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Global Markets Research

Issues

2 July 2013

Michael Blythe Chief Economist T. +612 9118 1101 E. michael.blythe@cba.com.au

mportant Disclosures and analyst certifications regarding subject companies are in the Disclosure and Disclaimer Appendix of this document and atww.research.commbank.com.au. This report is published, approved and distributed by Commonwealth Bank of Australia ABN 48 123 123 124 AFSL 234945.

The R-word returns

A number of respected commentators are talking about the risk of recession - which they put at 20-25%.

Among economists, a 20% recession risk is the default forecast.

Our view is that these risks are real but overstated.

Talking the economy down can weigh on sentiment but the ability to talk ourselves into recession looks quite low.

Concerns about the Australian economic outlook are lifting again. We have been down this path before. What is differentthis time is that a number of respected commentators are talking about the risk of recession - which they put at 20-25%.

Perspective is important of course. A 20% recession risk implies an 80% chance of dodging any recession bullet. And,among economists, a 20% recession risk is the default forecast. Australia has experienced four major recessions over thelast fifty-two years. So one recession every thirteen years on average putting the average odds over the period at 25%.A more sophisticated calculation looks at what financial markets are pricing based on the slope of the yield curve. Ourmodel implies markets currently place very low odds on a recession. More importantly, over the 1990-2006 (pre financialcrisis period) Australian markets have on average priced a 25% chance of recession.

Most of the recession risk is seen as stemming from the broader commodity story. There is either an income shockbrewing as commodity prices continue to slide. Or there is an expenditure shock looming as we go over the miningcapex cliff.

The income shockreflects a belief that the commodity supply-demand balance will favour lower prices as new projectscome on stream. But extra supply is needed to keep up with the growth in demand. The Chinese urbanisation process, forexample, has a long way to run. So just how the supply-demand balance plays out is not yet clear.

The bigger income risk may be the typeof demand. As economies mature the marginal dollar of GDP is more likely tocome from services than from (commodity intensive) infrastructure and manufacturing. But we shouldnt be afraid of thisgrowth transition. The Asian emergence offers some opportunities for Australias non-resources economy. Theseopportunities are there for the taking. A richer, older Asian population will want larger and better quality housing; betterquality food; more consumer durables; more education; more holidays; more health services and more financial services.

The expenditure shockreflects the likely rapid wind down in mining capex once existing projects are completed. But theresources story needs to be looked at in its entirety. About half the impact will be offset by lower imports of capital goods.And the other half can be covered by rising resource exports.

Alternative sources of activity are still needed to generate growth and absorb the potentially large labour market fallout thatcould follow the mining capex wind down. The necessary growth transition will not be a seamless baton pass. Variousbumps will be felt along the way. But these bumps are unlikely to push the economy into recession.

Can we talk ourselves into recession? It is certainly reasonable to argue that economic news will influence sentiment andsentiment can influence activity. But the linkages are loose and variable. The Melbourne Institute/WBC Survey ofConsumer Sentimentis a useful case study. Our analysis shows that consumer recollection of more negative economicstories does tend to be associated with a weak economy. But swings towards negative news recall sometimes lead andsometime follow changes in economic growth momentum.

A clearer story emerges in the detail. Sentiment surveys are typically based on a mix of current conditions andexpectations. Australian consumers are a pessimistic lot. They nearly always have a more negative view on the outlookthan they do of current conditions. Consumers views on expected conditions are strongly correlated with news recallabout the economy (correlation: 0.83). Consumers views on current conditions have a weaker linkage with news recallabout the economy (correlation: 0.53) and are more reflective of what they see around them.

So talking the economy down can weigh on sentiment. But the linkage from sentiment to activity is weaker and the ability

to talk ourselves into recession looks quite low. One reason for this weak linkage may actually be that fears about theoutlook can generate a response by policy makers and consumers that ultimately reduce activity risks.

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Here we go again?

Concerns about the Australian economicoutlook are lifting again. These concerns areunderstandable. They reflect disappointment

with some of the domestic and Chineseeconomic data. And the market turmoiltriggered by the approaching taper of QEmeasures in the United States.

Most economists have revised down theirgrowth forecasts for 2013 and 2014. But theseforecasts have been shaved rather than axed.The pattern is very similar to 2012 where growthforecasts were also revised lower as the datadisappointed (and subsequently revised upasthe year progressed and the data improved).

The R-word

What is different this time is that a number ofrespected commentators are talking about therisk of recession. The emerging consensuswithin this group seems to be that the odds ofAustralia sliding into recession at some pointover the next couple of years sits at 20-25%.

