Australia & New Zealand Weekly: RBA Governor Relaxed With Modest Increase in Household Leverage

Week beginning 27 November 2017

• RBA Governor relaxed with modest increase in household leverage.
• Australia: private capex, dwelling approvals, CoreLogic home prices, private credit.
• NZ: RBNZ Financial Stability Report, building consents, bus. confidence, terms of trade.
• China: Official and Caixin PMIs.
• Euro Area: Unemployment, CPI.
• US: Yellen testimony to Congress, beige book, GDP 2nd est, PCE deflator, Senate
• Banking Committee to confirm new Fed chair.
• Key economic & financial forecasts.

Information contained in this report was current as at 24 November 2017.

RBA Governor Relaxed With Modest Increase in Household Leverage

The RBA released the minutes of the Monetary Policy Meeting of the Reserve Bank Board for November and this was followed by Governor Lowe’s speech at the ABE annual dinner.

There were no major surprises in the minutes but the general tone seems somewhat more subdued than we have seen in recent reports. Further to that, the Q&A session following Governor Lowe’s speech later that day provided further insight into the RBA’s views on household leverage.

The minutes show the Board sticking with its expectation that inflation will increase but "only gradually". This is consistent with the revised forecasts in the Statement on Monetary Policy for underlying inflation. In August, the Bank forecast underlying inflation at 2.0% in 2018 and 2.5% in 2019 (mid-points of the range). This has now been revised to 1.75% in 2018 and 2.0% in 2019.

The downward revision in the level of inflation is attributed to the reweighting of the CPI by the Australian Bureau of Statistics. That explains the move from 2.0% (mid-point) to 1.75% in 2018. However, that downward revision does not explain the decision to reduce the 2019 forecast from 2-3% (2.5% mid-point) to 2.0% – a further 0.25ppt adjustment is not justified by the movement to annual revisions. This is likely to indicate the expectation that the pick-up in inflation will be slower than previously anticipated.

There is clear concern about weak wages growth, "various measures of growth in wages had not yet picked up and had been lower in preceding quarters than forecast a year earlier". Some recognition that part of this explanation might be structural is given, "the possibility that globalisation and technology were leading wage growth to be less responsive to changes in the demand for labour". This was noted as a global theme and may partly explain the decision to slow down the expected pace of pick-up in inflation.

Commentary around the consumer is downbeat. Retail sales have been weak and consumer spending in the September quarter is expected to be lower than in June – the outlook depends upon household income growth which is described as "uncertain". Of genuine concern is the risk that households could make sustained changes to their consumption and savings decisions if they expect low income growth to persist.

The Bank continues to recognise strong employment growth. However there is a high degree of uncertainty around associated wage pressures and resulting inflation. If pressure on margins from strong competition persists, and combines with faster productivity growth, there could be a delay in the pass through to inflationary pressures.

The Board noted that "expectations of future cash rate movements implied by financial market prices had been scaled back indicating that the cash rate was expected to remain unchanged over the following year or so". In fact, our assessment of market pricing still points to around a 70% chance of a rate hike by the end of next year. This interesting observation from the Board may indeed be revealing their own current preferences. Certainly the mood of these minutes is consistent with an expectation of no change in rates.

The minutes continue to emphasise the need to manage risks associated with high and rising household debt. Market participants that continue to expect a rate hike next year are probably relying on that concern. Certainly the inflation environment, as assessed by the Bank itself, does not support the case for higher rates.

The Board recognises that housing credit growth has eased a little but remains faster than household income growth. Prospects for this issue creating concern for the Board are encouraging – "conditions in the established housing market had eased in all major cities". These conditions are of course a lead indicator for credit growth and associated rising household leverage.

If household leverage is increasing modestly not because credit growth is lifting but because of subdued income growth, then authorities are likely to be comfortable with rising debt. Concerns around rising household debt should really be relevant only when credit growth itself is accelerating.

Delivered a few hours after the release of the minutes, Governor Lowe’s address to the Australian Business Economists touched on many of the topics outlined in the minutes and the November Statement on Monetary Policy, released earlier in the month.

