Looking through the cycle

Principal Economist's View 

Economists often focus on incoming data releases in excruciating detail. To some observers this may seem tedious, but the reason is to gain a complete understanding on what is going on in the economy; to fit all the jig-saw pieces together you might say.

This focus, along with our quantitative models, helps us to understand the state of the economic cycle. Are we recovering, expanding or slowing? Are there reasons to be optimistic, or should investors be concerned?

Last week, we highlighted how developments in the Australian labour market are crucial in the current cycle. In our view, the improving labour market conditions will help the economy withstand the headwinds emanating from the housing market correction and avoid recession.

While this focus on the near-term cycle is understandable, particularly for short-term active investors, economists sometimes take for granted the key longer-term, slower-moving, structural features underpinning the economy. In our view, these structural fundamentals should not be ignored. They are largely the reason the Australian economy has not experienced a recession in almost 28 years; a record feat amongst advanced economies. They will also help our economy stave off a recession as we undergo a housing market correction.

One of the key structural fundamentals underpinning the economy is our strong institutional framework. Australia’s credible central bank plays a significant role in smoothing out the cycle. By raising rates sharply during the mining boom years, it helped prevent our economy from overheating and by cutting rates sharply as the mining sector corrected it helped cushion the adjustment and ensured we didn’t fall into recession. The RBA’s track record of keeping long-term inflation expectations well-anchored, combined with a freely-floating exchange rate have historically played a very significant role in cushioning the economy during downturns.

Should the near-term economic cycle prove weaker-than-expected, the RBA has rightly pointed out that they have ample room to cut interest rates to support the economy. This would likely coincide with a sharp devaluation in the Australian dollar, providing a significant boost to our international competitiveness, both for exporters and our import-competing firms.

Despite our disappointment at times with developments in Canberra, our strong fiscal management also contributes to Australia’s resilience. Australia’s federal budget is almost back in balance after a period of consolidation since the mining downturn, while our government debt remains low and the envy of most other advanced economies. These sound public finances leave considerable fiscal-space to stimulate the economy should the downturn prove worse than expected.

Similarly, our financial system is also robust. Our banking sector is well capitalised and profitable, and while the Royal Commission unveiled some inappropriate behaviour, it did not raise into question the health of our financial system. Australia’s banks are among the highest-rated commercial banks in the world and APRA stress tests reveal that our banks can withstand a 35% fall in house prices and remain comfortably above the minimum required capital levels.

While some might point out that Australia’s high household debt presents a risk to the economy, Australian regulators moved swiftly to contain these risks. The decisions by APRA and the ACCC to put in place macroprudential measures to limit the growth in investor-lending, restrict interest-only loans and put in place other policies to improve the credit-worthiness of Australian borrowers have supported the economy. This is highlighted by little evidence of distressed sellers or rising loan arrears despite the fall in house prices.

Australia also enjoys favourable demographic trends. Although our population is ageing, it is relatively young compared to other advanced economies, and our significant immigration intake is expected to continue to deliver strong population growth.

These sound fundamentals help underpin Australia’s economic resilience and support our ‘AAA’ sovereign rating. Despite the near-term housing market risks, the longer-term outlook for the Australian economy remains robust and the strongest amongst the major advanced economies. This is not just our view. Consensus forecasts reach a similar conclusion. Based on the latest Consensus forecasts, the Australian economy is expected to expand by 2.6% over the next decade, outstripping the US (2.1%), Canada (1.8%), Euro area (1.3%), UK (1.7%), Sweden (2.0%), Norway (1.9%), Japan (0.8%), South Korea (2.4%), Hong Kong (2.4%) and New Zealand (2.5%).

Although the economic cycle will always remain an important driver of near-term returns, structural fundamentals should not be ignored for long-term investors. These factors underpin our economic resilience and will ensure that Australia remains a world leader.

Table 1: Financial market movements, 21 – 28 February 2019

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,784.5

0.3%

US

2.72%

2.4 bps

US Dollar Index (DXY)

96.16

-0.5%

Nikkei 225

21,385.2

-0.4%

Japan

-0.02%

1.6 bps

USD-JPY

111.39

0.6%

FTSE 100

7,074.7

-1.3%

UK

1.30%

10.0 bps

GBP-USD

1.326

1.7%

DAX

11,515.6

0.8%

Germany

0.18%

5.6 bps

EUR-USD

1.137

0.3%

S&P/ASX 200

6,169.0

0.5%

Australia

2.10%

4.8 bps

AUD-USD

0.709

0.0%

Source: Bloomberg

 

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