The slow motion recovery

The mining boom continues to drive divergent outcomes in the Australian economy. The income gains from the rise in the terms of trade caused nominal GDP to rise by 9.6% in the year to September 2010, well above the 2.4% gain in real GDP. Mining investment is at an historically high level and is likely to increase further given the substantial number of large resource projects now underway.

Outside the mining sector it's a different story. Firms are cautious about investment spending, the high Australian dollar is taking a toll and households are paying down debt instead of spending. The tourism industry has been hard hit – shortterm overseas departures exceeded visitor arrivals by 1.2 million last year as Australians took advantage of the low relative costs of overseas holidays.

Household savings have increased sharply over the past three years. Higher savings imply weaker spending growth out of incomes.

Retail spending has been surprisingly weak despite strong jobs growth, wage gains and rising household wealth.

Most forecasters anticipate that the mining boom will continue and that households will eventually lose their caution and start spending again. This view is behind the RBA's relatively hawkish forecast of GDP growth in a 3.25-4.25% range over the next two years. The latest Bloomberg survey of market economists has the RBA's cash rate at 5.50% by the end of the year, implying three more increases of 0.25%.

Our view on interest rate tightening is more measured. The lower-than-expected December 2010 quarter inflation figures and weak trends in retail spending and housing activity are pushing the next tightening further into the future. Our suspicion is that the pace of the RBA tightening might be more gradual than the market expects. We may see only one or possibly two 0.25% rate rises this year.

The pessimism of mid2010 had given way to a strong sense of optimism as economists upgraded global growth forecasts and posted bullish targets for share markets.

That optimism became more subdued after the natural disasters in Queensland, New Zealand and Japan, but the overall consensus is that they should not have a lasting material impact on the global recovery. At Russell we think that sharemarkets have upside, but we are wary of some of the more bullish forecasts. Volatility is likely to be an ongoing theme in 2011, generated by market events such as government debt concerns and shifting views about monetary policy. The challenge once again this year will be to maintain discipline amid potentially large swings in market sentiment.