The Australian bond market (as measured by the Bloomberg AusBond Composite 0+ Yr Index) returned 0.96% in October. Over the month, 3-year government bond yields fell to 2.56% from 2.71%, while 10-year yields fell to 3.28% from 3.48%. Shortterm bank bills were fairly steady over the month: the 1-month bank bill swap rate (BBSW) fell to 2.65% from 2.67%, the 3-month rate was flat at 2.74% and the 6-month rate was flat at 2.78%. The Australian dollar also remained fairly steady over the month, starting at USD 0.874 and ending at USD 0.879.

At its 4 November meeting, the Reserve Bank of Australia (RBA) again left the official cash rate on hold at 2.50%. The Australian Industry Group's Performance of Manufacturing Index (PMI) showed a continuing contraction in manufacturing activity in October, although the index rose by 2.9 points to 49.4 points (seasonally adjusted). Respondents to the survey indicated that despite a depreciation in the Australian dollar since early September, it remains relatively high and is still supporting intense import competition. More generally, businesses remain cautious and reluctant to invest. As the end of Australian automotive assembly moves closer and mining expansion slows, many manufacturers remain wary about the outlook for locallymade products and components.

Building approvals fell by 11% (seasonally adjusted) in September, with approvals down 13.4% over 12 months, according to the Australian Bureau of Statistics (ABS). Approvals for private sector houses fell 2.3% in the month, while private sector dwellings excluding houses, which includes apartment blocks and townhouses, fell by a huge 21.9% (seasonally adjusted). Most of the fall came from multi-unit approvals, which are notoriously volatile and not as important to the economy as standalone houses. In further negative news, Australia's terms of trade weakened by 3.1% in the September quarter, the third consecutive contraction. The fall was due to weak iron ore and coal spot prices dragging down exports, although falling petroleum import prices helped to offset this somewhat.

More positively, the RP Data CoreLogic Home Value Index increased by 1% in October across the capital cities, taking the aggregate capital gain to 8.9% year-on-year. Despite a slowdown in growth in September, values continued to rise, increasing by 2.2% over the past three months. "Looking at the increase in home values over the 12 months to October, it is clear that the rate of capital growth is continuing to moderate," said RP Data research director Tim Lawless. "Despite the fact that the annual increase in home values is slowing, other indicators remain strong."

Australian Market Outlook

The Australian economy seems to be struggling to achieve traction as the mining boom transitions from a capital expenditure phase (which is labour-intensive) to a shipment phase (which is good for net exports but less labour-intensive). The fall in the iron ore price hit Australia's terms of trade badly in the September quarter, although the decline should slow given the more recent drop in oil prices and if the Australian dollar continues to depreciate then we are likely to see increased export sales.

We are seeing improvements in housing, construction and consumer spending, but it is uncertain whether they are growing strongly enough to offset the decline in mining. Although employment growth is positive, it isn't sufficient to offset increases in the participation rate or population growth so employment remains weak. The significant drop in building approvals in September is concerning but could be an aberration. Given the current low interest rates, auction clearance rates of around 70% and continuing strength in property prices, we should see building activity remain relatively robust. In our view, the RBA is likely to keep rates on hold at 2.50% for some time and that the next move in rates will be upwards at some point in 2015. The recent depreciation in the Australian dollar is unlikely to affect this forecast unless it plunges to unexpected lows, particularly given that manufacturing firms continue to view it as too high. With a soft economy and further weakness in China, rate rises are unlikely any time soon.