Bill Evans - Chief Economist - Westpac
Markets have moved to price in three hikes for the RBA’s cash rate by end 2019. Other major banks concur broadly with that view.
Recall that in mid-August last year, these same players (markets and most other banks) were forecasting rate cuts over the course of the remainder of 2016 and 2017. Westpac’s view at that time was “rates on hold” in 2016 and 2017.
Readers of the Westpac Market Outlook publication for September will be aware that Westpac continues to forecast the cash rate to remain on hold out to mid-2019.
Indeed we are not convinced that the cash rate will need to rise any time throughout the course of 2017, 2018 or 2019.
This approach is clearly different to the thinking of the Reserve Bank Governor himself who expects to be tightening over that period (note his speech on “the next chapter” which was delivered yesterday).
However, we continue to point out that the RBA has a very different growth outlook for the Australian economy and Australia’s trading partners to our own.
The RBA expects growth in Australia to be 3.25% in 2018 and 3.5% in 2019 (above trend of 2.75%). Westpac expects a below trend pace of 2.5% in both years.
The RBA is also forecasting 2% underlying inflation in 2017 and 2018 (bottom of target band) to be followed by 2.5% in 2019.Underlying inflation is currently running at 1.8% (to June) and the upcoming revised weights are likely to reduce annual underlying inflation by 0.2-0.3%.
Going forward, the RBA’s inflation forecasts also look to be overly optimistic and are likely to be subject to downward revision. Recall that in 2016 when the RBA was forced to revise its inflation forecasts below 2% it believed it had little choice but to cut rates.
While the RBA does not provide detailed forecasts outside growth and inflation, comments from the RBA Governor and written reports point to a much more confident outlook for wages growth; incomes; employment; consumption; non-mining investment and the residential construction cycle.
The Reserve Bank expects wages growth to increase over the forecast period. A major puzzle for central banks globally has been the limited response of wages to stimulatory monetary policies since the GFC. Despite these policies in the US; Germany; the UK and Japan driving labour markets to near or full employment, wages have failed to respond. Explanations for this phenomenon have been structural: globalisation; technology; retiring higher paid baby boomers; low productivity growth; absence of pricing power for employers; low inflationary and wage expectations; high risk aversion following the GFC and job insecurity.
Consistent with that global theme, wages growth in Australia has also been weak. Australia’s wage price index has increased by 1.9% over the last year compared to average growth of 3.5%. The unemployment rate has held in the 5.5%-6.0% range compared to a generally accepted full employment rate in Australia of 5%.
Further, underemployment in Australia has been high at around 8.8% making total excess capacity around 14.5%. Given the global lessons on the structural wages outlook, it seems unlikely that wages in Australia (where spare capacity is higher than in these other developed economies) will lift significantly even in the medium term.
This weak wages performance has lowered annual real income growth to 0.6% while real consumption growth has held around 2.5%. The shortfall has been funded by a falling savings rate, particularly in the highly stressed mining states. Overall Australia’s household savings rate has fallen from 9% to 4.6% over the last three years.
Households will need to protect that fragile savings rate and pressures will emerge on consumer spending. Of course, other pressures are impacting households – rising energy prices; record high debt levels and political uncertainty. The latter effect will work through the business sector as businesses restrain employment and investment until political clarity is achieved following the 2019 election.
Markets may be underestimating the impact on the interest rate sensitive housing market of developments which are unfolding without official rate hikes.
The four majors (90% of the mortgage market) have been raising investor and interest only mortgage rates while applying tighter lending guidelines. House price inflation is slowing and regulators are unlikely to have any patience with a reversal of this trend.
To that point, six month annualised house price inflation (CoreLogic data) in Sydney has slowed from 22.4% in January to 4.8% in August. We observed a similar response to macroprudential policies in 2015/16 when six month annualised house price inflation slowed from 25% (July 2015) to -4.4% (April 2016).
Housing activity is also slowing despite a steady cash rate. Other factors, specifically relating to foreign investors, have turned the cycle. High rise building approvals have tumbled by 40% in the last year. This has been particularly due to investment restrictions in China; lending constraints by banks; and sharp increases in state government stamp duties for foreign investors. This downturn is likely to continue for at least a further two years.
While markets are currently captivated by expectations of a coordinated lift in global growth, we are more circumspect particularly around Australia’s trading partners.
With Chairman Xi likely to cement power following the National Congress in October, we expect that he will have little choice but to adopt policies to gradually deal with the excessive build up in corporate debt in China (now 166% of GDP), largely driven by the circa 30% compound growth rate of small and medium sized banks and non-banks over the last six years. These small banks now represent comparable asset bases to the heavily regulated policy banks which have only been growing at around 12% over the same period. It will be incumbent on the administration to arrest the growth rate of these small banks; off balance sheet vehicles; and non-bank institutions. Asset quality for these institutions must be suffering while reliance on overnight funding has lifted sharply.
Tighter credit conditions will slow China’s growth rate – we forecast a growth slowdown from 6.7% in 2017 to 6.2% in 2018.
Finally, the ongoing legacy of elevated risk aversion, which continues ten years after the Global Financial Crisis, is contributing to unusually steady interest rates around the world. Under our figuring, on the basis that this risk aversion persists for a few more years, a 40 month stretch of steady rates in Australia would not be out of place.