RBA on hold, but expect hikes in 2018: Paul Bloxham
GUEST OBSERVER
Most of the timely indicators of domestic economic activity suggest that growth is set to pick up pace in coming quarters (we expect year-ended GDP growth of 3.3% over 2017).
Key amongst these indicators are surveyed business conditions, which are around decade highs, and employment growth, which has picked up recently with sufficient momentum to push the unemployment rate lower.
A major driver of these developments has been an improvement in conditions in the mining sector, which has spent a number of years in retreat. Higher commodity prices and the end of the decline in mining investment mean that the resources sector is a tailwind, rather than a headwind for growth (see A commodity prices tailwind, finally, 17 January 2017). The latest manifestation of this has been the strong profits reported by Australia’s miners. The timely economic indicators have also been supported by a bounce-back in activity after poor weather held back Q1 GDP. Retail sales, non-mining investment and coal exports have risen recently. Reflecting this, we revise up our Q2 GDP growth forecast to 0.9% q-o-q (previously 0.5%).
A key question for the RBA remains whether the expected lift in growth will feed through to a pick-up in wages growth and domestic inflation. Weak wages growth has been a factor that has weighed on consumer sentiment and growth in household consumption. We expect wages growth to pick up modestly in the second half of 2017, due to a boost to the minimum wage and the impact that the lift in corporate profitability typically has on wages growth. This should mean that domestic inflation is past its trough, and we see the underlying inflation measures lifting back into the bottom part of the 2-3% target band in coming quarters.
Above trend growth, a modest lift in wages growth and underlying inflation, plus still uncomfortably exuberant Sydney and Melbourne housing markets are, in our view, likely to be sufficient to see the RBA lifting its cash rate in early 2018.
On fixed income strategy, we see potential for more money market risk premium but there is little to fear for the long-end even if the RBA tightens policy next year.
Business conditions and the labour market are improving
Surveyed business conditions have remained around their highest levels for a decade in recent months (Chart 1).
Across industries, this reflects continued positive business conditions for most of the non-mining sectors and a significant improvement in the survey results for mining companies.
The improvement in business conditions is consistent with the recent strong profit reporting season, with the mining companies the stand-out performers in terms of profitability.
The key business surveys also show a pick-up in capacity utilisation. To meet demand, firms are hiring more labour, with growth in employment and hours worked picking up pace in recent months (Chart 2).
There are also signs that non-mining business investment is set to rise, with the ABS Capex survey showing a pick-up in its forward-looking estimates (Chart 3). This fits with our view that business investment will turn positive for the first time in six years in 2018 (Downunder Digest: Australia’s next investment upswing, 21 March 2017).
Timely indicators of activity, such as retail sales and exports, have also lifted in recent months, partly because they were held back by wet weather (including Cyclone Debbie), which weighed on GDP in Q1.
Given an earlier bounce-back than we had expected (we were expecting the bounce-back to be stronger into Q3), we now expect Q2 GDP growth (due out on 6 September) to be 0.9% q-o-q (previously 0.5%).
However, we now expect a little less growth in Q3 and Q4 and are maintaining our through-the-year forecast for 3.3% y-o-y over 2017 (Chart 4).
The lift in economic activity is also starting to spread to Western Australia, which is the region that had been hardest hit by the end of the mining boom. Jobs growth in Western Australia has picked up to be running at around 1.5% y-o-y, up from falling at that pace 12 months earlier (Chart 5).
As we pointed out in a recent piece, the improvement in conditions in the mining states, particularly in Western Australia, is a signal that the process of rebalancing growth following the end of the mining boom has almost come to its end (Downunder Digest: States reveal the rebalancing act is almost done, 21 July 2017). For the RBA, this should mean that it may no longer need to maintain its current highly accommodative stance of policy.
Wages growth sluggish but expected to pick up
A key challenge for the RBA is that although growth is expected to pick up and the labour market is tightening, wages growth remains sluggish. The wage price index rose by 1.9% y-o-y in Q2, which is around its slowest pace on record, although it appears to have stabilised in recent quarters (Chart 6).
