There is a long list of worries that you may hear about our economy:
- The solid contribution to growth from housing construction seen over 2013-16 has faded and building approvals are off their highs.
- Average house prices have started to edge down, with fears of a deeper crash.
- The outlook for consumer spending is constrained and uncertain
- Wages growth is at record lows
- Underemployment is high.
- Consumers have been running down their savings rate (to now just 2.7%),
- Mining investment is still falling with investment plans pointing to roughly 15% falls this financial year and next.
- The Australian dollar at around $US0.78 risks threatening growth in trade-exposed sectors like tourism, agriculture and manufacturing.
- Underlying inflation is too low.
Yes, these are all a drag on the economy. But how much do they really matter? And what are the implications for your investments?
In this piece, we look at what matters most for the Australian economy and wrap up with a view on implications for investment outcomes.
Key drivers of GDP growth
If you were looking for one number to measure the economic wellbeing of an economy, GDP growth would be an important figure.
While it doesn’t tell the whole story, Gross Domestic Product (GDP) is valuable as a yardstick for our standard of living.
So, what does GDP measure? Well, here’s a neat little formula for you.
Y = C + I + G + NX
What this tells us is that economic growth – measured by GDP (Y) – is made up of four key components:
- C – is for consumption, which is the aggregate of consumers like us spending money on goods and services.
- I – is for investment, which is a measure of business spending on capital goods.
- G – is for government, which is a measure of government spending.
- NX – is for net exports, so that’s the difference between what we export out of the country and what we import.
In simple terms, if any one factor increases, and all other factors remain constant, then economic growth (GDP) would also increase – which would be a good thing for the economy.
Importantly, not all of these factors have the same weight – some matter more than others.
So, a question: Which one do you think matters the most?
The Australian economy is largely driven by the consumer
If you answered consumption, you’re right.
Consumer spending is the largest part of the Australian economy, representing nearly 57% of GDP. Which is why Australian GDP growth is still hamstrung by a constrained consumer.
The best measure for how consumers are feeling is the index of consumer sentiment. Over the past few years, the index has oscillated around the 100-mark – a reading below 100 means there are more pessimistic consumers then optimists, and above 100 means that the optimists outnumber the pessimists. The February Westpac Melbourne Institute Index of Consumer Sentiment survey result was 102.7.
While it is the fourth consecutive month where optimists outnumber pessimists, according to Bill Evans, Westpac’s Chief Economist “the level of the Index is still well below levels typically associated with a robust consumer.”
Evans notes that the survey is “sending a very weak signal about likely spending prospects”. A good starting point is to look at retail spending. While not all consumer spending is retail – it makes up roughly a quarter of all spending by households – it is a very good indicator of how households are spending.
Over the past five years, we have seen a steady downward trend – with the weakness mostly in discretionary items – items like household goods, clothing and footwear. This is being squeezed by increases in prices of basic goods – items like energy and fuel.
The next question we need to ask is: have consumers got more ‘fuel in the tank’ via wages growth, dipping into savings, or tapping into credit?
Alan Oster, chief economist for National Australia Bank, doesn’t see much room for the consumer to move: “Anything to do with the consumer is basically struggling. Wages are not growing… House prices are not as strong as they were, so you’re not getting the positive effects from that.”
The big issue, argues JP Morgan is lacklustre wages growth. Soft wages growth is likely to continue to be a handbrake on consumer spending.
Next, we ask: can consumers dip into savings or tap into debt to access funds for spending?
- With the savings rate currently at around 3%, households have very little scope to dip into savings or further decrease the amount saved.
- The debt story is equally unattractive. Australia has one of the most indebted household sectors globally. Debt to income has risen from around 148% in mid-2012 to a current record high of 200%. The challenge with having a highly indebted household sector comes from the fact that interest payments as a share of income are very high. And the principal must be paid too. This means that households have less income that can be spent on goods and services. Again, it acts as a brake on household consumption growth.
Implications for investment portfolios
Despite the headwinds facing consumers, most economists anticipate that the Australian economy will continue to grow, albeit at a low rate, thanks to some positive signs in other parts of the economy.
AMP Chief Economist, Shane Oliver sums it up well: “There is good reason to expect growth to continue and pick up a bit: the drag from falling mining investment is nearly over, non-mining investment is turning up, public investment is strong, trade should add to growth and profits are rising. But growth is likely to be constrained to just below 3% this year and underlying inflation is likely to remain low.”
When it comes to implications for investors, Oliver says that this continuing growth should provide a reasonable backdrop for Australian growth assets.
However, he cautions that, while Australian shares are great for income, global shares are likely to remain outperformers for capital growth: “Global shares have been outperforming Australian shares since October 2009 and over the last five years have outperformed in local currency terms by nearly 4% pa and by 9% pa in Australian dollar terms… While [corporate] earnings growth in Australia is around 7%, it’s double this globally, suggesting the relative underperformance of Australian shares in terms of capital growth may go for a while yet. Which all argues for a continuing decent exposure to global shares.”