Reviewing a year of renewed risk and reading the runes for 2019

In late November 2018, KangaNews hosted its annual roundtable discussion for Australian fixed-income strategists. At the end of a turbulent year for markets and geopolitics, the discussion was unusually wide-ranging – taking in factors as diverse as the long-term status of the US dollar as global reserve currency, the duration of the Australian housing-market decline and the credit-supply outlook.

PARTICIPANTS

Philip Brown Senior Fixed Income Strategist COMMONWEALTH BANK OF AUSTRALIA
David Goodman Head of Macro Strategy WESTPAC INSTITUTIONAL BANK

Alex Stanley Senior Interest Rate Strategist NATIONAL AUSTRALIA BANK
Martin Whetton Head of Australian Dollar Rates Strategy ANZ

MODERATOR

Laurence Davison Head of Content and Editor KANGANEWS

RISK FACTOR REVIEW

Davison We’ll start the discussion by looking back at some of the themes from the 2017 roundtable. A year ago one of the most notable recurring themes was the fact that inflation was seen as the missing link in the global growth story. Fast forward to November 2018 and inflation remains sluggish. What is going on?

GOODMAN Inflation is certainly still the missing link. This has been the reaction function which has changed since the financial crisis, thanks to the flattening of the Phillips curve. However, there are signs of labour-market tightness in the US and we know this leads to wage growth and inflation.

What we missed was how deep the scars from the financial crisis were and how much spare capacity the global economy had created. It is recovering and growth rates are picking up, but it is taking a lot longer than anyone expected.

STANLEY Unemployment has fallen significantly in a lot of countries but inflation still has not come through in a major way. However, as David Goodman says, the US is a good example that the lags are just longer this time.

It’s also important to remember that it wasn’t long ago that we were talking about heightened deflation risk in some places, such as Europe. There is more confidence now that these risks have eased. Growth has slowed a bit, but capacity measures and wages are starting to come through.

BROWN Perhaps it is a result of the deep scars that people just aren’t using credit, particularly in Australia. There is some credit coming through for households, but business credit just isn’t picking up.

For the first time, we are trying to have an Australian recovery without the credit cycle overlaying it. This means we are seeing what an economic cycle without credit involved looks like.

The answer is that it is very slow. Credit was a key part of the self-reinforcing recovery. Once people start feeling more optimistic, they are meant to borrow money, invest and create jobs – which then makes other people feel optimistic. This accelerant isn’t in the economy anymore, and we are learning what the business cycle is like without it.

WHETTON We have also been told by governments, regulators and central banks not to borrow. Corporates have been heeding this and not borrowing as much, and therefore the cycle has not been the same.

There should at least be confidence that we are in a growth cycle. It is creating jobs and supercharging profits, but it is not coming at the pace we would have seen previously.

The parallel back to the markets is that every time employee-cost indices have gone up, indicating that inflation and wages are slightly higher, bond markets have become scared. The biggest moves this year have been when inflation has reared its head. The biggest sell-offs have been in the US rates market, which is the vanguard for cash-rate hiking and inflation around the world.

"I have no doubt that November 2016, ie Donald Trump's election, will be looked back on as the point when the US dollar lost its status as the global reserve currency."

Davison Europe was another risk factor that came up a lot in our 2017 roundtable. The things that seemed problematic at the time haven’t blown up but also don’t seem to have gone away. How do strategists view European risk right now?

WHETTON In 2017 we had a positive view that we would see the European Central Bank (ECB) tapering, which it has. We were also confident in global synchronised growth and that we would see Europe on an upswing.

GOODMAN In 2017 we also used the words “a series of rolling crises”, which I think has been fairly accurate. There is the continuous issue of the EU being a monetary union without being a fiscal union. The politics associated with this will continue.

It is likely that there will continue to be flare ups but the project will continue to work. Risk has declined, but there are two potential things to keep an eye on. The first is when Mario Draghi is replaced as president of the ECB in October 2019. So much of what has been possible there has been because of Draghi’s “whatever it takes” speech.

STANLEY Every year there seems to be concern about political risk in Europe. But there is broad recognition in markets that the risk of an existential threat to the EU arguably hasn’t increased much and that the ECB is still a significant backstop.

GOODMAN The second risk factor is the ECB itself. In December 2018 it will stop buying corporate debt and we know many European investors are buying credit at tighter margins than they want, including with negative yield, just because they have to buy something.

