Australia’s economic news has been mostly good of late with relatively strong real GDP growth in Q2 including welcome signs of stronger growth in previously very weak national income. Nevertheless, we still question where the good news in the Q2 GDP report can be sustained with what strength there was in Q2 GDP coming mostly from a big lift in government spending in the quarter and the strong lift in national income driven by a sharp and most likely unsustainable lift in Australia’s terms of trade (export prices relative to import prices) in Q2. We still see Australia’s annual GDP growth fading over the next year and pressure remaining on the RBA to cut the cash rate further, although the next rate cut may not occur until early 2017, rather than in November this year.
Taking a closer look at the Q2 GDP report, real GDP looks reasonably strong, up 0.5% q-o-q and 3.3% y-o-y compared with revised 1.0% q-o-q, 2.9% y-o-y in Q1. Taking Q1 and Q2 together generates a favourable picture of first half of 2016 with annual GDP growth averaging 3.1% y-o-y or 3.0% annualising the two quarterly growth readings. If annual growth could continue around 3%, Australia would continue to perform very well by international comparison. Interestingly, the changing drivers of spending based GDP growth in Q2 with government spending lifting to part offset softer contributions to growth from household spending and exports happened just at the right time to salvage growth in the quarter. The problem is that government spending may need to lift at least as strongly again in Q3 and Q4 to keep GDP growth strong and that seems unlikely to occur even though the checks on the Federal Government’s ability to legislate its planned budget spending caused by its fragile lower house majority and a hostile Senate provide some back-handed impetus to government spending growth.
In Q2, government spending contributed 1.0 percentage points to GDP growth of 0.5% in the quarter. Private sector spending – consumption spending, housing and business investment spending – contributed -0.4 percentage points to GDP. The out-sized government spending contribution arose from government consumption expenditure lifting by 1.9% q-o-q in real terms, the biggest quarterly increase since the period of sharply higher government spending after the global financial crisis. Government gross fixed capital formation, however, lifted by an extraordinary 15.5% q-o-q and alone contributed 0.7 percentage points to GDP in the quarter. Part of this big lift reflected a change in ownership of assets between the private and public sectors, but part also reflected the ramping up of mostly state government infrastructure spending.
The key point is that is close to impossible to get another contribution to GDP from government spending anywhere near the 1.0 percentage point contribution achieved in Q2. After such a big rise in spending in a quarter there is usually a give-back the following quarter. A realistic forecast contribution from government spending in Q3 is in -0.2 percentage points to zero contribution implying that if all other contributions are roughly the same as in Q2, Q3 GDP would come in somewhere between -0.5% and -0.7% q-o-q.
Fortunately the other contributions to GDP growth will in total probably be a touch stronger than in Q2. The biggest detractor from GDP growth in Q2 was business investment spending, -0.7 percentage points. Part of that weakness was the flip side of the asset transfer that helped to boost government investment spending in Q2. However, the continuing run-down in mining investment spending still made up much of the rest of the negative contribution and even if it continues at slightly lesser pace in Q3 implies a negative contribution to Q3 GDP growth from business investment spending of around 0.3 percentage points.
Taking total government spending and business investment spending together and assuming other contributions the same as in Q2 places Q3 GDP between about -0.3% q-o-q to -0.1%. The other main contributions are household consumption spending, +0.2pp in Q2; housing, +0.1pp; and net exports, +0.2pp. Household consumption spending growth is fading in strength and retail trade data for July (0.0% m-o-m) point to the fade continuing in Q3. Home building activity is topping out and is unlikely to contribute to growth more strongly than in Q2. There is some hope that net exports may contribute more strongly in Q3, perhaps doubling its contribution to 0.4pp.
Taking these other factors and assuming no contribution either positive or negative to growth from changing inventories our GDP forecast for Q3 comes in between 0.4% q-o-q and 0.6% q-o-q. On the face of it that seems not too bad, although it would cut annual GDP growth to somewhere in 2.7% y-o-y to 2.9% range in Q3 and annualised growth over Q2 and Q3 would be in 1.8% to 2.2% range. It is worth keeping in mind that even these results are dependent on the net export contribution to GDP growth doubling compared with Q2.
It is good news that Australian real GDP grew 3.3% y-o-y in Q2. It is less good news that annual growth is very likely to slide in Q3. It will be even less good news if past GDP strength causes the RBA to bide its time before delivering further rate cuts as seems likely.