What are the risks of an Australian recession?

Introduction

The Australian June quarter GDP figures (released last week) confirmed that the Australian economy has been recession free for 104 quarters or 26 years – an impressive result compared to global peers. The outlook for the Australian economy remains good, but not spectacular. GDP growth is expected to lift back towards 3.0% over 2018, with mining investment still declining, but now being more than offset by a pick-up in non-mining business capital expenditure and infrastructure spending. Stronger growth should eventually lift underlying inflation back into the Reserve Bank of Australia’s (RBA) 2-3% target band. Australia’s solid growth record looks likely to continue for some time, with a low chance of a near-term recession.

Australia’s strong growth record has paved way for criticism that Australia is “due” for a correction. But, Australia is not immune to recessions. Since 1960, Australia has experienced six recessions in total, which is the same as the US. This may seem surprising given the good record lately. Perhaps one of the reasons that recessions were more frequent in earlier times was because economic structures were more rigid and regulated. There have been several reforms since the 1970’s including: floating of the exchange rate, RBA inflation targeting and labour market microeconomic reforms which have all allowed the economy to be more flexible. This has helped in avoiding downturns, making any downturns less severe and allowing automatic stabilisers (income taxes and welfare spending that work automatically to offset economic fluctuations) to work more efficiently.

Forecasting precise timings of recessions is a futile exercise because of the unforeseeable never-ending list of things that can go wrong (e.g. war, natural disaster, trade conflicts) and push an economy into a downturn. However, what is helpful to consider are the vulnerabilities or excesses that exist in an economy. Most recessions have been preceded by a build-up of excesses.

In this Econosights, we outline the Australian economy’s key domestic vulnerabilities, that could be catalysts for a downturn in activity. While the growth outlook is looking up over the next year or so, these vulnerabilities may present more of an issue around 2019 when infrastructure spending tops out (as federal government grants to the states start declining), housing construction is in a down cycle and interest rates start increasing again.

Australia’s key vulnerabilities

• Housing

The low interest rate environment has helped push owner-occupiers and investors into the housing market over the past few years, lifting housing debt and prices simultaneously. With the value of housing debt across households continuing to hold at a record high level, this means that households are left more vulnerable to changes in the value of the underlying housing asset, which is determined by changes in dwelling prices.

The boom in home prices has lifted household wealth (housing is more than 50% of household wealth), which has given consumers the confidence to tap into their savings (see chart below), that has then been funnelled into consumption. So, household consumption (at nearly 60% of GDP) has become more reliant on the performance of housing. We see interest rate hikes and a boom in the new supply of dwellings (particularly for apartments) as being the two key near-term headwinds for dwelling price growth and household wealth.

The expected improvement in Australian growth over 2018 and a corresponding rise in inflation should give the RBA room to lift interest rates in late 2018. We suspect that the RBA will be slow in lifting interest rates back to more “normal” levels because inflation is likely to be slow in returning (the US is a case in point) and the RBA would want to tread cautiously given high household debt levels. Nevertheless, interest rate hikes will increase debt servicing costs which is a hit to disposable incomes. On our estimates, a 0.50% increase in interest rates (which could easily happen over the space of a year when the RBA starts hiking rates) would increase interest payments to income (a measure of debt servicing costs) by 1% - back to levels last seen in 2012.

The other headwind for price growth is the boom in new dwelling supply. The housing construction boom has reached its peak, but there are still more dwellings to enter the market over the next six to nine months, particularly in the apartment space. Housing completions (supply) are running around a record high while demand for new housing (based on population growth, household formation and demolitions) is now running below housing supply. This has worked out until now, because there has been a large level of under-building that occurred across the nation before the latest housing construction boom. So, this accumulated demand is still being worked through. However, building approvals remain at very high levels, which will keep completions elevated and above our estimates of housing demand – this is demonstrated in the chart below. As a result, we expect some dwelling oversupply across the nation, but it will be region specific and concentrated in apartments, with the east coast capital city apartment market most at risk. State variations are important to keep in mind. Perth, for example, has already experienced a price correction after demand for housing post mining boom diminished.

The high skew of investor loan growth in this housing upswing also increases the risk of a housing downturn. Investors are a potentially riskier lending group because of the larger reliance on return (i.e. solid rental demand and capital growth) which increases the risk that they may exit the market if returns deteriorated, thereby accentuating price falls. Vacancy rates are important to watch, with any increases an early sign of lower rental demand. Part of the risk around investors has lessened with the Australian Prudential Regulation Authority driving interest rates higher for investors and interest only borrowers to encourage slower loan growth going ahead and limiting banks’ exposure to this group of buyers.

There is also talk about potential changes to taxation around housing, with the Labor Party, for example, indicating that it will reform negative gearing and reduce the capital gains tax discount if it wins the next election (in 2019). Any potential changes to housing policy should be implemented carefully, given the economy’s reliance on the sector. 

• China risk - commodity demand reliance 

Australian exports are very concentrated to the Chinese economy (a third of Australia’s export shipments go to China). This concentrated trade relationship was very helpful during the Global Financial Crisis, when China’s economy held up well, but is now a risk because Chinese growth has decelerated since then. This means that the commodity-intensive industrial production sector is growing more slowly. While the economic adjustment towards a more sustainable growth rate has been managed well so far, the major concerns around the Chinese economy are i) how policymakers will manage to lower growth to a more sustainable level over time, without crashlanding the economy; ii) how the economy can grow with a lower level of debt after such a large build up in debt balances and iii) how overcapacity in some industries (like steel) will be dealt with. The risks around China are more prominent now because of the need for the Chinese economy to grow at a more sustainable pace after so many years of fast growth.

There are also opportunities in China outside of commodities. China is still experiencing a rising urbanisation rate (currently at 57% while OECD countries are at 80%) which is leading to a boom in the middle-income Chinese consumer that creates opportunities for Australian exports in agriculture, healthcare, education and tourism.

The outlook for the Japanese economy is also very important for Australia because of Japan’s liquefied natural gas demand, which is one of Australia’s key exports now (around 11%).

Implications for investors

While we think an Australian recession will be avoided over the short term, the vulnerabilities that exist in the economy leave it exposed to any downside shocks. We still think Australian shares will continue to underperform global peers (Europe, Japan and US). Underlying profit growth in Australia at around 5-6% is well below that in the US (at around 11%) and Europe and Japan (at around 20-30%). This argues for a decent exposure to global shares relative to Australian shares.

Conclusion

Cycles are inevitable in economies and asset classes but gauging the precise timing of these events is difficult. Instead of forecasting the timing of downturns, the focus should be on trying to strengthen the economy so that when a downturn does occur the economy has the right levers to lessen the impact and the duration e.g. aiming for a balanced budget over the cycle (to potentially lift fiscal spending) and keeping interest rates well above zero. Keeping the economy flexible (through reviewing and adjusting regulation) and diversified is also important to maintaining downside shocks to growth. Australia’s diversified and flexible economy has been evident over the past few years, with Western Australia, Queensland and the Northern Territory all experiencing mining-related downturns that were contained in those states/territories and more than offset by stronger growth across other regions in Australia.