Strangulation not suffocation

04 January, 2024
By Sophie Photios, Graham McDevitt

Australia’s economy is slowing and is now in a “per capita recession” but has not yet had an outright recession. The heart of the slowdown is at home, and households are being hit from all angles, as the policy mix – monetary and fiscal – has been tightened, while the surge in inflation has made everything cost much more.

Population has been, and is expected to remain, the key macroeconomic differentiator and driver of economic outcomes in Australia relative to other developed economies. It has underpinned aggregate economic growth (“no suffocation”) but has, ironically, loaded stress on the economy on a per capita basis (“strangulation”). Population growth has also been keeping inflation much higher than desired. We expect Australia’s gross domestic product (GDP) growth to slow to stagnation and inflation to fall, but the path will be slower than other developed economies. We maintain our view that inflation will come down but remain above the Reserve Bank of Australia’s (RBA’s) target well into 2024, thus leaving the risk of rate hikes on the table despite household stress warranting a pause.

Introduction

The Australian economy is slowing, inflation has peaked and is falling, and monetary policy and fiscal policy have been working together to tame inflation. In previous issues of the Fixed Income Strategic Forum 2023, we highlighted that exponential population growth had impacted economic growth while creating upward pressure on the direction of inflation, leaving the RBA with a dilemma – whether to focus on inflation (which will be sticky in its decline) or wages (which will slow from the expansion of labour supply). In Issue 03 of the Strategic Forum 2023, we reassess the outlook for the Australian economy amid tighter monetary and fiscal policy and rapid population growth to determine that the economy is being slowly strangled but not yet suffocated because the growing population is masking the true state of the economic outlook.

Population, population, population

Population is driving Australia’s economic environment as immigration has skyrocketed – not just recovered from the COVID-19 border closures – and is taking a significant step up on an ongoing basis. Australia’s net overseas migration pre-COVID-19 averaged 110,000 per year and has stepped up to 600,000 in 2023 (Figure 1). The Australian government’s budget has set out that this is to progress at triple the pre-COVID-19 average over the next five years, a dramatically different story from what we have previously seen – and far exceeding that of other Group of Seven (G7) countries (Figure 2).

Figure 1: Australia’s net overseas migration

Figure 2: Australia’s population growth far exceeds that of other G7 countries

Australia’s net overseas migration has been coined “quantitative peopling” (QP) because it puts upward pressure on aggregate GDP but downward pressure on GDP per capita. This divergence between aggregate GDP and per capita GDP does not necessarily have to exist, and the increase in aggregate GDP could match or be exceeded by the increase in per capita GDP. Australia has had experiences in the past of high immigration consistent with each person being at least proportionally or actually better off, but this depends on productivity growth (i.e. skilled nature of the labour supply and utilisation of the capital stock available).

“Per capita recession” is here

Australia is now in a “per capita recession” (Figure 3), and there is a possibility of an outright recession, but it is by no means locked in as population has been masking the true state of our economic outlook. The heart of the slowdown is at home, and it means “death by a thousand cuts” for households as mortgage repayments are going up, rental payments are skyrocketing, labour supply is surging and hence wages are turning down, while petrol at the pump, utility bills, and grocery bills have all risen significantly. Australia’s pie, in other words, is growing, but everyone is getting a smaller slice, and this is a signal of future slower growth and falling living standards.

Figure 3: Australian GDP per capita

In Australia, consumption and confidence today resemble that of our last recession in 1992, known as the “recession we had to have.” Retail sales have fallen both in terms of values and volumes, and discretionary and nondiscretionary spending have been sliding since mid-2022. Australia’s real retail sales have turned negative for the first time since the 1992 recession (outside of the pandemic) (Figure 4), and Australia’s consumer confidence has not been this low for such a sustained length (Figure 5) since then (an indicator below 100 signals a decline in consumer confidence).

Figure 4: Australia’s real retail sales

Figure 5: Australia’s consumer confidence

Australian incomes have been under pressure, and Australian real wages have dived (Figure 6), while the ratio of people working multiple jobs has soared (Figure 7), and the permanent income trend is structurally unsupportive of much higher consumption (Figure 8).

Figure 6: Australian real wages

Figure 7: People holding multiple jobs

Figure 8: Permanent income trend

Australia’s household balance sheets are in a shaky position, and when compared against the household balance sheets of the US, UK, and Europe, they have an elevated debt-to-income position (Figure 9).

