Over the past year economy-wide profits grew by just 0.4 per cent – the weakest financial year outcome in the 17-year history of the series apart from the GFC period. No wonder businesses are seeking to cut costs and are refraining from hiring new staff.

The good news, as shown by other data out today, is that inflationary pressures are contained, making it an easy job for the Reserve Bank to leave interest rate settings on hold. We expect the Reserve Bank to stay on the interest rate sidelines for the remainder of the year, providing the economy with a shot of much-needed stability.

Given all the uncertainties – whether it be the global economy, domestic politics, the proposed introduction of the carbon tax or interest rates – it is far from surprising that businesses aren’t in the mood to hire at present. In trend terms job ads have now fallen for five months in a row. The silver lining could be that productivity will start to improve as businesses focus on working their existing employees harder or more efficiently.
The sharp increase in inventories in the June quarter is good news for economic growth. However, as we’ve seen in the past, large increases in stocks tend to be unwound, raising questions about future production, employment and overall economic growth. While the mining sector arguably needed to rebuild inventories to meet higher demand, clearly the same can’t be said for most other sectors, especially wholesale and retail trade together with food services.

What are the implications for interest rates and investors?
The Reserve Bank can rest easily on the interest rate sidelines. There is no need to rush ahead with rate cuts, while rate hikes are certainly off the agenda.

CommSec has reviewed the profit performance of big listed companies. Of the ASX 200 companies producing full year accounts, aggregate profits rose by 32 per cent in 2010/11. However the mining sector (especially BHP Billiton) drove the result. The ABS series shows that smaller companies, especially those outside the mining sector, struggled to lift profits over the past year. The multi-speed nature of the economy is clearly on show with the mixed results on profits across industry sectors.

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Could the market be its own worst enemy?
No doubt about it, negative sentiment trumped solid fundamentals in the market on Monday. As the Russell 2000® Index lost 63 points, or nearly nine percent of its value, and the Dow shed more than 630 points (approximately 5.5 percent), it was clear that general concerns about the economic growth rate only exacerbated the blow absorbed on Friday when S&P downgraded U.S. Treasury debt.

When high trading volumes combine with volatility spikes, it’s clear that sentiment is ruling the market, and on Monday that’s exactly what we saw, as 2.5 billion shares were traded on the New York Stock Exchange – an incredibly high volume – and the VIX , Wall Street’s key measure of volatility, topped 46. The good news is that despite the downgrade, it’s not particularly surprising that U.S. Treasuries are considered a relatively safe investment, which shows that investors are not subscribing to the notion that the U.S. is no longer credit worthy.

On the other hand, in sentiment-led markets like we saw Monday, it is possible for the market to effectively talk itself into a recession, and this fear is one of the largest threats to Russell’s current economic outlook, which calls for growth in the latter half of the year. To paraphrase President Franklin D. Roosevelt, “one of the things we have to fear is fear itself.”

Outlook is sound, but ride will be scary
Russell continues to expect equity markets to recover from current levels, an expectation that is based on strong fundamentals, and a view that the U.S. economy will grow 2.5 percent in the second half of the year. The balance sheets of operating companies remain extraordinarily strong, and profits haven’t just been good – they’ve been great, as evidenced by 18% growth in second quarter earnings in the S&P 500.

These companies have been able to accomplish all of this despite relatively low economic growth rates, and some of the headwinds that created the economic soft patch, namely the Japan supply chain disruption and higher commodity prices, are starting to lose steam. All of this means the outlook continues to be solid, and the events of Aug. 8 have all the hallmarks of being a very intense growth-scare market sell-off rather than an indicator of a double-dip recession.

From a consumer perspective, there are some opposing forces playing out. As a positive for consumer spending, consumers generally have more money in their pockets right now due to an increase in real income and a drop in commodities prices, but investment accounts have also taken a beating in the last week, so loss of wealth can be a negative factor. It remains to be seen which factor will determine consumer spending in the second half of 2011.

The good news is that dire predictions that the markets would interpret the downgrade as equating to U.S. bonds’ loss of value has not materialised to date. While a sentiment-driven recession is a possibility, we continue to believe that growth in the second half is a more likely scenario.

