Australia Update: RBA will cut again as growth slows, but not today

• We expect the RBA is likely to stay on hold in September, but we expect 50bps of cuts in Q4
• The partials released to date suggest Q2 growth will be weaker than expected (Inventories, Capex, Construction work, weak retail sales and consumption); growth could fall to as low as 1.1% annually
• Today, we receive balance of payments and government spending data (~23% GDP) which will provide additional info on Q2 GDP before its release on Wednesday, but even so the private sector continues to struggle
• Risks to Q2 growth are skewed to the downside alongside a deteriorating global backdrop (Consensus estimates 0.5% q/q), however strong net export data may offset some weakness and return current account to surplus
• The ongoing supply shock recalibration post the Vale disaster is likely to weigh on iron ore prices throughout the second half of the year so supportive net exports will be short lived

Despite the downside risks to growth we expect the RBA will remain on hold at 1% today, pausing to assess the impact of back to back rate cuts in June and July, income tax cuts and a weakening domestic currency. As well, hiring was solid in July and the housing market is stabilising, so even though growth looks set to undershoot the RBA’s forecasts they will likely remain on the sidelines for now.

Based upon the RBA’s own forecasts and (lack of) attainment of mandated targets, they could cut in September, but for the reasons listed above and so as not to invoke panic amongst consumers and unrest in financial markets given the probability of a cut is priced around 12% and recent rhetoric has signalled a pause, it’s likely the RBA hold off.

However, moving forward we expect 50bps of cuts in Q4. We see the unemployment rate continuing to drift higher as the construction cycle downturn spurs job losses, several quarters of below trend growth and weak demand will also weigh on employment in coming months. Forward looking indicators like ANZ job ads and capacity utilisation also point to continued deterioration of the labour market and a rising unemployment rate.

Despite strong jobs growth in July, the unemployment rate held steady at 5.2% as participation continues to rise, well above the 4.5% needed for the RBA to satisfy its objective of full employment. Underutilisation and underemployment, other measures of labour market slack, remain high and are a significant impediment to spurring wage gains. Underutilisation will need to fall substantially from the current level of 13.6% before seeing a material uptick in wages, in turn weighing on the ability for the RBA to reach their mandated underlying inflation target of 2-3%. Spare capacity in the labour market will continue to prevent upward pressure on wages and prices from materialising and weigh on the outlook for consumption. The longer that inflation remains below target, the more of a concern this becomes for the central bank as future inflation expectations play a role in current materialised inflation. Hence a persistent undershoot of the inflation target can risk de-anchoring inflation expectations making it harder to meet the inflation target in the future.

The outlook for consumption, the largest component of GDP, remains under pressure. Weak wage growth, high household debt levels and low levels of saving amongst Australian consumers means the propensity to spend the extra cash from the government’s tax cuts could be diminished. An over-leveraged consumer who has whittled away their savings and is now devoid of any material pick up in wage growth is unlikely to increase discretionary spending, particularly given recent consumer sentiment surveys point to rising concerns over the economic outlook. Likely, choosing instead to repair household balance sheets and deleverage. A dynamic that is favourable for the long-term stability of the Australian economy, but not favourable to current growth contributions.

Meanwhile the RBA are also having to contending with a deteriorating global growth environment particularly in Europe and Asia as the business cycle slows. Additionally, the mounting impact of trade uncertainties, for which monetary policy is ill-equipped to address, will weigh on the RBA’s outlook for rates. The non-linearities that accompany the trade war and its secondary effects are not something that central bank models cannot account for. And even if monetary policy is ill-suited to deal with the by-products of a trade war, whilst international cooperation remains on the decline and Frydenberg lavishes his coveted surplus, the RBA have little choice but to act. The policy decision tree has been hijacked by the alternative outcome of doing nothing, being worse than doing something and rates will be heading lower.

Fresh tariffs have moved ahead this week despite a more conciliatory tone materialising from both the US and China over the prior week. There is no deal at present and we need to tune out the noise/rhetoric and look at the path of continued escalation in actions. The planned tariff hike on October 1st, the 70th anniversary of the PRC, is something the Chinese are unlikely to look past so it will take a much larger olive branch from the US administration than just dialling down rhetoric to see a de-escalation before that date. China have again stipulated US must wind back existing tariffs, “The pertinent discussion at the moment should be about the US cancelling all tariffs on $550 billion Chinese goods,” says MOFCOM spokesperson. At this stage, the onus is on President Trump not to squander this opportunity to reset the relationship with China, the SP 500 likely has to be a lot lower before Trump would even consider this demand (if at all). These dynamics create an environment where the likely path for bilateral relations between the US and China is one of escalating tensions, despite any intermittent hiatus’. And even in the face of a future ceasefire, the relationship between the US and China has fundamentally changed, and the battle for tech dominance and hegemony will rage on.

The continued trade escalations heighten the risk of recession concurrent with what is now becoming a synchronized global slowdown. This dynamic will continue to weigh on global growth and without the trade war we still have a slowing economic cycle to contend with, and a strong USD (arguably more destructive) which will be a significant hinderance to any reflation. This dynamic will continue to weigh on the outlook for the Australian economy and the AUD.

This global dynamic also forces the Fed’s hand on rate cuts in the US, and we expect the FOMC to deliver a further cut in September, raising the probability that the RBA deliver another 25bps of cuts in October. At this stage we also expect the Fed to cut again before the year is out, and the RBA to cut once more in December.

Housing

Data from CoreLogic, released earlier this week, has shown that nationwide housing values increased 0.8% in August. The largest gain since April 2017, with Sydney and Melbourne leading the way rising 1.6% and 1.4% respectively. The overarching message from Jackson Hole that lower rates will not only be insufficient in countering global risks, but worse, may exacerbate structural problems currently inhibiting growth, is in plain sight here. The warning from RBA Governor, Philip Lowe, from Jackson Hole who said, “We can be confident that lower interest rates will push up asset prices, and I think that later on we will have problems because of that,” is illustrative of the aforementioned dynamic and will be a concern for the RBA moving forward.

The risks of a V-shaped recovery in housing process are rising, although we still maintain the recovery is likely to be more of an L shape. These risks will need to be addressed by macroprudential policy as the RBA move forward with continued easing.