Important insights from the past week.
This week, Australian data provided a constructive outlook on the economic outlook. Meanwhile, global financial markets were rocked by the strong US CPI report in August.
Beginning with consumer sentiment, the Westpac MI survey reported an increase in confidence, the headline index rose 3.9%. This is an encouraging result at a time of high uncertainty about the cost of living, the domestic interest rate outlook and global growth. However, at 84.4, the index remains near historic lows typically seen only during recessions and major economic disruptions. Arguably the main difference between now and these other periods is that Australia’s job market is extremely tight and the unemployment rate is at a 50-year low. Nominal wage growth is also strengthening, which is perhaps partly why “Family Finance Expectations for Next Year” rose 5% in September, even though “Family Finances YoY” rose 5% to a 10- year low have fallen. Notably, “time to buy an essential household item” is still 34% below average, and our quarterly “smartest place to save” questions indicate strong risk aversion.
Chief Economist Bill Evans provided a wide-ranging discussion of the impact of recent sentiment readings on the economy in a video update midweek. The outlook for the real estate market heading into spring was also a key topic in our latest podcast, Market Outlook in Conversation.
Australian firms are drawing strength and optimism from the current circumstances, according to NAB’s latest business survey, with August conditions up 1 pt to +20 and confidence up 2 pts to +10 – both well above average. Importantly, the momentum in business conditions across government and industry appears to be broad-based. The utilization prospects continue to point to full utilization of labor and capital. Fortunately for inflation, pressure on upstream costs eased somewhat in August, although it remains at very elevated levels after hitting a record high in July.
Although still affected by COVID-19 outages, August’s job print shows the job market remains in robust shape. At 33.5k, job growth for the month erased much of the decline seen in July (-40.9k). And a solid increase in labor force participation pushed the unemployment rate up to 3.5%. A better result might have been possible if the illness had not affected the working hours and the number of workers available. These obstacles should ease in the coming months, leaving room for further gains before rate hikes in 2022 slow the economy and consequently labor demand into 2023.
The release of August overseas arrivals and departures marked two important developments: a “normalization” of overseas travel towards typical seasonal trends; and suggests momentum is beginning to build on visa arrivals. In the case of the latter, the lack of net positive visa arrivals has contributed significantly to the tightening of the labor market. It is therefore promising that the group of “temporary workers” of visa arrivals will record a solid net gain of 10.3k in August. With more resources to clear visa backlogs, the return of foreign workers over time should help alleviate Australia’s labor shortages.
Over in New Zealand, second quarter GDP was strong, as Westpac expected, expanding 1.7% as the service sector benefited from returning international tourists. The result also confirms that the 0.2% decline in the first quarter was due to temporary factors, most notably disruptions related to the Omicron wave of COVID-19, which is now largely over. The Q2 result supports our expectation that the RBNZ will continue to rise to a peak cash rate of 4.0% by the end of the year. This is necessary to match demand and supply and mitigate inflation risks.
Let’s then turn to the United States. August’s strong core CPI push made all the headlines this week, but overall data flow was decidedly mixed.
Contrary to expectations for a monthly gain of 0.3%, the 0.6% rise in core CPI in August shocked markets as they braced for a surprise on the downside. With the recent hawkish rhetoric from FOMC members still fresh in their minds, market participants aggressively bid on the US dollar immediately after the release, while bonds and equities sold off equally volatile. Westpac and the market are now expecting at least 175 basis points of hikes by the FOMC by year-end, which will take the fed funds rate to a high of 4.125% (Westpac) or above (market).
Westpac sees the decision flow most likely as a 75 basis point increase in September, followed by a 50 basis point increase at the November and December meetings. However, the market is pricing in a greater risk of accelerated delivery in September and November, priced at 150bps for those two meetings, and the need for additional tightening in late 2022 or early 2023, priced around 215bps by March 2023.
The FOMC arguably sees the need to act with such vigour, to keep real yields well above zero along the yield curve – currently real yields on 5-10 year bonds are around 1.0%. This requires maintaining nominal yields at current levels until year-end and managing the expected decline in 2023 at a pace proportional to the decline in medium-term inflation expectations. Maintaining real yields around 1.0% well into 2023 should give the FOMC comfort that the remaining risks associated with inflation are over.
However, our concern is that the fall in output as a result of the fight against inflation will continue. Currently we see an output gap of around 3.0% of GDP by the end of 2023, which is expected to widen to 3.5% by the end of 2024 as rate cuts are not expected until 2024 once inflation has eased. If this forecast materializes, it will prove to be materially negative for US productivity, profitability and income over the medium term, as well as a major impediment to the US goal of reducing emissions by 2030 and beyond – as discussed in our September Market Outlook .
In particular, activity data released this week has made it clear that risks to US growth are on the downside. Control group retail sales were much weaker than expected in August (0.0% vs. 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 the latest regional Federal Reserve survey results point to increasingly fragile conditions and growing uncertainty about the outlook.
As a result, the latest estimate of GDP for Q3 from the Atlanta Fed’s GDPnow nowcast is just 0.5% on an annualized basis, less than a quarter of the contraction in activity in the first half of 2022. Year-end and into 2023, financial markets are likely given historically elevated starting levels of the US dollar, these risks for the USA, especially the foreign exchange markets, are increasingly to be taken into account.