We are going to find out if this approach makes sense when the big buyer is no longer there to perpetuate the crowding in to credit. European markets could face a very different backdrop and, at the same time, a new ECB president.

STANLEY The ECB is going to have to move very slowly and ween the market off the asset-purchase programme. It can also continue to use forward guidance on rates to lean against stumbles in the data.

Australia's future state of credit supply

Australia’s banking royal commission and the sluggish state of corporate capex seem likely to shape the future of domestic credit at retail and institutional level. Neither factor points to a major supply uptick.

Davison Stability is the centrepiece of the financial-sector regulatory system. How might the royal commission into banking misconduct change the way regulators think about the financial system and its purpose?

WHETTON What the Reserve Bank of Australia, the council of financial regulators and the Australian Prudential Regulation Authority say about financial stability is not going to change on a dime. I cannot see the RBA endorsing a policy about competition to provide credit at the expense of stability.

The pendulum hasn’t swung too far the other way yet but the atmospherics are not good in the housing market and one of the reasons is the availability of credit. There was too much for a while. At the moment I don’t think we have too little but we probably can’t afford to tighten much further.

The balance in the regulatory system is right. The banks are more stable than they were and are now able to weather a downturn thanks to the capital requirements that are largely in place. The regulator has been very effective in this. It is important not to introduce too many new things that may bring unintended consequences.

Atmospherics are not good in the housing market and one of the reasons is the availability of credit. There was too much for a while. At the moment I don’t think we have too little but we probably can’t afford to tighten much further.

MARTIN WHETTON ANZ

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Davison One thing that everyone seemed to predict when we met in 2017 was market behaviour becoming characterised by periods of calm interspersed with bouts of volatility. How closely has the reality matched what was predicted?

WHETTON It has matched quite well. Every bank is more constrained in its trading capacity and they can’t take on the risk they could before. There will be periods where lots of players have the same trade on and these will sometimes be exited in a hurry, prompting brief flurries of volatility before things settle down again.

I don’t think it is because there is some sort of magic central-bank put in the background. I think it is simply that the ability to take and warehouse risk is not what it previously was.

In this context, one important message is that borrowers should be willing to make hay while the sun shines, exploiting calm periods where spreads are tight and markets are able to absorb issuance.

GOODMAN I agree that market structure has changed. Positioning surveys place more importance on our thinking than they used to.

BROWN I agree with this – and what we saw in the New Zealand market at the start of November is a good example of why. I’d been thinking that volatility comes from technical reasons which are completely divorced from the data a lot of the time, but when the two overlap you can get a very nasty move.

That’s what happened in New Zealand: positioning moved against the backdrop of some surprise data. As a general rule, though, volatility does seem to be more about technical factors and positioning rather than anything underlying.

STANLEY I agree with Martin Whetton on the central-bank put, but there is also a perception that the strike for the Fed [US Federal Reserve] put is a bit lower than many would have thought earlier in the tightening cycle.

We saw this in the stock-bond correlation at various points in 2018. Often we would have expected more of a second-round bid for US Treasuries, but the Fed has been resolute on a number of occasions.

GOODMAN If we were equity analysts, we would be talking about exchange-traded funds and how they are changing market structures massively with algorithmic trading. I wonder whether bonds are just the tail of the dog, in other words equity price action is leading to some strange things happening in bond markets, or whether we are just a few years behind these developments.

DEMAND FOR AUSTRALIAN DOLLARS

Davison How resilient has demand for Australian dollar bonds been in 2018, in an environment of rates reversion and rising US dollar yield?

STANLEY There had been some concerns about demand for Australian dollar bonds given valuations relative to US Treasuries earlier in the year. However, I think many global investors have regarded long-duration positions in the Australian market as defensive and offsetting shorts elsewhere, such as the US. The relative steepness of the Australian curve versus the US also helps with carry.

In this way, the stability of the Reserve Bank of Australia (RBA) policy outlook has been very supportive. If you look at Japanese demand over the last six months, while hedging costs have significantly increased for funding Australian dollar bonds we can see there is a positive net inflow compared with the likes of Canada – which is advanced in a tightening cycle and has a flatter curve. This is important, notwithstanding the ructions we have seen in funding and FX forwards.

