Get off the fence

David Bassanese

Chief Economist, BetaShares

The Australian economy has been travelling along reasonably well over the past year or so, with inflation contained and the unemployment rate easing to what has been considered the ‘full employment’ rate of 5.0 per cent.

This performance is even more remarkable because house prices in our two major capital cities have been sliding for the past year and a half. China’s economy has also slowed notably as credit tightening to reign in excess debt and the negative impact of the trade dispute with the United States took their toll.

So, what’s been supporting the economy? It’s been growth across several fronts.

Sector growth

The Federal and State Governments have opened their purse strings and splurged on a range of infrastructure projects to meet the demands of our rapidly growing population. Private construction of offices, warehouses and high-rise apartment blocks has also been strong.

In the services sector, the ongoing rollout of the National Disability Insurance Scheme (NDIS) has created an employment boom in the health and social support areas. And the education sector continues to benefit from the influx of foreign students.

In the resources sector, LNG exports are ramping up strongly, while global demand for Australian coal and iron-ore production remains firm.

Of course, it’s not all been plain sailing. Not helped by falling house prices and (despite low unemployment) weak wages growth, consumer spending has waxed and waned – and more retail dollars are being directed online and away from traditional bricks and mortar establishments. Drought conditions in south-eastern Australia have caused farm output to drop sharply over the past year.  

Up until recently, the Reserve Bank of Australia (RBA) has been able to project an image of ‘confidence and stability’, by forecasting persistent above-trend economic growth, falling unemployment and an eventual lift in wage and consumer price inflation.  

Consistent with this outlook, the RBA had long maintained the line that the next move in official interest rates was “more likely up than down”.

For what it’s worth, I’ve long maintained a more cautious view. My main worry over the past year has been the risk that the ongoing slide in house prices (which I have expected to continue) would eventually have greater negative effects on the economy.

I’ve also been dubious that even an unemployment rate of 5 per cent would have much upward pressure on wage growth, given the still high level of underemployment in the economy and equally high level of work job insecurity.

My base case call for much of the past year has been that the RBA would not touch interest rates in 2018. It was a boring call, but eventually turned out to the correct one.

But I’m now getting off the fence.

Off the fence

Indeed, I now expect the RBA to cut the cash rate this year, and twice by early 2020, reflecting a weakening in a range of economic indicators and the RBA’s own acknowledgement of more downside risks.

Let’s start with the economy.

As mentioned, a range of Australian economic indicators have turned notably weaker of late.

The National Australia Bank’s Index of business conditions, for example, slumped nine points in December to a +2 reading. While the Index partly bounced backed to a modestly above-average +7 in January, there’s been a clear broad-based weakening in sentiment since earlier last year. Most worrying, indicators of business investment intentions appear to have softened.

One generalised factor that may account for some of the slide in business sentiment is the tightening in credit standards in the wake of the Hayne Royal Commission. Many small businesses in particular appear to be finding it much harder to secure funding, even if secured against the family home.

Also apparent in recent months is an acceleration of the decline in home building approvals and home loan demand. With foreign buyers deserting the market, affordability levels still poor in Sydney and Melbourne, Hayne-related credit tightening and the prospect of a crackdown on negative gearing and CGT advantages should the Labor Party win the next Federal election, it’s little wonder housing demand continued to slump.  

Up until recently, actual home building activity has held up well, thanks to the high level of work still in the pipeline - but as that pipeline is worked through, fewer home building jobs will be apparent as the year progresses.  

Also up until recently, consumer spending seemed to be holding up as well as might be hoped – but the ongoing slide in house prices now appears to be finally taking its toll. Retail sales volumes were flat in both the September and December quarter.  

ANZ job advertisements declined in both December and January and appear to be finally ‘rolling over’. Job ads are not usually too volatile, so recent weakness will likely indicate a shift in trend to a slower pace of hiring.

The best news is that the unemployment rate is still low at only 5 per cent. But this is a lagging indicator to a degree. Based on historic relationships, the recent weakness in building approvals – and especially given the chances of further weakness - suggests upward pressure on the unemployment rate is just a matter of time.

Interest rate cut

This sea shift in the economic outlook has not gone unnoticed at the RBA. Indeed, recent commentary from the Reserve Bank suggests it has moved to a ‘neutral policy bias’, conceding the next move in rates could be just as likely down as up.

In my view, however, the reality is that if local interest rates move anywhere this year, it’s now more likely to be down.

Of course, I suspect the RBA remains very reluctant to cut interest rates, given they are already quite low and further declines might have only a muted effect on the economy. The RBA would also be loath to unduly interrupt what it likely sees as a necessary, albeit uncomfortable, ongoing housing price adjustment in Sydney and Melbourne.

That said, should the unemployment rate begin to head higher, and given the still quite low rate of local inflation, I also suspect the RBA will feel the need to respond by lowering interest rates. That’s why I suspect the RBA will likely wait for the unemployment rate to actually rise (possibly to at least around 5.4 per cent) before acting, unless there is an even sharper deterioration in other forward indicators in the meantime.

All up, my base case view is that the RBA will cut rates if the unemployment rate rises above 5.3 per cent (i.e. prints 5.4 per cent or more) in coming months. I now also believe that the unemployment rate will breach 5.4 per cent by year-end given, especially, the depth of the recent downturn in home building approvals.

It’s on this basis that I now expect the RBA to cut rates by year-end, with a move to a 1 per cent cash rate by around February 2020.

Subject to what else happens in the economy, this should be a positive for interest-rate sensitive sectors of the market and companies with high offshore earnings exposure, given the A$ could also weaken to at least my first target of US68c. Exposures that therefore may be worthwhile to consider in the event of lower local rates include long duration corporate bonds (e.g. via CRED – BetaShares Australian Investment Grade Corporate Bond ETF) and listed property/infrastructure exposures (such as via RINC – BetaShares Legg Mason Real Income Fund [managed fund]).

None of the above, moreover, takes account of global developments. But I suspect even if global growth surprises on the upside, it won’t help the local economy all that much, given our most acute problems – housing and consumption – are home grown in nature.

And if the global economy does continue to slow, it will only make it even more likely that the RBA will need to cut rates.