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Headline developments of the past week

European debt problems took centre stage yet again over the last week. Until recently it appeared that the European Union had put a firewall around Greece, Ireland and Portugal in order to protect Spain and Italy and as a result their bond yields had been contained. However, the spike higher in their bond yields in the last two weeks is worrying because together they account for 28% of Euro-zone GDP (as compared to only 7% for Greece, Portugal and Ireland) and 32% of Euro-zone public debt (compared to only 8% for the three peripherals). Italy in particular is probably just too big to rescue and what’s more German and French banks have a heavy exposure to Spain and Italy. Fortunately, Italy has moved quickly to allay market fears by adopting another round of fiscal austerity. But while bouts of short term relieve are likely, it’s clear that austerity is only making the situation worse and whether it’s Greece, Ireland, Portugal, Spain or Italy the European debt crisis is likely to remain a recurring threat and source of volatility for financial markets for some time to come.

In the US, concern that US politicians won’t agree to raise the debt ceiling by the August 2 deadline has led to increasing fears that it may have a short term default, an event Fed Chairman Bernanke said would through the US financial system into “enormous disarray”. However, there are several points worth noting on this. First, if the debt ceiling is not increased in time spending is likely to be cut ahead of not paying interest payments. More fundamentally though, just as the negotiations between Obama and the Republicans went right down to the wire regarding an agreement on the US budget a few months ago (only just averting a US Government shutdown) the same was always likely to apply in relation to the debt ceiling negotiations. Given the adverse political consequences that would follow from not raising the debt ceiling as welfare and Medicare/Medicaid payments are not made and public servants don’t get paid, the most likely outcome remains a last minute deal…but that could still mean another few weeks of intense uncertainty as the battle between Democrats and Republicans over spending cuts versus tax increases becomes increasingly acrimonious. Australian economic data remains week, with falls in both business and consumer confidence. Against this backdrop a rate hike this year is looking very unlikely.

There were some positives for markets over the last week though. Firstly, Fed Chairman Bernanke indicated that another round of quantitative easing (QE3) could be undertaken if the economy doesn’t pick up as expected. However, he also indicated the Fed wasn’t prepared to do it yet – it’s clear that the US economy will have to get worse and inflation fall before QE3 becomes likely.

Secondly, and more fundamentally, the Chinese economy is continuing to do its part in keeping the global economic recovery going with growth of 9.5% over the year to the June quarter helped along by strength in industrial production and fixed asset investment. While growth has slowed from an unsustainable pace of nearly 12% early last year there is no sign of the much feared hard landing. While headline inflation came in at a worse than expected 6.4% over the year to June this was driven largely by higher pork prices on the back of pork disease with non-food inflation starting to stall on a monthly basis. With Premier Wen Jiabao indicating that the Government should “not only stabilize inflation but also prevent major economic volatility” our assessment remains that the moderation in growth will result in a fall in inflation during the second half and that the monetary tightening cycle in China is either at or very close to an end.

The past week has seen share markets (except in China) fall sharply on the back of debt worries in Europe and the US and concerns about the growth outlook. Volatility in share markets is likely to remain high in the short term as the worry list remains significant – focussed on European debt problems, the US debt ceiling, the soft patch in the US economy and whether China will have a hard or soft landing – and the September quarter is normally the weakest time of the year for shares.

In the US in the week ahead, expect housing related data to show signs of stabilisation or improvement with a home builders survey due Monday, housing starts due Tuesday, home sales due Wednesday and house price data due on Thursday. A survey of manufacturing conditions in the Philadelphia region for July is expected to show a modest improvement after a sharp fall in June. The US June quarter earnings reporting season will start in earnest with investors expecting profit growth of around 13-15% on a year ago. In Europe the focus will likely be on business conditions readings due Friday after falls in recent months, along with ongoing debt problems.

In Australia, the minutes from the RBA’s July meeting due Tuesday are likely to confirm that there is no urgency to raise interest rates. Data for car sales and export and import prices are also due for release.

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Just as the Reserve Bank uses decade averages to determine the level of “normal” interest rates; we have done the same with the economic indicators. For each state and territory, latest readings for the key indicators were compared with decade averages – that is, against the “normal” performance.

In the last report in April 2011 the ACT was judged the strongest economy from Western Australia. But in the latest quarter the tables have been turned with Western Australia now on top. Western Australia leads the way in overall economic growth and is strong in retail spending and commercial and engineering construction. The ACT economy benefits from strong housing and commercial construction and historically-high population growth.

Next strongest economy was Victoria, followed by South Australia with little separating the economies of Tasmania and Northern Territory. Victoria maintains a strong job market and has above-average growth on housing finance. And South Australia benefits from strong equipment investment and above-normal population growth.

