Domestic cyclicals set to outperform

Firstly, the Reserve Bank of Australia (RBA) kept its powder dry until the conclusion of the Federal election in May. It then responded decisively to the weakening domestic economy
by cutting interest rates three times, pushing the official cash rate down to a record low of 0.75% in October. Our expectation is that there will be one more 25 basis point rate cut from the RBA, with 50 basis points likely to be the effective floor for the cash rate.

We expect an improvement in global growth and trade. This view is partly based on an expected trade war truce between the U.S. and China, but also on a positive inventory restocking cycle which appears to be emerging. We are already seeing PMI indices in a number of countries starting to improve. 

While there are still a number of external risks and uncertainties, the backdrop for the global economy looks brighter in 2020 than last year.

We believe the RBA does not want to see a strong Australian dollar (AUD). This is because Australia’s major commodity exports such as iron ore and coal are priced in US dollars and a lower Australian dollar would also support domestic growth as well as putting upward pressure on inflation. While a stronger global economy would support the AUD we do not expect a dramatic currency move and a reasonable trading range for the USD/AUD in 2020 might be 65 to 75.

Putting it on the house

There are already signs that RBA rate cuts are starting to gain traction and stimulate the economy. The benefit of lower interest rates is most visible in Australia’s housing sector, which had until recently been in mild recession. Auction clearance rates in Sydney and Melbourne have nearly doubled, while home prices have risen by 5 to 10 per cent, depending on which region.

Australia’s housing correction has turned out to have been a mild one. While house prices in Australia still look expensive versus history and the household sector still appears to be highly leveraged, mortgage rates are at record lows. Besides residential investment, a recovery in housing is also important for the outlook for consumer spending. There tends to be a strong wealth effect in Australia from residential property to consumer demand, operating with a lag of about six to twelve months. As long as the improving trends in housing continue, we should start to see a positive impact on consumer spending by the middle of 2020.

More fiscal stimulus to come

Besides rate cuts from the RBA, we also expect to see a more expansionary fiscal policy from the government that will support growth in 2020. We have already seen tax rebates in July and a A$4 billion infrastructure package announced in November. We expect more to come, since Australia has strong public sector finances which allows the Coalition government to do more to support a sluggish economy.

We believe there is greater political advantage for the government from fiscal easing than from maintaining a conservative stance in order to post a large public sector financial surplus in FY19/20. The government surplus in FY19/20 on current budget projections could be as much as A$10-15 billion, thanks in part to a budget assumption for the price of iron ore that now looks far too conservative. Additionally, the weaker AUD will further support budget tax receipts.

Warming to Domestic Cyclicals

We see a stronger economy as benefiting some domestic cyclical stocks such as retailers that have been out of favour with investors. This is one area where our investment views are somewhat contrarian. We see the retail sector as being well-positioned to benefit from any additional economic strength, and there are already early signs that the better quality domestic discretionary and home improvement retailers are already benefiting from this dynamic. A more positive view relative to our peers on Australian domestic cyclicals is reflected in our holdings of stocks such as JB HiFi and Wesfarmers