Alan Oster Group Chief Economist

1
Alan Oster - Group Chief Economist

• Global Economic Overview
• Global Financial Instability Outlook
• Ramifications for Australia

2
2008 an amazing year from a financial markets
perspective.

• A year where we went very close to a breakdown in
  global financial markets.
• Basically authorities reactions included
• Actions aimed at restoring capital in banks
• started off via underwriting bad loans (TARP)
  ended up with large scale capital injections and
  in many cases effective / actual nationalisation
  of banks
• Actions to increase liquidity
• Central banks accepting bank assets for longer
  periods
• Widening the type of assets that Central banks
  were prepared to provide cash against
  increasingly innovative / unconventional ( and
  now in some cases includes corporate lending)

3
2008 an amazing year from a financial markets
perspective.

• Authorities reactions (continued)
• Actions aimed at restoring confidence in the
  system
• Aggressive rate cuts
• Aggressive bank rescues and big fiscal packages
• not allowing any failure with systematic
  ramifications
• The one big exception was Lehmans Brothers.
  Will go down as a major mistake and wont be
  repeated
• Government guarantees for deposits locally and
  internationally
• The aim was to
• Keep credit flowing ( limit credit rationing)
• Try to prevent financial market disruptions from
  fully flowing into the real economy

4
2008 Limiting the spread from financial
markets.. But in late 2008 a global collapse in
real activity started

• Was always going to be a hard task
• Equity markets
• Housing markets (as de-leveraging evolved)
• And banks globally were always going to try to
  protect capital positions in the face of
  accelerating bad debts from sub prime
• Currently global write-downs at around US750b
• New capital from Govts around US290b with
  another US 600bin the pipeline
• Confidence effects
• But Lehman brother seemed to change that
  completely
• Confidence collapsed in global system spread
  blew out
• And the real economy seemed to crunch

5
Short run funding costs to banks. The Lehman
brother spike is dramatic. More recently things
have improved somewhat especially offshore and
into early 2009. But still high overall.
In Australia around 60 points still not great
Banks short term lending costs

6
Longer term cost of funds to banks have also
eased a touch but remain at high levels. What is
more dramatic is that markets are increasingly
focusing on future deterioration of corporate
health as the real economy slows

7
And it cant be over emphasised what a dramatic
collapse there has been in global confidence and
activity in late 2008.

• Global industrial production now down 7 in year
  to November after being flat as recently as
  August
• Global PMI surveys at 33 in November (zero GDP
  equates to readings of around 50)
• that is it implies very large falls in GDP in
  key developed economies in Q4 2008.

8
Looking at the data by country underlines the
dreadful and unprecedented nature of the down
turn
In the USA
Industrial production is now falling at around
10 per annum and job losses are around 600k per
month
And while business surveys are dreadful the
actuals based on partials for GDP are even
worse

9
In EuropeIndustrial production is down around
7, confidence has collapsed and retail sales are
significantly negative.

10
In Non Japan Asia (Ex China)This very
trade exposed sector has also stopped
dramatically. Industrial production is falling
faster than 10 y/y while export earnings having
been up 20 in mid 2008 are now down 2 y/y.
Real retail sales are falling.

East Asian Real Retail Sales
11
On
ChinaIndustrial production has slowed
dramatically. And GDP has stalled in late 2009.

• Chinese IP has slowed from 15 in July to around
  6 by Dec 2008
• Heavy manufacturing has slowed even faster
• GDP has also slowed to around 6 ¾ in the year
  to Dec
• implying flat to negative growth in Q4 2009

12
Key drivers / themes of 2009 outlook.

• A key theme is that while global credit markets
  might improve, the real economy has and will
  continue to weaken in 2009. And we will be
  looking to see the second round feedbacks of
  activity falls into credit and equity markets.
  Almost the reverse of 2008 when all the focus was
  on financial markets.
• Key drivers of the outlook in 2009
• Recognition of the starting point problem the
  collapse in Q4 2008
• The on going flow through negative wealth effects
  from weaker housing and equity markets
• Commodity price effects (on inflation, mining
  activity, trade incomes)
• Consumers reactions to rising unemployment and
  businesss to lower confidence and profits
• Offset by further aggessive monetary policy
  easings (rate cuts and so called quantitative
  easing) and very aggressive fiscal packages.

13
Globally we see GDP growth of only ½ in 2009.
The worst result since WW2. Early 1980s the next
worse at ¾. Risks are that there is possible
downside to these numbers.

