Economic and Financial Market Update: Cold Water

By BOQ Chief Economist, Peter Munckton. 

Summary:

• The RBA kept the cash rate unchanged at 1.5%;
• The economy is doing well, the unemployment rate falling;
• Low wages and prices growth means that the RBA can sit back and watch economic developments unfold;
• Financial markets believe it will be at least another year before there will be any move in the cash rate.

‘And although time may take us into different places

I will still be patient with you

And I hope you know’’

‘Cold Water’, Major Lazer (featuring Justin Bieber)

Another RBA meeting, another no-change in the cash rate. No news is certainly good news for borrowers (if not savers). The last time the RBA changed the cash rate Glenn Stevens was the RBA Governor and ‘Cold Water’ by Major Lazer was the number one song on the Australian music hit list. It is not a song that is on my playlist. But certainly the lyrics listed above would be in line with how the RBA thinks it is handling the domestic economy.

The domestic economy is growing at a decent pace, and will enter 2019 with reasonable momentum. Interest rates are low. With Federal and NSW elections looming, fiscal policy is likely to become more supportive. The $A is a bit below its long-term average against the $US (although a bit above its long-term average against all major trading partners). Taken together this suggests the economy should have a decent 2019.

But there are signs that economic activity has shifted a little lower over the course of this year. Firms are still positive about business conditions, but less so as the year has progressed. Growth in the number of hours worked in the economy has moderated. Two financial signals of economy activity, the slope of the yield curve (the difference between 10-year and 2-year yields) and the performance of cyclical equities, both point to an economy performing decently but losing a little momentum.

By itself that slowing of momentum is not a big issue. So far it looks to be more a gentle tap than a slamming on the brakes. But there is always the worry that something will cause the economic traffic to stall. The issue that has gained plenty of headlines over recent times is the weakness of house prices, and the impact this might have on consumer spending. A decline in house prices is never going to be high on existing home owners wish list (although the boost to housing affordability has attracted more first home buyers back to the market). But the evidence about how strong the link is between changes in house prices and consumer spending is mixed. House prices rose aggressively between 2013-17 (particularly in Sydney and Melbourne), but consumer spending was soft. By contrast, the growth of house prices (after allowing for inflation) was moderate in the 1990s while consumer spending was more robust. The global evidence is also varied. For example, in the 1990s the Japanese consumer was spending more in the shops despite declining (real) house prices. But it is also true that at other periods there has been a tighter link between house prices and consumer spending.

The evidence suggests that the more important factors for consumer spending is the strength of jobs and wages growth (and the outlook for interest rates). If jobs stay plentiful and wages growth rises then consumer spending is likely to be stronger. And the evidence (rising job vacancies, decent consumer sentiment, the upward shift in wages growth) is that this is likely to be the case, at least for the first half of next year. 

A longer-term concern is that there is likely to be a sharp slowing of activity in the building of new homes. This is not a 2019 issue, as the order books are still pretty full for builders for the next year, or so. But with the supply of houses up and house prices down the desire to build more new homes has moderated (although conditions do differ between markets). Building approvals have already fallen 15-plus% from their peak. And if history is any guide a more substantial decline is possible. This indicates that residential construction is likely to be an economic negative as the economy moves through 2020. 

But for the construction sector there are two possible (likely) offsets. One is that Governments are likely to maintain a high level of infrastructure spending. The second is that relative to the size of the economy, household spending on alterations and additions is at its lowest level in over 40 years. That lack of spending may reflect low income growth. But it is also may indicate that builders have been so busy in recent years with all the other construction work available elsewhere in the economy. But as the construction of new homes declines, builders will become more available for renovation jobs.

But the journey for the local economy would get really difficult if growth in the global economy slows to a crawl. And there has been a change in sentiment about the global economy. The US economy performed at least as well as expected this year. But that resulted in higher US interest rates and $US, negatives for many emerging markets.  Europe has not performed to expectations (not helped by political concerns, such as Brexit and worries about the Italian Budget). And more recently there have been signs that the US economy might be shifting out of the economic fast lane.

But it has been the speed of the Chinese economy that has caused most worries. The Chinese Government entered the year worried about the amount of debt that the economy had accumulated over recent years. The Government has had some success in reducing leverage, but at the cost of slowing economic activity.  Concerned, the Chinese Government has again ramped up infrastructure spending (a plus for commodity exporters, such as Australia). But while the Chinese Government might be spending more, the Chinese consumer is spending less. The growth of retail sales has been the weakest in many years. Chinese company profit growth is also slowing. Private-sector borrowers are also feeling the pinch from rising real lending rates (the lending rate after allowing for the impact of inflation). China is easing monetary policy. But it is limited to how much it can reduce interest rates without substantially weakening the Chinese currency, something that would have wider global economic ramifications. 

While there are concerns it might be too early to get too pessimistic about the global economy. Economic momentum has slowed. But while US interest rates have risen they remain below ‘neutral’ (or the expected average cash rate level). Elsewhere, interest rates remain at very low levels. Fiscal policy in most major regions in 2019 will be a plus. The unemployment rate is low in most countries, business and consumer confidence is high. The Chinese economy is a risk. But providing they can manage their challenges successfully 2019 should be another decent year for the global economy. A resolution of the trade disputes would significantly aid confidence in the economic outlook. 

Ironically, if economic growth ends up being too strong that could create another risk. The stronger global economy led to a rise in interest rates (notably in the US). This was the key cause of the increase in financial market volatility. In recent weeks as doubts rose about the global economy, expectations about rising global interest rates diminished and helped soothe financial market nerves. But a burst of stronger growth could see thoughts about higher interest rates come back on the agenda. This is particularly the case as 2019 will not only see the European Central Bank no longer buying assets but the US Federal Reserve continuing to reduce the number of assets that it holds.

Overall, the RBA will be pretty happy how the economy is going. Economic growth has been at least as good as they hoped for this year. The decline in the unemployment rate has been even better. Sure inflation and wages growth is too low, although that would not have surprised them. Maybe the Chinese economy has been weaker and the fall in house prices more substantial than the RBA might have liked. But it is a rare year when economy can travel on a road without getting any red lights. The popular view amongst economists is that the cash rate will still be at 1.5% this time next year. The move higher in the cash rate does not the economist popular vote until H1 2020. But the economy has a fair way to travel before we get there.

The RBA is certainly showing patience with the current economic recovery. And the reward so far has been lower unemployment rate and some rise in wages growth. This patience has meant that the Australian cash rate market caused little excitement in financial markets in 2018. And the best forecast is that investors will have to look outside of the Australian cash rate market for their excitement again for much of 2019. Whether that ends up being the case only time will tell. Or as Major Lazer would put it, “Time may take us into different places.”

We live in interesting times.