- The Australian economy was picking up momentum in H2 2019;
- But then came COVID-19;
- How big an issue the virus will end up becoming is not yet clear;
- The Government response will be important in minimising the fallout;
- Financial market volatility is at a very high level;
- Over time, the $A is likely to head higher. When is the question.
‘It’s all happening’ was a famous line by the great Australian cricket commentator, Bill Lawry. Well there can be no doubt ‘it’s all happening’ right now in the global economy and financial markets. Below is some thoughts on major economic events of just the past week.
2019 was a better one for the economy than expected
The domestic economy was sub-par in the first half of last year. Jobs growth was strong but consumer and business sentiment was modest. It didn’t help that that the global economy was also struggling. Global trade declined in 2019. Industrial production was very weak, partly a result of problems in the aircraft (Boeing) and car industries (weak demand, changes in European regulations and Chinese tax). Countries such as Germany and South Korea were hard hit. The Japanese economy suffered from an increase in their GST rate.
But there was light appearing from the gloom. Towards the end of the year global manufacturing and service sector surveys indicated that business sentiment had either stabilized or was improving in many countries. Construction industry confidence was high (very low interest rates), as was consumer confidence (very low unemployment rates). Equity and credit markets rallied on the view that the worst for the global economy might be over and interest rates would remain low for an extended period.
And the recent Q4 economic growth numbers indicated the Australian economy was also doing better. By end-2019 annual growth had picked up to over 2% compared with the sub-1.5% seen at end-2018.
Government spending was a big part of the reason the economy did OK, helped by mining exports and IT capex spending. But domestic private demand (household consumption, housing construction and other business investment) was weak. Given that background, it is no surprise that the health/welfare, IT and mining sectors are doing best. By contrast the engineering and construction sectors have still been feeling the fallout from the end of the mining boom, as well as the slowing residential construction sector. One bit of good news is that ongoing jobs growth has meant that households’ disposable income are again starting to head north.
It is expected that the drought and bushfires would have a negative impact on economic growth in Q1 2020 (up to 0.2 percentage points). The rebuilding from the bushfires is expected to help the economy over the following couple of years. At the start of February the RBA expected GDP growth to pickup to 2.75% in 2020 and 3% the following year. Financial market forecasters were more pessimistic (2.0% in 2020 and 2.5% in 2021). The Q4 2019 GDP data was in line with the more optimistic RBA view.
RBA looking ahead
That was the start of February. By March the RBA had decided to cut the cash rate by quarter percentage point. Weak retail trade numbers in both December and January indicated that the consumer was still not spending. But the rate cut decision was not based on what had happened in the economy but on what might happen. And in particular the impact of COVID-19.
The first ‘shock’ from the virus was the impact that it had on the Chinese market. Hubei Province (where the virus originated) accounts for only 4.5% of total Chinese GDP. But it was the countrywide stringent quarantining that hit the wider economy. There are still restrictions (particularly around Hubei) and how long they remain will determine the extent of the final impact on the Chinese economy.
The relaxation of the conditions is allowing the Chinese economy to slowly get back to full capacity. It is entirely possible that the production side of the economy will be largely back into full swing over the next month. Even if China gets back to full production by month-end there will be a substantial backlog of orders. Supply chain problems might take 3-6 months to alleviate.
Chinese consumer spending might also take a while to power up as people remain worried about the potential further spread of the virus. From a global perspective it will be even longer before Chinese international students and tourism returns to their pre-COVID 19 ways (particularly given the rise in new cases outside of China).
The weakness of the Chinese economy has impacted Australian exporters (tourism, education, retail/restaurants, transport, mining, agriculture). Just for tourism, China accounts for around 15% of all arrivals to Australia and around 0.8% of GDP. Federal Treasury estimates that the direct impact of the slower Chinese economy will reduce Australia’s GDP growth by 0.5 percentage points in Q1. With another 0.2% for bushfires/drought and underlying growth of 0.5-0.6%, this implies a high chance of negative growth for Q1. Reflecting this firms’ views of trading conditions have declined since the start of the year (although the decline was not of the magnitude seen in the Chinese business surveys).
A shutdown of the Chinese economy also has significant indirect impacts. Between 50-90% of most construction industry products used in Australia is sourced from China. China also plays a large role in the production of computers, electronics, pharmaceuticals (causing problems in the manufacture of medicines) and transport equipment. The indirect impacts will be felt over the subsequent couple of quarters. Even in February a growing number of firms were reporting their stock levels were dwindling.
Global impact of the spread of COVID-19
But the virus is now spreading outside of China. It is not clear how big an economic problem COVID-19 will be. That will depend how widespread the virus becomes, the mortality rate, the consumer and business confidence reaction and government and central bank responses.
