Quarterly Economic Report

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Executive Summary

The Australian and Global Economic Outlook

Global economic growth was subdued last year and this year the pace of economic growth is expected to pick up only marginally to 3.4%, according to the IMF. The pace of growth in the US has picked up in recent quarters and economic growth in China remained robust last year.

The domestic economy has lost some momentum. However, despite economic growth contracting in the September quarter, we do not expect Australia’s economy to go into recession this year. We expect GDP growth of 2.1% for 2016, 2.3% this year and 2.7% in 2018.

The Outlook for Interest Rates

The Reserve Bank faces a difficult balancing act as we move through 2017. Any action on rates must consider the prospects of low inflation and growth at a time when house prices are reaccelerating.

Domestic swap yields and fixed rates for borrowers are set to head higher this year. Higher US bond and swap yields will push Australian yields higher, although at a more moderate pace than in the US.

The Outlook for the Australian Dollar

Key fundamentals for the AUD are providing mixed signals for the outlook. Resilient commodity prices could provide support for the Australian dollar, but the currency has not had a strong relationship with commodity prices recently. Meanwhile, the narrowing interest rate differential between Australia and the US points to downside pressure for the Australian dollar.

Our view that the US dollar will track sideways suggests that the Australian dollar will also end the year not far from current levels. We expect the AUD to end 2017 at 75 US cents.

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Consumer Price Index(annual % change)

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Australian GDP Growth(annual % change)

Wednesday, 1 February 2017

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The Outlook for the Global and Australian Economies

Global Economy

Global economic growth was subdued last year and this year the pace of economic growth is expected to pick up only marginally to 3.4% according to the IMF. Growth amongst developing economies is expected to outpace that of advanced economies. While the global economy continues to grow, the pace of growth is below trend, with growth over 1998 to 2007 having averaged 4.2%.

United States

The pace of US economic growth has picked up in recent quarters. GDP growth rose by 0.5% in the December quarter, following growth of 0.9% in the September quarter. For the year to the December quarter, GDP growth rose by 1.9%, its strongest pace in a year.

The US economy is in its sixth year of economic growth. This is the fourth longest US economic expansion since WWII, but also the slowest pace of expansion witnessed in an economic upturn over that period, with average growth of 2.1% pa. This recovery in the US economy since the GFC is not as strong as what we would ideally like to see.

US payrolls data suggests the economy is on firm footing, although the picture is somewhat mixed. The US economy added an average of 189k jobs per month in the six months to December, up from 171k average in the previous six months. Ongoing jobs growth has seen the unemployment rate fall to a nine-year low of 4.6% in November, before ticking back up to 4.7% in December.

Another critical indicator for US monetary policy is inflation. The PCE core, the Fed’s preferred measure rose by 1.7% in the year to December. Although this has edged up over the past year, progress has been patchy and it remains below the Fed’s 2% target.

Following his election, President Trump has indicated he will increase spending on infrastructure and lower taxes. Investors have taken up this promise with enthusiasm, driving expectations that increased fiscal spending will boost economic growth, as well as acting to boost stubbornly low inflation. This is despite a lack of detail on the economic policies.

Hopes that Trump’s promises of fiscal spending and tax cuts will boost economic growth have supported risk appetites, driving the US stockmarket to record highs. The Dow, the S&P 500 and the Nasdaq hit record highs last month. Over the past year, the Dow has risen more than 22%, the S&P 500 has gained over 19% and the Nasdaq is up more than 24%. The Australian stockmarket has followed the US market, although the gains have been more modest. Over the past year the S&P/ASX 200 is up more than 13%.

China

China’s economic growth has held in the official 6.5% to 7% target range this year, with growth of 6.8% in the year to Q4. Over recent years the role of manufacturing and investment in driving economic growth has increasingly made way for services. China’s retail sales growth has picked up in recent quarters. This year, however, additional fiscal stimulus has again boosted industrial activity in China and commodity prices globally. Despite solid economic growth, the level of debt in China’s economy remains a risk to the Chinese economy and hence Australia’s economic outlook.

