Key insights from the week that was.
Uncertainty has remained rife this week as Australian growth disappointed after the RBA cut rates and US trade tensions persisted.
Q1 2019 proved to be a particularly weak quarter for our economy, GDP growth rising just 0.4% and domestic demand weaker still at 0.1%. Over the 12 months to March, GDP growth was a full percentage point below trend at 1.8%, meaning per capita growth over the period was just 0.1%. Within the detail, there is a dramatic divergence between public and private demand. Spending by the government rose 1.1% in Q1 to be 5.7% higher over the year, as investment to meet the needs of a growing population continues at pace. In stark contrast, private sector demand fell 0.2% in Q1 to be 0.3% lower over the nine months to March – the weakest result since the GFC, when a 0.6% contraction in private demand was seen over the nine months to March 2009. April retail sales data points to continued weakness in consumer spending in Q2 2019 and hence a good chance of another below-trend read on GDP.
As highlighted by our Chief Economist Bill Evans this week, the above GDP outcome will come as a surprise to the RBA and mean they will likely have to revise their growth expectations down again from an already below-trend 2.6%yr at May 2019 (to 1 decimal place). Importantly that forecast was predicated on two rate cuts by year end. So with growth having disappointed again and Governor Lowe voicing a need to get the unemployment rate down to at least 4.5% (from 5.2% in April) to bring inflation back to target, we have strong confidence in our expectation that two more cuts will be delivered by year end – in August and November, taking the cash rate down to 0.75%.
Turning to the US, last Friday’s decision by President Trump to impose tariffs on Mexico from 10 June has continued to send shockwaves through financial markets. Equity markets initially moved sharply lower, but have since partly recovered as participants’ expectations of FOMC rate cuts by year end firmed. The market has been expecting rate cuts for much of 2019. Up until now however, we have not been convinced, believing that a lasting resolution to trade tensions could be found against the backdrop of clear strength for the US consumer.
However, together with the actions against Huawei, the Mexico tariffs point to trade tensions instead being an open-ended source of uncertainty for the US economy, forestalling investment as business remains concerned about what could happen next and, if not acted against, putting household demand at risk.
To that end, we now look for two cuts from the FOMC by year end, in September and December. If, as we expect, these cuts stabilise growth/ inflation near trend/ target (2%yr), then the FOMC will remain on hold through 2020 rather than cutting further as implied by market pricing for a November 2020 federal funds rate of 1.37% (100bps below today’s level).
Given that we have a more upbeat central view relative to the market, we see little scope for a further material move lower in the US 10-year to end 2019, with a modest rise then expected to end-2020. Along with trend US growth through 2020, revised market rate expectations should weigh on the Australian dollar in 2020, the cross trading around USD0.66 in the first half of 2020 and finishing the year at USD0.67.
Of course, central bank dovishness is not exclusive to Australia and the US. In Europe, the June ECB meeting marked a continued dovish shift with the ECB now “ready to act” in the case that “adverse contingencies” materialise. Ultimately, this is an acknowledgement that high economic uncertainty is going to linger for some time and downside risk has increased.
So what are these adverse contingencies? The dominant worry relates to the persistent weakness in the manufacturing sector which is more exposed to external demand. While he notes that that economic data is not bad and domestic demand remains robust (the Q1 national accounts show it currently tracking at 1.9%yr), he questions how long these areas of the economy can remain “insulated” from the difficulties of the manufacturing sector.
Regarding policy decisions in June, they are somewhat more ambiguous. Forward guidance was extended to rates being on hold at least through the first half of 2020, but the decision on TLTRO-III (new loans to banks) was to provide slightly less favourable pricing than its maturing predecessor TLTRO-II.
As with TLTRO-II, banks will receive loans at a base rate linked to the refi rate (currently 0%), with a conditional rate linked to the deposit rate (currently –0.4%) if banks exceed lending benchmarks. The key difference is that the new loans will come at a 10bp premium to the linked policy rates, and the linked rate that applies will be the average over the life of the respective TLTRO operation. Draghi’s rationale behind the TLTRO-III decision was that the loans are intended to be a backstop, and while there is a slight “disincentive” versus before, the terms are still very generous.