BROWN Those FX forwards are quite important because Australian outright yields are fairly low but the curve here is still quite steep. For offshore investors starting in US dollars, once they implement FX hedging they are picking up a lot more in Australian dollars because as the US curve flattens it affects the way the FX hedge works.

These investors are now being paid on the Australian dollars before they even start with bond yields. They can afford to take 40-60 basis points less than US Treasuries and still end up ahead because they have the FX carry coming through. Relative headline yield therefore hasn’t been as much of an issue as it might have been.

GOODMAN There has been a lot of worry about offshore demand holding up for Australian dollar bonds. But things are good in Australia at a macro level, the currency is still performing reasonably well and corporate Australia is in robust health. Demand for Australian dollar bonds, whether sovereign or credit, still sits in quite a good place.

Davison Is what you are saying that the type of demand for Australian dollar bonds has changed but net demand has remained stable?

WHETTON Japanese life-insurance companies have slowed down their need. But they are looking at it from the perspective of starting in yen, where they can buy Japanese government bonds now. They couldn’t do this even six months ago. They can also buy US Treasuries outright as well as investment-grade US credit, because the macro conditions there are good.

The global yield structure is higher, so while these investors can still consider Australia to be part of their portfolio the inflows that supported it in recent years have eased. It is still an important component but there are competing assets.

This is also helped by the stable RBA outlook. Offshore investors can buy with a reasonable amount of confidence that they won’t lose too much on the currency. The Australian dollar-yen was in the high ¥70s recently and long-term this is not a bad entry point. If the Australian curve is steep and yield is attractive enough there will be demand.

GOODMAN We always had a slightly more confident outlook on demand, based on our confident RBA view supporting our comfort even as Australian-US yield has gone deeply negative. I have to admit, though, that as the level hit minus-10, minus-20 and onwards we did wonder at each landmark whether it would be the end. We were certainly less confident when it hit minus-50 basis points.

BROWN It always seems that we are trying to come up with a good reason why it shouldn’t go further negative, but narrowing is an eight-year trend. We should be coming up with reasons for it to stop.

GOODMAN Exactly – and we have had this exact conversation with clients. They want to put on opportunistic wideners and we have to convince them that they should put the narrower on and come back to it in a few months’ time.

I also wanted to touch on credit demand. This has been an unusual year for Australian credit supply. Corporate Australia is not borrowing much because there isn’t much capex and at the same time there have been a lot of asset sales. Corporate Australia is flush with cash and there were also a lot of unique factors which made 2017 look like a big supply year, in particular some large Kangaroo deals. In fact, the 2018 run rate is probably close to normal.

Next step for Australian capital

The Australian Prudential Regulation Authority (APRA) made its first official pronouncement on a potential Australian equivalent of total loss-absorbing capacity (TLAC) rules in November 2018. Local market participants are still assessing the potential consequences.

Davison APRA’s TLAC focus is on tier-two capital. What might the market consequences be if the big-four banks each have to do an extra A$3-4 billion (US$2.2-2.9 billion) of tier-two funding every year?

WHETTON They will do that much less in senior funding. Senior pricing will come in and tier-two will go a bit wider. This is whether the banks do 10-year non-call five years in Australian dollars or bullets in the US supplemented by euro issuance.

If anything, there may be more of a bid to the cross-currency basis in that environment because there is a larger amount of issuance to be done. Investors in senior debt will have a larger buffer under them, which is good. It is not as good on the equity side, perhaps.

GOODMAN We are talking about big numbers and the issuance will come at the expense of senior. It remains to be seen whether the domestic investor base wants or has capacity for this much subordinated debt.

I think the Australian proposal is appealing for offshore investors. Having an asset class they are already comfortable with and have done their credit work on – rather than a new, untested regime – is probably a good thing.

DAVID GOODMAN WESTPAC INSTITUTIONAL BANK

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Davison We have finally seen the long-expected bond-market yield reversion in the last 12 months. However, the equity market has had a tough time in the second half of the year. Should we not have seen a bond market rally?

BROWN Yes and no. The equity market had an astonishing rally, so while the correction from peak to trough was also quite large the move is actually not that great in the whole year to date. Meanwhile, US Treasury yields are rising but not excessively so.

To my view, the bond market has it right. The Federal Open Markets Committee (FOMC) is still hiking and it is not going to turn around because there has been some success. If we were having this discussion 10-15 years ago, the view would be that economic conditions are improving, unemployment is low and there is a hint of inflation – in other words, there are good things happening so we need to raise rates.

