For financial advisers and professional investors only – not for distribution to retail investors.
02 May, 2023
By Sophie Photios, Patrick Er
The Macquarie Fixed Income Team expanded on its established Global Strategic Forum by conducting a specific forum on Australia – assessing the outlook for Australian growth and inflation and the impact on fixed income markets using the supply-and-demand lens applied at the global level.
Australia’s economy rebounded in 2022 but appears to be turning in 2023, with twin monetary and fiscal tightening pushing demand down as supply recovers. We experienced two supply shocks and resilient demand from successful fiscal policy, which drove up inflation to levels not seen since the 1980s. Policymakers have responded, with the Reserve Bank of Australia (RBA) delivering aggressive monetary tightening while fiscal policy is poised to contract as pandemic relief is withdrawn and conservatism re-establishes. This combination has elevated household stress at a time when household balance sheets are stretched and household income is about to come under pressure, as wages will be inadvertently dampened by the recent change in immigration policy. The global supply recovery gathered momentum in 2022, which should work to dampen inflation during 2023, but the combination of tighter policy and elevated household stress is expected to see demand deceleration become the dominant driver of macroeconomic outcomes in 2023.
Supply and demand: Changing relative forces
Australia was dominated by a compromised supply environment in 2020-2022, but now we see demand as taking centre stage from supply in 2023, with demand deceleration to be the driving force of economic outcomes. Australia experienced two supply shocks – first from the COVID-19 pandemic and second from the Russia-Ukraine war, which sent energy prices soaring – that, together with resilient demand from successful government fiscal policy, drove up inflation.
Source: Macquarie.
Households are facing a “cost of living crisis,” in which incomes have risen on a nominal basis but have dived on a real basis (that is, adjusting for inflation). Incomes have not kept pace with inflation, so now everything costs more and households feel worse off. The prolonged lagging of households’ income growth behind inflation over the past two “stagflationary” years has meant that the downward permanent income trend has not reversed, and this persists as a factor dampening consumer sentiment and consumption. Australia’s household debt-to-income and debt service ratios declined, while the household saving ratio rose during the pandemic, but they have now turned lower as incomes have not kept up with the cost of living crisis (Figure 1). The household saving ratio has returned to our pre-pandemic historical average, with excess savings stock also being run down (Figure 2).
Figure 1: Australian household debt-to-income and debt service ratios
Source: Reserve Bank of Australia, December 2022.
Figure 2: Australian household saving ratio
Source: Australian Bureau of Statistics, December 2022.
Businesses are doing far better than households as they are in a strong balance sheet position and have seen a surge in company profits. The share of national income going to profits is near all-time highs, while the share going to workers is near all-time lows (Figure 3). Australia’s real unit labour costs are on a downward trend, indicating that Australia is not facing a wage-price spiral as it did in the 1970s. These all-time high profits have seemingly not translated into higher capital expenditure (capex) growth, however, as we see Australian capex growth stagnating (Figure 4). China’s reduced growth outlook has poured cold water on the view that it is going to be an engine for global growth, and while it may see a bounce in external demand as the country reopens, the structural backdrop remains challenged. Businesses will be impacted as cautious household spending means sales and profit margins will be under pressure, and this will likely intensify the dim capex outlook. These negative household income and balance sheet effects will likely accelerate the pace of demand deceleration to the point of overtaking the positive impact of supply recovery, leading to weaker growth.
Figure 3: Australia share of total factor income
Source: Australian Bureau of Statistics, December 2022.
Figure 4: Australia gross fixed capital formation
Source: Australian Bureau of Statistics, December 2022.
Twin policy tightening
Australia is experiencing twin policy tightening, in which both monetary and fiscal policies are working together to tame inflation, and the tight policy environment is compounding the expected decline in demand. The RBA is tightening monetary policy in what looks to become the fastest and most significant tightening cycle in its history (Figure 5), and the full impact of monetary tightening via interest rate hikes is yet to play out because of the long and variable lags associated with monetary policy. The Australian government’s rhetoric on fiscal policy is skewed toward budget repair and, while still in deficit, has contracted dramatically post-COVID-19, which is tighter policy (Figure 6). The RBA has taken the average variable mortgage repayments to around double their April 2020 pre-tightening level and has indicated that its job is not done yet. This will most likely ensure that house prices continue to fall and households experience a material asset price shock, with consumption to follow. The RBA has said it is willing to keep hiking interest rates on the inflation overshoot if necessary, so we will likely see the share of household income used to service principal and interest debt repayments soar to the highest level in history.
