THE BIG PICTURE: How the weather became a crucial economic forecasting tool

Economists of all descriptions rely on models to predict where the economy is going. Unfortunately most are based on past relationships and events, and of course that can prove hit and miss as it is clear that every situation is different. And the other key variable affecting the economy is human behaviour, which again doesn’t follow a set script. So economic models are notoriously inaccurate.

The old joke is that economists were invented to make weather forecasters look good, but clearly economists would love to have some of the predictive models that weather forecasters use. For example, the models used to predict the La Niña weather event that is currently underway. La Niña is associated with wet weather in eastern Australia and dry conditions in New Zealand and western areas on northern and southern America.

The latest La Niña event developed in late winter/early spring and by October it was clear that this would be a major event – according to the World Meteorological Organisation “a moderate to strong event”. We highlighted this in a report on October 12, noting the potential effects on rural and regional areas as well as mining, insurance and retail sectors.

La Niña has continued to develop and some reports suggest that this could be the most severe event for 60 years. Certainly the Australian Bureau of Meteorology believes that this is the most severe La Niña “since the 1970s at least.”

To date the La Niña event has had major effects across the globe leading to flooding in eastern Australia, developing drought conditions in New Zealand and dry, warm weather in the US south-west. And here in Australia, mining companies have had to declare force majeure due to flooding in central Queensland, heavy rains have led caused downgrades to the quality of the NSW wheat crop and retailers have complained that consumers have delayed purchases of traditional seasonal items.

Events like La Niña and El Niño follow predictable patterns but clearly the severity and length of the events vary. However those that heeded the warnings 2-3 months ago and followed the trends over time have been able to stay ahead of the pack.

Economists would dearly love an economic model with the same predictive power as the La Niña/El Niño models, but sadly none exist. It’s worthwhile noting that the La Niña event is expected to run to at least March/April 2011.

The week ahead

By now, investors and analysts alike would no doubt like to be in wind-down mode ahead of the Christmas/New Year period. But unfortunately there is still a fair amount on the plate. Certainly there is a good spattering of data to be released in Australia over the coming week, in addition to the full suite of top-shelf indicators slated for release in the US.

In Australia the week kicks off with the release of credit and debit card lending figures from the Reserve Bank on Monday as well as lending finance data from the Bureau of Statistics. If there has been a common theme this year it is that neither consumers nor businesses are keen to take on debt. The Reserve Bank is arguably not unhappy with this situation, especially as it tries to cope with the strength in the mining sector. But certainly the conservatism is making life tough for consumer-focussed businesses.

On Tuesday the NAB business survey is released. Overall confidence levels are still reasonable but business conditions have deteriorated, falling to 15-month lows in October. Any further weakening of business conditions in November will cause the Reserve Bank to question its confidence about a lift in investment spending. Dwelling starts are also out the same day, and are expected to show a 5% fall in the September quarter.

On Wednesday, data on new car sales is issued together with the latest consumer sentiment survey results. And on the same day RBA Assistant Governor Debelle delivers a speech. Consumer confidence should have rebounded from the rate hike induced slump in November. And car sales probably rose by 1 per cent in November.

On Thursday data on imports is released alongside the Reserve Bank quarterly Bulletin and the financial accounts publication. The financial accounts include estimates of household financial wealth, which should have rebounded in the September quarter in line with the sharemarket.

Turning to overseas events, the week actually kicks off a day early on Saturday (brought forward from Monday) with the key monthly readings on the Chinese economy. The data covers indicators such retail sales, production, investment and inflation and is quick becoming a highlight on the monthly calendar.

On Tuesday, attention shifts to the US with new readings on producer prices, retail sales and business inventories. And the Federal Reserve meets to discuss monetary policy settings. No major changes are expected but the accompanying text will prove interesting reading and perhaps a bit contentious.

On Wednesday, data on consumer prices, capital flows and production are issued together with the Empire State manufacturing survey. On Thursday housing starts and the current account are in focus while the Philadelphia Fed survey and leading indicator series are published on Friday.

Overall the activity indicators in the US are likely to be encouraging. Retail sales (excluding autos) are tipped to have lifted by 0.6% in November with production up 0.3% and housing starts up 5 per cent. If the customary weekly jobless claims data (released Thursday) also shows improvement then a Santa Claus rally has potential to take hold.

Sharemarket

There are perceptions that the Aussie sharemarket is ‘cheap’ at present. We don’t share those views, believing that valuations are fair rather than being ‘cheap’ or expensive. The historic price-earnings ratio stands at 15.14, a touch above the 30-year average of around 15.00. And given that investors, just like consumers and businesses have become more conservative and risk averse, current valuations are unlikely to prove sufficiently tempting. We do expect, though, that the sharemarket will ratchet higher over the coming year, lifting to 4,900 points in March, to 5,100 points in June and ending 2011 around 5,400 points.

Interest rates, currencies & commodities

It may seem like the Aussie dollar has had a volatile time over 2010. But actually the year has been far from extraordinary and certainly significantly less volatile than the past two years. It’s worth noting that the Aussie tracked over a range of around US38 cents against the greenback in 2008 and a near US32 cent range in 2009. In 2010, the range so far has been just over US21 cents. The Aussie hit lows of US80.65c on May 25 in the midst of the European debt crisis, before scaling peaks of US$1.0182 on November 5.

Certainly the ‘red letter’ day for the Aussie was October 15 when it cracked parity with the greenback for the first time in 28 years. The Aussie had rallied from US87.70c on August 25, so certainly it covered a lot of ground in a short period of time. Since mid October, the Aussie has undergone a period of correction and consolidation, holding between US95c and US$1.02. We expect that this broad range will hold now for around the next six months before a stronger US economy boosts the US dollar in late 2011, pushing the Aussie dollar down to around US92 cents by the end of the year.

But anyone expecting the Aussie dollar to fall back to its long-term average of US73 cents any time soon is likely to be disappointed. Relatively high interest rates, a sluggish US economy and firm commodity prices should leave the Aussie dollar camped above US90 cents for most of 2011.

Craig James is chief economist at CommSec.