Rod Ireland
Welcome to Strategic Alternatives, the RBC Capital Markets podcast, where we uncover new ways to raise capital, drive growth and create value in this ever changing world. I'm your host, Rod Ireland, Head of Global Markets for APAC. In this episode, we turn our focus to Australia, diving into the key factors shaping the outlook for 2025. Joining me today are Su-Lin Ong, Chief Economist, and Rob Thompson, Macro Rate Strategist. Australia faces subdued growth, driven largely by public sector demand, as private consumption slows and inflation remains a challenge, with the Reserve Bank of Australia maintaining a cautious stance. It has been on hold at 4.35% since November 2023 despite a global easing cycle with only modest cuts expected in 2025. An additional layer of complexity stems from Australia's close economic ties with China, while China has historically been a critical driver of demand for Australian resources, recent announcements of underwhelming stimulus measures have dampened expectations for a robust recovery in the resources sector. A new Trump administration and the threat of 60% plus tariffs on China are an added risk to Chinese growth. In this episode, we'll explore how these dynamics interplay with global trends, including rates divergence and geopolitical tensions, while unpacking these signals, we're watching closely to assess the economic direction for the year ahead. Thank you for being with us here today.
Su-Lin Ong
It's good to join you, Rod.
Rob Thompson
Great to be here. Thanks. Rod.
Rod Ireland
So Su-Lin, why don't we start with you. What do you see as the most important themes for Australia in 2025 in an APAC context?
Su-Lin Ong
I'd like to focus on three main themes for Australia in 2025 and they're all related to some of your opening comments, Rod, about how weak the Australian economy is at the moment, and what's keeping it afloat, which is some of that public demand, but some much weaker sectors elsewhere. So the three that I want to focus on for ‘25 that I think will be important is the consumer, what's happening on that front. The public spending is the second one. And then we really can't escape the geopolitics and what will happen as we look into ‘25 under a new U.S. administration. So let me start first with household consumption. The economy is pretty weak. The most recent set of national accounts data for Q3 showed growth of sub 1% might be a little bit firmer in the current quarter, but we are looking for activity this year to be about 1% for the year as a whole ’24, picking up a bit next year. A big part of the reason for the weakness and the sub trend pace of growth is really what's been a very subdued and flat consumer for the last 12 to 18 months. It's reflected a bunch of factors, but the most important one has been some real weakness in household disposable income. Disposable income has been going backwards for a lot of the last 12-18, months, and that's really what's hit consumers pretty hard in a high cost of living environment. And if we're hoping for stronger growth in 2025, and we are looking for growth to pick up a little bit to a bit above 2%, a lot does hinge on that consumer. I think what's interesting in Australia, and a little bit unique that could support a stronger consumer outlook, is income tax cuts that kicked in from the first of July this year. All households got them to varying degrees. They were concentrated in low to middle income, and we've also had some cost of living relief here. So utility rebates, electricity subsidies, some childcare help as well, and rental assistance. But so far, it's been pretty patchy. We haven't had any real signs that consumers have responded to the income tax cuts/. They look to have saved a lot. So it's really that interaction between higher savings and when consumers start spending that we're looking for. So that's really quite key for the Australian outlook next year. The second factor that's important, really, and you alluded to it as well, Rod, is this public demand. So this is government expenditure. It's government consumption, what governments spend on health, education, defense, as well as government capex. So the capex side, particularly around infrastructure. That public demand in Australia has been really strong for some time now. It was on an upward trend prior to COVID. Obviously, a lot of assistance throughout COVID, and it's remained really very high. So it's a big part of the economy. It's almost 30% of GDP now, and even if we cut through some volatility, it's been growing on average, this public demand at about 5% a year for the last decade. A unique factor here is a government program called the National Disability Insurance Scheme, the NDIS. It's a very large scheme. It's hard to see this public expenditure shifting anytime soon. It's likely to remain strong. We are going into a political cycle where there'll be a federal election due by May 2025. It’s pretty tight in the polls at the moment, we would expect the government to spend some money and add to that public demand. And of course, there's structural elements to that public demand, whether it's the demographics and aging