Australia & New Zealand Weekly: Australian Dollar Supported in 2017, But to Fall to 70¢ in 2018

Week beginning 14 August 2017

• Australian dollar supported in 2017, but to fall to 70¢ in 2018.
• RBA: August minutes and assistant governors Kent and Ellis speak.
• Australia: employment, wage price index, Westpac-MI Leading Index.
• NZ: retail sales.
• China: retail sales, fixed asset investment, industrial production, property prices.
• Euro Area: ECB July minutes.
• US: FOMC July minutes and retail sales.
• Key economic & financial forecasts.

Information contained in this report was current as at 11 August 2017.

Australian Dollar Supported in 2017, But to Fall to 70¢ in 2018

The past two months have seen a substantial rally in commodity prices. Since mid-June, iron ore has risen from USD53 per tonne to USD76 currently.

Also supportive has been a lift in coal prices, thermal coal increasing from USD81 per tonne to USD99, as well as a rally in crude oil, the Brent benchmark rising from a mid-June low of USD45 per barrel to around USD52 currently.

As a result of this broad-based rally, our Australian commodities index currently sits at 234, 10% above its level at the time of the release of our June Market Outlook publication.

Foreign exchange markets have, unsurprisingly, reacted quickly to this shift, with the Australian dollar rallying from USD0.75 to USD0.785 currently following a peak of USD0.80 in late July. The rally in commodity prices and associated currency market reaction has seen us revise our near-term outlook for the Australian dollar higher.

At September, we now look for the Australian dollar to trade at USD0.78, a touch below the current spot level. Past this point, we rely on our assessment of the global economy and our structural fair value model to guide our forecast for the currency.

The key inputs to our fair value model are commodity prices (denominated in USD); US/AUD short term interest rate differentials; and Australia’s net debt (as a share of GDP).

We continue to expect that growth in China (our key commodity export market) will slow through the remainder of the year and in 2018 as the authorities continue to tighten credit and, particularly in 2018, ease up on government sponsored infrastructure programs.

However, in retrospect, our expectations for the extent of the reversal in commodity prices were overdone with the expected falls in 2018 in line with the proportional corrections we saw in 2015, when the authorities took a particularly hard line against corruption and debt fuelled excess.

The ferocity of the policy reversal in 2016 now indicates that Chinese authorities recognise that the policies through 2014 and 2015 were excessively tight and would be unlikely to repeat such an exercise. Further, we expect that through the remainder of 2017, policy will continue to tighten but at a modest pace.

Evidence on the pace of the China slowdown in 2015 can be assessed by the change in investment growth. The slowdown in real estate investment was the stand out with annual growth slowing from 14% in 2014 to 1% in 2015. Manufacturing growth slowed from 15% to 8%; with total investment growth slowing from 17% to 10%.

In 2016, in response to renewed stimulus, housing investment growth recovered to a solid 7% growth pace while house prices in Tier 1 cities surged by 30% following a 5% fall in the previous year.

Our Australian commodities index is expected to fall by only 7% by the end of 2017. As a result, we now expect the Australian dollar to end the year at USD0.76, previously USD0.73. However, as discussed, the bigger change to our commodity and Australian dollar view comes in 2018.

Previously we had anticipated a 30% decline in commodity prices, in part associated with a policy-induced pull back in investment in China. That 30% was in line with the falls we saw in 2015. Based on the 2015/2016 experience, we now expect the policy tightening will be more in line with around a 20% fall in commodity prices.

Other key factors in our thinking are unchanged. In particular, we see quite a different configuration for US/AUD interest rate differentials by the end of next year than is currently priced into the market.

Markets are anticipating only one more hike by the Federal Reserve through end 2018 while we are maintaining our call for three, with the next move coming in December to be followed by June and December next year.

In our opinion markets are overreacting to the inertia in core inflation and negativity around Trump. The FED has confirmed consistently that it expects inflation to approach 2% in the medium term. It emphasises considerable lags between tight labour markets and wage pressures. Both the unemployment rate and U6 (measure of underutilisation in the US labour market) have converged on pre GFC lows. Labour force participation has recently lifted from a low of 58.2% to 60.3% still below the pre GFC level of 63.3% but much of this shortfall can be attributed to the ageing of the population.

However, from my perspective the outstanding opportunity for the FED is that despite rate hikes in December; March and June, financial conditions have eased. The Chicago FED’s index of financial conditions has fallen from -0.6 a year ago to -0.9 and is now easier than pre GFC levels of -0.78.

