Economic and Financial Market Update: Interest Rates And The Best Laid Plans

Summary:

• The RBA kept the cash rate at 1% followings its August meeting;

• The accompanying Statement made it clear the RBA has a bias to reduce rates further;

• And that interest rates will be kept low for an extended period;

• At the time of writing financial markets have fully priced in another half percentage point of rate cuts;

• That pricing looks appropriate given the domestic and global economic risks.

 

‘Tell me why all the best laid plans

Fall apart in your hands’

‘Best laid plans’

James Blunt

 

James Blunt’s words would be pretty much how the RBA would be feeling at the moment. In an attempt to have the economy regain its 2018 mojo, the RBA aggressively cut rates this year. And things had started to line-up such that the RBA could reasonably forecast a decent bounce in economic growth. Not only were interest rates lower, but so was the exchange rate. Taxers had been cut, miners looked likely to boost Capex Budgets. Infrastructure and NDIS spending will remain strong. The decline of housing prices looks to be over.

Of course risks to the domestic economy remained. There will be a residential construction downturn over the next 1-2 years. Technological change was creating challenges for a number of sectors, not the least retailors. Doubts remained as to whether disposable incomes would rise high enough to get consumers’ spending again. And there are signs of a slowing jobs market. But overall there was enough for the RBA to sit back this month and see whether the rate cuts to date has led to any improvement in the economic mojo. 

 

But the global backdrop was always the biggest risk to the RBA’s plans. And very recent developments has meant these risks have grown. The Chinese economy has been slowing, impacting Europe and other Asian economies. With global interest rates very low and Government debt high in a number of countries, the ability of governments and central banks to get the global economy back on track is now more limited. But things have got even tougher as the USA and China have embarked on an increasingly bitter Trade War. These concerns increased with the recent announcement by President Trump of increasing the number of goods that will be subject to tariffs and the Chinese response in letting its currency depreciate. 

Until the Trade developments of the past week I had been hopeful that the economy could improve without the need for additional rate cuts. But the increased risk of problems in the global economy means that it is now more likely that an even lower domestic cash rate will be required. 

The RBA Statement released followings it August meeting is still relatively upbeat. This is understandable as the RBA will rarely react to a couple of bad days in financial markets. Nonetheless, the recent trade developments would be a significant concern. Below is a comparison of the RBA latest economic and financial markets views with those they held following the June meeting (when the RBA first cut rates).

Overall Monetary Policy

June

Today's decision to lower the cash rate will help make further inroads into the spare capacity in the economy. It will assist with faster progress in reducing unemployment and achieve more assured progress towards the inflation target. The Board will continue to monitor developments in the labour market closely and adjust monetary policy to support sustainable growth in the economy and the achievement of the inflation target over time.

August

It is reasonable to expect that an extended period of low interest rates will be required in Australia to make progress in reducing unemployment and achieve more assured progress towards the inflation target. The Board will continue to monitor developments in the labour market closely and ease monetary policy further if needed to support sustainable growth in the economy and the achievement of the inflation target over time.

Comment:  

The RBA has made clear two things. First, if there is going to be any change in interest rates any time soon it will be down. Second, interest rates are going to be low for an extended period. The RBA would be pretty comfortably with the current level of interest rates given its economic view. But if the outlook deteriorates further more rate reductions will be required. Unemployment rate movements will be important. The next big domestic number will be the Q2 GDP data released in early September. But global developments are coming increasingly into focus. Fiscal policy (lower taxes, higher government spending) will become increasingly important to get the economy humming.

Aut Real Cash Rate
(cash rate minus underlying inflation)
Graph
Australian Operating Budget Balance
(12 month rolling sum, $Ab)
Graph

 

Global Economy

June

The outlook for the global economy remains reasonable, although the downside risks stemming from the trade disputes have increased. Growth in international trade remains weak and the increased uncertainty is affecting investment intentions in a number of countries. In China, the authorities have taken steps to support the economy, while addressing risks in the financial system. In most advanced economies, inflation remains subdued, unemployment rates are low and wages growth has picked up.

August

The outlook for the global economy remains reasonable. However, the increased uncertainty generated by the trade and technology disputes is affecting investment and means that the risks to the global economy remain tilted to the downside. In most advanced economies, unemployment rates are low and wages growth has picked up, although inflation remains low. The slowdown in global trade has contributed to slower growth in Asia. In China, the authorities have taken steps to support the economy, while continuing to address risks in the financial system.

