Now is a time for investors to be cautious about prospects for the Australian economy. With China’s economy slowing, our biggest mining boom since the 1850s ending, and the US Federal Reserve (Fed) entering an interest rate hiking cycle, Australia might be facing a challenging period ahead. Major commodity economies such as Canada, Brazil and Russia are already in recession. The risk of an Australian recession in the next few years remains elevated, and global events could exacerbate domestic economic challenges.
Key challenges for the Australian economy
Let’s first look at the headwinds facing the economy:
1. China’s credit and property bubble
China’s rapid growth may be taking a significant turn. As Australia’s largest trading partner, its slowdown presents a major risk to the economy.
When demand for Chinese exports deteriorated in the GFC, Chinese banks responded by lending to state-owned enterprises, local governments, private businesses, households and other Chinese entities. It resulted in a credit-fuelled investment boom, much of which found its way into the Chinese property market.
Now, China has to deal with the credit overhang, a massive property oversupply and excess industrial capacity. As China’s property market adjusts to lower rates of construction and the economy rebalances towards consumption and away from investment and heavy industry, Australian exports could contract. Given the strong linkages between other Asian economies and China, any slowdown in China will likely spill-over to Australia’s other key export partners in the region.
2. US interest rate normalisation
The ongoing recovery of the US economy poses both opportunity and risk for Australia. As the world’s largest economy (one quarter of global GDP), a growing US economy will provide an important economic stimulus to many of Australia’s major trading partners.
With the US approaching full employment, the Fed is entering an interest rate hiking cycle that will put pressure on economies with asynchronous economic cycles and large foreign debts such as Australia. Australian households, banks and businesses have benefited from ultra-low global interest rates since the GFC, which enabled large debt burdens to be sustained. A normalisation in lending rates and risk premia poses a risk to economies like Australia dependent on foreign capital inflows. As the foreign debt matures and is refinanced, borrowers may face higher interest rates. With the cash rate already at a historic low of 2%, the RBA may have limited scope to offset further weakness in the domestic economy or tighter global financial conditions.
3. Domestic vulnerabilities
Following one of the largest terms of trade booms in Australia’s history, a number of imbalances have developed in the economy, making Australia vulnerable to economic shocks.
- High household debt: Australian household finances are stretched and most of this debt is tied to the property market. An increase in unemployment or a general tightening of global financial conditions could lead to defaults and forced sales, with consequences for the property market and financial system.
- Labour market: A normalisation of economic conditions and a fall in employment, most likely in the construction and mining industry, could trigger broader job losses and credit events among highly geared households.
- Mining investment: With the mining and terms of trade boom unwinding, capital expenditure has begun to decline and may still have some way left to fall. A sharp fall in capex could cause a recession, particularly if investment overshoots on the downside and if there are significant multipliers and linkages to other sectors.
- Property market excesses: With Australia’s population growth slowing in recent years, the increased quantity of homes under construction appears unsustainable.
Do opportunities exist for Australian businesses?
The headwinds are, as always, balanced to some extent by tailwinds:
1. Depreciation of the Australian dollar
Trade-exposed businesses such as manufacturing, agriculture, tourism and tertiary education will see an improvement in their competitive positions from the significant depreciation of the Australian dollar. Due to the strong wage growth during the commodities boom and its impact on international competitiveness, it is possible that the Australian dollar still has further to fall, adding further impetus.
2. Domestic population growth
Australia’s population growth rate of 1.4% p.a. currently exceeds that of all other major advanced economies. While this will not generate higher per capita incomes, it will help stimulate the economy and create opportunities for Australian businesses. The benefits of population growth are mitigated to some extent by the impact of population ageing, however Australia’s working age population (15-64 year olds) continues to grow in aggregate.
3. Productivity growth
Productivity growth is a key long term driver of real GDP. Although relatively weak in recent years, global technological progress has continued. Australian businesses will have the opportunity to modernise and harness this innovation in the years ahead. New jobs will be created in as yet unknown industries as creative destruction takes its course and the economy evolves.
4. Growth in Asia
With Asia accounting for three quarters of Australian goods exports, the region is likely to present significant growth opportunities for Australian businesses. In addition, 50% of the world’s population growth in the next 10 years (380 million people) is expected to come from Asia.
What this means for investors
The challenges facing the Australian economy serve as a reminder to investors of the importance of achieving meaningful portfolio diversification. Substantial home bias still exists among Australian investors, including many professionally-managed portfolios in the superannuation industry. Tax structures typically favour domestic assets, while investor and manager preferences are often skewed towards areas of familiarity.
Australia is of course just one of about 200 countries in the world. By investing most of our assets in the same economy in which we live and work, Australians run the risk of having all our eggs in one basket. This approach worked sufficiently while the Australian economy was the beneficiary of significant tailwinds starting with the global economic boom in the 1990s and followed by the China-driven mining boom of the 2000s. However, it would be foolish to assume that Australia’s recent economic good fortune is a function of our own good management, and will continue unchecked into future.
The Australian economy may be in trouble. The end of the mining boom poses a major challenge to income growth and our standard of living. Global risks are complicating the adjustment process and could lead to slower growth or a recession in the years ahead. Although Australia has a number of opportunities to generate sustained economic growth, investors should be cautious about prospects for the Australian economy.
Sam Churchill is the Head of Macro Research at Magellan Asset Management. This material has been prepared by Magellan Asset Management Limited for general information purposes only and must not be construed as investment advice. It does not take into account your investment objectives, financial situation or particular needs.