Ok, it’s time to put my neck on the chopping block and make some forecasts for the economy and financial markets for 2019.
While I agree with my good friend Con Michalakis, market guru and CIO of State Super, that point forecasts on a calendar year basis are largely an artefact of the calendar and do not meet the demand of serious investment strategy, I do find it a useful discipline to make such forecasts each year. These forecasts capture where my analysis and judgment reveal which fundamentals are at greater risk of moving a particular way and most importantly, what this might mean for markets.
For me, the broadest themes for Australia in 2019 are on going sub-trend economic growth, while wages and inflation will remain disappointingly low. The RBA will finally succumb to facts on the economy and will cut interest rates to below 1 per cent in the latter part of the year and the Australian stock market, which has been a dog in recent times, will surge, rising perhaps 20 per cent by the end of the year. Bond yields are likely to fall further in the first part of the year, although a lot of the rally I was looking in 2018 for has already occurred.
There might be another moderate yield reduction the mid to longer end of the curve, but once the RBA finally gives a bit of monetary policy stimulus, the yield curve will steepen in the latter part of 2019.
Now some details.
No real heroics in the forecasts for GDP with more of the same expected in 2019. Annual GDP growth to be in a 2 to 2.5 per cent range, about 0.5 to 0.75% per cent quarter. Household consumption will be weaker and dwelling investment will start to fade during 2019. Business investment will flat line a little longer but could start to edge higher in the second half of the year. Exports and public demand will add a bit to growth. Odds of a recession remain a fraction above 0 per cent. For growth to get anywhere near the much needed 3.5 per cent, there needs to be a global surge which seems very unlikely. The housing market will obviously be an issue in terms of both construction and the wealth effect on consumers and banks.
After the labour market clearly surprised in 2018 with the employment out-performing the underlying strength of the economy, below trend GDP growth in 2019 will skew employment growth lower. Already, job ads and vacancies are declining and this points to employment growth tapering to a 0.5 to 0.75 per cent annual pace through the year. As this unfolds, the unemployment rate will be skewed towards 5.5 per cent with underemployment remaining uncomfortably high above 8 per cent. Wages growth will be mired at 2.5 per cent which will feed into the sluggishness in household spending, noted above.
Inflation is likely to tick lower from an already near record low rate. The drivers are straight forward – sub-trend domestic growth, a slack labour market and importantly, disinflation pressures from around the world as evidenced with the recent free-fall in commodity prices. Annual inflation, therefore, is forecast to hover around 1.5 to 1.75 per cent. The risk to this is squarely to the downside, which suggests 1 per cent is possible at some stage during 2019. In simple terms, the economy is too weak and has been for too long for there to be a material lift in the inflation rate. The RBA looks like missing its target for another year.
Monetary policy and bond yields
The only serious questions about monetary policy and the RBA is when the next interest rate cut will be delivered and how low will rates go in the cycle? With the RBA on track to miss the mid point of its 2-3 per cent inflation target for half a decade, perhaps longer, the pressure is building on the RBA to abandon its star-gazing approach to monetary policy which is a mix of a wish for stability and a setting that is designed to deflate household debt. When the fallout of that mistake shows up further in the hard economic data, the RBA will abandon its high interest rate strategy which has dampened growth, stopping the labour market from moving to full employment and lead to historically low wages growth. While it is clear the RBA needs to cleanse its modelling and forecasts to deliver an about face on rates, it seems that by the June quarter or thereabouts, it will have done this and will deliver the next cut in the current cycle. In my view, rates will be cut to 0.75 per cent by year end.
For the bond market, the 10 year yield should fall as this policy review unfolds, but it would take some form of economic hard landing for yields to sustain a break below 2.0 per cent (around 2.3 per cent today). By year end yields should be entering a bear steepening with a move to 2.75 per cent, or a little higher, on the cards. The spread to the US, currently around 45 basis points in Australia’s favour, should revert to zero to 25bps.
Soft global economic growth is usually a negative for commodity prices. In the final months of 2018, commodity prices were smashed, with oil in particular dropping sharply. There was some resilience in coal and iron ore prices which, incidently, may have been a factor limiting the fall in the AUD. While the oil price is likely to be broadly flat through the year (US$50 to 55) iron ore should soften towards US$50 and the various coal prices could easily fall 15 to 20%, in part linked to slower growth in global industrial production, a move to renewables and a surge in supply.
Short term weakness in house prices seems assured as the tight credit conditions and restrictive monetary policy settings constrain demand. Nationwide prices may drop 5 per cent by the September quarter, with sharper falls likely in Sydney and Melbourne. Late 2019 will be the likely trough in house prices as easier monetary policy unfolds, there is a step up from previously frozen out first home buyers and the strength in demographic demand as fresh supply falters in line with the slippage in building approvals are all likely to put a floor under prices. The call boils down to something like a 5 per cent drop over first half of 2019 and a 2 per cent rise in the second half. 2020 might see a 3 per cent house price lift but that will be next year’s forecast.
US stocks are prone to some near term downside as the effects of the Trump tax cuts fade and the impact of past policy tightening from the Federal Reserve bite. That said, we are close to a point where the market will find a base. With the Fed tightening cycle almost over and an interest rate cut likely in Q4 2019 and then further cuts priced into 2020, US stocks should gain favour and end the year higher than today. S&P today 2,480: Target: Year end 2,650
It is worth repeating that Australian stocks are inexorably linked to commodity prices and the housing cycle. Hence the dog of a year in 2018. Housing in particular has been smashed and a lot of gloomy news is priced in. The ASX has been a dismal under-performer for several years, hamstrung by RBA policy errors and the slump in housing. With the RBA soon to realise the error of its ways and move to a rate cutting cycle, the housing market and economy more generally will likely get some support, particularly in the second half of the year. In these circumstances, the ASX is poised for a strong rebound through the year. ASX200 today 5,650: Year end: 6,750.
The Australian dollar
A lot of bad news has been priced in to the Aussie dollar and it remains a couple of cents from multi-year lows. It does look like there is some more downside, especially as the market pricing for interest rate cuts intensifies. The sharp fall in commodity prices has not yet been reflected in the AUD, partly because of the relatively high interest rates prevailing. A target for the AUD on a 3 to 9 month view is 0.65 and it will remain soft versus the NZD and EUR. There could be a partial recovery in the AUD in the latter part of the year as US economic downturn and the growing prospect for interest rate cuts from the US Federal Reserve filter into currency markets. AUD today 0.7040, NZD 1.05, EUR 0.62: Year end: 0.6700, 0.9900, 0.5900.
Labor will win the Federal election and such will be its support in that poll, that the Senate result will leave it in a powerful position with reliance on the Greens and a small number of minor parties to get its agenda legislated.
The budget is likely to remain in small / tiny deficit as the economy under-performs the Treasury estimates. The budget balance will hover around a deficit of $5 billion to balance in 2019-20, although any measures from the new Labor government will impact that result. This is not a bad outcome given the macro framework
Good luck – may the markets go your way.