By Michael Kodari
Having enjoyed a strong period of economic growth over the past 24 years, it’s becoming clear that the Australian economy is under-the-weather going into 2015. A drop off in mining investment, non-mining sector weakness, and a tight fiscal environment have all contributed to the below average year-on-year GDP growth rate. From the US to Europe, Canada to Peru, countries around the world have embarked almost simultaneously on a series of monetary policy easing decisions. At the most recent Reserve Bank Australia meeting the central bank followed suit. The RBA Board entered into unchartered territory with a 0.25 basis point cut taking the official cash rate to a record low 2.25 per cent as February continued to reflect the undeniable slowdown in the Australian economy.
The RBA also released a forecast stating that the return to trend growth is now expected to be slower than previously hoped, with GDP growth expected to slow to 2 per cent p.a. in 2015 as resource exports and population growth serve as the only significant contributors, before recovering to a more respectable 3.50 per cent in 2016-17. Inflation is also expected to remain subdued allowing for further interest rate cuts going forward. Compounding the issue has been the deteriorating terms of trade caused by the broad scale and rapid decline in the price of commodities. The terms of trade fell 3.5 per cent in the September quarter, for a year on year decline- 8.9 per cent. Although Australia’s terms of trade have been trending lower for over 100 years, it’s the rate of fluctuations that is important and recently the fluctuations have been rapid.
Falling commodity prices essentially means Australia receives less for its exports. Fundamentally the declining export revenues will buy a decreasing amount of imports from Australia’s trading partners, and this situation causes the terms of trade to deteriorate. Although falling commodity prices should lead to a lower Australian dollar in due course, the risk remains that the AUD doesn’t depreciate by enough to assist with the rebalancing of the economy. Eventually this will translate into weaker corporate earnings, falling government revenues and constrained wage growth.
Lower tax receipts tends to create an environment comparable to a fiscal tightening, while weakness in wage and disposable income growth makes it hard for the consumer to assist domestic demand, and subsequently GDP. Government spending restraint due to the budget deficit, and a decline in tax revenues stemming from the fall in commodity prices has forced the Government to contribute negatively to growth for the first time since 1959. The Government purse is already under pressure where expenditures equate to 25 per cent of GDP and revenues only 22 per cent. Currently the Government already pays $149 billion in social security, a whopping 33 per cent of government expenditure and 25 per cent higher per person than our New Zealand cousins.
As far as wages are concerned, the picture is equally bleak. Real net national disposable income, which as outlined by the ABS measures what Australian governments, businesses and households receive in exchange for goods and services, declined for the second quarter in succession, which in some circles constitutes a recession. Weak growth in national incomes is one of the main explanations given for the low level of consumer confidence and subsequent muted domestic demand levels. Unfortunately all this comes of the back of a terms of trade boom which has culminated in a significant and rising budget deficit, an unemployment rate trending higher and a benign inflation rate around 2 per cent. It would seem hard not to be overcome with a melancholy sense of missed opportunity when reflecting on the economic fruits of the past 15 years.
With that economic image in mind, are further RBA interest rate cuts in 2015 a fait accompli?
Firmer than expected growth in early 2014 caused the RBA to rethink the idea of further rate cuts. Nevertheless the fresh recent slowdown has probably shown that to be a misjudgement, igniting a new discussion on the direction of interest rates in 2015. So far we’ve highlighted the factors driving arguments for further interest rate cuts, however there are certainly reasons why the argument is far from clear cut.
As a result of the recent cuts, individuals and businesses alike have never before been able to borrow and service their loans so cheaply. As demonstrated in the chart of household finances, interest paid as a ratio of household disposable income has fallen, at least theoretically, thus giving the consumer greater capacity to extend themselves financially. In addition, as illustrated in the chart of the 3 year swaps rate below, a recent rally in the Australian Bond market, and more particular the Swaps Market, has enabled banks to fund themselves and convert rates from floating to fixed (and vice versa), at the cheapest levels in history. This is important because these are the mechanisms used by the banks to price their mortgage offerings. In the process, this enables lenders to offer mortgages at all-time low rates without necessarily being prompted by a further RBA rate cut.
With housing markets around the country, in particular Sydney and Melbourne performing very strongly, the RBA will remain cautious throughout 2015 as they aim to avoid inflating a property bubble. It would seem from the RBA’s most recent statement that they aren’t overly alarmist, stating “Credit growth is moderate overall, but with a further pick-up in recent months in lending to investors in housing assets. Dwelling prices have continued to rise.” If house prices can remain subdued in 2015, then the chance of an interest rate cut in 2015 will increase.
Just like with the growth in the housing market, the economic growth rates of the states vary across the country. In the September quarter, Victoria, Queensland, South Australia and Western Australia all recorded negative growth, with New South Wales as the highest contributor. The disaggregation of growth across the states would be a point of concern for the RBA. There is no doubt that if each state had autonomy over their monetary policy, the majority of states with the exception NSW would be running significantly lower interest rates.
Another factor potentially standing in the way of an interest rate cut is the household saving rate. The household savings rate in Australia is still holding up at around 10 per cent of household disposable income, after rising strongly in the aftermath of the GFC. The lift in household wealth since the end of 2011 suggests that households have the potential to lift spending much further through reductions in the savings ratio and without needing to be enticed by further rate cuts. An instance where prevailing interest rates remain low and the savings rate high is often referred to as a ‘liquidity trap’. Typically a liquidity trap can erode the effectiveness of monetary policy. As consumers already have access to liquidity via the savings rate, they become less excited by the prospect of additional disposable income provided by an interest rate cut. For this reason the RBA may remain steadfast believing any further rate cut could be rendered useless.
In the last couple of months we have witnessed the start of the much anticipated fall in the Australian Dollar. The Australian dollar has fallen back towards levels that many would consider more appropriate. Even still, in the eyes of the RBA, it remains above the “estimate of fundamental value, particularly given the significant declines in key commodity prices in recent months”.
In time the falling dollar should help to reignite areas of the economy that have been struggling in recent years. An example of such an industry is the tourism industry. A boost to tourism flows directly through to sectors such as leisure, restaurants and hotels, all of which employ a large number of Australians. If the dollar continues to fall into 2015, there’s a chance the RBA may deem the declining exchange rate as a sufficient stimulus mechanism, leading them to resist the urge to reduce interest rates. In my opinion, the recent rapid decline in oil price will eventually be viewed auspiciously by the domestic and global markets. The oil multiplier should eventually flow through to help stimulate the global economy in 2015, particularly aiding those economies that are considered to be energy importers. Although Australia is a net energy exporter, there are still benefits to be had. Oil is obviously a key input for most businesses as well as the average consumer.
The Brent crude price in 2014 fell by more than 40 per cent to sit below $60 USD/BBL. Lower oil prices naturally translate into lower prices at the petrol bowser, boosting the disposable incomes of lower income workers, and leading to a welcome boost in consumer spending around the world. Such a sequence of events again will be considered by the RBA, possibly reducing the chance of a rate cut in 2015.
With all the above-mentioned in mind, I think it’ll be remiss of me to not offer a view as to the direction of interest rates in 2015. Despite the Terms of Trade beginning to correct, there is still a long way to go before it reaches the long term trend. If the terms of trade does continue to deteriorate as expected, then I believe the RBA will cut interest rates again in the first half of 2015. Traditionally the RBA doesn’t muck around when it comes the rate cuts, as after all, a cut of 25 pts has only a marginal impact on the economy anyway. For that reason I stick to my belief that we could be in store for 50 pts of interest rate cuts in 2015.
Michael Kodari is the CEO of KOSEC – Kodari Securities, www.kosec.com.au
