August Economic Update

August Economic Update

In this month’s economic update Kaplan speaks with senior ANZ Research economist Felicity Emmett about the outlook for the Australian economy, household debt, consumer optimism and the reality facing the Federal Government’s (Government) Budget measures.

Question 1

GDP growth in Australia has averaged around 2.5% over the past five years, which is a little bit below RBA estimates. Do you agree with the central bank’s prediction of “at or above 3%” over 2018 and 2019?

Broadly we agree with that. Our forecasts are a little bit lower. We’re looking for growth of about 3% this year and next year, whereas the RBA is looking for a tick up to around 3.25%. We think that public investment will be supportive, non-mining business investment and exports, particularly LNG [liquefied natural gas] exports, will also help to support growth.

Consumer spending is really important. It’s the biggest single component of GDP, it makes up about 55%, and it’s really the outlook for that that’s providing the biggest risk to the domestic outlook, so we’re really watching that closely.

The RBA, I think, is a little bit more optimistic than we are. We’re expecting relatively modest growth over the next couple of years and that’s probably where the gap is between our forecasts and the RBA. But still 3% is above trend and is a relatively good outcome for the economy.

Question 2

Do you see any significant inroads into the spare capacity in the economy being made over the next 12 months and how is this most likely to occur?

I think we will see that. With growth running above trend, we’ll see that gradual decline in spare capacity, and that’s going to be evident in the labour market. When we look at business surveys across most industries, they have capacity utilisation rates that are above long-run average, so they are using up that spare capacity. Some, like construction and mining, are running a bit faster than others, like retail, but we are seeing that relatively well across the board. But it’s in the labour market that we want to see that reduction in spare capacity.

The unemployment rate has come down from a peak of 6.3%. It’s currently about 5.5%. The underemployment rate though remains really quite high, only just off its peak, and that is a little bit concerning.

So, overall, labour market spare capacity is still quite high and we really need to see that come down to generate stronger wage growth. We think it will reduce over the next couple of years with growth running above trend, but it’s likely to be quite a gradual reduction. That labour market spare capacity will continue to be a headwind for wages growth.

Question 3

Aside from the contribution to growth from the public sector, two of the biggest current trends appear to be the significant pick-up in the contribution of investment by non-mining firms and that dwelling investment is no longer contributing to growth. How do you see these factors playing out?

The non-mining investment story is very encouraging. Over the past two years, we’ve seen really strong growth, up about 10% each year over the past two years. Most of that has been in non-residential construction, so on the engineering side as well as the non-residential building. That is after a long period where it was really quite weak, so this has become now quite an important driver of the economy.

We’re also seeing some overflow effects from the public infrastructure spending. We’re seeing an increase in plant and equipment investment by private contractors that are doing some of this public engineering work.

We’re also seeing the potential for non-residential office space, in particular in Sydney, for example, with the building of the metro. They’ve had to pull down a number of buildings. Those offices are going to be rebuilt, so that will provide a big pipeline of activity. Along with public spending, they are the two key drivers for the economy at the moment. As you say, residential investment has come off its peak.

There’s probably another quarter of growth there, given what there is in the pipeline. And that pipeline of activity is likely to keep construction activity in the housing sector relatively elevated. We’re not expecting a sharp decline. We’re expecting it to gradually decline through the second half of 2018 and 2019, but it shouldn’t be a big drag on growth.

Question 4

In November, you told us that the RBA was far more worried about household debt than house prices. Do you think the combination of high household debt and low wage growth and its drag on consumption spending is a continuing concern for the central bank?

This is a very big factor for the bank. [RBA governor] Phil Lowe has spoken about this recently; about people who have taken out mortgages, expecting wage growth to be in the order of 4% or so, and now it’s actually really running around 2% and how this is affecting their ability to pay off that debt over the longer term. So, it really still is a very big issue for the RBA.

We’ve seen a bit of a decline in house prices and slower growth in household debt alongside that. But we really need to see a period where household debt grows more slowly than household income for those metrics to improve and the longer-run outlook for consumption to improve. It is something that the RBA continues to watch very closely.

We obviously don’t want to see sharp declines in house prices, but it would be encouraging to see much slower growth in household debt. It’s going to be a long-run adjustment really for households and for the consumption outlook.

Question 5

The Federal Budget has been described as a typical pre-election Budget with a little something for everybody. What are the key battle lines for the Government over the remainder of this year as it attempts to legislate these measures?

The Government is obviously coming from behind in the election. They’re behind in the polls and have been for some time. Certainly, the Budget was a little bit of an election sweetener with those quite significant personal income tax cuts. They may not seem significant on an individual basis but, in terms of stimulus to the economy, they are quite significant.

As well, they have the company tax cuts. Now they’ve managed to legislate the income tax cuts, but some of those company tax cuts have not been legislated. That’s clearly going to be some of the battle lines for the Government over the next year prior to the elections.

I think there’s quite a bit of horse-trading likely to go on over the next year. There’s also likely to be further election sweeteners, I would imagine, given that the Government really has an uphill battle over the next year or so.

What’s really been a little bit lacking though from this Government has been any sort of wholesale reform. We’ve had tweaks to both the company tax and income tax systems, but really there has been very little overall reform. That’s something that has been lacking, but something perhaps that the electorate does not really have much appetite for at the moment.

Question 6

Globally, there are currently a number of geopolitical risks for analysts and economists to contend with. Which of these risks in your opinion have the greatest potential to distort capital markets and which are you watching with particular interest from an Australian perspective?

There are a number of geopolitical risks at the moment. There’s obviously the trade tensions. There’s North Korea. There’s Brexit and there’s the Russia inquiry, and there are other ones as well. But they are probably the most prominent at the moment. Really, it’s trade that we are watching most closely, especially that that has the potential to most affect Australia, given we’re a small open economy, we have large exports and imports as a share of our economy. So, we’re watching that very closely.

So far, the measures that have been enacted have been relatively small in the whole scheme of things — tariffs on $34 billion worth of Chinese imports with another $16 billion to be covered in the next couple of weeks, and China introducing equal retaliatory measures. How that escalates will be really the key risk to the outlook.

I mean [US President] Trump has threatened to put tariffs on $500 billion worth of Chinese goods. If these trade wars continue to escalate, that will gradually erode the prospect for global growth and that will flow through to Australia. Australia sends more than a third of its exports to China, so our economic outlook here is very much dependent on the outlook in China.

If their economy is negatively affected by increasing trade tensions, then that will flow through to Australia. It’s something that we’re watching very closely, but these sorts of political developments are very difficult to forecast. It’s sort of a binary outcome to some degree that it’s very difficult to factor into our forecast, but we do see it as quite a strong negative risk for the outlook.


Sacha Loutkovsky
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