Australia’s economic outlook is strong, but risks are growing

Australia is one of the most expensive places in the world to live, but perhaps that’s unsurprising as its population is among the wealthiest in the world. We are not a nation like the United States or China, where a massive population can generate enough demand to stimulate the local economy. We have to trade with the world to generate the wealth we need to grow, and when we look at the world today, there are many risks involved.

The conflict in Eastern Europe is driving up fuel prices and fueling inflation, which was already on the rise due to a severe disruption in global supply chains, resulting from two years of pandemic-induced shutdowns and changes in people’s spending habits.

As much of the world puts the pandemic behind it, China is tightening its lockdowns to try to maintain a zero Covid-19 policy. The slowdown in economic growth this is causing is impacting key commodity markets important to Australia, adding a growing source of risk over the past two months as major Chinese capitals go into lockdown.

Nationally, the rising cost of living and the threat of a rapid series of interest rate hikes to stem inflation are making daily headlines about tougher times ahead. While this may be true, Australia’s economy remains resilient with record high unemployment, subdued inflationary pressure compared to many major western countries and strong terms of trade, the latter giving the government revenue to explore measures to reduce the cost of living.

However, we need the global economy to stay on track to ensure strong demand for the products Australia sells to the world.

The International Monetary Fund, in its latest report entitled “War sets back the world economy” forecasts global growth to slow from around 6.1% in 2021 to 3.6% in 2022. This is 0.8% lower than what he forecast in January this year and is mainly attributed direct global fallout from the Russian-Ukrainian war.

This projected growth remains under pressure for further downward revisions. If we look at the major regions of importance, the European Union is between a rock and a hard place due to its heavy dependence on Russian energy and the cost of trying to quickly expand the options of alternative supplies. Meanwhile, inflation in the United States accelerated to 8.5% in March, including a 32% jump in the energy process and an 8.8% rise in food prices, the largest rising since 1981, according to economic data analysis group Trading Economics.

Australia’s own outlook took a bit of a hit in late April when it was revealed that March’s inflation rate of 2.1% had pushed the annual inflation rate to 5.1%. This is the highest annual level since the introduction of the Goods and Services Tax in June 2001.

Although the cost of living and inflation will continue to dominate the headlines throughout the year, there are still plenty of reasons to be optimistic about the economic outlook.

Merchandise

Prices for commodities like iron ore soared after the outbreak of war in Eastern Europe. Australia is a major energy and food exporter with very limited direct trade with Russia or Ukraine. While hostilities fuel inflation, our exports have increased, which has direct benefits for the economy.

Rising major export products are driving Australia’s income and growth. GDP is projected to grow by 4.25% in 2021-22 and 3.5% in 2022-23 in real (inflation-adjusted) terms, according to ABS data.

Inflation

Cost of life recently recovered strongly in Australia, reaching 5.1%. However, this level is low compared to the last US record of 8.5% and the UK inflation rate of 7%. This gives Australia an advantage in terms of the quantity and speed with which the central bank must act to keep prices in check. Additionally, after 2022, as oil prices are expected to begin to gradually decline and supply chain pressures ease, inflation is also expected to moderate.

labor market

The jobless rate fell to 4% and is expected to fall further to 3.75% by the end of the year, according to government data. Wages are also rising at an annual rate of 2.75% so far this year, a trend that is expected to continue. This compares to an average of 3.1% between 1998 and 2021, according to Trading Economics.

Additionally, labor force participation is at high levels, meaning that a higher percentage of the working-age population is working or looking for work. On the other hand, recent flooding in Queensland and New South Wales caused major disruption and had a direct impact on total hours worked. People were simply working fewer hours due to extreme weather conditions.

Business and consumer confidence

Data collected from several industry sources indicates that the companies surveyed are seeing the glass half full. The focus has been more on positive news as mobility and economic conditions improve, rather than negative news from abroad. Australia’s tourism sector is one of the main areas of improvement in business conditions, which have been stronger than before Covid-19.

On the other hand, consumers are not as confident as businesses. Consumer confidence has deteriorated recently, which is mainly attributed to expectations of higher interest rates and deteriorating financial conditions. In addition to expected interest rate hikes, consumers are also more worried than businesses about the consequences of national natural disasters and the effects of the Russian-Ukrainian war on the local economy and daily life.

Interest rate

Set by the Reserve Bank of Australia (RBA), the official interest rate has remained for more than a decade at a historic low of 0.1%. This changed on May 3 when the RBA raised the rate from 0.25% to 0.35%. This is the first of what should be a series of rate hikes this year. Other central banks had already started raising their key rates. The Bank of England has raised rates three times since last December to 0.75% and in March the US Federal Reserve announced the first of multiple rate hikes expected this year.

There is no doubt that interest rate expectations have moved higher, and this is reflected in current bond and futures market prices. In other words, while the RBA policy rate remains low, market participants have already adjusted their expectations and are pricing Australian bonds and futures as if several rate hikes have already taken place, as markets negotiated are forward-looking. Remarkably, the implied market rate for the end of 2022 is 2.8%, which may turn out to be excessive.

Debt and deficit

The government has increased spending and accumulated additional debt in order to deal effectively with the pandemic. Rising interest rates are also contributing to the increase in medium-term public sector debt repayments. However, according to a report by the Secretary to the Treasury and the Secretary to the Ministry of Finance, the budget deficit is expected to narrow from 3.5% of GDP today to 1.6% in 2025-26 and 0.7% in 2032- 33.

In conclusion, the Australian economy remains resilient and has performed well compared to most other developed countries. Idiosyncratic characteristics such as being a major exporter of raw materials helped Australia minimize the effect of the Russian-Ukrainian war on the local economy. At the same time, a strong labor market and less extreme levels of inflation have put Australia in a good position from a monetary policy perspective. The full reopening of the economy and international borders could be a positive catalyst for Australia, as migrant flows could accelerate working-age population growth and increase domestic demand.

Panos Mamolis is an investment specialist for City, a sponsor of Firstlinks. Any advice is general advice only. It has been prepared without taking into account your objectives, financial situation or needs. You should also obtain and consider the relevant product disclosure statement and terms and conditions before making any decision regarding a financial product. Investors are advised to obtain independent legal, financial and tax advice before investing. Past performance is not an indicator of future performance.