Looking ahead, the NSW economy should benefit in coming months from relatively high population growth and firm housing lending. And Queensland should benefit from rebuilding activity after the floods and cyclones in early 2011.

Western Australia now on top, from the ACT and Victoria
Western Australia is back on top, judged to have the strongest economy in the land. Western Australia continues to benefit from strength in mining and engineering, driving commercial construction, exports and overall economic growth. But the housing sector remains soft as is clear by the sharp slowdown in dwelling starts and falling home prices.

Looking across the indicators, the ACT leads the way on four of the eight indicators – population growth, commercial & engineering construction, housing finance and dwelling starts. The main blots on the copybook have been the weakening job market and weaker business investment. In addition retail spending in the ACT is under-performing other state & territory economies.

There has been little change in the relative performance of the Victorian economy over the past three months. Unemployment remains historically-low and that is supporting housing lending, retail spending and home building.

The South Australian economy has benefited from stronger investment and plant and equipment spending stands at record highs in trend terms. Above-average population growth also provides support to the economy although home lending is under-performing other economies.
Tasmania has been a clear improver over the last three months benefitting from stronger construction work which is now 32 per cent above decade averages. The Northern Territory maintains its top rankings on the job market and retail spending but business investment is now 39 per cent below the decade average.

The performance of the NSW economy continues to be restrained by the construction sector – both new home building as well as commercial and engineering activity. The job market has also softened in relation to other states and territories but relative strength in population growth augurs well for future spending and investment.

The Queensland economy is still in the early stages of recovery from the floods and cyclone that occurred earlier this year. Once rebuilding gets fully underway it should provide momentum through the broader economy. But activity in coal producing areas is still hampered by flooding. The housing market also remains weak, whether it be new building, home lending or home prices.

How was performance judged?
Each of the states and territory economies were assessed on eight key indicators: economic growth; retail spending; equipment investment; unemployment, construction work done; population growth; housing finance and dwelling commencements.
The aim was to find how each economy was performing compared with “normal”. And just like the Reserve Bank does with interest rates, we used decade-averages to judge the “normal” state of affairs. For each economy, the latest level of the indicator – such as retail spending or economic growth – was compared with the decade average.

While we also looked at the current pace of growth to look at economic momentum, that can yield perverse results to judge performance. For instance retail spending may be up sharply on a year ago but from depressed levels. Overall spending may still be well below “normal”. And clearly some states such as Queensland and Western Australia consistently have faster economic growth rates due to historically faster population growth. So the best way to assess economic performance is to look at each indicator in relation to what would be considered ‘normal’ for that state or territory.

For instance, the trend jobless rate of 4.0 per cent in the ACT is lower than in all but the Northern Territory. But compared with its ‘normal’ or decade-average rate of 3.5 per cent, the jobless rate is actually higher in percentage terms than any other economy, affecting activity in the retail sector. Trend measures of the economic indicators were used to assess performance rather than more volatile seasonally adjusted or original estimates.

Economic growth
Ideally gross state product (GSP) would be used to assess broad economic growth. But the data isn’t available quarterly. Rather state final demand (household and business spending) is added to exports less imports to act as a proxy for GSP. Excluding the trade sector would provide an incorrect assessment of growth for economies such as Western Australia and Queensland.
Western Australia continues to lead the rankings on economic activity from the ACT and Northern Territory. In the March quarter, Western Australia’s economic output was just over 28 per cent higher than the state’s decade average level of output. ACT output was up 22 per cent on its long-term average, followed by the Northern Territory (up 17.5 per cent).

At the other end of the scale economic activity in NSW in the March quarter was just over 9 per cent above its decade while Queensland activity was up 10 per cent on its “normal” or average output over the past decade. The ACT has the fastest annual economic growth rate in the nation at 7.2 per cent, ahead of Western Australia with 6.1 per cent and South Australia with 6.0 per cent. The weakest trend economic growth rates were recorded in Queensland (-3.6 per cent) from Northern Territory and NSW.

Retail trade
The measure used was real (inflation-adjusted) retail trade in trend terms with March quarter data the latest available. Monthly retail trade was also assessed (May data available) to provide further information on trends. There were no differences in the rankings despite the monthly data being two months advanced on the real, quarterly readings.

