After 25 years of steady economic growth, Australia is on the verge of wresting bragging rights from the Netherlands for the longest period on record without a recession. While this historic event should be celebrated, the future may not be as rosy.
PIMCO’s base case calls for Australia to keep growing moderately over the next three to five years, in a range of 2% to 3%, with inflation well contained in the 1.5% to 2.5% range. On a positive note, Australia’s sovereign balance sheet is relatively healthy, and its credit rating was recently affirmed at ‘AAA’ by Standard & Poor’s. But if there is any hint of a downturn in developed markets, or if China migrates toward a worse-than-expected outcome, the resilience of the Australian economy over the next three to five years will be extremely challenged.
Mining and housing: past their prime
Australia’s GDP growth has averaged 2.6% since the end of the global financial crisis, and during this time, the two most important marginal contributors have been mining and housing. Australia produces some of the highest-quality and lowest-cost ore and remains a reliable and competitive energy exporter; however, the demand for these exports would suffer under a weak China scenario, given that Asia represents almost 50% of Australia’s export volumes. As for the housing sector, Australian households are already highly leveraged and major city property prices are elevated, so room for housing to add significantly to the economy would be limited in a period of global weakness.
Australia’s economic growth since the financial crisis has also been supported by other important factors: first, steady growth in the U.S. economy, which is in the midst of its third-longest recovery on record; second, China’s uninterrupted growth, which has been driven by an increase in the national debt level from 161% to 258% of GDP; third, Reserve Bank of Australia (RBA) rate cuts from 7.25% to 1.5%, which have kept the economic engine ticking; and finally, Australian households, which have increased debt to well over 100% of GDP even as household debt in other developed nations has decreased. It follows that any changes to this supportive environment could have ramifications for Australia’s economy.
Policy and interest rate outlook
Rising household debt and property prices in major Australian cities have created a high hurdle for the RBA to move the policy rate from its current record low of 1.5%. With Sydney now the second-most unaffordable housing market in the world (according to Demographia), the RBA would not want to be blamed for inflating housing bubbles with a rate cut. On the flip side, the relatively tepid state of the domestic economy should ensure that any RBA rate hikes are delayed at least until well into 2018.
If the Federal Reserve continues on its path of raising interest rates in the U.S. as expected, then for the first time in more than 15 years we may see the U.S. fed funds rate and the RBA policy rate reach the same level. As we move into 2018, there is a strong likelihood that the RBA cash rate will actually be below the fed funds rate.
The likely crossover of Australian and U.S. policy rates also has implications for investors: Expected returns from hedging U.S. dollar investments back to Australian dollars, which have provided a boost to many portfolios in recent years, will likely fade. In this environment of interest rate convergence, we expect Australian bonds will continue to provide a robust diversification anchor in balanced portfolios.
For more on our long-term views on the global economy, read PIMCO’s 2017 Secular Outlook, “Pivot Points.”
Robert Mead is co-head of Asia portfolio management at PIMCO in Sydney and is a regular contributor to the PIMCO Blog.