Tuesday 12 June 2018 by Opinion

Australia’s economic outlook remains foggy at best

In this second part to Australia's investment outlook, we look at eight big factors confronting investors today and the implications for portfolio risk


Bond, equities and property investors alike are dependent on the outlook for macroeconomic factors such as interest rates, inflation and employment growth. 

Over the past few years, some of our long term economic predictions have sat outside the mainstream economists’ forecasts. That’s typically because most organisations don’t like to make long term projections as they are so hard to get right. 

The irony of course is that the very fact long term projections are so hard for economists to make, is the exact reason why they must be made – if they are hard for the professionals, it is obviously even harder for every day investors.

So we start this outlook note with a quick review of the environment investors are confronted with today:

1.   Global economy is in line with our expectations

The global economy is in good, albeit not great health, in line with our projections over the past few years.

2.   More Trump, more trouble

The US economy remains the backbone of global health, despite its extraordinary political volatility.  We have not changed our view that four years of Trump won’t be enough to derail the US economy, but eight is likely to be.  

3.   Global trade is under threat

The antics of the Trump Administration have triggered dry tinder that has been building globally since the GFC, particularly in Europe.  Anti globalisation sentiment has been growing due to very high levels of youth unemployment and the structurally unemployed manufacturing workers in high wage economies such as the US, UK, EU, Canada and Australia. Trump didn’t start the anti globalisation movement but the longer he is in power, the faster the movement will build.  Global trade fell by 70% the last time this movement grew in the late 1800s prior to WWI and WWII.  Such a fall now is unlikely due to the heavy interdependence, but more nimble sectors such as agriculture and electronics could be radically impacted.

4.   Inflation remains low in most countries or at target levels at best

US core inflation is right on target at 2.0%pa (using Fed’s preferred PCE measure) having risen from basically zero in 2015, showing the health of the US economy.  But EU inflation is just 1.3%pa and struggling (estimate to end May 2018, excluding food and fuel).  

5.   Digitalisation continues to hold down wages and therefore inflation

The gap between digital prices and non digital prices continues to widen – further evidence that inflation is likely to be increasingly subdued in years ahead.  Low wage growth is a major feature in the EU, the UK and Australia, and while US wages are rising, its unemployment rate is just 3.8%, a level not seen since the tech boom of the late 1990s.  At those levels, wage growth should be much higher.  

6.   Quitaly and implications for the Euro

Nationalism’s threat to the stability of the EU has increased, and as predicted a few years ago, Italy is at the epicentre. The coalition formed by the anti EU parties will not be easy to manage. However, they present a united, aggressive front against the EU in the right to manage the Italian economy.  The EU wants to keep Italy in the fold. If it left it would likely trigger a major restructure and cause more volatility for the Euro.  

7.   Equity markets face earnings threat, the worst is yet to come

Equity markets continue to be strongly supported by the massive global pool of retirement funds, whether institutionally owned or via the equivalent of our self directed SMSFs. This means high dividend paying companies have enjoyed a strong run, that is, until significant threats to earnings emerge.  Australian investors now know what that can look like and the risks of sourcing too much income from equities instead of spreading the load across bonds as well.  In the space of the past year, Telstra has fallen nearly 30% as earnings growth fails to keep up with dividend payouts, and the major banks have fallen 14% on average thanks to poor governance and misconduct revealed in the Royal Commission.  These sorts of capital losses wipe out years of income, and in both cases it isn’t hard to see that the worst is yet to come.  

8.   China's debt binge

China is managing its way through its debt crisis without incident so far.  Ironically, given its role in stirring up Trump’s anger over trade, a trade war would place China’s ability to manage any slow deleveraging of its economy in significant peril.  The RBA issued a warning on China’s debt binge particularly on its shadow banking growth, which has grown at 40%pa since 2009. This is now at the same levels as the US and UK where governance, transparency and regulatory controls are reportedly far stronger.  Investors would be well positioned to take a leaf from the RBA’s book and choose to keep watch rather than panic, but be ready to act as the implications for China could look a lot like Japan’s lost decade. Not a great outcome for Australian investors, particularly for sectors exposed to property and mining investment.

Outlook for Australia

Australia’s economy appears to be growing well, but the domestic economy remains very sluggish.  Wage growth is still at record low levels, and household debt obligations at record highs. 

If the US economy can hold on to its growth, China avoid a lost decade or a credit crisis, and the EU avoid a complete breakup, then Australia has the immigration demand to get through the next decade with sufficient economic growth to avoid a major downturn.  However, the risks are on the downside and more so now than they have been at any time in the twenty years I have been working in investment markets. 

In these benign global conditions, the biggest risk is complacency. Investors need to understand what risks they are taking in terms of the chances of capital losses for equities or property, credit losses in corporate bonds, and insufficient income to maintain wealth in the case of term deposits.  That doesn’t sound like a particularly upbeat outlook, but the outlook is actually for more benign conditions and a “muddling through” for Australia.  It is just that the risks are to the downside, and sharply, so now is the time to build more security in your portfolio and be ready to act quickly if any of these downside risks emerge.