Comment: 

For much of this year, it has been a two-speed global economy. The manufacturing sector (particularly the car industry) has had a tough time, reflecting a weaker Chinese economy and the Trade War. But the service sector had done better, helped by very low unemployment rates in most countries. But now the service sector looks to be shifting down a gear. And the Trade War is not improving. Although it is not clear from the RBA’s August Statement, the global economic risks have increased. Lower global interest rates will help. But financial markets are indicating that even further reductions will be required.

World Business Surveys
 

Graph

Chinese Imports
(annual % change, 3 month average)
Graph

 

Financial Markets

June

Global financial conditions remain accommodative. Long-term bond yields and risk premiums are low. In Australia, long-term bond yields are at historically low levels. Bank funding costs have also declined further, with money-market spreads having fully reversed the increases that took place last year. The Australian dollar has depreciated a little over the past few months and is at the low end of its narrow range of recent times.

August

Global financial conditions remain accommodative. The persistent downside risks to the global economy combined with subdued inflation have led a number of central banks to reduce interest rates this year and further monetary easing is widely expected. Long-term government bond yields have declined further and are at record lows in many countries, including Australia. Borrowing rates for both businesses and households are also at historically low levels. The Australian dollar is at its lowest level of recent times.

Comment:  

Increased concerns about the global economy has seen interest rates decline and the $A fall. Commodity prices have started to struggle. Most recently, the Renminbi shifted down to be at its lowest level against the $US in over a decade.  The equity market has struggled over the past couple of days although this followed a period of strong rises. But the stronger sharemarket was mainly a result of the substantial fall in interest rates. Earnings expectations are low. For much of this year, investors have believed that global central bank rate reductions will be enough to achieve a reasonable economic outlook. Recent developments in tariffs and the Renminbi may lead to investors’ to question that assumption. An abatement in the Trade War will help. Global central banks have made it clear as much as they can they will support the economy.

Australia Equity Market Forward EPS Growth
(annual % change over year)

Graph

Renminbi/$US Exchange Rate

 

Graph

 

Australian Economy

June

The central scenario remains for the Australian economy to grow by around 2¾ per cent in 2019 and 2020. This outlook is supported by increased investment in infrastructure and a pick-up in activity in the resources sector, partly in response to an increase in the prices of Australia's exports. The main domestic uncertainty continues to be the outlook for household consumption, which is being affected by a protracted period of low income growth and declining housing prices. Some pick-up in growth in household disposable income is expected and this should support consumption.

August

Economic growth in Australia over the first half of this year has been lower than earlier expected, with household consumption weighed down by a protracted period of low income growth and declining housing prices. Looking forward, growth in Australia is expected to strengthen gradually from here. The central scenario is for the Australian economy to grow by around 2½ per cent over 2019 and 2¾ per cent over 2020. The outlook is being supported by the low level of interest rates, recent tax cuts, ongoing spending on infrastructure, signs of stabilisation in some housing markets and a brighter outlook for the resources sector. The main domestic uncertainty continues to be the outlook for consumption, although a pick-up in growth in household disposable income and a stabilisation of the housing market are expected to support spending.

Comment:  

The ABS, firms and consumers all agree that the economy is currently a notch or two below par. RBA still appears reasonably comfortable with the economic outlook. While marking down their 2019 growth forecast, their projection for 2020 remains the same. Consumer incomes (and therefore spending) was again nominated as the biggest risk, although tax cuts and the end of house price falls may help. If it was just down to domestic factors a reasonable economic outcome is possible. But global developments are making things tougher.

Business Conditions
(SD from average, 3 month average)

Graph

Time To Buy A Major Household Item
(6 month average, difference from average)
Graph

 

Employment

June

Employment growth has been strong over the past year, labour force participation has been increasing, the vacancy rate remains high and there are reports of skills shortages in some areas. Despite these developments, there has been little further inroads into the spare capacity in the labour market of late. The unemployment rate had been steady at around 5 per cent for some months, but ticked up to 5.2 per cent in April. The strong employment growth over the past year or so has led to a pick-up in wages growth in the private sector, although overall wages growth remains low. A further gradual lift in wages growth is expected and this would be a welcome development. Taken together, these labour market outcomes suggest that the Australian economy can sustain a lower rate of unemployment.

August

Employment has grown strongly over recent years and labour force participation is at a record high. There has, however, been little inroad into the spare capacity in the labour market recently, with the unemployment rate having risen slightly to 5.2 per cent. The unemployment rate is expected to decline over the next couple of years to around 5 per cent. Wages growth remains subdued and there is little upward pressure at present, with strong labour demand being met by more supply. Caps on wages growth are also affecting public-sector pay outcomes across the country. A further gradual lift in wages growth would be a welcome development. Taken together, recent labour market outcomes suggest that the Australian economy can sustain lower rates of unemployment and underemployment.

