The surprises will keep coming. Preparing for the possibilities
By Damien Horth, 28 February 2025
Chaos Monkeys, Chinese Debt Deflation Spirals or just fine?
As is almost always the case, conventional wisdom at this time of year is that the economic outlook for Australia this year is ‘fine’. Bloomberg consensus currently has Australia’s 2025 Real GDP growth accelerating to 1.9%, the CPI moderating to 2.7% and the policy rate coming down to 3.55%. 10-year rates are expected to remain just above 4%.
The incoming Trump administration is clearly pro (US) growth and seemingly pro-deficit (Elon Musk and the DOGE have led few economists to materially alter their outlook for the deficit at around 6.5% of GDP in 2025/06). Consensus appears to believe that any ‘chaos monkey’ tendencies at the US administration will be kept in check by the US stock market reaction function and Trump’s desire to ensure that inflation is controlled.
The outlook for China has been Australia’s biggest concern in recent years but it has seemingly muddled through relative to the worst fears. The recent discussion of fiscal stimulus has led to some optimism about the short-term outlook and there have been some bolder moves to address the structural challenges underlying the Chinese economy. The recent launch of the DeepSeek-R1 chatbot has refocused the world on China’s technological and innovation capabilities, which clearly extend across many sectors, including the EV supply chain, renewables and Healthcare.
Australian domestic concerns remain focused on inflation and the housing market, but most assume that if the rest of the world is ‘fine’ then Australia will also be ‘fine’.
Our sense is the conventional wisdom is probably broadly correct, but we also know that there are always surprises. As most of the surprises for the economic outlook in 2024 were positive, this should lead to some caution as we enter 2025.
At an Asia Society conference in September last year, Richard McGregor (Lowy Institute) made the point that the Australian and Chinese economies have probably past the point of ‘peak complementarity’ (China historically needed vast and growing volumes of iron ore/coal and Australia had it). This view resonated with us partly because China is now five years into its ‘property downturn’ and partly because if Chinese growth surprises on the upside from here, it is likely to be much less commodity intensive.
The possibility of a downward debt/deflation spiral in China remains non-trivial (we would describe the GFC as a rapid debt/deflation spiral whereas Japan’s lost decades was a drawn-out version). The Chinese government has the fiscal firepower to cushion further shocks, but it is possible that this may come too late. If the Trump administration doesn’t go beyond the recently announced 10% tariff, we would assume limited impact on the growth outlook but the prospect of 60% tariffs hasn’t been taken off the table.
If China does enter some type of financial crisis, the implications for Australia would be profound (China still accounts for over 60% of global iron ore imports & almost 40% of Australian exports) and the implications for the Australian dollar could limit the RBA’s policy flexibility.
Education services had been one of the recent bright spots for Australian exports of late and while China is important, the sector is much less dependent on China than mining. The timing of the recent government cuts to student visas may prove unfortunate just as recent geopolitical events improve our competitive position in this segment (the strength of the US dollar of note). The longer-term damage to our reputation is also a concern given the challenging outlook for commodities.
The imminent Australian Federal Election will no doubt captivate attention over coming months, but it is difficult to envisage outcomes that would radically reshape the economic outlook. Granted, the policy debate is yet to fully unfold but aside from meaningful changes to immigration levels, the local focus is likely to remain on inflation (particularly given ongoing US dollar strength and the threat of tariffs). The RBA’s ‘higher-for-longer’ stance weighed on growth in 2024, but it has also increased their firepower for easing if material growth shocks arise in 2025.
Economic & Geopolitical outlook increasingly intertwined
The economic and geopolitical outlook are now much more intertwined now than in previous decades, which means shocks on this front could have real implications for FX rates, inflation, and potential growth rates. This means geopolitical shocks could have a material impact on the Australian interest rate outlook.
Australia’s political relationship with China has improved recently which should be supportive for growth at the margin (Iron Ore was never disrupted). However, if the US/China relationship deteriorates in 2025, it is possible that China retaliates with economic measures against all US allies and Australia with the potential for corresponding significant financial impacts. The weakness of the Chinese economy increases the risk of poor outcomes because while tariffs may be somewhat mitigated by fiscal stimulus, the prospect of a further hit to consumer/business confidence could be the ‘final’ trigger for a rapid debt/deflation spiral.
There is also a school of thought that believes if the China’s economic performance continues to disappoint, the prospect of cross-strait and other military incursions increases. As the Trump administration evolves, at the very least, posturing on both sides would appear likely to increase. Let’s hope it goes no further than posturing and that other flashpoints in the region, such as North Korea, also remain calm.
