The RBA kept the cash rate on hold at 2% p.a. today. History will tell us if this was the right decision, but the reality is that we are facing headwinds from a global economy that is in unchartered waters
What we do know is that there is a strong argument for a rate cut, whether that was this month, next month or early next year. We also know that with the Sydney property market now showing signs of slowing, the only reason for considering a rate rise in the near future has now disappeared.
With the November RBA decision behind us, the question now is what happens in December and into 2016. The arguments for lowering rates needs to abate, or 2016 will see rates fall as low as 1.5% p.a. More importantly, without a turnaround in global growth, there is a very strong likelihood of rates staying that low for most of 2016 and 2017. Financial markets are expecting rates to stay at or near 2.0% p.a. for the next five years. Beyond that, global economic growth is the key. If the world economy, particularly the EU, Japan and China are unable to increase economic growth, the Australian economy will face severe challenges, and rates could stay at these levels for even longer.
Top ten arguments for further rate cuts:
1. Housing market boom appears over
This was the strongest argument for not reducing rates, namely that the RBA did not want to further inflate the risk of a property bubble in Sydney or Melbourne. Sydney’s auction clearance rate has fallen from 84% in July to 63% on Saturday, with the north-west of Sydney experiencing just 27% clearance rates. Construction continues at a record pace, but demand is dropping. The only reason not to reduce rates, other than “not now”, has disappeared.
2. Rates were effectively raised by the banks
The four majors, Macquarie and ME Bank all increased mortgage rates in the last few weeks and 34% of Australian households were impacted. But, unlike an RBA increase, retirees and other savers received no benefit. The RBA would need to reduce rates by 25 bps just to offset this increase by the banks, otherwise they face lower confidence and spending, slowing the economy at the very time they can least afford any further reduction in economic growth.
3. Housing market fall will impact consumer confidence and retail spending
Macquarie are predicting a 7.5% fall in house prices in 2016. Morgan Stanley, Credit Suisse, AMP and Bank of America Merrill Lynch have similarly highlighted the growing risks for the property sector, many singling out Sydney and Melbourne. Typically when forecasts have turned negative for housing, they have erred on the optimistic side as no-one makes friends predicting falling house prices in Australia. The RBA will be very conscious of the downside risks for confidence linked to Australia’s love of housing. Around a quarter of the year’s retail spending typically occurs in the next two months alone, so if confidence takes a slump right now, the impact on retailers will be heightened.
4. Terms of trade, particularly commodity prices, are getting worse not better
The RBA looks at the terms of trade, or the price we sell our average exported good for, versus the price we pay for our average imported good. Not surprisingly, our terms of trade are driven by commodity prices, our largest export. Most forecasts show commodity prices falling slightly into 2016 and then recovering, but there is no rationale for these rises other than “commodities typically rise with inflation”. We prefer to look at fundamental rationales, and when it comes to commodities, it’s all about China. China’s economy is at best in a gradual slowdown, but a sharper slowdown will mean even more bad news for commodity prices and Australia’s terms of trade.
5. AUD still overvalued
Whether you use terms of trade or any other economic measure of relative strength, there is little argument for the AUD to gain strength against the USD. Most economists are forecasting 60-65 cents for the AUD, in line with or even below our own once contrarian forecasts. There are plenty of arguments for it falling, not the least of which is that the RBA wants it to fall. A lower AUD means our exporters become more competitive, particularly for local mining operations (local costs fall while commodity prices are in USD); education and tourism. The RBA made its position clear earlier in the year that it would not be afraid to lower interest rates if they believed it could lower the AUD to fair value.
6. Lower global rates for longer
One of the most used arguments put forward by Australian economists is that rates are already at record lows, so they can’t go much lower. This argument didn’t stop the US, Europe and Japan from pushing rates to zero and holding them there for a record period. The world has fundamentally changed and the forces of demographics along with slow recovery from the GFC mean that a decade of ultra-low interest rates is quite possible. Our view is that this is the base case. Looking backwards to see ahead is rarely a rational approach.
7. Slowing population growth
The mining boom coinciding with GFC-driven recessions for the rest of the world saw domestic population growth boom. Higher population means higher economic activity. As jobs are harder to come by now, many of those migrants are going home. For example, the number of Kiwis arriving has nearly halved since 2012. In the longer term, net migration from China and India is set to replace that from New Zealand and the UK, but for the next few years lower population growth will weigh on economic growth.
8. China’s economy is NOT growing at 6.9%pa
Australia is driven by the world economy, and in particular by China’s growth. 32.5% of our exports go to China, up from just 6.5% ten years ago. While the headlines might suggest that China’s economy is still growing at 6.9% p.a. (the 3rd quarter GDP figure released recently), it is more likely to be around 5% p.a. and falling. China reduced its interest rates last week, something that it is highly unlikely to do if they believe that they are on track to achieve a 7.0% p.a. growth rate as the official GDP data suggests.
9. The US economy is moderate, not great
The US economy has been the one bright spot on the global economic horizon. In 2014 and for much of 2015, the US economy was showing signs of a strong recovery, and it mostly still is. But, the higher US dollar has reduced exporters’ competitiveness and the oil price slump has slowed the massive oil and gas investment boom. Growth in the 3rd quarter was just 1.4% p.a., and jobs growth has slowed, neither measure can be deemed ‘great’.
10. Global currency war
Japan and the EU are at the centre of a global currency war. They both have zero interest rates, and effectively negative interest rate policies taking into account the massive quantitative easing program they launched last year. Both have made strong indications that they will extend their QE programs into 2017. These programs and the zero interest rate policy make their currencies unattractive to the pools of money that travel the world looking for yield. Like all assets, unattractive currency prices fall. The theory that Japan and the EU are attempting to execute is that lower currencies mean more competitive exporters, which boosts their economies. That would be true if it were just one of them, but when both Japan and the EU follow this approach, and China is attempting to lower its currency too, the US is forced to keep its rates lower or run the risk that their currency rises too quickly and hurts their exporters. The result is a cycle of global rates remaining very low until the world economy can heal. While 1.75% cash rates in Australia might seem very low compared to historical levels, relative to the level of rates around the world, they seem normal and perhaps even too high.
Investors in bonds do so for two reasons:
1. They want a source of income that is reliable regardless of the economic cycle.
2. They have chosen to shift some of their wealth away from equities to avoid experiencing losses in every part of their portfolio if the economy slows.
As shown by this rather gloomy list of factors facing the Australian and global economies, the decade ahead is more uncertain than at any time in the past 30 years, so a shift into bonds for either of these reasons seems to hold a lot of merit as we head into 2016.