The USD has also fallen around 10% in 2017 despite these rate hikes. We know the FED gauges policy "opportunities" partly in terms of prevailing financial conditions. With these "easy" conditions, the Chair must be sorely tempted to use the opportunity to lift rates further towards neutral and away from "emergency" levels. We are surprised that markets are only attributing a 40% chance of a December rate move.

On the other hand, markets are pricing in around one 0.25% rate hike by the RBA next year whereas we expect rates to remain on hold.

As discussed in last week’s note, our growth outlook is pointing to below trend growth in 2018 precluding the opportunity to raise rates.

The net effect of these differences is that we see AUD rates around 0.4% below US rates by end 2018 whereas markets are expecting AUD rates to remain around the current configuration of 0.4% above US rates.

Accordingly, taking all these factors into account, we have revised up our target level for the AUD by the end of 2018 from USD0.65 to USD0.70.

Bill Evans, Chief Economist

Data wrap

Jul NAB business survey

• Conditions elevated, confidence lifts. Conditions: up 1pt to +15. Confidence: up 4pts to +12.
• The NAB business survey reported that business conditions remained elevated in July and that business confidence increased. The survey was conducted from July 25 to 31.
• In July, the conditions index rose 1pt to +15. This is well above the long-run average for this series, of +1 (dating from 1989), but below the highs of 2007 ahead of the GFC.
• The components of business conditions for July were: trading conditions down 1pt to +20; profitability up 4pts to +18; and employment conditions held onto earlier gains, steady at +7.
• Business confidence moved higher, up 4pts to +12. Business confidence has improved since 2016, mirroring the global trend, and is at above average levels, although it continues to trail actual conditions.
• How to interpret the survey? The elevated level of the business conditions index is overstating actual conditions across the broader economy, as it has tended to do since the GFC (see chart overleaf).
• Directionally, the survey suggests that the Australian economy is experiencing a trend improvement in underlying conditions after the slowdown in mid-2016, associated with the July Federal election.
• The official data was mixed early in 2017, impacted by weather disruptions. More recently, partial indicators have improved (retail sales, exports, jobs), lending support to our view that the economy will rebound in 2017 from these temporary disruptions, although consumer spending is likely to be constrained by weak wages growth.
• On employment growth, the previously weak official data has fallen into line with the positive signal from the private business surveys, meeting our expectations. The survey suggests that the recent trend improvement in employment will be sustained in coming months.
• On investment, the outlook is less certain, with the survey’s capex measure pulling back in July (see chart overleaf).
• By industry, a strengthening of conditions in 2017 relative to 2016H2 is evident in: construction; manufacturing; and mining. Construction has strengthened on an upswing in public investment; a lift in commercial building; elevated home building activity (ahead of a 2018 downturn); and the waning of the mining investment drag. Mining is enjoying better cash flows associated with higher commodity prices. Manufacturing is benefitting from strength in construction, mining, agriculture and the lower AUD. Positive spillover effects are also evident in wholesale and in transport & utilities.
• Retail conditions reportedly dipped in July, possibly in part due to a mild winter, with Sydney experiencing its 2nd warmest July on record. Official data reports that real retail sales jumped in Q2, up 1.5%, after a weather disrupted 0.2% gain in Q1. The uncertainty is around the strength of consumer spending over the second half of 2017 and beyond.
• By state, business conditions for July are positive in all states, with the exception of WA. Trend conditions are most favourable in the major non-mining state of NSW and Victoria. In NSW conditions jumped in July, to +22, possibly in part due to unseasonably mild and dry weather conditions. Looking through month to month volatility, the improvement in overall conditions between 2016H2 and 2017H1 is largely driven by the mining states of WA and Qld, as well as SA.