Perspective is important of course. A 20%recession risk implies an 80% chance ofdodging any recession bullet. And, amongeconomists, a 20% recession risk is in manyways the default forecast.

One simple calculation is to note that Australiahas experienced four major recessions over thelast fifty-two years. So one recession everythirteen years on average putting the averageodds over the period at 25%.

A more sophisticated calculation looks at whatfinancial markets are pricing using a probitmodel based on the slope of the yield curve.Some care needs to be taken with thesemodels given the distortions imposed by QEmeasures in recent years. Nevertheless, ourmodel implies markets currently place very lowodds on a recession.

More importantly, over the 1990-2006 (prefinancial crisis period) Australian markets haveon average priced a 25% chance of recession.

Past performance doesnt guarantee futurereturns as the old disclaimer goes. So it isworth examining the arguments that lie behindthe recession risk.

Is this time different?

Most of the recession risk is seen as stemmingfrom the broader commodity story. There iseither an income shock brewing ascommodity prices continue to slide. Or there isan expenditure shock looming as we go over

0

1

2

3

4

0

1

2

3

4

Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 Jul-13

AUS GDP CONSENSUS FORECASTS(annual % change)

Forecast made in...

%%

Source: ConsensusEconomics

2013

2011

2012

2014

-2

-1

0

1

2

3

Sep-59 Sep-67 Sep-75 Sep-83 Sep-91 Sep-99 Sep-07

THE BUSINESS CYCLE(smoothed growth in private spending) %

-2

-1

0

1

2

3

%

Recessions/slowdowns

0%

20%

40%

60%

80%

100%

0%

20%

40%

60%

80%

100%

Mar-84 Mar-90 Mar-96 Mar-02 Mar-08

AUS RECESSION ODDS(derived from slope of yield curve)

Recessions/slowdowns

1

3

5

7

9

40

60

80

100

120

2000/01 2004/05 2008/09 2012/13

% ofGDP

Index

Terms oftrade(lhs)

Miningcapex(rhs)

MINING: INCOME & SPENDING

Concerns about theAustralian growthoutlook are lifting

again

and somecommentators placethe risk of recessionat 20-25%.

Among economists,a 20% recessionrisk is the defaultforecast.

The recession riskreflects the broadercommodity story.

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the mining capex cliff.

We have set out our views on these topics anumber of times over the past few years. Ourview is that these risks are real but overstated.(see CBA Research: The end of the supercycle? 25July 2012 and The mining capex pothole how deep

is it? 3 April 2013).

An income shock?

Commodity price falls back towards morenormal levels have been central to forecastsfor most of the period since 2004 (facing chart).And it has been the wrong view for most of thatperiod.

Never change a good forecast has alwaysbeen a good rule to follow. The concern still isthat the commodity supply-demand balance will

shift in a way that favours lower prices. Thecurrent global resource investment phase willsee a significant lift in supplyin coming years.But extra supply is needed to keep up with thegrowth in demand. The Chinese urbanisationprocess, for example, has a long way to run.So just how the supply-demand balance playsout is not yet clear.

The bigger swing variable is likely to be demandand the belief that a structural shift towardslower economic growth rates is underway in themajor consuming nations.

But a step down in economic growth rates isthe inevitable consequence of a maturingeconomy. It need not mean a reduction incommodity demand. China, for example, sits atthe end of the Australian commodity pipelineand drives demand. China grew at an averagepace of 11%pa over 2003-12. That growth wasboosting the size of Chinese GDP (orcommodity demand) by USD300bn per annumin 2011-12 (constant price terms). Lookingahead, a similar increase in commodity demandwould require GDP growth of only 6.9% in 2014and 4.9% in 2020.

The bigger risk may be the typeof demand. Aseconomies mature the marginal dollar of GDP ismore likely to come from services than from(commodity intensive) infrastructure andmanufacturing.

But we shouldnt be afraid of this growthtransition. The Asian emergence offers someopportunities for the Australian non-resourceseconomy just as it has for mining. Anexpanding middle income population, forexample, will underwrite growth in Asianconsumer demand. The standard estimate has

the middle income group in the Asia-Pacificregion trebling in size to >1bn people by2020. The number of consumers in Asia withmoney to spend is growing at a rapid rate rightnow!

