Friday, November 07, 2008

Unemployment to rise 1% or 5% - nothing in between

Scott Haslam at UBS on what's at stake:

"How bad will the growth slowdown be? The debate seems to be centred around the somewhat banal question of whether Australia is going to incur a technical recession over coming quarters or not.

But regardless of whether GDP shows zero, slightly positive or slightly negative growth – none, one or two quarters of negative growth – it’s going to feel weak, consistent with our most significant downturn in about a decade.

The more relevant debate is about whether the unemployment rate is going to rise 1%pt or 5%pts, because history shows very clearly over the past 50 years, that there is nothing, no nothing, in between...

Indeed, in the two most recent periods where the unemployment rate rose 5%pts, 1982/83 & 1990/91, these were not short sharp slowdowns, but involved almost two years of broadly negative growth. While it’s impossible to say the latter more dire outcome won’t emerge, the shorter period of near zero growth seems more likely at this stage.

Sure, it’s true that it’s hard to see a more perfect negative storm for a credit loving commodity rich Australia than one involving a credit crisis and collapsing commodity prices. But it’s also true that if there was ever a period of time that Australia was going to outperform its advanced economy peers – given the fiscal and monetary fire-power on hand (and the insulating force of a falling exchange rate) – this also would be it.

As we’ve noted over recent months, to our advantage, the RBA has been leaning on the interest-sensitive sectors of the economy since Australia’s housing boom back in 2003, to contain inflation risks in the face of an overwhelmingly strong commodity and investment boom. Indeed, over recent years, the Australian consumers have noticeably reduced the pace at which they consume credit and increased their saving.

Deep recessions tend to arrive due to either consumers or businesses sharply curtailing their spending. Policy is working hard to counter the former - the so-called paradox of thrift. By our estimates, the 185bp of cash rate cuts passed on to date will be worth circa 9½% of after-tax income for an individual with an average mortgage, which adds to the over 2% of disposable income from this year’s tax cuts and cash-handouts.

So there’s no doubt consumer’s will have income, particularly if, as this week’s October jobs report shows, employment growth is slowing in a relatively orderly way to date (and remains positive).

But do unhappy consumers spend? We think they do, if they have money (though credit growth will surely be the victim of the Government’s most recent cash hand-out).

Challenging this notion, however, is the negative wealth effects due to the most significant fall in household net worth we have on record. If this week’s level of the Australian equity market holds through to the end of the year (…our equity strategists think we’ll see a double digit rise by then), net worth as a share of income will have fallen from its peak of 7.7 times income to just 5.7 times income. Falling wealth hashistorically aligned with rising saving rates…as people feel less wealthy, they save more out of their current income.

Helpful, in part, is the fact that in contrast to history, very little of the rise in wealth has been spent (which may reflect the most recent period was driven more by equity markets than house prices). Indeed, the rise in the saving rate over recent years is not out of line with the wealth destruction to date, suggesting the saving rate may not rise too much further, though we forecast a further rise toward 4% from 1%.

A sharp drop in business investment (the other driver of recessions) is a more worrying risk, though the much lower level of (economy-wide) corporate gearing and low and falling debt servicing costs provides some hope businesses will cut jobs growth to zero, not move it materially negative, as in 1982/83 and 1990/91."