Australia: On Two Tracks Gerald Minack (Sydney) The gap between the domestic and export sectors is likely to widen in 2006. We have lifted our GDP forecasts, largely on the basis of upgraded assumptions for commodity prices and export volumes. We still expect that the adjustment in consumer finances, which started in 2005, will drag on domestic activity. Market implications. This is a growth mix that is unlikely to force any policy changes in the near term, but we expect that the domestic weakness will prompt the Reserve Bank of Australia to cut interest rates in the second half of 2006. The prospect of further narrowing in the Australia-US interest rate spread will likely lead to a weaker A$. The domestic equity market is now pricing in overly optimistic earnings for the domestic corporate sector, and we think that 2006 will start an extended period of Australian equity market underperformance. Risks. The biggest upside risk is that the consumer does revive, helped by lower petrol prices and further tax cuts. If the domestic economy accelerates, then we will see rate increases in 2006. The obvious downside risk is weaker global growth, which would remove the external offset to domestic weakness. Upgraded forecasts. We've lifted our 2006 GDP forecast to 2.2% from 0.6% previously. This partly reflects a higher starting point. The through-the-year 2006 growth forecast has been revised up by only 0.8%. This revision is almost solely due to higher export volumes associated with the surge in commodity demand, and the (partial) unblocking of supply-side constraints. In addition, further price gains imply a big lift in nominal exports, and will provide the government with the wherewithal to cut taxes in 2006. In contrast, we still think that the adjustment in consumer finances and weakness in residential activity will put a lid on domestic activity. Real consumer spending is expected to rise by 1%, and residential investment to fall by 9%. Business investment — notably, engineering construction — will provide a partial offset, but the bottom line is that we expect final demand growth of 1.7%. There are a couple of follow-on points to note about this. First, we expect further tax cuts next year as the government continues to redistribute its profit-driven tax windfall. But as with the last tranche of tax cuts, we think households will save, rather than spend, most of the windfall. Second, it’s important to realise how important the commodity boom has been in the soft landing. In the year to September, GDP growth was 2.6% while real national income growth was 4.8% — effectively a 2.2% boost to national income from improving terms of trade. That windfall will likely moderate (to just under 1%) in 2006, and disappear in 2007. Two-track markets. Booming resource exports and sluggish domestic activity will be opposing forces for domestic markets. For the RBA we think the domestic weakness will ultimately be the dominating factor. Although mining is booming, it accounts for only 1.3% of employment. The sectors that will be weak in 2006 include the big job generators. We expect that a softening labour market will prompt the RBA to start cutting rates in the second half of 2006. The prospect of lower rates will be critical for the A$. The long-standing link between commodity prices and the A$ has broken down and the currency is now much more a creature of debt flows. There is a heavy redemption schedule of debt for 2006 and 2007, and with the interest rate spread to the US narrowing (125 basis points now, down from a peak of 425 bp in 2004), we don't expect enough inflow to prevent the A$ from softening. Equity investors remain too optimistic about domestically sourced profits. The sell-side consensus expects margins in FY2006 to expand at a faster pace than in FY2005. With domestic growth slowing, unit labour costs rising, and the A$ turning, this looks very unlikely. Moreover, the domestic equity market is not cheap (excluding the miners, on a P/E of 15) considering that margins are already at all-time highs. Having been a stellar outperformer through the past five years, we expect that the local share market is about to commence an extended period of global underperformance.