Economic and Financial Market Update: What Comes In Threes

Summary:

• The RBA cut rates by 0.25%. The cash rate is now 0.75%;

• Economists and financial markets agree that lower rates are likely;

• And if jobs growth does not improve, the RBA has indicated that another rate cut is on the cards;

• Right now the identifiable risks are tilted towards further economic weakness.

‘They say all things come in threes

Three by three

Here comes the third degree.’ 

Where were you hiding when the storm broke

The Alarm

As expected the RBA today decided to cut rates by quarter percentage point. It is no typo, the cash rate is now 0.75%. And the RBA Statement made it clear that it is very open again to reducing interest rates unless there is a notable improvement in the jobs market.

Understandably, the RBA is still comfortable with the economic outlook. Their inflation forecasts remain essentially unchanged. But they also agree with most analysts that the risks are towards further economic weakness. And following the Alarm’s advice, there are three risks in particular that would be getting the RBA to rub their collective chins.

World economy

Central banks, government and investors have become increasingly worried about the global economy over the past year. The RBA is no exception. The Trade War has gained plenty of headlines. And it has had an impact, not only reducing exports and imports but also business capex decisions (it is hard to invest if you don’t know what the new trade rules will be). A Technology War between the US and China also is brewing.

The manufacturing sector is doing it tough (notably the car industry). Economies heavily exposed to manufacturing and trade (such as Germany) are struggling. More generally, there is a heighted degree of uncertainty about economic policy (Brexit, South Korea/Japan trade spat, problems in the Middle East and possible impeachment proceedings in the US).

But it is developments in the US and China that really matter. Together they comprise about 40% of the global economy. Over the past thirty years it has been the combined power of the US consumer and the Chinese producer that has driven the global economy forward. 

The Trade War has taken a little skin from the knees of both economies. But the bigger issue in China has been the Government’s concern there is too much debt. Bankers indicate that loan demand from medium-to-large companies is relatively low. That might reflect that larger companies are more exposed to global trade. But it is also the case that bigger companies are more likely to have taken on too much debt (small firms have struggled in the past to get access to finance). 

The bleaker global economy and downturn in the manufacturing sector has led to economists revising up the chances of a US recession. A good forward indicator of economic downturns (the US yield curve – the difference between 3-month and 10-year interest rates) also suggests gloomier times ahead.

Right now these are risks, not a certainty. Most central banks have been busy reducing interest rates (and doing other ‘unconventional’ policies). Unemployment rates in most countries are low. Service sectors are mainly doing fine. Alarm bells are not yet ringing in the credit, equity of foreign exchange markets. Some Governments have pulled the fiscal lever (US, India, China). But that fiscal lever needs to be pulled even harder (particularly in Europe).

Global factors are impacting Australian interest rates in other ways. As noted in the RBA Statement, “The Board also took account of the forces leading to the trend to lower interest rates globally and the effects this trend is having on the Australian economy and inflation outcomes.”

Household income

The RBA’s second big concern is the weakness of Australian household income growth. Wages growth has been modest across most sectors. The sectors that have achieved the biggest boost in pay have typically had some association with the government (such as health and utilities). 

But overall households have essentially faced an ‘income recession' over recent years. The modest growth of household incomes partly reflects modest growth of income in the wider economy. But it also reflects the relatively high underutilisation rate (unemployment rate plus those working part-time looking a full-time job). The economy has not been strong enough for long enough to afford big pay rises.

Tax cuts will boost the size of pay packets. And that they have been skewed towards low- to middle-income earners should mean a good portion of the tax cuts should be spent. But how much is the question. Surveys suggest that households are not in the mood to make big spending commitments. And they also indicate that households are more interested in using their spare cash to pay off debt or boost bank accounts. The upcoming monthly retail sales numbers will help provide an answer.

Economy v Jobs

The RBA noted that economic growth was weaker than they expected over the year to June 2019. They believe that the economy might be approaching a ‘gentle’ turning point. Positives the RBA note include lower rates, tax cuts, high infrastructure spending, stabilisation of housing markets and a decent resources sector outlook.

One of the big conundrums as noted by the RBA (and a pleasant surprise) is that jobs growth has been strong despite the weak economic growth. Yes, the unemployment rate has risen from its recent lows. But part of that has been driven by the participation rate rising to a record high. 

One reason why jobs growth has been strong is that wages growth has been low (making it more affordable to hire workers). Another is that the jobs growth over the past year has been strongest in sectors most closely associated with the government. The health (including NDIS) and education sectors have been big employers. The number of professionals working has also risen strongly, likely reflecting the demand for engineers (infrastructure projects) and the desire of many firms to digitise. There has been a notable decline of manufacturing jobs in line with the wider struggle of that sector globally.

But as the RBA noted, the risks are that jobs growth will slow. The growth of job vacancies is down. There has also been a decline of business-hiring intentions. A number of firms during the recent profit reporting season noted that they would look to restrain costs given the weaker revenue environment. Surveys suggest that consumers have become a little more concerned about unemployment over recent months.

The weaker domestic economy required lower interest rates. And the current economic momentum and the risk that it may continue suggest that further declines are likely. The RBA appeared to be very open to further rate cuts in its Statement released with the interest rate decision. Most economists expect another quarter percentage point rate cut by early next year (and a handful expect rates could fall by a further quarter percentage point). At the time of writing financial market pricing was consistent with this view. 

The RBA also stated that, “It is reasonable to expect that an extended period of low interest rates will be required in Australia”. Investors agree. At the time of writing, financial markets are pricing that rates will only start to rise in about 5 years!

Source:  Survey from Reuters. Financial markets pricing is cash rate futures sourced from Refinitiv 

A weaker economy required lower interest rates. And the indefinable risks suggests that further rate declines are likely. But interest rates moving even lower from this level will only do so much. A stronger fiscal response at some stage is likely to be required. If we get things right hopefully instead of talking about three risks, we will be discussing three benefits (rising incomes, falling unemployment and stronger growth).  

We live in interesting times!

Peter Munckton - Chief Economist