7 July Quarterly Economic Report July 2016

Transcription

1 7 July 216 Executive Summary The Australian and Global Economic Outlook We still expect the Australian economy will grow marginally in excess of 3.% in 216, which is above our potential growth rate of 2.75%, and maintain a similar pace in 217. This would be a creditable outcome given the monumental transition the economy faces following the resources construction boom. Global growth forecasts have been shaved down. There are risks to global growth but at this stage they appear manageable. The Outlook for Interest Rates Australia s official cash rate sits at an historical low of 1.75%. We expect the RBA to cut the cash rate to 1.5% in August and then remain on hold for the remainder of 216. Further declines in Australian and global bond yields seem likely in light of modest global economic growth, low inflation, uncertainty surrounding the UK s decision to leave the EU and the ongoing search for safe haven assets. The Outlook for the Australian Dollar 1 8 There has been a significant range of events that have influenced currency markets in recent months. Nonetheless, the AUD has settled in a mid-7 US cent range, close to where we had expected it to trade for most of this year. Our view that commodity prices will likely track sideways over the medium term supports our expectation that the Australian dollar should continue to trade close to the mid-7 cent US range for the remainder of the year. We maintain our forecast of US$.74 for the end of 216. Australian GDP Growth (annual % change) 12 Unemployment Rate (per cent)

2 The Outlook for the Global and Australian Economies Global Economic Outlook The June quarter saw the IMF reduce their forecasts for global economic growth in 216 and 217. The downgrades were not large. The IMF expects growth of 3.2% in 216 and 3.5% in 217. Weaker commodity prices have hurt commodity exporters but importing countries have not seen these lower prices boost activity in their economies. Political uncertainties in Europe, Latin America and the US, plus concerns over the effectiveness of stimulatory monetary policy, also appear to have dampened global activity. US growth has lost some momentum but continues at a modest pace. Markets now doubt that the US Fed will lift its Fed funds rate in 216. China continues to grow at a solid pace but faces headwinds. These include the burden of rising corporate debt and China s own policy of transitioning away from heavy industry and export, towards services and domestic consumption. European growth remains fragile with unemployment still close to 1% and the Brexit vote adding to the region s trauma. In our view, US economic growth will continue at around 2.% in 216 and 217 with unemployment just below 5% and inflation picking up towards 2% next year. While this is unlikely to create much excitement, it is a reasonable outcome in a fragile post-gfc word. Similarly, if China can continue to grow at close to 6%, it should be able to avoid widespread corporate failures and continue its slow but steady transformation towards a more market- based economy. The introduction of the Chinese Yuan into the wider financial system as part of the IMF s Statutory Drawing Rights (SDR) system in October 216 is part of that transition. Europe s post-gfc journey has been difficult. We doubt that growth will pick up beyond a crawl with 1.6% a stretch target for 216. Inflation appears set to remain below 1.5%. Political, banking and national debt issues continue to plague European efforts to grow their economies. Ongoing global growth is positive for Australia s economic outlook; however, bouts of uncertainty seem likely to keep global financial markets on edge for the remainder of the year. Triggers for market volatility could include Brexit developments, a referendum in Italy, banking issues in Europe, the US electoral process, US Federal Reserve decisions, Chinese economic policy decisions and oil price developments. Domestic Economic Outlook The Australian economy last experienced a recession in We do not expect the economy to slip into recession over the next two years unless some unforseen global disruption was to emerge. Ongoing modest global growth remains our base case even in the face of the UK s decision to leave the EU and the ongoing fragility of Europe. The latest read on the Australian economy had it growing at an annual pace of 3.1%. The March quarter national accounts show the economy growing marginally above Australia s potential growth rate of 2.75%. We still expect the Australian economy will grow at marginally in excess of 3.% in 216, which is above our potential growth rate of 2.75%, and maintain a similar pace in 217. This would be a 2

