- The RBA kept the cash rate at 1.5% following its February meeting;
- Despite the economic ups and downs, the RBA looks to have largely kept their forecasts unchanged;
- The most likely outcome is no cash rate change this year;
- But if there is to be a move this year we believe that it is more likely to be down.
Last year was the year of the surprise for financial markets. At the start of 2016, analysts were very concerned about the economic outlook (notably China). Commodity prices were falling, as were equity markets. The bond market was worried that inflation would stay too low for too long and central banks needed to do more to pump up the world economy. Such was the concern, one analyst achieved global headlines with his call of ‘sell everything’. In the event, things turned out better than expected. The economy was stronger than most forecasts, not the least because a number of central banks cut rates in the first half of the year and governments eased fiscal policy. Financial markets realised they had become too pessimistic, and commodity prices, equity markets and bond yields all rose. Optimism reached its maximum with the ‘Trump trade’ (rising equity prices, rising bond yields) following the US election.
But the economics was not the only surprise of 2016. At the start of the year, Brexit and a Trump victory were two of the ‘low probability but high risk’ factors commonly cited by analysts. After an initial spike in volatility, financial markets decided that both events would be good for the economy. So as it turned out, the reaction to the surprise was the surprise!
So 2016 saw plenty of surprises. But we have started the year with a very expected outcome, the RBA decision to keep the cash rate unchanged at 1.5% followings its February meeting. Since the RBA last met in December, the global economy has been stronger than expected. The Q3 GDP number was negative, although the RBA put that down to temporary factors. If anything, the RBA appear a little more positive about the domestic economy (despite the recent data). Higher commodity prices is pushing up national income growth. And with strong resource shipments, exports are on fire. Major infrastructure projects are also helping to boost growth, and there are plenty of cranes still building units. The RBA notes the rise of investor credit growth, although they appear sanguine because of regulatory response has led to some tightening of lending standards. The RBA read is that the housing market is mixed, with strong house prices rises in some places (Sydney and Melbourne), and falling prices in other places (Perth).
But our read is that unlike the East Coast weather of recent times, the economy is far from hot. Jobs growth has been moderate, and consumer and business sentiment is around long-term average level. The Q4 CPI numbers suggest that inflation might be bottoming around 1.5%, and higher oil prices means headline inflation is rising. But wages growth remains muted, and inflation expectations by both business and consumers are low. The Australian dollar is rising. Mostly that reflects a higher terms of trade. But the risk is that the $A might go too high, a negative for the economy. So with inflation still well under target, the risks are that another rate cut might be required. This is consistent with financial market views, with around 30% of analyst expecting a lower cash rate in Australia in 2017.
Probably the main risk to the domestic economy is international. The global economy is improving, and the unemployment rate in many countries continues to decline. Federal Reserve officials are speculating about the need for three quarter percentage point rate hikes this year. But markets are only pricing two worried about that inflation will remain too low. And concerns remain around the large buildup of debt that has occurred place in China in recent years (something the RBA also noted in its Statement).
The biggest surprises this year might end up happening in the political arena (as was the case in 2016) . Analysts are still trying to come to grips with the full ramifications of the Trump victory. Initially financial markets took the election result well. It was assumed that the combination of large tax cuts, major infrastructure spending and a significant reduction in regulations would super-boost company profits and the wider economy. But since the start of this year, investors are having second thoughts. While Congress agrees with a number of Trump’s proposals, they do not agree with them all. With the US economy nearing full employment, a strong fiscal boost might end up being largely offset by higher interest rates. And the inevitable delays in the political process means that any changes to fiscal policy would not be felt until 2018. More broadly, it is becoming increasingly probable that there will be a shift in US trade policy towards protectionism. If implemented most economists agree that protectionism would be negative for global growth.
And there is the plenty of potential for other political surprises in 2017. There are general elections due in the Netherlands, France and Germany (and probably Italy). The European elections have the potential to significantly alter the future of the Euro. China will also hold its five-yearly meeting where significant leadership changes will be announced. These changes could have far-reaching impacts on Chinese economic policy. The level of uncertainty about economic policy globally is currently at a very high level.
So there is plenty of reason for uncertainty, something that is currently not fully priced into financial markets. Given this level of uncertainty we believe that an unchanged cash rate in 2017 is the most likely outcome, with a rate cut more likely than a hike. With commodity prices likely to renew their fall and the interest rate differential with the US to narrow further, we look for the $A to move lower against the USD by year-end .
Warren Buffet said that “the rear view mirror is always clearer than the windshield.’ True, but we mostly keep our eyes on the road ahead. And we can be sure that in 2017 the economic road ahead will be full of twists and turns.
We live in interesting times.