The virus will have both supply and demand impacts:
- Supply will be reduced by the direct worker impact (sick people), quarantining (school closures forcing parents to stay home) and higher business costs (supply chain disruptions).
- Demand will be lower due to increased uncertainty (reducing business capex and possibly house purchases), worried consumers (not going to restaurants) and containment efforts (travel restrictions hitting airline bookings).
- Financial markets are likely to remain risk averse, at least until there are signs of slowing of the spread of the virus. It could also change both the amount that consumers save (increasing saving ratio) and the composition (more money in cash, less in equities).
The IMF has indicated that around one-third of the economic cost comes from the direct impact (sick people, quarantines, work closures) and two-thirds from indirect impacts (risk aversion by consumer, businesses and financial markets).
Lower demand will impact the economy but particularly sectors involved with public gatherings (tourism, transportation, entertainment, tourism, retail). Most at risk are highly leveraged firms and SME’s who are likely to face cash flow problems. Contract workers will also be vulnerable. Government policies can help limit job losses.
The potential impact on inflation from the virus is mixed. Supply problems and panicked buying causing shortages leading to higher inflation. This is at the same time as food prices (eg, beef) will be higher reflecting re-stocking post the drought. But falling demand will lead to lower prices for other goods and services. For example, there has been a large drop in oil prices due to lower global demand (and a lack of agreement from OPEC and Russia about the appropriate supply response). Firms are likely to offer bargains to try and attract consumers to come to restaurants or take holidays.
In any event, the RBA will likely see any rise of inflation to be temporary. And lower inflation would be another argument to reduce interest rates. Either way there are no inflation arguments for higher interest rates.
Government/central bank response
The RBA initially reacted conservatively to the COVID-19 outbreak (as did I). But this changed at the end of February with confirmation of the weakness of the Chinese economy, clear signs that the virus was spreading globally and the rise of investor risk aversion. The result was the cash rate reduction of one quarter percentage point at the March meeting, with the clear statement that the RBA will cut rates again if necessary. The Statement also made it clear that the rate cut reflected the change in their view of the impact of COVID-19 on the economy. The RBA expects the economy to returning to decent growth rates once the spread of the virus has been contained.
Another reason for the RBA to ease monetary policy is that the global level of the cash rate is falling. Concerns about the coronavirus led the Federal Reserve to cut the cash rate by 50bp followed shortly after by the Bank of Canada. Other central banks are likely to follow although the European Central Bank (ECB) are reluctant cutters.
Financial markets expect that the RBA will cut rates again by another quarter percentage point by May this year. With both the Federal Reserve and the Bank of Canada already cutting rates by half percentage point, April is a real possibility. The RBA has indicated that any additional easing would then be done by ‘quantitative easing’ (the RBA does not want negative interest rates). This will be done by purchasing Australian Government bonds, encouraging investors’ to buy other assets.
One speculated strategy that the RBA may follow is to keep different interest rates along the yield curve within a set range (‘yield curve control’). This has been a strategy followed by the Bank of Japan for over the past three years. In practice it would mean the RBA would set an interest rate target for different parts of the yield curve (difference between 10- and 3-year yields). For example, 3–year yields on Australian Government bonds could trade within 0.1-0.3% and 10-year yields within 0.2-0.4%.
The benefit of this strategy is that it would ensure that yields remain above zero and the yield curve positive to minimise problems for the banking system. The question then becomes once interest rates are within that range what else could the RBA do if they need to further stimulate the economy.
Quantitative easing will also be done by ‘forward guidance’ (ie, the RBA indicating the cash rate will not be changed until either a particular date in the future or until an economic target such as the unemployment rate is met). In practice this will likely mean that the cash rate will not be rising for at least two years.
Importantly all central banks (including the RBA) have made it clear that they will supply ample liquidity to the financial system (ie, they will ensure that banks will have enough funding).
It is widely agreed though that easier monetary policy will have limited impact in this crisis. Not only are interest rates already extremely low, but the economic problem is a supply shock and reduced demand as a result of risk aversion. Lower interest rates (and fiscal policy) though can help with the economic recovery.
This crisis will require a greater role by the Government. This includes making sure the health system runs as efficiently as possible, critical goods and services remain widely available, addressing firms temporary cashflow problems and minimising any rise in the unemployment rate.
The Australian Government has announced that it will shortly introduce a fiscal boost addressing a number of these issues. Policies may include accelerated depreciation allowances, grants and tax concessions for a short period (1-2 years). The key outcome is that the policies must help with business and household cashflows and be able to be implemented quickly. With interest rates so low the Government should also err towards a bigger package to assist in the recovery.
