Over the last week I have been visiting real money managers and hedge funds in London.
I have been emphasising the following key messages:
- Australia’s mining boom is slowing more sharply than had been suspected, posing a growth challenge for the Australian economy.
- Business and consumer confidence has failed to respond to the Reserve Bank’s rate cuts with the deleveraging sentiment dominating spending and investment/employment decisions.
- Inflation pressures have eased in Australia with companies lacking pricing power and soft labour markets easing wage pressures.
- The recent fall in the Australian dollar has largely resulted from market fears of an imminent tapering of securities purchases by the US Federal Reserve, sparking a boost to the US dollar and a correction to the 'over valued' currencies, such as the Australian dollar. This correction is likely to be phased out over coming months as US data disappoints and markets push back the timing of the tapering process.
- The Fed sees the fall in the US labour market participation rate as cyclical rather than structural. Any improvement in US growth is likely to see a rise in the participation rate, thereby slowing the fall in the unemployment rate and ensuring that QE policy holds well into 2014.
- Reserve Bank concerns around a resurgence of inflationary pressures are likely to be allayed with a stronger Australian dollar and ongoing evidence of a lack of pricing power for Australian firms.
- Concerns around a housing bubble in the Australian economy are overdone. Regional disparities in underlying economies, ongoing deleveraging by the household sector and a lack of participation by First Home Buyers will constrain price pressures.
- Global growth is likely to ease in 2014 as China slows, Europe remains in recession and US consumers are cautious in light of limited improvements in the US labour market.
- European risks are still apparent. Spain is currently rated at BBB, on negative watch. One more downgrade would see Spain go sub investment grade necessitating widespread selling by investors who cannot hold sub investment grade paper. Such a development is likely to see a marked downgrade in global growth and extensive financial instability.
- Under these circumstances the Reserve Bank will be required to ease rates by 75 basis points over the course of the next year. The next cut is expected in August, in response to a benign inflation report and ongoing evidence of limited traction from recent rate cuts. There is a high degree of confidence amongst the customers around three key big picture issues:
1. US economy will surprise on the upside
2. Australian dollar is unlikely to recover and may fall further
3. European risks are much diminished
Of course those views are directly opposed to the messages I have been delivering during the meetings. It has made for interesting discussions. The issues are also inter-related. If the US does surprise on the upside then the Fed tapering will be accelerated, bringing down the 'QE over valuation' of the Australian dollar. Our view, of course, is that US data will surprise on the downside, arguments around the structural fall in the participation rate are overdone (it is still weak demand that has lowered the participation rate) and the sharp fall in the US unemployment rate has been exaggerated by the fall in the participation rate.
In fact, my rejoinder in those Australian dollar discussions is that the fall in the Australian dollar has already priced in the tapering. If the tapering timing (next few Fed meetings) gets pushed back then that will lead to a 'bounce' in the Australian dollar, especially given the prevailing negative sentiment and associated short positioning. The optimism around the US economy is largely related to the debt/balance sheet debates – with some suggesting corporates and households are in good shape, and that the government's budget position is improving.
Our view is that household leverage is still too high and it is too early to declare victory on government debt, particularly given our growth outlook. We expect income growth to be relatively soft – wages and jobs are still looking weak. Given this, and without households supplementing demand with leverage, spending will remain subdued.
Of course, others who have argued for the Australian dollar to be overvalued 'for years' are finally getting some encouragement. While we see 'fair value' around US 93 cents these people see it 'sub 80' on a basis. We do agree that the path of the Australian dollar will impact Reserve Bank policy. Our call for the central bank to push rates to 2.0 per cent will be impacted by the Australian dollar profile. A marked fall in the currency would preclude aggressive cuts in the near term as the Reserve Bank pauses to assess the impact on inflation, growth and confidence of a lower Australian dollar.
That sentiment seems to be behind the Reserve Bank's more cautious assessment of the inflation outlook in the governor's latest statement prompting us to confirm our August cut forecast.
However, this statement preceded the surprisingly weak March quarter GDP print encouraging speculation of a July move. Given our prior call for a much lower cash rate (2.0 per cent target) we do not dismiss the July possibility, especially if our expectation of a retracement of Australian dollar back towards parity develops over the next few weeks.
Finally, discussions around European risks were interesting. It was generally confirmed that global fund managers (who have 7 per cent of assets invested in Spain/Italy) and European fund managers (who have around 20 per cent of assets invested in Spain/Italy) would be forced to sell in the event of a downgrade. It was also recognised that most managers have been forced to hold Spain due to a risk of underperformance.
The optimists argue that: the Spanish data is improving (second derivative); the ECB has arranged to buy Spanish paper; and that the ratings agencies would not dare downgrade Spain due to potential financial market disruptions. Others were much less sanguine, recognising the potential risks but claiming that competitive forces would not allow them to disinvest.
Others highlighted Italian elections and structural decay in France as the more important risks to the European story.
Overall a fascinating trip, highlighting how our markets are so intricately linked to the big global issues. I remain very comfortable with our key views and will enjoy watching our story unfold from the safety of my holiday abode!
Bill Evans, is Westpac’s chief economist.
