Macro: what chance a recession?

Between 1982 and 2008, The Netherlands experienced 103 quarters between recessions. Australia is on the verge of breaking that record. Despite one negative quarter of economic growth at the time of the GFC, Australia hasn't had a recession since the second quarter of 1991 (technically, a recession is two consecutive quarters of negative economic growth). Despite a rather weak recent figure, 97 quarters have elapsed since the '91 recession. One more year would do it.

But there's a problem. Economic theory sees recessions as a necessary part of capitalism, one that cleanses poorly allocated capital from the system and restrains animal spirits. Recessions clear out the dead wood, making way for new growth. Against that backdrop, 24 years of uninterrupted growth is both impressive and worrying.

So we must be due, right?

Not necessarily. Although a long recession-free period increases the chances of, say, banks writing underperforming loans that will need to be written down in a recession, we cannot assume the future will look like the recent past.

Firstly, China's industrialisation, an economic one-off like no other, has been a huge fillip. Secondly, the politicians of the last few decades were far braver than the current crop, undertaking reforms that mean we're now more resilient to the risk of recession and face less adverse consequences when they do occur.

What kind of changes?

The dollar was floated in 1983 and foreign exchange controls were removed. That allowed the currency to act as a cushion against external shocks – witness the recent fall in the Australian dollar as China's growth has slowed.

Enterprise bargaining and the removal of tariffs exposed our industries to international competition, reducing feather-bedding. Government-owned enterprises were floated and industrial policy was directed towards benefitting the consumer. That sounds obvious now but it was a radical idea back then. A good example is in aviation, where the market was opened up to foreign carriers at the expense of Qantas because we wanted a larger tourism industry even if it meant a smaller international airline.

The effect of reforms on labour and financial markets, competition policy, fiscal and monetary policy and a bi-partisan approach to making industry more competitive were, in retrospect, incredible in their scope and success.

Former Secretary to the Treasury Dr Martin Parkinson made this clear in a speech last year. The early '80s recession resulted in the unemployment rate increasing from 5.4% in June 1981 to 10.3% in May 1983. The oil shock recession of the mid-'70s increased the rate of unemployment by about 4%.

After the reforms undertaken by Whitlam, Hawke, Keating and Howard we have experienced the Asian crisis, a massive economic shock to some of our largest trading partners, the Global Financial Crisis and the bursting of the tech bubble. And yet unemployment barely budged. After the tech wreck it increased by 1%. Following the GFC it rose by 2%.

Prior to the reforms, the costs of a recession were largely borne through the rate of unemployment, at huge economic and social cost. With a more flexible, open economy economic shocks are now better absorbed, through fewer hours worked, a lower currency, improved productivity and real wage growth rather than unemployment. Along with China's growth, this is why Australia has enjoyed 24 years without a recession, plus a bit of luck.

So we have nothing to worry about?

Not so fast. Only in retrospect do the causes of a recession become apparent. Let's rake over the suspects anyway. First in the identity parade is China, undergoing a slowdown that has caused huge commodity price falls.

In 2004, China accounted for 8.5% of our exports. Last year that figure was 32.4%. China now supplies more overseas students than any other country and is our second-largest source of tourists. This is a country industrialising at an unprecedented rate on an incredible scale. But there are only so many apartment blocks, rail lines and airports a country can build before it experiences a declining rate of return on its investments. Evidence suggests this is occurring in China now.

Furthermore, China must make the transition from an investment-led economy to one driven by consumption. With China buying about a quarter of our exports, this will reduce the rate of growth in demand for raw materials at the very least. Frank Stillwell, emeritus economics professor at the University of Sydney says, 'The bottom is not about to drop out of our exports, but even a slowing down will create stresses.'

That's already apparent. Mining has doubled its share of the economy in the past decade and is now moving from an investment to an output phase. But falling commodity prices have hit the terms of trade. We have advanced over the mining cliff but non-mining sources of growth have yet to fully take up the slack.

Housing has done some of the heavy lifting but is potentially a bigger source of risk than the end of the resources super cycle. Chris Watling of UK firm Longview Economics calls Australia 'the most obvious bubble in global housing' and sees parallels, ironically, with The Netherlands, which experienced a housing bubble that burst in 2008, ending its record.

'A disorderly exit from the housing cycle is a higher risk event than a China hard landing,' warns Bank of America Merrill Lynch chief economist Alex Joiner. Australia's household debt, which at about 130% of GDP is 50% more than the UK's and substantially higher than when The Netherlands experienced its crash, makes the country vulnerable.

There are two more concerns. Wage growth is weak. In the most recent September quarter real wage growth was negative. Whilst this emphasises the flexible, shock-absorbing nature of our economy, sustaining aggregate demand is critical to a high-performing economy. The effect is somewhat offset by a declining household savings ratio but weak wages still threaten the RBA's target of GDP growth of 3% next year.

Australia's companies aren't coming to the party either, sitting on huge lumps of cash and demanding stupidly high hurdle rates from proposed investments. According to a Deloitte CFO Survey, almost 90% of respondents demanded a return of at least 10% per year for an investment to take place and about half wanted over 13%. No wonder non-mining investment fell 8.2% in the latest quarter.

For Australia to maintain its unblemished recent record, China, our corporate sector or consumers are going to have to pick up more of the slack left by the collapse in mining investment.

Sounds bad. What about the counter argument?

Well, you could try Commonwealth Bank chief economist Mark Blythe's 10 reasons why we won't face recession or NAB's similar effort. But these are business most exposed to a recession so perhaps we shouldn't place too much faith in their arguments.

Former Reserve Bank board member Warwick McKibbin believes there's a 50% chance we'll be in recession in the coming year while Goldman Sachs chief economist Tim Toohey puts the figure closer to 30%. Paul Krugman is also concerned, while the perma-bears over at The Daily Reckoning believe we're already in recession.

No-one really can know, of course, but the risks are obvious. More worrying is the lost decade during which we have let a host of problems take root, from under-investment in infrastructure to a perpetual budget deficit. Returning to Martin Parkinson: 'Unless we tackle structural reform, including fixing our fundamental budget problem, we will not be able to guarantee rising income and living standards for Australians.' Over to you pollies but I for one am not holding my breath.

How do I prepare my portfolio?

My colleague James Carlisle will touch on this in his review of the year early next week, but I'm pretty sure buying cheap stocks will be part of his argument. One of the few good things about recessions are the opportunities they bring. That's going to be one of the themes of next year. In the meantime, you may want to revisit this piece where we cover the strategies and stocks to help you prepare, and profit from the possibility of recession.