Warning signs: could Australia fall into recession?

Article written by Kyle Rodda, Ausbiz

Financial markets are flashing recession signals for the Australian economy. In this week’s edition Macro Intelligence, we provide a health check of Australia’s economy, analyse the signals markets are sending about future policy and growth, and take a look at three markets to watch as the country teeters on the edge of recession.

The fundamentals: low unemployment, high inflation

A snapshot of the current state of the Australian economy paints a mixed picture. Joblessness remains historically low, with the unemployment rate floating around levels not seen for several decades. However, the economy is running above capacity. Inflation is still more than double the top of the RBA’s 2 - 3 percent target range.

While the situation is multi-faceted, tightness in the labour market is considered to be a significant driver of price pressures. Job openings remain very high, even despite the re-opening of national borders following the end of pandemic-related restrictions. According to the latest ABS figures, vacancies remain more than double pre-pandemic levels.

Although the situation is far less difficult than in other parts of the world, the tightness in the labour market, combined with the overhang of massive fiscal and monetary stimulus, has put upward pressure on wages. The latest Australian Wage Price Index release (WPI) shows wage growth at an 11-year high and trending higher, although “real wages” – wage growth minus the inflation rate – is still profoundly negative.

The dynamic has the RBA concerned about what it refers to as “inflation psychology” that risks “unanchoring” inflation expectations. This refers to a self-fulfilling cycle where the expectation of price rises in the future leads workers to demand higher wages, which, in turn, fuels higher prices via increased business costs and stronger consumer demand.

In Australia, inflation expectations are elevated but appear well-anchored and lower than last year's highs.

However, financial markets have grown wary of upward pressure on wages from the recent Fair Work Commission decision to lift the minimum wage. It decided to raise the minimum wage by 5.75% in order to support lower wage earners with the significant cost of living increases in the past 12 months. The ruling stoked concern from many economists – and seemingly the RBA – that it could contribute to runaway inflation. This is especially given the rise comes despite falling productivity growth in Australia.

Could the RBA hike rates into a recession?

Following June’s stronger-than-expected inflation indicator numbers, the Fair Work minimum wage decision, and the so-called “hawkish hike” from the RBA, financial markets have shifted to pricing in more aggressive policy tightening and a potential Australian recession.

Though its communication about policy has recently been muddy, the RBA clearly outlined in its May Statement on Monetary Policy (SOMP) that its forecasts for the Australian economy have been predicated on the assumption of a 6% inflation rate by June and a cash rate that peaks at just over 3.75%.

The latest CPI indicator for May revealed a headline and trimmed mean inflation rate that will likely remain above the RBA’s forecasts. In addition, the Fair Work decision was higher than the central bank’s forecasts implied, suggesting inflation risks are skewed further to the upside. This set of circumstances led the RBA to hike the cash rate to an 11-year high of 4.1% and deliver its more hawkish forward guidance last week.

As a result, market participants have priced in a more aggressive path for the RBA’s cash rate. Futures pricing indicates another hike by September, with a roughly 50/50 chance of another before the end of the rate hiking cycle, which would see the cash rate peak above 4.5%.

Judging by rates markets, the lifting of the cash rate last pushed policy closer to sufficiently restrictive territory. The RBA’s benchmark rate is now above the 2-year Australian government bond yield (along with the yield on most tenors along the curve), indicating that the RBA’s hiking campaign is approaching its end.

However, the market is signalling that the RBA could potentially hike the Australian economy into a recession. The spread on the 10-year and 2-year Australian government bond yields inverted for the first time since 2008 last week. Although it’s proven a less reliable indicator for predicting a recession than in the US, it still signals very restrictive policy and a very pessimistic growth outlook.

Three markets to watch

• ASX200

The higher weighting of cyclical stocks within the ASX200 has dragged on the index. The market appears in a short-term downward-sloping trend channel. Buyers have appeared below the 7100 level, which marks a confluence of support levels. Resistance appears to be around 7210 and 7300.

• AUD/USD

The AUD/USD is trending lower as the US Federal Reserve’s aggressive rate hike cycle and falling commodity prices as global growth slows weigh on the pair. The RBA’s recent hawkish language and the prospect of a pause from the Fed have boosted the Aussie Dollar, with the currency breaking out of descending wedge and testing resistance at 0.6800. A break above that level could open a push to downward-sloping resistance at 0.6990.

• ASX Consumer Discretionary

As rate hikes bite and growth in Australia slows, household discretionary spending will likely slow considerably. The consumer discretionary sector is turning lower, breaking trendline support as momentum skews to the downside. The price of Australia 200 Consumer Discretionary Index has reverted to its 200-day moving average. Support sits at 2860, and resistance sits at 2970.