“It was the best of times, it was the worst of times”. Sure, comparing Australia’s outlook to the period of the French Revolution is both a stretch and an overstatement. Still, at its most simplistic level, the duality of human experience that Charles Dickens was speaking to (and which may persist in Australia over the next few years) has some similarities. As an economy, our weak productivity tells a tale of a lack of reform and rising inefficiency. The conflict between monetary and fiscal policy may well deliver a mix of sub-trend growth and higher inflation than our peers. And the disruption to our past sources of growth (housing and China) may rend economic strain. Slower-than-expected rate cuts may also have the potential to extend the current contrast in lived experience between borrowers and savers.
In this month’s Core Offerings, we look at the likely path for Australia’s growth, inflation, and interest rates over the coming year or so. While recession will likely be avoided and inflation should moderate further, the mix of growth and inflation may disappoint. There is also the risk that interest rates may be slower to fall. For markets, return drivers may have more to do with income than ‘animal spirits’, and higher yielding defensive assets may outperform the prior growth engines of the equity market. In contrast, we note improved dynamism (both on the policy and economic front) overseas, as the US Federal Reserve (Fed) joins the global rate-cutting cycle, as it attempts to stick a soft landing. This month we increase our tactical equities overweight to reflect this supportive outlook.
“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair...".
Recent data suggest Australia’s economy is approaching ‘stall speed’. Annualised growth in H1 2024 was a mere 0.8% against an historic trend pace nearer 2.5% (and resilient US H1 growth annualising near 3.0%). Excluding the pandemic, the year to mid-2024 was the weakest financial year for growth since the recession of 1991/92. With growth in the population estimated to be running at 2.3%, we are also clearly in a per capita recession (now for a year and a half), with growth and spending ‘per person’ in decline.
Moreover, most of that growth is coming from government consumption (up 1.4% over the past year), led by spending on benefit programs for health services. According to Tim Hext from Pendal, “this remains a major source of strength for employment and inflation, and is central to the current animated debate between Treasurer Chalmers and the Reserve Bank of Australia (RBA)”on who’s to blame for Australia’s sticky inflation (with core at 3.4% in August, compared to the mid-2% for most of our peers who are already trimming policy rates). Elsewhere, consumer demand fell in Q2, and is up a tepid 0.5% over the past year, dwelling activity is 3.0% below a year ago, while business investment has slowed from 10.1% a year ago to just 2.5%. Growth in our exports has also slowed from almost 8% a year ago to ‘flat’ in mid-2024 on weaker resources and rural export volumes.
Ironically, the US economy is delivering faster growth and lower inflation than Australia. One of the key differentiators is its stronger productivity growth at around 3%, compared with ours at closer to zero. As Barrenjoey Research notes, “productivity sets the pace of sustainable trend growth”, together with population and participation. Further, Barrenjoey notes that in the current cycle “the public sector drag on productivity growth is sizeable” due to zero or negative productivity within the sector, that is also growing in size. Declining productivity is also generating higher unit labour costs (real costs of labour to businesses), underpinning higher service sector inflation, impacting equity return on investment.
“Productivity [is] the key determinant of living standards and the economy's overall competitiveness. At the moment, it is a centrepiece of the debate about interest rates as the economy stalls but inflation remains persistent.”
As noted, real consumer spending is up just 0.5% over the past year. In light of 2.3% population growth, demand per person is now falling. Moreover, the mix of that spending has swung sharply to items that inevitably fit into the ‘un-fun’ basket, notably essentials like housing costs, utilities, and health, where spending has risen 1.3%, versus discretionary items (including clothing, cars, and recreation), which are down 0.5%.
And like elsewhere globally, there have crudely been two types of consumers. Savers (who have benefited from higher interest income) and borrowers, who have faced challenges with greater cost of living pressures. Ongoing (or greater) spending by savers has likely supported demand (and corporate pricing power), delaying the path to lower interest rates.
But arguably, the ‘worst of times’ may be behind the consumer, given interest rates have peaked and the RBA has at least indicated sympathy to current market pricing for modest rate reductions from early 2025. Recent reporting season feedback from retailers also suggests trading conditions in early Q3 have improved, most likely on the back of the significant (cumulative) 1 July fiscal easing via the prior government’s stage-three tax cuts and the current government’s ‘cost-of-living’ relief (and solid minimum wage increases).
This boost to household income, according to UBS and CBA, should help (real) consumer spending pick up from around 1% on average in 2024 to a little under 2% in 2025. This largely ‘fiscal’ boost (notwithstanding some likely modest rate cuts through 2025) is likely to go a long way to mitigating the risk of recession for Australia in the period ahead.
But it may also keep the RBA on the sidelines for longer, relegating Australia to a more sluggish growth outlook by shifting the balance of consumer ‘support’ more toward fiscal stimulus (and higher average rates) and away from the arguably more powerful impact of greater rate cuts that would benefit those facing the greatest cost-of-living pressures (and the greatest likelihood to accelerate consumption). This may explain why forecasts for 2025 consumption are well below the 3% trend pace of the past 20 years to 2022.
