The Australian economy is shifting and opinions are divided. After years of “surprising” economic results, the divide between the “lower-for-longer” and the “return to normal” interest rate camps is widening. In this article we look at who is in each camp and what the key arguments are so that readers can form their own view. Importantly, I consider yields on long term bonds an opportunity
There have been a few data releases lately that signal the Australian economy may be improving. Business confidence and investment, jobs growth and earnings data have been stronger in the past few months than they have since 2015. Data is dividing economists and fund managers that increasing sit in one of two camps, with little fence-sitting:
Outlook 1: Green shoots will not overcome core issues - weak wages growth and high household debt will constrain consumer spending and therefore the domestic economy.
Outlook for interest rates: Lower for longer, with RBA cash rate at 1.5%pa until 2019 at least.
Outlook 2: The Australian economy will be dragged upwards by the rising global economy, particularly in the US and EU, and wages growth will return to boost consumer spending.
Outlook for interest rates: RBA cash rates rising to 2.0%pa by the end of 2018.
It will be of no surprise that I sit firmly in the first camp and have done for three years. My arguments for this position have, and still do, include:
- Underemployment above 12% (currently at 14.1%) means that there is a significant amount of labour looking for work and not enough demand for labour to take up that slack. That adds up to weak wages growth as employers don’t have to compete for supply
- Very high household debt growth has brought forward spending, but eventually rising debt repayments and low wage growth will mean consumer spending will become very constrained
- Digital economy reshaping the structure of the economy, both locally and globally. This is resulting in structural weakness for entire sectors such as retail and professional services, but also increasing pricing pressure for almost all sectors. More price pressure means weaker demand for new labour and more investment in cost saving initiatives such as technology or offshoring
- Weak small business lending growth means the engine room of the domestic economy is constrained and not investing in growth
- Construction has provided a welcome substitute for the sudden ending of the mining investment boom, and Australia did face a significant shortfall in residential property, but that shortfall has been slashed and sometime during 2018/2019 will become an oversupply at the current pace. This will reduce demand for labour even further
- Risks to this outlook are to the downside, particularly the growing risk of a slowdown in Chinese spending if its credit bubble bursts. Coupled with risks to the retail and services sector as the digital economic revolution continues to cut margins and demand for labour
- But what do the other economists say? Here’s a quick overview of the latest forecasts for the better known commentators in Australia, grouped into the two camps mentioned above. I’ve included their forecasts made in 2014 when we saw the last major pivot in the Australian economy
Interest rate forecasts by major economists, as at September 2017
| Outlook in 2014 | Outlook now | Rationale/comments |
Lower for longer camp
|
| Capital Economics | RBA cash rate of 2.5%pa by 2017
| On hold until 2019 at earliest
| Weak wages and high household debt. China risks |
| Westpac | 3.75%pa
| On hold until mid-2019 at least
| Weak domestic economy and digital economy impacted wage growth
|
| NAB | 3.75%pa
| On hold until end of 2018 at least
| Weak wage growth
|
| ANZ | RBA cash rate of 3.5%pa
| On hold “deep into 2018”
| Low inflation risk
|
| BIS Oxford |
| On hold until at least 2019
| Weak wages, weak domestic economy and strong dollar
|
| QIC | 3.0%pa
| On hold at least until end 2018 if the AUD/USD falls to 73c, but otherwise cuts possible
| Household debt and high dollar
|
Returning to normal camp
|
| IFM |
| On hold to last quarter 2018, maybe 2019
| Rates won’t rise until wage growth well entrenched, which could take longer than expected due to lack of international competitiveness and lack of productivity gains
|
| AMP | RBA cash rate to be 3.75%
| On hold to last quarter 2018, maybe 2019
| Low wages, high household debt and strong $A outweigh recent strength in business investment. Eventually low rates will boost inflation
|
| HSBC | RBA cash rate of 4-4.25%pa
| RBA cash rate rising to 2.0% by end 2018
| Inflation returning
|
| CBA | RBA cash rate of 3.75%pa | 1.75%pa by the end of 2018
| Inflation will return to 2-3% range. Low rates will stimulate demand enough to see a return to normal
|
| Saul Eslake | RBA cash rate of 3.0%pa by 2017
| 1.75% by end 2018
| No reason to believe that wages won’t return to historic levels. Employment intentions and infrastructure spending will boost labour markets and strengthen domestic economy
|
Conclusion
Over the past three years, there has been a major shift in the long term outlook by leading economists in Australia. In 2014, almost every economist forecast a return to “normal” rates of 3-4%pa in Australia. Now, no one is brave enough to forecast that far out, but shorter term forecasts have heavily shifted toward the “lower for longer” camp. What is interesting is that most forecasts of the 10 year bond yield in Australia are for a return to around 3%pa, yet with no change over the next two years, this means an expectation of rise back to 3.5-4%pa from 2019. Yet the conditions that have fostered weak wage growth are not short term conditions, particularly the global digital economic revolution and record high household debt in Australia.
Economists are slowly getting on board with the fact that there is no law of nature that requires interest rates, wage growth or inflation to return to some normal rate and that every fifty years or so, dramatic changes to the structure of an economy can mean use of old models make terrible forecasts. In my view this is one of those times and until the majority of the market catches up to this, investors buying and holding long term bonds will lock in high yields that we are not likely to see exceeded for a very long time.