3 creditable outcome given the monumental transition the economy faces following the resources construction boom. So where will growth come from? We continue to expect the primary drivers of growth to come from household consumption and net exports. Ongoing population growth combined with historically low interest rates, reasonable jobs growth and some wages growth should keep the household sector ticking over. Increased export capacity in the resources sector and growth in Australia s global competiveness in mining, LNG, tourism and international education are expected to see the trade sector add to growth. Indeed, the export sector was a major contributor to growth in the March quarter. The Australian dollar is down around 2% against the US dollar over the past three years and down 12.5% on a trade weighted basis. The largest drag on growth over the next year, as it has been over the past two years, is likely to be business investment. While non-mining business investment picked up in the second half of 215 and in early 216, it cannot compensate for the vast amounts that were spent by mining businesses during the resources investment boom. Most of those large projects are finished and there are insufficient new projects to fill the gap. The ongoing decline in business investment will keep economic growth subdued for the next twelve months. The housing and infrastructure construction sectors have been bright spots in the Australian economy. Strong infrastructure spending looks set to continue for several more years. However, the contribution to overall economic growth from housing construction may wane over the next twelve months as price growth eases and as excess supply possibly emerges in several capital cities (excluding Sydney). With the recent election failing to deliver a strong mandate for either party, it seems probable that fiscal policy will not deviate excessively from current settings, however, there may be some pressure for extra spending or the abandonment of savings measures. If so, the path towards budget surplus would be slowed and Australia s AAA credit rating could come under threat. State governments have lifted spending on infrastructure and are contributing towards economic growth. With population growth a little weaker than in the past, we expect the unemployment rate to hover around current levels over the next twelve months. Pressure for wage growth will remain subdued which suggests that core inflation could sit below 2% until late 216 and sit in the bottom half of the RBA s 2-3% target band over the course of 217. Risks to Domestic Growth There are risks to every forecast. In the case of the Australian economy, the major uncertainties and risks surround the level of business investment, the pace of export growth, weak commodity prices or the possibility of a stronger AUD (not our base case). The services sector has been growing; however its appetite for large scale capital expenditure is less than in the resources or manufacturing sectors. As such it is possible we may see a lift in employment without a corresponding lift in business investment. The expansion of our resources sector should see greater export volumes which will add to growth but if commodity prices fall further, incomes will decline and this would act as a drag on activity. The risk is that the supply of commodities continues to rise while demand fails to increase significantly thus depressing commodity prices. The full range of our forecasts can be found on page 1. 3

4 $bn 3 Capital Expenditure (by industry) $bn 3 2 Consumer Price Index (annual % change) 25 Mining Other Manufacturing Interest Rates What s the Lowdown? Australian bond yields have fallen sharply. An interest rate cut from the RBA in May, ongoing monetary stimulus from some of the major central banks and a shock exit vote from the UK referendum on EU membership have conspired to push bond yields lower. It is likely the rout in global bond yields has yet to fully run its course. RBA Australian interest rates are at historical lows. The RBA cut its official interest rates by 25 basis points to 1.75% at its May meeting. Lower than expected domestic inflation was a major catalyst for the rate cut, with a softening in the global economic outlook and mixed labour market data also contributing to the decision. Why the RBA Cuts Again This Year The RBA has not given guidance on the future direction of interest rates and the minutes from the May meeting indicated the decision was a close call. There is a high risk that the June quarter CPI inflation read, to be released on 27 July, is weak, which could lead the RBA to cut interest rates again. We favour the August meeting as a strong possibility for an RBA interest rate cut. Financial markets are fully pricing in one rate cut by year end and some market participants are expecting the cash rate to fall further still. We expect the RBA to cut in August and then remain on hold for the remainder of the year. Australian Bond Yields Australian bond yields have fallen sharply over the past quarter, hitting record lows. The Australian three-year bond yield fell to a record low of 1.46% on June 24 th, following the UK referendum. The 1-year government bond yield fell to a record low of 1.85% in early July. 4

