Australia cuts as global growth slows

My thesis for the global economy right now is that global nominal GDP growth will continue to slow, leading to more policy accommodation, with the outliers converging toward zero. The question mark in this is the Federal Reserve. Generally, this constellation of outcomes means favouring Anglo-Saxon bonds, particularly ones from New Zealand and Australia. On the equities side, we should expect profit growth deceleration to continue.

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My thesis for the global economy right now is that global nominal GDP growth will continue to slow, leading to more policy accommodation, with the outliers converging toward zero. The question mark in this is the Federal Reserve. Generally, this constellation of outcomes means favouring Anglo-Saxon bonds, particularly ones from New Zealand and Australia. On the equities side, we should expect profit growth deceleration to continue.

Let me start with the rates in Australia and New Zealand. Here’s how I described the convergence to zero trade in January: “Right now, we are still in the midst of a global growth slowdown. And while there are some countries like Britain, Canada, the US, New Zealand and Australia, which have been outliers in terms of growth performance, the downward drift of oil and commodity prices, the lack of external demand, the lower rate of EM growth and the rebalancing in China is going to put inexorable downward pressure on nominal GDP growth in these countries. This will put downward pressure on future policy rates and help to make the convergence to zero trade most severe in these countries in 2015.”

Today, the Reserve Bank of Australia cut rates again, to 2.0%. This move was unexpected as just last week the Guardian newspaper was saying that economists expected a rate cut, but not until August. The crucial part of the RBA’s statement reads as follows:

…some other major central banks are stepping up the pace of unconventional policy measures. Hence, financial conditions remain very accommodative globally, with long-term borrowing rates for sovereigns and creditworthy private borrowers remarkably low.

In Australia, the available information suggests improved trends in household demand over the past six months and stronger growth in employment. Looking ahead, the key drag on private demand is likely to be weakness in business capital expenditure in both the mining and non-mining sectors over the coming year. Public spending is also scheduled to be subdued. The economy is therefore likely to be operating with a degree of spare capacity for some time yet. Inflation is forecast to remain consistent with the target over the next one to two years, even with a lower exchange rate.

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My interpretation of this is that the RBA feels that with inflation low and other central banks easing, the weakness in commodity prices and the slowdown in capital spending this implies makes now a fortuitous time to cut. And to the degree these conditions continue I would expect further cuts in the future. In an ode to the currency wars, the RBA also says that “[f]urther depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices.” That means, the RBA feels pressure both in terms of domestic economic weakness and n terms of currency strength, to cut rates in the future. This is bullish for bonds.

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New Zealand, then, remains an outlier, and therefore, attractive from a yield pick up perspective, and potentially from an asset appreciation perspective as well. The Reserve Bank’s March statement reads as follows:

The Reserve Bank today left the Official Cash Rate unchanged at 3.5 percent.

[…]

The domestic economy remains strong. The fall in petrol prices has increased households’ purchasing power and lowered the cost of doing business. Employment and construction activity are strong. Net immigration remains high, and monetary policy continues to be supportive. The housing market is showing signs of picking up, particularly in Auckland…

On a trade-weighted basis, the New Zealand dollar remains unjustifiably high and unsustainable in terms of New Zealand’s long-term economic fundamentals. A substantial downward correction in the real exchange rate is needed to put New Zealand’s external accounts on a more sustainable footing.

I take this statement as an affirmation of the relative strength of the New Zealand domestic economy but a warning that the currency wars are creating angst for the Reserve Bank of New Zealand that make cuts to interest rates likely. And In a statement last Thursday, they dropped any references to their anticipated “period of rate stability” going forward. That means cuts are coming, with declining dairy prices and the exchange rate as key reasons why.

The bottom line: it is very hard to remain neutral or to tighten when everyone else is easing, at a minimum because of the negative effects on the external account. This is particularly true for small open economies like Australia and New Zealand, and a big reason to expect downward rate convergence.

Now, from a global economic perspective, we see slowing pretty much everywhere that matters except Europe. North America, Japan and China are notable in slowing. And that brings the Federal Reserve’s interest rate policy into question. The Atlanta Fed’s GDPNow forecast of 0.1% annualized Q1 2015 GDP growth was very close to the actual advance number of 0.2%. And this number is subject to revision. To the degree US growth is in fact decelerating, we should expect downward revisions here. Moreover, the Atlanta Fed’s new Q2 GDPNow forecast is surprisingly low because incoming data for Q2 have also been weak. The risk is that we have a major US slowdown here that is not being reflected in the headline unemployment number that seems to be guiding Fed tightening policy.

The Fed wants to hike and will hike this summer if the data hold. However, if the data continue to be poor, the Fed will have to delay its first rate hike and that would be bullish for US government bonds. Contrary to what Bill Gross is saying, it is not clear, the end of the bond bull is here. We need growth for this to be the case. At the same time, equities, which should benefit from lower discount cash flows, could still be challenged as the evidence of slowing earnings growth is still upon us. I believe this earnings slowdown is not just a temporary blip and could portend a near end-of-cycle phenomenon that precedes a more significant headcount reduction and capital expenditure slowdown. However, I would expect the $1 trillion in buybacks and dividends that are coming online in 2015 to mask the top-line growth and the equivalent operating earnings slowdown. At some point, perhaps in 2016, companies will not be able to paper over the earnings slowdown and will have to bite the bullet. The capital expenditure slowdown has begun, but the headcount reduction will be the last to occur.

What stops the incipient earnings slowdown from becoming an end-of-cycle precursor is an increase in wage growth, consumption and or household debt that can fuel more top-line growth. Right now, my eye is focused on the tug of war between signs of slowing earnings and re-acceleration in household consumption patterns. How this plays out will not only alter the Fed’s 2015 tightening bias. It may also alter the shape of the present cyclical bull market inequities.

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