Weekly note (7/12) | Trade optimism fades; Australian GDP slows

Global markets were heavily focused on developments from last weekend's G20 Summit in Buenos Aires in search of signs for an easing in trade tensions. Initially, the signs were taken as positive with a temporary truce reached between the US and China. Under the agreement, US President Trump announced that his plan to raise to raise tariffs on $US200bn of imports from China from 10% to 25% from January 1 would not go ahead. Instead, the two nation's will aim to reach a long-term solution to their differences that mainly relate to trade within 90-days, though if not secured would see tariffs raised to 25%. In return, China announced it will import more US goods, which the US described as "very substantial" quantities of agricultural, energy, industrial and other products. There were several other areas of consensus reached, though these details were the focus for markets.  

The conciliatory nature of the meeting between the President's and the details of the agreement were enough to improve risk sentiment in global equity markets early in the week driving strong rallies in the US, Europe, and Asia. However, the optimism would prove fleeting as reports emerged over confusion regarding the details of the agreement, while President Trump continued to tweet in support of tariffs should the US and China be unable to reach a solution by March next year. These tensions were seen to be escalating following the US arrest of a Chinese technology company executive in Canada.  

Another unsettling development for global markets during the week came from movements in the US yield curve. Yields on 10-year government bonds tumbled to below 2.9% after reaching a 7-year high of 3.23% in early October, resulting in further flattening of the curve. The spread between 5 and 2-year yields turned negative. These moves provided an indication that markets were pricing in a deterioration to the growth outlook in the US over the next few years.

At the end of another highly volatile week, equity markets had fallen by well in excess of 4% in the US and by around 3 to 4% in Europe, while Asian markets declined between 1 to 3%. Australia's benchmark S&P/ASX200 index was, however, able to post a modest rise this week — its first weekly gain in a month. The US 10-year yield fell by a sizeable 14 basis points this week reflecting the impact of concerns around trade and the growth outlook, closing at its lowest level since August.    

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The highlight of the week in Australia was the Q3 National Accounts, which contain the quarterly economic growth figures (see our overview here). Other features on a full calendar were the Reserve Bank of Australia's (RBA) final meeting for 2018 (see our note here), monthly updates on building approvals, retail sales, international trade, property prices, and a speech from the Deputy Governor of the RBA, Guy Debelle (view here). 

Growth in the domestic economy increased at a slower-than-forecast pace of 0.3% in Q3, which saw growth in year-ended terms decelerate from its above-trend 3.1% pace to an around-trend rate of 2.8%. Markets had expected growth of 0.6% in the quarter and 3.3% for the year. Growth in Q3 was impacted by slowing household spending, declining farm output following drought conditions and a contraction in business investment reflecting the completion of major projects in the LNG sector. 

Most focus was around the result from household consumption, which is the largest share of the domestic economy. Growth in expenditure on goods and services was a soft 0.3% for the quarter and annual growth slowed to 2.5% — the same level from a year earlier. Within this result, weakness in discretionary areas of spending such as new vehicles, household goods and clothing and footwear was noticeable. 

Weak income growth remains the predominant headwind facing households. For the second consecutive quarter, real growth in household disposable income (income less taxes and interest) was flat, while the annual pace has declined over 2018 to just 1.0% from 2.2% at the end of 2017. 

As our chart of the week shows, growth in real household disposable income continues to be clearly outrun by growth in consumption spending. As a result, saving continues to fall reaching a new post-financial crisis low of 2.4% in Q3 with households having to direct more of their income to cover living expenses. In the absence of a lift in income growth, it is highly uncertain for how long this can persist, particularly with property prices continuing to decline in the two major capital cities of Sydney and Melbourne. This points to a likely moderation in the growth of household consumption spending, though the RBA has remained sanguine to this risk by highlighting factors such as strong labour market conditions and official forecasts for above-trend economic growth driven by non-mining business investment, public demand and resources exports. 

         

Chart of the week

Regarding those forecasts, given the soft growth outcome in Q3 it now appears that the RBA's central expectation for economic growth to reach 3.5% in year-ended terms by the end of 2018 is unlikely as it would require a sharp pick-up in Q4 of around 1.3% — an outcome not seen since 2011 when mining investment was contributing strongly to output growth.

Financial markets reacted to the Q3 GDP data with futures traders reducing pricing for an RBA rate increase over the next 18-months, while the OIS market has started to price in a small chance of a rate cut by around Q3 next year. For the moment, the guidance from the RBA is the expectation for its next move to more than likely be an increase than a decrease, though not in the near term. 

This was a point reiterated by Deputy Governor Debelle in his speech on Thursday. Comments from the speech that gained wide-spread attention were that there was still scope for cash rate reductions and that "quantitive easing is a policy option in Australia, should it be required". The context of the speech was, however, in relation to learnings taken by central banks from measures implemented in response to the global financial crisis, rather than signaling an expectation to follow down that path. 

While the outlook for household consumption is key to Australia's growth outlook, it will likely take more than Q3's soft outcome to change the RBA's assessment of economic conditions. Over recent years, growth in household consumption has been fairly volatile from quarter to quarter, with a general pattern of a soft quarter following a stronger quarter. That trend was again evident in Q3 where the growth outcome of 0.3% came after a 0.9% result in Q2, with that outcome being upwardly revised from the initial estimate of 0.7%.