Aug Westpac-MI Consumer Sentiment

• The Westpac Melbourne Institute Index of Consumer Sentiment declined by 1.2% in August from 96.6 in July to 95.5 in August. The consumer mood has deteriorated over the last year with August marking the ninth consecutive month where pessimists are outnumbering optimists. We have not seen such a succession of weak reads since 2008.
• The survey detail suggests increased pressures on family finances; concerns around interest rates; and housing affordability in NSW and Victoria are more than outweighing increased confidence around jobs.
• The further weakening in consumer sentiment comes despite some positives leading into this month’s survey. The RBA again opted to leave interest rates unchanged at its August meeting while the Governor sent a clear signal in a recent speech that rates were on hold in the immediate future. Other positives include: a continued improvement in labour market conditions; lower petrol prices (average pump prices down 15c/litre nationally since early June) and a booming Australian dollar, which briefly touched USD 0.80.
• The Index components point to clear pressure on family finances. The sub-index tracking views on ‘finances vs a year ago’ fell 5.1% to 78.1, the lowest level since June 2014, when consumers were shocked by the Abbott government’s first Budget. Much of the weakness is likely to reflect a mix of weak growth in wages; increases in key costs such as electricity and emerging concerns about rising interest rates.
• Despite the bleak picture around current finances, consumer expectations are more upbeat. The sub-index tracking expectations for ‘finances over the next 12 months’ firmed 2.1% to 100.4 in August. A reading over 100 indicates that optimists slightly outnumber pessimists. Consumers were also a touch more positive on the economy: the ‘economic conditions, next 12 months’ sub-index nudged up 0.4%; and the ‘economic conditions, next 5 years’ sub-index posted a stronger 2.3% gain, though coming off a sharp 9.6% drop over the previous two months.
• However the weak picture on current finances appears to be affecting consumer attitudes towards major purchases. The ‘time to buy major a household item’ sub-index fell 4.9%, unwinding most of the 6% improvement seen over June- July. Notably, the pull-back has come despite increasingly aggressive price discounting amongst retailers and a likely further improvement in purchasing power from a higher Australian dollar – up over 6c US from its low in May to nearly US 0.80.
• Some of the softening in sentiment in August may be a delayed reaction to recent mortgage rate increases – the major banks raised rates on ‘interest only’ mortgages in late June. After posting a surprisingly firm 4.7% rise in July, sentiment amongst consumers with a mortgage fell 6.3% in August. Note that despite the increase in ‘interest only’ rates, the average standard variable mortgage rate declined a little between June and August.
• Perhaps more importantly, most consumers expect rates to move higher over the next year. Responses to an extra question this month around the outlook for mortgage rates show that, of those consumers with a view, 71% expect rates to be higher in 12 months; 27% expect rates to be steady; and just 2.6% expect further rate cuts. That compares to 60% expecting higher rates when the question was last run in February and just 37% this time last year.
• The one relative bright spot for consumers continues to be around jobs. The Westpac Melbourne Institute Unemployment Expectations Index declined 2.6% to 132.5 in August (recall that lower reads mean fewer consumers expect unemployment to rise in the year ahead). The Index is now at its lowest level since November 2011.
• Sentiment around housing improved slightly in August. The ‘time to buy a dwelling’ index edged 0.8% higher but remained at a low level by historical standards. The detail shows mixed moves across different regions with buyer sentiment falling towards very low levels in Sydney and Melbourne – where affordability pressures remain acute – but surging in Western Australia, where affordability has improved markedly.
• Consumer expectations for house prices also firmed slightly overall. The Westpac Melbourne Institute Index of House Price Expectations rose 0.6%, extending last month’s 8.6% bounce. Expectations consolidated in the major eastern states but rose strongly in WA which posted its second strongest reading since late 2014.

Jul housing finance

• Australian housing finance approvals surprisingly firm Owner- occupiers (no.) +0.5%mth, -4.0%yr; Investors (value): +1.6%mth, +5.7%yr; Total ex refi (value): +1.5%mth, +7.1%yr
• Australian housing finance approvals to owner occupiers edged up 0.5% in June, undershooting market expectations of a 1.5% gain. However, the detail was considerably more positive: approvals ex-refinancing posted a much stronger 1.9% gain to be up 3.4%yr with both the value of investor loans and construction-related loans also posting solid rises.
• Note that the macro prudential tightening measures introduced in late March and associated increases in rates for investor and ‘interest only’ loans have likely given indirect support to owner occupier loan activity. That said, the value of investor loans was stronger than expected, posting a 1.6% gain to be up 5.7%yr. The total value of loans was up 0.8%mth – ex refi up 1.5%mth, 7.1%yr. The latest round of mortgage rate increases for ‘interest only’ loans came in late June and is likely to impact in Q3.
• The owner occupier loan detail showed a continued surge in construction-related finance approvals – the number of finance approvals for construction up 3.6%mth, 8.9%yr and approvals for the purchase of newly built dwellings (which includes for settlement of ‘off the plan’ apartment purchases) up 3.5%mth, 10.2%yr. The latter is related to settlements on the massive wave of new high rise apartments now reaching completion. The lift in finance for construction however bears close watching – the rise is consistent with a recent firming in non high rise dwelling approvals and although other indicators such as consumer views on ‘time to buy a dwelling’ suggest this will give way to a renewed weakening over the second half of the year, the links between home buyer sentiment and new home building can often be loose.
• The detail also shows a notable lift in first home buyer approvals – up 8.8%mth, 6.7%yr. Although the levels are still very low, this may be an early sign that the various increases in state government policy assistance for first time buyers in recent months may be generating some traction.
• The state detail is of somewhat limited use as investor loans are not split out in this release. However for owner occupier approvals (ex refi) a dip in NSW (-3.1%) was offset by small gains across other states (Qld up 3.6%, Vic up 1.6%). Notably the lift in construction finance is coming across all major states.
• Overall, the numbers will be disappointing for regulators looking for a more material slowing in investor activity although the full impact of macro-prudential measures has yet to come through.