Still leading the retail rankings is Northern Territory with spending in the March quarter 22 per cent above decade average levels. Spending has been supported by a strong job market and rising home prices. But it’s worth noting that actual growth in spending in the “top end” has been weakening and is down 1.4 per cent on a year ago in real terms.

Western Australia was next strongest, courtesy of low unemployment, with spending 19 per cent above decade-average levels. Western Australia also has the strongest growth in retail spending, up 2.8 per cent on a year ago. Victoria was next strongest, with spending 16 per cent above decade averages, followed by Queensland and South Australia. Tasmania is now at the bottom of the leader-board, with spending up just 11 per cent on the decade average. And real retail spending in Tasmania is 3.7 per cent down on a year ago – the weakest performance of the states and territories.

Equipment investment
Compared with longer-term averages, Western Australia currently is leading other states and territories on equipment investment with spending in the March quarter almost 50 per cent above “normal” – or decade-average. Next placed is NSW (up 31.9 per cent), followed by South Australia (up 23.3 per cent).

By contrast, equipment spending in the Northern Territory was largely unchanged compared with its decade-average. Next weakest economy – ACT – had business investment 6.9 per cent above its longer-term average in the March quarter.
Equipment investment was only lower than a year ago in two of the state and territory economies – Northern Territory (down 39 per cent), Victoria (down 6.0 per cent and Queensland (down1.4 per cent).
In the ACT, equipment investment is 42.5 per cent higher than a year earlier, while investment in South Australia is at record highs, up 13.1 per cent on a year ago.

Unemployment
The Northern Territory still has the strongest job market in the nation, but there has been clear slippage in the past three months with similar softening in the ACT. The trend jobless rate in the Northern Territory stands at 3.7 per cent – well below the long-term average of 4.7 per cent. But unemployment has lifted from a rate of 2.4 per cent in January. And in the ACT, the jobless rate has lifted from 3.1 per cent to 4.0 per cent over the past 10 months and is now 15 per cent above the decade average of 3.5 per cent.

Victoria was next strongest to the Northern Territory with a jobless rate of 4.7 per cent, 12 per cent below the decade average of 5.3 per cent. And Tasmania has a jobless rate of 5.6 per cent, below its “normal” rate of 6.3 per cent.

Construction work
The measure used for analysis was the total amount of residential, commercial and engineering work actually completed in trend terms in the March quarter.In all states/territories except the Northern Territory, construction work is substantially higher than decade averages. Construction peaked in the ‘top end’ in the March quarter 2009 at record levels. The relatively small Northern Territory economy is affected to a greater extent by the ‘lumpiness’ of major construction projects. Construction work in the Northern Territory is down 28 per cent on the decade average.

In the ACT construction work done in the March quarter was just shy of 74 per cent above the decade average. Construction work in the ACT is also up 22.5 per cent on a year ago – the fastest rate in the nation. Next strongest was Western Australia with construction work 65 per cent higher than decade averages followed by Tasmania, up 32 per cent, and South Australia, up 31.5 per cent. Construction work is higher than a year ago in all states/territories except South Australia (down 8.8 per cent), Queensland (down 3.0 per cent) and Northern Territory (down 2.1 per cent).

Population growth
Across the states and territories the current annual rate of population growth was compared with each economy’s decade-average growth pace. And currently population growth is above ‘normal’ in all states and territories except Northern Territory (down 49 per cent), Queensland (down 29 per cent) and Victoria (down 1.4 per cent).

Population growth is fastest in Western Australia (2.09 per cent) followed by the ACT (1.95 per cent) and Queensland (1.70 per cent).
At the top of the rankings on the population growth leader board is the ACT with current annual population growth, well above the 1.3 per cent decade average. Next best was NSW, followed by South Australia and Tasmania. While Tasmania’s population growth of 0.77 per cent remains the slowest in the nation, it still remains 2.8 per cent higher than the decade average.

At the other end of the leader-board in Northern Territory with the 0.83 per cent population growth the slowest in seven years and 48.6 per cent the 1.6 per cent decade-average growth pace.
In Queensland, population growth has eased from 2.86 per cent in December quarter 2008 to 1.70 per cent – the slowest growth pace in 11 years.

Housing finance
The measure used was the trend number of housing finance commitments and this was compared with the decade-average for each respective state and territory.
 
Housing finance is not just a lead indicator for real estate activity and housing construction but also is an indicator of activity in the financial sector. It would be good to also use figures on commercial, personal and lease finance, but unfortunately trend data is not available for states and territories.

