Is the Lucky Country's luck finally running out?

Melbourne, Australia
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Australia is dealing with an array of dismal factors that indicate its run as the economically 'lucky country' may be ending, with increasing predictions that it may soon experience its first recession in more than two decades.

"I've always been very optimistic but I'm afraid the evidence is overwhelming now, the tea leaves seem to be in place for what I suggest will be a recession in the next six to twelve months," Jonathan Pain, author of investment newsletter The Pain Report, told CNBC on Friday.

Former Reserve Bank board member Warwick McKibbin shares a similar view; the economist told local news media on Friday that the probability of recession in the world's twelfth-largest economy within a year was 50 percent.

Such views are in stark contrast to Treasurer Joe Hockey's adamant assertion last week that there was no risk of recession following a deluge of poor economic data.

Australia hasn't experienced a recession since the early 90s, marking the longest non-stop growth streak of any advanced country after the Netherlands. But quarterly economic growth fell to a two-year low at 0.2 percent during the April-June period, slowing from 0.9 percent in the previous quarter, due to soft consumer spending, business investment and net exports.

The definition of a recession is two consecutive quarters of contracting gross domestic product, or negative growth.

Canada and Brazil—two other major commodity-exporting nations—recently entered recessions, and speculation is high that the country 'Down Under' will be next. Economists point to a weak April-June performance in Australia's non-mining sectors, key to transitioning the nation away from resources-led growth, as the biggest tell-tale sign.

Net exports subtracted 0.6 percentage points from GDP, compared to an addition of 1.1 percentage points in the first quarter, while manufacturing capital expenditure fell 3.8 percent and spending in other non-mining industries fell 0.3 percent. Overall non-mining investment is set to slide 7.5 percent this financial year, according to estimates by AMP Capital.

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Monetary stimulus is a popular remedy to slowing growth, but it might not work in Australia's case. The nation has one of the world's highest levels of household debt, with recent research revealing that average credit represented 18 months of annual income, tripling in the past 25 years.

This means that even if the Reserve Bank of Australia (RBA) cut interest rates below their current record-low of 2 percent, demand for loans is unlikely to be high because the household sector is already heavily burdened, explained Pain.

Further weighing on Australia's outlook is a noticeable slowdown of Chinese investment, as the world's second largest economy experiences its slowest pace of growth in six years.

Chinese outbound direct investment (ODI) into Australia fell to $8.3 billion last year from $9.1 billion in 2013, according to figures released in a May KPMG report. The United States remains China's top investment destination, with ODI hitting $12 billion last year.

How Australia is coping with China's slowdown

A bear case

The economic pall could soon cast a shadow over the benchmark S&P ASX 200, already down more than 10 percent so far this year. The index traded around 5,070 points on Tuesday after losing more than 4 percent in the past seven days.

Morgan Stanley cut its one-year target for the benchmark index from 5,650 to 5,150 points last week, citing caution against "an increasingly stagnating economic environment." The bank also cut its 2016 GDP forecast by 0.5 percentage points.

"Australia remains somewhat out of sync with other developed market peers and weaker-than-consensus growth will keep pressure on earnings (now seeing negative 1.9 percent in FY16e) and ultimately valuations," Morgan Stanley said in a report

"We stay focused on the negative bias to the risk-reward opportunity in Australia. Indeed, the bear case is one centered on recession risk, while the bull case is one of significant fiscal policy reversal - which at present seems an elusive ideal rather than a tangible option."

On the bright side, data released last Tuesday suggests that a slowing Chinese economy may not be as damaging to domestic equity markets as expected.

Chinese foreign direct investment equity in Australia only contributes to 2 percent to the country's grand total, according to the Australian Bureau of Statistics. Ranked ninth in terms of direct investment in Australia, equity capital and reinvested earnings, China is well behind the U.S., Europe, Japan and Singapore.

But ultimately, expectations for a protracted housing slowdown combined with the downturn in global commodity prices are fueling Australia's bear case scenario, more than offsetting any potential boost from a lower Australian dollar.

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Australia's housing boom absorbed much of the impact from the unwinding in resources capital expenditure, but now macro-prudential policies are being tightened materially to slow home price growth and construction activity, Morgan Stanley explained.

"Our bear case sees the housing slowdown drag the economy into recession."