The fallout from Australia’s incredibly weak March quarter inflation report continues to ripple across financial markets.
Following its release on April 27, the Reserve Bank cut official interest rates to 1.75%, the lowest level on record, and followed that up with a series of downgrades to its inflation forecasts in the years ahead, indicating that further rate cuts are likely.
Markets certainly think that’s going to happen, predicting that there’ll be at least one, maybe two, rate cuts before the year is out.
As a consequence of the change in market pricing higher-yielding stocks on the ASX 200 have been rallying while the Australian dollar has fallen with a thud, dropping below the 73 cent level for the first time since March 3 in Asian trade on Friday.
Now, like markets, economists have been busy revising their rate forecasts, seemingly making more aggressive calls each and every day in a bid to outdo each other.
It’s been a remarkable turn of events, particularly as most had the next move in interest rates as higher on May 26, the day before the inflation report was released.
As my colleague Greg McKenna wrote today, it’s seemingly a race to the bottom when it comes to the outlook for interest rates.
Well, the race looks like it may be over already.
Vimal Gor, BT Financial Management’s Sydney-based head of income and fixed interest, is one analyst who thinks that interest rates are going much lower, writing in the group’s April newsletter “that the RBA will be easing to 1%” with “a move to 0% or lower a distinct possibility”.
Not one rate cut or two, but everything in the arsenal of traditional monetary, with a move into negative rates or asset purchases also a possibility.
Along with the benign inflation outlook, now commonly cited as a reason why many expect rates will fall further, Gor suggests that there are a number of factors that could lead to an even steeper, more aggressive easing cycle from the RBA in the years ahead.
For one, he believes the Q4 2015 GDP reported indicated a “lack of sustainability”, indicating that “future growth is unlikely to be above the RBA’s forecasts for much longer”.
“Net trade was still a big contributor (+1%) to the GDP figure which is mostly made up of commodity exports. Using iron ore exports as a proxy, 2015 represented a huge uplift in volumes exported over 2014,” he wrote. “With steel production in China levelling out it is tough to see how it can grow indefinitely at this rate, so a large part of this export growth will have to vanish.”
Gor also suggests that markets should be paying more attention to the value of Australia’s commodity exports, rather than price-adjusted volumes as used in the GDP report.
“This volume metric is mostly academic though, as these volume increases do very little in terms of Australians seeing income growth, so the total value of exports is a more important metric,” he notes. “Because of falling prices, total value has decreased substantially over the two years even though volumes are up.”
He also casts doubt on the ability of residential construction to make any meaningful dent in helping to offset the unwinding mining investment capital expenditure boom, something that he describes as having a “lot further to go”.
“The GDP numbers over the last few years haven’t been as bad as expected because housing construction has really stepped up to offset a large amount of mining capex, but the outlook here is far from rosy,” says Gor.
In particular, he is concerned about a potential apartment glut forming, suggesting “the key is how the upcoming supply of apartments is taken down in the next 3 years”.
“If it progresses poorly then we could be in for negative contributions in this sector,” says Gor. “If we assume no further growth in this sector (i.e. we keep on building at the same rate as we are) then that is another 0.5% of GDP growth that could disappear.”
The chart below, supplied by Gor, reveals how residential construction has helped to offset private business capital expenditure in recent years.
In combination, along with weak wages growth and high levels of private sector indebtedness, Gor believes it could see Australian economic growth decelerate to uncomfortably low levels.
“This takes us to roughly 1.5%-2% GDP growth per year after taking away unsustainable sources. This remains a far more realistic target for Australia with domestic demand growth tracking at about 1%,” he suggests.
“High debt will make further gains from consumption unlikely so we need to tap other sources, such as exports or business investment, to generate growth.”
He also notes that “the government is highly unlikely to step up spending from here with the loss of our AAA rating on the cards.”
Given continued disinflationary forces and concerns that Gol has in relation to the domestic economy, it’s clear why he has made such an aggressive call on interest rates.
However, he’s not alone in suggesting that Australia risks being dragged into the zero interest rate malaise seen in many other highly indebted western nations over recent years.
In late April Warren Hogan, the former chief economist at ANZ, noted that some of the low interest rate and wages outcomes in the economy in recent years may be permanent rather than cyclical, suggesting that the real risk to the medium term inflation outlook is if it falls too far, threatening deflation.
“It will be a negative shock to economic growth that would cause inflation to fall further,” wrote Hogan. “In an environment of weak economic activity, deflation can do tremendous damage to a heavily indebted economy. This deflation risk must be addressed in advance.”
Although Hogan is not as aggressive as Gor in terms of his view on the outlook for interest rates, he suggests that “best way to ward off deflation is to keep monetary conditions accommodative”.
“Unless the fortunes of the global economy turn around quickly, the most likely outcome is an RBA cash rate at or below 1% by the end of 2017.”
While both calls are well below current market and economist expectations, if there’s one thing that we’ve learnt in recent years, not only in Australia but in other major nations, it’s that what was once considered impossible can quickly turn to a possibility, and eventually reality, in seemingly the blink of an eye.
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