Opinion

Four surprises that Australia will spring on investors this year

Paul Dales

Jan 16, 2018 – 11.00pm

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Normally at this time of year investors can relax knowing that Australia will deliver faster economic growth and higher yields than most of its peers. This year, however, the rest of the world will catch up.

The Australian economy has grown at a faster pace than the average OECD economy for 14 of the past 17 years. It's not even been a close contest, with Australia on average each year beating its peers by one percentage point. That's the economic equivalent of a 4-0 hammering in a cricket test series.

However, Australia's growth advantage is slipping away. This is partly because a decade on from the GFC other advanced economies are returning to full health. The US economy probably grew by 2.3 per cent last year and, partly due to President Trump's fiscal stimulus, it may expand by about 2.5 per cent this year. Even the euro-zone is getting in on the act. It grew by about 2.3 per cent last year, which was the fastest in a decade, and it may repeat that performance this year.

Due to its more favourable demographics and higher rates of net migration, Australia may grow by 2.75-3 per cent a year over the next decade. In contrast, America's potential growth rate may be 1.5 per cent and the euro-zone's may be about 1 per cent. Pat Scala

But it is also because the Australian economy may not make much progress this year: 2018 will be the first year this century that growth in Australia won't be supported by a mining or housing boom. Admittedly, the outlook for business investment is better than it has been since the mining boom turned to bust in 2013. But while recent indicators have improved, homebuilders and households still won't support economic growth by as much as in recent years.

Fall short

So while GDP growth may rise from about 2.2 per cent last year to 2.5 per cent this year, it will fall short of the consensus forecast of almost 3 per cent and leave Australia growing at much the same pace as the average OECD economy.

This may generate four surprises for investors. First, official interest rates in Australia will be lower than rates in America for the first time since 2001. This loss of Australia's official interest rate premium is widely expected. But the extent of the shift will probably be bigger than most anticipate.

We expect that the improving US economy will prompt the Fed to increase its interest rate target range four times this year, from 1.25-1.50 per cent to 2.25-2.50 per cent, rather than the two to three times widely expected. And, unlike others, we don't think the Reserve Bank of Australia will raise interest rates from 1.5 per cent at all this year. So by the end of March, the policy rate in the US will probably be above the rate in Australia. By the end of December, it may be almost one percentage point higher.

Second, 10-year government bond yields in Australia may soon be lower than 10-year yields in the US. The consensus view is that 10-year yields in the two economies will rise in lockstep, resulting in Australia hanging on to its yield premium. But late last year two-year yields in the US rose above those in Australia. And the extent of the divergence in official interest rates we expect suggests that 10-year yields in the US will rise by more than in Australia.

The latest leap supports a view that 10-year yields in the US will rise from 2.6 per cent now to about 3 per cent by the end of the year. And while Australian 10-year yields have also risen, to 2.8 per cent, the more benign outlook for Australian policy rates means they may not rise above 3 per cent.

Third, this erosion of Australia's yield premium will surely contribute to a weaker Australian dollar. This hasn't already happened because the dollar takes its cue from commodity prices as much as interest rate differentials, and their strength has driven it up to $US0.80. But if my yield forecasts are correct and if an easing in economic growth in China prompts the iron ore price to fall in line with my forecast, from US$77 per tonne now to US$55, then the dollar may slip to $US0.70 this year.

So in terms of GDP growth and interest rates, 2018 might be the year that parts of the rest of the world catch up with Australia.

More favourable demographics

The good news is that this relative underperformance may not last long. Due to its more favourable demographics and higher rates of net migration, Australia may grow by 2.75-3 per cent a year over the next decade. In contrast, America's potential growth rate may be 1.5 per cent and the euro-zone's may be about 1 per cent. So it is only a matter of time before Australia is back at the top of the ladder.

In fact, this will probably happen in 2019. That's unlikely to be because Australia starts growing by 3 per cent a year and instead will be due to growth in other advanced economies slowing again.

By the start of next year the boost to the US economy from the fiscal stimulus will be fading and the rises in interest rates will be biting. US GDP growth may slow from 2.5 per cent this year to 1.7 per cent next year. Growth in the euro-zone and Japan will probably also weaken.

So in the second half of 2019 when the Reserve Bank of Australia may finally be in a position to raise the official interest rate from 1.5 per cent, the financial markets may be pondering the possibility of a recession in America in 2020 and interest rate cuts by the Fed. Ten-year yields in the US may therefore fall back below yields in Australia and the Australian dollar could strengthen back to $US0.75.

The fourth surprise of 2018, and perhaps the most important, may therefore be that towards the end of the year some small cracks in the global economy and its financial markets start to emerge.

Paul Dales is chief economist for Australia and New Zealand at Capital Economics.