August Economic Update – “Geopolitical tensions take center stage”

Geopolitical issues dominated the headlines this month.  In the Strait of Hormuz, the world’s busiest transit lane for seaborne oil, tensions escalated following the seizure of a tanker under a British flag by Iran in July and the downing of an Iranian drone by the US (Figure 1).  Protests in Hong Kong initially in response to a proposed extradition law allowing alleged offenders to be sent and tried in mainland China continue to escalate into broader pro-democracy rallies. In the Eurozone Boris Johnson won the conservative party leadership and pledged to exit the EU with or without a deal on October 31.  On August 1 the US China trade war took another worrying step with the US announcing a 10% tariff on the remaining $300 billion worth of Chinese goods from September 1. China responded by devaluing its currency only to be labelled a currency manipulator by the USA.  New tensions emerged this month between Japan and South Korea (albeit historically based) and are also being played out via trade restrictions.

Figure 1  (Staff, 2019) 1

It is both the number of flash points and the limited progress on their resolution, particularly the US China trade war and Brexit, that is concerning.  Risks to the downside on growth and earnings have increased this month and the International Monetary Fund (IMF) lowered global growth forecasts.  In the real economy these things matter.  They impact business and consumer confidence which in turn slows business investment and consumer spending.  This flows through to earnings for companies supplying goods and services to businesses and consumers.  Unsurprisingly, volatility returned to markets in the first week of August post the latest escalation in the China/US trade war.  The sharp selloff followed record highs in both the Australian and US market in July.  Should geopolitical tensions remain elevated further volatility can be expected.

The US capitulated this month and lowered interest rates.  The trade war is now turning into a currency war further fuelling the race to the bottom on interest rates. On August 1 the US Federal Reserve cut interest rates by 0.25% to a range of 2.0-2.25% for the first time in more than a decade reversing the upward trend in rates that began in December 2015 and ended in May 2019.  The narrative was consistent with last month.  The US is in good shape economically with the rate cute designed to insure against the downside risks from weakening global growth and trade.  US rates remain relatively high in a global context and further cuts at this point seem likely.  Several other nations followed suit announcing cuts including India, Thailand and New Zealand. 

Following cuts in June and July the Reserve Bank of Australia kept the cash rate on hold at 1% with a similar narrative to last month. Australia’s 10-year bond rate reached an historic low of 1%. Commentary by Philip Lowe Governor of the RBA indicated a sense of frustration at the reliance by government on monetary policy suggesting the government needs to do more in other areas such as infrastructure spending, taxation and productivity enhancing reforms and be ready with a broader policy toolkit if required.

Domestically economic conditions on balance remained unchanged with the positives offsetting the negatives.  The main negative indicators for the month were dwelling approvals and a decline in services sector activity.  The main positives included a record trade surplus, the unemployment rate staying unchanged at 5.2% and a slight uptick in inflation.

The Australian Industry Group performance of services index (PSI) fell sharply in July to its lowest level since November 2004 and is likely to reflect a further softening in consumer spending and particularly discretionary spending in areas such as entertainment and recreation.  Dwelling approvals continued to slide with private sector housing approvals down 15% and other dwellings (ie apartments, units, townhouses etc) down 29.0% for the year to June 2019 with the monthly trend for apartments still firmly to the downside.  Residential dwelling construction has now joined retail and agriculture as sectors that are experiencing recessionary conditions.

Conversely, and in sharp contrast to global trade trends our export sector is booming.  The ABS trade data released on August 6 showed we had a record trade surplus for the FY 2019 of $49.9billion and a record monthly trade surplus of just over $8billion.  The mining sector is doing most of the heavy lifting with rural exports declining due to the ongoing drought.  The total value of exports of goods and services increased by 16.5% for the year to June, and while some factors such as elevated iron ore prices due to global supply issues will abate, the underlying trend for exports remains very positive.  This is a major boost to our national income.  Our exchange rate is now at 10-year lows providing further support for the export outlook.

As noted in recent updates the main cause for optimism both domestically and globally remains the employment data.  In Australia the latest unemployment rate remained unchanged in June at 5.2% and the US unemployment rate for July also remained unchanged at 3.7%.  The latest unemployment data for the Eurozone fell slightly.  Despite the escalating risks, global growth is still estimated to be running at around 2.25% and while now below trend, growth remains above recessionary levels and seemingly at levels high enough to absorb more workers.  

On another positive note, the Australian Bureau of Statistics released its biennial Household Income and Wealth report for the 2017-18 year in July.  Average Household wealth in Australia passed the AUD $1million mark in 2018 up 37% for the decade.  We may bemoan the lack of wages growth since the GFC but increases in net wealth and income growth via capital gains across most asset classes inside and outside superannuation has been impressive.  Australian households remain the second wealthiest in the world after Switzerland.  Importantly and contrary to popular opinion the survey also showed that income equality has been relatively stable over the last five years.  We are indeed a nation of aspirational asset owners. 

While we are concerned about the rising geopolitical tensions, they are yet to translate into any economic indicators that would suggest an imminent global recession.  As interest rate policy swings back to an easing stance and investors take their cue to increase exposure to risk assets such as high-growth shares, the risks to the downside increase. 

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