RBA will continue to cut cash rate as economic storm clouds brew: Shane Oliver

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 to 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.

The cash rate is low but lending rates are not

While the RBA has cut the official cash rate to within 0.25% of its GFC low, because of bank funding issues lending rates are still well above their 2009 lows.

Basically banks have been seeking to reduce their reliance on non-deposit funding which has proved unreliable since the GFC and to do this they have had to offer higher deposit rates relative to the cash rate than would normally be the case. This has resulted in higher lending rates relative to the cash rate than was the case pre-GFC. Banks have done well to raise the proportion of their funding they get from deposits to 53% from around 40% pre-GFC, but they still lag behind banks in other major countries and tougher capital requirements mean they are under pressure to do more.

The standard variable mortgage rate at around 6.6%, assuming banks pass on around 0.2% of the RBA’s latest 0.25% rate cut, is below its long-term average of 7.25%. But normally rates need to fall well below their long-term average to be confident of stronger growth. And in an environment of household and business caution post-GFC the neutral rate has likely fallen, probably to around 6.75%, which is shown as the “new neutral” level in the next chart. This would suggest that current mortgage rate levels are only just starting to become stimulatory.

In the last two easing cycles the mortgage rate had to fall to around 6.05% in 2002 and to 5.8% in 2009. Given the fall in the likely neutral level for mortgage rates and the current headwinds coming in the form of the strong Aussie dollar and fiscal tightening, mortgage rates will at least need to fall to these lows. Given the ongoing issues with bank funding, to achieve a circa 6% mortgage rate the cash rate will need to fall to around 2.5%.

Chart assumes average large bank standard variable mortgage rates fall to 6.6% following latest RBA rate cut. Source: RBA, AMP Capital

Our assessment is that the RBA is coming around to this view. As such we expect another 0.25% cash rate cut next month on Melbourne Cup day, followed by a cut to 2.5% in the March quarter next year.

Based on the assumption that the RBA cuts interest rates further, the global economy stabilises and growth in China stabilises around 7.5% next year, then Australian economic growth should pick up again by the end of next year.

Implications for investors

There are a number of implications for investors.

Interest rates need to fall a lot further. This means that term deposit rates are likely to fall further in the years ahead, even though the size of the decline will lag that of the official cash rate for bank funding reasons. As a result, the attractiveness of bank deposits for investors will continue to deteriorate.

Source: RBA, Bloomberg, AMP Capital

While record low bond yields mean bonds are poor value for long-term investors, yields will likely remain at the low end as the RBA cuts interest rates. However, if foreign investors start to panic about Australia, international bonds will do better than Australian bonds.

Australian shares should benefit from interest rate cuts and cheap valuations. As such we continue to see the Australian sharemarket being higher by year end. Key sectors likely to benefit from lower rates are retailers, building materials and home builders.

Declining interest rates in Australia will take pressure off the Australian dollar. However, falls are likely to be constrained by quantitative easing in the US and central bank buying. Overall, we see the Aussie dollar stuck in a range around $US0.95 to $US1.10. The best has likely been seen for the Aussie dollar.

Dr Shane Oliver is the head of investment strategy and chief economist at AMP Capital. Please note that this article is intended as general information and not as investment advice.

This article originally appeared on SmartCompany.