Figure 9: Global household debt service coverage ratios

Businesses, by contrast, have been more resilient but have now turned and profits are pointing lower. Australian business profits were supported by the Australian government via fiscal support and by surging commodity prices during COVID-19, but these have both now come off. Mining profits have turned as the RBA Index of Commodity Prices declines and non-mining profits are turning down as domestic demand weakens. Business capital expenditure (capex) typically turns with income (i.e. weaker profit growth) (Figure 10) and the weakness in Australian New Orders, a leading indicator for capex (Figure 11), confirms this. In addition, the net trade contribution to growth looks set to decline in line with the fall in commodity prices, and the terms of trade are coming off as export earnings are falling and import costs are not falling by as much.

Figure 10: Business capex typically turns with income

Figure 11: Australian New Orders

Monetary policy and fiscal policy working together

This Australian picture sits against a backdrop of a policy mix in which monetary policy and fiscal policy have been working together to tackle inflation and slow growth. The Australian story and the US story have differed in recent months. The US policy mix has “slowed the slowdown” as fiscal policy has counteracted tighter monetary policy. On the other hand, the Australian policy mix has contributed to the slowdown as monetary policy and fiscal policy have worked together to tackle inflation and slow growth.

Australia’s monetary tightening has been the fastest and most significant rate-hiking cycle in its history. The RBA has taken the average variable mortgage repayments to more than double their April 2020 pre-tightening level (Figure 12) and has indicated that its job may not be done yet. We are sitting at the precipice of Australia’s fixed rate mortgage cliff, where the majority of the ultra-low fixed rate mortgages have been reset in 2Q and 3Q of 2023 (Figure 13), and the transmission of interest changes will soon be felt by these borrowers.

Figure 12: Australian mortgage lending rate (discount variable)

Figure 13: Projected expiration of fixed rate loans

Australia’s fiscal position has tightened significantly post-COVID-19 and even returned to surplus in 2023 (Figure 14). The Australian government budget projects both the underlying budget balance and government payments to tighten more than their projections from their prior budget update, but the state governments, on the other hand, are planning for loosening, and their budgets are projected to widen in 2024, having upped their new spending policy decisions (Figure 15).

Figure 14: Australia versus US budget balance

Figure 15: Commonwealth versus state budget balances

Here, the population story creates a conflict for fiscal policy in which Australia’s federal government is incentivised to increase immigration, but the state governments bear the brunt of the cost. Immigration improves the federal budget as it expands the economy thus generating higher tax receipts, and more input in people means more output in GDP. However, immigration worsens state budgets as the states are primarily responsible for the infrastructure and services required for growing populations.

We expect Australia’s policy mix going forward to be for monetary policy to remain tight and for fiscal policy to neutralise. There is divergence between the federal and state government budget pictures, and while the federal picture is expected to remain tight, the states are planning for loosening. There is a risk to this base case that the state governments’ spending plans are not realised as they are far more budget constrained than the Commonwealth and may come into funding constraints.

Outlook for growth and inflation

Australia’s outlook therefore is all about population as it is population that is holding up growth, keeping inflation higher than desired, and pushing down growth per capita. We expect Australia’s growth to slow to stagnation between 0-1%, the “per capita recession” likely to persist into mid-2024, with the possibility of an outright recession remaining. There is a strong likelihood that a persistent per capita recession turns into an aggregate recession, as it is a signal of future slowing growth and falling living standards. It would appear that population growth has a short and immediate boost to aggregate economic activity, but without the accompanying productivity growth, this would translate into a weaker, slower economy.

We maintain our view that inflation will come down but that the path will be slower than other developed economies. We expect that inflation will remain well above the RBA’s 2-3% target for most of 2024, with the level of elevated household stress warranting a pause in interest rate hikes. However, the stickiness of inflation will leave the risk of hikes on the table. The RBA is between a rock and a hard place because households are being “strangled,” but inflation is still too high and the RBA cannot think about cutting interest rates yet. The RBA can hike interest rates to try to bring down inflation, but given that inflation is being driven by population, the more it hikes, the more it negatively impacts the supply-side responses, which are needed to accommodate the increased populus. The more the RBA hikes, the more likely it tips the aggregate economy from stress to recession. In turn, this will likely bring forward the probability of earlier rate cuts.

When could the RBA cut rates?

The RBA has historically cut rates as inflation moderates (Figure 16). That is, it typically does not wait for inflation to return to target nor for a slowdown in economic activity. The RBA’s 1994 tightening cycle paused for 19 months until the first cut, the 1990-2000 cycle paused just six months, the 2002-2008 cycle pause also lasted six months, and the 2009-2010 cycle paused 12 months. We can therefore acknowledge that while there is no clear pattern for the length of the RBA pause, the RBA can step away from restrictive policy before year-on-year inflation is at target and before a downturn in economic activity. This means a recession is not needed to cut rates.

