Australia’s economic expansion is on the brink of turning 100 in 2016 – that is, 100 quarters (or 25 years) without a recession. That is remarkable,
considering the economic volatility the world and specifically the Asian region have experienced over this period. From Asia’s financial crisis to the
global financial crisis and mining boom-to-bust, Australia has had only three isolated quarters of negative real GDP growth over a quarter of a century. So
should investors prepare for a centennial celebration or brace for growing recession risks? Can Australia manage one more miracle? Portfolio managers Rob
Mead and Adam Bowe discuss the outlook for Australia and investment opportunities in 2016.
Q: What is your expectation for growth next year in Australia? Is the worst of the transition away from mining behind us?
We expect growth, and particularly domestic demand, to remain sluggish in 2016. Although we are approximately three years into the structural rebalancing
away from the mining sector, we still have a couple of years to run. Mining investment peaked a bit above 7% of GDP in 2012 and at the end of the third
quarter in 2015 it had fallen back to around 5%. To put this in context, its long-run average prior to the boom was a bit above 1%. So the headwinds from
lower mining investment, slower growth in China and lower commodity prices will continue to blow in 2016 and likely beyond.
Q: With the economic expansion likely to pass 25 years in 2016, should investors be worried about the risk of recession afterward?
It certainly has been a remarkable run, particularly when you consider that only three isolated quarters during that period have experienced a contraction
in real GDP, and one of those was related to the 2011 Queensland floods.
With the extent of the macro headwinds Australia faces and the scope of the structural change in the economy as a consequence, we should be alert to the
risk of a recession. When you are riding a bike very slowly, it is much easier to topple off. However, over the next six to 12 months, we see plenty of
evidence that the economy will be rebalancing rather than recessing, and that continues to be our baseline forecast for 2016.
The sluggish-rebalance narrative is particularly evident in the labour market. Employment growth has accelerated during 2015 — which clearly isn’t
suggestive of a recession. However, looking into the details, we should not be expecting a significant acceleration of growth either. In the two years
through the third quarter of 2015, healthcare and education were the industries experiencing the fastest employment growth, and workers in those sectors
were earning average weekly wages of A$1,051. The mining and wholesale trade sectors have been suffering the worst contraction in employment over the same
period, and those industries have been paying an average weekly wage of $1,750.1 So clearly the labour market is rebalancing, which is a good
thing, and aggregate employment is growing. However, the structural shift into lower-paid jobs will continue to weigh on wages and through that, on
household consumption, which remains the largest component of GDP.
Q: How concerned are you about the increasing cost of funding for the banking sector and the consequent rise in mortgage rates? Does this influence
your views on RBA (Reserve Bank of Australia) policy next year?
Australian banks still have some catching up to do in terms of capital raisings, given the changes to mortgage risk-weights and the higher targets for
overall capital levels. That said, the increased costs of funding are largely already reflected in credit spreads across the entire capital structure.
Importantly, though, even if the cost of capital is steady, the shift in the funding mix as banks attempt to meet the new capital targets will put some
additional pressure on bank margins, which will most likely be passed on to borrowers. Because the RBA focuses on the actual market borrowing rates when
setting policy, this ongoing bank margin pressure is likely to place a firm cap on the 2% RBA policy rate in 2016, and given other stresses in the economy,
an easing bias is also likely to be maintained.
Q: The housing market was a clear driver of growth in 2015. Will this be the case again next year?
The rebalancing of growth away from mining to the housing sector has already peaked and will likely become a less powerful force going forward. Why? The
Australian consumer is already the most levered in the world, housing prices have increased significantly across the major Australian cities,
macro-prudential controls are limiting the capacity of banks to lend to the investor segment of the market and mortgage rates have risen from their lows.
This doesn’t necessarily imply a significant correction to property prices, but it does limit the ability of the housing sector to contribute to growth in
the coming year.
Q: What investment opportunities does this outlook present, and how should investors be positioning their portfolios in 2016?
If our sluggish-rebalance outlook evolves as we expect, then the RBA is certainly unlikely to raise interest rates. But outside a recession, they are
unlikely to significantly lower the cash rate either. So with the market continuing to price in the chance of modest interest rate reductions, we do not
see value in having large active interest rate positions in either direction. Instead, we think focusing on carry, or yield pickup, in portfolios will
deliver the best risk-adjusted returns as we enter 2016.
Broadly speaking, we remain constructive on credit, particularly down the capital structure in the bank sector. While global bank capital securities have
been an attractive source of returns for a while now, the pricing of new issuance in the domestic Australian market more recently is reaching fair value
Dislocations in global currency and swap markets are also presenting investors with attractive sources of structural carry currently. An example of this is
in the U.S. dollar/ Japanese yen basis market, which has widened significantly over the course of 2015 as Abenomics continues to encourage Japanese
financial institutions to shift their assets offshore.
In short, we are seeing plenty of opportunities to deliver on our clients’ risk-adjusted return objectives in the current market without the need to take
outsized directional macro positions.
1 Source: Haver, ABS. Latest available wage data as at 30 June 2015.