Key insights from the week that was.
This week, we received a set of downbeat updates on the consumer and housing in Australia. Meanwhile, a slew of rate hikes and updated policy guidance from across the US, Europe and the UK gave markets plenty to think about.
Beginning in Australia, the week began with a downside surprise for the consumer, December’s retail sales posting a sizeable 3.9% decline against the consensus estimate for a 0.2% fall. The decline was generally broad-based albeit with some seasonal volatility likely at play, with non-food retail, department stores and clothing all posting very weak reads. Having said that, December’s result more than reversed the upwardly revised gain of 1.7% in November, suggesting that an underlying down-trend in consumption is beginning to materialise in response to the rising interest rate burden. For a comprehensive update on the current state of the Australian consumer, see our January edition of the Red Book.
Developments on the housing front continued to point toward further weakness to come. CoreLogic’s home value index fell another 1.1% in January and, at -8.7%yr, the annual pace of decline has now exceeded that of the 2018-19 correction to be the weakest reading dating back to 1981. The current correction remains broadly-based and firmly entrenched, with all capital cities and major regional areas recording price declines and continued easing in turnover.
A similar theme was also present in December’s dwelling approvals release, with non-high rise approvals (a better gauge for underlying trends given the 90% spike in high rise approvals) posting a 2% decline in the month to be down 14.8% from its August peak. Given the extensive set of headwinds facing the construction sector and the broader housing market, further significant declines are expected in the period ahead, which will also feed through to demand for housing credit.
In a video update mid-week, Chief Economist Bill Evans outlined Westpac’s views on the outlook for Australian interest rates and the consequences for activity. In essence, our expectation for a 3.85% peak in the cash rate in May is reflective of robust wage pressures – a forecast 4.5%yr peak by end-2023 – and a slower retreat in services inflation. However, we do not expect this to result in a ‘classic’ recession as households are relatively well placed to weather these headwinds. Indeed, with a savings buffer of around $250 billion and a historically-tight labour market as supports, we anticipate a stalling in household consumption rather than an outright contraction in response to rising interest costs. If inflation recedes as we expect, there will be room for the RBA to deliver 100bps of rate cuts over 2024, easing the pressure on demand and facilitating a return to around-trend growth by end-2025.
Offshore, market participants were buoyed by the guidance given by key central banks this week. While the US FOMC raised by 25bps and the European Central Bank (ECB) and Bank of England (BoE) followed with 50bp hikes, the market took their data-dependent guidance on the outlook to mean the end of the tightening cycle is near.
After slowing the pace of hikes to 25bps at their January/February meeting, subtle but significant changes in communication highlighted the evolving balance of risks faced by the FOMC, with inflation having “eased somewhat” and the Committee now focused on the cumulative impact of policy versus the pace of meeting-by-meeting hikes. With annual headline inflation having slowed from 9%yr to 6%yr June to December 2022, and we might add the six-month annualised pace now back at the 2%yr target, the FOMC could have been more constructive on the outlook for inflation than they were. The reason they held back was made clear in the press conference, with Chair Powell highlighting that the deceleration to date has been concentrated in goods, with services inflation yet to ease.
Still, with market estimates of rent growth decelerating rapidly and wage gains slowing quicker than the FOMC anticipated, Chair Powell expressed growing confidence that disinflation will broaden in 2023. From the partial data and the trajectory of short-term momentum in service CPI components, this is our expectation too. Indeed, we remain of the view that the FOMC will on need to hike once more, taking fed funds to a peak of 4.875% at March. They may decide to continue to May; but, in either case, the US tightening cycle will conclude by June.
As expected, this week the ECB were decidedly more hawkish than the FOMC, with a 50bp hike delivered and a strong signal given that another 50bp increase will follow next month. The justification for doing so is that core inflation remains at peak levels in the Euro Area while both economic activity and the labour market continue to outperform, signalling a much-reduced chance of recession in 2023. It also has to be remembered that the ECB is a long way behind the FOMC, the current level of the ECB’s deposit rate being 2.50% versus US fed funds at 4.625%. Despite the ECB’s near-term hawkish resolve, the market still reacted favourably to the Governing Council’s guidance, taking “future policy rate decisions will continue to be data-dependent and follow a meeting-by-meeting approach” to signal that the ECB’s tightening cycle will also end by mid-year.
In the UK, the BoE’s 50bp hike to a bank rate of 4.00% with two dissenting opinions and a materially-improved outlook for inflation in 2023 (4.0%yr from 5.25%yr previously) has seen the market price an almost immediate end to the tightening cycle, with bank rate now forecast to peak circa 4.25% — only +25bps from the current level. Arguably, the Committee’s expectation that inflation will be back below their 2.0%yr target in 2025 is providing the market with further confidence.
With each of these key central banks now more mindful of the outlook for activity and, while still risk aware, showing confidence over the outlook for inflation, the market is clearly now focused on the scale and timing of rate cuts. This is highlighted by the spread between 10 year yields and central bank policy rates. For the US, Euro Area and UK, the current market expectation for peak policy rates are approximately 4.875%, 3.25% and 4.25% whereas their 10 year yields are circa 3.40%, 2.10% (German Bund) and 3.00%. For risk assets, also critical is that these materially-lower term interest rates are paired with more favourable outlooks for growth than previously feared. Note that this week Euro Area GDP growth was reported to have remained positive in Q4; while, at February, the scale of the Bank of England’s recession forecast for 2023 and 2024 was materially reduced.
The US is the one jurisdiction in this group which has a deteriorating growth outlook, highlighted last week by the deceleration in domestic demand growth, and this week by weakness in the manufacturing sector (the ISM manufacturing survey pointing to a further decline in activity in January) and construction activity. We remain of the view that the US’ contraction will be shallow; but, given the much-improved outlook for the Euro Area and UK versus 2022’s expectations, this calls for further weakness in the US dollar to the end of 2024.
Another reason to expect continued weakness in the US dollar is that China and other developing markets are showing great promise at the start of 2023. Following December’s turmoil, this week a dramatic rebound in China’s official PMIs to near long-run average levels was reported. This signals that, not only has there been no lasting impact from the end of COVID-zero for manufacturing, but more importantly confidence amongst households has snapped back. In our view, Chinese consumers also have plenty of capacity to spend given accumulated savings and positive real income growth through 2022.
A final note on China. This week also saw authorities change their rules regarding tertiary education. To be recognised, students now need to undertake courses in person not online. As a result, in coming months Chinese students will need to quickly return to the countries in which their tertiary institutions are based, including Australia. As the visa and arrivals data allows, we will assess the implications.
