Surprising economic news necessitates a view change

Wed, 21 May 2014  |  

I am very, very surprised at the extent to which some key drivers of the Australian economy have hit a brick wall.

It is increasingly clear that this means the RBA is on hold for a while longer and my earlier view that the economy would sustain a period of strong growth was probably wrong. This upbeat view has been superseded by a strange and disconcerting run of economic news.

Consumer sentiment has been smashed, with the ANZ-Roy Morgan measure dropping a tub-thumping 14 per cent in a month. With interest rates obviously on hold, stock prices sort of flat and no other significant factor about, it must be reaction to the budget that is driving this collapse in sentiment. It is a similar story with the Westpac-Melbourne Institute measure of consumer sentiment which dumped 6.8 points in May to be at levels associated with very weak growth in consumer spending.

Why the fall in sentiment matters is that it is reasonably closely correlated with consumer spending. The rampaging retail sales growth of the last 9 months or so is therefore under serious threat.

What is also important is the evidence, however sketchy at this stage, that house prices are topping out. While the RPData house price measure is not seasonally adjusted and is very volatile at the best of times, it has fallen by about 1.5 per cent in the last few weeks. After 18 months and more of strong house price growth, a bit of a pull back is nothing to worry about. That said, it is odd that the possible topping out in prices has occurred without any interest rate hikes or even threats of rate hikes. If house prices were to fall, say something close to 10 per cent, it would have massive implications for the banks and with them, the economy.

The labour price (wages) data are remarkably soft, with annual growth of just 2.6 per cent with little or no sign of a pick up in the March quarter data released today. Real wages are falling, which does not bode well for spending, at least in the short term.

The other issue of surprise is the drop in the iron ore price. Moves to the low US$100s from around US$130 were neither here nor there with export volumes booming and around US$105 to US$110 a tonne, the price was still relatively high.

But in recent weeks, the iron ore price has fallen to US$97.50 a tonne, with no signs of a floor being reached. This price momentum and level are at a point that is now likely to materially threaten the growth in national income. This is particularly so with the Australian dollar remaining resilient above US0.90.

That's it really – there are been some big and unexpected moves in key areas of tghe economy which are important. And these indicators are contemporary which is why I am giving them considerable weight – the most recent GDP data are for the December quarter and all of these recent trends, if sustained, will not impact on GDP until the September and December quarters 2014.

Suffice to say, the latest available data on a range of other parts of the economy remains strong.

In the next few months, the data will likely show that both real GDP growth and inflation above 3 per cent, a situation that would normally demand a cash rate around 3.5 per cent compared with the current 2.5 per cent.

But things are not normal for all the reasons noted above and it is now possible that GDP growth will slip back below 3 per cent towards the end of 2014 and into 2015.

The other things to recall are that global economic outlook remains solidly firm, the direct impact of the budget measures on the economy is very small and consumer finances are still well positioned with high savings and solid wealth gains in recent years. In addition, housing construction is buoyant and the growth in exports is particularly powerful with these two areas certain to contribute a decent chunk to GDP growth over the next year or two.

For 2014, it has been a hugely successful trading year with the rate cut proponents and AUD bears handing me their cash, even if the RBA has not yet hiked rates and the AUD rally has stalled at recent levels. Thank you to them.

My market calls now are to be short the AUD and to stay away from bond and interest rate trades for a while. It now looks like the RBA will now be on hold and the trading opportunities on the back of a monetary policy change and market mismatch is very limited.

Just as most of those calling for rate cuts and a weaker AUD have reversed in recent weeks and months, which really surprises me, I am tending the other way – a weaker AUD and a rate cut no longer a wild call, even if it is still unlikely.

Let's so how we go with this.

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