Second quarter 2016 commentary

26 Jul 2016

By Shadforth Financial Group

Reserve Bank of Australia adopts a monetary easing bias

The Reserve Bank of Australia (RBA) lowered the cash rate unexpectedly by 25 basis points during the second quarter 2016 to a historical low of 1.75 per cent. Inflation was an important catalyst in the decision to lower the cash rate, as it is currently well below the RBA’s medium term target zone of two to three per cent.

Headline inflation for the first quarter recorded a very weak -0.2 per cent in the three months through March and the annual rate recorded 1.3 per cent. This caught the market by surprise and sparked concerns about deflation, prompting consumers and businesses to delay consumption and investment.

The RBA was also concerned that the strong AUD, which fetched over US78c at one point during the quarter, would complicate Australia’s economic progress. It is likely that the RBA will cut the cash rate again this year due to the weakness in domestic cost pressures attributed to low wage growth, softer rental and housing construction markets and declines in inputs to the cost of business.

2016 Federal Election – political uncertainty

Treasurer Scott Morrison delivered the 2016-17 Federal Budget during the marathon eight week campaign for the Prime Ministership of Australia. The Treasurer forecast economic growth of 2.5 per cent until 2016-17 against a backdrop of challenging global economic conditions that will see the budget blow out to an expected $39.9 billion deficit (-2.4 per cent of the GDP) in 2015-16.

This means that the Government has a tough balancing act between focusing on responsible spending constraint and ensuring Australia’s economic success by driving growth through new investment and job creation. The Government has projected that the deficit will decrease to $6 billion (-0.3 per cent of the GDP) by 2019-20, but this is susceptible to headwinds facing the global economy that could affect the efforts to haul in the deficit.

Malcolm Turnbull claimed victory and won the 76 seats needed to form majority government but will face a potentially hostile Senate with no guarantee of achieving structural reforms. A lack of progress on any serious structural reform to reduce the deficit will leave the task of supporting the economy on the RBA’s shoulders.

US Federal Reserve – a credibility issue?

The US Federal Reserve (Fed) maintained the federal funds rate in the target range of 0.25-0.50 per cent in the June quarter as market expectations for monetary policy tightening in 2016 fell from four hikes to no hikes. The Fed surprised the market a number of times as it yo-yoed between dovish and hawkish stances after getting spooked by incoming data whilst on the verge of raising rates.

Communication from the Fed has been used to prepare the market for a rate hike sooner rather than later because the Fed understands that rates should be higher than current levels in the cycle following a recession. In a typical recession, the Fed would respond by cutting rates four to five per cent, however it currently does not have scope to do so in the event of an unexpected economic shock.

It is therefore likely that the Fed will use any form of positive data to shape market expectations for a rate hike, but will do so cautiously. The Fed’s changing status on interest rate hikes has created a credibility issue with investors because markets place significant emphasis on the direction of the Fed. Communication from the Fed will be cautious going forward but it is still pricing in rate hikes for 2016 even though the market isn’t.

Brexit – A ripple effect

Market performance over the June quarter was largely driven by the UK’s decision to leave the EU in a shock 52 per cent/48 per cent outcome that signalled the beginning of a lengthy period of uncertainty. The initial market reaction sent markets plummeting up to nine per cent, but market concerns seemed to recede within one week as indices recovered to levels seen prior to the UK’s vote. The economic impacts are difficult to assess but the risks are predominantly centred on the eurozone.

It is unlikely that Brexit will have a significant impact globally because trade with the UK is small for most economies. Less than five per cent of Australia’s total exports go to the EU (UK inclusive), so even a large decrease in exports to the EU will have a minimal impact on Australia’s growth.

The impact is expected to be localised within the Eurozone. This will be reflected in the EU and UK being unable to hit their 2016 and 2017 growth forecasts because business confidence, investment and consumption will be impacted over the short term. We expect this will put pressure on the Bank of England and the European Central Bank to adopt additional monetary policy measures in 2016 to cushion the fallout from Brexit.

Educational guides