During the Q&A, I was very interested in gauging the Governor’s views on household leverage. The minutes do refer to rising household debt, but the issue is more about leverage.

Over the course of 2018, we expect that household credit growth will slow from 6% to 4.5%. That will be due to a further easing in housing market demand and even tighter lending policies from the banks. In fact, it is reasonable to expect that overall house prices are likely to flat line in the major cities.

With housing credit slowing and income growth possibly lifting from the muted 2.0% of 2017 to 3-4% in 2018, household leverage will rise further. But that will be in an unusual circumstance where income growth remains weak and credit growth, while stronger than income growth, is slowing.

My question to the Governor was how he viewed rising leverage under the circumstances set out above. It is my view that slowing credit growth should not be seen as consistent with a destabilisation of household balance sheets since there is no evidence of credit excess.

I put my point to the Governor and his response was clear. He accepted that household credit growth at around 6% (not even meeting the slowdown which I expect) was quite okay, implying that even if leverage was rising due to tepid income growth, financial stability was not being threatened. This is a very important observation since, while the RBA consistently denies an interest in house prices, there is a very clear interest in credit growth. If that is slowing, probably due to a consolidation in house prices, then there is a degree of comfort in official circles despite possible rising leverage.

From our perspective, given the inflation environment and our views on economic growth, the only possible scenario that would lead to a rate hike would be some concern around rising leverage. This concern would only be relevant if there was a marked increase in credit growth. That prospect seems highly remote and for us eliminates the only obvious upside risk to rates in 2018.

Westpac continues to expect that the RBA cash rate will remain on hold over the course of 2018 and 2019.

The Week that Was

In a week that was cut short by Thanksgiving in the US, policy makers again took centre stage. On the whole, their tone was cautious.

For Australia, there was an increased focus on the minutes of the November RBA board meeting following the downward revision to their inflation forecasts in the November Statement on Monetary Policy. Consistent with these revised forecasts (underlying inflation of 1.75%yr at end-2018 and 2.0%yr at end-2019), the minutes cited an expectation that inflation will pick up "only gradually".

While these revisions have been attributed to the ABS’ CPI re-weighting, to our mind the 0.5ppt revision to the 2019 forecast is too large to solely be due to this factor. Disappointing wages growth and the consequence for consumer spending (more below) as well as more modest expectations for wages and inflation are clearly at play.

Following the release of the November minutes, Governor Lowe delivered a speech to the Australian Business Economists’ Annual Dinner. In it he again highlighted the weakness in wages (growth in average hourly earnings "running at the lowest rate since at least the 1960s") and paid close attention to the consequences for consumption: annual growth of near 2.5%yr against the RBA’s perennial expectation that it would accelerate to 3.5%yr. While they have now lowered their forecast peak in consumption growth to 3.0%yr, this is arguably still too high. We in contrast believe consumption growth is set to remain around 2.5%yr, which will deliver GDP growth near that figure over the forecast horizon.

A risk to our forecast that the cash rate will remain on hold through both 2018 and 2019 has been household credit growth’s material outpacing of income growth – resulting in a significant increase in household leverage. While the RBA and APRA remain vigilant, Governor Lowe and the RBA Board have taken confidence in macro-prudential policy’s power as both house price growth and credit growth have slowed. For a full discussion of this topic, see Bill’s weekly essay on the previous page.

Taking a step back from the immediate, the release of the latest state accounts for the 2016/17 financial year offers a great deal of detail on sectoral and industry performance across the states. At the top level, in 2016/17 broad based gains across industry as well as in infrastructure investment by the public sector saw Victoria and NSW outperform, with growth of 2.9% and 3.3%. Of the mining states, Qld saw moderate growth, +1.8%yr, while in WA activity continued to contract as the mining investment downturn reached its nadir.

For those with an interest in the New Zealand economy, this week also saw the release of our New Zealand team’s quarterly outlook. The election of the new government in New Zealand has resulted in a softer growth forecast for 2018, but upward revisions to 2019 and 2020. On the RBNZ, our New Zealand team anticipates that current market expectations will be disappointed as the RBNZ remains on hold until late-2019.

