Cliff Notes: market unease over inflation expectations to persist
Key insights from the week that was.
For Australia, GDP was the focus this week along with the RBA’s September decision and a speech by Governor Lowe. Globally, central bank decisions and views on the outlook remained key.
Q2 GDP for Australia met the market’s expectation at 0.9%, 3.6%yr. As expected, household consumption drove growth in the quarter, consumption’s strong 2.2% gain in the 3 months to June coming as a result of the economy’s progressive re-opening and as spending was supported by both robust nominal income gains and a further reduction in the savings rate. While discretionary services spending remains materially below pre-pandemic levels, in coming months households will feel the full effect of the rapid rise in interest rates and the hit to real incomes from historic inflation, limiting further upside. We continue to expect consumption growth to decelerate to a pace well below trend from Q4 2022 through end-2023, taking GDP growth with it. At December 2023, annual GDP growth is expected to have slowed to just 1.0%yr.
The consequences for growth of an abrupt tightening cycle and the hit to discretionary spending capacity from inflation are clearly on the mind of the RBA. Having taken policy to a broadly neutral stance with a fourth consecutive 50bp increase in the cash rate at their September meeting, the Governor’s decision statement recognised that consumer sentiment is weak and household wealth falling, with “the full effects of higher interest rates yet to be felt in mortgage payments”. As discussed this week by Chief Economist Bill Evans, with policy “normalised”, a slower pace of rate hikes is likely to prove prudent from here.
That being said, with inflation yet to peak and, as per the Governor’s speech, risks remaining for inflation expectations, we are still some way from this hiking cycle ending. Westpac continues to see four further 25bp increases to a 3.35% peak in February 2023 after which the stance of policy is set to remain on hold to end-2023 as inflation retreats back to the top of the RBA’s target range.
Q2’s trade and financial account data is also worthy of comment. In the quarter, the current account widened sharply to a surplus equivalent to 3.0% of GDP as a result of a record trade surplus circa 7% of GDP. The flip-side of the record profitability of our mining sector however is an outsized flow of dividends to foreign shareholders. As a result, Australia’s net income deficit has once again jumped higher to around 4% of GDP, a percentage point above the average since 1980.
Underlying this result though is a favourable structural change in the equity return Australians are receiving from their rapidly growing overseas investments. Highlighting the significance of this trend, over calendar 2021, Australia’s net foreign liabilities declined by 15% of GDP to 36% of GDP with 65% of the reduction the result of equity investment abroad and favourable price changes.
While prices have moved adversely since, presumably this is temporary and, all the while, new capital is being invested. Splitting the equity outflow between direct and portfolio holdings (the difference being whether an investor’s equity interest is more or less than 10%), it becomes apparent that the buoyant appetite of Australian super funds for offshore assets (both listed and unlisted) is a primary driver of this trend, one that is likely to endure. Such a sizeable, steady outflow of capital, with little-to-no immediate offset from distributed returns, could have a substantial and lasting dampening impact on the Australian dollar.
Over in the US, this week’s mixed data highlights the variable conditions faced by businesses across the nation. The ISM services PMI edged higher in August; although respondents seemed cautious on the outlook, with the production and new order indexes printing above 60 as employment held around 50 – the divide between expansion and contraction. In stark contrast, the S&P Global services PMI was very weak, coming in at 43.7, around 3.5 points below the July read. Our take on these two outcomes is that large service providers have the market position and pricing power to weather a weak economy; however, the smaller providers picked up by S&P Global do not. The combined effect seems most likely to be a stagnant economy, the latest Beige Book indicating economic activity was “unchanged, on balance”.
Speaking towards the end of the week, Chair Powell kept to a hard line against inflation. Clear in his remarks was a need to act swiftly against these risks so as to not allow expectations of higher inflation to become entrenched. History suggests this will limit the need for contractionary policy and the ill effects for the economy. For the upcoming September meeting, this points to another outsized increase. Whether it is 50bps (as we currently forecast) or 75bps will depend on the pulse of core inflation in August, due for release next week.
Either outcome will take the fed funds rate to the top end of the FOMC’s neutral range for policy, allowing a return to 25bp increments for the remaining hikes of the cycle. To our mind, given underlying inflation dynamics and the absence of activity growth, 3.375% at end-2022 is the most appropriate peak rate for this cycle, particularly as it is to be held for 12 months. Though, the market continues to see modest risk of a higher peak, and some FOMC members agree. 75bp increases by both the Bank of Canada and European Central Bank this week (following 100bp and 50bp hikes respectively at their last meetings) fanned these expectations.
Looking more closely at the ECB’s decision, concerns around the intensity and breadth of inflation and the risk of de-anchoring inflation expectations were clearly front-of-mind for the Committee. Indeed, they now see annual headline inflation at 8.1% in 2022 and holding above target to end-2024. Regarding growth, the ECB’s sanguine baseline view sees output growth only stalling to March 2023 before a robust rebound takes hold, with 1.9% growth forecast through 2024.
However, these outcomes depend heavily on how current risks evolve. The ECB knows this well and estimates that a “downside scenario” – involving protracted conflict and compromised energy security – could see growth print 2ppts lower over the forecast horizon relative to their baseline projection. That inflation is not expected to be materially different in such circumstances supports the ECB’s intent to deliver further rate hikes into year-end, the pace and scale of which will depend critically on incoming data.
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