Royston Capital Economic Update
July edition 2018, By Chris Boag
The global economic expansion continues to truck along although there are conflicting signs of strength and weakness. The expansion has become more dependent on the US economy which should be enough to support further equity gains. Rising political risks, particularly a trade war, is now the single biggest risk to continuing global economic growth along with the prospect of rising inflation and interest rates. In Australia, signs are promising as the pace of business activity picks up.
US GDP growth continues to strengthen each quarter with US household spending lifting sharply in April and May. The long recovery is showing signs of being late stage with little spare capacity. As labour markets tighten the cost of labour will be id higher, leading to higher inflation. Charts for headline inflation and labour markets confirm this. Adding to this, large tax cuts are coming into play at a time when household spending is picking up leading us to believe that US economic capacity is set to become more strained. The US Fed indicated 2 more interest rate hikes this year and another 3 in 2019. This will be needed when you consider increased government spending will add to growth (and inflation) but eventually the international trade war could weigh on US economic growth. The risk of higher inflation looks greater than any other material set back and the US Fed may need to be more aggressive in hiking interest rates.
China looks to be weakening along with some other large emerging economies who are struggling with higher borrowing costs from US Dollar denominated debt. There were some upside surprises in the data for May, particularly international trade, but this is unlikely to continue as US import tariffs start to take effect. The Chinese would like to see more input to GDP growth from consumption, however this is proving to be elusive. The poor welfare safety net encourages high savings levels and will take some time to address.
China is trying to defend its currency after the steepest drop since the Nineties. The Renminbi has plummeted and authorities have issued a plea for calm. Local stock markets have also been falling. An escalation of the trade war with the US could add to the risk. China has tightened credit controls to stem the flow of capital. As much as China will defend the currency, a currency war with the US would seem out of the question and likely to backfire. Unlike the crisis in 2015-16, the US will continue to raise interest rates pushing the US dollar higher making it more difficult for China.
Broadly the world economy is enjoying synchronised business expansion. Virtually every sector, in the HIS Markit Purchasing Managers Index (PMI), is growing except for mining. The strength of the US economy could translate into substantial increases to US corporate profits. The risk to this remains confrontational protectionist policies. European growth continues to moderate and in Italy they have elected an anti-European government, but this does not seem to be deterring the ECB from moving towards its first interest rate hike in the cycle.
Australia is again the odd-man-out. Our GDP growth rate remains one of the strongest in the world at 3.1% year on year. The RBA is choosing to keep its powder dry keeping the official cash rate at 1.5% for record 23 months in row. This is exceptionally accommodating monetary policy because with inflation 1.9% nominal GDP is at 5%! The RBA continues to site high household debt and low wages growth…… avoiding a housing bust.
Regardless of the RBA’s position, GDP is set to be strong again at the next quarterly reading. Retail trade continues to firm, and jobs growth is also robust. Wages growth has only been edging up, but signs are indicating that this could change rapidly and cause wages growth to accelerate. The participation rate appears to have peaked, job vacancies are increasing and there is mounting evidence that skilled workers are hard to find. The trend for most economists has been to continue to push out their rate hike expectation every month with Westpac Bank now forecasting the first rate rise in the cycle to be in 2020.
Should the labour market tighten further as it appears it will, there is a risk that the RBA surprises with an earlier then anticipated hike. Our house view was that rates should never have gone below 2.0%. The two rate cuts to 1.5% have contributed to a hot property market and significant household debt. This is the trap that Dr Philip Lowe has entered. As pressures build up in the economy the RBA may need to react harshly with steep rises in the official cash rate to control inflation. This could lead to a recession with stubbornly high inflation and high interest rates……not a desirable scenario. I doubt that the RBA can hold out much longer in the face on continued strength in the economic readings and we expect a rate rise sooner than later.
The global economic expansion continues, supported by the strength of the US economy. The Chinese economy is growing but the authorities are struggling to transition to an internally driven consumer economy due to the lack of a quality social welfare support system. Financial conditions remain expansionary and supportive for equity valuations, but this support is slowly being removed, most notably in the US. The outlook for the labour market in Australian is strong, despite this, inflation is expected to remain low for some time reflecting current expectations for wages growth. Wages growth could surprise on the upside causing the RBA to move ahead of economists’ expectations. For now, the low level of interest rates continues to support the Australian economy.
This information was prepared by Royston Capital, ABN 98 158 028 392 AFSL 438262. The information in this presentation is current as at 6 July 2018 unless otherwise stated.
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Sources: Alexander Funds Management (Steve Roberts); RBA, Morningstar Adviser Research. https://www.smh.com.au/business/the-economy/financial-panic-likely-china-calls-for-calm-as-clouds-turn-darker-20180704-p4zpcc.html by Ambrose Evans-Pritchard; https://www.afr.com/news/economy/monetary-policy/philip-lowe-delivers-bis-recession-warning-on-low-rate-risks-20180705-h12bc5 by Jacob Greber.