Here’s an excellent dissection of the Australian economy by Westpac chief economist, Bill Evans:
As we contemplate 2018 and 2019 there are a number of key themes that we believe will dominate economic and market developments.
Our advice to customers throughout 2017 has been to expect Australia’s growth rate to be anchored below trend in both 2018 and 2019. That has contrasted with official forecasts (Reserve Bank) which anticipate growth picking up to 3.25% in both 2018 and 2019 while Commonwealth Treasury is forecasting growth nearer 3%.
We have recognised a solid ongoing boost to growth from non-residential construction; government spending and exports. However we are much more downbeat than official forecasts on the consumer; residential construction and equipment investment.
Slowing household incomes
Signals from the September quarter national accounts are not encouraging for the official view. There is some evidence that households are reassessing prospects for income growth, particularly with respect to a lift in wages growth. Ongoing positive expectations for a boost in income growth have encouraged households to cut their savings rate from 7.5% in 2013 to 3.2% in September 2017 (up from 3.0% in June).
We believe that household labour income growth will ease again in 2018 as wages growth remains benign and hours worked start to slow. Households which are also constrained by high debt and high energy prices are unlikely to be able to lift spending to allow the official growth forecasts to be reached.
Housing downturn
Resulting below trend consumption growth will also discourage any recovery in equipment investment. Residential housing and alterations and additions have also started to slow and, based on the downturn in high rise approvals, we expect this downturn has further to run. Large increases in supply and a marked slowdown in sales to foreigners are weighing on the outlook for residential building.
House price inflation is disappearing. On a six month annualised basis prices are now falling in Sydney and Perth while price gains are slowing in Melbourne, Brisbane and Adelaide.
The regulator’s macroprudential policies are restricting interest-only loans and tighter guidelines for all new loans are slowing house price inflation and credit growth. We expect housing credit growth to slow from 6.5% in 2017 to 5% in 2018 and 4.5% in 2019.
In previous cycles the authorities have relied on raising interest rates to slow the highly cyclical housing market. This time, the same effect has been achieved by the regulator as banks have independently raised loan rates, with the downturn in foreign demand also weighing on activity.
Inflation below target
Inflation is expected to remain benign holding a little below the bottom of the Reserve Bank’s 2–3% target band. In this regard we are in agreement with the Reserve Bank which is forecasting that underlying inflation will hold at 1.75% in 2018 before lifting modestly to 2% in 2019.
Under these circumstances we can not fall into line with most other economists who continue to anticipate that the Reserve Bank will begin to raise rates in 2018. Indeed we have been of the view through 2017 that the official cash rate will remain on hold in both 2018 and 2019.
With rates on hold in Australia and the US Federal Reserve continuing to raise rates, Australia’s cash rate is set to fall below the Federal funds rate by mid-2018.
Sustained period of negative Aus-US rate spreads
The US economy is operating with much less ‘slack’ in its labour market (unemployment rate of 4.1% compared to a estimated full employment rate of 4.75%) than Australia (unemployment rate of 5.5% compared to a full employment rate of 5.0%) but little wage pressure has emerged. Over the course of 2017 the USD has fallen by around 8% despite four rate hikes since December. With financial conditions also easing via a 20% rally in the US equity market, the Fed has seized on the opportunity to raise rates in anticipation of rising inflation. Without access to an effective macro-prudential policy (due to the highly regionalised and low concentration of lenders in the market) it has relied on higher rates to deal with the threat of financial instability.
We expect that process to continue in 2018 with two more 25 basis point hikes in June and December. That would see the AUD/USD yield differential in the overnight market contract to minus 38 basis points – a situation we have not seen early 2000. A heavy toll will be taken on the AUD with the currency forecast to fall to USD 0.70 by the end of 2018.
With upward pressure on the USD in 2018 and inflation remaining benign we expect that the Fed will hold rates steady through 2019 ensuring that the negative yield differential with Australia holds through 2019 and that the AUD will fall further. We expect a move down to USD 0.68 in 2019, with downside risks.
Heightened period of political uncertainty
Political uncertainty will remain a feature of the Australian economic picture in 2018 and 2019. The government is likely to embrace expansionary policies, particularly around tax, and may be prepared to compromise the proposed 2021 budget surplus to achieve a more constructive fiscal stance.
Coupled with the boost from a much lower Australian dollar, markets will eventually start to sense an improved growth outlook for Australia and even begin to anticipate higher overnight cash rates in 2020 following the 2019 election. Bond markets and the AUD will respond.
Global risks
The two major global risks for 2018 and 2019 centre around the US share market and the Chinese financial system.
The US share market has risen by over 20% over the last year or so. Pundits have been labelling this lift as a potential bubble. But earnings growth and the interest rate outlook are not severely out of line with current valuations. Share market collapses are generally triggered by sharp increases in bond rates. Such an increase would be in response to a significant upgrading in inflation and growth prospects. Westpac expects a reasonably benign path for inflation in the US through 2018 prompting the Fed to raise rates by 50 basis points and pushing the 10 year bond rate to 3% – not a sufficient enough move to trigger an equity market collapse. Furthermore, we expect the Fed to remain on hold in 2019 as policy in other major jurisdictions ‘catches up’ and the balance sheet gradually contracts. The more markets fear the sell off and the more cautious the rally becomes the more sustainable it is likely to be.
On the other hand the uncertainties and risks around the Chinese financial system are daunting.
Much has been made of the synchronised lift in global growth in 2017. From Australia’s perspective, the key development has been the faster than anticipated growth in China. We expect China’s growth rate will reach a comfortable 6.8% in 2017 but anticipate a decent slowdown in 2018, to 6.2%
China realises that it must move away from its domestic growth model based on exports and investment. In particular the role of the financial sector must change from channelling high savings at low cost to strategic sectors to facilitating China’s economic transformation to a more sustainable model based on services and consumption with risk efficiently priced. But the ‘old’ model has resulted in financial assets growing from 260% of GDP in 2011 to 470% in 2016 (IMF, 2017). The growth has been in the ‘lightly regulated’ bank sector and the non-bank sector. The tightly regulated large state owned banks have only kept pace with GDP growth.
We accept that China has the fiscal flexibility and depth of foreign reserves to deal with instabilities around liquidity and confidence but as the ‘system’ continues to grow at break neck pace, dominated by lightly regulated entities, risks of instability will heighten.
With President Xi holding absolute powers, 2018 and 2019 seem likely to be the years China begins to step up actions to tackle the challenges around its old growth model and the need to transition the financial system to a fully regulated; well capitalised; stable system. That will mean restricting credit to underperforming firms and industries.
Growth is certain to slow, the deceleration likely to be sharper than currently anticipated by markets. Australia’s terms of trade and boost from investment from some entities is likely to suffer.
Without that restraint something far worse is in the offing as the Chinese financial system spins out of control and becomes too large even for the well-armed Chinese authorities to manage.
If we are speculating on the most significant ‘unknown’ for 2018 and 2019, the Chinese financial system, particularly for Australia, stands above any other issues that should be worrying us.
Bill Evans, Chief Economist
Nailed it. It’s not often that we read something that is so closely aligned to MB’s view of the world.
