The Australian economic outlook


Matthew  Peter, Chief Economist

Following a lengthy period of consensus over the outlook for the Australian economy and monetary policy (i.e., extended period of below trend growth, elevated unemployment rate, weak wage growth, cash rates on hold or being cut), economic commentators are now splitting into two distinct camps: the populists and the conservatives.

The populist camp is bullish on the global economy, particularly the prospects for the China economy, which makes them bullish on the outlook for Australia’s terms of trade. A bullish view on Australia’s terms of trade frees the populist camp from concern over a rising Australian dollar and makes them feel comfortable that the economy can afford a sharp acceleration in wage growth. A positive view on the terms of trade also leads the populist camp to believe that governments can accelerate spending. The populist camp is largely unconcerned with fiscal consolidation and potential downgrades to Australia’s sovereign credit rating. The populist camp also views the risk of a sharp slowdown in the Australian housing market as overstated. They point to strong population growth as justifying current levels of dwelling investment, particularly in Victoria.

The populist camp’s bullish views on the economy, wage growth (and hence inflation) and lack of concern over the Australian dollar and housing market makes them advocates of Reserve Bank of Australia (RBA) rate hikes in early 2018. The effect on capital markets of tighter monetary policy, a strong AUD and robust wage growth are of little concern to the populist camp who feel that strong economic growth and rising terms of trade will provide sufficient offsets to avoid sharp corrections to asset prices.

The alternative outlook is provided by the conservative camp. This camp disagrees with most of the populist’s key assumptions. They view the Chinese economy’s need to address excessive debt and to transition away from reliance on infrastructure spending (including dwelling investment) as a negative for China growth and the global demand for steel. Consequently, their view is that prices of iron ore and coal will continue their retracement of gains made over 2017H2. The fall in the terms of trade will place downward pressure on corporate profits and government revenues that will restrict public sector spending. The conservative camp is also bearish on the outlook for the housing market. A typical view of the conservative camp is for a fall in house prices of around 5% and a drop in Australian dwelling investment of around 10%.

A falling terms of trade, constrained governments and a domestic housing market in decline lead the conservative camp to be sceptical over the ability of the Australian economy and capital markets to handle a combination of sharply higher wages, AUD and cash rates. The conservative camp adopts a dovish stance on monetary policy, with expectations that the RBA will remain on hold until late 2018 at the earliest.

For their part, markets are struggling to decide which camp will prove to be correct. The AUD has been trading in a range between US$0.78 and US$0.81 for the last two months, with the recent fall in iron ore prices pressuring the AUD lower and favouring the conservative camp’s outlook. However, the market has also been pulling forward expectations of RBA rate hikes, with a move in May 2018 now viewed as a 50/50 proposition favouring the populist camp’s outlook. As for the RBA, Governor Lowe’s speech this week provided something for both camps’ views. For the populists, Governor Lowe remained upbeat on global and domestic economic growth and the need for the cash rate to rise over time. For the conservatives, Governor Lowe emphasised that while the expectation is that the cash rate will be rising, the first move is still some way off.

As for QIC, we gravitate more to the conservative camp than the populist camp. Our view is that while wage growth and interest rates can drift higher, they can do so only gradually lest they destabilise financial markets and drive the AUD to an unsustainably high level. We view the housing market as correcting and the terms of trade as falling over 2018, while the Federal government will pursue a course of fiscal consolidation over coming years. Under these conditions, the Australian economy will struggle to break consistently above trend growth and the RBA will keep rates on hold well into 2018, with our long-held view that the next rate hike will not be until the September quarter of 2018 intact.

Table 1: Financial market movements, 14 - 21 September 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,500.6

0.2%

US

2.28%

9.2 bps

US Dollar Index (DXY)

92.26

0.1%

Nikkei 225

20,347.5

2.7%

Japan

0.04%

-1.0 bps

USD-JPY

112.48

2.0%

FTSE 100

7,263.9

-0.4%

UK

1.37%

13.7 bps

GBP-USD

1.358

1.4%

DAX

12,600.0

0.5%

Germany

0.46%

4.2 bps

EUR-USD

1.194

0.2%

S&P/ASX 200

5,655.4

-1.5%

Australia

2.83%

10.4 bps

AUD-USD

0.793

-0.9%


Source: Bloomberg


Economic Update

 
United States

Federal Reserve to begin balance sheet unwinding in the US
  • Retail sales in the US fell in August on the back of a large drop in auto sales, which were possibly affected by Hurricane Harvey impacting Texas in the last week of the month. Retail sales were 0.2% lower in August, while growth in June and July was also revised down. This suggests consumption spending in the third quarter is unlikely to be as strong as the 3.3% annualised rate in Q2.
  • Industrial production fell by -0.9% in August, the biggest monthly decline in more than eight years, after Hurricane Harvey disrupted oil and gas production along the Gulf Coast. Hurricanes Harvey and Irma also hit consumer sentiment in September, according to a preliminary reading from the University of Michigan’s surveys. The consumer sentiment index fell to 95.3 in the month from 96.8 in August, as consumers’ expectations of future conditions declined.
  • As expected, the Federal Open Market Committee left the federal funds target band unchanged at 1.00–1.25% following their meeting this week, and also announced their intention to begin balance sheet reduction from October in line with plans outlined in June. According to these plans, the Fed will stop re-investing the principal proceeds from their maturing asset holdings up to an initial cap of $10 billion per month ($6b for Treasuries & $4b for agency debt and MBS), with the total cap rising by $10b every three months to a maximum of $50b. Our modelling suggests that the balance sheet reduction by the Fed will raise US 10-year bond yields by around 20-30bps.

Euro area / United Kingdom

Retail sales grow strongly in UK despite high inflation
  •  Consumer confidence in the euro area jumped to a new 16-year high in September, according to a flash estimate from the European Commission. The index climbed to -1.2 in September from -1.5 in August, and eclipses the previous high of -1.3 reached in June.
  • Retail sales volumes in the UK grew strongly in August, despite the rapid pace of retail price inflation. Sales grew by 1% over the month in August and were 2.4% higher in year-ended terms (2.8% higher excluding auto fuel). 

China / Japan

Exports continue to grow strongly in Japan
  • Exports from Japan surged in August, with year-ended growth in yen-denominated export values climbing to 18.1%, up from 13.4% annual growth in July and marking a ninth straight month of expansion. In volume terms, exports were 10.4% higher than the same period a year earlier, led by autos and semiconductor manufacturing equipment. Exports to Asia picked up particularly strongly, mirroring the recovery in trade seen more broadly in the Asia region. Import values were 15.2% higher in year-ended terms, though much of this was due to higher import prices, with import volumes up 2.4%.

Australia / New Zealand

Residential property price growth slows in Q2 in Australia
  • Data from the ABS confirmed that residential property price growth slowed in the second quarter, falling from 2.2% quarterly growth in Q1 to 1.9% in Q2 across Australia’s eight capital cities. Year-ended growth remained high at 10.2%, matching the first quarter’s rate, with prices 13.8% higher through year in Sydney and Melbourne.
  • New Zealand GDP growth for Q2 was in line with expectations, ahead of this weekend’s general election. Real GDP grew 0.8% in the June quarter to be 2.5% higher over the year, driven by household consumption, government expenditure and net exports, with strong dairy exports and tourist spending in the quarter. Building investment continued to drag on growth in Q2.

Sources: Thomson Reuters, ABS







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