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Commodity prices have benefited from better than expected economic growth in China and more buoyant risk appetites following Trump’s election win. The iron ore price has jumped 100% over the past year to around US$83 per tonne. In early January the iron ore price hit its highest level in more than two years. Given ample supply, it appears recent highs in the iron ore price will be difficult to hold onto. The coal price has fallen from its highs. The price of coking coal is now around 45% below the recent highs of late 2016. The coal price is, however, still up 122% over the past year.

Domestic economy

The domestic economy has lost some momentum. Australia’s economic growth was weak in the September quarter, falling by 0.5%, the first decline since the March quarter 2011. This weak data saw the annual rate of growth decline from 3.1% in the June quarter to 1.8% in the September quarter.

The Australian economy last experienced a recession in 1991. Despite GDP growth retreating in the September quarter, we don’t expect Australia’s economy to go into recession this year. Weakness in the September quarter GDP can be attributed to a number of one-offs, which are likely to be reversed in the current quarter. Having said that, the likely profile of annual GDP growth over the next year is now expected to be softer following the weak September quarter outcome. We expect growth of 2.1% for 2016, rising to 2.3% this year. The full range of our forecasts can be found on page 11.

We expect key contributors to economic growth over the coming year to include household spending and net exports. Business investment weighed on economic growth over the past year and is likely to continue to do so this year.

The labour market has added jobs over the past year, although a fair degree of slack remains. The unemployment rate edged up to 5.8% in December, from 5.7% a year earlier. In the year to December, a net 91.5k jobs have been created, although jobs only grew in the part-time category, with the number of full-time jobs declining over that time.

Wages growth is very weak. It hit a record low both in quarterly and annual terms in the September quarter 2016. Against a backdrop of soft price pressures and spare capacity, both domestically and globally, wage growth is expected to remain subdued in coming quarters.

Inflation remains low, both in the domestic economy and globally, necessitating very low interest rates globally. Headline CPI inflation rose by just 1.5% in the year to the December quarter 2016. Underlying inflation also remains very subdued, rising by 1.5% over the same period, which is well below the RBA’s 2 to 3% per annum target band for inflation.

Population growth has slowed in recent years, to 1.4% in the year to the June quarter 2016, from a recent peak of 2.2% prior to the GFC. Despite the slowing, the pace of population growth remains solid, which should help support economic growth.

Fiscal Policy

In December’s Mid-Year Budget update, it was revealed that the deficit for the 2016-17 fiscal year is expected to be slightly smaller than forecast in May. However, Budget deficits beyond 2016-17 are expected to slip further into the red. Australia appears to be edging closer to losing its AAA credit rating, potentially some time this year.

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Risks to Domestic Growth

There are risks to every forecast. Although we expect modest domestic economic growth this year, extended weakness in business investment, an approaching downturn in dwelling investment and the possibility of less strong growth in consumer spending present risks to the domestic economy. The global economy has a large impact on Australia which also poses risks. Softer than expected economic growth in China, US trade policies that weigh on global economic growth and renewed weakening in commodity prices are all potential risks for domestic economic growth.

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Capital Expenditure(by industry)$bn $bn

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Unemployment Rate(per cent)

Our economic growth and inflation forecasts can be found on page 11.

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The Outlook for the Interest Rates

The Reserve Bank Juggling Act

The Reserve Bank faces a difficult balancing act as we move through 2017. Economic activity remains sluggish and inflation sits below the Reserve Bank’s 2-3% target band. We are unlikely to see this picture change in 2017. But, against this backdrop, house prices are reaccelerating at a time when wages growth is at a record low. It means household balance sheets are being stretched.

In the minutes of its December 2016 board meeting, the Reserve Bank chose to highlight this juggling act in its considerations for monetary policy. The minutes said that “over recent years the Board had sought to balance the benefits of lower interest rates in supporting growth and achieving the inflation target with the potential risks to household balance sheets”. This paragraph suggests the hurdle for a rate cut is higher, even with inflation running below target and economic activity travelling at a torpid pace. It further suggests that the Reserve Bank might tolerate inflation being below target for longer given that it is also eyeing potential risks to household balance sheets.

