Key insights from the week that was.
This week has, once again, seen a pall descend over the global economy as the US ISMs surprised to the downside and other global PMI’s remained weak. At home, the RBA took the cash rate to a new historic low of 0.75%.
Westpac was the first to call the cash rate below 1.00% back in May and, as we expected, the RBA delivered in October. Opening the door to further measured easing, the decision statement was purposeful but unhurried.
Whereas the September statement highlighted that the RBA’s labour market aim was to merely “reduce unemployment”, the October statement instead focused on achieving “full employment”. This is a much more difficult task to be sure, with ‘full employment’ estimated by the RBA as an unemployment rate 0.8ppts below the current 5.3%. But it is also clearly not a goal that can be achieved with haste. With evidence of a “gentle turning point” in the economy noted elsewhere, we continue to believe that the RBA will bide their time until February 2020 then cut again to 0.50% as data continues to disappoint their expectations. Markets are looking for a move to occur sooner than February. We think current November pricing at 50% is too high but acknowledge that the RBA do have the option to move in December if circumstances around global rates and the employment reports warrant earlier action.
The other major factor justifying further policy accommodation at this stage is the frail global growth outlook. For the RBA, there are two key concerns: the impact this uncertainty could have on Australian firms’ investment and employment decisions; and, more broadly, the potential for our currency to appreciate if Australia does not keep “to the trend to lower interest rates globally”, with negative consequences for both growth and inflation. Much like the domestic assessment, caution rather than urgency was shown towards the global outlook in September. Save an unforeseen shock, the RBA will also feel justified in taking time to assess global conditions.
Regarding risks to this view, given the quick turn in Sydney and Melbourne house prices, the RBA could have shown unease over affordability and bullish market sentiment. But this was not the case. Since momentum has only just turned, and given credit growth is weak, the RBA remains unperturbed regarding price growth. Their concern over housing is instead the outlook for construction activity with approvals back at 2013 levels and yet to find a base.
Offshore, this week’s data has continued to point to the global economy remaining weak and susceptible to a shock. PMI data from across the world signalled that the manufacturing contraction is continuing, and spill-overs are increasingly being seen in the broader economy. Even the US economy, the strongest in the developed world, is now being heavily affected.
In September, the US ISM manufacturing survey fell to a 10-year low, while the non-manufacturing survey dropped to a 3-year low. The weakness was broad based, but particularly concentrated in new orders (owing to global growth and the strength of the US dollar) and employment. On the latter, ADP payrolls also disappointed market expectations, further raising concerns over the spread of weakness from manufacturing to the broader economy. Key for the outlook are the employment and wage trends which we will receive a full update on tonight in the September employment report.
We remain of the view that this deterioration will continue through end-2019 and hence that the FOMC needs to remain pro-active with policy, cutting at both the October and December meetings, then twice more by June 2020. That would see the federal funds rate back at 0.875%. These rate cuts should be enough to sustain growth near trend to end-2021, allowing the FOMC a chance to achieve their inflation mandate – in time. Following this week’s data, market pricing has moved to be broadly in line with this view, with October seen as a 85% probability and another cut by year end around a 50% chance. The terminal federal funds rate expectation of the market is now around 0.95% – effectively the same as ours – although it is not priced until late-2020. Notably, Fedspeak has also progressively taken on a more concerned tone this week, the FOMC’s Evans showing concern over the ISMs overnight and putting a strong emphasis on tonight’s employment report.
Turning to Europe, the weakening in activity became present 6-12 months before the US with its economy much more externally focussed and therefore tightly linked to global supply chains. This week’s PMI’s showed the manufacturing index declined to 45.7, led by a deepening contraction in Germany, and this softness appears to now be spilling over to services which slowed to 51.6. This supports our view for further deposit rate cuts from the ECB and a lift in the rate of asset purchases to €40bn per month. But will that be enough to stabilise the European economy? On its own, probably not, and this week once again saw outgoing ECB President Draghi call on Governments to increase fiscal stimulus as well.
Lastly on Brexit, UK Prime Minister Boris Johnson’s last ditch attempt to formulate a new exit plan to leave before the current October 31 deadline appears to have fallen flat. The response from the EU has been decidedly negative with the EU’s Brexit Steering Group stating that it did not offer a “serious alternative”. Johnson remains insistent that the UK will leave the EU by the current deadline despite the previously passed Benn act effectively forcing a request for extension. Accordingly, the two weeks leading up to the October 17-18 EU Summit will no doubt be intense.