Figure 5: Fastest RBA hiking cycle in decades
Source: Reserve Bank of Australia, March 2023.
Figure 6: Australian government budget surplus/deficit (monthly)
Source: Australia Department of Finance, January 2023.
Australia has extremely high levels of household debt and a structural preference for short-term variable-rate mortgages, which means the transmission of interest rate changes is felt rapidly by borrowers, in contrast to the US, where mortgages are fixed rate and typically 30 years. In addition, Australia’s household debt-to-income ratio is one of the highest in the world, far higher than that of the US. The financial position of households is in a shaky position, as the growth in Australia’s net wealth has turned and our excess savings stock is being run down.
Macquarie Fixed Income has built a proprietary model to measure household stress, accounting for both the interest burden and inflation (Figure 7). Australia’s household stress is at all-time highs and, looking back historically, hasn’t been at these levels since the 2008-2009 global financial crisis (GFC) or 2001 dot-com crash. The “real effective interest rate burden” is the highest in more than 30 years (Figure 8), and in recent months, most indebted households have experienced a decline in spare cash flows, which is the income they have available to spend or save after meeting their loan payments and essential living expenses (Figure 9).
Figure 7: Macquarie Fixed Income proprietary model of household stress
Source: Macquarie, December 2022.
Figure 8: Australia’s “effective stress” is the highest in more than 30 years
Sources: Reserve Bank of Australia, Australian Bureau of Statistics, December 2022.
Figure 9: Distribution of changes in spare cash flows
Sources: Reserve Bank of Australia, RBA Securitisation System, Australian Bureau of Statistics, October 2022.
Supply alert: Australia’s population growth
We believe one of the key factors in Australia’s outlook is the Australian government’s recent push for population growth, through mass migration. The country has opened its borders to net overseas arrivals post-COVID-19 like most other countries but on a scale far greater relative to the existing population. This impacts the labour market as net overseas arrivals – or foreign labour supply – add spare capacity to the labour market. The employment-to-population ratio is expected to be lower (due to an increase in the denominator), and this raises both unemployment and underemployment (Figure 10), leading to conditions of suppressed wage growth (Figure 11).
Figure 10: Net overseas migration vs. unemployment
Sources: Australia Department of Home Affairs, Australian Bureau of Statistics, February 2023.
Figure 11: Leading indicator (inverted) for wage growth
Sources: Australia Department of Home Affairs, Australian Bureau of Statistics, February 2023.
This also impacts the housing market as it keeps pressure on inflation by causing magnified and prolonged increases in rents. We have seen this in Australia (especially in capital cities already), where migrants tend to rent rather than buy houses, as rents have skyrocketed and rental vacancy levels have tightened as migration has risen (Figure 12). This is interesting because while central bank tightening commonly results in short-term spikes in rents following rate rises (when landlords pass on higher borrowing costs to renters), in Australia we are likely going to see longer and more sustained rental inflation contribution to the Consumer Price Index (CPI). As a result, we have an environment in which the RBA has to keep hiking on the inflation overshoot even though the economy is slowing significantly, thus increasing demand deceleration in Australia.
Figure 12: Net overseas migration vs. rents
Sources: Australian Bureau of Statistics, SQM Research, February 2023.
Conclusion
In the Macquarie Fixed Income Strategic Forum, we assessed the outlook for growth and inflation and their impact on fixed income markets using the supply-and-demand lens. Our analysis shows that Australia’s supply recovery is in full swing; however, we believe a combination of tighter monetary and fiscal policy will exacerbate the negative income and balance sheet effects to the extent that demand deceleration is expected to overtake the positive impact of supply recovery. This would ensure a path of lower inflation through 2023. That said, Australia’s inflation is strong in magnitude as well as breadth, and this puts the RBA between a rock and a hard place. We expect the RBA monetary tightening and Australian government fiscal tightening to persist in 2023, which is likely to unleash demand destruction and ultimately cause Australia’s economic growth to slow to recession, with risks for a deeper impact than the US. Australia’s inflation narrative is similar to what has unfolded globally; it is just lagging. Where the fall of inflation in the US is likely to be more pronounced in the first half of the year, the fall of inflation in Australia is likely to be more pronounced in the second half of the year.
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