Arguably, the ‘worst of times’ may be behind the consumer, given interest rates have likely peaked ... but fiscal easing may also keep the RBA on the sidelines for longer, pressuring those with the greatest ability to accelerate the economy’s growth.
Australia’s housing construction outlook faces a multitude of headwinds, alongside a seemingly endless (but largely unfruitful) commentary on where the problems lie and whose fault it is. Relative to the government’s target of 1.2 million homes over five years (at 240,000 per year), activity has been annualising at 170,000 over the past two months, well below the 200,000 plus average over the past decade.
There is no shortage of demand, given strong immigration and population growth, nor the pent-up demand from those who can afford to transition away from the rising cost of renting. Yet, affordability is challenged by higher rates and the cost of construction (led by higher commodity costs). Those in the industry highlight government planning and approval (and worker) inefficiencies as adding to cost and delaying new supply. Sadly, higher rates are also being flagged as a headwind to developers lifting supply. The ‘best of times’, arguably, involves more affordable housing and less constrained growth.
These challenges are leading analysts to predict modest growth over the coming year. CBA expects a contraction in housing investment in 2024 of 2.2%, before recovering modestly to 1.4% in 2025. UBS is more pessimistic, expecting further contraction in 2025. Approvals for construction are expected to trend higher into 2025 (UBS 180,000, CBA 174,000), but remain well short of that required to ease the imbalance (or spur growth).
Australia’s housing construction outlook faces a multitude of headwinds, alongside a seemingly endless (but largely unfruitful) commentary on where the problems lie and whose fault it is.
China remains the world’s second largest economy. While global businesses (motivated by geo-political instability) are seeking to shift their supply chains away from China, China is unlikely to be de-throned as the world’s manufacturing hub any time soon. And if an economy this size can grow near the 5% pace that the authorities are targeting, it will continue to make a significant contribution to world growth in the years ahead.
All that said, the world has become somewhat used to a more dynamic pace of growth, and the risks of a substantially weaker result remain elevated (despite the recently announced fiscal and monetary stimulus). As Longview Economics notes, “China’s balance sheet recession dynamics have intensified. After the bursting of China’s real estate bubble (in 2021), falling land and property prices have increasingly put downward pressure on private sector balance sheets. This year, the decline in asset prices has accelerated. The liabilities associated with those assets, though, have remained broadly unchanged. As such, and in the absence of any meaningful policy stimulus, China’s private sector remains under growing pressure to retrench (i.e., save and deleverage).”
For Australia, the shifting mix of China’s growth (as authorities seek to boost consumer spending rather than drive commodity- intensive leveraged housing and infrastructure investment) could be a headwind for resources companies and Australia’s fiscal firepower.
Efforts to support China’s growth through over-production are, for now, aiding commodity prices and leading to some renewed exporting of deflation to the world. Positively (at least in the short term), this may foster global disinflation and lower global interest rates.
Recently announced stimulus measures may be enough to underpin markets, but unless authorities follow through, China’s transition from commodity-driven investment to consumer spending could be a headwind for commodities and Australia’s fiscal firepower.
“China must act on deflation, former central bank governor warns. Yi Gang calls for looser monetary policy in rare admission of pressing economic concern.”
Prior to the recent Fed cut, markets were pricing nine 0.25% Fed rate cuts by the end of 2025 (to 2.78%) about twice the number of rate cuts expected for the RBA (to 3.16%). Notwithstanding the RBA never went as high as the Fed, this still reverses the current US rate premium. While the exact outcome is uncertain, the likely greater magnitude of Fed cuts relative to the RBA may impart upward pressure on the Australian dollar (even with the headwinds of China’s more subdued commodity demand). Indeed, Société Générale (SG) expects the first RBA cut in May 2025, by which time the Fed may have cut 1.5%.
Trailing other central banks may well be one of the tools in the arsenal of the RBA to contain inflation, as a higher currency will put some downward pressure on import prices (albeit the impact is modest and over time). Consensus expects the Australian dollar to appreciate almost 5% to USD 0.70 (UBS and CBA forecast USD 0.72, a rise of almost 7%).
Markets are currently pricing a further nine 0.25% Fed rate cuts by end-2025 (to 2.78%), about twice the number of cuts expected for the RBA (to 3.16%), which could put upward pressure on the Australian dollar.
It’s hard to craft a recession view for Australia over the coming year, given fiscal stimulus, a backlog of infrastructure work, and the need for more housing. Still, holding rates higher for longer (were weak productivity to slow inflation’s return to target) runs the risk of unexpectedly shunting the economy onto a sharply weaker path. This is not our central case. Still, the RBA, hawkishly, continues to believe that economy-wide demand is outpacing supply, limiting its ability to ease rates. While supply could lift, this seems less likely near term, amid our productivity woes, leaving the RBA focused on reducing demand.