STANLEY The market questioned the Fed’s resolve a bit more a few years ago when there were bouts of volatility and it might have been less sure of itself. This tells us how far the US has come in its expansion.

BROWN I agree, though, that it was a bit surprising there wasn’t more movement in the bond market when we experienced the big fall in equities. At some points there were even opposite moves, which was odd. But looking at a longer timeframe, it seems about right. Equities got ahead of themselves and came back whereas bonds didn’t get as far ahead of themselves.

GOODMAN We have seen a bit of a wobble very recently but in the long term it is apparent that the Fed will keep hiking and yields will keep rising. [Fed chair] Jay Powell has spoken about the cycle continuing indefinitely, which is ‘Greenspanesque’ language.

WHETTON One of the local Fed chairs recently made a speech in which they compared the expansion of the US with the expansion of Australia – in the sense that there is no reason why the expansion has to end.

STANLEY Expansions don’t end because of old age – they end because of imbalances.

BROWN This goes back to the earlier point around credit. If there is no credit supercharging the expansion, why does it need to end?

“Our economists’ models on wages have underemployment included. It’s still providing a drag, but less so than it was a few years ago. Broadly, wages growth is bottoming out.”

GEOPOLITICS AND ECONOMIES

Davison The supercharging force arguably could be the unfunded stimulus the US has put into its growing economy over 2018, in the form of an estimated US$1.5 trillion tax cut. Should markets be more worried about the consequences of the tax cut than they appear to be?

WHETTON James Carville, who was an economic adviser to president Bill Clinton, said in the 1990s that when he comes back in the afterlife he’d like to be the bond market – so he can scare the life out of everyone. In 2018, everyone just seems to shrug over levels of debt.

It is bizarre, and there should be worry about the path of the US. Not just the political path but the brazen late-cycle, unfunded and somewhat pointless tax cuts.

GOODMAN It is an unusual policy mix, but in the short term there is no need for concern because the US can fund these deficits. It is not going to cause a crisis now. The problem comes in the long run, because it means higher inflation and higher rates than would otherwise be the case.

STANLEY There is an argument that it leaves the US government with less headroom. But if push came to shove it would just do the same again – and also with monetary policy.

GOODMAN This is the “exorbitant privilege” of being the world’s reserve currency. Until this changes, the US can do whatever it wants with US dollars.

BROWN This is exactly the point I would make. The US will regret this in another two or three business cycles when the US dollar isn’t king anymore and the US has to borrow in a competitive market. When investors can make a choice, rather than just taking US Treasuries because they are the reserve market, there will be a point where the US regrets not having dealt with this differently.

GOODMAN I have no doubt that November 2016, ie Donald Trump’s election, will be looked back on as the point when the US dollar lost its status as the global reserve currency.

The political machinations that are happening now – from the South China Sea to the Port of Darwin to One Belt, One Road – are all part of it. But November 2016 will be seen as the trigger, similar to when sterling lost reserve status.

BROWN It is not what the US is doing, though. It is more what it is not doing. There is no-one like Barack Obama in the background having a reserved and strategic pushback globally. There is no consequential pushback in the South China Sea, for example. Australia is trying and Canada is trying, but what can they really do?

If there is no cooperation within NATO, there is no pushback. Whenever president Trump’s term ends, lots of people are going to realise they should have been watching what was happening in other parts of the world over this period.

When Deng Xiaoping was in power in China the official policy was to “hide your strength and bide your time”. About six months ago this policy was retracted and China has been taking a much more muscular stance ever since – to which no-one is reacting.

STANLEY There are also the tariffs, which can be seen in the context of trying to limit the progress China is making in a lot of spheres, given China is a more trade-exposed economy than the US. The trade war is increasingly being viewed as part of a longer cold war between the US and China.

BROWN For this kind of geopolitical tension, 2-3 per cent of GDP growth is fairly immaterial. It is a matter of who will be Donald Trump’s “coalition of the willing”. It appears Australia will be but there are not many others that will come along. It is a complete realignment, and the soft power which China is deliberately cultivating with One Belt, One Road is the same power that is being squandered by the rest of the world.

