The RBA seems to be little concerned by Brexit and believes it’s far too soon to pass judgment on the effect of the ‘leave’ Europe June vote on the U.K economy, implying that a weaker sterling (down -11% since June 23) could temper the economic fallout. The RBA’s Governor Stevens and his fellow policy makers have noted that the direct effect of Brexit on Australia was “likely to be quite small” given the small trade ties with the U.K.
However, the RBA was less confident about the domestic outlook in its latest statement referring to both the labor market and the housing market with some degree of uncertainty and highlight inflation concerns as their primary focus with weak wage growth and space capacity in the job market adding to deflationary downdrafts.
This outlook would imply greater market sensitivity to inflation metrics as fallout from the drop in energy prices are expected to keep inflation subdued for the foreseeable future. As a result, this should imply a greater probably of additional interest rate cuts through 2016. On Monday, the Reserve Bank of Australia (RBA) did what was expected, cut its overnight cash target rate by -25bps to +1.50% (new record low).
Lower domestic interest rates, in turn, will weigh negatively on the Australian Dollars Yield appeal. Inflation concerns will be a major driver of Australia dollar sentiment through Q3 and Q4 if not beyond.
Risk Sentiment
While domestic issues will continue to weigh on longer-term sentiment, external factors will continue to drive short-term momentum. Specifically, the AUD will continue to be driven at the mercy of shifting risk sentiment, as the Aussie tends to have an unyielding correlation with investor risk appetite. Given that global easy monetary policy is expected to remain intact, this should provide a tail wind to risk sentiment and provide a backstop for the Aussie dollar throughout the remainder of 2016.
Federal Reserve Policy remains a dominant force in shaping expectations of all G-10 currencies and even more so for the Australian dollar, which has benefited from yield appeal, and safe haven flows post-Brexit. The U.S economy appears to be gathering pace after a slow start to the year, raising investor optimism about the US growth prospects in the second half of 2016. While the Fed is faced with their inflation versus strengthening economy conundrum, the resurgent U.S economy could lead the Federal Reserve board to a path of interest rate normalization greater than the scope the market has priced. This shifting attitude would greatly tarnish the AUD yield appeal and significantly weigh on investor sentiment.
Aussie’s largest trading partner
China will remain critical in the AUD equation as anticipated yuan weakness amidst flagging exports weighs on investor sentiment. It’s expected that mainland policymakers will stand ready to act even more aggressively to counter anticipated Brexit global demand headwinds, but there’s still a high level of uncertainty how this Brexit fall out will materially weaken the global outlook.
As Brexit risks fade, China’s growing economic concerns, including growing issues regarding both asset and credit bubbles, will come to the fore, and with the anticipation of Fed rate curve normalization, there could be some negative fallout in the mainland’s equity markets.
GDP and PMI’s will continue to be a major “ hotspot,” but the PBoC stimulus efforts may temper the increasing risk of further economic slowdowns. And while mainland’s near-term outlook may have improved, China may still require additional stimulus and increased infrastructure spending to maintain a GDP above +6.5 %. Overall I suspect the Australian Dollar will trade neutral against the foreseeable China backdrop.
Commodities
Commodity price outlook remains clouded as oversupply concerns weigh heavily amidst global economic slowdown concerns. China remains the ‘800-pound gorilla’ as infrastructure spending, and stimulus efforts could be a supportive force through 2016. But with Australia’s efforts to rebalance the economy away from an over-reliance in the mining sector, this may have a lesser influence on the AUD in 2016.
Gold prices, post-Brexit, have soared as investors take shelter in the yellow metal. However, with Brexit concerns abating we may well see a short-term reversal of the Brexit premium in gold as investors move back into riskier assets.
ASX
On Brexit day (June 23/24), the ASX was down -3.2 percent, giving back all of the gains in the lead up to the decision and more. However, the Australian benchmark has quickly recaptured those losses with Australian gold producers being the big winners on the back of resurgent bullion prices.
While the geopolitical fallout from Brexit exists, in an environment where interest rates are expected to remain lower for longer, the ASX should remain solid throughout 2016. Banking sector stocks should continue leading the way with mining stock expected to trade sideways but experience pockets of support from Chinas stimulus efforts