Far away in top position for housing finance is the ACT. The number of housing finance commitments in the ACT is 15.5 per cent higher than the decade-average at a time when all other states and territories except Victoria are recording negative growth. The high level of activity is positive for financial institutions, real estate agents and builders in the territory. And not is housing lending in the ACT above longer-term averages, it is also growing, up 4.9 per cent over the year and second strongest behind Western Australia (up 9.3 per cent).
Victoria is in second spot for housing finance, with the number of commitments 0.5 per cent above the long-term average. And just like the ACT, home lending is also growing, up 4.1 per cent in trend terms compared with a year ago.

NSW was third on housing finance, albeit down 15.7 per cent on the decade average followed by Western Australia (down 16 per cent) and Tasmania (down 21.5 per cent).

The Northern Territory remains the weakest economy for housing finance with trend commitments 31.1 per cent lower than its decade average. In addition, housing finance commitments in May were over 11 per cent down on a year ago. Queensland is next weakest with home lending 30.7 per cent below decade averages and down 10.6 per cent on a year ago.

Dwelling starts
The measure used was the trend number of dwelling commencements (starts) with the comparison made with the decade-average level of starts. Starts are driven in part by population growth and housing finance and can affect retail trade, unemployment and overall economic growth. However any over or under-building in previous years can determine the current level of starts.

The ACT continues to lead the pack on dwelling starts. In the March quarter the number of dwellings commenced stood at a record 1,294 in trend terms, just off the record high of 1,332 in the December quarter. Starts are almost 82 per cent and up 20.3 per cent on a year ago.
In second spot was Northern Territory with dwelling starts in the March quarter almost 42 per cent higher than ‘normal’ or “decade average” levels while Victorian starts were 24.2 per cent above the decade average. Strong home prices over most of 2010 together with low unemployment have driven the improvement in home building in the “top end’. Starts are at 11-year highs in trend terms.

Victoria was followed by Tasmania with starts up 7.5 per cent on decade averages. At the other end of the scale, Queensland dwelling starts were not only 26.6 per cent below decade averages but also they are 18.3 per cent down on a year ago. In NSW, dwelling starts were 13.4 per cent below decade averages in the March quarter, with Western Australian starts 10.4 per cent below decade averages and South Australian starts 10 per cent below its “normal” rate of activity. NSW was the only state of these three to post stronger starts compared with a year ago (up 4.4 per cent).

Other indicators
Consumers in all states and territories except South Australia continue to enjoy real wage gains (wages growing faster than prices). South Australian wages are growing in line with prices. Western Australian workers are doing best with wages up 4.1 per cent over the year, outpacing a 2.6 per cent lift in consumer prices. As would be expected retail spending in the state is also solid, with real growth the fastest in the nation with spending 19 per cent above the decade average.

Home prices are now falling in all capital cities except Sydney (dwelling prices up 1.0) per cent. Next best was the ACT with dwelling prices just 0.1 per cent on a year ago. Wages are expected to outpace prices over the remainder of 2011. And while home prices are currently down on a year ago in most capital cities, the trend for the remainder of the year is expected to be sideways rather than down. Housing markets are generally under-supplied with stock.

Implications and outlook
There has been little change in the state rankings over the past three months, Western Australia and the ACT are at the top; Victoria has held ground in third spot followed by South Australia with Northern Territory and Tasmania together. Provided China continues to grow then the Western Australian economy will continue to thrive. But just as the broader Australian economy is multi speed, so is the situation in Western Australia. Mining areas are thriving but weaker housing activity is creating challenges in Perth and non-mining regional towns.

The ACT economy is being propelled by above-average population growth, driving construction activity. But the lift in the jobless rate raises questions about whether the strong economic performance can be maintained. There is unlikely to be major changes in the middle rankings with Victoria and South Australia modestly ahead of Tasmania and Northern Territory. But there is little to separate these economies.
An extended period of interest rate stability could provide the momentum that NSW and Queensland economies both need – injecting interest in the housing sector. We continue to expect that the Queensland economy will benefit from rebuilding and refurbishment activity as well as a recovery in coal production. But the high Australian dollar will continue to provide challenges for the tourism sector – fewer international visitors and more Aussie travelling abroad.

Consumer conservatism and the uncertainty provided by proposed carbon and mining taxes will provide challenges for all the states and territories over the next 3-6 months.

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