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A surprise domestic growth slowdown

Growth in the Australian economy slowed to 2.8% in the September quarter. There were a number of significant developments in the GDP report.

Firstly, we saw the first 'negative' on new dwelling construction in the quarter following a particularly strong first half. Westpac expects this will be the start of a long run of falls in residential construction reflecting the downturn in dwelling approvals and the expected further contraction as tight funding conditions and falling house price expectations deter both demand and supply of new construction.

Secondly, we saw a particularly weak print on consumer spending reflecting weak income growth (real household disposable income was flat over the year to date) and a decade-low savings rate.

Wages growth is lifting only very slowly while strong employment growth is expected to slow in 2019 as political uncertainty and global tensions in trade and softening demand weigh on the confidence of business. There is also likely to be some wealth effect on consumption through 2018 H2 and 2019 as the impact of falling house prices on households’ balance sheets plays out.

Non-residential construction is also falling – down from the surge in activity we saw in 2017, although we expect this to stabilise through 2019.

Weak second half of 2018 will feed into 2019

Overall, we expect growth in 2018 will print around 3% with the 4% annualised momentum in the first half slowing to 2% in the second half. That weak second half momentum will weigh on 2019. We expect growth to slow in 2019 to 2.6% following ongoing contraction from new dwelling construction; continuing below trend growth in consumer spending; and uncertainties around the Federal election and the global economy.

House prices will be important in 2019. Even though prices have fallen by 9.6% from their peak in Sydney and 5.8% in Melbourne, these adjustments follow cumulative increases in Sydney (40%) and Melbourne (32%) over the previous four years. Affordability is still stretched in both cities.

Unlike previous cycles where affordability was boosted by sharp reductions in interest rates and strong (4% wages growth) income growth, the necessary restoration of affordability in this cycle will need to come from prices.

The additional complication is that even if affordability has been restored and buyers are attracted back into the market, credit is being tightened by the major banks. As we have recently seen in Perth, affordability can be restored but prices can still fall further if credit is tightened.

On the positive side there are other construction cycles which are likely to continue to boost growth. Government infrastructure spending, in particular, continues to lift; we are at the bottom of the mining investment cycle and positive prospects particularly around iron ore and lithium are boosting investment plans.

The September quarter GDP print will come as a disappointment to the Reserve Bank. Recall that in the Governor’s Statement on Tuesday, he noted that “one continuing source of uncertainty is the outlook for household consumption”.

Note that the Bank’s forecast for GDP growth in 2018 which appeared in the November Statement on Monetary Policy was 3.5%. With the first three quarters of the year totalling 2.2%, the December quarter would have to print growth of 1.3% (a 5.2% annualised growth pace) – a highly unlikely event. We can expect the Bank to lower its forecast for GDP growth in 2018 from 3.5% to 3.0% when it next releases its forecasts on February 8, 2019.

That forecast will then challenge the 2019 forecast of 3.25% which appeared in the November Statement. It was reasonable for the Bank to assume some slowing between 2018 and 2019 (Westpac’s growth forecast for 2019 has been 2.7%) particularly with a more clouded outlook for global growth and a likely accelerated contraction in residential investment. That would immediately push the likely 2019 forecast back to around Westpac’s forecast of 2.7%.

So, although we did not get a growth assessment from the Deputy Governor in his speech on Thursday, the GDP print is likely to change the Reserve Bank’s growth rhetoric of strongly above trend to slightly above trend drifting back to trend in 2019.

Westpac has consistently forecast that the cash rate would remain on hold through 2019 and 2020. If we are right that the Bank will revise down its growth forecasts on the basis of this result, then lower expected growth momentum going into 2020 may also temper the Bank’s attitude to rates in 2020 as well.

From our perspective, a central bank forecasting growth around trend rather than well above trend is much less likely to feel the 'responsibility' to normalise rate setting.

The market is too cautious on the Federal Funds Rate

With this domestic growth profile as a backdrop, we confirm our long-held views that the Reserve Bank will keep the cash rate on hold through 2019 and 2020. The RBA's on hold decision will also be backed up by slowing global growth, particularly in 2020 when the US economy will slow back to trend growth of around 1.75%- 2.0% from an above trend 2.5% in 2019 and near 3% in 2018.

Furthermore, the first half of 2019 will see markedly faster growth than the second half when, in particular, the interest rate sensitive parts of the economy (housing and durables) will be weak and employment growth will slow. Despite the fading of the tax cuts, we believe rising wages and strong employment growth will boost household incomes in 2019, supporting solid consumer spending, particularly in services.

Unlike current market assessments of a potential inverse yield curve, we expect that the Federal Reserve will be able to pause earlier than has been experienced in previous cycles ensuring that soft landing. With this growth profile in mind, we expect that the last hike from the FOMC will be in September 2019. By that time, employment growth will have slowed from 2% in the second half of 2018 to 1%, providing the FOMC with the opportunity to go on hold around a neutral setting – full employment; trend growth; and 2% inflation.

That timing implies four more hikes, beginning in December 2018. Markets are currently pricing one hike in December 2018 and less than one more through 2019, indicating that we expect a sharp market surprise around the policy approach from the Fed.

In turn, this 'surprise' is likely to see higher US bond rates and a stronger US dollar. We have slightly lowered our expectation that the US 10-year bond rate expecting a peak of 3.4% by the second half of 2019 and the USD Index will appreciate a further 3-4% by the September quarter. The time for a sustainable fall in bond rates and the USD will be around the time of the FOMC pause, rather than the current circumstances when the US economy is growing near 3% and wage inflation risks are apparent.

Trade policy and China are major risks

Markets are too influenced by the recessions that followed the last two rate hike cycles of the Federal Reserve. These resulted from unique imbalances – the bursting of the dot com bubble and the GFC. No such comparable risk presents itself in this cycle, including trade policy, although ongoing tensions will unnerve markets It seems unlikely that the Chinese authorities will be prepared to make the specific changes to their industry and trade policy that would specifically satisfy the US needs. These would include changes to forced technology transfer, intellectual property protection, non-tariff barriers, forced joint venture investment, cyber intrusions and government industry subsidies.

Consequently, trade disruptions are a certain theme through 2019 although President Trump and China are likely to find ways to avoid the US imposing tariffs on the remaining (around $200 billion, mainly consumer goods compared to the current tranche which is only around 25% consumer goods) imported to the US from China that are not affected by tariff decisions to date. However, we believe the most recent 10% tariff on $200bn will be increased to 25% before mid-year.

We have seen that trade concerns have also weighed on the Chinese economy. Other more significant drags on Chinese growth have been winding back the shadow banking system and pollution policy. Credit policies to direct more growth into the regulated banking system; a more liberal approach to pollution policy; and direct fiscal stimulus will all be used to maintain a managed slowdown in China. We are targeting a 6.1% growth rate in 2019 from 6.4% in 2018.

Other regions are less important to the overall global view. Emerging markets will suffer under the weight of rising US interest rates and a higher USD. Japan will be preparing for the introduction of a new consumption tax and Europe will be impacted by the China/emerging markets slowdown; supplemented by Brexit; Italian instability; political unrest in France and Germany; and a gradual tightening of monetary policy as the ECB halts its balance sheet expansion from the beginning of 2019.

 

Bill Evans is Chief Economist at Westpac.

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