However, we expect wages growth to edge higher in coming quarters for a number of reasons. First, the minimum wage was lifted by more this year than last year, which should directly add around 0.2-0.3ppts to wages growth from Q3 2017.
Second, the labour market is tightening, which should provide some support for wages growth. Third, there is a strong positive historical correlation between corporate profits in Australia and wages growth. Typically, when profitability improves, as it has done recently, some of this additional income feeds through to the household sector in the form of wages growth (see Downunder Digest: Show me the money, 20 April 2017).
The AUD has risen but so have commodity prices
Another concern has been that the Australian dollar has risen recently and that this could weigh on growth, by reducing export competitiveness and driving import substitution, and could also weigh on inflation. However, it is important to keep in mind that the increase in the AUD has been accompanied by a pick-up in the prices of Australia’s commodity exports, led by iron ore and coal, and a lift in global growth.
Because of this, the RBA has been reluctant to suggest that the AUD ought to fall. In its public commentary the RBA has, instead noted that ‘an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast’.
There is clearly considerable uncertainty about what the lift in the AUD could mean for the Australian economy. A pure mechanical model would suggest that a 10% rise in the real trade- weighted AUD index would weigh on export growth to the tune of 4% of exports. However, this assumes all else equal. If the lift in the AUD reflects a pick-up in global growth or commodity
prices, the rise in the currency may itself be a signal of better growth to come (see Downunder Digest: Trade leads the way, 24 August 2017). Historically, it has often been the case that the first sign that local growth is set to pick up shows up in a higher Australian currency.
RBA Governor Lowe says ‘up rather than down’
At a testimony to a parliamentary committee the RBA Governor, Phil Lowe, noted that the current market pricing implying a greater probability of a rate rise than a reduction was a ‘reasonable assumption’. He stated that it is reasonable to assume that the ‘next rate move will be up rather than down’, but that ‘it’s quite some time away if things play out as we expect’.
That the next move is likely to be up is a view we have had since September 2016 (The RBA Observer: The case for no more cuts is strengthening, 30 September 2016). As we noted last month, the RBA does not give forward guidance. So Governor Lowe’s comments are by no means a promise to deliver but are instead his best current judgement as to what is likely, given the RBA’s forecasts.
We see the first hike as likely to arrive a bit earlier than the market is currently pricing. Our view partly hinges on continued expected concerns about the housing market. Although the RBA has been noting that there are ‘signs that conditions in the Sydney and Melbourne markets had eased somewhat’, the housing price growth in these markets is still running at double-digit rates y-o-y (Chart 8).
If, as we expect, by early 2018, growth is running at an above trend pace, underlying inflation is back in the 2-3% target band (albeit around the bottom edge of the band) and wages growth is past its trough, the RBA may see little need to maintain its highly accommodative monetary policy stance, particularly given its ongoing concerns about the exuberance in the housing market.
Fixed income: more front-end risk premium
There have been modest signs of a cyclical improvement in the region since we turned bullish on bonds in Q1. Given the RBA’s one-sided guidance – that the next move is likely to be a hike – this argues for more money market risk premium and we see the 2-3Y segment of the swap curve as most vulnerable to re-pricing, having lagged the move higher in the RBA dates.
Fundamentally, it is also worth noting that above-average increases to the minimum wage and fair work awards as well as rising utility prices should add around 0.2ppts to the y-o-y rates of both the wage price index and headline CPI, respectively, in Q3. While the long-term impact is uncertain, such prints should at least embolden those arguing that these gauges have bottomed.
Yet there is little to fear for long-dated bonds even if central banks tighten policy as our economists expect in Q1 2018, sooner than currently priced. History tells us that yield curves flatten when the RBA hikes and long-end rates often fall (Chart 10). That valuations are not stretched, especially on a cross-market basis, emboldens our view (see AUD & NZD Rates: Little to fear for the long-end, 30 August 2017).
PAUL BLOXHAM IS CHIEF ECONOMIST (AUSTRALIA AND NEW ZEALAND) FOR HSBC.