The 2017 Australian economic outlook

2017’s outlook is a continuation of key themes from our 2016 report. The themes have been reinforced by recent developments including volatile GDP growth, softening retail sales growth, slowing employment growth and significantly higher bond rates.

Overview

Australia’s transition to a strong post-mining boom economy continues to be slow and difficult. The lower dollar will help but there will still be significant negative shocks, headwinds and structural change. The successful outcome of the transition will depend on our ability to rebuild non-mining industries, starting with the dollar-exposed export and import-competing industries and flowing on to services.

GDP growth has come off a high of 3.1% at the start of 2016 and will continue to soften to average around 2.5% over the next three years. Employment growth, which peaked at just under 3% in 2016, will average 1% over the next three years, with the unemployment rate drifting up to 6%.

The medium term is still a story of slow structural change with many bumps on the road. However, already we can see the first signs of this change in the strength of tourism and international student education services. But there’s a long way to go before business investment comes through as a driver to strengthen economic growth and complete the transition.

Transition involves substantial structural economic change

We are only two thirds of the way through an estimated three quarters decline in mining construction. The negative shock it brings to economic growth will continue for another two to three years.

Fortunately, this is being offset by strong increases in mining production and exports as investments move into the production stage. Headline GDP growth has been saved by strong export and production volumes.

In many mining regions however, weak demand, lower employment and reduced incomes make it feel like a recession. Take out mining production (which has little flow-on to the rest of the economy) and it is a recession in these regions.

The mining boom involved a structural change towards an economy servicing high levels of mining investment. There was a huge boost to activities and employment related to design and engineering, development and regulatory approvals, construction, equipment, implementation and installation of services, through to other support sectors such as administration, legal and accounting. The boost came in both the mining regions and the capital cities (mainly Perth and Brisbane) servicing the mines.

The resultant boom and high dollar destroyed the competitiveness of Australia’s dollar-exposed export and import-competing industries. Many went into recession. Some like the car manufacturing industry were lost forever.

The flip side of the coin is that in a post-mining boom economy, a lower dollar will boost export and import-competing industries. They will be the first industries to invest, stimulating services and broadening into non-mining industries.

The world economy is still recovering from the effects of the global financial crisis

The GFC didn’t come out of the blue. It followed a ‘financial engineering’ boom which drove significant global over-investment. All being well it was always going to take a decade to absorb the excess capacity created during that investment boom. This has dominated world economic outcomes since.

Weak world growth and fears of financial after-shocks drove central banks to print money and lower interest rates. As many central banks have discovered the hard way, cheap money doesn’t necessarily stimulate investment where it makes no sense to do so.

Nevertheless, broadly speaking the world economy is tentatively on a path to slow and gradual recovery.

The US is growing again, with low unemployment. Fiscal policy initiatives and/or lower corporate tax rates from the new Trump administration will help further.
Europe is on a more difficult path with different national economies growing at different speeds.
The UK recovery, post-GFC, was aided by the low pound. Now, with uncertainty surrounding the implementation of Brexit, further falls in the pound will help cushion any additional negative shocks.
And then there’s always the fear that China’s growth will unwind.

Though these are all serious issues they will have relatively minor impacts on Australian outcomes. Australia’s current problems are primarily domestic.

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The start of a long phase of rising interest rates

Global growth, even tentative growth, brings back to the table the prospect of a long phase of rising interest rates. That comes after a long phase of falling interest rates, which has left interest rates worldwide at unsustainably low levels.

The US Federal Reserve is leading the world into the phase of rising interest rates. The Fed’s second interest rate rise last December has confirmed the process. What we don’t know is how quickly rates will rise and by how much. The consensus is that they will rise slowly but each rise will have a disproportionate impact given the low starting point.

In Australia, given the buffer between Australian and US rates, the RBA will keep cash rates low while the economy remains in transition, at least until US rates rise to Australian levels. The impact on bond rates however is more immediate. With little margin between Australian and US rates, we expect Australian bond rates to track US movements. This has already begun.

The Australian dollar has only a little further to fall

A narrowing in the differential between Australian and US interest rates will take pressure off the Australian dollar, but not by much. Further forecast falls in the differential with the US, as their interest rates rise, will take us from around $0.75 closer to $0.70 US. That should be enough to stimulate non-mining dollar-exposed industries.

Australia, too, is still recovering from the GFC.

While Australia didn’t experience an actual recession during the GFC, even now, close to a decade on, non-mining industries remain weak. Weak demand, weak profits and excess capacity have kept business in cost-cutting and cost containment mode as the primary way of increasing profits.

There are other cyclical factors in play:

The pendulum has swung strongly away from mining industries and regions. People go where the jobs are. NSW and Victoria are the strongest growth states, with the mining states weak. Regional shifts in jobs, industry and services will play a major role in future demand.
The residential boom is running its course as the high levels of building send some cities into oversupply. The Perth market has already started to fall. Apart from Perth, worst affected will be inner-city apartment markets in Melbourne and Brisbane. In the mining regions, falling housing demand has already led to a collapse in building and property markets.
Australia-wide, building construction will hold up as major projects are completed; the next stage is a significant downturn in residential building, with a corresponding negative impact on growth.
Infrastructure spending is growing after years of decline. Funding is coming from asset sales, with a boost from the Commonwealth. However, the magnitude won’t be enough to offset declines in mining construction and residential building.

Three years from now, the negative impact of falling mining investment will be over. At that point, non-mining business investment will have built momentum and be driving economic growth. Once that happens, growth will strengthen above 3%. The 2020s will be a stronger decade.

Meanwhile, we face three years of slow to moderate growth. That will keep inflation contained and allow the RBA to keep interest rates low. The level of growth will mask major differences between industries and regions. The ‘transition’ will continue to be a long and difficult process.

Research and Insights