population, greater defense expenditure, energy transition costs. And then the final one is around geopolitics, and there's obviously multiple pressure points around the world. What clients are saying to us at the moment, and what investors are most interested in, and markets, is really some of these implications from a new Trump administration in 2025 for Australia. I like to say that while we know there's a lot of uncertainty, there is also some certainty in all that uncertainty, we know there are four key areas that the new administration will be focused on, tariffs, migration, tax cuts and deregulation in some kind of form, maybe not entirely what's been proposed, but some of it is likely to come in, and the sequencing is important as well. And so for Australia, and more broadly, for APAC, there will be transmission through from these policies, from a number of channels, some of it for Australia and the region will be second order. So whatever happens to the US economy and US yields and asset markets will transmit through, but some of it will be a bit more direct. And in particular, as you can imagine, what we're focused on most closely is anything that hits Australia's major trading partner, largest export market, which is China. And the discussion around tariffs, obviously, potentially quite large, 60% or higher is really significant. Anything that places downside risk to Chinese growth will transmit through to Australia. China takes a third of Australian goods exports. It takes a disproportionate amount of our commodities, 80% of iron ore, for example, which is the largest goods exports. We have adjusted slightly our export forecasts down next year and ‘26 to try and capture some of that, and it does take our growth down a little bit for ‘25 and’ 26 so they're really the three key areas that we're focused on.
Rod Ireland
Su-Lin, so you referenced household income, broad based consumption, income tax, public expenditure. What else do you see as the key factors driving your inflation and employment outlook for the next year or so?
Su-Lin Ong
So on both those fronts, there's some interesting developments. The Australian economy is pretty weak and has been for some time. What has been the key upside surprise is the labor market in Australia. It has been remarkably resilient. Unemployment rate of 4.1% and it's been there for about the last six months, and then it's gone sideways. Is quite low by historic standards. It's only lifted a little above half percent from its lows. We've had ongoing employment generation and job creation month after month, and that surprised to the upside, employment to population is at record levels. Participation also near record levels. This is a pretty healthy labor market, right across the board, despite very weak growth and the easiest way to explain it, and what is very clear is that public demand that we've been discussing, where a lot of the job creation has occurred in Australia, is in what we call non-market jobs. These are jobs in the public sector and adjacent so we're talking about health, social assistance, education, public administration, that is a big and growing part of the labor market, it counts for about 30% of total employment. Health now is about 15% of total employment. So the starting point for the labor market is really good. We do think, though, that the weakening in overall demand and the broader economy, the softening in some of the leading indicators will see the unemployment rate rise over the course of 2025, so up towards four and a half percent is our forecast by the end of next year, some loosening up in the labor market, we actually need to see that to get inflation lower. Inflation, like most places around the world, has continued to moderate over the last 12 months, but it is still too high, particularly the core underlying measures. The trim mean here is about three and a half percent. It is above target still. Services inflation is about four and a half and quite sticky, and so that's softening up in activity, and the labor market should help inflation move lower over the course of 2025 into the RBA’s two to 3% target range. We'd have to say, though, that some of the challenges are still there for inflation. It's really quite a key factor in terms of the growth outlook and the challenges for inflation so we're very mindful of that.
Rob Thompson
And some of these numbers are quite a contrast versus international G7 peers. If you look at Canada and New Zealand, whereas cycles have looked a little bit different, labor market outcomes have weakened a lot more quickly, and they've had very different rate cycles as well. It's quite a contrast versus the starting point here, as we head into 2025, for Australia. And inflation outcomes too, both of those have seen inflation dipped a bit more noticeably and allowed those central banks to be more comfortable and easing, versus the RBA here, which is, as we'll get into a bit later, a bit more reluctant for good reason.
Rod Ireland
So staying with rates and inflation for a moment, the Reserve Bank of Australia has signaled a cautious approach to rate cuts. How do see this playing out throughout the year?
