FIIG Research published our quarterly Macro Outlook recently against a more uncertain backdrop than has existed for some time. Our judgement remains that Australia is relatively well placed compared to international peers, thanks to comparatively strong domestic data and the ability for the RBA to cut rates if needed should the data weaken. However, with so much policy-induced uncertainty around investors need to continue to monitor diversification and outright risk.
The disconnect between the current economic data and the suite of risks facing Australia is particularly large at present. The risks are mostly coming in the form of deliberate policy choices from President Trump, while the underlying Australian economic data is somewhere between benign and good. The labour market is showing signs of returning to balance slowly (as hoped) while inflation is now looking much more under control. It will take another quarterly print or two to know for sure, but the signs on inflation are very good.
Our overall understanding of the domestic Australian economy has not changed much since we published our BOLD strategy in January. The RBA cut rates in February, rather than May as we had thought most likely, but the RBA’s severe reticence and hawkish commentary accompanying the cut do suggest they would have been happy waiting had other factors not been at play. The market has started to change the medium-term assumptions for the RBA. Previously, only a short, mild rate cut cycle was expected by the market, while we have long argued that a slower, elongated rate cut cycle is more likely as our base case. As we’ve explained before, we think the labour market is showing clear evidence that the true rate of full employment occurs at a lower unemployment rate than where the RBA current estimates. The unemployment rate and the underemployment rate are both staying very low at around 4.1% and 6% respectively, without any real signs of a nascent breakout in wages growth.
If that premise proves true, then the feared bout of wage inflation won’t materialise in coming years, and the RBA will feel comfortable gently lowering the cash rate periodically in search of even higher employment. All in all, the domestic economy is looking fairly good at present – as long as we’re not derailed by offshore moves.
And that offshore risk is clearly the problem. Trump’s decision to launch a trade war, simultaneously, with the rest of the world all at once could have very nasty consequences for both the US and the world at large.
To understand the dynamics of a trade war it’s important to understand that any country which imposes tariffs on their imports sees a moderate rise in domestic inflation and a fall in domestic growth. A country that has tariffs imposed upon it has a fall in growth and a slight reduction in inflation. When two countries impose tit-for-tat tariffs you end up with a situation where they both end up with higher inflation and lower growth rates. That’s the likely outcome for the US, Canada, China and Mexico, since they have all had large tariffs imposed.
Australia, in contrast, has not imposed any new tariffs. We have had a small number of tariffs placed on our exports to the US, but this was never that material a number to begin with. Australia’s largest exposure to the current trade war is actually via China. If the US/China trade ceases to exist (which with 100% plus tariffs in both directions now seems relatively likely) then the Chinese economy suffers. Although the US is not a large market for Australian goods directly, China is a very important partner. So a reduction in growth in China impacts the Australian economy and causes weaker growth here. Very importantly, however, it does so without increasing inflation. In fact, in a trade war scenario, the drop in things like oil prices from reduced global growth means Australia should be facing a fairly typical economic scenario of falling prices and weakening growth.
It's that typicality which makes us feel confident about Australia. If we do strike a problem the RBA can lower rates to stimulate domestic demand very easily. It would be better if they don’t have to, of course, but if the circumstances dictate that an abrupt rate cut cycle is required, then an abrupt rate cut cycle will come.
This is in stark contrast to the United States, where the direct impact of the imposition of tariffs is the combination known as stagflation: lower growth and higher inflation at the same time. If the trade war causes US stagflation, the Federal Reserve will need to balance the desire to lower rates to stimulate growth with the need to raise rates to keep inflation in check. It’s not at all clear what a Central Bank should do if the economy is experiencing stagflation, though the consensus is probably that you need to fix inflation first, before you can fix growth. That argues for either rate rises, or failing to cut rates even in the face of poor growth and employment figures.
This is the nexus of the current clash of heads of between President Trump and Federal Reserve Chairman Powell. Powell is emphasising that tariffs can be expected to cause an inflation response and so rate cuts might not be appropriate. Trump, with an eye on growth and possibly also an eye on the Federal Deficit and interest costs, would prefer rates to be lower. So Trump is actively pressuring the FOMC in a way that would have been unthinkable until quite recently.
The current mix of US policies is causing markets to reassess the safety of the US Treasury bonds. Now, we must neither overemphasise the risk nor underplay it. (Bond investors are neither Cassandra nor Pollyanna.) The US policies are causing markets to reconsider if the US bonds are the safest investment in the world anymore. They used to be – but the US government used to be a source of stability, not a source of volatility. Instead, markets are now charging the US a premium over and above the expected cash rate that covers the risk that markets feel is inherent in the US Government.
This US Government Credit risk is now quite evident and has been rising during the periods of intense trade war activity – like Liberation Day. Unfortunately, this means US Government bonds no longer provide the negative correlation with equity markets and overall risk. Australian bonds have been caught in the cross-fire a little too, though have generally been outperforming the US during the worst periods.
FIIG research continues to suggest that a focus on diversification is important during this volatile period, with also a preparedness to take advantage of good prices when the volatility makes them available.
The full FIIG Quarterly Macro Update is available here.