It’s hard to argue that the Australian economy isn’t strengthening right now.
Business conditions, as measured by the National Australia Bank’s monthly business survey, currently stands at the highest level since before the global financial crisis, mirroring strengthening activity levels in the Ai Group’s manufacturing, services and construction PMI surveys.
And, although in its infancy, it looks like improvements in Australia’s business sector and labour markets are now been seen in household indicators. Retail sales have beaten expectations in each of the past three months while consumer confidence, although volatile from week-to-week, has also started trending higher.
Throw in strong demand and higher prices for many of Australia’s main commodity exports, helping to boost national income levels, and there’s not much to dislike about the state of the economy right now, at least in comparison to recent years.
But some believe it’s unlikely to last.
Analysts at Capital Economics argue the promising signals being generated by the economy in mid-2017 will be thwarted by a decline in residential construction and continued weakness in household spending growth in the period ahead, snuffing out expectations for a pickup in economic activity and the need for higher interest rates.
“The Australian economy is entering a new phase where the drag on GDP growth from mining investment is coming to an end, but the boosts to growth from dwellings investment and consumption are starting to fade,” the group wrote in a note released this week.
In essence, while mining investment will no longer drag significantly on GDP growth as has been the case in recent years, dwelling investment and household consumption — two areas that helped to underpin economic activity through Australia’s economic transition — won’t be able to carry that form into the future.
The housing investment problem
Pointing to recent reversal in Australian building approvals, the group says residential dwelling investment will likely detract from growth over the next couple of years.
“The 15% drop in building approvals since last August is a sign that homebuilding activity will soon peak,” the group says.
“After adding 0.5 percentage points (ppts) to the annual rate of real GDP growth in recent years, we expect that in each of the next two years it will subtract 0.2ppts.”
This chart from Capital Economics shows its forecasts for dwelling investment over the next few years, seeing this component go from a tailwind to a headwind in terms of economic growth.
And alongside that expected decline, the group doesn’t expect that household consumption — the largest component within the Australian economy — will be able to pickup the slack despite recent strengthening in labour market conditions.
“The recent surge in employment, which appears to explain the rebound in retail sales, means that real household disposable income growth won’t fall below 1.0% this year as we had thought, but an easing from 2.0% to around 1.2% will still prompt weaker consumption growth,” it says.
“What’s more, the hikes in utilities prices at the start of July and the recent rises in mortgage rates will mean that households’ incomes won’t stretch as far. And the record high level of debt means households are less likely to use credit to compensate for low income growth.
Given that outlook, along with the inclination of households to save or pay down debt in recent consumer sentiment surveys, the group paints a fairly downbeat picture on the outlook for Australia’s main growth engine, forecasting that household consumption will likely slow from 2.6% in 2016 to 2.3% this year. It then expects that to slow further to 2% in 2018.
With households and residential construction unlikely to deliver the growth returns that have been seen in the past, Capital Economics says this will deliver a scenario where economic growth and inflation continues to undershoot, disappointing policymakers at the RBA who will have little choice to leave interest rates unchanged.
“The net result is that GDP may rise by only 2.0% this year and by just 2.5% in both 2018 and 2019,” the group says, adding “that would fall well short of the RBA’s lofty expectations of gains of 3.0% and 3.25% in 2018 and 2019 respectively”.
“When taken together with our view that underlying inflation will remain below 2.0% for another two years, this explains why we don’t expect interest rates in Australia to rise until late in 2019,” it says.
Although only one forecast from one economic forecaster, Capital Economics is not alone in the view that the current momentum in the Australian economy will be sustained beyond the short-term.
Bill Evans, chief economist at Westpac, also remains unconvinced, suggesting on several occasions this year that the outlook for economic growth in 2018 remains “underwhelming”.
Like Capital Economics, he is forecasting that weakness in dwelling construction consumer spending will see growth undershoot expectations over the next 18 months, although he see risks that could flow through to labour market conditions and business investment, further pressuring growth.
“A downturn in domestic sales growth as consumers and housing activity slow is hardly likely to reboot business investment in 2018,” Evans said last month.
He’s currently forecasting that Australian GDP will grow 2.5% next year, a scenario he says will see unemployment push back towards 6%.
Understandably, Evans sees the RBA leaving interest rates unchanged at 1.5% over the remainder of both 2017 and 2018.
Others, such as Alan Oster, chief economist at the National Australia Bank, are also reluctant to get too excited about the recent improvement in the Australian economy.
“We remain apprehensive about how the disconnect between the business and consumer sectors will be resolved, he said following the release of the NAB’s monthly business survey today.
“Additionally, the previously emphasised hurdles to growth — elevated underemployment, household debt and peaks in LNG exports and housing construction — remain firmly in place.
“These factors will weigh on the longer-term economic outlook, following a re-acceleration of growth in coming quarters from the temporary disruptions to activity seen earlier in the year.”
George Tharenou, economist at UBS, also points to an expected decline in dwelling investment as a reason for caution.
“We see (this) as constraining growth more than the RBA expects in 2018, beyond a likely rebound of Q2 GDP,” he said in a note today.
He says that relatively contained inflation pressures will limit the RBA’s willingness to hike in the near-term, especially amid record-low household cash flow at present.
In each and every one of these assessments, there is a common theme.
Each expects that while economic growth is likely to rebound near-term as weather-related disruptions subside, it’s unlikely to be sustained.
And should the economy falter again next year, it’s unlikely that the Reserve Bank’s forecasts will be met, curtailing continued chatter that the bank may be considering lifting interest rates sooner than most think.