electricity changes, but not all households are renters. If you are renter, you won’t be exposed to purchasing an owner occupied dwelling. Households won’t be exposed to each and every category. Some of these categories are discretionary, some are not.

If it is wages driving some of these costs, then somehow, that cost is being off-set or margins are being reduced. Look at the lowest ranking categories above – household staples of eggs, milk, bread and breakfast cereal. These are categories with high household penetration – yet there has been a slight deflationary trend in these prices over the last year. On the bright side, this could be due to improvements in productivity and those savings are being passed onto the retailer and then onto the consumer (although this is not likely in my experience).

I think this data supports the assertion that across most categories, pricing pressure in Australia is low. The exceptions are housing, electricity & medical services.

Looking more broadly at ALL the CPI categories, it may not be surprising to find that housing was the major contributing category to the total CPI change in the March quarter. This category includes rents, new dwelling purchases by owner occupiers, maintenance and repair and property rates and charges. In second place was education, possibly due to the start of the new school year (seasonality).

Source: ABS 6401.11

During the quarter, quite a few categories experienced price falls. Food (mainly fruit and vegetables) & non-alcoholic beverage prices have fallen. In the more discretionary categories such as clothing footwear, furnishings & household equipment, price pressures have also abated. Some of these categories have started to experience a rebound in retail sales (clothing & footwear), possibly as a result of price declines. There has been the assertion that, rather than discounting, these price changes are as a result of ‘convergence’ with global prices. If this is so, then we can expect to see growing margins.

Contrast these more short-term changes with the annual contribution to CPI by group (the same chart on an annual basis);

Source: ABS 6401.11 

On an annual basis, housing, utilities and health are the major contributors to inflation in Australia. But note that there are more categories overall making a positive contribution to inflation, albeit modestly.

Across all the major measures, inflation is still within the acceptable range in Australia.