1. Global Overview & Australia – where to now for the multi speed economy Alan Oster – Group Chief Economist

2. 2 The global economic story  Global Overview – Mixed and Muddling along  Still below trend growth in 2014. Real concerns about Europe Japan and Latin America. USA and China better. 3% this year rising to 3½% in out years.  Europe  Still very poor – indeed core economies recently flat lining. Hence rate cut (0.15 to 0.05%) and QE coming – around Euro 1 Trillion. Unemployment a risk to political stability. UK the bright spot (rates to rise soon)  USA  US hit by weather in Q1 – but fundamentally recovery on track. Q2 4% annualised growth. Q3 started well.  Consumers, housing, business investment to improve. Less fiscal drag  Tapering to finish by late 2014 and rate rises by H2 2015 (or earlier).  Japan  Fiscal and monetary policy stimulus was big – weakening currency and stimulating equities. But growth momentum (ex GST kick in Q1 2014) fading with little in the way of structural reform. A concern  China  Focus on quality of growth rather than quantum  Growth still robust (7%+) but rapid pace of previous years over

3. 3 Europe (the core) and Japan in serious trouble – despite “Abeconomics”- are real concerns. Ditto Latin America

4. 4 Global economic forecasts. Still below trend in 2014 – Europe & Latin weakness. Moving to trend over time

5. 5 Currency model. USD.92 +/- 5c. Recent correction a touch overdone but lower in 2015 - on commodities & stronger USD. * Model driven by: commodity prices; US TWI – as measure of USD weakness; long and short run rates; relative unemployment; relative equity markets and VIX. Currency Model* and AUD / USD Forecasts: End 2014 = 88c AUD/ USD End 2015 = 82c AUD/USD

6. 6 Australia – Key themes and challenges  The key challenges – not about GDP  Mining exports will look after that  Rather key theme is managing the impact of transition from labour/capital intensive “investment phase” on domestic demand  The extent of the mining slowdown in investment is significant  Can we fill in the gap. The RBA’s challenge  If not what does it mean  Composition of growth GDP v Domestic demand  Unemployment  Rates

7. 7 Put differently it involves a fall in the investment / GDP ratio of around 4% And 100k less construction jobs..

8. 8 What is happening to iron ore prices  Iron ore prices have fallen to 5 year lows.  That is not because Chinese steel output has collapsed. Rather it is up 5% in real terms  The key driver is increased Australian supply. Iron ore exports are up 28% in the first 7 months this year. 79% of which has gone to China.  That said slower Chinese construction and manufacturing growth has not helped  As a result stocks of iron ore on China ports are approaching record highs

9. 9 And what does it mean  From an Australian GDP point of view the current combination is mixed  Export growth will be large – and positive. GDP is “volumes / tonnes” based. Iron ore exports up from 651mn to 753mn tonnes (16%) in 2014/15  But clearly it will reduce income flows within the Australian economy  less return per tonne and falling terms of trade  equity values lower  And more difficult for junior miners (cash burn) and mining services  To take up to 0.6% off domestic demand.  If prices & currency stay where they are takes $12bn off national income.  And critically the noise around iron ore and China could also unsettle consumer and business confidence. Less spending, investment and employment

10. 10 Business confidence still a touch above trend. Conditions struggled to maintain July levels. Now near trend growth.

11. 11 By industry: Construction & services strong. Construction huge confidence. Other conditions a struggle. Retailers’ confidence?? Business Conditions and Confidence August 2014; (sa) Source: NAB

12. 12 By Industry construction the big improver as has transport. Finance and recreational services sideways

13. 13 Bankers clearly see the recovery in property And tough discretionary retail

14. 14 RBA’s rationale for low rates  Aim is to keep rate low to:  Help boost consumer spending  Direct impact on liquidity and indirect through wealth effects on equities and house prices  To help increase construction in dwellings  And to boost non mining investment  So how are they going….

15. 15 Consumers still are conservative but are starting to spend. But are unhappy about cost of living Cost of living highest source of consumer anxiety And its all about “non discretionary” items  Utility costs, education, housing, transport Source Nab Consumer Anxiety Survey Q4 2013

16. 16 And we are seeing it in their spending decisions But they remain anxious – re longer term finances Consumer Anxiety Index Q3 2014 Source NAB Economics

17. 17 Our models suggest consumption still lower than expected – hit by Budget but to improve to 3 - 3¼%

18. 18 Australia house (and unit )prices growing around 11%. But mainly Sydney Melbourne

19. 19 Cyclically many markets are still below previous peak. Sydney the stand out exception

20. 20 House prices not out of line relative to the ability to borrow (rates, LVR, bank asset test, incomes)

21. 21 Higher unemployment will generate further headwinds Expect price growth of 7½% this year and 5% in 2015

22. 22 Foreign demand has had a big impact on apartment market. But has it already peaked.. *percentage changes represent through the year growth rates to Q4

23. 23 Non Mining Business investment shows some signs of improving but still very weak

24. 24 And capacity utilisation in non mining is still below trend

25. 25 We expect GDP to be around 3.1% in 2014 & 2015 But domestic demand of only around 1-1¼% per annum GDP and Domestic Demand – At 6 Mthly Annualised rate

26. 26 Hence we still see unemployment at 6½% by end 2014 Growth in Employment and the Unemployment rate %

27. 27 Labour market is also dealing with structural change

28. 28 Inflation not a problem. Key drivers (wages, labour market, output gap) point to lower inflation in near term

29. 29 RBA on hold for now but path of unemployment critical.  RBA now very comfortable  Signs of better business confidence (will it last)  Housing construction coming  Inflation under control and going lower  These factors all favour a wait and see mode  But little sign yet of non mining investment  Could also see “modest” rule changes to slow investor housing in Sydney / Melbourne. If so rates “lower for longer “  Key factor on rates is the extent of the deterioration of the labour market  But will need time to assess. July / August labour market statistical noise  But we expect unemployment to increase further to 6½% by late 2014  Any more (if it is sustained) and rate cuts back on the agenda  Hurdle to another cut is high – really talking about 2 cuts.  But overall we expect a long period of no change (late 2015 before rate rises).

30. 30 201420152016 Real GDP3.1 3.3 Domestic demand1.41.51.1 Employment1.31.42.7 Unemployment rate* 6.56.25.8 CPI underlying** 2.42.23.0 RBA cash rate* 2.503.04.0 $US/$A* 0.880.820.80 Nominal GDP 4.34.75.3 Terms of trade -3.4-1.7-1.3 *at end of period; ** through-year growth; Australian economic forecasts