Volatility Takes Early New Year Lead but Growth Ploughs Ahead

March 2018

Volatility Takes Early New Year Lead but Growth Ploughs Ahead

By Simson Sanaphay

Global markets were thrown into turmoil early this month when President Trump announced steel and aluminium tariffs that aroused global condemnation.

A trade war is one of the items we listed in Market Outlook 2018 as a potential threat to our 3.4 per cent global growth forecast for this year. It is a situation we will continue to monitor.

And it comes at a time when many factors are already driving stronger US growth, including tax cuts, full employment, strong trade flows and relatively accommodative financial conditions.

With the US economy shifting up a gear, we believe the US Federal Reserve will continue to remove monetary accommodation and increase rates to a range of 1.50 to 1.75 percent.

This will effectively take the US cash rate above the Australian cash rate for the first time since 1999. We expect the Australian cash rate to remain at its historical low of 1.5 per cent for the remainder of the year. However the risk is that the Reserve Bank of Australia (RBA) increases its rate much later than earlier.

A large degree of this “policy crossover” has been priced into financial markets, the AUD is somewhat weaker relative to the USD, 10 year US Government Treasury yields are above Australia’s Commonwealth Government bond yields.

More importantly we believe the AU-US rate divergence is likely to grow with expectations for the Feds to hike a further two times in 2018, followed by three rate hikes in 2019 as inflation returns to the US from its transitory 2017 lows.

The RBA on the other hand will be hoping the transition of the Australian economy away from residential housing continues to gain traction. We’re encouraged by the ongoing infrastructure “mini boom” from both public and private sectors that’s taking place.

It has been a key growth driver, particularly on the east coast with the real value of state and federal public sector non-defence investment rising 8.5 per cent in the past 12 months.

Figure 1.
Major projects with a value of $AU2.0bn or more 2018 Global Outlook

We expect infrastructure spending to lessen the impact of lower housing contribution for years to come and to deflect impacts from what we expect is a peak in public sector investment spending.

Figure 2
Annual growth in public sector investment spending 2018 Global Outlook

On the private sector front although capital expenditure is less than forecast it is showing selective improvements. Importantly the capital expenditure outlook saw a solid upgrade to $5.3bln from $4.6bln for FY18. It’s still early days yet, but it’s the first upgrade to capex intentions relative to previous years since 2013.

However infrastructure’s contribution to growth is about half of the contribution that had previously come from the mining boom so it’s not the only growth driver needed.

We forecast global synchronised growth and its positive spillovers will be central to Australia’s economy via export trade but also to domestic business confidence, as high levels of business confidence translates to actual spending and investment.

We expect the latter to be 4 per cent on average for the next two years, this should continue to support employment gains and offset the weakness in highly indebted households facing weak wages growth and assist to maintain our economy’s growth at trend of 2.6% GDP in 2018.

Encouragingly, the strongest growth in the number of new business formations since 2010 identifies the underlying structural shift taking place and suggests health in the transition of the Australian economy away from housing and mining.

Perhaps now all we need are corporate tax cuts to move things along. However given the Federal Government is intent on delivering a budget surplus by 2021, that means strong fiscal stimulus akin to the US is highly unlikely.

So while we are seeing infrastructure and business contribute to Australia’s growth, it will take time, mainly because the constrained household makes up more than 50 per cent of the economy. This will likely mean the RBA continues to show patience in 2018 and remain on hold, even if the Fed continues to raise rates.

Simson is a Citi Wealth Management strategist

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