The Australian economy contracted by 0.5% in the September quarter. Australia is unlikely to record a technical recession when figures are released in the December quarter. In fact, Australia remains on track to take out the title for the world’s longest economic expansion. But our projected growth rate of 2.3% for this year is well below the potential growth rate. This growth projection takes into account waning headwinds from commodities and mining capital expenditure. Residential construction has provided a boost to economic growth, but the cycle is turning and will start to slow as we near 2018. Growth in household spending is likely to stay modest.

An environment of low growth and low inflation, if persistent, could force the RBA to return to cutting rates, but it might take time to do that. The risk of another rate cut remains, but if it happens, it will likely occur later rather than sooner. August is our favoured timing. Previously it was May. But with the reacceleration in Sydney and Melbourne dwelling house prices over December and January, we have pushed back our timing for a potential rate cut.

Whether the RBA moves again will depend on the data, particularly data on inflation and employment. Employment growth has more than halved from the same time a year ago. In December 2016, employment grew by just 0.8% but a year ago was growing by 2.6%. Jobs growth lags economic activity, but with no noticeable pick up likely in economic growth this year, unemployment is unlikely to drop substantially.

While the RBA might tap on the accelerator one more time, it is clear that the easing cycle is nearing the end. In a recent survey of economists, published by Bloomberg on 27 January 2017, ten economists were forecasting a rate cut in 2017, thirteen had a projection of no change to rates and one economist expects a rate hike. This sort of divergence in views is often observed at turning points in the rate cycle.

Market pricing remains out of sync with economists. Interbank-cash-rate futures are attaching a 10% probability of a rate hike by the end of this year.

Businesses and corporates do not borrow at the cash rate. They typically borrow at rates that are priced off the swap yield curve. The three-year and five-year swap rates have been more heavily influenced by US developments than domestic ones. So while there is a risk that the RBA might cut

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rates once more, swap rates over the year ahead are likely to continue to grind higher. We believe the low in swap yields has passed.

Indeed, Australian swap yields have moved a long way from the low on 31 August 2016. Australian 3-year swap yields are up 49bp and 5-year swap yields have jumped 72bp since the end of August. Swap rates have retreated from their 2016 peaks since the US Federal Reserve meeting in December, but rates are likely to resume moving higher once this pullback has ended.

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Australian 2-Year Government Bond Yield (lhs)

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The push higher in US bond and swap yields has been driven by robust US economic data that suggests the US Federal Reserve will raise the Fed funds target rate further. We are expecting two rate hikes in the US in 2017.

The case for more rate hikes in the US this year is compelling. US labour market conditions continue to tighten. Unemployment is at 4.7% and the economy is widely considered to be at close to full employment. A lift in wages growth and inflation should follow.

Trump’s presidency has added uncertainty to the US and global economic outlook. It is too early to make a concrete assessment of Trump’s plans because it is not clear if he will focus on trade restrictions or fiscal stimulus or both. If trade restrictions were emphasised, economic growth could be hindered. If fiscal stimulus (tax cuts and infrastructure spending) were emphasised, the economy would receive a boost; under this scenario, the US Federal Reserve might need to hike rates more than twice, taking US bond and swap yields higher.

In an environment where US yields are being pressured higher, Australian swap yields are likely to also press higher, although at a more moderate pace than in the US. We expect Australian three-year swap yields to be around 35bp higher by the end of this year.

It means any reasonable pullback in swap yields should be viewed as a possible opportunity for businesses/individuals with interest-rate exposure to take some risk off the table by hedging.

Our full interest rate forecasts can be found on page 11.

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The Outlook for the Australian Dollar

The Australian dollar traded within a narrow range over most of the second half of 2016, although it dipped briefly at the end of the year to finish 2016 at US$0.7208. Strength in commodity prices and stronger than expected growth in the Chinese economy have continued to prop up the AUD. However, USD moves have also been a major factor in determining the AUD’s value.

