Economic update: what to watch in 2014

Australian growth

The Australian economy remains in very good shape, both in the context of its own historical performance and when compared to other developed economies. Very few developed nations can match Australia’s combination of vital economic statistics: low unemployment (5.6 per cent), solid credit rating (AAA rating), low government debt/GDP, low inflation (2.4 per cent), solid economic growth rate (3.1 per cent) and strong relationships with global economic powerhouses.

We expect to see reasonably strong GDP growth in the domestic economy driven by export growth and a gradual recovery in consumer demand in 2014. Interest rates remain at historically low levels and the Reserve Bank of Australia has shown little inclination towards a tightening of monetary conditions in the short to medium term.

State and federal governments are expected to take advantage of the low interest rate environment to embark on a number of infrastructure projects. This, along with productivity improvements as corporates maximise operating leverage, will support employment growth stability.

 Economy in transition

The stability of the Australian economy is dependent on a transition from mining capex led growth to an increase in domestic consumption. And while the transition is unlikely to be orderly, we believe all the necessary ingredients are in place for a gradual lift in the non- mining economy.

Australia’s prosperity is not about resources alone. The services industry continues to grow in Australian sectors such as tourism and financial services. Manufacturing and agriculture continue to make a meaningful contribution to GDP as Australia embarks on niche products and value add production lines. Despite Australia having likely witnessed the peak in mining capex, bulk commodity and liquefied natural gas (LNG) exports are forecast to grow significantly in 2014, pushing the balance of payments into surplus. Retail sales are showing signs of improvement from a 50 year trend low and a very strong 2013 Christmas period.

Contributing to the improved retail outlook has been the increase in household wealth. The savings rate remains above historical averages. Combined with an average 10 per cent increase in house prices, there is a strong ‘wealth effect’ for Australian households with significant pent-up demand. The very high savings rate in Australia is likely to fall, funding an improvement in discretionary spending.

China is now the third largest source of inbound tourists to Australia and increasingly a significant investor in the Australian housing and commercial property market. The falling Australian dollar will see this trend strengthen and also encourage domestic travellers to holiday within Australia. A substitution of domestic for international tourism will also provide a fillip for the non-mining economy.

Australian equities for income

After a strong 2013, we are still positive on the outlook for Australian equities in 2014. We believe the market is still attractively valued given a price-to-earnings ratio of 14.7x which is around the historical average. The dividend yield of the market also remains highly attractive compared to other asset classes with a gross franked yield of 6.2 per cent, significantly better than cash (2.6 per cent) and bonds (4.3 per cent). We expect to see continued improvement in market earnings revisions and economic growth. We view the tapering of quantitative easing as confirmation of a lower macro risk environment which will see higher returns from higher beta, or more cyclical stocks, that have not been rewarded in the last few years of high uncertainty, especially in Australia. Australian equities as a global source of income will remain a very strong theme. Income, will be a large percentage of total return in 2014 with high quality companies with minimal income risk a key focus for the income portfolios.

 Source: Legg Mason, February 2014