Cliff Notes: Jackson Hole casts a long shadow
Key insights from the week that was.
The Australian data flow started the week with a positive surprise, but has disappointed since.
Against an expectation for another broadly flat outcome, July retail sales instead jumped 1.3% higher. Apparel and department store sales were particularly strong, while consumer spending at cafes & restaurants, ‘other’ retail and food grew robustly. A second consecutive decline for household goods provided only a marginal offset. While we continue to expect higher interest rates, declining house prices and historically-weak consumer sentiment to materially curb households discretionary consumption into year end, currently spending has momentum.
The housing sector stands in stark contrast to consumption having already been hit hard by actual and expected interest rate increases. The CoreLogic home value index fell 1.6% in August – the biggest monthly decline in nearly 40 years – indicating the housing market correction is shifting into a higher gear. This was further emphasised by a steep fall in housing finance approvals (-8.5%mth) and a materially soft outcome for housing credit growth in July. Meanwhile, dwelling approvals surprised with a 17.2% decline driven by a slump in high-rise approvals, but with the surprising resilience of non high-rise segments continuing despite the wider downturn. Nevertheless, weakness in Australia’s housing market will persist as the RBA delivers further rate hikes in the coming months.
Arguably the key domestic releases for this week were the two investment partials for Q2 GDP. Construction work done surprised materially to the downside in the three months to June, declining by 3.8%. That construction activity fell sharply as hours worked for the economy overall jolted higher (4.6%) suggests material and labour shortages remain acute for the sector; wet weather was also likely a factor in Q2. While national construction work has fallen 1.5% during the pandemic (since end-2019), the sector’s pipeline remains in robust health. An uptrend should become apparent hence.
The Q2 CAPEX survey also signalled a robust outlook for investment in construction and equipment despite a disappointing reading for activity in the quarter. Estimate 3 for FY2022/23 implies a circa 15% gain for total investment, broadly in line with estimate 2. Importantly, this strength was broad-based across the mining and non-mining sectors and comes amid considerable uncertainty over the state of the global economy and as interest rates move higher. A note of caution though: the CAPEX survey projections are nominal and so include cost inflation which was substantial during the current financial year at 8.2%.
Despite the downside surprise in Q2 for construction and CAPEX, we continue to expect GDP to gain 2.0%, 4.5%yr. As detailed in our GDP preview, offsetting weaker investment is strength in net exports. Also due next week is the September RBA decision. Ahead of the meeting, Chief Economist Bill Evans has laid out our rationale for a 50bp increase, taking the cash rate to 2.35%, near the RBA’s neutral estimate. Thereafter, we expect the RBA to shift back to a 25bp pace from October through February, when we see the cash rate at a peak of 3.35%. In the note, Chief Economist Bill Evans also discusses the potential medium-term challenges that central banks may face as they try to return GDP growth to trend or above while keeping inflation at target.
Moving offshore, the Asian data flow was very light this week, with only China’s official PMIs worthy of note. Power outages and the lingering effect of COVID-zero policies held the manufacturing index below the expansion/contraction divide of 50 for another month. The service sector performed better, printing at 52.6 in August; however, it is clear that the Hainan outbreak and COVID-19 flare ups elsewhere are continuing to impact momentum in the services sector as well.
Turning to the US, Chair Powell’s remarks continued to impact markets throughout the week ahead of the all-important August employment report (due tonight). Chair Powell’s speech was certainly a decisive stand against inflation, albeit conditional. A contractionary policy stance is necessary now and likely throughout 2023. However, at 2.375%, much of the work has already been done, with the full effect of policy tightening still to be felt. Chair Powell’s views and those of other FOMC members since speak to a desire to complete the tightening cycle by year end and to then remain on hold as a negative output gap grows, removing the risks for inflation and inflation expectations.
The FOMC’s guidance on timing is consistent with our own view; though we expect their actions to have a greater impact on the economy and, from December 2023, see a need to materially lower the fed funds rate to restore growth to trend and thereby stabilise the labour market. To leave growth well below trend for another year (2024) risks economic weakness becoming entrenched, to the long-term detriment of US households. This would also threaten the US’ path to a 50% reduction in emissions by 2030 and the eventual aim of a net zero economy come 2050. This is because much of the planned reduction in emissions requires the consumer to be in good financial health and willing to spend.
Given the swift move higher in US term interest rates and the US dollar this week, a final word on financial conditions. The focus of the FOMC on inflation this week has arguably been primarily about maintaining tight financial conditions rather than expressing a particular level the fed funds rate must get to. At the end of the day, market rates are what economic agents pay, not the fed funds rate itself. To maximise the inflation/ growth trade-off, the stance of policy must be tight now and inflation expectations guided lower. For the US at least, if conditions deteriorate further than the FOMC anticipate, the market will adjust in time, reducing the risk of policy becoming too tight. A focus on near term price dynamics and the risk of inflation persisting at rates materially above target if policy makers do not act aggressively is also likely to be the approach taken by the ECB next week.
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