Finally, turning to the US, the FOMC clearly sought to cement market expectations of a rate hike in December in their October/November meeting minutes. The economy was seen as continuing to enjoy above-trend growth thanks to robust gains for household consumption. Built on income gains as well as strong confidence, this trend is expected to persist. Inevitably though, an economy cannot be built on consumption alone. Investment is necessary, and this is an area of the growth outlook where we harbour doubts. Should, as we expect, investment growth remain tepid, then productivity and income growth will be held back. This is a key reason why we believe that this rate hike cycle is likely to top out around 1.875%, after the December decision and two further hikes in 2018.

Chart of the week: Amazon soon to launch in Australia

Looking to the very near future is the long-awaited launch of Amazon Australia. The consequences for our economy will be varied and take time to play out. But briefly, based on offshore experience, expect further disinflationary pressures and margin compression for retailers, and a shift in the investment plans of retailers away from ‘bricks and mortar’ toward their online presence.

While Amazon’s launch may spur consumption in the near-term, the overall impact on the volume of sales in the medium to long-term is likely to be marginal. On this point, it is important to recognise the power that sentiment and expectations around family finances have on spending. Until we see a lift in wages growth, consumers’ capacity to spend is likely to remain restricted.

New Zealand: Week Ahead & Data Wrap

Growth slowdown under way

Our latest quarterly Economic Overview, released this week, traces the contours of growth that we expect for the New Zealand economy over the coming years. We’ve revised down our GDP forecast for 2018, but upgraded our forecasts for 2019 and 2020. These changes reflect the impact of the new Government’s policies, but also the tone of the recent data.

Market opinion generally seems to be that the new Government’s policies will boost GDP, inflation and the OCR. We agree with that, but only up to a point. Increased government spending will certainly boost activity, but the crowding-out of private activity must also be considered. Meanwhile, the Government’s plans to cool the housing market and reduce net migration will weigh on the economy next year. Our view remains that the Reserve Bank will not need to raise interest rates until late 2019.

This week’s data releases highlighted some of the conditions we see for a slowdown in growth in the near term. Retail spending eked out a modest gain of just 0.2% in the September quarter, after a 1.8% rise in the June quarter. This was partly a comedown from major sporting events such as the Lions rugby tour in the June quarter, reflected in particular in a sharp drop in accommodation and hospitality spending in September. But there has also been a more widespread slowdown in spending growth compared to recent years, especially in housing-related categories such as furniture and hardware.

In New Zealand, consumer spending growth tends to be closely correlated with the strength of the housing market. The latest slowdown in retail spending suggests that the relationship is alive and well. House sales are down by about a third from last year’s peak, and the double-digit house price growth we saw in previous years has given way to a period of quite subdued gains.

We think that the recent housing slowdown will persist for some time. To be fair, nationwide house prices have perked up in the last few months, and we wouldn’t be surprised to see a further rise in the near term – there have been some reductions in fixedterm mortgage rates, and there could be a short-lived rush to get into the housing market ahead of the new Government’s restrictions on non-resident buyers. But we think that other policy changes, such as the planned extension of the ‘bright line’ test for taxing capital gains on investment properties, will push house prices lower again over 2018 and beyond. If we’re right, that implies a significantly slower pace of spending growth than retailers have been used to over recent years.

Another factor that will dampen spending growth in coming years is a slowdown in migration-led population growth. While net migration in the month of October was a little higher than we expected, the details support our view that the balance has passed its peak.

Departures of non-New Zealand citizens have been steadily rising since mid-2016 and are now 30% higher than this time last year. This group includes people who would have come over in recent years on temporary work and student visas. Typically those who come over on these programs stay for around three to four years. Given that the surge in foreign arrivals began in 2013, we’ve been expecting to see a corresponding surge in departures. This trend looks likely to continue for some time yet, and will drive a substantial downturn in total net migration over the coming year.

