THE BIG PICTURE: Taking stock of the economy ahead of the RBA’s meeting

The Reserve Bank is meeting to decide interest rates on Tuesday, so it is an opportune time to review all the recent domestic indicators as well as take stock of the global scene.

Firstly the international environment has softened. The European debt crisis is again in focus, putting upward pressure on borrowing costs for banks and sovereign debt issues. In addition, softer economic indicators in the US are causing more analysts to re-assess whether there will be a third tranche of monetary stimulus – QE3. And discussion on the Chinese economy has shifted from concern that growth is too strong, to questions about whether the economy is actually now slowing too much.

On the domestic front, weaker economic readings have clearly dominated over the past month. First, the economy contracted by 1.2% in the March quarter. And while the result was heavily influenced by the floods and cyclone in Queensland, it is also clear that the broader economy has lost momentum.

The economy should rebound in the June quarter but given the softness of a range of indicators, the RBA is unlikely to take a risk and lift rates on the assumption that the downturn is temporary.

Certainly consumers are reluctant to spend, as evidenced by no change in retail spending over the March quarter in real terms. Consumer confidence fell in April. Tourist arrivals hit an 11-month low in March, restraining economy-wide spending. And employment fell by 22,100 in April – the biggest fall in 22 months.

Then there is the housing market with new lending at decade lows, home prices falling and with building approvals well below longer-term averages.

On the corporate front, profits have fallen now for three straight quarters, an event that only happened once before – during the global financial crisis. And while businesses are hopeful about investment next financial year, short-term plans were downgraded by 4% – the biggest downgrade on record.

The good news on the inflation front is that price pressures are contained. Wages only grew by 0.8% in the March quarter, well short of expectation for a 1.1% increase. Miners may be getting healthy wages, but it is clearly not translating to higher earnings for all.

All in all, it is hard to justify a rate hike in this sort of environment – even if you took the view that weaknesses in the economy may prove temporary. In short, the Reserve Bank has time on its hands. Certainly the Reserve Bank has made it clear that a rate hike appears likely at some point in the future to keep inflation in check. But that point hasn’t been reached as yet. We continue to pencil in a rate hike in August, but if the soft readings on the domestic economy continue, and overseas jitters remain, the timing of any move would be put out a few months.

The week ahead

The first half of the coming week is dominated by key economic events but the excitement tails off as the week progresses with thankfully nothing of note slated for Friday. Overseas, the US economic diary is sparsely populated although Chinese trade data is slated for Friday.

On Monday TD Securities and the Melbourne Institute release the May inflation gauge – the most current measure of price pressures in the economy. Importantly, underlying inflation is well contained, reflecting significant discounting by retailers. Data on job advertisements are released the same day.

On Tuesday the Reserve Bank Board meets to decide interest rate settings while the NAB business survey is also released. We can’t see any reason why the Reserve Bank would be touching rates in the current environment. While people have jobs, they aren’t spending, thus causing businesses to discount in order to move stock. And rate cuts would only be put on the agenda unless there was an unexpected and significant loss of momentum in the economy. The NAB business survey should provide justification for a decision to leave rates on hold. Caution is the watchword for both consumers and businesses.

On Wednesday consumer sentiment and housing finance data are released. Little change in consumer confidence is likely especially with the economy contracting in the latest quarter. But housing finance is expected to have finally lifted after dropping for three straight months. The number of owner-occupier loans is tipped to lift 4% with the value of all lending up 7%. Lending has slid almost 13% over the past three months.

And the monthly job figures are issued on Thursday with employment expected to have rebounded. We are tipping a 25,000 increase in jobs for May, reversing the 22,100 drop recorded in April. The jobless rate will likely be around 4.8-4.9%. Another fall in jobs would not be a good look for the economy, especially after a 16-page report by The Economist magazine has just hailed Australia’s miracle economy.

A quiet week is in prospect in the US with a paucity of ‘top-shelf’ economic indicators due for release. On Monday the employment index is due with consumer credit on Tuesday and the Federal Reserve’s Beige Book on Wednesday. The Beige book is a summary of economic conditions across the Federal Reserve districts. As such it is a qualitative rather than quantitative reading on the economy. But it is timely and comprehensive, giving some hint about whether the Fed needs to keep stimulating the economy.

On Thursday, international trade, wholesale sales and inventories and weekly jobless claims data are all released. The trade deficit is expected to widen from US$48.2 billion to US$48.9 billion, boosted in part by high oil prices.

And on Friday, data on import and export prices and the monthly federal budget are issued.

Elsewhere, China releases trade data on Friday. Analysts expect annual export growth to slow from 29.9% to 22.6% while import growth is tipped to lift from 21.8% to 24.4%. Data on money supply and lending could be released either on the Friday or Saturday. The data on production, investment, inflation and consumer spending are targeted for June 14.

Sharemarket

The general assumption is that when the economy is strong and optimism is high that investors favour smaller companies or small cap stocks. The assumption being that smaller companies have the most to gain from a stronger economic environment. And when times are more uncertain there is a belief that investors should stick with large companies or big cap stocks. But how does a strategy of following big or small cap stocks play out over the longer term

Over the past 20 years returns on the broad market (All Ordinaries) have risen by 570% or about 28% a year with the star performer actually found in mid cap stocks (up 38 per cent a year) rather than big caps (up 32%) or small caps (up 23%). But in the much shorter time frame of the past five years, big caps (13% annual returns) were slightly in front of the broader market and small caps (both around 10% returns) followed by mid caps (8% a year). The key message being that strategies should always be revised over time with total returns rather than capital growth monitored for performance.

Interest rates, currencies and commodities

The new adage is that Australia rides on the back of a dump truck, rather than on a sheep’s back, but higher wool prices have certainly given farmers another reason to be happy as well as boosting Australia’s export prospects.

And it is just a simple matter of demand and supply. Supply is tight at present, recently causing the cancellation of a sale in New Zealand. But on the other side of the equation, demand from China, Europe and Taiwan is strong. As a result, the eastern market indicator is back near record highs. Over April and May, the EMI fell from 1386 cents to 1294 cents, but the price has rebounded to 1384 cents.

Could fixed-interest home loan borrowers receive good news in the next few weeks? The three-year swap rate hit a two month low of 5.23% in late May, well down from levels near 5.45-5.50% recorded earlier in the month. And while rates have edged back, it is apparent that rates have been falling, not rising, over the past month. The outlook for fixed-term rates will clearly depend on what the RBA says on Tuesday.