New Zealand: Week ahead & Data Wrap

The Reserve Bank left the Official Cash Rate unchanged at 1.75% in its August Monetary Policy Statement, and the guidance that it provided was very similar to its previous reviews. Monetary policy will need to remain accommodative for a long time, in order to support growth and guide inflation towards the RBNZ’s target on a sustained basis.

Other than updating for recent data outturns, the RBNZ made few changes to its economic forecasts compared to the May MPS. The weaker than expected consumer prices in the June quarter were treated as temporary, though they will linger in the annual inflation rate calculations over the coming year. As a result, the RBNZ now expects inflation to briefly drop below 1% in the March 2018 quarter, before rising back to the 2% midpoint of the target by early 2019.

Similarly, the softer than expected GDP growth over the last two quarters was viewed as temporary. The RBNZ expects GDP to grow by 3.4% over this year and 3.6% next year, both of which would be well above the country’s potential growth rate. This implies a shift from a zero to a positive output gap over the next couple of years, and a subsequent lift in the pace of non- tradables inflation.

That lift in non-tradables inflation will be needed, because the outlook for tradables inflation remains soft. The RBNZ has for some for time been highlighting that the global economy still has substantial spare capacity and that worldwide inflation remains slow. The lack of import price inflation is compounded by the lingering strength of the New Zealand dollar, which is running about 3% higher today than the RBNZ had assumed in its May forecasts.

The RBNZ still expects the NZ dollar to decline gradually over the next few years, so the recent rise in the currency is expected to suppress inflation over the next year or so but not over the medium term. Still, there was some escalation of the RBNZ’s concerns in the language of the statement, which noted that a lower exchange rate is "needed" (as opposed to "would help") to rebalance the outlook for growth.

In a subsequent interview, Assistant Governor McDermott confirmed that this change of wording was meant to nudge the market towards considering the possibility of the RBNZ intervening in the foreign exchange market. The NZD fell after this interview was published, having initially risen after the MPS. We don’t think the message was any different, though: it still feels like the RBNZ is giving the exchange rate a nudge, whereas we and no doubt others in the market were expecting more of a shove.

The RBNZ has acknowledged the slowdown in the housing market over the last year, but it remains concerned about the risk of a resurgence in house prices. This is a significant point of difference for us. We believe that the rise in mortgage rates since 2016 has played a major role in cooling the housing market, and will continue to do so.

The July house sales figures, released after the MPS, support our view. House sales have been falling steadily over the last year, and are now at a three-year low. House prices in Auckland continued their gradual decline (now down 4% from their peak), and prices were flat in the rest of the country for the second straight month. There are still some pockets of strength, but prices are off their peak in a growing number of regions.

We expect the rise in mortgage rates to persist, as it is the product of two factors that are beyond the control of domestic monetary policy: rising global interest rates, and increased competition among banks for deposits. That points to the housing market remaining very soft over the next year or two; the Reserve Bank’s forecast of even a relatively modest 4% rise in prices this year looks too high. That implies a softer path for spending, investment and housing construction, and less home-grown inflation pressure than the RBNZ is looking for.

The RBNZ’s interest rate projections this time were identical to the May Monetary Policy Statement, with a flat track for the next two years followed by a gentle upturn. We’ve been broadly in agreement with that view for some time, and if anything we see downside risks to the RBNZ’s view on growth and inflation pressures. We will be releasing our latest quarterly Economic Overview next Tuesday, which will detail how our views on the economy have evolved.

One forecast change that we have already made is to push out the expected timing of OCR hikes even further. Previously, we expected the first hike to be delayed until the March quarter of 2019; we now expect it to be in the December quarter of that year. As we’ve noted before, it’s hard to be specific about dates over this sort of time horizon. The bottom line is that we think the market’s insistence on pricing in an OCR hike by August 2018 is well off the mark.

