Economic outlook

Australian Dollar Downside

The Australian Dollar has proven resilient over the past year, averaging about 77 cents and continuing the shallow uptrend formed since a multi-year low around 70 cents in early 2016. Looking forward, the Australian Dollar faces downside risks given Australia’s lower interest rates, lower economic growth and large foreign debt, a stronger US and possible rollover in China-linked commodity prices.

Australian Interest Rates below the US: First in 17 Years

Historically Australia has offered foreign investors premium interest rate yields. Indeed, since the early-1990’s Australian-US cash and 10-year rate spreads have averaged 206bps and 130bps respectively. 

In March, however, Australian cash rates fell below the US for the first time in 18 years! If the RBA leaves rates on hold at 1.5%, while the US Fed continues its tightening cycle, the Australia-US cash and bond spread should reach 37-year lows late this year (Figure 1). Beyond that, given Australia’s record household debt ratios, Australia is unlikely to regain a rate premium to the US (Figure 2).

FIG.1: AUS-US Rate Spreads, Negative for the first time in 18 years, should soon reach 37-year lows!

Source: Datastream, Baillieu Holst

FIG.2: AUS Elevated Household Debt Ratio has lowered AUS’ neutral cash rate to around US levels

Source: Datastream, Baillieu Holst

Australian Growth below the US and Europe

Over the past 25 years, Australia has consistently offered foreign investors exposure to premium GDP growth, outperforming its Advanced Economy peers 89% of the time, and by an average of 1.1%pa. Australian growth, however, has fallen below both the US and Europe (Figure 3), something that should continue given the massive US fiscal stimulus, whilst Australia is held back by pressure on its household sector, elevated housing risks and a moderation in China.

Over the medium-term, Australian growth faces challenges. Population growth is now driving most of Australian GDP growth, with a lack of reforms and the end of the resources boom driving weak productivity growth (Figure 4). Whilst strong infrastructure investment currently underway is positive, rising urban congestion should limit its impact. By contrast, the GFC and Eurozone debt crises have led to renewed reform, while an investment recovery is underway.

FIG.3: AUS GDP Growth has fallen below both the US and Eurozone!

Source: Datastream, Baillieu Holst

FIG.4: AUS GDP Growth now driven by Population growth, not Productivity

Source: Datastream, Baillieu Holst

Commodity Prices – The Risk of China Moderation

Booms in China housing and infrastructure investment over 2016-17 delivered a positive growth surprise and surge in commodity prices (Figure 5). With President Xi reappointed for life, however, financial stability and sustainable growth have become key priorities. Policymakers have sharply slowed shadow banking sector growth, curtailed local government borrowing and contained the growth of highly indebted companies, driving money and credit growth to record low levels.

China represents ~50% of global steel production, with a majority of end demand in construction. With record iron ore port inventories, a slowdown in demand could push iron ore prices much lower. The iron ore price has fallen ~16% since the Lunar New Year in mid-February.

Looking further ahead, as China converges on Advanced Economy levels of urbanisation, negative underlying demographics are likely to drive a dramatic decline in underlying commodities demand.

FIG.5: AUD has rallied with higher commodity prices

Source: Datastream, Baillieu Holst

US Dollar Weakness Since Early 2017

A key driver of Australian Dollar resilience has been US Dollar weakness, with the US Dollar index falling 9% to below longterm average levels. High and rising US rates and robust US growth, supported by strong fiscal stimulus, should help turn the US Dollar despite its twin budget and trade deficits.

FIG.6: Australia is a large Foreign Debtor

Source: Datastream, Baillieu Holst

Financing Australia’s Net Foreign Debt

The vast majority of economies with interest rates below US levels are creditor countries, with net foreign assets. Australia, however, has a high net foreign debt at 56% of GDP. Whilst Australian interest rates and GDP growth were much higher than other Advanced economies, the funding of Australia’s current account and foreign debt positions was a non-issue. But with Australian rates and growth below other Advanced Economies, and particularly the US, funding Australia’s net debt position may become more difficult.

Investment Implications

Given our views of Australian dollar weakness in the coming few years, it would also be beneficial to consider some unhedged exposure to international equities in your portfolio.