• Alexander Funds Management

Upside Risk

For the first time in more than a year, we see greater upside than downside risk to Australia’s economic growth prospects, measured by the average of GDP growth forecasts by all government and private sector analysts. Part of the change in our thinking is the result of too much downgrading to growth forecasts by analysts since mid-2018 from near 3% real GDP growth forecast for 2019 and 2020 to sub 2.5% currently. A more important part of the change is the very big policy stimulus coming through – the two back-to-back RBA cash rate cuts; the easing of the interest rate benchmark used by banks to assess ability to meet home loan repayments; and the lump sum tax cut for low and middle income taxpayers in their 2018-19 tax returns – at a time when conditions have already started to improve for the household sector.

Greater upside risk to Australian economic growth prospects increases the likelihood that employment growth will stay strong and of the unemployment rate falling to 4.5% or lower in 2020. In turn, pockets of labour shortage are likely to become more common next year and annual wages growth should accelerate from current 2.3% y-o-y pace. There is a greater chance that annual inflation will be in 2-3% range in 2020, rather than in 1-2% range where it has languished this year so far.

If our view that there is more upside than downside risk to growth prospects gains more traction among analysts, it is reasonable to expect that views about interest rates will change as well. Many analysts expect the RBA to cut the cash rate below the record low 1.0% set last week. This lower cash rate view already seems dubious. It is likely to change to an extended period of cash rate stability, with the next move ,when it comes eventually, more likely to be a hike rather than a cut. Australian bond yields would start to rise as well, although probably not by much as it is still unlikely that the prospective lift in annual inflation in 2020 will be large.

Many analysts will take some convincing that Australia’s growth prospects are improving. The most recent hard economic evidence is still mostly leaning towards real GDP growth losing momentum beset by factors weighing down household spending – slow income growth; high household debt; and a hit to household wealth from falling house prices since mid-2017. There are, however, some signs already showing of improving conditions for households.

Household wealth in aggregate stopped falling in Q1 2019 when it rose by 0.2% q-o-q to $10,242.6 billion. Housing real estate assets were still falling in value in Q1, but the fall was more than offset by rising value of financial assets. Household wealth per person, however, still fell in Q1 but the fall in the quarter of $1,511.9 to $404,566 was much less than the $9,992.7 fall recorded in Q4 2018. When the Q2 2019 household wealth report is released in mid-September it is likely to show much stronger evidence of improvement with household wealth in aggregate rising more strongly than the 0.2% increase reported in Q1. More importantly, it will also show a rise in household wealth per head given that house prices fell less in Q2 than in Q1 (house prices actually rose slightly in June, the first monthly increase in 18 months) and financial asset prices rose more strongly in Q2 than in Q1.

The period of falling household wealth finished in Q2 2019 and with the turn in house prices that started in May/June household wealth looks set to continue rising in Q3 and Q4. Falling household wealth has been a key reason why many analysts have penciled weak household spending into their forecasts. With the household wealth tide demonstrably turning those analysts have reason to upgrade their household spending forecasts.

Household income growth has also taken a better turn this year at least in real terms. In nominal terms annual wages growth has been edging up only slowly 2.3% y-o-y in Q1 2019; Q4 2018; and Q3 2018 after rising 2.1% y-o-y in Both Q2 and Q1 2018. Over that same period, annual CPI inflation was 1.9% y-o-y in Q1 2018, lifting to 2.1% in Q2 before falling to 1.9% in Q3; 1.8% in Q4; and 1.3% in Q1 2019.

Taking annual wages growth and adjusting for CPI inflation annual real wages growth was 0.2% y-o-y in Q1 2018; 0.0% in Q2; 0.4% in Q3; 0.5% in Q4; and 1.0% in Q1 2019. In short, real wages growth has improved significantly and largely unremarked since mid-2018. Moving into the second half of 2019, the household sector is already experiencing real growth in wages and household wealth is no longer falling and is starting to rise.

This is the household sector backdrop for the May and June RBA cash rate cuts (most of which are being passed through in borrowing rates); the APRA change to lending requirements lifting the amount that homebuyers can borrow by more than 15%; and the imminent $1,080 tax refund for most single taxpayers. The household sector also has some certainty of more tax cuts in the future. Conditions in the household sector were already starting to improve ahead the big policy stimulus. It is reasonable to expect that the combined policy stimulus will boost household spending growth and probably by a big amount.

We expect indicators of household spending to improve noticeably through Q3 and Q4 reinforcing our view that Australian economic growth prospects are improving and leading other analysts to upgrade their forecasts as well. Annual real GDP growth should accelerate above 3% y-o-y in 2020 with annual CPI inflation lifting to around 2.5% y-o-y. On these forecasts, the RBA’s cash rate goes no lower than the current 1.00% and by late next year the RBA could be priming the market for a rate hiking cycle starting in 2021.

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