The Week in Review: March 23, 2018

What's the risk of a credit crunch in Australia?

Investment markets and key developments over the past week

  • Share markets fell again over the last week not helped initially by tech stocks (partly due to a privacy breach at Facebook) and then later in the week after President Trump proposed around $US50bn of tariffs on imports from China fuelling renewed fears of a trade war. Further changes in Trump's team with John Bolton replacing HR McMaster as National Security Adviser were arguably also seen as adding to the risk of a more hawkish/less market friendly US foreign policy. Reflecting safe haven demand, bond yields generally fell. Commodity prices were mixed though with oil and gold up but copper and iron ore down. The $A fell but only slightly.
  • Trump proposes around $50bn of tariffs on imports from China along with proposed restrictions on Chinese investment in the US and China threatens to hit back with a tariff on $US3bn on imports from the US. It looks scary and the risk of a trade war has escalated, but it's not necessarily on the way. Trumps latest move was well flagged (although share markets didn't seem to think so!) and flows from a US investigation into the alleged theft of US intellectual property by China. However, while it looks messy there are grounds for optimism that an all-out trade war between the two countries will be avoided.
  • First, so far the US tariffs on China are really just a proposal – they have not yet been implemented. The goods affected have yet to be worked out and after that there will a period of public comment, so it could take up to 45 days before they are implemented. So, there is plenty of scope for US industry to challenge them and for a deal with China. In fact, Trump's aim looks to be a negotiation with China so consistent with The Art of the Deal he is going in hard up front with the aim of extracting something more acceptable to both. Just as we saw with his steel and aluminium tariffs, the initial announcement that seemed to apply to all countries has since been softened to exempt several countries including the EU, Australia, Brazil and Korea. And despite China's planned retaliation (which at $US3bn actually looks quite modest!), it looks open to negotiation with Chinese Premier Li a few days ago acknowledging that China's trade surplus is unsustainable, talking of tariff cuts and pledging to respect US intellectual property and playing down concerns that China would dump US treasuries. It's arguably in China's interest to avoid retaliation and try to come off as the good guy. Ultimately despite what he says in his tweets, a full-blown trade war is not in Trump's best interest either as it will mean higher prices in Walmart and hits to US exports like Harleys, Jack Daniels, pork and fruit that will not go down well with his base and he likes to see a higher, not lower, share market. As a result, a negotiated solution with China looks to be the more likely outcome. That said trade is likely to be an ongoing issue causing share market volatility in the run up to the US mid-term elections with Trump again referring to more tariffs. So while we may not see a full on trade war, we won't see trade peace either.
  • Out of interest $US50bn would be 10 per cent of Chinese exports to the US and 2 per cent of its global exports. Australia is vulnerable to a US/China trade war as 33 per cent of our exports go to China (mostly raw materials) with some turned into goods that go to US. The impact on Australia may be less than feared if the US tariffs, as flagged, focus on aerospace, IT and machinery. That said it's in Australia's interest to do the best it can to work with both our partners to help head off any trade war.
  • Fed more upbeat and we continue to expect four rate hikes this year. Another 0.25 per cent rate hike was no surprise and supporting this the Fed noted that the economic outlook has strengthened and revised up its growth and inflation forecasts and its expected interest rate increases over the next three years. While the median Fed official still sees three hikes this year it will only take one more official to move up to see the median move to four which is likely to happen in June. US monetary policy is a long way from being tight and so is a long way from threatening US growth, but it's still likely to be a source of market volatility this year and a constraint on share market returns. For Australia, the RBA is a long way from following the Fed thanks to there being much more spare capacity in the Australian labour market and hence much weaker wages growth and so we don't see the RBA starting to raise rates until early next year. So while rising US interest rates risk some upwards pressure on Australian bank funding costs and hence maybe on fixed mortgage rates, for owner occupier variable rates this is likely to be offset by continuing low official interest rates in Australia. For the $A, the now negative interest rate gap versus the US which is likely to blow out to near 1 per cent by year end, points to downwards pressure on the $A.

Major global economic events and implications

  • US business conditions PMIs fell this month but remained in the solid range they have been in for the last 18 months and existing home sales were strong. While the US Congress appears to be close to a funding deal it may not reach agreement in time to head off another Government shutdown from Friday night so another short-term funding extension may occur. Neither side wants to take the blame for another shutdown.
  • Eurozone business conditions PMIs slipped in March, possibly suggestive of a dampening impact from trade war fears and from the stronger Euro. That said they remain strong and consumer sentiment remained unchanged at a high level.
  • Japan's manufacturing conditions PMI also slipped in March but remain relatively high. Meanwhile core inflation edged up to 0.5 per cent year on year in February (from 0.4 per cent) as expected, but it's still a long way from the 2 per cent target so the Bank of Japan's easy money program still has a long way to go.
  • China raises interest rates, but not enough to get excited. The PBOC increased its key 7-day money market rate by 5bp to 2.55 per cent. It's likely part of the deleveraging effort and also to contain capital outflows after the latest Fed hike, but it's hard to get excited as it was only 5bps! Meanwhile, China's moves to reorganise and streamline government departments and regulators, a new leadership team of four vice-premiers and the appointment of former PBOC deputy governor Yi Gang as governor are all consistent with pursuing President Xi Jinping's reform agenda. Yi Gang's appointment in particular signals continuing support for retiring PBOC Governor Zhou's policies to open the economy and modernise monetary policy.  

Australian economic events and implications

  • In Australia, jobs growth remained strong in February but it's just keeping up with labour force growth. The good news is that employment is up a very strong 3.5 per cent over the last year, full time jobs are up by 4 per cent and leading labour market indicators like job vacancies and hiring plans point to continued strength. Against this, unemployment is trending sideways as rising participation and strong population growth boost the labour force and worker underutilisation remains very high at just below 14 per cent. All of which points to wages growth remaining low and the RBA staying on hold.
  • Which is what the minutes from the RBA's last meeting implied it is likely to do. However, there were two things of interest in the minutes. First, the RBA appears to have paved the way for a downgrade to its growth forecasts for this year indicating that it expects growth to be above potential which at around 2.75 per cent or so is a lower hurdle than its previous description of above 3 per cent. Second, the RBA is not too fussed by the reset of interest only to principle and interest loans noting that the schedule of resets will be little different from recent years and while it would be significant for individual households the aggregate impact on consumer spending is likely to be small.
  • Meanwhile, Australian population growth remains strong at 1.6 per cent year on year in the September quarter last year. This was led by Victoria at 2.4 per centyoy helping explain the resilience of the Melbourne property market, the ACT at 1.8 per centyoy, Queensland at 1.7 per centyoy (likely to be next to see faster property prices?), NSW at 1.6 per centyoy, WA at 0.9 per centyoy, Tasmania at 0.7 per centyoy and NT flat. Clearly this is a boost to overall economic growth (albeit it's per capita growth that counts and we aren't doing so well on that front) and to underlying housing demand which combined with a failure to boost housing supply until recently to match underlying demand explains why housing is so poorly affordable in many Australian cities.
  • What's the risk of a Banking Royal Commission induced credit crunch? We are only two weeks into the Royal Commission, but it seems a real risk around the issues of lax lending standards is that banks move to a far more rigorous assessment of applications for loans – in terms of each applicant's income, expenses, assets and other debts. This is most unlikely to cause a full-on credit crunch, but the end result could be much tougher lending standards and a slowing in credit growth. It's early days yet but it's worth keeping an eye on. It could serve to further delay any move to higher interest rates by the RBA, into say 2020.

Shane Oliver is the Chief Economist at AMP Capital

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