Data previews

Aus Jul Westpac-MI Leading Index

Aug 16, Last: -0.76%

• The six month annualised growth rate in the Leading Index, a guide to the pace of economic activity three to nine months into the future, fell sharply from 0.51% in May to -0.76% in June, the first below trend reading since July 2016. The abrupt slowdown in momentum mainly reflects international factors including a sharp turnaround in Australia’s commodity prices in Australian dollar terms.
• The Jul read will include updates on: the ASX200, down -1.3% vs -0.1% last month; the Westpac-MI Consumer Expectations Index, up 1.6% vs -1.4% last month; US industrial production, up 0.2% vs 0.4% last month; commodity prices, down -16% (in AUD terms) vs -8% last month; dwelling approvals, up 10.9% vs -5.4% last month; the yield spread, widened 25.8bps vs a 12.5bps narrowing last month; the Westpac-MI Unemployment Expectations Index, down -2.6% vs -3% last month; and total hours worked, up 0.3% vs 0.5% last month.

Aug 16, Last: 0.5%% WBC f/c: 0.5%

Mkt f/c: 0.5%, Range: 0.5% to 0.7%

• Total hourly wages ex bonuses gained 0.5% in Q1 which was a lift from 0.4% in Q4 (which was revised down from 0.5% and is now the record low quarter print). Nevertheless it is holding surprisingly soft momentum with the annual rate at a historical low of 1.9%yr.
• The relative softness in the labour market seen in broader measures, such as underemployment where a worker is willing and able to work more hours than they do, has coincided with the record low in wage growth.
• Those looking for a minimum wage increase in the Q2 WPI are one quarter too early as the increase was not applied until July 1, 2017. So while it is true that the minimum wage rise is likely to boost wage inflation back though 2%yr in Q3, for Q2 we are looking for modest 0.5%qtr/1.9%yr print.

Aus June Labour Force employment ‘000

Aug 17, Last: 14.0k, WBC f/c: 35k

Mkt f/c: 20k, Range: 10k to 35k

• May and June were robust updates from the Labour Force survey. The recovery in employment was something that our Jobs Index had been pointing to for some time and our employment forecasts going forward incorporated on-going strength at least to year end.
• Total employment rose 14k in June compared to the market’s forecast of 15k. Full-time employment surged 62.0k following on from a 53.4k gain in May. In the year full-time employment gained 175.4k/2.1%. Part-time employment fell 48k following a -15.4k in May. In the year part-time employment lifted 64.8k/1.7%, slower than full-time employment for the first time since Mar 2015.
• Employment is now running on par with our Jobs Index which is pointing to it accelerating as we near year end. Our forecast for 35k will hold the annual pace at 2.0%yr.

Aus June Labour Force – unemployment %

Aug 17, Last: 5.6% WBC f/c: 5.6%

Mkt f/c: 5.6%, Range: 5.4% to 5.7%

• The solid June gain in employment was matched by a 0.1ppt lift in participation. This led to a 27.1k gain in the labour force thus holding the unemployment rate flat at 5.6%. However, at two decimal places the unemployment rate was 5.65% up almost 0.1ppt from 5.56% in May so it was a very small smidgen off being rounded up to 5.7%.
• We believe we have seen the low in unemployment and expect it to hold around 5.6% until it starts to drift higher as we move into 2018. Robust employment growth is drawing workers back into the labour force (and/or holding more in the labour force), lifting participation and preventing any near term dip in unemployment.
• For July, strong employment should again be associated with higher participation. At 65.1% participation should lift the labour force enough to hold unemployment at 5.6%.

NZ Q2 real retail sales

Aug 14, Last: +1.5%, Westpac f/c: +1.5%, Mkt f/c: +0.8%

• Retail spending rebounded in March, rising by 1.5%. Much of this was the result of a very large increase in motor vehicle sales. However, there were gains in most categories including a strong lift in categories linked to the tourism sector.
• We expect another solid gain in the June quarter, underpinned by solid growth in core categories. Once again, much of the strength in spending is expected to be in areas related to tourism. During the June quarter, we saw strong tourist inflows on the back of high profile sporting events, like the Lions tour. This provided a large boost to spending in areas like food services and accommodation. We also expect to see gains in other categories, supported by softness in import prices and continued strong population growth.

US Jul retail sales

Aug 15, Last: -0.2%, WBC 0.5%

• During the June quarter, there was a distinct loss of momentum in retail sales – a 0.3% gain in April followed by a 0.1% decline in May and a 0.2% fall in June. Core retail sales (ex autos and gas) were a little stronger but still quite weak, with a gain of 0.4% followed by a flat outcome and a -0.1%.
• Through the quarter, weak inflation was a key cause of the soft nominal sales trend, both for gas and more broadly. Importantly, from the GDP consumption detail, it is evident that volumes were actually better in the June quarter than in the March quarter, when durables sales volumes were flat.
• The momentum in sale volumes in the June quarter points to a rebound in nominal retail sales from July as the negative influence of prices abates. We look for a 0.5% gain in headline retail sales and a similar result for the core series. This growth should continue in coming months.