Households hit the accelerator, but business is in neutral

Why Australian business investment needs a jumpstart

This week’s June quarter national accounts delivered a modest upside surprise, with real GDP rising by 0.6% in the quarter compared to our forecast of 0.5%. This lifted annual economic growth to 1.8% from 1.4% in March and a low point of 0.8% in late 2024. While still below trend, the economy is clearly less anaemic than it was a year ago.

The economic recovery is being driven by household consumption, which posted solid growth of 0.9% in the June quarter. The gain was led by a strong 1.4% rise in discretionary spending while essentials spending grew by a more modest 0.5%. Discretionary spending was boosted by end-of-financial-year sales and new product releases, as well as extended breaks due to the timing of Easter and ANZAC Day holidays which lifted tourism-related demand. While some of this boost is likely temporary, underlying growth is robust; the household spending indicator rose by 0.5% in July, suggesting a solid start to consumer spending for the September quarter.

We remain confident that consumer spending should continue to expand, though at a more modest pace than in the June quarter, as it is underpinned by recovering incomes that have seen household budgetary pressures start to ease.

While real disposables incomes were flat in the June quarter, this was distorted by insurance payouts and emergency assistance packages in the March quarter associated with Cyclone Alfred. Looking over the last year to avoid this distortion, real disposable incomes rose by 4.1%, providing a solid base for households to either spend or save. For now, they are choosing a mix of both: the household saving ratio rose from 2.2% to 4.2% over the last year, while real consumer spending grew by 2.0%. Micro-level data from the CBA show that the improvement in incomes has allowed the age cohorts that faced the largest rundown in savings to increase both saving and spending in the last year. The data also indicate a shift toward discretionary spending, particularly in prime mortgage age cohorts, suggesting monetary easing is having its desired impact of stimulating the economy.

Another area of the economy benefiting from lower interest rates is the housing sector. House prices began rising again after the RBA first cut rates in February, as lower interest rates increased demand. Price momentum is building as rate cuts filter through, with the Cotality National home value index rising by 0.7% monthly in August. Importantly though, the supply of new homes is also starting to revive, with a 0.4% rise in dwelling investment in the June quarter taking annual growth to 4.8%. Housing investment should continue to support economic growth as household incomes recover and governments push for reforms to address the structural undersupply.

While households are spending again, businesses clearly remain stuck in the slow lane. Business investment fell by 0.1% in the June quarter and was flat over the past year, with weakness spread across both non-residential construction and investment in machinery and equipment. The only category of business investment to show signs of growth is intellectual property products, such as computer software, which grew by 6.8% over the last year. RBA research suggests that most of the investment to date has been in cloud computing and cybersecurity. Firms expect to continue to invest heavily in cybersecurity, but to shift more investment into AI and automation.

While there has been some modest growth in non-mining investment over the last year, mining investment has fallen as price declines in key commodities have eaten into profits. The weakness in profitability has also broadened beyond mining to the manufacturing sector and retail industry, where sales growth has been tepid and margins have been squeezed. Profits have been better in the financial sector, but there too, margins have tightened.

It would be convenient to blame this weakness in investment on poor profitability or global trade uncertainty, however the truth is that this is not a recent phenomenon - business investment has been a laggard for a number of years. The investment share of the economy fell to 12.3% in June, well below its historical average of 14%. But it has languished at these low levels for almost a decade now. Low rates of business investment contribute to the weakness in productivity growth due to less capital deepening. Closing the gap between the current level of the investment to GDP ratio and its long-term average would require a 10-15% increase in business investment. The OECD estimates an even larger business investment gap of 30%.

Strong growth in business credit of around 10% a year suggests that interest rates aren’t currently too high a hurdle for investment. This leaves fiscal policy is the prime lever to boost ailing business investment. The recent Economic Reform Roundtable sharpened the government’s focus on changes to the regulatory environment that it expects will unleash investment and improve productivity. But these reforms will take time. In the meantime, targeted tax incentives could provide the short-term spark needed to lift business investment and provide the durability required for the economic recovery, with the benefit of kickstarting productivity.