“In 2018, everyone just seems to shrug over levels of debt. It is bizarre, and there should be worry about the path of the US. Not just the political path but the brazen late-cycle, unfunded and somewhat pointless tax cuts.”

Davison The fiscal and monetary armouries that were emptied in the wake of the financial crisis have not really been restocked in the succeeding decade. Should we be worried about governments’ capacity to respond given the general assumption that we are getting close to the end of this cycle?

BROWN I challenge the assumption. If there is still slack in the labour market and there hasn’t been any major investment for 15 years there is still work to do. If you convince business to be confident enough they will invest.

Previous FOMC cycles were 12-16 months. We are currently at 33 months since the first rate hike in the US; 57 months if you count tapering as the start of the hiking cycle. That is five years this cycle has been going for.

STANLEY If you had this roundtable 10 years ago no-one would have predicted rates would be negative in Europe or that there would be massive central-bank balance sheets. To say we could never see anything more extreme in another downturn than what we have seen would be a dangerous assumption.

There is still arguably scope for varying amounts of policy intervention in the instance of a downturn in different parts of the world. In Australia, rates never got to extremes so there is arguably more room to cut if needed. The US has done 2 per cent of hikes so it has room as well.

The other point worth making is that the financial system is now better placed to deal with a downturn because of regulation implemented in the last 10 years. Banks have increased capital and lengthened funding profiles. Other responses, like central-bank swap lines, have been set up to deal with liquidity pressures.

BROWN The RBA hasn’t raised rates but it has done a lot of other things that are generically contractionary. At the same time, it is widely believed that there has been a long, slow-down trend in the neutral rate and arguably the neutral rate has fallen even further in the past two years. This essentially means there has been a 25 basis point effective rate hike because the neutral rate has fallen.

GOODMAN The key point is that what was unconventional policy is now a part of the regular toolkit, and the Fed will continue to find new weapons. If you were really worried about the cycle ending now, which I agree it doesn’t necessarily have to, there are more tools available even than we have seen deployed in the past decade.

I am talking about things like electronic money and “time-bomb money” – money which has to be spent within 12 months or it becomes invalid. These sound fanciful but, as Alex Stanley said, they are no more fanciful than if we sat here 10 years ago and said there would be negative rates or that central-bank balance sheets would go to US$15 trillion.

I think we may move to fiscal rather than monetary dominance in the coming decade. We have experienced an extraordinary decade for monetary policy, and perhaps the balance of power might start leaning towards politicians using more fiscal policy – whether it is expansionary or contractionary.

BROWN This essentially happens in Australia anyway, through bracket creep. Governments set tax rates and bracket creep takes care of tightening. Even if there are small tax cuts there is effective fiscal tightening.

Davison Speaking of changing norms, could we also be at a point where the conventional way of talking about the health of public finances is abandoned completely? In different circumstances there would surely be more commentary about the wisdom or otherwise of the US running a substantial deficit at this point in the cycle, yet this issue just doesn’t seem to be on the agenda in most places.

GOODMAN Realistically, over the next 12-24 months funding costs will flare in markets. At some point the narrative will be that yields are rising, there is a growing deficit to fund and near-term issuance requirements are in the trillions of dollars. There will be weeks in which funding becomes an issue. Then there will be charts which show bigger deficits in the past and everyone will move on.

STANLEY Supply pressures tend to be periodic in bond markets for countries with fiscal credibility. Some concession might be required from time to time, but I doubt deficits will reset yields substantially higher.

BROWN I agree that the US dollar won’t lose reserve-currency status for a couple of cycles. But the growing reality gap in how the US government communicates about the deficit is a concern. The US administration hasn’t said the deficit doesn’t matter. What it has actually said is that cutting taxes is necessary in order to cut the government deficit. This is completely divorced from reality and it means it will be very difficult to explain to people why their taxes are going up when time comes to repay the debt.

This reality deficit is a concern over the medium-to-long term. It will probably not bite in the next 5-10 years but it definitely will in 15-20 years. It could take longer – but it will come back and bite eventually.

WHETTON The bottom line is that it has been one of the best expansions in US history – whether you take the president’s rhetoric or the reality – and we have to ask why the US is still producing such enormous deficits. This hasn’t been adequately explained.

BROWN The deficit was improving until the tax cuts. It went to around US$400 billion from around US$1.4 trillion.

STANLEY The deficit as a percentage of GDP bottomed after the financial crisis, at around 10 per cent. It then improved to 2-3 per cent and has since come back to around 4 per cent.