Figure 16: Timing of RBA rate cut cycles

The RBA tends to lag rather than lead the cycle, and if our view from Issue 03 continues to play out and aggregate growth slows as it is held up by population, then it’s looking like a longer pause in Australia relative to other developed countries. However, we believe that the RBA will show a willingness to cut rates when inflation is trending down.

Conclusion

In Issue 03 of the Fixed Income Strategic Forum 2023, we reassessed the outlook for the Australian economy and have determined that given existing conditions of tighter monetary policy and fiscal policy, the explosion of population growth is slowly strangling the economy on a per capita basis but, ironically, expanding the aggregate economy and thus overall growth, thereby masking the “true” state of the economic outlook. In summary, our analysis shows that population growth is holding up aggregate growth but pushing down per capita growth while keeping inflation sticky. The RBA is between a rock and a hard place because, despite rising household stress (“strangulation”), it can’t think about cutting rates; inflation is too high, and the aggregate economy is still growing positively (no “suffocation”). As a result, the overall policy mix going forward is expected to, at best, be less tight as fiscal policy is expected to be more neutral into 2024. This is despite the risk that constraints on state government budgets might prevent full realisation of spending plans and thus push fiscal policy back into a tighter stance. This contrasts with the US outlook in which the policy mix has “slowed the slowdown” as fiscal policy has counteracted tighter monetary policy.

We expect GDP to slow into stagnation and for inflation to fall, but the path will be slower than other developed economies. We maintain our view that inflation will come down but remain well above the RBA’s target for most of 2024, with household stress warranting a pause but the stickiness of inflation leaving potential hiking on the table.

Authors

[3282730]

IMPORTANT INFORMATION

The opinions expressed are those of the author(s) are as of the date indicated and may change based on market and other conditions. The accuracy of the content and its relevance to your client’s particular circumstances is not guaranteed.

This market commentary has been prepared for general informational purposes by the team, who are part of Macquarie Asset Management (MAM), the asset management business of Macquarie Group (Macquarie), and is not a product of the Macquarie Research Department. This market commentary reflects the views of the team and statements in it may differ from the views of others in MAM or of other Macquarie divisions or groups, including Macquarie Research. This market commentary has not been prepared to comply with requirements designed to promote the independence of investment research and is accordingly not subject to any prohibition on dealing ahead of the dissemination of investment research.

Nothing in this market commentary shall be construed as a solicitation to buy or sell any security or other product, or to engage in or refrain from engaging in any transaction. Macquarie conducts a global full-service, integrated investment banking, asset management, and brokerage business. Macquarie may do, and seek to do, business with any of the companies covered in this market commentary. Macquarie has investment banking and other business relationships with a significant number of companies, which may include companies that are discussed in this commentary, and may have positions in financial instruments or other financial interests in the subject matter of this market commentary. As a result, investors should be aware that Macquarie may have a conflict of interest that could affect the objectivity of this market commentary. In preparing this market commentary, we did not take into account the investment objectives, financial situation or needs of any particular client. You should not make an investment decision on the basis of this market commentary. Before making an investment decision you need to consider, with or without the assistance of an adviser, whether the investment is appropriate in light of your particular investment needs, objectives and financial circumstances.

Macquarie salespeople, traders and other professionals may provide oral or written market commentary, analysis, trading strategies or research products to Macquarie’s clients that reflect opinions which are different from or contrary to the opinions expressed in this market commentary. Macquarie’s asset management business (including MAM), principal trading desks and investing businesses may make investment decisions that are inconsistent with the views expressed in this commentary. There are risks involved in investing. The price of securities and other financial products can and does fluctuate, and an individual security or financial product may even become valueless. International investors are reminded of the additional risks inherent in international investments, such as currency fluctuations and international or local financial, market, economic, tax or regulatory conditions, which may adversely affect the value of the investment. This market commentary is based on information obtained from sources believed to be reliable, but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no obligation to correct or update the information or opinions in this market commentary. Opinions, information, and data in this market commentary are as of the date indicated on the cover and subject to change without notice. No member of the Macquarie Group accepts any liability whatsoever for any direct, indirect, consequential or other loss arising from any use of this market commentary and/or further communication in relation to this market commentary. Some of the data in this market commentary may be sourced from information and materials published by government or industry bodies or agencies, however this market commentary is neither endorsed or certified by any such bodies or agencies. This market commentary does not constitute legal, tax accounting or investment advice. Recipients should independently evaluate any specific investment in consultation with their legal, tax, accounting, and investment advisors. Past performance is not indicative of future results.

