RBA holds rates steady as trade war overwhelms markets

President Trump's surprise decision to bring back tariff threats and re-escalate the China-US trade war came just as central bank-supported markets had been lulled into a false sense of security. The latest shift adds a new dimension of uncertainty to what most market participants were assuming was a done deal.

For now, markets are unsure what to make of Trump’s latest outburst. Is this just an aggressive negotiating tactic aimed at securing more concessions from China before the final deal is struck, or have negotiations broken down in a more profound manner? With the President’s strategy being somewhat opaque, markets have remained pragmatic and taken the glass half full interpretation. Traders are taking solace in the indication that the talks will continue as Chinese chief negotiator Vice-Premier Liu He will still visit the US this week. As always, the devil will be in the details, but for now we take comfort in the fact that China have not yet retaliated to the US threats.

But it is likely that Trump's strategy to negotiate harder has been emboldened as the S&P 500 hovers around all-time highs and recent economic strength, as seen in the latest strong US jobs print, reduces the incentive for a swift conciliation. The rhetoric has reversed course radically, and it could be wishful thinking to expect the president to be pacified in just one day. This disruption of the status quo coupled with the current positioning in VIX futures – the largest-ever speculative short – presents the risk of a downside correction in financial markets and pickup in volatility if the latest developments turn out to be more than just posturing; as such, we urge against complacency. 

This could all come to prove a storm in a teacup and Trump’s tweets could all be straight out of “The Art of the Deal” playbook, so while we warn against complacency, it is worth keeping an open mind until the President’s true intentions are known. Is he really willing to jeopardise the recent rally in the stock market, which we know he views as a live barometer of his success?

If the US follow through with their threat on Friday, markets will have to reprice the expectation of a trade deal. In that scenario you cannot rule out a mutual retaliation, particularly as the Chinese side are also more confident in the outlook for their own economic stabilisation. This would push the final conclusion of the trade deal out several months, allowing for a prolonged period of uncertainty and plenty of bumps along the way before the deal is struck. 

All told, until we see a more robust macro environment and confirmation of a self-sustaining re-acceleration in economic growth, we are moving into capital preservation mode, as stated yesterday by Saxo Chief Economist Steen Jakobsen. Equities are now priced for perfection and if the right catalyst were to present itself, the shift from complacency to risk-aversion could be sharp. Given the recent market melt-up despite mixed economic data, one could be forgiven for wondering whether there is any point to analysing the business cycle when it seems to be all about the Federal Reserve and benevolent central banks.

This is why we are recommending investors to be cognisant that risks still remain and on that basis to trim into strength, taking profit in sectors that have run hard since December lows, thus raising cash to deploy on a correction. Alternatively, while volatility is low this presents an opportunity to hedge against some degree of market risk as there are still a lot of question marks on the horizon and extrapolating the previous quarters' returns into the year ahead is unreasonable.

Across the pond, the Reserve Bank of Australia continued to sit on its hands, remaining on hold for the 33rd consecutive meeting as we expected.

The RBA has again remained adamant that deterioration in the labour market is a crucial component in pushing it over the edge to cut the official cash rate. So long as unemployment is trending lower, the RBA will not capitulate on policy guidance. Unemployment is now sitting close to cycle lows at 5% and in March the economy added 25,700 jobs, a beat on the median forecast of 15,000 and most of the beat was for full-time jobs, which rose by 48,300. While we recognise that unemployment is a lagging indicator, the RBA continues to operate monetary policy by looking in the rear-view mirror. 

It is inevitable that the RBA’s hand will be forced into cutting the cash rate, but we have to play the man and not the ball. In that case the labour is key to the outlook for monetary policy in Australia. Several leading indicators are pointing to a slowdown in hiring ahead, ANZ job ads and capacity utilisation continue to illustrate that it may only be a matter of time before softness creeps into the labour market: persistent sub-trend growth will eventually lead to a slowdown in hiring and pick up in unemployment. Regardless, the current underutilisation rate is too high to present enough wage price pressure to materially boost wages. This boost in income growth is necessary for the RBA to see the pickup in inflation forecast and to offset the negative wealth effect generated by slumping house prices.

Another problem is that construction is one of the largest employment sectors, making up nearly one in 10 jobs in Victoria and New South Wales. As residential construction activity deteriorates over the coming months, this will hit jobs. Employment will not continue to hold up as confidence is eroded and growth continues to lose momentum. 

The labour market remains resilient to date, but unemployment is a lagging indicator so the data only gives us a rearward-facing view.
Once evidence of softness creeps into the labour market, the RBA will move to cut the cash rate quickly.