US debt as a percentage of GDP is actually no worse than many countries in Europe, even if the US continues down the path the president has put it on.

BROWN There are forces that can step in and save Italy, though, if they really want to. There is no backstop for the US Treasury.

Benchmark reform

The demise of interbank offered rates globally looks set to be the latest major upheaval international capital markets will have to confront. Australian borrowers need to start preparing for a major shift in the years ahead.

Davison Australia has taken its own path on benchmark reform. What are the considerations for Australian issuers that borrow offshore if they end up having to swap issuance priced off overnight, risk-free – and possibly secured – base rates back to bank-bill swap rate (BBSW)?

STANLEY The end of LIBOR might seem a long time away right now, but with the amount of work that needs to be done I think market participants will have to start preparing sooner rather than later.

BROWN We are less convinced that BBSW will survive, even though the banks have said they want it to. The main reason is that there will be the secured overnight financing rate (SOFR), sterling overnight index average and other rates offshore which, for cross-currency basis swaps, need to be set against an Australian equivalent.

As soon as this Australian equivalent is created it could be used for anything. I suspect there would be strong pressure from offshore over time to use a risk-free rate. It’s hard to imagine a big US-based issuer like World Bank, which will be using a risk-free rate everywhere else in the world, wanting to issue against BBSW in Australian dollars.

The end of LIBOR might seem a long time away right now, but with the amount of work that needs to be done I think market participants will have to start preparing sooner rather than later.

ALEX STANLEY NATIONAL AUSTRALIA BANK

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AUSTRALIAN HOUSING

Davison The housing-market correction in Australia so far seems to be the orderly downturn more or less everyone in the market wanted. But has the downward trajectory now persisted for long enough – with no sign yet of the bottom being reached – that it might be time to start thinking about revising views on whether what we are experiencing can still be called a healthy correction?

WHETTON If it were accompanied by the typical cycle of higher unemployment it would be more worrying. But this is a very atypical cycle.

STANLEY I think the backdrop gives the RBA a lot of comfort. There probably isn’t a better time for a housing correction than when inflation and rates are low and unemployment is falling.

At a macro level, the Australian dwelling investment cycle peaked near the level of some previous cycles as a percentage of GDP. It was nothing like what was seen ahead of some of the offshore housing corrections a decade ago, where there were excess supply issues. The Australian population has also continued to grow strongly so supply, demand and unemployment are all positive stories.

BROWN I think we have to be aware of where we are, though. At the start of the correction we estimated a 7-10 per cent downturn. In Sydney it is sitting at around 7 per cent now and we wouldn’t want this to continue for much longer.

It would be great if prices bottomed out in the next six months at around 10 per cent below peak. But once the fall gets to around 12-15 per cent it starts touching homeowners’ loan-to-value ratios (LVRs), which can cause some nervousness.

So far, you will still have some equity in your house unless you bought at 95 per cent LVR. Once the market gets towards a 15 per cent fall, factoring in transaction costs, there is nothing left even if you started with 80 per cent LVR. This would start to alter behaviour and I think we would begin to see the negative wealth effect coming though. At present I think most people who bought recently should still be comfortable.

GOODMAN We believe it is still manageable and orderly, and it is still what policymakers wanted. Clearly, though, it is getting to the point where the atmospherics are poor.

The jobs market is very strong if we believe the figures. But house prices are falling – something is going on here. Meanwhile, political changes that may come next year around negative gearing, investors, immigration and foreign-buyer restrictions could conspire to push the housing market further into negative territory.

Two things give me confidence. First is that transaction volume is still very low. It was quite low on the way up and has been low on the way down as well. It is possible that people weren’t realising the wealth on the way up – they weren’t cashing out. If the jobs market remains strong there shouldn’t be many forced sellers, even with a change of policy.

The second is sentiment data. Our sentiment survey found that people think affordability has improved and it may be a good time to buy. Sentiment has improved, and this has been most marked in New South Wales (NSW).

“At the start of the correction we estimated a 7-10 per cent downturn. In Sydney it is sitting at around 7 per cent now and we wouldn’t want that to continue for much longer.”

Davison How serious a factor is underemployment when it comes to housing affordibility and loan serviceability?

