Weakening Fundamentals Corroborate Our FX And FI Views

BMI View: We believe the Australian dollar will weaken and Australian bond yields will head lower in light of the economic slowdown that is becoming more evident. We expect the economy will continue to struggle due to domestic and external factors, which we believe will translate to depreciatory pressures on the currency and provide room for the Reserve Bank of Australia (RBA) to cut its policy rate by 50 basis points, underpinning our bullish position on Australian bonds.

We believe our forecasts for a weaker Australian dollar and lower long-term yields remain well-placed, as economic indicators are deteriorating in line with our expectations for growth to slow. We see the economy struggling on both the domestic and external fronts, due to a rigid labour market and weakening demand for commodities from China.

Indeed, on the domestic front, Australia's rigid labour market has meant that businesses have been unable to lower wages in response to falling demand, forcing firms to cut jobs instead. Inevitably, unemployment has been rising from 5.4% at the start of 2013 to 6.0% in January this year, which bodes poorly for private consumption growth. On the external front, the impact from the structural rebalancing that is underway in China on Australia is beginning to materialise. Latest capital spending indications surveyed by the Australian Bureau of Statistics (ABS) suggest that businesses are actively reassessing their plans given the dimming outlook for demand and prices of Australia's main export, iron ore (which accounts for more than 30% of total merchandise exports).

Mining Sector Now A Liability
Australia - Planned Capital Expenditure, By Sectors (% Of Total) & Mining Sector Contribution To Overall Growth (RHS)

Weakening Fundamentals Corroborate Our FX And FI Views

BMI View: We believe the Australian dollar will weaken and Australian bond yields will head lower in light of the economic slowdown that is becoming more evident. We expect the economy will continue to struggle due to domestic and external factors, which we believe will translate to depreciatory pressures on the currency and provide room for the Reserve Bank of Australia (RBA) to cut its policy rate by 50 basis points, underpinning our bullish position on Australian bonds.

We believe our forecasts for a weaker Australian dollar and lower long-term yields remain well-placed, as economic indicators are deteriorating in line with our expectations for growth to slow. We see the economy struggling on both the domestic and external fronts, due to a rigid labour market and weakening demand for commodities from China.

Indeed, on the domestic front, Australia's rigid labour market has meant that businesses have been unable to lower wages in response to falling demand, forcing firms to cut jobs instead. Inevitably, unemployment has been rising from 5.4% at the start of 2013 to 6.0% in January this year, which bodes poorly for private consumption growth. On the external front, the impact from the structural rebalancing that is underway in China on Australia is beginning to materialise. Latest capital spending indications surveyed by the Australian Bureau of Statistics (ABS) suggest that businesses are actively reassessing their plans given the dimming outlook for demand and prices of Australia's main export, iron ore (which accounts for more than 30% of total merchandise exports).

Mining Sector Now A Liability
Australia - Planned Capital Expenditure, By Sectors (% Of Total) & Mining Sector Contribution To Overall Growth (RHS)

The profit outlook for the mining sector will also have a significant impact on the level of private investment and, corresponding, economic growth, as it accounts for almost 65% the total domestic capital expenditures. According to ABS' data, the mining sector will turn from a driver to a drag on capital spending growth, with actual spending contracting by 5.1% year-on-year (y-o-y) in Q413. This trend is likely to continue as estimates collected in December showed a planned decline of 17.4% in capital expenditures for FY2014/15 (July-June) versus the previous period.

More Weakness On The Cards
Exchange Rate - US$/AUD

Financial Market Implications

Given the deteriorating macroeconomic outlook, we see scope for the Australian dollar (AUD) to depreciate, as foreign investment into the mining sector slows on the back of weakening performance. The dimmer profit and growth outlook suggests that foreign demand for local financial assets could also decline and add more downward pressure on the currency. We forecast the AUD to average US$0.8460/AUD in 2014, which translates to a 7% depreciation versus an average of US$0.9108/AUD recorded in 2013.

Potential Head-And-Shoulders Formation
Australia - 15-Year Government Bond, % Yield

The slowdown in economic activity further bolsters our forecast for the Reserve Bank of Australia to cut its official policy rate by 50 basis points (bps) to 2.00% by the end of 2014, which bodes well for our bullish position on Australian yields. Moreover, we see scope for the declining profitability to drive local investors to the safety of domestic fixed income, as equity returns wane from their current highs.

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