Economic Update - Outlook more positive, Interest rates set to rise in 2018

We are more positive about the outlook for Australia, with downside risks to growth and inflation easing over the past few months. We have recently nudged our forecasts for growth higher. The key reason for the small upgrade to our forecasts is strength in investment, both on the private and public side.

After a period of weakness, public spending is now growing strongly, with both government consumption and investment picking up. The pick-up in public infrastructure spending has been quite marked, particularly in New South Wales. There is now a very substantial pipeline of work that will support public investment over the next couple of years.

The outlook for private investment has also improved and is now quite rosy compared with the past five years. The drag from the fall in mining investment has largely run its course, while growth in non-mining investment is accelerating. The strength in non-residential building approvals supports our view that a solid recovery is underway.

Housing construction looks set to slow but only very gradually. There is still a substantial amount of work in the pipeline which should support construction activity over the next year. Moreover, the recent surge in housing finance approvals for construction of new homes suggests that approvals are likely to remain well supported over the next few months. This should see construction activity remain elevated through 2017 and early 2018, before falling from mid-2018.

Elsewhere though, households are likely to remain cautious given the debilitating combination of soft wage growth and high debt. We continue to believe that households will bring their consumption and income growth closer into line, and we expect that two rate hikes next year will have an outsized impact on consumption as the implications of record levels of indebtedness hit home. Strong growth in house prices as well as the high level of housing construction have been key supports to consumption and sales of household goods in particular. But that support is now fading.

Retail sector

The retail sector in particular remains under pressure. Households are spending an increasing proportion of their income on non-discretionary consumption, such as rents, health, education and utilities and more discretionary spending is being squeezed out. The recent weakness in retail sales is a good illustration: we think that the sharp 0.6% fall in retail sales in August was largely in response to the rise in electricity and gas bills in the quarter. At around 2% of total spending, utilities spending is only a small share of overall spending, but we think the “sticker shock” of hefty bill increases weighed on confidence and spending in the month. While we do expect an improvement in retail spending in September, we continue to think the sector will remain under pressure.

Softer demand is only part of the problem for the retail sector. Prices and margins have come under pressure from both on-line shopping as well as the surge in openings from foreign retailers over the past few years. This competitive pressure is evident across different sectors of retail: supermarkets, clothing and household goods. And the pressure is only likely to increase further with the arrival of Amazon in Australia in coming months.

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