20

45

70

95

120

20

45

70

95

120

Sep-99 Sep-02 Sep-05 Sep-08 Sep-11 Sep-14

COMMODITY PRICE FORECASTS(RBA Non-Rural Index, USD)Index Index

Source: RBA, CBA,Consensus Economics

Dec'04

Actual

Consensusforecastsat various

points

Jun'13

0

4

8

12

16

0

4

8

12

16

2003 2007 2011 2015 2019 2023 2027

% ch%ch

ActualGDP

growth

CHINA: GDP GROWTH(2003 prices)

Growth ratesrequired toproduce an

equivalent risein comoditydemand asachieved in

2011-12

5

15

25

35

45

0

1

2

3

4

2009 2020 2030

Bn

INCOME & DEMOGRAPHICS

Source: Kharas & Gertz/United Nations

Years

Number ofmiddle income

earners(Asia-Pacific,

lhs)

Median age(East Asia, rhs)

But a shift in Asiangrowth compositionoffers opportunitiesfor the non-miningeconomy.

The income shockfear reflects anongoing slide incommodity prices

as supply lifts

or the Chineseeconomy matures.

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The historical experience is that middle incomeconsumers want certain things. They want:

larger and better quality housing;

more and better quality food;

more consumer durables; more education services; and

more holidays.

The opportunities are there for those who wantto take them. Education and tourism, forexample, already rank in Australias top-5exports. Food-related exports are wellrepresented as well. Our international trade ismore than just a hard commodity story.

Asian demographics also involve an ageingpopulation. And again experience tells us that

older consumers have certain needs notably:

health; and

financial services.

Australias experience in these areas means weare, again, well placed to take advantage.Insurance, pension & financial services alreadyrank in Australias top-25 exports.

An expenditure shock?

One commodity-related growth risk that is

unavoidable is the end of the boom in miningconstruction activity. The stockpile of projectsis now being worked through at a faster ratethan new projects are being approved. Weexpect mining capex to peak at just under 8%of GDP in the second half of 2013.

So the economy is set to lose a significantgrowth driver. And the potential drag on theeconomy is quite large if this cycle follows therapid retracement of previous episodes.

But looking at the broader mining picturethrows a question mark over just how

threatening a more savage pull back in miningcapex would be. Table 1 looks at the impact ofa 20%pa fall in mining investment spending.Over three years that fall would halve the miningcapex share of GDP to about 4%.

But recent RBA research concludes that abouthalf that capex is met through imports. So inGDP growth terms there is an automatic 50%offset from lower imports. Half the pain will beexported to those countries that provide uswith the capital goods!

The final line in Table 1 shows the required

growth in resource exports to fully fill in themining capex pothole. As the facing chartshows, these sorts of growth rates look easilyachievable given the very rapid growth in themining capital stock.

Table 1: Some pothole figuring

Peak Year 1 Year 2 Year 3

20%pa cut inmining capex

($bn)~ -23.6 -18.8 -15.1

Mining capex asa % of GDP

8 6.5 5.1 3.9

Import offset($bn)

~ 11.8 9.4 7.5

Required

growth inresourceexports (%pa)

~ 7.7% 5.7% 4.3%

0 25 50

Iron oreCoal

TourismGold

EducationNatural gas

Crude petroleum

Prof, tech & businessWheatCopper ores

Aluminium oresBeef

AluminiumBusiness travel

CopperMedicaments

Refined petroleumCotton

WoolMeat (excl beef)

Insur, pension & finAlcoholic beverages

AUSTRALIAN TRADE(top export categories, 2011/12)

$bn

*Source: DFAT/ABS

0

2

4

6

8

10

0

2

4

6

8

10

1861 1881 1901 1921 1941 1961 1981 2001

%

CBA(f)

Source: RBA/CBA

MINING INVESTMENT(% of GDP) %

Previousbooms

-8

0

8

16

24

-8

0

8

16

24

1976 1981 1986 1991 1996 2001 2006 2011

%%

Capital stock(advanced 3 yrs)

(lhs)

Resourceexports

(rhs)

MINING CAPITAL STOCK & EXPORTS(annual % change)

The end of the

mining constructionboom is in sight.

But the loomingcapex pothole is

less threateningwhen looking at thebroader miningpicture.

The opportunitiesare there for thosewho want to takethem.

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These outcomes would leave the levelof GDPunchanged. Alternative sources of activitywould still be needed to generate growth andabsorb the potentially large labour marketfallout that could follow from the winding downof mining construction capex.

Timing issues

The growth transition that policy makers aretrying to engineer is underway. Resourceexports are starting to grow quickly. There areearly indications that residential construction isrising. But the transition is uneven. Miningcapex seems to be coming off a little morerapidly than expected. And the desired lift innon-mining capex is yet to appear.