The election of Donald Trump to the US presidency has provided a major boost for the US dollar over the past few months. Expectations of increased infrastructure spending and tax cuts saw the US dollar index scale to its highest in almost 14 years. Nonetheless, the US dollar has since retreated as Trump failed to deliver any further details on these stimulus plans. Moreover, there are concerns that Trump’s protectionist policies including high tariffs and restricting borders will weigh on economic growth.

The Australian dollar has moved inversely with the US dollar, falling to an intraday low of US$0.7160 on 24 December 2016, but rebounding over the past month to trade around 75-76 US cents on 1 February.

Trump, the Fed and the US Dollar

The election of Donald Trump to the US presidency saw a significant reaction in financial markets. Rhetoric from Trump has hinted at reducing company regulation, cutting taxes and ramping up infrastructure spending. Such policies would act to boost GDP growth, at least over the next couple of years, and have heightened expectations of higher inflation. Bond yields have increased sharply as a result, along with the US dollar.

Expectations that the Fed might need to raise official interest rates more quickly than previously expected have also been a factor in propping up the US dollar, and therefore placed downward pressure on the AUD.

While hope of fiscal stimulus and a faster pace of rate hikes by the Federal Reserve are providing significant support for the US dollar, a lot of optimism has been priced into markets. If the Federal Reserve raises official interest rates by 50 basis points in total in 2017 as expected, then there is unlikely to be a significant reaction to the currency. Fed funds futures are suggesting that markets are mostly pricing in a total of 50 basis points of hikes by the Fed. While we expect the USD to remain elevated, we do not expect the US dollar to rally much further from current levels. Indeed, the US dollar and bond yields have since retreated from their peaks suggesting that their earlier moves were overdone.

There is also a large amount of uncertainty to the extent that Trump’s proposals will be enacted. Little detail on his policies has been provided and measures will need to be passed through Congress. This would suggest significant uncertainty around the impact on the US economy and the US dollar. Nonetheless, we expect the US dollar is likely to remain elevated against major currencies while the Federal Reserve continues to raise interest rates.

The Australian Economy and RBA Outlook

The other factor which will have a major influence on the currency is the outlook for the Australian economy and interest rates.

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The Australian economy has been growing at just a modest pace while the unemployment rate has tracked sideways over the past year. Inflation and wage growth has been subdued, and suggest that there exists spare capacity within the economy.

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Where Will the Fed Funds Rate be end 2017?

(based on fed funds futures)

Implied two 25 bps rate hikes over 2017

Without strong prospects of a pickup in the Australian economy to an above trend pace, official interest rates are likely to remain low. This suggests that if the RBA were to move rates this year, there is a greater risk that they will be lower than higher. Market pricing is suggesting just a small chance of a rate cut this year and even a slight chance of a hike by December. Therefore any shift towards an easing bias or a rate cut by the RBA would pose a downside risk for the AUD.

Ongoing low interest rates in Australia and rising interest rates in the US would suggest that the interest-rate differential between Australia and the US will likely continue to widen. This widening points to downside risk for the Australian dollar.

Commodity Prices and China

A rebound in commodity prices has been a key support for the Australian dollar over the past few months. Commodity prices have risen significantly over recent months, particularly prices of coal, iron ore and metals. Monetary and fiscal stimulus in China has boosted growth and demand for commodities. At the same time, there have been some measures to cut excess capacity, particularly in the production of steel and coal. There has also been a more speculative activity in China, as investors seek alternative assets outside of the stock market and real estate. This speculative activity could help explain a lift in volatility over recent months.

However, we are unlikely to witness a surge in global commodity demand. The IMF is expecting growth to pick up in 2017 and 2018 to 3.4% and 3.6%, respectively, after estimated growth of 3.1% in 2016. A key factor behind this improvement reflects expectations there will continue to be stimulus supporting growth in China. Nonetheless, rapid credit growth remains a key downside risk, as high debt levels can weigh on the economy. There have recently been measures to curb housing market activity, which could weigh on construction and demand for raw materials.

