The rally in risk assets in the early months of 2019 came to an abrupt halt in May with one or two notable exceptions such as the Australian share market. Most major share markets experienced big falls in May caused by a souring global economic growth outlook as market perception of US/ China trade negotiations moved from close to a deal in late April to shattered in May. Falls in the major share markets in May ranged from 3.0% for the British FTSE 100 to 7.5% for Japan’s Nikkei. The US S&P 500 fell by 6.6%, led by technology stocks (the NASDAQ fell 8.7%) squarely in the firing line in the escalating trade war.
Australia’s ASX 200 was one of the few odd men out in May share market weakness, rising by 1.1% and assisted by the unexpected election win of the more business-friendly incumbent Coalition Government; the likelihood of an early boost to the economy from easier monetary policy and tax relief; and stubbornly high iron ore prices. The out-performance of the Australian share market in May could have further to run if easier policy conditions on the part of the RBA, APRA and the Government are delivered, but ultimately the health of the global economy will matter and if trade tensions escalate and the outlook for global economic growth continues to deteriorate eventually the Australian share market will deteriorate as well.
Australian credit markets weakened in May taking their lead more from falling international share markets rather than the rise in the Australian share market. The weakness in global share and credit markets and the growing view that the next policy change by most central banks, including the US Federal Reserve (Fed), is likely to be policy easing caused strong buying in government bond markets. The US 10-year bond yield fell by 38 basis points (bps) to 2.12% while the 30-year yield fell by 36bps to 2.57%. The 10-year yield is below the 2.25% to 2.50% Fed funds rate, a sign that the market expects the Fed to lower rates.
The case for the next rate change by the Fed to be a cut is still not clear cut in our view. While some leading indicators of US economic activity have softened, notably relating to housing, other indicators of consumer sentiment and actual consumer spending are strong. The US labour market remains very tight. The unemployment rate at 3.6% is the lowest in 50 years and growth in average hourly earnings at 3.2% y-o-y is the strongest in a decade. The latest annualised real GDP growth reading at 3.1% in Q1 is above long-term trend.
The greatest downside risk to US economic growth emanates from increasing damage to the supply chains of a widening group of US businesses as President Trump increases restrictions on Chinese imports provoking retaliatory moves by China increasingly targeted at key US business sectors. An escalating trade war is not in the interest of either President Trump with the 2020 election year not far away or President Xi facing potential political instability from rising Chinese unemployment. Both need a trade agreement yet any agreement seems to be slipping further away as both sides slip in to a dangerous brinkmanship based on view that each is in a better position to hold out longer. Without a break in this view, US economic growth could falter later this year prompting the Fed to ease policy in 2020.
The Australian bond market has also rallied in May with the 10-year bond yield falling by 33bps to a record low 1.45%. While the RBA left the cash rate unchanged at 1.50% at its early May policy meeting, every comment from the RBA since makes it plain that it is about to start cutting the cash rate. Essentially, the RBA is considering cutting the cash rate because it now believes the unemployment rate can be pushed below 5% without creating untoward inflationary pressure.
Annual inflation has moved further below the RBA’s 2-3% target band over the past year even at a time when the unemployment rate has been down near 5% – a level that in the past has been consistent with rising wages and upward pressure on inflation. One puzzle has been that low unemployment has occurred at a time when real GDP growth has been quite weak and because of persistently slow growth in household spending is threatening to stay weak. The RBA is starting to reason that low unemployment is unlikely to persist if real GDP growth remains sub-par.
The RBA has two reasons to start cutting rates, below-target inflation fed by sub-par GDP growth; and an opportunity to drive down the unemployment rate without fostering untoward inflation. It also has reasons not to cut. Housing activity seems to be bottoming out; tax cuts are coming soon and will boost household spending; and it was high household debt that left the household sector in its current anemic spending state, rate cuts might promote an even higher household debt burden and eventually even weaker household spending.
From recent RBA comments the reasons to cut rates seem about to win over the reasons not to cut. The RBA looks set to cut the cash rate 25bps to a record low 1.25% this week. It will probably follow up with an additional 25bps rate cut to 1.00% either in July or August. The Australian economy is about to receive its biggest policy boost in a decade – RBA rate cuts (probably a weaker AUD exchange rate too); easing of APRA restraints on bank lending; and bigger income tax rebates starting in July. This combined policy boost is likely to promote stronger Australian economic growth in the second half of 2019.
What happens beyond is likely to depend mostly on the outlook for global economic growth. If the US/ China trade dispute continues to worsen over the remainder of 2019, global economic growth prospects will suffer and Australia’s likely 1.00% cash rate could last through 2020. If global economic growth prospects brighten in the second half of 2019 the RBA will look to start taking back its mid-2019 rate cuts probably later in 2020.