Australia may be about to eclipse the Netherland’s record of 25 years without a recession, but the future may not be so rosy, writes Pimco’s Robert Mead.
Pimco’s base case calls for Australia to keep growing moderately over the next three to five years, in a range of 2-3 per cent, with inflation well contained in the 1.5-2.5 per cent range.
On a positive note, Australia’s sovereign balance sheet is relatively healthy, and its credit rating was just affirmed at ‘AAA’ last month by Standard & Poor’s.
But if there is any hint of a downturn in developed markets, or if China migrates towards a worse-than-expected outcome, the resilience of the Australian economy over the next three to five years will be extremely challenged.
Mining and housing: past their prime
Australia’s GDP growth has averaged 2.6 per cent since the end of the global financial crisis, and during this time the two most important marginal contributors have been mining and housing.
Australia produces some of the highest-quality and lowest-cost ore and remains a reliable and competitive energy exporter.
However, the demand for these exports would suffer under a weak China scenario, given that Asia represents almost 50 per cent of Australia’s export volumes.
As for the housing sector, Australian households are already highly leveraged and major city property prices are elevated, so room for housing to add significantly to the economy would be limited in a period of global weakness.
Australia’s economic growth since the financial crisis has also been supported by other important factors.
First, steady growth in the US economy, which is in the midst of its third-longest recovery on record.
Second, China’s uninterrupted growth, which has been driven by an increase in the national debt level from 161 per cent to 258 per cent of GDP.
Third, Reserve Bank of Australia (RBA) rate cuts from 7.25 per cent to 1.5 per cent, which have kept the economic engine ticking.
And finally, Australian households, which have increased debt to well over 100 per cent of GDP even as household debt in other developed nations has decreased.
It follows that any changes to this supportive environment could have ramifications for Australia’s economy.
Policy and interest rate outlook
Rising household debt and property prices in major Australian cities have created a high hurdle for the RBA to move the policy rate from its current record low of 1.5 per cent.
With Sydney now the second-most unaffordable housing market in the world (according to Demographia), the RBA would not want to be blamed for inflating housing bubbles with a rate cut.
On the flip side, the relatively tepid state of the domestic economy should ensure that any RBA rate hikes are delayed at least until well into 2018.
If the Federal Reserve continues on its path of raising interest rates in the US as expected, then for the first time in more than 15 years we may see the US Fed funds rate and the RBA policy rate reach the same level.
As we move into 2018, there is a strong likelihood that the RBA cash rate will actually be below the fed funds rate.
Investment implications
The likely crossover of Australian and US policy rates also has implications for investors: expected returns from hedging US dollar investments back to Australian dollars, which have provided a boost to many portfolios in recent years, will likely fade.
In this environment of interest rate convergence, we expect Australian bonds will continue to provide a robust diversification anchor in balanced portfolios.