On the supply-side, bulk commodity producers, especially in Australia, have the ability to increase production if prices continue to lift. Moreover, high prices may encourage Chinese authorities to restart idle capacity. Authorities have already temporarily relaxed their policy to limit Chinese coal output.

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Other commodities, such as oil, also face uncertainty. The outlook for oil prices will depend on whether OPEC will successfully curb output. However, US shale producers have the ability to ramp up output particularly if prices lift from current levels.

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Higher commodity prices are likely providing the AUD with support, but the AUD appears to be trading much lower than what commodity prices are currently suggesting (see charts above). It appears that the Australian dollar has “decoupled” from commodity prices. This divergence between commodity prices and the AUD might reflect that financial markets are already anticipating that commodity prices will reverse their gains. Consensus forecasts are suggesting iron ore prices will fall to US$40-60 a tonne by the end of 2017, far below the current price of US$83 a tonne. Moreover, nearly all contributors to the survey are expecting a decline in prices. There is a similar story for coal prices. Consensus forecasts for coking coal prices are at US$130 a tonne for the end 2017 in comparison to the current price of US$170. This could imply that the AUD may not necessarily come under much downward pressure should commodity prices retreat. That said, there is significant uncertainty around the outlook for commodity prices. However, we do not expect that commodity prices will revisit the unsustainable lows that they hit in January.

Australian Dollar Outlook

Key fundamentals for the AUD are providing mixed signals for the outlook. The narrowing interest-rate differential between Australia and the US point to downside risks for the Australian dollar. However, resilient commodity prices could provide support and, in our view, a modest fall in commodity prices may not necessarily bring down the Australian dollar. Indeed, a pullback in coal prices since December appears to have had limited impact on the Australian dollar’s value in recent months.

Commodity prices have tended to be better predictor of the AUD, over the long-term. While we expect commodity prices will undergo some further declines over the medium term, a modest decline in prices would still be consistent with an Australian dollar trading close within the 75-80 US cent range.

The US dollar and how markets react to Trump’s policies and the Federal Reserve will also be a major influence on the Australian dollar. In our view, this will be an important driver for currency markets, particularly given other fundamentals are providing mixed signals for the outlook.

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As discussed, we expect the US dollar to remain elevated given our expectation that the Federal Reserve will continue to raise official interest rates. However, given at least two rate hikes appear to be priced into financial markets, we think that further significant appreciation in the US dollar is limited. Fiscal stimulus from Trump could provide the US dollar with support, but this is likely to be outweighed by Trump’s protectionist agenda and the unpredictability of Trump’s policies are likely to weigh on risk appetites and therefore the AUD.

On balance, we think that the US dollar index will mostly track sideways over the course of the year, notwithstanding some volatility in between. This would suggest that the Australian dollar will also end the year not far from current levels. We expect the AUD to end 2017 at 75 US cents.

Our detailed currency forecasts can be found on page 11.