BROWN We try to figure it out, and we have found that things like the Phillips curve behave a lot better when you do it with underemployment rather than unemployment. The switch to monthly data was only very recent, but it seems to be improving fairly well.

STANLEY Underemployment is elevated, but it has come down a bit. Our economists’ models on wages have underemployment included. It’s still providing a drag, but less so than it was a few years ago. Broadly, wages growth is bottoming out.

BROWN The wage data is interesting. Wage growth is at 2.3 per cent but growth with bonuses it is doing a lot better. This is not financial bonuses. It reflects the fact that, across the economy, there has been a big change in the political power of labour unions. This in turn means the way wage growth is manifesting is not through clear ongoing increases but through things like one-off bonuses. Wages growth looks alright when this trend is factored in.

WHETTON This is probably factored in more when unemployment is at 5 per cent rather than 7 per cent. Knowing that the labour market is becoming tighter, whether looking at unemployment or underemployment, might make us feel a bit more confident.

The jobs market certainly provides this type of confidence in the US. Actually, we can now say with reasonable confidence that wages have bottomed around the world. They are rising faster in some countries than others, but either way it could spur some inflation down the track. It also can feed into confidence if there is some comfort that income won’t go backwards.

Davison Which of the potential political inputs into the housing market is of most cause for concern?

GOODMAN Clearly the political situation is adding to uncertainty. We are already seeing a political scare campaign around differences in housing tax policy. This is just the start, and it already creates a poor backdrop for the marginal buyer to make a decision.

BROWN Actually I think there is a reasonable chance that Labor’s capital-gains-tax policy triggers a pull-forward of investment. The grandfathering of the law will be very important. Labor originally had the change set to be retrospectively implemented from July 2016 but policy introduction has been changed to “a future point”.

The policy could be formulated to allow for long enough that property investors would be able to get their last ‘bite’ of negative gearing. The rules around grandfathering will be very important.

GOODMAN It is an interesting comment. We already know that, when the policy starts, negative gearing will still be available for new developments. This could lead to a bifurcated market or investors being willing to pay up for new development because it is tax-favoured.

Ultimately, though, they will sell and the secondary market is not tax-favoured. A rational investor should never pay more if the next buyer won’t get the same value. When people start investing based mainly on tax outcomes you can get a problem of oversupply.

Risk factors for 2019

In a world of renewed volatility with political risk at a heightened level in Australia and abroad, it is no surprise that strategists find it easy to highlight a raft of potential future risk factors for markets.

Davison What is the main risk factor you are looking out for in 2019 and what risk do you think is most overstated?

GOODMAN I think the main overstated risk is China falling off a cliff. Through 2017 and 2018 there has been a fear of China’s growth stalling. It is slowing, but we are comfortable that this is an overstated risk to the world economy and to Australia’s economy. The main risk globally, I think, is quantitative tightening (QT) and what it means for liquidity. The US$15 trillion which has been inserted into the global economy in the last decade peaked in March 2018. It is slowly coming off, but I think we are still playing in that experiment.

Domestically, with an upcoming federal election there is uncertainty around corporate regulation. This clearly makes for an uncertain environment for investment.

It is very difficult to test the regulatory system for funding when QE is being run at the same time. But we have changed the rules on funding, and we are now starting to test them. The outcome of these tests is a risk.

PHILIP BROWN COMMONWEALTH BANK OF AUSTRALIA

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Davison Presumably if there is any expectation of property investment being pulled forward ahead of a change to negative-gearing rules it would have to rest on an assumption that finance will be available for this investment rush?

BROWN Yes, it is on that assumption. Negative gearing is also most effective if you borrow at 100 per cent LVR – which is almost definitely not going to happen in the current lending environment.

GOODMAN There seems to be a lot of talk about Labor dropping the policy or modifying it. I’m not sure whether this is just property spruiker noise, wishful thinking or because the prices have already adjusted.

WHETTON The policy will have some powerful enemies and I don’t think it is a zero probability that it does disappear. In fact this possibility might be higher than we currently think.

GOODMAN Another thing to look at is what might happen to prepayment rates if there is grandfathering. Prepayment could slow and the policy could also affect whether or not investors choose to refinance. When you have any sort of policy that squeezes the balloon there will always be unintended consequences. This policy could have the effect of changing things like stamp duty.