5 Earlier in June, Australian bonds briefly lost their position as the highest yielding AAA-rated bonds. Yields on 1-year Singapore government bonds rose to 2.9%, while those on Australian 1-year government bonds were at 2.8%. The situation has since reversed, with Australian 1-year bond yields falling less rapidly than those of Singapore, to 1.85% and 1.73%, respectively. The makeup of the new Federal government remains unclear at the time of writing. A minority government is could result in some deterioration in Australia s fiscal position resulting in increased Government bond issuance. Credit ratings agencies have flagged the possibility that Australia s AAA rating could come under threat if the fiscal position worsens. S&P have already changed their rating outlook from stable to negative. While a ratings downgrade would theoretically result in higher interest rates, this relationship has not borne out in other countries in recent years. US Federal Reserve The US Federal Reserve raised interest rates in December last year and official interest rates have been on hold since then. The decision to raise interest rates is heavily dependent on US economic data. Recent economic data in the US has not been sufficiently robust to convince the FOMC to raise interest rates again. At its June meeting, the Fed s dot plot predictions for interest rate hikes showed members of the FOMC had toned down their rate hike expectations. Following softer than expected payrolls data at the beginning of June, investors pushed out their expectations for rate hikes. This move intensified following the Brexit vote, so that financial markets are pricing in a small chance of a rate cut by the end of 217, with only 25% chance of a rate hike by the end of 217. When Is a US Rate Hike Likely? We had expected two rate hikes from the Fed later this year. We now expect just one rate hike in 216 due to mixed economic data and global financial market uncertainties. There is, however, a growing risk that financial market volatility and lacklustre US economic data could cause the Fed to leave interest rates unchanged in 216. US Bonds Speculation regarding a slower pace of rate hikes from the Fed and the surprise outcome of the UK referendum weighed heavily on global bond yields. US bond yields declined sharply, with yields on 1-year government bonds hitting a record low of 1.35% earlier this month. Yields on the 2-year government bond fell to a record low of.5% following the Brexit vote. Global Bond Yields Uncertainty about the outlook for global economic growth and ultra-stimulatory monetary policy (including negative official interest rates and massive bond purchases) have led to strong demand for bonds globally, pushing bond prices even higher and hence bond yields to record lows. This move intensified after the Brexit vote led to safe haven flows into bonds. In the past quarter German bond yields moved into negative territory for the first time, with German 1-year Bund yields hitting a record low of -.19%. Yields on sovereign bonds from other European countries were already negative. The yields on Swiss bond are lowest, with yields on three-year bonds falling to -1.11% earlier in June. In Denmark, there are cases where banks are paying borrowers interest on their mortgages. 5

6 Japanese bond yields across much of the yield curve (from 3-month to 15-year) remain in negative territory. According to the Bloomberg Global Developed Sovereign Bond Index, the total value of all negativeyielding sovereign bonds globally, is now worth almost US$1 trillion. This underlines the attraction of Australian bonds. Forecasts The outlook for global economic growth is subdued and this is reflected in the current, ultra-low bond yields. Our expectation of a rate hike by the Fed could put upward pressure on US bond yields this year but there will continue to be downward pressure from the UK and Europe, with central banks there likely to engage in further policy easing. Additionally, there is the potential for increased monetary stimulus from the Bank of Japan. Ongoing concerns about the outlook for global economic growth will continue to support safe haven flows into government bonds. In aggregate, we expect further downward pressure on government bond yields. We expect US ten-year bond yields to fall from 1.38% at the time of writing to 1.1% by December 216 and to rise back to 1.8% by December 217. This will feed through to Australian ten year bond yields which we see decreasing this year, before starting to rise in 217. The yields on Australian 1-year government bonds are expected to decline from 1.94%, at the time of writing, to 1.7% by December 216, before rising to 2.5% by December 217. Likewise, yields on 3-year government bonds are expected to fall from 1.52% at the time of writing to 1.4% by December 216 and to 1.9% by December 217. Our full interest rate forecasts can be found on page 1. % 9 Australian Cash & Swap Rates (weekly data) % 12 Australian & US Bond Yields (monthly data) 7 9 Australian 1yr bond rate GFC lows RBA Cash Rate 3-Year Swap Rate 3 US 1yr bond rate

7 The Outlook for the Australian Dollar A Recap Quarterly Economic Report July 216 What a difference a few short months can make in the world of financial markets. Since March, there have been a number of significant events that have impacted on the value of currencies and the Australian dollar. The UK vote to leave the European Union has triggered a significant amount of uncertainty for the global economy, Europe and the UK. The immediate reaction to the AUD was to fall sharply from a recent peak of 76.4 US cents. Another key factor influencing the AUD in recent months was the reduction in official interest rates by the RBA to a new record low of 1.75% in May in response to very weak inflation. This has had the impact of keeping the AUD under pressure. Working in the other direction, expectations of rate hikes by the Federal Reserve have scaled back and are providing support to the AUD. A slowdown in US job growth has further reduced the chance of rate hikes by the Federal Reserve. Over the course of these events, the AUD has fallen from a four-month high of US$.7835 to a low of US$.7145 on 24 May before settling near 74.5 US cents at the time of writing. Despite the wide range of events, the AUD is trading within the mid-7 US cent range, close to where we had expected it to trade for most of this year. We examine these factors and other fundamental drivers of the Australian dollar below and how they may affect the outlook for the Australian dollar. 2 AUD/USD and Iron Ore Prices AUD/USD (rhs) AUD/USD & Risk Appetites VIX index, inverted axis (rhs) Iron Ore Prices (lhs).75.7 AUD/USD (lhs) 3 Jan-9 Jan-11 Jan-13 Jan Jan-15 2-Jul-15 2-Jan-16 2-Jul Brexit and Risk Aversion Over the past week, worries about Brexit have resulted in a lift in volatility in financial markets, and increased uncertainty for the global economy. Typically, the Australian dollar will fall when risk aversion is high. Nonetheless, the Australian dollar has held up relatively well. This is likely because the most recent bout of risk aversion, which has been driven by concerns in the UK and Europe 7