In an economic context, the conflicts in Ukraine and the Middle East mostly impact Australian via oil prices (and to a lesser degree other commodity prices). A ceasefire in Ukraine would be good news for European economic growth albeit that the prospect of Trump tariffs also overhangs these economies. China’s involvement in these conflicts, mostly via support for Russia, presents challenges for the Australian government. Our primary concern is the prospect of sanctions on the Chinese financial system for facilitating trade with Russia. In some ways, this could be just as damaging to the Chinese economy as the proposed tariffs.
However, there is also the potential for geopolitical upside surprise because there is the possibility that China uses its influence to agitate for a cease-fire in Ukraine. This would appear to be in China’s interests (reducing the risk of sanctions and potentially lower oil prices). It also may help with US negotiations regarding its future trading relationship.
Is Quantum the next AI?
The ongoing investment in AI-related chips and the broader ecosystem, including power generation and distribution, should continue to be supportive of global growth and stock market valuations (arguably the emergence of Deep Seek enhances these growth prospects). The recent indications of a slow-down in the rate of improvement of AI model performance are debatable but will need to be monitored given where the valuation of AI exposed companies is now (and by proxy the S&P 500).
That said, there remains the prospect of AI underpinning a multi-year productivity growth cycle across the globe. The direct benefits for Australia may be peripheral (enhanced productivity growth would be very welcome) although if the Trump administration reduces the global focus on curtailment of fossil fuels, increased power demand could be helpful for our coal exports.
The customization of AI models for the Australian market is likely critical for us to unlock the potential productivity gains for application in each industry. Management teams will need to ascertain the potential application within their industry and the suitability of general applications versus custom-built platforms. The AI regulatory framework remains nascent, but we assume that data privacy and model accountability will be a key focus from all stakeholders. Therefore, it will be important to ensure that global best practices are applied.
The latest technological innovation to excite investors was the announcement by Alphabet (Google) in December 2024 of a new quantum computer chip, called Willow. This was followed last week by the launch of the Majorana quantum chip by Microsoft and Chinese researchers unveiling the world’s first large-scale quantum entanglement on an optical chip. There are many challenges with quantum computing, but the key problem is that the error rate is very high (i.e. quantum can manipulate information in ways that is impossible for classical computing but makes substantially more errors). The excitement around Willow is that errors can be suppressed exponentially as the quantum computer increases in size. This has not solved the error rate problem, but it demonstrates progress and a roadmap to further reduce error rates.
There is still an indeterminate timeline before we see practical applications of quantum computing but the implications for cryptography are material enough for Willow to implicated in the sell-off in cryptocurrencies from a Trump induced record highs. There is also hope that this technology can help with drug discovery, fluid dynamics, the modelling of complex systems (such as financial markets) and to enhance AI. At this point, we seem very early in the hype-cycle so it is probably not the ‘next AI’ just yet but it an innovation to monitor in 2025.
Scenario planning for a wide range of possible outcomes
While consensus believe that the outlook for Australia and beyond is ‘fine’, it is important to remember that the current range of forecasts for the Australian 10-year bond rate at the end of 2026 is between 2.4% and 5%. We think that the ‘worst case’ outcome of ‘just 5%’ appears benign given the rhetoric on tariffs and the potential implications this may have for the AUD outlook. The probability of worse-case outcomes is always a debate, but we feel that managers need to at least prepare for the implications of what might now be considered shocking scenarios.
Preparing for shockingly good scenarios should also be part of the process, particularly as optimism about the prospect of peace in Ukraine increases. Long-term interest rates below 3% would be great for most businesses but it is currently difficult to envisage this outcome without a negative outcome for global growth expectations. That said, faster growth and lower inflation is the theoretical promise of many of the recent technological developments. Maybe we are just yet to see the impact on productivity growth in the numbers.
Damien Horth has over three decades investment analysis and investment research experience. In the early part of his career, he was a #1 ranked research analyst and covered companies in over 20 jurisdictions (including China, Hong Kong, most of Europe, India, Southeast Asia and Australia). He then served as Head of Research (Asia Pacific) for UBS, a team of over 250 professionals located across 14 countries. UBS’s research team was consistently ranked #1 by institutional investors during this period.
Damien holds a Bachelor of Commerce from the University of New England (Australia) and has completed the Advanced Management Program at Harvard Business School. Damien is now a Senior Advisor to Nauta and a Senior Advisor to Bilby AI (a start-up that uses Machine Learning & AI to predict and analyze government and policy data).
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