The drivers of Australian economic growth are changing as the recently released Q1 GDP report attests, but the changeover is proving to be lumpy and at times a somewhat uncertain process. Uncertainty about the changeover is we believe a key reason why Australian risk assets, more particularly the Australian sharemarket, have underperformed over the past month. The Australian dollar has also fallen quite sharply over the past month and in our view provides the best clue as to whether the Reserve Bank (RBA) has any more leeway to smooth the change of growth drivers by cutting the cash rate further.

Going back to the Q1 GDP report, the two main categories of demand generated within Australia’s borders (domestic final demand), final consumption and gross fixed capital formation, pulled in different directions in Q1. Final consumption rose by 0.6% q-o-q and by 1.7% y-o-y while gross fixed capital formation fell by 2.3% q-o-q and by 0.2% y-o-y. When combined, these two components showed a very soft result with domestic final demand falling by 0.3% q-o-q and up only 1.1% y-o-y. Much of the weakness in gross fixed capital formation in Q1 was the beginning of the fallback in mining sector investment (investment in private sector machinery and equipment was down by 6.9% q-o-q). If this were the end of the story, GDP growth would have been exciting talk of recession. What kept GDP growth in Q1 well above the zero line was demand from outside Australia’s borders. Exports rose by 1.1% q-o-q, while imports fell by 3.5% q-o-q and together contributed 1.0 percentage points to Q1 GDP.

Returning to domestic demand, the fall in mining investment spending in Q1 hit particularly hard demand in the big mining states and territories. When the 0.3% q-o-q national fall in domestic final demand is split between the states and territories Western Australia showed a 3.9% q-o-q fall and the Northern Territory a 10.2% q-o-q fall. In contrast, domestic final demand rose by 0.4% q-o-q in New South Wales and by 0.8% q-o-q in Victoria. Even though demand growth was reasonably good in the high population states (helping to account for why employment growth is relatively robust despite soft Q1 GDP growth) it was still far from strong enough to offset the big falls in the western half of the nation.

The main question is whether demand in the high population eastern states will accelerate sufficiently to more than offset further reductions in mining investment and support GDP growth nearer to trend around 3.2% y-o-y as opposed to the sub-trend 2.5% y-o-y in Q1? At its latest policy meeting held last week the RBA indicated in the unusually brief statement accompanying its decision to leave the cash rate unchanged at 2.75% that there was strong evidence that demand was showing signs of responding to earlier interest rate cuts, notably the beginnings of significant improvement in housing activity. The statement finished with a reminder that low inflation still leaves capacity for further cash rate cuts if needed.

We agree with the RBA that a marked improvement in housing activity is underway and importantly it is taking very firm hold at last in New South Wales. Moving beyond Q1, April home building approvals rose by a much stronger than expected 9.1% m-o-m and with New South Wales, up 33.3% and Victoria, up 9.3%, both showing  particularly strong increases. Housing activity at the leading edge of domestic demand would not appear to need any further assistance from lower interest rates.

In order to ensure that the change in drivers in the economy is as smooth as it can be, it is also important that the Australian dollar falls closer to a level considered to be “fair value”, itself a problematic calculation, but widely assessed as another 10-15% below where it is currently trading. Over the past month the Australian dollar has fallen by more than 5% against the US dollar and on a trade weighted basis. A falling Australian dollar is on balance growth friendly helping to underpin the contribution of external demand to growth, but also fostering areas of domestic demand. However, a falling Australian dollar, particularly if too large a fall too quickly, can generate concerns about inflation pressure and in foreign investors eyes the stability of the Australian economy. The pace of the fall in the Australian dollar is perhaps the key restraint preventing the RBA from touching the cash rate lever again.