This market commentary may include forward looking statements, forecasts, estimates, projections, opinions and investment theses, which may be identified by the use of terminology such as “anticipate”, “believe”, “estimate”, “expect”, “intend”, “may”, “can”, “plan”, “will”, “would”, “should”, “seek”, “project”, “continue”, “target” and similar expressions. No representation is made or will be made that any forward-looking statements will be achieved or will prove to be correct or that any assumptions on which such statements may be based are reasonable. A number of factors could cause actual future results and operations to vary materially and adversely from the forward-looking statements. Qualitative statements regarding political, regulatory, market and economic environments and opportunities are based on the team’s opinion, belief and judgment.

Other than Macquarie Bank Limited ABN 46 008 583 542 (“Macquarie Bank”), any Macquarie Group entity noted in this document is not an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Commonwealth of Australia). The obligations of these other Macquarie Group entities do not represent deposits or other liabilities of Macquarie Bank. Macquarie Bank does not guarantee or otherwise provide assurance in respect of the obligations of these other Macquarie Group entities. In addition, if this document relates to an investment, (a) the investor is subject to investment risk including possible delays in repayment and loss of income and principal invested and (b) none of Macquarie Bank or any other Macquarie Group entity guarantees any particular rate of return on or the performance of the investment, nor do they guarantee repayment of capital in respect of the investment.

Past performance does not guarantee future results.

Diversification may not protect against market risk.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt. This includes prepayment risk, the risk that the principal of a bond that is held by a portfolio will be prepaid prior to maturity at the time when interest rates are lower than what the bond was paying. A portfolio may then have to reinvest that money at a lower interest rate.

Market risk is the risk that all or a majority of the securities in a certain market – like the stock market or bond market – will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.

Natural or environmental disasters, such as earthquakes, fires, floods, hurricanes, tsunamis, and other severe weather-related phenomena generally, and widespread disease, including pandemics and epidemics, have been and can be highly disruptive to economies and markets, adversely impacting individual companies, sectors, industries, markets, currencies, interest and inflation rates, credit ratings, investor sentiment, and other factors affecting the value of the Strategy’s investments. Given the increasing interdependence among global economies and markets, conditions in one country, market, or region are increasingly likely to adversely affect markets, issuers, and/or foreign exchange rates in other countries. These disruptions could prevent the Strategy from executing advantageous investment decisions in a timely manner and could negatively impact the Strategy’s ability to achieve its investment objective. Any such event(s) could have a significant adverse impact on the value and risk profile of the Strategy.

International investments entail risks including fluctuation in currency values, differences in accounting principles, or economic or political instability. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility, lower trading volume, and higher risk of market closures. In many emerging markets, there is substantially less publicly available information and the available information may be incomplete or misleading. Legal claims are generally more difficult to pursue.

Currency risk is the risk that fluctuations in exchange rates between the US dollar and foreign currencies and between various foreign currencies may cause the value of an investment to decline. The market for some (or all) currencies may from time to time have low trading volume and become illiquid, which may prevent an investment from effecting positions or from promptly liquidating unfavourable positions in such markets, thus subjecting the investment to substantial losses.

Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.

Capital expenditures (capex) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment. CapEx is often used to undertake new projects or investments by a company.

Inflation is the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.

The Group of Seven (G7) is an intergovernmental political forum consisting of Canada, France, Germany, Italy, Japan, the UK, and the US; additionally, the European Union is a “nonenumerated member.” It is organized around shared values of pluralism, liberal democracy, and representative government.

The global financial crisis (GFC) refers to the period of extreme stress in global financial markets and banking systems between mid-2007 and early 2009.

Gross domestic product (GDP) is a measure of all goods and services produced by a nation in a year. It is a measure of economic activity.

Recession is a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters.

The Australia Consumer Price Index (CPI) measures household inflation and includes statistics about price change for categories of household expenditure.

The Consumer Price Index (CPI) is a measure of inflation representing changes in prices of goods and services purchased for consumption by households.

A commodity index is an index that tracks the price and returns on a basket of commodities. The value of these indexes fluctuates based on their underlying commodities; similar to stock index futures, this value can be traded on an exchange.

Index performance returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and one cannot invest directly in an index.

Economic trend information is sourced from Bloomberg unless otherwise noted.

Macquarie Group, its employees and officers may act in different, potentially conflicting, roles in providing the financial services referred to in this document. The Macquarie Group entities may from time to time act as trustee, administrator, registrar, custodian, investment manager or investment advisor, representative or otherwise for a product or may be otherwise involved in or with, other products and clients which have similar investment objectives to those of the products described herein. Due to the conflicting nature of these roles, the interests of Macquarie Group may from time to time be inconsistent with the Interests of investors. Macquarie Group entities may receive remuneration as a result of acting in these roles. Macquarie Group has conflict of interest policies which aim to manage conflicts of interest.

All third-party marks cited are the property of their respective owners.

© 2024 Macquarie Group Limited