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RBA has more to do – how low will the cash rate go?

The need to boost the non-mining sectors of the economy as the mining boom fades at a time when the $A remains strong and fiscal cutbacks are intensifying means the RBA will have to cut interest rates further.

Post GFC caution has likely resulted in a reduction in the neutral level for bank lending rates, such that they are only just now starting to become stimulatory.

Our assessment remains that standard variable mortgage rates will need to fall to around 6 per cent, which implies that the official cash rate will need to fall to 2.5 per cent. We expect this to occur over the next six months, with the RBA cutting again next month by another 0.25 per cent.

Bank deposit rates will fall further, but the Australian share market is likely to be a key beneficiary as lower interest rates eventually boost housing activity & retailing.

Introduction

The Australian economic outlook has clearly deteriorated. Recognising this, the RBA has resumed interest rate cuts. Our assessment remains that the RBA has more work to do. But how low will rates go? What does it mean for investors?

The growth outlook

While economic growth in Australia has been reasonable of late, eg 3.7 per cent over the year to the June quarter, and well above that in comparable countries, our assessment is that storm clouds are brewing and that growth will slow to around 2.5 per cent over the year ahead, which is well below trend growth of around 3-3.25 per cent. The basic issue is that the mining boom is losing momentum at a time when the non-mining part of the economy is weak and fiscal austerity is intensifying:

  • Mining investment looks like it will peak next year. For the first time in years the June quarter survey of mining investment intentions did not show an upgrade in plans for the current financial year and projects under consideration have peaked. Falling mining sector profits suggests mining projects remain at risk. Investment outside the mining sector remains weak. This all points to a sharp slowing in business investment in 2013-14.

Source: Thomson Reuters, AMP Capital

  • At the same time, a sharp fall in Australia’s terms of trade is leading to a loss of national income which will also slow spending and growth. Stronger mining exports, ie stage 3 of the mining boom, will provide a boost to growth but this may not become evident until around 2014-15.

Source: Bloomberg, AMP Capital

  • This is all occurring at a time when non-mining indicators for the economy remain soft. Consumer and business confidence are sub-par, despite being almost a year into an interest rate cutting cycle.
  • Retail sales remain subdued, with Government handouts providing a brief boost in May and June, only to see softness return again. Annual retail sales growth is stuck in a range around 3 per cent. With confidence remaining sub-par, job insecurity running high and interest rates still too high its hard to see a strong pick up yet. Ongoing consumer caution in terms of attitudes towards debt and spending is highlighted by the next chart showing a much higher proportion Australians compared to the pre GFC period continuing to nominate paying down debt as the wisest place for savings.

Source: Westpac/Melbourne Institute, AMP Capital

  • While housing related indicators have probably bottomed on average, taken separately they present a very mixed picture with house prices up over the past few months, housing finance, housing credit and building approvals looking like they have bottomed but remaining soft and new home sales still falling. The fact that there has only been such a tentative response to lower mortgage rates indicates that mortgage rates have not fallen enough.
  • The jobs market remains soft with weak job vacancies pointing to soft employment and rising unemployment ahead. Whereas anecdotal news of job layoffs was previously limited to the non-mining sectors of the economy, it has now spread to the mining sector. This is likely fuelling ongoing household caution, acting to constrain retail sales and housing demand.

The bottom line is that with the mining boom likely fading over the year ahead, the non-mining part of the economy – notably retailing, housing & non-mining construction, manufacturing, tourism, etc – needs to pick up to fill the breach. The good news is that the RBA appears to recognise this. The bad news is that its task is being made hard by two factors:

  • First the continuing strength in the Australian dollar, presumably on the back of safe haven buying out of the US dollar and euro in the face of QE3 etc and its high correlation to the US share market as part of a “risk on/risk off” trade, which has meant that it has so far not provided the shock absorber to falling commodity prices that it usually does.
  • Second, having seen the budget handouts around mid year, fiscal tightening will now kick in at the Federal level and may even intensify if the Government seeks to retain its projected surplus for the current financial year. At the same time various states are announcing budget cutbacks, including job cuts.

In order to offset these forces and ensure that non-mining demand strengthens sufficiently interest rates will have to fall further.

The cash rate is low but lending rates are not

While the RBA has cut the official cash rate to within 0.25 per cent of its GFC low, because of bank funding issues lending rates are still well above their 2009 lows.

Basically banks have been seeking to reduce their reliance on non-deposit funding which has proved unreliable since the GFC and to do this they have had to offer higher deposit rates relative to the cash rate than would normally be the case. This has resulted in higher lending rates relative to the cash rate than was the case pre GFC. Banks have done well to raise the proportion of their funding they get from deposits to 53 per cent from around 40% pre GFC, but they still lag behind banks other major countries and tougher capital requirements mean they are under pressure to do more.

The standard variable mortgage rate at around 6.6%, assuming banks pass on around 0.2 per cent of the RBA’s latest 0.25 per cent rate cut, is below its long term average of 7.25 per cent. But normally rates need to fall well below their long term average to be confident of stronger growth. And in an environment of household and business caution post GFC the neutral rate has likely fallen, probably to around 6.75 per cent which is shown as the “new neutral” level in the next chart. This would suggest that current mortgage rate levels are only just starting to become stimulatory.