Major Upcoming Data and Events

Australian Data / Events Underlined

February

1st

US FOMC Rate Decision

1st

China Manufacturing PMI Jan

2nd

Aust Trade Balance Dec

2nd

Aust Building Approvals Dec

3rd

China Caixin Manufacturing PMI Feb

6th

Aust Retail Trade Dec

7th

Aust. RBA Cash Rate Decision

10th

RBA Statement on Monetary Policy

10th

Aust. Housing Finance Dec

14th

NAB Business Survey Jan

15th

China CPI Jan

15th

WBC-MI Consumer Confidence Oct

16th

US Retail Sales Jan

15th

Industrial Production Jan

16th

Aust Labour Force Jan

16th

US Housing Starts Jan

21st

Aust. RBA Meeting Minutes Feb

21st

US Markit Manufacturing PMI Feb

22nd

Aust. Wage Price Index Q4

22nd

Aust. Construction Work Done Q4

22nd

US Exisitng Home Sales Jan

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US FOMC Minutes Feb

23rd

Aust. Private Capex Q4

24th

US New Home Sales Jan

24th

US UoM Consumer Sentiment Feb

27th

Aust. Company Profits Q4

27th

China Industrial Profits Jan

28th

Aust. Current Account Q4

28th

Aust. Private Sector Credit Jan

28th

US GDP Q4

28th

US S&P CoreLogic House Prices Dec

March

1st

Aust. CoreLogic House Prices Feb

1st

Aust. GDP Q4

1st

China Caixin Manufacturing PMI Feb

1st

China Manufacturing PMI Feb

1st

US ISM Manufacturing Feb

2nd

Aust Building Approvals Jan

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Forecasts

2016 2017 2018

End Period: Q3 Q4 Q1 (f) Q2 (f) Q3 (f) Q4 (f) Q1 (f) Q2 (f)

Interest Rates:

RBA Cash Rate, % 1.50 1.50 1.50 1.50 1.25 1.25 1.25 1.25

90 Day BBSW, % 1.72 1.80 1.75 1.75 1.55 1.55 1.55 1.55

3 Year Swap, % 1.69 2.18 2.15 2.25 2.35 2.45 2.45 2.50

10 Year Bond, % 1.91 2.77 2.90 3.00 3.05 3.15 3.20 3.30

USD Exchange Rates:

AUD-USD 0.7664 0.7208 0.7400 0.7500 0.7500 0.7500 0.7600 0.7600

USD-JPY 101.35 116.96 113.00 113.00 112.00 112.00 110.00 110.00

EUR-USD 1.1235 1.0517 1.0600 1.0600 1.0700 1.0700 1.0800 1.0800

GBP-USD 1.2972 1.2340 1.2500 1.2800 1.2800 1.3000 1.3000 1.3200

USD-CHF 0.9714 1.0190 1.0100 1.0100 1.0000 1.0000 0.9900 0.9900

USD-CAD 1.3127 1.3441 1.3400 1.3400 1.3300 1.3300 1.3200 1.3200

NZD-USD 0.7286 0.6934 0.7000 0.7100 0.7100 0.7200 0.7200 0.7300

USD-CNY 6.6718 6.9450 6.9000 6.9000 6.8000 6.8000 6.7000 6.7000

USD-SGD 1.3631 1.4468 1.4200 1.4200 1.4100 1.4100 1.4000 1.4000

AUD Exchange Rates:

AUD-USD 0.7664 0.7208 0.7400 0.7500 0.7500 0.7500 0.7600 0.7600

AUD-EUR 0.6820 0.6850 0.6980 0.7080 0.7010 0.7010 0.7040 0.7040

AUD-JPY 77.70 84.30 83.60 84.80 84.00 84.00 83.60 83.60

AUD-GBP 0.5910 0.5840 0.5920 0.5860 0.5860 0.5770 0.5850 0.5760

AUD-CHF 0.7440 0.7340 0.7470 0.7580 0.7500 0.7500 0.7520 0.7520

AUD-CAD 1.0060 0.9690 0.9920 1.0050 0.9980 0.9980 1.0030 1.0030

AUD-NZD 1.0520 1.0400 1.0570 1.0560 1.0560 1.0420 1.0560 1.0410

AUD-SGD 1.0447 1.0429 1.0508 1.0650 1.0575 1.0575 1.0640 1.0640

* Note that the AUD cross exchange rates have been rounded.

2015-16 2016-17 (f) 2017-18 (f) 2015 2016 (f) 2017 (f) 2018 (f)

GDP, % 2.5 1.7 2.7 2.3 2.1 2.3 2.7

CPI (Headline), % 1.4 1.6 2.0 1.5 1.3 1.8 2.2

CPI (Underlying), % 1.8 1.6 1.8 2.2 1.5 1.6 2.1

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Contact Listing

Chief Economist Senior Economist Senior Economist

Besa Deda Josephine Horton Janu Chan

dedab@stgeorge.com.au hortonj@stgeorge.com.au chanj@stgeorge.com.au

(02) 8254 3251 (02) 8253 6696 (02) 8253 0898