Su-Lin Ong
So the Reserve Bank has left the cash rate at 4.35 since November 2023 so we've been on hold for 12 months, and that's against a backdrop, as Rob mentioned, particularly in dollar block, but elsewhere as well, where we've seen, rate cuts in many parts of the world, and a very clear global easing cycle. The RBA has not participated yet. And there are a number of reasons for that, and there is a bit of caution. The clearest reason is we never took rates as high as most other places. So the rest of the dollar block had cash rates up at 5% or higher before they started cutting from about the middle of this year at 4.35 the Australian cash rate sits relatively low by dollar block standards and is only mildly restricted by our estimates, and that's really because labor markets proved remarkably strong and resilient, and inflation has remained above target. So the RBA rightly has stayed on the sidelines. It's kept policy restrictive. It's tried to engineer a moderation in activity without delivering too much damage to the labor market, and it's done a reasonable job of that so far. The risk, though, is that that inflation stays higher than it would like. Our base case is for two 25 basis point cuts in May and August of ’25. It's very modest. It would take the cash rate to 3.85, which is probably still on the mildly restrictive side of neutral. But we'd have to say the risk to that is, they start a little bit earlier, possibly at the first board meeting of ‘25 in February. And we say that because we had the final RBA board meeting. While they left the cash rate unchanged at 4.35 there was quite a dovish shift in the RBA statement and the accompanying press conference, and it was quite deliberate in our view as well. The bank looks to be laying the groundwork for easing in ‘25 and keeping the door open for it to start as early as February. So a real shift in tone, a greater confidence that inflation is coming down and will move sustainably within target. Acknowledgement of some softer data, particularly around activity in the consumer and a greater comfort lower inflation is coming a little bit clearer. While it's a long time between now and the February board meeting, it's longer than usual, and we've got a lot to get through. I think if some of the domestic data disappoint, particularly the labor market data, and shows greater signs of loosening up, then it's entirely possible the bank does start some modest easing next year. And then, I suspect, the discussion like we've seen around the world, is really how much will they do? Will they do 50 points, 100 point cycles? We've been very much of the view that the RBA will likely deliver a shallow cycle compared to its dollar block counterparts. That reflects the starting point that is lower in terms of cash. It reflects the strength of this public demand, and it also reflects the resilience in in the labor market compared to dollar blocks.
Rod Ireland
So with looser global monetary policy, expected, how much spillover impact do you anticipate for Australia?
Rob Thompson
So markets have struggled for some time to figure out when the RBA is going to start easing, how much it's going to do, and in many ways, the default position is to follow US rates instead, while we wait that direction from the bank. But again, what we've seen the last couple of weeks is a couple of key data events, first GDP, and then, the Reserve Bank itself changing the emphasis in a statement a bit to signal a bit of a closer position towards eventual cash rate cuts, which has allowed markets to start to price a bit more easing from the RBA, which in turn, has allowed some of our particularly front end bond yields to really start to drop away from where those US bond yields sit. It's also happened further up the curve as well. But the key thing here is that we are just seeing a bit more of that divergence come through, a bit more outperformance from the Australian side. The setup into next year, however, will be interesting because we're not going to complete the unlink from global bond yields, and particularly from the Fed and the direction that sets. And our view there is that the Fed stops its cutting cycle at four to four and a quarter, which is well above what the market's currently pricing. And some element of that, we think probably transfers through to Australia. So you could see some bond yields underperform in both, although we still do expect that especially the Trump inflationary type forces might see a bit more impetus to high yields in the US than here. If I rewind about six months or a year ago, essentially, markets were so unsure, they were pricing terminal cash rates about the same level across dollar block space. That dynamic has now most assuredly disappeared, some real divergence has open up, and it does open up more opportunities for directional trades between countries, in markets for investors.
Rod Ireland
So when we look at markets currently, I can see that about 75% of a 25 basis point rate cut is now priced in in February. Are investors pricing in too much optimism, more caution into markets right now?
Rob Thompson
At the margin, we'd probably think that they're getting overextended in terms of how much they are pricing in for the RBA. A lot of people have been positioned for the RBA not to cut rates at all, certainly for the course of this year, which has proved correct, but then also through much of next year, which is suddenly being challenged by a few of these recent data points. So there is some element here, perhaps, sort of positioning where people are being forced to stop out of trades and go the other way. But there's also the global linkage. There's a lot priced in, and more being priced in for other countries too and we’re again very much linked to that.
