Little optimism for dairy price recovery

About 10 per cent of farms hold about a third of the dairy sector debt. Photo / Brett Phibbs

Opinion

Many regions will feel brunt of belt-tightening and weaker outlook increases the chances of cut to OCR.

The only topic that seems to be competing with Auckland house prices at present seems to be the declining Fonterra payout, and what it means for the economy as a whole.

The $4.40 payout for the current season will be the lowest level since 2006/07, and well below the ten-year average of $5.85.

More importantly, the opening forecast for next season has been set at $5.25, not as much of a rebound as many would've hoped.

This will undoubtedly change over the coming year, probably more than once. The opening forecast for the past two years has been $7. Last year this was reduced five times and ended up at $4.40, while the previous year it increased to a record $8.40.

A lot can change over a year, particularly given the volatility of commodity prices, weather conditions and global demand. However, with prices at yesterday's dairy auction falling for the sixth consecutive time to the lowest levels since 2009, there isn't a lot of optimism about a recovery at the moment.

A payout of about $5.25 is roughly breakeven for the average farmer, although this depends on debt levels. About 10 per cent of farms hold about a third of the dairy sector debt, so while many farmers will cope with a couple of weaker seasons, this highly-indebted group is much more susceptible to worsening conditions.

In terms of the impact on the broader economy, the loss of income this season is about $7 billion. Many regions will feel the brunt of the belt-tightening that will go along with this.

For investors, the weaker dairy outlook certainly increases the chances of an OCR cut over the coming months.

However, it remains a much closer call whether we see any change at next week's OCR review. There are still many areas of strength in the economy at the moment and the RBNZ might well choose to "watch this space" for a bit longer yet.

The currency would also react if things deteriorate further. The NZ dollar fell from US80c in 2007 to below US50c in early 2009. Numerous factors led to this 39 per cent decline, but a 66 per cent fall in global dairy prices was certainly one of them.

In terms of the sharemarket, there aren't a huge number of companies directly affected. Fonterra, Synlait and a2 Milk are key operators in the sector, although in some ways milk prices are a cost of production, so they don't necessarily feel the brunt of the downturn the way farm owners do.

However, further weakness in the dairy sector could see a slowdown in the broader economy generally, which would affect companies highly leveraged to economic conditions, such as Freightways, Metro Glass and Air New Zealand.

However, I would be hesitant to get too cautious on these just yet, given the positive signs in other areas of the economy and the offsetting impacts we would see from a potentially lower OCR and a weaker currency.

We don't need to get alarmed about the lower payout just yet. It certainly warrants keeping a close eye on, but there's a lot of water to go under the bridge over the coming year, and with room for interest rates and the currency to fall in response, we have some levers to pull if necessary.

For worried investors, the best protection is a healthy dose of international assets, a focus on local companies with overseas earnings and some good quality fixed-interest securities that will perform well in the event of interest rates going even lower than they already are.

Mark Lister is head of Private Wealth Research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.