Long-term outlook for Australia: less rosy

Robert Mead | 14 Jul 2017

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After 25 years of steady economic growth, Australia is on the verge of wresting bragging rights from the Netherlands for the longest period on record without a recession. While this historic event should be celebrated, the future may not be as rosy.

 

PIMCO's base case calls for Australia to keep growing moderately over the next three to five years, in a range of 2 per cent to 3 per cent, with inflation well contained in the 1.5 per cent to 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 toward 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.

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Robert Mead is co-head of Asia portfolio management at PIMCO in Sydney. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.

This report appeared on www.morningstar.com.au 2017 Morningstar Australasia Pty Limited

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written content of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.