In the last two easing cycles the mortgage rate had to fall to around 6.05 per cent in 2002 and to 5.8 per cent in 2009. Given the fall in the likely neutral level for mortgage rates and the current headwinds coming in the form of the strong $A and fiscal tightening, mortgage rates will at least need to fall to these lows. Given the ongoing issues with bank funding, to achieve a circa 6 per cent mortgage rate the cash rate will need to fall to around 2.5 per cent.

Chart assumes average large bank standard variable mortgage rates fall to 6.6 per cent following latest RBA rate cut.
Source: RBA, AMP Capital

Our assessment is that the RBA is coming around to this view. As such we expect another 0.25 per cent cash rate cut next month on Melbourne Cup day, followed by a cut to 2.5 per cent in the March quarter next year.

Based on the assumption that the RBA cuts interest rates further, the global economy stabilizes and growth in China stabilizes around 7.5 per cent next year then Australian economic growth should pick up again by the end of next year.

Implications for investors

There are a number of implications for investors.

  • Interest rates need to fall a lot further. This means that term deposit rates are likely to fall further in the years ahead, even though the size of the decline will lag that of the official cash rate for bank funding reasons. As a result the attractiveness of bank deposits for investors will continue to deteriorate.

Source; RBA, Bloomberg, AMP Capital

  • While record low bond yields mean bonds are poor value for long term investors, yields will likely remain lowish as the RBA cuts interest rates. However, if foreign investors start to panic about Australia, international bonds will do better than Australian bonds.
  • Australian shares should benefit from interest rate cuts and cheap valuations. As such we continue to see the Australian share market being higher by year end. Key sectors likely to benefit from lower rates are retailers, building materials and home builders.
  • Declining interest rates in Australia will take pressure off the Australian dollar. However, falls are likely to be constrained by quantitative easing in the US and central bank buying. Overall we see the $A stuck in a range around $US0.95 to $US1.10. The best has likely been seen for the $A.

Published: Friday, October 05, 2012

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Europe and the USA get thumbs up

There are three reasons why stocks could go up or down in the final quarter of the year — a quarter historically prone to a nice rise for stock markets. Those three are Europe, the USA and China and two of these key determinants for share prices got it right overnight.

As a consequence, the Dow was up 80.75 points or 0.6 per cent to 13,575.36 while the S&P 500 index added 10.41 points or 0.72 per cent to finish at 1461.4.

The markets are doing well despite technical readings suggesting current levels of key indexes could be tested. The charts can be baffled by left-field events and we got one from Europe with the European Central Bank (ECB) boss, Mario Draghi, saying the bond-buying program had reduced borrowing costs of the likes of Italy and Spain and that the Bank is ready to move when it has to. This was a strong hint that when Spain asks for its bailout assistance, the ECB is ready to help. The markets liked this as it reduced fears about Europe and any future mess, but the response would be better if Spain gave in and faced up to its predicament.

The ECB kept interest rates at 0.75 per cent, which means it still has three shots left in its locker, which most hope won’t have to be fired.

On Wall Street

Meanwhile the Yanks liked Mitt Romney’s stronger than expected showing in the first presidential debates and while factory orders showed a big drop, it was less than experts tipped.

Also jobless claims as well as planned layoff data, which was at a 20-month low, added to a slowly improving economic picture in the USA. The Yanks could really do with a great jobs number tomorrow and if it happens that way, stocks could soar. However, the opposite could be the case.

The key number for tomorrow is 113,000 — that’s what the experts have speculated about — and so if it’s better, markets could get even more positive.

Helping the bulls believe in a US recovery was BlackRock’s CEO — Larry Fink — who told CNBC that the US fundamentals were “quite strong” and the housing sector was “inching closer to a compete rebound”.

Though he thinks there’s a year to go for a “full rebound”, this positivity from someone who runs the world’s greatest funds business, effectively managing more money than the Federal Reserve, as CNBC pointed out, is a nice prop for anyone who believes the worst of the GFC issues are gradually getting behind us. We’re not there yet, but it’s an improving picture and that’s why stocks are up.

Doll’s view

Fink’s head of equities, Bob Doll, thinks stocks will have another year of gains over 10 per cent next year and he has proved to be a good predictor of share price movements.

However, he thinks the ECB has got it right but worries about European politicians.

On the fiscal cliff, he says it’s a big negative holding back US companies but if it gets resolved he sees a “huge rally”. But obviously, if Fink is right, and I think he is, if this fiscal cliff proves to be a big problem for Congress to settle, then stocks could be trashed.

In summary, both Europe and the USA are giving me positive vibes — at least for the moment — but the new question mark is China and whether it can start producing something that adds to my positive picture.

I will be watching the Shanghai Composite index and sweating on some overdue rises.

Importantinformation:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Published: Friday, October 05, 2012

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