Su-Lin Ong
I think a lot will depend on a couple of really important data points domestically between now and that February meeting, Rod, because we've got two labor force prints that really will be quite significant, and then a full Q4 inflation print. And the expectation is they may be a little soft. Markets may be getting a little optimistic in terms of February, but you'll only need one quite weak print of those three. The first 25 point cut was not really priced until June, July of next year. So markets had kind of given up a little bit. We've had a couple of soft prints that kind of moved all the way the other way. The truth may lie somewhere in between, which is our base case. And data prints that could swing it either way.
Rod Ireland
So Rob, Su-Lin stay under that the at the beginning by suggesting that geopolitics will be an increasingly important theme for Australia this year. How could that impact rate markets?
Rob Thompson
Volatility is going to be the way next year. The risks to market pricing in either direction are just magnified by potential geopolitical eruptions here, and especially, of course, for Australia to do with US-China relations and spillovers there, but they could well go another direction. And we've certainly discussed scenarios where, if you had sanctions posed on China, China needs to export its goods elsewhere. Markets like Australia, where we don't have a particular reason to impose barriers of the same nature, might be recipients of more Chinese goods to kind of makeup that glut. So there are actually some deflationary forces as well stemming from that. Whereas, of course, on the US side of things would probably see the risk skewed towards inflationary outcomes from the Trump administration.
Rod Ireland
So let's just change tack slightly and talk about fiscal policy. Do you see Australia's fiscal strategies effectively addressing domestic challenges such as housing affordability or infrastructure gaps?
Su-Lin Ong
Fiscal policy is really key for Australia, And when I think about housing affordability, it's where economics and politics really intersect because it is probably very high on the list of concerns for Australians. It will be important as we go into a federal election year. National House Price Index is at a record level. We had a little bit of a soft patch in mid ‘22 into ‘23 when rates started rising. But really annual house price growth at the moment nationally is about six to 7% but house prices are up about 40% from their pre COVID levels, so we've had very little pull back here despite higher rates, despite reduced borrowing capacity, and despite worsening affordability. What has happened a lot in Australia is that there's been a reliance on subsidies, on grants to help first homeowners. But all that does ultimately is lift house prices. The real issue is around supply and the need for greater supply to meet demand. And we've obviously had very strong population growth in Australia as well. We've had an under supply of housing and a real need to get more built housing in many forms, particularly higher density in Australia. It's really those measures to address supply. Whether planning measures to allow for faster approvals, higher multi-density around transport, skilled migration in construction. When we look at all the various housing metrics when it comes to resi construction, they're starting to pick up a little bit, but they're coming from decade plus low. So there's not a lot of pipeline activity happening, and it's also because its expensive, materials are high, labor is short, planning times are really difficult, regulation is costly, taxed impulses. And so, it's really about governments and fiscal policy addressing those issues to try and boost supply. The federal government has a very ambitious target of 1.2 million new dwellings over the next five years. We are well behind already on that. It's going to be a real challenge, but that's really the role of fiscal policy and government in the housing space.
Rob Thompson
There's a good segue here into infrastructure spending. We've seen a real explosion of infrastructure spending, especially on the Eastern Seaboard. So Victoria, New South Wales, really leading the way in the last few years, and Queensland starting to really pick up on it as well, which for markets, has meant a lot more fiscal pressure on the state side, they've needed to fund a lot more through the bond market. The state government bond market in aggregate has more than doubled in size since pre-COVID with what some have termed an explosion in issuance. A very healthy increase, perhaps, would be more appropriate there. But it has been quite a step change. It's been a much more interesting market to be in through these times, but quite interesting to see the contrast there between Commonwealth government deficits, which have really not looked too bad in recent times, partly thanks to the nominal boost to income from inflation that's come through income tax and corporate tax and commodity royalties, versus the states which haven't had the same level of boost to their revenues but have had to face all the challenges from increased infrastructure and other spending requirements in the post-COVID era. So been quite a split there between the state and Commonwealth side on the spending requirements. And this time, the infrastructure spending will be going on for quite some time. It's been very topical for a number of reasons, partly because it's taking away from the ability to construct. So as well as being necessary to build infrastructure to support more housing, it's also taking away, in many ways, from the workforce, the labor supply of construction workers and the pipeline and materials and so on needed for that sector. So a lot of competition for resources to build, whether it's across the infrastructure side or indeed on the home building side, making things difficult for policy makers to try and get right. And of course, as I mentioned, increasing the size of the government debt market, which has increased spreads to bonds. So made the semi government bonds, more attractive to investors, but also raised some questions over longer term fiscal sustainability, given the pace of debt increases.
