15 Nov November 2017 Economic Update
This month Michael Pollack of Kaplan Professional speaks with ANZ’s senior economist Felicity Emmett about the RBA’s recently released Financial Stability Review.
Firstly, what were your key takeaways from the RBA’s Review with regard to the outlook for the Australian economy and more specifically interest rates for 2018?
There are a couple of things to focus on. Firstly, there is obviously the housing market, which is always a big focus for the Financial Stability Review and I think it makes clear that the RBA is not worried about house prices per se but they’re really more worried about household debt.
I don’t think that they think there’s going to be some sort of sharp adjustment there but they’re worried that if there was a shock from offshore that that would be amplified through the Australian economy because of that high household debt. I think they’re also worried that this combination of high household debt and low wage growth is weighing on consumption spending at the moment.
The other area that was the focus of the RBA in the FSR was the idea of this search for yield — there’s low yields and low volatility everywhere. In a part of the cycle where central banks are starting to raise rates or reduce quantitative easing, inflation is looking like it’s starting to ease up slightly and so I think that they are concerned that there could be, at some point, abrupt adjustment in the markets.
The RBA raised concerns in the Review that the combination of low interest rates and low volatility in financial markets was promoting excessive risk-taking among global yield seekers. What does this development mean for more risk averse investors seeking secure and reliable income from their investments?
That is a concern. When you look at credit spreads, they’re incredibly narrow. There’s a possibility that we’ll perhaps see a sharper pick-up in inflation than markets are expecting and central banks may have to scramble to catch up.
The bond market might adjust quite quickly and then you can have a situation where some investors are exposed and that can perhaps amplify the shocks through financial markets and through economies. So, I think that’s where the RBA is worried; not that they have a central case that there is going to be a problem, but that these abrupt adjustments in markets can have flow-on effects into the economy.
Globally, there are currently a number of geopolitical risks for analysts to contend with: Trump’s provocation of North Korea and Iran, the ongoing Brexit saga, high corporate debt and shadow banking in China and the rise of populist politics to name a few. What geopolitical risks in your opinion have the greatest potential to distort capital markets and which risks are you watching with particular interest?
Geopolitical risk is always an interesting one. We look at all of them and keep an eye on all of them but it’s always very difficult to quantify how that could or would impact markets. For Australia, we really are more focused on China. Australia’s economy is so linked in with China now, not just for selling our iron ore but we also sell a lot of our services, exports to China. They’re our number one tourist arrival, they’re heavily invested in both our residential real estate market and commercial real estate, so our fortunes are very much tied to China.
So that is where we really focus in terms of the risks of some sort of external shock and that’s what we will be looking for. It’s certainly not our central case but that is certainly something we watch out for.
Could you just elaborate on what you’re watching in China?
I suppose in terms of China, perhaps it’s less geopolitical risk and more economic and financial stability risk. As the FSR mentioned, there is a high level of shadow banking, their financial system is quite opaque to some degree.
So I think we’d be worried that perhaps there could be a policy misstep and that some abrupt adjustment again could be amplified through the economy given their very high levels of debt and that then impacts on the real economy that flows through to Australia.
That’s where we see the largest risk. We hear a lot about the capital controls and how that’s going to affect the money coming in from China and over the last few years there have been many instances where there have been anecdotes that the gates have closed, but that hasn’t actually been the case.
There really haven’t been any signs that the flow of money out of China has stopped, even though probably the interest in our real estate market is gradually slowing.
Looking more closely at Australia, what in your opinion will it take for the economy to break out of the cycle of low interest rates, low wages growth, low unemployment and low inflation?
I think we’re probably past that cycle. Unemployment has actually been declining for a little while, very, very gradually but it has been declining and importantly, we’ve actually seen a decline in the underemployment rate recently as well. So, we are seeing a reduction in labour market spare capacity.
Inflation also looks as though it has troughed. Headline inflation is well up from its lows and core inflation is also trending higher, very gradually, but it does look to have troughed.
So, I think we are really out of that cycle now and our view is that we will actually start to see interest rate rises from the RBA next year. We’re at the bottom, and the economy is gradually improving. Labour market spare capacity is gradually reducing and that will eventually see wage and price inflation go higher. So, the central bank can return the cash rate to something closer to normal but that process will be very slow.
There have been recent signs of conditions easing in over-heated housing markets such as Sydney and Melbourne. What’s your outlook for these markets for 2018 given the persistence of supply issues?
We think we will continue to see some easing in house price pressures. We expect house price growth to slow. We’re not really looking for falls, particularly in the Melbourne and Sydney markets. A lot of that though is in response to the tightening of macroprudential measures early in the year that were targeted towards investors and we think that that is really helping to take some of the heat out of the market. In Sydney, in particular we had a long period of under-building, so I don’t think there are too many issues about absorbing that supply.
We’ve also had relatively solid population growth for a long time. [Sydney is] taking a good proportion of the new immigrants to Australia and that’s helping to keep housing demand quite strong. In Melbourne, they’ve also had very strong population growth and even though they’ve got more supply coming on stream, they do seem to be absorbing that supply relatively well. We are seeing some weakness in apartment prices there but at this stage it doesn’t look really to be too concerning and given this ongoing strong population growth, we’re pretty comfortable with that market.
The market that we’re more worried about is probably Brisbane, given the increase in supply there compared with their stock is very large – much larger than the other two cities – and they haven’t had the sort of population growth that Sydney and Melbourne have had recently.
It is picking up, so that will help, but there is a lot of stock coming on stream there and they’re already seeing apartment prices fall and vacancy rates rise. So that market is possibly in for more of an adjustment than the larger Sydney and Melbourne markets.