Key insights from the week that was.
This week, Australian data provided a constructive view on the economic outlook. Global financial markets meanwhile were jolted by the US’ strong August CPI report.
Beginning first with consumer sentiment, the Westpac-MI survey reported a bounce in confidence, the headline index gaining 3.9%. Coming at a time of high uncertainty around the cost of living, the domestic rate outlook and global growth, this is a pleasing result. Though, at 84.4, the index remains near historic lows typically only seen during recessions and major economic disturbances. Arguably, the key difference between now and these other periods is that the Australian labour market is extremely tight, with the unemployment rate at 50-year lows. Nominal wage growth is also strengthening, which is perhaps, in part, why ‘family finance expectations for the year ahead’ rose 5% in September even as ‘family finances versus a year ago’ declined 5% to a 10-year low. Notably, ‘time to buy a major household item’ is still 34% below average and our quarterly ‘wisest place for savings’ questions point to intense risk aversion.
Chief Economist Bill Evans provided a full discussion of the implications of the latest sentiment readings for the economy in a video update mid-week. The outlook for the housing market heading into spring was also a key theme of our latest Market Outlook in Conversation podcast.
According to NAB’s latest business survey, Australian firms are drawing strength and optimism from current circumstances, with conditions up 1pt to +20 and confidence up 2pts to +10 in August – both well above average reads. Importantly, the momentum in business conditions looks to be broad based by state and industry. Views on utilisation also continue to point towards labour and capital being at full capacity. Thankfully for inflation, upstream cost pressures moderated somewhat in August, although they remain at very elevated levels, having reached a record high in July.
Despite still being impacted by COVID-19 absences, August’s employment print indicates the labour market remains in robust health. At 33.5k, job growth in the month was able to offset much of the decline observed in July (-40.9k). And a solid increase in participation led to the up-tick in the unemployment rate to 3.5%. A stronger result would have arguably been possible had illness not affected hours and the number of workers available. These impediments should subside in coming months, giving room for further gains before 2022’s rate hikes slow the economy and consequently labour demand into 2023.
The August overseas arrivals and departures release meanwhile marked two key developments: a ‘normalisation’ of overseas travel towards typical seasonal trends; and hints that momentum in visa arrivals is beginning to build. On the latter, the lack of net positive visa arrivals has been a key contributor to labour market tightness. It is therefore promising to see the ‘temporary work’ group of visa arrivals post a solid net gain of 10.3k in August. With more resources dedicated to reducing visa processing backlogs, the return of foreign labour should, in time, go some way towards alleviating Australia’s labour supply constraints.
Over in New Zealand, as anticipated by Westpac, Q2 GDP was strong, gaining 1.7% as the service sector benefitted from the return of international tourists. The result also confirms that the 0.2% decline of Q1 was due to temporary factors, particularly disruptions related to the omicron wave of COVID-19 which have now largely passed. The Q2 result supports our expectation that the RBNZ will continue to hike into year end to a peak cash rate of 4.0%. This is necessary to bring demand and supply into line and mitigate inflation risks.
Turning then to the US. August’s strong core CPI print got all the headlines this week, but the dataflow was decidedly mixed overall.
Against an expectation of a 0.3% gain for the month, August’s 0.6% rise for the core CPI was a shock to markets, particularly as they had prepared for a downside surprise. With the recent hawkish rhetoric of FOMC members still fresh in their minds, market participants bid the US dollar aggressively straight after the release, while bonds and equities sold off in an equally volatile fashion. Westpac and the market now expect at least 175bps of hikes into year-end by the FOMC, taking the fed funds rate to a peak of 4.125% (Westpac) or above (market).
Westpac sees the flow of decisions as most likely being a 75bp hike in September followed by a 50bp increase at both the November and December meetings. The market however is pricing a greater risk of an accelerated delivery during September and November, with 150bps priced for those two meetings, as well as the need for additional tightening in late-2022 or early 2023, with around 215bps priced by March 2023.
Arguably, the FOMC sees a need to act with such vigour to keep real yields along the yield curve materially above zero – currently 5-10 year real yields are around 1.0%. To do so, nominal yields need to be kept around current levels into year end, and the anticipated 2023 decline managed to a pace proportional to the fall in medium-term inflation expectations. Maintaining real yields around 1.0% well into 2023 should give the FOMC comfort that the remaining risks related to inflation will pass.
Our concern however is that the hit to output from the fight against inflation will endure. Currently we see an output gap circa 3.0% of GDP by end-2023, likely increasing to 3.5% come end-2024 given rate cuts are only expected to commence in 2024 once inflation has abated. If this forecast eventuates, it will prove a material negative for US productivity, profitability and income into the medium-term as well as a material hindrance to the US’ emission reduction ambition to 2030 and beyond – as discussed in our September Market Outlook.
Notably, the activity data released this week has highlighted that the risks to US growth lay to the downside. Control group retail sales were much weaker than expected in August (0.0% against 0.5% consensus) and the July growth rate was halved to 0.4%. Industrial production also contracted 0.2% in August (0.0% consensus), while recent readings from the regional federal reserve surveys point to increasingly fragile conditions and growing uncertainty over the outlook.
As a result, the latest estimate of Q3 GDP from the Atlanta Fed’s GDPnow nowcast is just 0.5% annualised, less than a quarter of the decline in activity experienced over H1 2022. At the turn of the year and through 2023, financial markets are likely to increasingly factor in these risks for the US, particularly FX markets given the US dollar’s historically-elevated starting level.