Risk assets rallied in July as a range of uncertain factors with the potential to limit global economic growth started to resolve. The EU and Greece reached an accord allowing Greece to meet its immediate contractual debt commitments, but at the expense of more austerity measures and effectively an even bigger Greek debt burden to service over time. Another long-standing geopolitical issue was resolved with an agreement concerning Iran’s nuclear ambitions paving the way for removal of trade sanctions against Iran. China also adopted initiatives to stabilize its sharply falling sharemarket. While trading in most sharemarkets was bumpy early in July, the resolution – possibly only temporary resolution – of a number of worrying issues paved the way for strong relief rallies later in the month. All major equity markets lifted in July ranging from up by 1.1% for Britain’s FTSE 100 to up by 5.2% for the European Eurostoxx 50. The Australian ASX 200 rose by 3.8% recovering much of its 4.1% loss in June.
Australian credit gained over the month recovering from a bout of weakness earlier in the month driven by uncertain international factors besetting all risk assets. In government bond markets, the selling of recent months gave way to renewed buying causing yields to fall quite sharply by month end. The US 10 and 30-year bond yields fell in July respectively by 17bps to 2.18% and 19bps to 2.91%. Australian bond yields fell by more than their US counterparts and the 10-year bond yield fell by 31bps to 2.75%. The RBA left its cash rate unchanged at 2.00% at its July policy meeting but continued to indicate that although cutting the cash rate further risked fanning high house prices and was something of a balancing act, it was still in a position to cut further in need
On the US economic data front the advance reading of Q2 GDP showed US growth improving by 2.3% on an annualized basis, a weaker growth rate than widely expected, but up from a revised 0.6% growth reading for Q1. Other US economic indicators have turned mixed-strength still with pockets of strength in housing activity and employment although a much weaker edge showing in consumer confidence and wages growth. Employment costs rose by only 0.2% in Q2 the weakest growth in the 33 year history of the survey. At its July policy meeting the Federal Reserve continued to point towards a first hike in its Funds rate later in 2015. The market has been working on the assumption that the Fed may start lifting rates at its September policy meeting but the softer turn in some key US economic readings would seem to imply a later start.
In China, Q2 GDP was a touch firmer than expected at 7.0% y-o-y matching the annual growth rate in Q1. June economic readings were also stronger than expected, notably industrial production up 6.8% y-o-y from 6.1% in June and retail sales up 10.6% y-o-y from 10.1% in June. More recent purchasing manager surveys point to growth fading in Q3. Weakening commodity prices and the still struggling Chinese sharemarket, notwithstanding the substantial efforts of the authorities to arrest the decline, also attest to downside risks to growth. Most likely the authorities will continue to ease policy settings including more fiscal spending and further reductions to official interest rates and banks’ reserve ratio requirements.
In Europe the Greek debt crisis reached a resolution of sorts, although one that implies the Greek growth rate will remain under downward pressure and that its debt will stay too high to service. In short, the Greek crisis will probably flare again, although probably not in the near-term. European growth still seems to be travelling in the slow lane on basis of the unemployment rate flat-lining over recent months at a high 11.1%. The flicker of inflation in Europe also remains just that at 0.2% y-o-y in July the same as in June. The European Central Bank has kept its policy setting unchanged since announcing QE – 60 billion euro of asset purchases a month – earlier in the year. Pressure is starting to build for the ECB to adopt an even easier policy setting.
In Australia, although employment has been surprisingly firm and the unemployment rate appears to have stabilized around 6.0%, GDP growth is still slipping and Q2 annual GDP growth (due to be released in September) appears to be tracking around 2.0% y-o-y down from 2.0% y-o-y in Q1. Strong contributors to growth in Q1, such as housing activity and exports look less strong in Q2. Household consumption spending also appears to have lost momentum on the basis of quite soft monthly retail trade readings in April and May. Business investment spending is still declining and the pace of decline may have accelerated too. A key issue remains declining national income driven by falling export prices, down another 4.4% in Q2. Very low wages growth also represent a tightening income constraint on how freely households can spend. The RBA left the cash rate unchanged at 2.00% in July and by canvassing issues such as whether Australia’s potential economic growth rate has fallen below the historical average around 3.2% and the unsure benefit of further rate cuts has muddied the waters concerning the outlook for the cash rate.
Looking ahead, it is quite likely that the RBA will need to reduce its growth and inflation forecasts further later this week when it publishes its next quarterly Monetary Policy Statement. We see the RBA wanting to provide further support for growth even though it is wary of the impact of lower interest rates driving house prices up even higher. We feel that there is a clear marginal benefit from cutting interest rates further. We place a high probability on the RBA cutting the cash rate another 25bps to 1.75% at its policy meeting tomorrow. Even if it chooses not to ease tomorrow we see a weaker run of Australian economic data leading the RBA to cut, probably in November. Beyond the next few months it still seems likely that growth will be soft for some time. It is possible the cash rate may need to be cut further but our base case is that the cash rate is stable at 1.75% until late 2016.