Weekly Economic Commentary 13 March 2023
Analysis and forecasts of the economy and markets, along with previews of data for the week ahead.
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Scratching below the surface.
At first glance, the economy appears resilient in the face of high interest rates and red-hot inflation. However, scratching below the surface reveals clears signs of weakness. And it’s on this basis, that we expect the economy to continue to slow, with a recession kicking in from late 2023.
In some ways, business conditions have remained surprisingly resilient. Notably, domestic spending levels have remained firm. That’s despite the deterioration in financial conditions over the past year as interest rates have jumped progressively higher and inflation has run red hot.
The retail sector is case in point. The December quarter data showed nominal retail sales climbing a decent 1.7% over the quarter and a solid 5.4% over the year. At first glance, these numbers don’t hint at any particular weakness.
Similarly, manufacturing survey data out last week pointed to a sector that, whilst not exactly shooting the lights out, is still in expansion. Over February, the PMI was up 0.8 percentage points to 52.0, with the reading pointing to expansion for the second consecutive month.
Meanwhile, the last PSI survey from January ticked up higher and pointed to healthy service sector activity levels on the back of the rebound in tourism sector activity – tourism arrivals have rebounded back to two thirds of their pre-Covid levels. The combination of those two surveys also points to relatively resilient activity.
But buried below the surface of these relatively positive headlines are signs of clear weakness. For example, looking underneath the firm nominal retail spending figures, the volume of goods sold (i.e. spending adjusted for price changes) has fallen by around 4% over the past year. In other words, households are feeling the squeeze - red hot inflation is gobbling up consumers’ spending power meaning that they are getting less and less bang for their buck.
Firms are also coming under pressure. In our discussions with businesses, a clear theme has emerged. That is, while sales and revenue remain resilient, firms’ costs continue to rise at pace, and this is putting a squeeze on firms’ profits. Indeed, average operating costs have risen by around 8% over the past year. In a few sectors such as the construction, manufacturing and agriculture sectors the jump has been even higher at 12% or more over the same period.
Firms are also telling us that they are beginning to act on these trends. First up, they are dialling back their hiring plans. And these anecdotes gel with the trend in job ads data: these have fallen by over 20% since their peak back in August 2022. Secondly, firms are becoming increasingly cautious about capital expenditure, with recent surveys showing that plans for investment spending have been wound back.
From here, we expect economic activity to continue to slow. As we have noted in recent publications, many households and particularly those with mortgages are likely to tighten their belts over the year ahead, with a decline in retail spending levels likely to flow from there. In fact, many households are now facing an increase in their mortgage interest rate payments as they roll off fixed terms considerably lower than prevailing rates. Recall that we have estimated that the average mortgage rate was 3.8% in December 2022 and that it will rise to circa 5.3% by December 2023.
Similarly, we expect building activity to slow. Financial conditions in the housing construction sector have become a lot tougher. Operating and financing costs have risen sharply over the past year. And at the same time, house prices are tumbling in many parts of the country. That’s meant prospective buyers are increasingly nervous, and developers are cautious about bringing new projects to market. Builders, as well as those supplying into the industry, have told us that those conditions are weighing on demand, with forward orders dropping off. Data out this week were consistent with this trend. The amount of residential building work put in place fell by 2.6% over the December quarter.
Household spending and residential investment account for the largest chunk of the economy. Household spending alone represents over 60%. As a result, declining activity in these two areas will be enough to tip the economy into recession from the end of the year and into early 2024. Although, the ongoing rebound in tourism arrivals and the boost to activity from reconstruction after the recent storms will help to support activity through 2023 and 2024.
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