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Recovery on track

This article appeared in the February 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Learn why the economic backdrop in 2011 is positive for shares.

Photo of Amanda Tan By Amanda Tan, St George

Australia's economic recovery was on track heading towards the end of 2010 thanks mainly to the appetite of emerging nations for resources. However, with record rainfall in many parts of Australia the weather has emerged as a significant factor in considering our economic prospects.

Three quarters of Queensland was declared a disaster zone and that will have a significant impact for Australia as a whole. Queensland is Australia's third largest employment market and is an important producer of agricultural and mining output including 60 per cent of the nation's coking coal exports.

Overseas demand had led to a 60-year high in Australia's terms of trade and paved the way for more strong growth in national incomes and a solid improvement in private investment. Then along came La Nina (the girl child), a weather phenomenon born in the Pacific. It was the most intense of these rare events since 1974, when Brisbane and much of South East Queensland experienced its last major floods.

The above-average rainfall in the eastern states throughout 2010 intensified in December and into the New Year, causing devastating floods in Queensland and parts of New South Wales, Victoria and South Australia.

The effect this time, economically and on a human scale, is more severe than in 1974. Brisbane's population has almost doubled, along with the rest of Queensland, and in the past 30 years there have been huge additional mining and infrastructure projects.

Three quarters of Queensland has been declared a disaster zone and that will have a significant impact for Australia as a whole. Queensland is Australia's third largest employment market and is an important producer of agricultural and mining output including 60 per cent of the nation's coking coal exports.

Short-term impact on growth and inflation

Some agricultural crops have been wiped out, mines flooded and brought to a halt, railway lines and roads wrecked or severely damaged, along with other public and private infrastructure and property. The disruption to production, exports and business activity is likely to result in the economy contracting in the March quarter.

Queensland agricultural production, according to ABARE, could be reduced by at least $500-600 million this financial year. (In Victoria, preliminary official estimates put agriculture's economic loss in crops and infrastructure at $2 billion and counting.)

The disruption to Queensland's coal exports between December and March could amount to 15 million tonnes, worth around $2-$2.5 billion in earnings.

In many flood areas the hiring of new labour will be on hold, especially in the first few months of the year. Indeed, in December, Queensland's unemployment rate rose to 6.0 per cent, the highest in a year.

Food prices are taken into account in measuring inflation. The disruption to agriculture is forcing up food prices which were already increasing due to higher demand from a growing world population, higher production input costs and weather-related issues outside Australia.

The headline inflation rate (the extent to which prices of goods and services in an economy have risen in a given period) in the March quarter could be well above the Reserve Bank objective of 2-3 per cent.

At this stage it is difficult to judge if the disruption to growth and price inflation will be contained to the first quarter of 2011. If there is more heavy rainfall there may well be more flooding.

At the time of writing a massive cyclone was headed for northern Queensland. Even if the rainfall eases, floodwaters will be slow to recede and the ground is sodden, so the full extent of the damage to crops, infrastructure, mining, coal exports and business activity will take some time to quantify.

The longer-term aftermath

Employment is already strong, with job advertisements having increased 27 per cent in the year to December. Once floodwaters fully recede, rebuilding efforts, insurance payouts and government spending should provide a boost to economic activity. And there should be an increase in hiring labour for rebuilding and repair work.

This means the employment gains of 2010, totalling 364,000 over the year, should eventually resume. If this happens there is potential for the unemployment rate to fall below its current two-year low of 5.0 per cent. The flip side to this is wages pressure.

The flood-related spike in food inflation will eventually unwind, however inflation may remain high due to rebuilding and repair efforts pushing up the cost of some materials and wages.

The outlook for interest rates

We believe the Reserve Bank will not increase interest rates for most of the first half of this year. The modest inflation outcome in the December quarter supports the case for this. (Editor's note: high inflation can force the RBA to life interest rates to help slow the economy).

But the RBA is unlikely to resist holding off on interest rate rises for too long. Additional interest rate rises from the middle of this year cannot be ruled out. Our current forecast is for rates to move higher in June. We could see another increase in the September quarter, with the risk of one more by the end of the year.

The China factor

It is important to look at the outlook for Australia's most important trading partner. The impact of a tightening of economic policy will inevitably be felt throughout the wider Chinese economy, particularly in the second half of the year. However, we do not anticipate a hard landing in China and therefore see modest downside risks to the Australian economy.

Since October China has lifted interest rates and the Government has orders banks to set aside more cash. This tightening has caused some uneasiness among investors in Australia because any measure that could curb growth in the world's second-largest economy and fastest-growing major economy would present risks to the global economy.

The Chinese Government wants to avoid inflation getting out of hand. In November, annualised inflation surged to a two-year high of 5.1 per cent. Although it has since eased to 4.6 per cent, it remains well above this year's inflation target of 4.0 per cent.
Spiralling global food prices have been a factor but rising rents and rapid increases in wages are also to blame.

These inflationary pressures are likely to continue. Combine this with a weak Chinese currency as well as high commodity prices and inflation could remain above the target, at least for the first half of 2011.

Outlook for the Australian dollar

The Australian dollar will remain well supported this year but we are expecting the currency to end 2011 slightly lower at 96 US cents.

We know that Australia's fortunes are highly dependent on China so it follows that movements in the Australian dollar tend to be closely tied to developments there, so measures to curb inflation and growth in China would mean downside risk for the currency.

The potential for an improving US dollar could also undermine strength in Australia's currency. We expect the US economy to continue to improve throughout this year. The US Federal Reserve could unwind some of its emergency measures, including lifting record low interest rates late in 2011. Hence, the US dollar could start to become more attractive to investors.

Overall, however, decline in value of the Australian dollar should be modest. Interest rates in Australia are well above those in the major economies, and with the possibility of RBA  lifting rates later in the year the Australian dollar will still be in demand. This should mean that any fall in the Australian dollar will be slight.

About the author

Amanda Tan is a market economist at St. George Bank. The St. George Bank economics team publishes regular updates on financial markets and economic developments.

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