Introduction

Ever since commodity prices and the mining investment boom peaked 3 or 4 years ago there has been a constant chorus of doom regarding the Australian economy: the reversal of the mining boom will knock the economy into recession, house prices will crash and banks will tumble. This view was particularly prevalent amongst foreign commentators who seemed to think that resource extraction was the only thing Australians do. While this tale of doom has not happened, the economy has been a bit lacklustre: growth has been sub-par, wages growth has fallen to record lows, unemployment has drifted up and confidence readings have remained poor. Against this background, the RBA has rightly cut interest rates again. This note looks at the key implications.

Interest rates and the economy

There are good reasons for the RBA to be cutting rates further:

Confidence remains subdued

Source: Bloomberg, AMP Capital

Partly reflecting this, consumers have started to become more focused on paying down debt again, which is a sign of increasing caution and will threaten spending if sustained.

Australia's becoming a bit more cautious again

Source: Westpac/Melbourne Institute, AMP Capital

 

Iron ore and the terms of trade has fallen more than expected

Source: Bloomberg, AMP Capital

The main risk in cutting rates again is that it further inflates the residential property market. However, strong property price gains are largely concentrated in Sydney and the RBA sees this as more of an issue for the prudential regulator, APRA.

Overall, we see the RBA’s cut as justified and, given that there is rarely just one move, we expect another 0.25% cut taking the cash rate to 2% in the months ahead.

Reasons for optimism

However, it’s not that I am bearish on the economy. Rather it makes sense for the RBA to be taking out some insurance to make sure growth holds up and improves. There are several reasons for optimism that growth will improve:

 

Record or near record low interest rates

Source: RBA, Bloomberg, AMP Capital

 

Weekly petrol bill for a typical Australian household

Source: AMP Capital

Overall, we see growth picking up gradually as the year progresses to a 3-3.5% pace through next year, but the RBA’s latest rate cut and one more to come provide confidence that this will occur.

Implications for investors

There are several implications for investors. First bank term deposit rates are becoming even less attractive and will remain low at least into next year. As a result, there is an ongoing need to consider alternative sources of yield and return.

Not a lot of value in Australian term deposit rates

Source: RBA, AMP Capital

Second, remain cautious on the $A. While the $A is nearly back to the $US0.75 level that marks fair value on the basis of relative prices, past experience tells us it can overshoot and it hasn’t fallen nearly as much against the Euro and Yen putting more pressure on for further weakness against the $US. The RBA has indicated “a lower exchange rate is likely to be needed”, and it is likely to ease further till it gets this. The $A is oversold short term and so could have a short term bounce, but expect a fall to $US0.70 by year end. So continue to favour unhedged over hedged global shares.

The A$ back to around fair value on relative prices

Source: RBA, ABS, AMP Capital

Third, overweight Australian versus global bonds. While Australian bond yields are low they are high by global standards and likely to provide better returns than global bonds as the global search for yield results in ongoing convergence of Australian bond yields with the lower rates seen globally and as further RBA easing pulls down local bond yields. This should also benefit Australian corporate debt relative to global.

Finally, with low interest rates growth assets providing decent yields will remain attractive. This includes commercial property and infrastructure but also Australian shares which continue to offer much higher income yields relative to bank term deposits.

Australian shares offering a great yield v bank deposits

Source: RBA, Bloomberg, AMP Capital

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.