Recessionary Clouds Forming with a Chance of Local Sunshine
Combating high inflation is now the primary focus of Global Central Banks with interest rates continuing to rise. The monetary tightening has created headwinds which have led to a weakening in the economic data from the US, which increase the chance of an economic downturn. While there has been softening in some economic data in Australia, most economic factors suggest a healthy state of the economy. As a consequence, market consensus suggests Australia faces less than half of the recession probability of that in the US which provides a better outlook for Australian equities.
Over Q2 2022 the Reserve Bank of Australia (RBA) has hiked rates three times for a total of 125bps. This is the fastest tightening cycle we’ve seen historically, which has been driven by soaring inflation. Inflation hit 5.1% in the last quarter (Q1 2021), a 20-year high which is well above the RBA target range of 2 to 3%. In the US, annual inflation has hit 9.1% in June, the highest rate in the last 40 years. As a result, the Federal Reserve (Fed) has increased rates by 150bps over the last 6 months, the biggest move since 1994, with more to come. The combination of high inflation and rising interest rates has put downward pressure on the markets. Year-to-date1 the S&P/ASX 200 Index is down 9.9% and the S&P 500 Index is down 15.4%.2 Concerns about growth and the potential for a recession have been front and centre as global Central Banks have become more hawkish given the persistence of inflation.
The latest US economic data has been weakening. US gross domestic product (GDP) shrank by 1.6% in the first quarter of 2022 with the Atlanta Fed GDP now estimate for 2Q at -1.2%. Jobless claims have risen to a 6-month high in July while the latest S&P US Composite PMI Output Index reading is the lowest since start of the year, with factory production slipping into decline. Consumer sentiment has weakened quite dramatically with the University of Michigan Consumer Index hitting the lowest reading since inception (1970). Despite supply disruptions, commodity prices have seen a downturn over the last month suggesting concerns about future growth. While recession is not a foregone conclusion, a further weakening combined with higher rates increases the risk. Consensus forecasts a 33% chance of recession in the US in next year.3
In a notable exception to the global trend, we’ve upgraded Australia’s GDP growth this year and next to 4.0% and 3.0% respectively in our latest quarterly update. Most economic factors suggest a healthy state of the economy. Consumer spending seems poised for continued strength on the back of pent-up demand and a strong labour market. Retail sales were up 10.3% YoY in May, higher than growth rate of 2.9% in May 2019 and 7.1% in May 2021. While part of this growth may be attributable to higher inflation, retail sales growth outpaces that of inflation suggesting strength. Labour markets also remain strong. The ratio of unemployed to vacancies was at 1.14 in May compared to a ratio of 3 prior to the pandemic. The unemployment rate fell to a 50-year low at 3.5%.
Australian corporate earnings hit record levels in March (we saw the Corporate Profits to Real GDP ratio reach 24.1%4) driven by the strong rebound in commodities from the start of the year, while the high savings rate has supported consumer spending. However, seen some softness recently in the consumer sentiment and Purchasing Managers’ Index’s (PMI) on the back of rising inflation, while commodity prices have come off their highs. Despite this, we believe that strong corporate balance sheets and household savings should support resilience in the domestic economy. This means that the potential for a recession in Australia is much lower relative to other major economies. Consensus forecasts a 15% chance of recession in the next year.3
Historically, the Australian economy has diverged in its performance relative to the rest of the world. Australia did not go into recession during the Asian Financial, Global Financial and Euro Debt Crises or the Tech bust in the early 2000s, (unlike the US and Europe). The chart below highlights the quarter-on-quarter (QoQ) GDP Growth5 since 1995 for the US, Germany, and Australia. In the last 25 years, Australia has had only 7 quarters of negative GDP growth, compared to 32 in Germany, and 13 in the US. Australia hasn’t had a recession since 1992 with the exception of 1Q/2Q 2020 during the Covid lockdown period.
Figure 1: GDP Growth Rate QoQ 1995-2022
We see three key reasons that Australia has had so few periods of negative GDP growth. Firstly, exports contribute a high proportion of Australia’s GDP. Australia has been a key beneficiary of the rise in global trade including with China after its accession to the World Trade Organisation (WTO). Secondly, Australia’s demographics are favourable relative to other developed OECD countries. Strong population growth has supported higher economic growth. Thirdly, Australia has experienced a rise in the services industry as the economy has shifted away from manufacturing. Growth in services has helped to provide cushion to the economy during periods when the industrial sector was under pressure.
Inflation is expected to remain high, peaking at around 7.0%YoY sometime in the second half of the year. On this basis, the RBA is likely to continue to hike rates and we expect a terminal rate of 3.0% by the year-end. This increases the potential for recession, but the risk in Australia is low compared to other major developed markets. Australian growth is expected to benefit from a favourable base effect providing support to household consumption. Meanwhile, business fixed investment shows no signs of a slowdown as of yet, and the moderation in residential investment spending should be manageable. Favourable terms of trade and strong demand for commodities are an added plus.
Tactically the Investment Solutions Group are modestly underweight equities in a multi-asset portfolio context given the economic uncertainty and weak investor risk sentiment. However, on a relative basis, we remain positive on Australian versus US equities. We expect growth concerns to ease which should benefit commodities and financials. On a relative basis, Australian economic growth is expected to hold up with a lower comparative risk of recession.
1Source: Bloomberg Finance. AUD Year-to-Date as of 30 June 2022. 2Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable. 3Bloomberg Consensus Estimates as of 31 March 2022. 4SSGA Calculations, MacroBond, and Australia Bureau of Statistics as of 31 March 2022. 5Federal Reserve Economic Data as of 31 March 2022.
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