Australia not immune to Global Deleveraging

Australia not immune to Global Deleveraging

PIMCO's head of portfolio management in Australia and Chair of Asia-Pac Portfolio Committee, Rob Mead, on the interest rate and economic outlook for Australia.

After hiking rates seven times post-crisis between October 2009 and November 2010, then leaving rates on hold for twelve months, the Reserve Bank of Australia (RBA) recently changed direction by cutting rates by 25 bps in both November and December to take the policy rate from 4.75% down to 4.25%. This shift was the result of a combination of global and domestic factors.

The rapid escalation in the European sovereign crisis and consequent financial market volatility, coupled with a decline in global growth expectations, have weighed heavily on the confidence and outlook of both businesses and consumers in Australia.

The deteriorating global backdrop plus restrictive domestic monetary policy have nudged the rate of underlying inflation back to the middle of the RBA's target band of 2% to 3% and the unemployment rate up to 5.3%, which should ease wage pressures. This more benign inflation outlook meant restrictive interest rates were no longer appropriate.

The important question is whether this change in policy direction is a modest move back to neutral or the start of a more prolonged easing cycle. Prior to the financial crisis, a 5.50% cash rate roughly corresponded to neutral policy, but with mortgage spreads widening by around 1.25% due to higher bank funding costs since 2008, we now estimate neutral to be closer to 4.25%, the current level of rates.

Looking forward, we expect the global environment to be less supportive, with lower than consensus growth forecasts for China in particular. With the Australian dollar remaining stubbornly above parity to the U.S. dollar and domestic house prices declining, broader financial conditions are set to remain tight despite neutral interest rates. Additionally, the Australian Federal Government remains committed to further fiscal tightening, with the target of bringing the budget back to surplus in the 2012-2013 year despite lower realized revenues resulting from slower-than-forecast domestic growth. For these reasons, we think the RBA will need to ease further in 2012.

Given the starting point of a strong sovereign balance sheet and neutral interest rates, there is ample scope for policy support if required. This is not to suggest that the longer-term secular outlook for Australia doesn't remain constructive - we can expect continuing demand for commodities from China. Investment commitments in the mining sector are very strong and despite recent falls in commodity prices, the terms of trade remains near historically high levels.

However, the past six months have been an important reminder that small open economies such as Australia are not immune to the broader global business cycle despite their fates being more closely aligned with stronger growth in the emerging world in recent times. Australia will continue to be relatively better positioned than the majority of the developed world, however the forces of deleveraging are truly global. Bond yields have been a good leading indicator of economic growth outcomes, so investors should take heed of what this implies for risky asset returns.

About PIMCO
PIMCO is a leading global investment management firm with more than 1,900 employees in offices in all major financial centres, including Sydney. PIMCO is a specialist fixed interest manager for clients world-wide and acts as advisors and asset managers to central banks, corporations, universities, foundations and endowments. In Australia, PIMCO manages more than $30 billion across a wide range of fixed income funds and strategies, for large superannuation funds , self managed super funds, institutional investors and tens of thousands of individual investors. The company is headquartered in Newport Beach, California.

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