UBS: Negative headwinds are about to batter Australia's once high-flying economy

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Australia has become accustomed to strong levels of economic growth over the past two generations. Strong population growth and the emergence of China as a global economic superpower saw the island country’s trend economic growth rate average an impressive 3.5% since 1959, a level many other developed nations could only dream of.

While Australia is now approaching a quarter century of uninterrupted economic growth, an unbelievable effort only bettered by the Netherlands, the boom times may be coming to an end, a scenario that may see economic growth slow sharply and have implications for interest rates, national incomes and the dollar in the years ahead.

According to George Tharenou, economist at UBS, Australia’s GDP growth rate has fallen to a sub-trend level of just 2.5% since the end of the global financial crisis. He believes that level may be now be the norm, rather than the exception, in the period ahead. Pointing to slowing population growth, an ageing workforce, increased levels of indebtedness, a deteriorating fiscal position and slower global growth, Tharenou suggests the growth rate now looks set to stay slower for longer, predicting the economic headwinds appear to be large and persistent.

“Global growth has slowed to just 3% y/y, near the weakest since the GFC, and is likely to remain below its pre-GFC average of 4%,” writes Tharenou. “Specifically, with the slowdown in China (Australia’s largest export market) and structural shift away from industrial activity, the terms of trade is unlikely to recover materially.”

Besides the drag on growth from a slowdown in global economic activity, largely as a result of a moderation in Chinese growth levels, Tharenou also suggests that domestic headwinds will also weigh on prospective growth.

“Domestically, the 50-year boost from demographics is starting to reverse,” he notes.

“Population growth recently dropped to 1.4% y/y, the slowest since 2006, and is unlikely to rebound. Indeed, the total dependency ratio, after falling sharply for the last 50 years, is now starting a multi-decade surge, which is a new and increasing drag on the economy and budget ahead. Specifically, working age population growth is set to ~halve from the prior 15-year trend, to just 0.75% y/y ahead (albeit still above many major economies which are flat or negative).”

The chart below from UBS reveals the dependency ratio of major developed nations, along with forecasts for the decades ahead. It simply measures the number of persons aged 0-14 and above 65 as a percentage of population. Having steadily fallen over the past half century, it is expected to increase in the years ahead as Australia’s population ages.

Australia’s mounting debt levels, largely as a result of increased household indebtedness in line with increasing house prices, are also likely drag on growth in Tharenou’s opinion. He notes that doubling of Australia’s debt-to-GDP ratio in recent decades to 247% is unlikely to be repeated, noting that the recent spike of more than 30% over the past three years is “clearly unsustainable.”

Essentially what Tharenou is saying is that having powered economic growth in recent decades, the sharp uplift in debt levels is now likely drag on prospective economic growth in the years ahead. Households are heavily leveraged, and that debt needs to be serviced, potentially limiting the ability to take on additional debt or increase household consumption levels.

Like households, Australia’s government is also likely to undergo a period of fiscal consolidation, limiting expenditure in an attempt to narrow the budget deficit. Tharenou estimates that this consolidation is likely to last for at least the next four years, potentially dragging 0.5 to 0.75 percentage points off growth each and every year.

After years of being in the right place at the right time, it appears that Australia’s strong growth tailwinds are now shifting sharply in the opposite direction, potentially hindering the speed of the economic transition currently underway.

As a consequence of this conflux of negativity influences, Tharenou believes that it will not only hinder potential economic growth, but also interest rates and the level of the Australian dollar.

“CPI has undershot the RBA’s target 2-3% target for the longest time since the 1990s, finally more in line with slower GDP & global trends, meaning the cash rate is likely to stay lower for longer,” he wrote.

Tharenou suggests the neutral RBA cash rate – the level seen as neither stimulatory nor restrictive in terms of economic growth – now may be closer to 3% rather than the 5.5% levels deemed neutral before the global financial crisis.

As a consequence, this is likely to limit the interest rate yield advantage Australia has over other nations, something that is likely to keep the Australian dollar under pressure.

“We still forecast more downside for the AUD to 0.68 in 2016,” says Tharenou.

“While the currency is a cyclical near-term support to the economy – evident by the improvement in business conditions – at this stage, the level of the currency is still probably not providing a large structural boost that could lift trend GDP. Indeed, despite business reporting better conditions after the AUD dropped, intentions for capex, which is what ultimately lifts GDP, remain weak.”

The RBA releases its updated economic forecasts on Friday as part of its quarterly statement on monetary policy. At this stage the bank forecasts that Australian economic growth will rebound strongly in the years ahead. In light of the negative headwinds highlighted by Tharenou, it will be interesting to see what changes – if any – it will make to this widely-regarded optimistic assessment.

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