• USA, Japan, UK, Europe all to see falls in GDP
  of more than 2
• Developed world falling by more than 2 ½ during
  2009 negative till late 2009
• Non Japan Asia (ex China) to see GDP fall -1 ¼ -
  reflecting trade exposure. Latin America stalled
• China to slow to 6 ¼ but only on the back of
  massive fiscal stimulus
• U shaper recovery with growth of 2 ½ in 2010
  well below trend

14
Key global risks are still USA and ChinaOn the
USA

• The USA is as noted in late 2008 the US
  activity, production and employment numbers are
  falling faster than we would have expected
• Nor is there much sign that house prices
• are stabilising
• indeed the Shiller index at -18 fall in y/y
  terms
• is getting worse
• we assume house prices will fall 10 from here
• Also the full impact of recent equity market
  falls are yet to flow through
• Finally our assumptions are that the current
  extremes of credit rationing in the USA for some
  time before gradually ease back over the next
  year or so. We are also assuming the Obama
  fiscal package (US850b) gets through.
• roughly 1/3 tax cuts and 2/3 public spending
  (infra structure)

15
Our forecast have USA GDP falling by 2 in 2009.
Worse than 2009 similar to 1980s. Not a lot new
govt can do in near term change might help
confidence and fiscal policy will help in H2
2009. Unemployment to rise to 9.

• We are more pessimistic than the IMFs most
  recent forecasts (-1.6) but we are still worried.

16
On China We are expecting growth of only 6 ¼
in 2009 but only on the back of large fiscal
packages. And a marginally better but still
sub trend 7 in 2010.

• Industrial production has fallen sharply to
  around 5. Albeit the fall in production
  stabilised in some variables in December
• And growth in the year to date has slowed to 6.8
  (vis the year average numbers of 9)
• We are now forecasting growth in 2009 of 6 ¼
  (below the IMFs 6 ¾) and 7 in 2010
• But only on the basis of the large government
  stimulus signalled (16 of GDP)
• And further aggressive rate cuts
• Much lower GDP growth could well cause social
  disruption

17

AUSTRALIA
18
September accounts highlight that growth has
slowed a lot. Led by the consumer and indeed
non farm GDP went backwards Even so, a lot has
happened in recent months.
19
After a plunge in confidence and activity from
September, results were marginally better in
December month due to the Govts 10b
package.But confidence still worse than the
bottom of 1990 recession activity depressed

20
Critically business is still shedding labour and
there has been no improvement in forward orders.
That is business see no improvement in the
fundamentals and are preparing for further
downward adjustments

21
And business is rapidly cutting back on actual
and expected capital expenditure
22
And in trend term confidence is down
dramatically in all industries.An important new
development is the deterioration in mining
confidence since September 2008.

23
Interesting to note that while credit rationing
is very common in offshore markets business here
is not reporting much more difficulties in
getting credit. Rather they are reporting less
need for credit recently.

Demand for credit rather than supply issues
currently dominate. Reflecting lower investment
demand
24
Recent drivers of the outlook

• The global credit crunch has clearly had a
  significant impact on the real economy
  consumers and business are scared and are
  adjusting their behaviour
• Also we have to deal with
• A much weaker global outlook
• A fall in commodity prices (around 40) and the
  implications for the terms of trade (down around
  30)
• Lower equity markets (an especially the recent
  fall of around 30)
• Lower confidence (business and consumer)
• Lower mining production and exports
• Against that
• Lower oil price (around current levels)
• Much more aggressive rate cuts and
• More aggressive fiscal expansion

25
Important to differential the private and public
sector outlook

• The big negatives to the outlook are private
  investment and consumption (given poor outlook
  for profits, sales and wealth destruction). And
  exports
• Offset by very strong government spending
• Our forecasts see
• Private demand down 1 ½ in 2009
• Public demand up 6 (15-20b new spending and
  deficit of 40b in 2009/10)

26
Consumption Outlook - Consumer stalls in
2009Key drivers of model are incomes (employment
/wages) wealth effects from house prices
(indirectly interest rates) and equity prices.
hurt . Model points to downside risks in the
next 12 months despite rate adjustments.