WHETTON States control planning and they have the option of lowering the bar for developers, which would lower the cost. This might be through payroll-tax relief for those businesses – but it is definitely achievable. Victoria and NSW are having to ween themselves off big stamp-duty revenues and they are having to look at ways to encourage investment.

BROWN Forecasting for house prices was quite good across the states. The Victorian pre-election fiscal outlook write-down was only A$600 million (US$433.8 million). This is still a fair bit, but it is close enough if we are trying to predict the fall in the property market.

Davison Could it be said that the Perth market is a plausible base case for the Australian housing trajectory overall? Prices in Perth seem to have bottomed but are now drifting along flat-to-down rather than rebounding.

GOODMAN Perth has a supply-demand imbalance and prices there have been falling since 2014. It is a plausible assumption nationally, especially if you take potential cuts to immigration into account. But I am less worried about this while we continue to have fast immigration growth.

BROWN Zero growth doesn’t seem likely to me. A long period of 2-3 per cent seems more probable as a base case. A lot of the things that caused this fall were one-off changes.

Specifically, there was a big run up then changes to foreign investment and macroprudential rules. These changes are now done. There are still some changes to come with the interest-only loans that are rolling over in the next 2-3 years. The lowest base case I see is a couple of years with close to zero growth then a more prolonged period at 2-3 per cent.

It is difficult to see how there could be inflation in the general economy, wages trending up, strong employment and a functioning credit system – it isn’t providing as much as it used to but it is still functioning – and non-rising house prices.

Davison It has been interesting to observe the gradual capitulation of Australian rate-hike expectations. Are the risk factors now such that the next move is as likely to be down as it is up?

STANLEY The bar to the RBA cutting is still very high and I can’t see it being cleared. We are in an environment where unemployment is edging lower and wage growth has bottomed. The last 50 basis points of rate cuts were partly due to inflation uncertainty and I think the RBA is now a lot more comfortable with the path it is on.

Relative to what we have seen, there is a degree of slowing in the high-frequency indicators for global growth. But this is coming from an above-trend, strong level. I’m not concerned about short-term risks that would lead to the RBA cutting rates. This does not mean there aren’t challenges to the idea of it hiking next year, but I can’t yet see the case for a cut.

GOODMAN Three months ago we may have said there was a chance that the next move could be down. But the labour market and wages outcomes we have seen recently give us more confidence. Our forecast has been for rates to be on hold throughout 2018, 2019 and 2020. Our chief economist, Bill Evans, has been leading the call on this.

I agree with Alex Stanley that the barriers to a rate cut are huge. [RBA governor] Philip Lowe’s speech where he said financial stability is the goal will be referred to again and again.

BROWN I can see a path to a rate cut, but it is long and requires a lot of things to happen. The first is that house prices keep falling and there is no recovery. If we are on hold for another 18 months and things go badly in the US at the end of the tax-cut sugar hit, there may be US rate cuts which strengthen the Australian dollar.

This could trigger a rate cut, but it requires some big assumptions. First is that a US recession starts at that point and second is that it is particularly nasty. Neither of these are self-evidently true. In fact the last couple of unemployment prints have been very good.

STANLEY On this, the National Australia Bank survey suggests Australia has come off like all global purchasing managers’ indices. But it is still consistent with employment growth of around 20,000 jobs per month.

GOODMAN The leading indicators are still optimistic. We have unemployment dipping below 5 per cent in 2020, yet we still have the RBA on hold. It becomes a discussion about NAIRU [non-accelerating inflation rate of unemployment] and wages. There are a few scenarios in which we could see a rate cut happening but I don’t think any of them are likely to eventuate.

WHETTON Our forecast for the Australian economy is good. So far the consumer has not really been hurt by house prices falling. There is risk if the market falls further but to date this has not happened.

Business and consumer confidence remain relatively high and the federal government is moving towards surplus. If it needs to have a bit more in the tin to spend it can do so, as can the states, so there can be stimulus if necessary.

Exports are going well in bulk commodities, services, education and tourism. Even with the proposed immigration cut, population growth presents a strong backdrop for consumption. All of this conspires to make a high hurdle for a rate cut.

But it is also not easy to see a rate hike. It is easier, purely because it is what the RBA is saying. But we have just extended our expectation for the RBA hike into 2020 given the weakness in housing. I think waiting as long as 2021 is a bit of a stretch. But the near-term risk of a hike is not there, and I think the market has priced this accurately.