8 have resulted in flows leaving GBP and the euro. Consequently, the AUD has likely benefited to some extent from these flows. The significant uncertainty regarding the UK, its political situation, its trading relationship with the EU and questions about the EU itself could continue to keep financial markets on edge for some time. However, if some of the fog clears, there is a risk that both the Australian dollar (and the pound sterling) would rally, although it could be some months before a degree of clarity emerges. Some of the downside risks to the global economy, brought about by the uncertainty facing businesses operating in Europe and the UK could work in the other direction and prevent any substantial rally. The Central Bank Divergence There are downside risks from expectations that the RBA will lower interest rates again. Indeed, we expect that low inflation will persuade the RBA to cut official interest rates in August. That suggests that we are likely to see large swings in the Australian dollar around the CPI data release on 27 July and around upcoming RBA decisions. In contrast, we expect that the Federal Reserve will raise official interest rates once by 25 basis points this year, although there is a risk that they may not move interest rates at all over 216. The expected widening interest rate differential between Australia and the US suggests that the Australian dollar could weaken (see chart below left). However, markets are already fully pricing in an RBA rate cut by the end of the year, suggesting that if the RBA cuts rates as we expect in August then there would unlikely be much downward pressure on the AUD. We recognise that there is a risk that markets will move to price in further rate cuts from the RBA, given there are a number of downside risks to the global economy. These risks include uncertainty in Europe and lingering risks from China. However, these factors would also pose downside risks to official interest rates in the US. Moreover, interest rates are not the only determinant of the Australian dollar. Indeed, the AUD has been relatively firm despite the diverging stances of the Australian and US central banks AUD/USD & AU-US 2-Year Government Bond Spread AU-US 2-Year Govt Bond Spread, % (rhs) AUD & RBA Commodities Index AUD/USD (rhs).8.6 AUD/USD (lhs) 6 RBA Commodity Price Index (SDR Terms) (lhs) Jan-95 Jan-1 Jan-7 Jan-13 Jan-19 2 Jan- Jan-4 Jan-8 Jan-12 Jan

9 Follow the Commodity Price Road A major factor supporting the Australian dollar has been a partial rebound in commodity prices since January. While interest rates may be pointing to a lower Australian dollar, commodity prices are suggesting a different story. We remain of the view that commodity prices are unlikely to revisit the lows hit in January. Nonetheless, the outlook for commodity prices is mixed. High cost producers are likely to continue to reduce production, particularly for iron ore. Oil prices have been supported by supply disruptions in Canada and Nigeria. However, supply remains abundant for many commodities. Australia is expected to continue to increase production of iron ore, and the disruptions to oil supply are likely to be temporary. In the meantime, the pace of global growth remains ordinary, which suggests that commodity prices are unlikely to rally substantially. That leaves us with the view that commodity prices will likely track sideways over the medium term. The China Effect A key risk to the outlook for commodity prices is the outlook for China. While authorities continue to aim to achieve a high rate of growth of between 6.5% and 7.% this year, downside risks to the outlook remain. There continue to be concerns over high debt levels among the corporate and government sectors, and there remains uncertainty regarding the ability of authorities to liberalise financial markets. An escalation of concerns over China could raise anxiety within financial markets and could result in a selloff in the Australian dollar. Summary The Australian dollar has been impacted by a significant range of factors over the past few months. However, in spite of recent events, the Australian dollar is within the low-to-mid 7 US cent range we had anticipated for the remainder of the year. Our expectation that the RBA will cut official interest rates once again does pose some downside risk, however the decision to cut rates is mostly priced into financial markets. Moreover, while there are downside risks for interest rates and the Australian dollar coming from current global economic conditions, these downside risks also increase the chance of further monetary easing from other central banks including the Bank of England, The European Central Bank and the Bank of Japan thereby placing downward pressure on other major currencies. The Federal Reserve would also be less inclined to raise official interest rates, although we expect that it will still lift the Fed funds rate once this year. The commodity price outlook is also a predominant driver for the Australian dollar, and tends to have a stronger relationship with the currency than interest rate differentials. Our view that commodity prices will likely track sideways over the medium term also supports our expectation that the Australian dollar should trade close to the mid-7 cent US range for the remainder of the year. We have revised our point forecast for the end of the September quarter upwards from 72 US cents to 74 US cents, and left our end of year forecast for the AUD unchanged at 74 US cents. Our detailed currency forecasts can be found on page 1. 9

