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A recession seems unlikely but the economy is failing to fire

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The Australian economy has continued to muddle along reasonably well over the past year and tentative signs are emerging that the pace of growth could quicken a notch in the year ahead.

If so, it would help bolster corporate earnings and sharemarket performance, though it would raise the risk of the Reserve Bank of Australia seriously contemplating an interest rate increase by early 2019.

Despite very solid population and employment growth, weak productivity has left the economy stuck in the "terrible twos" growth path for some time - enough to avoid recession but not enough to make serious inroads into the rate of unemployment or lift wage growth.

Dragging down the economy have been steep falls in mining investment following the end of the commodity price boom some years ago and, so far at least, little pick-up in non-mining investment to help take up the slack.

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Consumer spending has also been relatively subdued, reflecting weakness in income growth and desire to pay down high debts levels.

Against this, home building and government infrastructure spending have been strong, while miners have also enjoyed a ramp-up in exports. The composition of economic activity has favoured the non-mining states of NSW and Victoria most notably, which in turn has helped boost their house prices.

Looking forward, however, both the federal Treasury and the Reserve Bank anticipate growth can accelerate to around 3% or so over the next few years.

How so? For starters, the drag from declines in mining investment is gradually beginning to level out. On an even more positive note, investment expectations among the non-mining corporate sector is also finally starting to lift, helped by strength in health, education and tourism.

Following huge investment in new capacity, LNG exports are also set to boom for the next few years. Government transport and energy infrastructure projects will also continue, as will extra staffing for the National Disability Insurance Scheme.

Against this, however, the contribution to growth from home building activity is starting to wane and consumer spending - which accounts for more than half of the economy - remains patchy.

We also remain crucially dependant on continued good growth in the global economy, which has enjoyed a broad-based upturn over the past year but which must now increasingly contend with rising interest rates and tightening labour markets. The once red-hot Sydney housing market has also turned, with house prices in modest decline since late 2017.

A major wild card for the global economy in the coming year is whether the very tight labour market in the US leads to strong wage and price inflation, which could cause the Federal Reserve to raise interest rates aggressively. China also remains an ongoing risk as it tries to transition economic growth from reliance on unprofitable and polluting smoke-stack industries towards consumption without creating undue unemployment and social unrest.

All up, it seems likely the economy will at least continue to muddle along - with gentle downward pressure on the employment rate and gentle upward pressure on the rate of inflation. That should mean the Reserve Bank leaves interest rates on hold for most of this year at least, and possibly into early 2019 also.

As for the sharemarket, a better economy should mean better corporate earnings, especially if the Australian dollar manages to drop closer to US70c.

But due especially to our low technology exposure, corporate earnings growth might still lag that evident among global peers, such as in the Europe, Japan and the US. Sharemarket valuations will probably need to decline somewhat as global interest rates rise.

That suggests modest but not spectacular sharemarket gains over the coming year.

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