• Assume equity markets flatten out and up 8 in
  2009
• House prices overall to fall between 5-10 over
  the next 12 -18 months
• Rate cuts to 2 ½ by mid year
• And aggressive fiscal spending another 15-20b
  in spending and a deficit of around 40b in
  2009/10.
• Model not picking up transfer payments

27
Lower confidence, deteriorating domestic sales
prospects, sharply lower global outlook
(especially for mining) all put downside risks
to business investment

• We now expect business investment to fall by 10
  during 2009
• The big risk is that it will fall more sharply
  as suggested by models

28
From venture capital viewpoint this is not a
great environment.Funds offshore will be very
hard to raise and on shore business will be very
much in caretaker mode

• Business will be very cautious on their funding
  spend
• On information technology the outlook will be
  very different as to whether the spend is for
  on going maintenance or new development
• On health care if for normal medical services
  fine but not if its to invest in new drugs /
  medical equipment much harder
• Really the world of PPP will be missing an
  important P
• Against that infrastructure public sector
  related projects will be very positive
• Can thus see big differences in demand for local
  IT and health care between private and public
  sector

29
For 2009 we now see GDP falling by -1/4 in
2009That see GDP going backwards through most of
2009And the forecast is for a U shaped
recovery not a V.

• GDP marginally negative out to late 2009
• No return to reasonable growth till 2010 and
  trend growth till H2 2010
• GDP
• -1/4 in 2009
• 1 in 2010

30
And that means employment growth will be going
backwards by mid 2009 and unemployment will move
up to around 6 by late 2009 and around 7 by
late 2010.

31
The key near term driver now is increasing
purchase costs. But commodities have already
fallen. Wages have also eased sharply (especially
in mining) and will fall further as capacity
utilisation falls

32
Clear that inflation has peaked. Headline
inflation fell because of oil.But core also much
slower as activity bites.Core CPI back in RBA
target in H2 2009. Inflation irrelevant in the
near term

• Headline driven by oil prices and falling
  commodity prices
• But core also lower 0.8 or 4.4 y/y. Non
  tradeable (ie domestic orientated) inflation at
  0.5 the lowest since 2005
• Basically weak demand is limiting the ability of
  retailers to pass on purchase cost increases
  putting further pressures on profits
• Wages are also slowing sharply. We see core
  inflation back into target by Sept 2009.
• And at bottom of target by mid 2010

33
On short term interest rates dynamicsRBA more
worried about demand risks in 2009 than inflation

• RBA now very much focused on trying to prevent
  hard landing in 2009.
• Accordingly we now see
• 125 points over the next two meetings (Feb /
  March)
• The RBA will then probably wait to see how demand
  evolves
• But by mid 2009 with the unemployment rate moving
  sharply higher will need to go another 50 point
• Bringing the bottom of the cycle to 2½ by Sept
  2009
• We still see downside risks to that forecast
  (depending on GDP and financial market behavior)
• With a tentative move back up in rates starting
  in late 2010
• Back to 3¼ by late 2010.

34
Globally central banks have been very aggressive
And will continue to be for some time
bottoming by mid 2009Rates not really moving up
till 2010

• Fed to remain around zero with the focus on
  quantitative easing etc
• Japan around 0.25
• ECB down to 1½
• UK down to 1
• China down to 4½
• Australia to 2 ½

Global Short Term Cash Rate Forecasts
35
Recent events have also seen dramatic moves in
the currencyAUD / USD model not wonderful but
shows currency is over sold unless commodities
fall more than we expect (35 fall over the next
12-18 months). Currency will stay below
fundamentals until investors get more comfortable
on the global outlook. We see AUD going back
into the mid 70s by mid year and the high 70s in
late 2009.

• Model driven by
• Commodities
• USD / EURO as a measure of USD weakness
• Long run rates
• Relative unemployment
• Stk break for late1990s (around 13c).
• Relative Equity Mkts

36
Financial markets Summary

• Economy going backwards in 2009 with U shaped
  recovery.
• RBA to cut
• 125 pts in Feb/March 2009
• And another 50 pts by July/ August 2009 (cash at
  2½ )
• Risks to growth and rates down in 2009
• Some moves back up in H2 2010
• Long bonds broadly unchanged at around 4 in
  2009 following global developments
• Again some limited downside risks if cash rates
  fall below our expectations
• Bonds to then move higher during 2010 (4-5) as
  recovery becomes more entrenched
• Currency has over corrected but no recovery soon
• Risks that AUD/USD stays below 70c for some time
• Recovery not until risks of global hard landing
  seen as overblown
• AUD into mid 70c by late 2009