All eyes on the Aussie dollar as Australia stalks recession

By not moving interest rates last week, the US Fed has simply added to uncertainty within financial markets. Speaking in front of the House of Representatives Standing Committee on Economics, Reserve Bank Governor Glenn Stevens suggested it is only a matter of time before the Fed raises rates. Futures markets are pricing in a 55% chance of a move at the December meeting. In the meantime, uncertainty is already driving more volatility in financial markets, including Australia’s S&P/ASX 200 which slid more than 2% on Monday.

In the statement that accompanied its decision, the Fed cited continued improvement in the labour market, an improving housing sector, and continued expansion in domestic economic activity. However, a lack of inflationary pressures, together with concerns about the global outlook, seem to have proved decisive in the Fed staying its hand.

The result was largely expected by financial markets, with just a 25% chance of a 0.25 percent rate hike priced into Fed Funds futures prior to the meeting (although the majority of economists, including myself, favoured a rate rise).

However, after first rallying by 1.4%, the stock market gains evaporated as Janet Yellen (the Fed Chair) spoke about contagion from emerging markets affecting the US economy. The S&P500 Index actually closed lower on the day. The losses in the US dollar were also pared back. Several reports suggest traders are concerned that the Fed has greater concerns about the situation in China, and the global economy, than have been revealed so far.

Australian investors to remain cautious

Moving forward, it is likely that investor focus will shift back to the evolving situation in China. In addition to the Fed apparently focusing on developments there, there is a direct impact on Australia’s economy. With China being Australia’s largest trade partner by some margin, any further slowdown in China is going to have a negative impact on Australian economic growth.

Over the past 18 months, the Australian economy has started to transition away from the investment-led mining boom of the past decade or so. A decline in the Australian dollar (a 14% depreciation on a trade-weighted basis) has aided this transition. As well as increasing the competitiveness of Australian exports, service industries such as education (Australia’s 3rd biggest export) and tourism have benefited. It is perhaps a little unfortunate that there is little of the manufacturing sector left to benefit from this. In addition, the declining value of the dollar has offset some of the steep price decline in commodity prices (which are usually priced in US dollars).

The RBA has pinned its hopes on the the declining dollar, coupled with housing construction fuelled by the east coast property boom, offsetting the investment cliff created by the wind down in mining and energy (e.g. LNG) related construction. Business and consumer confidence appears to have received a boost following the replacement of the (in my view) inept Abbott government, and this may help in the short term.

Recession?

But there are early signs that property prices are starting to cool. As the economies of major trading partners are slowing, the resulting fall in commodity prices has pushed many of the newly completed (or soon to be compeleted) projects into the red. It may take a magic wand from the RBA (or the new Turnbull government) for Australia to escape a recession. Already, Australian (per capita) living standards are stagnating, so for many this may feel like a recession, even if the technical definition of recession (two consecutive quarters of declining GDP) is not met.

With this in mind, the effect of Fed action on the Australian dollar may be of more importance. The last thing the RBA will want is for the dollar to start appreciating on the back of a declining US currency.

Until the situation in China is resolved somewhat (which may take many months), Australian investors have every right to be cautious. With uncertainty likely to continue, accompanied by higher volatility levels, risky assets (such as stocks) will be in less demand. Investors may not have witnessed the end of the recent slide in stock markets.

Lee Smales does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond the academic appointment above.