This is a snippet from Morningstar analyst's Australia and New Zealand Equity Market Outlook Q3 2021. Morningstar Premium subscribers can access the full report here.

The Australian economy has rebounded quickly from the coronavirus downturn. The total value of goods and services produced, that is, the gross domestic product, or GDP, reached record levels in the March 2021 Quarter. The 2021-22 Australian federal budget, released in May 2021, forecasts real GDP growth, excluding the impact of inflation, to gradually recover to around 2.5% per year over the next two years.

We do not expect these forecasts to be materially impacted by the latest lockdowns as vaccination rates are increasing and Covid-19 cases remain low. Our expectation is for lockdowns to likely be reversed reasonably quickly.

The Australian economy has already recovered from the pandemic

Exhbit1

Sources: Australian Bureau of Statistics, Reserve Bank of Australia, 2021-22 Australian Federal Budget, Morningstar

Australia’s economic recovery is reflected in the rapidly improving unemployment rate. It fell to 5.1% in May 2021, its lowest level since December 2019 despite the federal government’s JobKeeper scheme ending in March 2021. Unemployment is already below the Federal Budget forecasts, released in May 2021, which envisage an unemployment rate of 5.5% for the June 2021 quarter.

Unemployment brushed off the end of JobKeeper and is likely to improve

Exhibit 2

Sources: Australian Bureau of Statistics, Reserve Bank of Australia, 2021-22 Australian Federal Budget, Morningstar

Although unemployment has fallen, it has been supported by a reduction in the supply of labour due to the closure of Australia’s national border. This has cut immigration and reduced total population growth to near zero. Temporary migration by working holidaymakers and students is an important source of labour and is currently lacking.

Population growth is a key component of long-term economic growth and Australia’s population growth depends on immigration. This means long-term economic growth expectations require reopening of the borders, particularly given the gradual long-term decline in the fertility rate. The federal government expects the borders to reopen in mid-2022, but the economy will need to be sufficiently strong to withstand the potential impact on unemployment, although the resumption of international tourism and tertiary education should provide an offsetting boost in this regard.

The resumption of immigration is a key component of economic growth

Exhibit 3

Sources: Australian Bureau of Statistics, Reserve Bank of Australia, 2021-22 Australian Federal Budget, Morningstar

Investors obsess on the likely timing and magnitude of interest rate rises. However, the Reserve Bank of Australia, or RBA, recently reiterated its commitment to "…highly supportive monetary conditions…" to promote a return to full employment and consumer price inflation, or CPI, within its target of 2% to 3%.

Consumer prices inflation expected to recover to around 2.5% per year

Exhibit 4

Sources: Australian Bureau of Statistics, Reserve Bank of Australia, 2021-22 Australian Federal Budget, Morningstar

Full employment reflects the lowest level of unemployment that prevents significant wages and CPI growth, generally considered to be around 4.5%. However, the RBA was already struggling to meet its inflation target before the pandemic and the RBA expects wage growth needs to increase to at least 3% sustainably to meet its CPI target. This would require a reversal of the trend of recent years. Also, wage growth faces a headwind from the superannuation guarantee, which is scheduled to incrementally rise from 10% of gross wages to 12% between July 2021 and 2025, meaning wage growth could be challenging even with low unemployment.

Wage growth needs to increase sharply to hit the RBA’s target

Exhibit 54

Sources: Australian Bureau of Statistics, Reserve Bank of Australia, 2021-22 Australian Federal Budget, Morningstar

The net result is the RBA thinks the target cash rate is unlikely to increase from its current level of 0.10% until 2024 at the earliest. Although this may be "jawboning" to prevent short-term upward pressure on interest rates, target cash rate futures also imply little change from current levels for the next couple of years.

Interest rate rises look some way off despite the strong economy

Exhibit 6

Sources: Australian Bureau of Statistics, Reserve Bank of Australia, 2021-22 Australian Federal Budget, Morningstar

The somewhat unintentional consequence of low interest rates is asset price inflation, with residential real estate prices rising quickly again. Equity prices have also experienced price/earnings ratio expansion in recent years as investors have lowered risk-free rate expectations. Putting this another way, low interest rates and low returns on other asset classes in general mean the opportunity cost to hold equities is lower.

The relative return for equities appears more attractive–even though earnings yields have compressed and P/E ratios expanded. This may prove appropriate in hindsight if interest rates remain low for the long term. However, we continue to caution that the equity market as a whole looks overvalued currently and that investors should be particularly selective when deploying new capital into the stock market. We recommend considering the top sector stock picks in this special report ($), in addition to our Best Ideas list ($), as a starting point.

Read Morningstar analyst's Australia and New Zealand Equity Market Outlook Q3 2021 on Morningstar Premium.