The Lucky Country is out of luck
Australia is referred to as the ‘Lucky Country’, and with good reason.
It has a relatively small but well-educated population and is endowed with abundant natural resources including iron ore, copper, gold, water, farmland, moderate weather and protected port cities.
Australia also earns huge amounts from foreign tourism.
The country has a solid rule of law, which makes it an attractive destination for direct foreign investment.
Australia has not had a recession since 1990 (the US has had three recessions in the same period).
Even the global financial crisis of 2008 did not slow the Australian economy enough to trigger a technical recession.
Your strategist at Sydney Harbour during a recent visit Down Under.
But the Australian economy does have an Achilles’ heel that is already causing a slowdown and may even tip Australia into its first recession in decades.
That weakness is Australia’s close and highly concentrated trading relationship with China.
Aussies hitched their wagon to the Middle Kingdom
Australia has been well positioned to be a major provider of natural resources to China’s industrial and manufacturing juggernaut.
Australia supplies iron ore, bauxite and copper needed to build critical infrastructure and the ‘ghost cities’ that dot the Chinese landscape.
Australia also exports liquid natural gas (LNG) to fuel China’s voracious appetite for energy. In other words, to keep its factories humming and keep the lights on.
At the same time as China is importing natural resources from Australia, it is exporting capital to purchase residential and commercial properties there.
Such interdependence is a boon when China is growing and Australia is booming to meet Chinese demand. But it is a headwind to growth when the gears are thrown into reverse.
Growth in the Chinese economy is dropping sharply.
This is due to a combination of excess debt, trade wars with the US and an overpriced Chinese yuan.
Reduced demand by China for resources needed for building (iron ore, copper, bauxite), as well as agricultural goods, has been felt in Australia.
Even more damaging is the drying up of Chinese capital investment in Australian real estate. This has led to steep declines in Australian property prices.
These declines have not yet hit bottom because of a pipeline of pending projects. Meanwhile, prospects for property prices over the next two years are negative.
China stops money leaving the country
The single most important factor in the forecast is continued decline in Chinese growth.
This decline results in fewer Australian exports to China and much less Chinese investment in Australian property.
Chinese investment in property markets such as Australia, Canada and New Zealand ended abruptly in 2017 after China lost US$1 trillion of its original US$4 trillion reserve position.
China closed its capital account to conserve the remaining US$3 trillion (of which only US$1 trillion was available for capital flight; the remainder was tied up as a precautionary reserve or in illiquid alternative investments).
The end of Chinese capital flight pulled the rug out from under the boom in commercial and residential real estate in Melbourne and Sydney.
There were many ripple effects from the drying up of new investment, including reduced purchases of household goods and office furnishings, along with some job losses.
Can consumers prop up the Aussie economy?
The situation in Australia is not all bad news.
Retail sales showed a strong gain in November. Lower oil prices have given consumers more money in their pockets since the price of fuel has declined.
Yet even if consumers have not entirely pulled in their horns, these sales gains are unlikely to completely offset the damage from falling residential and commercial property prices, especially in the largest cities of Sydney and Melbourne.
In fact, over the remainder of this year, Australians will likely reduce consumption and increase savings to offset declines in their net worth due to falling real estate prices.
The chart below shows the close correlation between home sales and retail sales of household goods.
With home sales expected to decline further in 2019 and 2020, it is expected that retail sales will also decline — another headwind for growth in Australia.
Australian house sales and retail sales data 2006-2020
Source: CoreLogic, Australian Bureau of Statistics
Declining oil and natural gas prices are also a drag on Australian economic growth because Australia is a major exporter of LNG.
With gas prices dropping, new investment in Australia’s LNG-producing sector will also decline.
This hurts the investment component in GDP and also reduces job gains connected to cancelled LNG projects.
Aussie political headwinds
Another negative for Australian growth is the political calendar.
Your federal elections will be held this year.
The leadership of the government will be determined based on the number of seats gained by each party.
Right now, the government is led by the Liberal-National Coalition under the leadership of Prime Minister Scott Morrison.
As you know, the Liberal Party is the most conservative of Australia’s major parties. The opposition Labor Party is led by Bill Shorten.
The exact date of the election has not been set.
The Senate vote must take place by 18 May and the House vote must take place by 2 November, but they could be sooner.
Right now, the Labor Party is favoured to take control of the government. Labor has campaigned on a platform of higher tax rates for the rich and elimination of certain property tax loopholes.
These new laws would drive property prices even lower and add to the headwinds facing the Australian economy.
First recession in three decades
Another lifeline that could help Australia, but will probably not be used, is lower interest rates.
The Reserve Bank of Australia (RBA) could cut interest rates, weaken the Australian dollar, make Australian exports more attractive, and import inflation from trading partners to boost wages and spending.
This probably won’t happen.
The RBA is wedded to the same failed Phillips curve models as the US Federal Reserve.
The RBA looks at relatively strong job markets in Australia and concludes that inflation must be imminent. This has led to rising expectations of rate hikes by the RBA.
In fact, the Phillips curve is non-existent and there is no strong linkage between unemployment and inflation.
The RBA should be cutting rates instead of considering rate hikes.
Australia is facing a constellation of challenges.
Chinese flight capital investment in Australia is drying up.
Chinese demand for Australian natural resource exports is also diminished, due to the slowdown in the Chinese economy.
Property prices are already in steep decline, and political forces will make matters worse with tax increases and the end of property tax loopholes if the Labor Party wins the upcoming elections.
Finally, the RBA will drop the ball by not cutting rates further.
Political, tax and economic factors are aligned to slow the Australian economy even more than it has already slowed.
If these trends continue or accelerate, Australia may even face a recession in 2019 or 2020, which would be its first recession in almost 30 years.
|All the best,|
Strategist, The Daily Reckoning Australia