RBA will continue to cut rates as it tries to head off an economic slowdown

The Australian economic outlook has clearly deteriorated. Recognising this, the RBA has resumed interest rate cuts. Our assessment remains that the RBA has more work to do. But how low will rates go? What does it mean for investors?

The growth outlook

While economic growth in Australia has been reasonable of late –3.7% over the year to the June quarter – and well above that in comparable countries, our assessment is that storm clouds are brewing and that growth will slow to around 2.5% over the year ahead, which is well below trend growth of around 3-3.25%.

The basic issue is that the mining boom is losing momentum at a time when the non-mining part of the economy is weak and fiscal austerity is intensifying.

Mining investment looks like it will peak next year. For the first time in years the June quarter survey of mining investment intentions did not show an upgrade in plans for the current financial year and projects under consideration have peaked. Falling mining sector profits suggests mining projects remain at risk. Investment outside the mining sector remains weak. This all points to a sharp slowing in business investment in 2013-14.

Source: Thomson Reuters, AMP Capital

At the same time, a sharp fall in Australia’s terms of trade is leading to a loss of national income which will also slow spending and growth. Stronger mining exports, i.e. stage three of the mining boom, will provide a boost to growth but this may not become evident until around 2014-15.

Source: Bloomberg, AMP Capital

This is all occurring at a time when non-mining indicators for the economy remain soft. Consumer and business confidence are sub-par, despite being almost a year into an interest rate cutting cycle.

Retail sales remain subdued, with government handouts providing a brief boost in May and June, only to see softness return again. Annual retail sales growth is stuck in a range around 3%. With confidence remaining sub-par, job insecurity running high and interest rates still too high it’s hard to see a strong pick up yet. Ongoing consumer caution in terms of attitudes towards debt and spending is highlighted by the next chart, which shows a much higher proportion of Australians compared to the pre-GFC period continuing to nominate paying down debt as the wisest place for savings.

Source: Westpac/Melbourne Institute, AMP Capital

While housing related indicators have probably bottomed on average, taken separately they present a very mixed picture, with house prices up over the past few months, housing finance, housing credit and building approvals looking like they have bottomed but remaining soft and new home sales still falling. The fact that there has only been such a tentative response to lower mortgage rates indicates that mortgage rates have not fallen enough.

The jobs market remains soft with weak job vacancies pointing to soft employment and rising unemployment ahead. Whereas anecdotal news of job layoffs was previously limited to the non-mining sectors of the economy, it has now spread to the mining sector. This is likely fuelling ongoing household caution, acting to constrain retail sales and housing demand.

The bottom line is that with the mining boom likely fading over the year ahead, the non-mining part of the economy – notably retailing, housing and non-mining construction, manufacturing, tourism, etc – needs to pick up to fill the breach. The good news is that the RBA appears to recognise this. The bad news is that its task is being made hard by two factors:

• First, the continuing strength in the Australian dollar, presumably on the back of safe haven buying out of the US dollar and euro in the face of QE3, etc, and its high correlation to the US sharemarket as part of a “risk on/risk off” trade, which has meant that it has so far not provided the shock absorber to falling commodity prices that it usually does.
• Second, having seen the budget handouts around mid-year, fiscal tightening will now kick in at the federal level and may even intensify if the government seeks to retain its projected surplus for the current financial year. At the same time, various states are announcing budget cutbacks, including job cuts.

In order to offset these forces and ensure that non-mining demand strengthens sufficiently, interest rates will have to fall further.

Continued next page.