Brexit unlikely to trigger a cash rate cut from the RBA in July: HSBC's Paul Bloxham
GUEST OBSERVER
Brexit has delivered a shock to global financial markets. Australia’s markets have, however, seen much smaller moves than elsewhere, particularly in Europe.
This partly reflects that commodity prices have held up well, with the iron ore price above its pre-Brexit referendum level. The AUD is down from USD0.76 to USD0.74, but the fall in the AUD is largely explained by strength of the USD.
The market’s reaction seems consistent with the apparent limited economic significance of the UK for Australia. Britain takes only 2.8 percent of Australia’s exports and, although financial connections are larger, recent net capital inflows to Australia have mostly come from Asia. In short, Australia’s economic story is much more about Asia than about Britain or Europe. To the extent that Brexit affects Australia, it is mostly through an impact it could have on growth in Australia's major trading partners in Asia. We see Brexit as unlikely to trigger a cash rate cut from the RBA this month.
Locally, economic focus will shift to the federal election this weekend (2 July), with current polling suggesting a tight race. The latest Newspoll show the Coalition slightly ahead, at 51:49 on a ‘two-party preferred basis’, although a 2pt lead is within the margin of error. We see the election as unlikely to have market implications, although the desire to be apolitical could explain the central bank’s recent reluctance to give much policy guidance (see Australian Election Observer, 17 June 2016).
More generally, Australia’s growth remains strong, business conditions are at high levels, jobs growth has continued and house prices are rising. Last weekend’s consumer confidence and housing auction clearance rates remained high, despite the Brexit vote. We expect continued solid growth, although inflation remains low.
We continue to see the RBA’s next potential trigger as the Q2 CPI print, due on 27 July. Our central case sees a 25bp cash rate cut in August, after a low CPI print.
What does ‘Brexit’ mean for Australia?
Brexit has had a large impact on global financial markets, although the local effect has been smaller than elsewhere. Australia’s equity market sold off only modestly and the AUD has fallen, but the decline can be fully explained by strength of the USD rather than weakness of the AUD. Commodity prices have held up well, with the Bloomberg commodity price index broadly unchanged since prior to the Brexit vote and up 13% year-to-date. Iron ore prices have risen since the Brexit vote.
The more limited local market impact reflects the relatively small economic significance of the UK to Australia. The UK only accounts for 2.8% of Australia’s exports (Chart 2). The rest of the European Union accounts for 4.6% of Australia’s exports, so a wider effect of Brexit on Europe could be more significant. However, this event would only be a big deal for Australia if it significantly affects Asia, as 74% of Australia’s exports go to Asia.
Although trade linkages are small, Australia has more significant financial exposures to the UK. The UK accounts for 16% of the stock of foreign investment in Australia and a similar share of Australia’s investment abroad is in the UK. The UK accounts for 11% of Australian-owned banks’ offshore exposures on an ultimate risk basis. However, much of the recent growth in capital inflows into Australia has been coming from growing links to Asia (Chart 2).
For the RBA, it is likely that the comparatively muted local financial market response to Brexit and the small trade linkages to the UK are the most important elements for monetary policy. The other key issue will be the effect that the UK’s recent, post-Brexit vote, sovereign rating downgrade could have on the AUD. S&P has downgraded the UK by two notches, from triple-A to AA. Australia retains a triple-A rating, and is one of only nine countries with a triple-A rating from all three major rating agencies. Australia’s strong rating could put unwanted upward pressure on the AUD at a time when a competitive currency is needed to support growth.
Local growth is strong and housing prices are rising
On the latest readings local growth has remained solid running into Q2, following the strong GDP print for Q1 (1.1% q-o-q). Surveyed business conditions remained at around post-global financial crisis highs in June and capacity utilisation has recently also picked up strongly (Chart 3 and 4). Should the lift in capacity utilisation prove persistent, it may be expected to motivate non-mining firms to ramp up their investment plans, which is a much needed next stage of the rebalancing of growth following the end of the mining investment boom.
The lift in capacity utilisation and business conditions also helps to explain continued jobs growth in recent months. Employment growth is running at around 2.0% y-o-y, which has been enough to keep the unemployment rate steady at around 5.7% in the past couple of months (Chart 5).
As activity has picked up, local firms have, so far, been choosing to take on more labour, rather than increase investment to meet demand. At some point, they may start to need to increase investment to support a continued pick-up in local production. The improvement in the labour market may also, at some point, start to put some upward pressure on wages growth, which could lift local inflation.
For the RBA, another factor that could discourage a near-term cash rate cut is the recent re- acceleration of house price growth (Chart 6). Housing prices rose by 8% y-o-y in June (based on daily data), up from a rate of 6% y-o-y in March. However, given that loan approvals have been weaker recently, housing supply is coming online and the prudential settings remain tight, we expect that housing price growth will slow in coming quarters (for more on this see Downunder Digest: Australian housing is still set to cool, 21 June 2016). Nonetheless, the RBA may want a bit more evidence that the re-acceleration does not persist before cutting again.
The Q2 CPI print on 27 July is all important
Although we expect the RBA to be on hold on 5 July, our central case is for a 25bp cut on 2 August. This view depends on the Q2 CPI print, which is due on 27 July. Keep in mind, the almost singular motivation for the cash rate cut in May, was the significant downside surprise to the Q1 CPI print, which pushed underlying inflation to well below the RBA’s 2-3% target band (Chart 7). On a q-o-q and y-o-y basis, the first quarter underlying inflation print was the lowest result since inflation targeting began in 1993 (Chart 8).
In our view, if the Q2 print shows underlying inflation below the bottom edge of the 2-3% target band on a quarterly basis, that is, below 0.5%, we see the RBA as likely to cut in August. As our current forecast is for the average of trimmed mean and weighted median to be 0.45%, our central case is for the RBA to cut in August. A higher print will make a cut less likely, although much will then depend on other economic developments.
Australia’s election has little bearing on the RBA
Australia will hold a federal election on 2 July. The latest Newspoll shows the current Liberal/National coalition, led by Prime Minister, Malcolm Turnbull, slightly ahead of the Labor Party, led by Bill Shorten, at 51:49 on a ‘two-party preferred basis’, although a 2pt lead is within the margin of error. Perhaps more interestingly, the Coalition is currently leading in more of the marginal electorates. All in all, however, the polls suggest it will be a tight race.
The market implications of the election are expected to be limited. Neither major party is proposing radical reforms. Both major parties agree on the fundamental economic framework, supporting a floating currency, independent central bank, free flow of capital and trade. For more on the economic policies of each party, see Australian Election Observer, 17 June 2016.
For the RBA the election is unlikely to make any difference to its approach to policy. However, on the margin, a desire to remain apolitical may help to partly explain the central bank’s reluctance to provide much guidance in its recent statements. Keep in mind that the RBA’s recent statements have not included an explicit easing bias.
We expect the RBA’s post-meeting statement to note that the board is waiting for more information, particularly on prices, thus suggesting that the Q2 CPI print will be of key focus for the RBA in determining its next move.
PAUL BLOXHAM IS CHIEF ECONOMIST (AUSTRALIA AND NEW ZEALAND) FOR HSBC.