Comment:  

The jobs market has been a standout feature of the Australian economy over the past year. Jobs growth has been decent. The unemployment rate has edged up, although this is at least in part due to a record high participation rate. But there are signs that the labour market is not what it was (the proportion of workers that feel comfortable about quitting their jobs has fallen). And leading indicators suggest that jobs growth will slow in coming months. The RBA does not look to be expecting any substantive pickup in wages growth in the near future. This is understandable given they project only a very modest decline in the unemployment rate over the next couple of years.

National Participation Rate

Graph

Australian Workforce Quit Rate
(2 quarter average)Graph

 

Inflation

June

The recent inflation outcomes have been lower than expected and suggest subdued inflationary pressures across much of the economy. Inflation is still however anticipated to pick up, and will be boosted in the June quarter by increases in petrol prices. The central scenario remains for underlying inflation to be 1¾ per cent this year, 2 per cent in 2020 and a little higher after that.

August

The recent inflation data were broadly as expected and confirmed that inflation pressures remain subdued across much of the economy. Over the year to the June quarter, inflation was 1.6 per cent in both headline and underlying terms. The central scenario remains for inflation to increase gradually, but it is likely to take longer than earlier expected for inflation to return to 2 per cent. In both headline and underlying terms, inflation is expected to be a little under 2 per cent over 2020 and a little above 2 per cent over 2021.

Comment:  

The lower than expected Q1 CPI numbers was one of the key factors behind the June/July rate cuts. While the Q2 inflation data were not as disappointingly weak they did underline that inflation is both low and not showing any clear signs of rising. Increasingly, consumers, business and financial markets expect inflation to remain very low, making it harder for inflation to rise. The RBA have modestly marked down their inflation forecasts. If the RBA forecast of an inflation rate at just over 2% in 2021 proves correct then an interest rate rise is unlikely for at least the next 2-3 years.

Underlying Inflation
(average of median and trimmed mean, over the year % change)
Graph
Proportion Of CPI Items
Graph

 

Housing

June

The adjustment in established housing markets is continuing, after the earlier large run-up in prices in some cities. Conditions remain soft, although in some markets the rate of price decline has slowed and auction clearance rates have increased. Growth in housing credit has also stabilised recently. Credit conditions have been tightened and the demand for credit by investors has been subdued for some time. Mortgage rates remain low and there is strong competition for borrowers of high credit quality.

August

Conditions in most housing markets remain soft, although there are some signs of a turnaround, especially in Sydney and Melbourne. Growth in housing credit remains low. Demand for credit by investors continues to be subdued and credit conditions, especially for small and medium-sized businesses, remain tight. Mortgage rates are at record lows and there is strong competition for borrowers of high credit quality.

Comment:  

The clear bit of good news over recent months is that house prices declines look to have ended, notably in Sydney and Melbourne. The fall in house prices has been a plus for first-home buyers. A significant rise in prices is unlikely with a large supply (particularly of units) still to hit the market. Borrowing conditions have eased a little but remain relatively tight. Credit growth remains constrained.

Firms' View On Net Borrowing Conditions
(3 month average)
 
Graph
Total Credit
(annual % change)
Graph

 

Cash Rate Outlook

 

Financial Markets

(as at 6 Aug 2019)

Economist views

(survey conducted 22 July 2019)

Date

Median

Low

High

Sept 19

0.88

1

0.75

1

Dec 19

0.61

0.75

0.5

1

Mar 20

0.50

0.75

0.5

1

June 20

0.46

0.75

0.5

1

Sept 20

0.44

0.75

0.5

1.25

Dec 20

0.46

0.75

0.5

1.25

Source:  Refinitiv

Comment:  

At the time of writing financial markets have not only fully priced in two more quarter percentage point rate cuts by early 2020 and but have even priced in a chance of a third reduction. This pricing is more aggressive than any economist forecast for the next 18 months, although the survey of economists was conducted prior to the latest tariff announcement by President Trump and the Renminbi depreciation.

The combination of weak data, surprising Trade announcements has recently turned investor sentiment sour. Investor sentiment could turn again if China and the US come to an agreement, or the global economy starts to show the benefits of the amount of global monetary and fiscal support provided this year. The RBA’s pro-growth plan could still work. But the growing risks suggest that further rate cut announcements (and fiscal policy moves) are likely.  

 

 

We live in interesting times!

Peter Munckton - Chief Economist