We expect annual net migration to slow from around 70,000 people now to a low of 10,000 people by 2021. Most of the expected change is due to natural forces that drive net migration (such as the strength of the global economy), and has been a feature of our forecasts for some time. However, the new Government’s proposed changes to visa requirements for students and low-skilled workers has given us reason to revise our forecast even lower.

The slowdown in net migration will have a number of significant impacts on the economy. Most notably, it will result in population growth slowing from 2.1% currently to 0.8% – a huge reduction in the rate of potential GDP growth and a key reason that we expect lower GDP growth over time.

The other notable development this week was a further fall in dairy prices at the latest GlobalDairyTrade auction. The decline in dairy product prices since the middle of this year, despite cuts to milk production forecasts in that time, suggests that the weakness lies on the demand side of the equation.

We noted in our latest Economic Overview that while global growth as a whole is improving, the mix of growth is not quite as favourable for New Zealand’s exporters. China – the dominant market for many of our agricultural exports – is starting to slow, as it looks to reorient away from the credit-fuelled investment that has driven growth in recent years.

The outlook for dairy isn’t gloomy by any means – we expect a farmgate milk price of $6.20/kg for this season, which is close to the average of the last decade. But it’s likely to leave farmers cautious about new spending and more focused on debt reduction, after two very poor seasons in 2015 and 2016 that put a severe strain on dairy farm balance sheets.

Data Previews

Aus Oct dwelling approvals

Nov 30, Last: 1.5%, WBC f/c: -1.5%

Mkt f/c: -1.0%, Range: -4.0% to 2.0%

• Sep dwelling approvals came in above expectations with total approvals up 1.5% and the detail showing a surprise 20% jump in high rise and a modest gain for non high rise approvals.
• Both high rise and non high rise segments are still pointing to likely slowdowns in the months ahead. Site purchases point to a further wind down in high rise projects. Meanwhile construction-related housing finance approvals – a reasonable proxy for non high rise approvals – pulled back sharply through Aug-Sep. Of course, linking these indicators to month to month moves in approvals is difficult, particularly for high rise activity. On balance we expect approvals to retrace 1.5% but the high rise jump in Sep could see a sharper pull back depending on the ‘lumpy’ projects in this segment.

Aus Q3 business capex

Nov 30, Last: 0.8%, WBC f/c: -0.3%

Mkt f/c: 1.0%, Range: -5.5% to 3.0%

• Business spending on capex increased by 0.8% in the June quarter, to be 3% below the level of a year ago. Weakness is centred in mining, -15%yr, with a partial offset from services, +3.7%yr.
• Equipment spending rebounded in the June quarter, +2.7%, led by services, to be flat over the year.
• There is an emerging stabilisation in building & structures with the mining investment wind-down almost complete. The Q2 outcome was -0.6%qtr, -5%yr.
• For Q3, we anticipate a 0.3% decline in capex spend, including: a rise in equipment (+0.8%), led by services; and only a relatively small decline in building & structures, -1.2%.

Aus 2017/18 capex plans, AUDbn

Nov 30, Last (Est 3): 101.8

Mkt f/c: 105.4, Range: 103.0 to 110.0

• Capex spend will inevitably decline in 2017/18, with the final stages of the mining investment wind-down the key force.
• Recall that Est 3 for 2017/18 is $101.8bn, which is 3.6% below Est 3 a year ago, a decline of $3.8bn. That was an improvement on -6.4% for Est 2.
• Est 3 by industry is: mining -22%, -$9.2bn; services +10% (upgraded from +6%); and manufacturing -2.6%.
• Est 4 of 2017/18 capex plans is likely to paint a broadly similar picture: mining lower and services advancing, led by a rise in non-residential building work as indicated by the lift in approvals (notably for offices, particularly in Victoria).
• An Est 4 of around $104n would be 3% below Est 4 a year ago, broadly equivalent to the -3.6% for Est 3 on Est 3. It would represent a near 3% upgrade on Est 3, matching the average for the previous four years.

