This chart paints an unsettling picture on the outlook for Australia's economy in 2018

Now here’s a pretty unsettling chart on the outlook for the Australian economy.

Source: Westpac

It’s the latest Westpac-MI Leading Index, an indicator that uses eight specific indicators from home and abroad to evaluate how the Australian economy is likely to perform looking three to nine months in the future.

A reading of 0 indicates that it’s likely to perform around trend, seen by many as around 2.75% to 3%. Anything above 0 points to the likelihood of above-trend growth while a sub-zero reading points to slower than usual growth looking ahead.

The news for June was not good.

The index fell to -0.76%, a sharp turnaround from the one per cent plus levels seen just a few months ago. For a gauge on how the economy is likely to perform in the future, it doesn’t paint a pretty picture on what lies ahead in 2018.

According to Westpac, it was the first time the index fell below zero July last year. As a lead indicator, it did a pretty good job in predicting the sharp slowdown in growth seen in the first quarter of 2017, seeing GDP growth decelerate to just 1.7% year-on-year, the slowest pace since the GFC.

Given its recent track record, that alone suggests it’s worth paying attention to.

Westpac noted that two of the survey’s eight components accounted for all of the reversal in the index since the start of the year: lower commodity prices for Australia’s key commodity exports and a flattening in global yield curves.

That’s highlighted in the table below from Westpac which shows the contribution each component made to the index over the past six months.

Source: Westpac

While other the lead indicators have fluctuated within a relatively small range, the movement in commodity prices and yield spreads have turned from a serious growth tailwind for Australia to a major headwind.

Although commodity prices and yield spreads have rebounded in recent weeks, suggesting that the index will rebound in July, Bill Evans, Westpac’s chief economist, retains faith in what the index is predicting.

“Westpac expects that growth in 2018 will be a below trend 2.5% with limited prospects of that improving much in 2019,” he says.

“Furthermore that growth rate is unlikely to be associated with much improvement in the labour market with considerable spare capacity likely to remain for some time.”

Given that assessment, Evans says the RBA is likely to downgrade its growth and inflation forecasts for the remainder of this year and for 2018, suggesting this will see recent market excitement over the prospect of a rate hike “dissipate”.

“The Reserve Bank has forecast 3.25% growth in 2018 and 2019,” he says.

“With that profile it may be ‘expecting’ to begin the tightening process but with inflation below the bottom of the target range, the housing market cooling under the weight of regulators’ macro prudential policies and benign wages growth, they have ample time to assess the reliability of that view.”

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