While my “on hold” call for the RBA turned out correct last year, I now expect the RBA to cut the cash rate this year, and twice by early-2020. This reflects a weakening in a range of economic indicators and the Reserve Bank’s own acknowledgement of more downside risks.
Economic Storm Clouds
Let’s start with the economy. As mentioned, a range of Australian economic indicators have turned notably weaker of late:
- The National Australia Bank’s Index of business conditions slumped 9 points in December to a + 2 reading. While surveyed conditions recovered somewhat in January (to +7), the speed of the decline from earlier levels is jarring and was broad based across sectors.
- Home build approvals dropped sharply in both November and December. While a downtrend has been in place for some time, the speed of decline has accelerated of late.
- Retail sales were flat in both the September and December quarter. Retail sales volumes have enjoyed a saw tooth pattern in recent years – one quarter of weakness has been followed by a quarter of strength. Yet sales were weak in the last two quarters.
- ANZ job advertisements declined in both December and January and appear to be finally “rolling over”. Job ads are not usually too volatile, so recent weakness likely indicates a shift in trend to a slower pace of hiring.
The best news is that the unemployment rate is still low at only 5%. But this is a lagging indicator to a degree and, as seen in the chart below, even just the recent weakness in building approvals suggests upward pressure on the unemployment rate in the months to come.
The housing sector remains a key swing variable for the economy – both through the “wealth effect” of weaker property prices on consumer spending, but also more directly through reduced employment in the housing construction sector.
Although Sydney and Melbourne house prices have already declined notably, they still remain expensive based on long-run affordability measures. The absence of foreign buyers and proposed changes to negative gearing and capital gains tax laws – should the Labor Party win the next Federal election – are likely to continue to weigh on the sector. As is usual, the upcoming Federal election campaign could also undermine business and consumer sentiment at a vulnerable time, especially as the Morrison Government is likely to wage a scare campaign over the threat to the economy posed by Labor.
Globally, while the US economy continues to post good economic growth, conditions in Europe and China especially have eased. The lingering risk of a US-China trade war persists.
RBA turns dovish
Meanwhile, commentary from the Reserve Bank last week suggests it now sees economic risks as more evenly balanced. The RBA has dropped reference to the next move in rates as likely being up. While this implies only a “neutral policy bias”, in my view the reality is that if local interest rates move anywhere this year, it’s now more likely to be down.
However, I suspect the RBA remains very reluctant to cut interest rates – given they are already quite low and further declines might have only a muted effect on the economy. The RBA would also be loath to unduly interrupt what it likely sees as a necessary, albeit uncomfortable, ongoing housing price adjustment in Sydney and Melbourne.
That said, should the unemployment rate begin to head higher, and given the still quite low rate of local inflation, I also suspect the RBA will feel the need to respond by lowering interest rates. That’s why I suspect the RBA will likely wait for the unemployment rate to actually rise (possibly to at least around 5.4%) before acting, unless there is an even sharper deterioration in other forward indicators in the meantime.
Cash rate predicted to fall to 1%, $A to US68c
All up, my base case view is that the RBA will cut rates if the unemployment rate rises above 5.3% (i.e. prints 5.4% or more) in coming months. I now also believe that the unemployment rate will breach 5.4% by year-end given, especially, the depth of the recent downturn in home building approvals.
It’s on this basis that I now expect the RBA to cut rates by year-end, with a move to a 1% cash rate by around February 2020.
Subject to what else happens in the economy, this should be a positive for interest-rate sensitive sectors of the market and companies with high offshore earnings exposure – given the $A could also weaken to at least my first target of US68c.
Lower rates favour bonds and infrastructure
Among the BetaShares suite of exchange traded products, some investment opportunities worth considering in the event of lower local rates include long duration corporate bonds (via CRED) and listed property/infrastructure exposures (such as via RINC).