Aus Oct private credit

Nov 30, Last: 0.3%, WBC f/c: 0.4%

Mkt f/c: 0.4%, Range: 0.2% to 0.6%

• Credit to the private sector grew by a more modest 0.3% in September, down from a 0.45% average over Q2 and Q3. Over the past year, credit expanded by 5.4%.
• The September outcome was largely driven by a softer month for business (a +0.1% down from the recent average of 0.4%). Notably, commercial finance has pulled back, partially reversing earlier gains. Over the past year, business credit rose by 4.3% as business investment expands.
• For October, we anticipate a 0.4% rise in credit, constrained by another relatively soft update for business.
• Housing credit is slowing gradually, a trend that is likely to continue at this late stage of the cycle as the sector responds to tighter lending conditions. In September, housing credit grew by 0.48%, 6.6%yr, with the 3 month annualised pace at 6.2%, down from a peak of 6.8% in May.

Aus Nov CoreLogic home value index

Dec 1, Last: flat, WBC f/c: -0.1%

• The CoreLogic home value index held flat in Oct taking annual growth to 7%yr, an abrupt slowdown from the 11.4%yr peak in May. Policy measures continue to have a material impact. Although official rates remain near historic lows, regulators introduced a new round of ‘macro prudential’ tightening measures in late March. Meanwhile a range of other changes have also seen a progressive tightening of conditions facing foreign buyers.
• The daily measure points to another weak month in Nov with prices nationally looking to have dipped -0.1%. That would drag annual price growth down to around 5.5%yr, the slowest pace since this time last year.

NZ RBNZ Financial Stability Report

Nov 29

• The RBNZ’s six-monthly review of the state of the financial system is likely to be relatively sanguine. Banks are well capitalised, loan impairments remain low, and mortgage lending growth has slowed.
• The RBNZ has said it is reviewing the criteria for easing the loan-to-value ratio restrictions on mortgage lending. We think the key hurdle is whether easing the LVR restrictions would lead to a resurgence in housing market pressures. For now the RBNZ has taken a cautious view as to whether the new Government’s policies will suppress house prices, but on our forecasts there should be sufficient evidence of this by mid-2018.

NZ Oct residential building consents

Nov 30, Last: -2.3%, WBC f/c: -2.0%

• Consent issuance softened in September, but remained at a firm level. Much of the recent strength in consents relates to the apartments/multiple category. Issuance in this category can be lumpy on a month-to-month basis. And following a large rise in recent months, we expect a moderation in this group will pull total consent issuance down 2% in October.
• Issuance in Auckland will warrant close attention. If the pickup we saw in recent months is sustained, Auckland would finally start eating into its significant shortage of housing.
• While a large amount of work is being consented, there are questions about capacity in the construction sector. We expect that the level of building activity will remain elevated for some time, but future increases may be gradual.

NZ Nov business confidence

Nov 30, Last: -10.1

• Business confidence has been dropping since August, falling into negative territory in October. A key reason for this was uncertainty ahead of September’s general election. New Zealand business confidence is expected to decline further in November reflecting nervousness around the policy environment following the formation of the Labour-led government.
• On the activity front, we anticipate that capacity constraints will continue to hinder activity in a range of sectors, particularly construction. In addition, tightness in credit conditions, difficulties accessing skilled labour and slowing economic growth will continue to weigh on businesses’ expectations for activity over the coming months. Putting this together, we expect businesses’ investment intentions will soften going into 2018 as businesses adjust to the new policy environment.
• Inflation expectations are expected to remain close to the RBNZ’s target midpoint.

NZ Q3 terms of trade

Dec 1, Last: 1.5%, WBC f/c 1.5%

Mkt f/c: 1.3%, Range: 0.0% to 3.7%

• New Zealand’s terms of trade rose 1.5% in the June quarter, falling just shy of setting a new 66-year high. We expect it to reach that milestone in the September quarter.
• We estimate that export prices were flat overall for the quarter. Dairy prices were unchanged after a strong surge in the previous few quarters. Meat and log prices were up slightly, while the stronger currency suggests lower prices for manufactured goods exports.
• We expect a 1.5% fall in import prices, largely due to a 6% fall in petroleum products.