10 Major Upcoming Data and Events Australian Data / Events Underlined July 8 th China CPI Jun 8 th US Non-farm payrolls Jun 11 th Housing Fiance May 12 th NAB Business Survey June 13 th WBC-MI Consumer Confidence Jul 14 th Labour Force Jun 14 th UK BoE Monetary Policy decision 15 th China Industrial Production Jun 15 th China Retail Sales Jun 15 th China GDP Q2 Forecasts 15 th US Industrial Production Jun 15 th US UoM Consumer Sentiment Jul 15 th US CPI Jun 19 th RBA Board Meeting Minutes Jul 19 th US Housing Starts Mar 21 st ECB Monetary Policy Decision th US Democratic Nat. Conven. 26 th US New Home Sales Jun 26 th Durable Goods Orders Jun 27 th CPI Q1 27 th US FOMC Rate Decision 28 th Trade Prices Q2 29 th US GDP Q1 29 th Private Sector Credit Jun 29 th Japan BoJ Monetary Policy Decsison August 1 st China Manufacturing PMI Jul 4 th UK BoE Monetary Policy decision 4 th Building Approvals May 5 th RBA Cash Rate Target 5 th US Non-farm payrolls Jul 8 th China Exports and Imports Jul End Period: Q1 Q2 Q3 (f) Q4 (f) Q1 (f) Q2 (f) Q3 (f) Q4 (f) Interest Rates: RBA Cash Rate, % Day BBSW, % Year Bond, % Year Bond, % USD Exchange Rates: AUD-USD USD-JPY EUR-USD GBP-USD USD-CHF USD-CAD NZD-USD USD-CNY USD-SGD AUD Exchange Rates: AUD-USD AUD-EUR AUD-JPY AUD-GBP AUD-CHF AUD-CAD AUD-NZD AUD-SGD * Note that the AUD cross exchange rates have been rounded (f) (f) (f) 217 (f) GDP, % CPI (Headline), % CPI (Underlying), %

11 Contact Listing Chief Economist Senior Economist Senior Economist Senior Economist Besa Deda Hans Kunnen Josephine Horton Janu Chan kunnenhstgeorge.com.au (2) (2) (2) (2) The information contained in this report ( the Information ) is provided for, and is only to be used by, persons in Australia. The information may not comply with the laws of another jurisdiction. The Information is general in nature and does not take into account the particular investment objectives or financial situation of any potential reader. It does not constitute, and should not be relied on as, financial or investment advice or recommendations (expressed or implied) and is not an invitation to take up securities or other financial products or services. No decision should be made on the basis of the Information without first seeking expert financial advice. For persons with whom St.George has a contract to supply Information, the supply of the Information is made under that contract and St.George s agreed terms of supply apply. St.George does not represent or guarantee that the Information is accurate or free from errors or omissions and St.George disclaims any duty of care in relation to the Information and liability for any reliance on investment decisions made using the Information. The Information is subject to change. Terms, conditions and any fees apply to St.George products and details are available. St.George or its officers, agents or employees (including persons involved in preparation of the Information) may have financial interests in the markets discussed in the Information. St.George owns copyright in the information unless otherwise indicated. The Information should not be reproduced, distributed, linked or transmitted without the written consent of St.George. Any unauthorised use or dissemination is prohibited. Neither St.George Bank - A Division of Westpac Banking Corporation ABN AFSL ACL , nor any of Westpac's subsidiaries or affiliates shall be liable for the message if altered, changed or falsified. 11