Economic and Financial Market Update: The RBA and 2020

Summary:

• The RBA kept the cash rate unchanged at 0.75% following the December meeting;
• The February meeting is potentially ‘live’, although a deterioration in the data will be required for a rate change;
• Financial markets and most economists expect at least one more rate cut next year;
• Whether rates fall again depends upon a variety of global and domestic factors.

RBA Dec 2018 decision

The RBA decided to keep the cash rate unchanged at 0.75% following the December Board meeting. No surprises given the (somewhat) better tone of the global economic data of the past month. And no surprise given that the RBA had already signalled a time of reflection was necessary after already cutting the cash rate by 0.75% this year. Otherwise much of the accompanying statement was broadly similar to the preceding month.

Many factors will drive monetary policy in 2020. Below are five of the issues that will be important in determining the interest rate outlook.

Issue 1: Slowing Chinese economy

Much attention this year has been focussed on the Trade War. Certainly export volumes are down. And the Trade War has created a high level of uncertainty that is impacting global business sentiment and capex spending.

Both the US and China have incentives to agree to some sort of Trade deal. The Chinese would like to reduce uncertainty to help their economy. The US because of the 2020 elections. But mistrust has grown between the US and China. And the issues discussed are too complex to find an easy comprehensive agreement. And leaving aside the Trade dispute the extended period of low disposable income growth has made the global political environment more volatile.

But politics has taken the focus away from the bigger issue of the sustained weakening of the Chinese economy. China is looking to make its economic growth model more sustainable, shifting from an investmentdriven to a consumption-led economy. At the same time it is looking to reduce pollution and income inequality, two of the problems with its present economic model. China is looking to make these changes at the same time as the size of its work force is declining (because of an aging population) and the global economy is weak. And they are fighting a Trade War with the world’s largest economy.

It is unsurprising then that the Chinese economy slowed over 2019. The Government is trying to support the economy. But it is wary about opening up the credit tap to much as debt has risen too high too fast over the past decade. Fiscal policy has been ramped up but so far with mixed success. The history of the past forty years is that you should back the Chinese Government to get the economy motoring. But success in the past doesn’t always guarantee success in the future.

Issue 2: High global debt

High debt levels was a cause of the GFC. But the extremely low interest rates in subsequent years encouraged the level of global debt to rise even further. The global debt to GDP ratio is at a record high. Two parts of the global economy showing signs of excess debt is associated with US firms and Chinese banks. The Chinese central bank (People’s Bank of China) recently announced that 13% of banks (mainly smaller rural-based lenders) were considered to be ‘high risk’. And concerns about US firms with the lowest credit rating is rising.

Of course the worrywarts have been shaking their heads about too much debt for at least the past five years. And while there has been some isolated issues there has been no systemic problems. The reason is that very low interest rates makes it easy for borrowers to service their debts. And this means less bad debt problems for banks.

But the very high level of debt makes the global economy vulnerable to either a surprising rise of interest rates or a surprising fall of economic growth. Global central banks have been at pains to emphasise that interest are not going to be rise any time soon. Financial markets fully agree. But there is more worry about the possibility of an economic downturn. There is growing signs that Governments are priming the fiscal pump to help the global economy. But while the global debt to GDP ratio remains high the world economy remains vulnerable.

Issue 3: Downturn in the construction sector

The global economy is one reason why the domestic economy has struggled this year. But there has also been local factors. Weak wages growth has been a constant feature. More significantly has been the slowdown of the residential construction sector (and the flow on impact to manufacturing and retail). The RBA November 2019 forecasts has the sharpest part of the slowdown in residential construction taking place this year. But they acknowledge that the downturn could be sharper (and maybe last a little longer) than their forecasts. The recent building approvals data certainly doesn’t signal any sign of an imminent turnaround.

But there are now more than just a few green shoots appearing for the housing sector. The rate cuts, (some) easing of bank lending standards and the election has all led to housing prices having a better tone (mainly in Sydney and Melbourne). Turnover has yet to significantly pickup but often does lag changes in house prices.

The weakness of rents in most cities points to oversupply. But population growth remains strong. And unless that changes the RBA has rightly warned that there is a risk of an under supply of housing appearing. At some stage this will lead to a turn in the residential construction cycle. But that is looking like a 2021 story. 

4: Weaker jobs market

The biggest positive for the Australian economy over the past couple of years has been the strength of jobs growth. An average of around 20,000 jobs had been created each month over the year to October, above the long-term monthly average. The participation rate rose to a record high. The strength of the labour market was important for the consumer given the weakness of wages growth.

But things are changing. The October jobs number was weak. Profit growth is under pressure. Firms are trimming their Capex Budgets. It is no surprise that firms are starting to look at their recruitment strategies. Surveys indicate that employer employment intentions are sliding, as are the number of job ads. Consumers are starting to become more worried about unemployment. Slowing jobs growth is a sign of a slower economy. A weak labour market is a worry given the high level of household debt.

5: Domestic policy stance

The RBA has cut rates three times this year reflecting too-low inflation, slowing domestic economy and the global economic risks. Financial market views of the long-term view of what the ‘average’ cash rate has also been marked down over the course of this year (as it has in most countries).

For now the RBA seems happy with the current level of the cash rate. In real terms (the cash rate after allowing for inflation) the cash rate is back to where it was in 2017 when the economy was last humming along in top gear.

But there has been growing discussion that interest rates will not be enough to get the economy moving back towards top speed. Government spending has been an important driver of growth. But the impact of taxation has also been rising (and why there is a budget surplus), taking an increasing chunk out of household disposable incomes. Infrastructure spending has been strong. But the recent data from the Parliamentary Budgetary Office suggests that it close to its peak (and will be declining in upcoming financial years).

Maybe a better global economy, the low level of rates and an improving housing sector will be enough to get a stronger economy. The tax cuts would have helped. But it is also likely that a bigger government presence in the economy will be required.

Cash rate outlook

The RBA has taken the cash rate down to a level where they are currently comfortable. RBA forecasts have the economy (slowly) improving, inflation (slowly) rising. But these are forecasts. The current evidence is that despite the rate cuts the economy is still sub-par, inflation too low and the risks are that the unemployment rate will rise.

Financial Markets and economists agree that another quarter percentage point cash rate cut will be required in the first half of next year. At the time of writing Markets had also priced in a reasonable chance of a second rate cut. According to a recent Reuters’ survey very few analysts are looking for a rate hike at any stage over the next couple of years.

Source:  Reuters, Refinitiv

After inaction for almost three years the RBA had a busy 2019. The RBA would like nothing better than to be out of the headlines in 2020. How the economy evolves, and the Government’s response, will determine whether they get their wish.

We live in interesting times!

Peter Munckton - Chief Economist