Indeed, unless China’s stimulus measures succeed in re-igniting growth, a dysfunctional housing sector and our relatively lagged interest rate cuts present a more challenging outlook for Australia. The usual uncertainty facing businesses and consumers as we approach a federal election in H1 2025 may also add to headwinds.
Consensus expects growth to recover in 2025 to 2.1% from this year’s likely 1.2%...not a recession, but still noticeably below trend. A likely later rate-cutting path suggests any recovery in Australia’s growth rate may be relatively modest over the coming years. Recent fiscal stimulus should see consumers lift their spending moderately ahead, housing activity should edge higher on the back of peaking rates, while government expenditure, including capex and infrastructure, should remain strong.
To some extent, Australia’s outlook reflects a mix of opportunities and disappointments. Structurally poor productivity impacts our ability to deliver improved standards of living via sustainable real wages and real wealth gains. And our fiscal position is vulnerable, given emerging deficits, despite elevated commodity prices. Yet positively, underlying growth dynamics (even if below trend) combined with sticky inflation should deliver reasonable nominal growth, while also sustaining the attractiveness of higher yielding defensive assets.
Structurally poor productivity impacts our ability to deliver improved standards of living via sustainable real wages and real wealth gains. And our fiscal position is vulnerable, given emerging deficits, despite elevated commodity prices.
Notwithstanding a more challenged disinflationary outlook, the likely ongoing patchy sub- trend growth outlook is unlikely to lead to any further rate hikes from here. Rate cuts are still the likely outlook. As such, fixed income will potentially remain an attractive asset class in Australia, though the mix of returns may have less significant capital gains and more persistent income than offshore (or prior cycles).
With the RBA likely to be one of the last G10 central banks to start easing, we expect bond yields to remain elevated relative to Europe, the UK, and the US, keeping the opportunity to add domestic duration alive for longer. Investment grade credit spreads should also benefit if a (US) soft landing is achieved, default rates remain low, and equity markets react well to rate cuts. We suggest investing in fixed rate investment grade bonds between four and seven years to maturity to lock in current yields while also taking advantage of the higher three-month Bank Bill Swap Rate, with floating rate products. We also like private debt managed by our preferred managers, targeting returns between 3-4% above cash.
Australia’s market is dominated by two large sectors, which are not without headwinds, namely resources and banks. Recent earnings growth has been sluggish, suggesting some over-achievement, given the market’s price/earnings (P/E) ratio has risen from around 15x to 17x. Resources are unloved and cheap, but potentially challenged by weaker global commodity demand. In contrast, banks are expensive and lack the catalyst of an aggressive cutting cycle (while housing activity is constrained). Still, the market’s valuation is relatively ‘fair’, growth exists, and parts of the consumer complex are well supported by fiscal easing.
To this end, on balance, we expect more opportunities to present themselves within the index, than at the index level itself (absent a China recovery that lifts commodity prices and large-cap resource stocks), and therefore continue to prefer actively managed portfolios. At a factor level, investors should continue to seek exposure to mid-cap equities (where the growth dynamic is more structural and resilient) and small-cap equities (as rate cuts come more clearly into view).
While generally advocating for greater allocations to global private debt, given a much broader opportunity set, a slower easing cycle locally naturally supports higher unlevered yields for domestic private debt in the near term. Given the previously noted proliferation of global product, this can also support patience in finding the right global portfolio mix. Simply put; continue to allocate to domestic private debt, where we maintain a preference for corporate and consumer-based strategies.
Within private equity, Preqin data continues to point towards Australia-focussed funds, showing outperformance (vintage years 2013 to 2020) over global peers with a median net internal rate of return of 14.5%, ahead of North America (14.0%), Asia (14.0%), Europe (13.8%), and the rest of the world (8.8%). When combined with normalising deal activity, a healthy secondary market, and likely greater interest in Australia from overseas investors (given outflows from China), the domestic market warrants its bias.
Yet, positively underlying growth dynamics (even if below trend) combined with sticky inflation should deliver reasonable nominal growth, while also sustaining the attractiveness of fixed income returns.
While Australia’s outlook seems lethargic, we are growing more constructive on the near- term pathway for the global economy, particularly the US. Growth in the US is moderating but, importantly, not falling off a cliff, with still limited signs of corporate or leverage excesses that might presage a left-field shock. Meanwhile, as inflation continues to trend towards target, the Fed has more leeway to focus on the other side of its dual mandate, supporting growth and inflation. This has allowed it to join the global rate cutting cycle, with a sharp 50 basis points (bps) easing.
We have also responded to the various stimulus packages announced by China in late September. While it is uncertain whether they are sufficient to spark a re-acceleration in growth, they may be enough to put a floor under already-depressed markets. We think this overall macro and policy backdrop increases the likelihood of the fabled ‘soft landing’, and we have implemented a modest overweight to US equities and closed our emerging market equity underweight to reflect this more constructive outlook. This takes our overall equities overweight to +3 from +1. This is a meaningfully constructive position, but one that still leaves us with the flexibility to respond to evolving risks and opportunities as they emerge.
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