Rod Ireland
You touched on immigration and the impact that it's had on housing. How do you see the current immigration trends influencing labor markets and the broader economic growth in 2025 and beyond?
Rod Ireland
The very short version to that, as we stand, seems to be that it's clearly additive to growth and to inflation. Take something out of the labor market by adding labor supply in there, but the inflationary effect seems to be slightly larger, or at least has been over the last year, and probably still over the next year or two, that still seems to be the direction of travel, and so definitely a challenge for the Reserve Bank and other policy makers to try and account for and allow for this level of extra people coming into the country. It's not really a function of natural population growth at all. If anything, that's actually slowed, but our increase has almost exclusively come through immigration channels. So certainly quite challenging, and certainly feeds into the infrastructure problem the governments are facing there as well. But still, it'll be very challenging for the government to realize its forecasts for a drop in net migration over the next couple of years. Population growth still remaining quite strong, would be our view, and at the margin, that probably does continue to add to inflationary pressures and makes the Reserve Bank's job just that little bit harder for the moment.
Rod Ireland
I thought I would finish with one last question that I'm sure is on the minds of all of our listeners. What could go wrong with your forecasts?
Su-Lin Ong
History shows in Australia that it's usually external shock that causes the most disruption, the greatest risk, and the weakest outcomes in Australia. And clearly there are multiple risks and pressure points globally that could transmit through here, whether it's disruption to trade and supply chains, a world that is more protectionist with lower trade volumes, that never bodes particularly well for a small open economy like Australia, commodity price shocks that transmit straight through to here. It's really that external shock that we worry about the most. Australia does have buffers, both interest rate and fiscally, but nevertheless, we won't be immune at all. So that worries us, because I think there's more of that in ‘25 than we've seen for some time. A lot of uncertainty around that new US administration, and so we worry about external shock. The second one I'm a bit worried about is really the consumer. The consumer in Australia has really bunkered down, as I said, if we are hoping for a bit stronger growth next year, we do need the consumer to lift. My worry is a consumer that doesn't revive, that continues to save and that will have implications, definitely will see a much weaker economy and labor market as a result.
Rob Thompson
And then on the sort of non-shock side of things, it could be that we, we've tended to associate ourselves more as looking like the US in terms of decent enough labor market outcomes, strong growth, etc. And could be that we actually are more like Canada and New Zealand, and perhaps there is just a longer lag to monetary policy having a large impact. Perhaps a good labor market will actually soften more than we expect, and that could result in a very different outcome for the RBA inflation, other key metrics. So that's something where our base case. Might just look a little bit different to how we expect, but at the moment, we think we are more like the US in terms of looking pretty strong, even if it's for different reasons, things do look pretty well supported here relative to some of the weaker markets in developed space.
Rod Ireland
So that was a great point to end on. It's been tremendously insightful. I want to thank both of you for joining the podcast today.
Su-Lin Ong
Thanks, Rod.
Rob Thompson
Thank you very much. Rod.
Rod Ireland
To our listeners. That's all for this episode. Thank you for tuning in today. Please remember to subscribe to get more great content and to be alerted about future episodes. You've been listening to strategic alternatives, the RBC podcast. This episode was recorded on December 11, 2024. Listen and subscribe to Strategic Alternatives on Apple podcast Spotify, or wherever you listen to your podcast. If you enjoyed the podcast, please leave us a review and share the podcast with others.