Government’s globally are boosting their spending and cutting taxes. For example, Hong Kong will unconditionally provide each citizen over 18 almost $2000 (we did something similar during the GFC). In Singapore the Government will assist hotels to renovate, upgrade IT systems and train staff during a period when tourism will be low.
Financial market reactions
Concern about the economic outlook and the rise of investor risk aversion has seen significant changes in financial market pricing. Bond yields, commodity prices (notably oil) and most stock markets globally have fallen substantially (although the Chinese market is the one market that is up for the month). The recent widening of funding and credit spreads needs to be watched. The lowest-rated US credit spreads have shifted out to their widest level in three years. The widening of Italian bonds spreads over recent days could also be a concern.
Why have we seen such big market movements over the past couple of weeks? One is that investors’ views about the economic outlook are changing as it becomes increasingly clear that the virus has gone global. Markets are now debating the time and the duration of the economic weakness.
There has also been concern about the valuation of a number of assets. For example, credit spreads were extremely low and price-earning ratios for (particularly the US) sharemarkets were high. The main argument for buying these assets was yield pickup given the extremely low level of interest rates. But this left equity markets vulnerable if investors had a second think about the economic outlook.
This has been exacerbated by investors positioning. For some time investors have been ‘long’ the $US (expecting it to go up), and ‘short’ volatility (expecting volatility to remain low). Recent events have called into account both these views leading to investors’ having to unwind their positons.
Finally, there have been market-specific issues. There seems to be more extreme bouts of volatility in financial markets these days reflecting changes to who is doing the buying and selling (more short-term computer driven trading, less done by bank dealers). Oil prices have cratered partly because of expectations of lower demand. But this has been exacerbated by a tiff between Saudi Arabia and Russia that could actually lead to an increase of oil supply.
Lower oil prices is clearly a negative for oil producing countries and companies. In the US the problems could be exacerbated by highly indebted shale oil companies. But lower oil prices should be good for consuming countries (such as China) and household budgets. It is also good for firms where oil is a big input cost (such as airlines) but they are feeling the pinch of a big fall in demand.
The billion dollar question is what might stop the volatility. The best sign would be that the spread of the virus is slowing, but that is unlikely to be visible for some time. Many central banks have done their bit by cutting the cash rate and making sure financial markets have ample funding. They may have yet more tricks in their bag. But it is the credibility of the size and composition of Government policies, and how they are implemented, that will probably be of greatest interest to financial markets and the wider economy.
Currency market implications
The $A has also declined sharply over the past couple of weeks (so has the New Zealand dollar). And despite having perhaps the strongest economy, the $US (and Canadian dollars) have also weakened because their higher cash rate means central banks can be most aggressive in easing monetary policy.
Purely on the ground of ‘fundamentals’ (the terms of trade, relative interest rates and the current account), there are good reasons to suspect the $A should be trading higher.
The terms of trade (the ratio of export to import prices) remains at a relatively high level. Much of this is driven by the level of commodity prices. While iron ore prices have fallen (down about 6% since mid-January) they have done better than other commodities because of expectations that China will boost spending to keep its economy going (and with new virus cases falling China can start re-focussing on economic activity).
Interest rate differentials have also moved (sharply) in the $A favour. Australian 2-year yields have moved from being about one percentage point below US 2-year yields in mid-2019 to trading above US yields by March this year. And the current account is in surplus.
A Reuters survey conducted in early March had 70c as the median consensus forecast of economists of where the $A will be in early 2021 (although that survey was done before the recent volatility). The high level of volatility is a key reason why the $A is not at that level now. A widely used benchmark of risk in financial markets is the VIX index, a measure of volatility of the US equity market. That index indicated that in early March US equity market volatility had moved to its highest level since the GFC.
The $A usually does not do well in periods of high uncertainty as it coincides with investor concerns that global growth might be weaker (and therefore the risk that commodity prices go lower). In this environment investors tend to shift to ‘safe-haven’ currencies (typically the yen and Swiss franc).
There have been periods when the $A has traded lower. And in a world of growing uncertainty there is the clear risk that it may do so in coming weeks. But the $A is below its long-term average value against the $US. And at some point the ‘fundamentals’ will reassert themselves. Providing China does not have a sustained economic problem iron ore prices should hold their own and help the $A to head higher. The timing of when that happens is problematic. But better news about the virus or global government policies are the signals to watch.
‘He is like a cat on a hot tin roof’ was another Lawryism. Financial markets have acted like that over recent weeks as the COVD-19 situation has unfolded. Like a typical cricket match, at some point (hopefully soon) financial markets will settle back down and better news on the virus front emerges. Until then we can but watch the action.
We live in interesting times!
Peter Munckton - Chief Economist