The transition was never going to be a seamlessbaton pass. Various bumps will be felt alongthe way. But these bumps are unlikely to pushthe economy into recession.

Can we talk ourselves into recession?

Sentiment is influenced by many factors fromthe hard edged economic data to the softersocioeconomic influences. This mix ofinfluences makes it difficult to determinecausality when thinking about the linkage toactivity. And it makes it difficult to come to adefinitive conclusion on the risks of self-fulfillingrecession talk.

It is certainly reasonable to argue thateconomic news will influence sentiment andsentiment can influence activity. But thelinkages are loose and variable.

The Melbourne Institute/WBC Survey ofConsumer Sentimentis a useful case study.The facing chart shows the correlation betweeneconomic growth and consumer recall ofeconomic news (favourable less unfavourable).Consumer recollection of more negativeeconomic stories does tend to be associated

with a weak economy. But swings towardsnegative news recall sometimes lead andsometime follow changes in economic growthmomentum.

A clearer story emerges in the detail. Sentimentsurveys are typically based on a mix of currentconditions and expectations. So sentimentreflects what is happening in the economy now.And it also reflects perceptions about where theeconomy is going.

Returning to our consumer case study, it isclear that:

Australian consumers are a pessimistic lot.They nearly always have a more negativeview on the outlook than they do of currentconditions. For 90% of the period since

-3.0

0.0

3.0

6.0

9.0

-30

0

30

60

90

Sep-08 Dec-09 Mar-11 Jun-12 Sep-13

%%

GDP(rhs)

Miningcapex(lhs)

"New"growthdrivers*

(rhs)

THE GROWTH TRANSITION(annual % change)

* Residential construction, consumerspending, resource exports, non-mining capex

0

2000

4000

6000

0

2000

4000

6000

Sep-12 Dec-12 Mar-13 Jun-13

"RECESSION" COUNT(no. of media mentions of recession in Australian)

Source: Factiva

-4

-2

0

2

4

-110

-70

-30

10

50

Mar-99 Mar-02 Mar-05 Mar-08 Mar-11

% %pa

Net % recallingfavourable news about

the economy (lhs)*

GDPgrowth

momentum

* Source: Melbourne Institute

ECONOMIC NEWS & GROWTH

-40

-20

0

20

-40

-20

0

20

Sep 80 Sep 86 Sep 92 Sep 98 Sep 04 Sep 10

Indexpoints

Indexpoints

CONSUMER SENTIMENT*(expected conditions less current conditions)

* Source: Melbourne Institute/WBC

The transition tonew sources ofgrowth will not beseamless but anybumps are unlikelyto push theeconomy intorecession.

The linkages fromsentiment to activityare loose andvariable

but somesentimentcomponents arestrongly correlatedwith economicnews.

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1980 expected conditions have fallenshort of current conditions.

Consumers views on expectedconditions are strongly correlated withnews recall about the economy (correlation:

0.83).

Consumers views on current conditionshave a weaker linkage with news recallabout the economy (correlation: 0.53) andare more reflective of what they see aroundthem.

So talking the economy down can weigh onsentiment. But the linkage from sentiment toactivity is weaker and the ability to talkourselves into recession looks quite low.

One reason for this weak linkage may actually

be that fears about the outlook generate aresponse by policy makers and consumers thatultimately reduce activity risks. The RBA, forexample, has cut interest rates partly becauseof concerns about the end of the mining capexboom. Australian households have taken stepsto shore up their balance sheets partly becauseof concerns about household debt levels.

70

93

117

140

-110

-55

0

55

Sep 06 Sep 08 Sep 10 Sep 12

IndexNet%

News recall aboutthe economy

(lhs)

Currentconditions

(rhs)

SENTIMENT & ECONOMIC NEWS(Melbourne Institute/WBC consumer survey)

Favourable news recall

Unfavourable news recall

Expectedconditions

(rhs)

So talking theeconomy down canweigh on sentiment.

But the ability to

bring on a recessionlooks quite low.

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+612 9118 1097

+612 9118 1102

monica.eley@cba.com.au

maca@cba.com.au

New Zealand Telephone Email Address

Nick Tuffley

Jane Turner

Christina Leung

Daniel Smith

ASB Chief Economist

Economist

Economist

Economist

+649 301 5659

+649 301 5660

+649 301 5661

+649 301 5853

nick.tuffley@asb.co.nz

jane.turner@asb.co.nz

christina.leung@asb.co.nz

daniel.smith@asb.co.nz

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+612 9117 0190

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+613 9675 6815

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+44 20 7329 6266

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+852 2844 7539

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