Australia: How to ride a bumpy disinflationary path

GDP growth in Australia has slowed every quarter since the third quarter of 2022, and looks set to deliver another weak quarter of growth in the second quarter of 2023. NowCasting estimates are pointing to only about a 0.2% quarter-on-quarter increase, and 1.5% year-on-year annual growth rate in the second quarter.

This suggests that the RBA’s rate-tightening is indeed working, on top of the external factors weighing on growth (weak China re-opening, US and EU slowdown).

But on many measures, the Australian economy remains robust, and this is a concern when we dig into the inflation data and see that on some measures (admittedly not all) inflation is still running quite strong.

In particular, Australia’s labour market shows only limited signs of a slowdown. At 3.5%, the unemployment rate is close to its all-time low of 3.4% in October last year. And almost all of the jobs that have been created over that time have been full-time jobs, with commensurately higher weekly earnings, benefits and security than part-time jobs. That means household spending power is being supported. The consequence of this is that wage growth, though only measured quarterly, and with long lags, remains, according to the RBA’s own anecdotes, on an upward path. And this will help keep service sector inflation higher than would ideally be the case.

Into the mix of things that you wouldn’t normally expect to see after one of the biggest tightening cycles in history, is the fact that the residential housing market, known for its interest rate sensitivity, is not only holding up quite well, it is actually strengthening in some locations and real-time real estate sources suggest that this continued during the second quarter of this year and even on into the early third quarter.

This is partly a factor of how ahead of the game many households got during the period of low interest rates, overpaying their mortgages, and accruing a buffer against times just like these. Many others have paid off mortgages entirely, though there are certainly some households for whom the current situation is creating genuine hardship. It is also a response to record high immigration rates which are putting upward pressure on house prices at a time when housing supply has been weak.

When it comes to the inflation story itself, and how this may develop and feed through into future RBA policy, the monthly data tell the most coherent story. This data show how very high month-on-month rates of growth in the first six months of last year are one of the main reasons why the annual inflation rate has dropped. All that has needed to happen each month is that the CPI index rises less than it did last year, and the inflation rate automatically drops. That is basically how year-on-year inflation works.

But the month-on-month increases in the CPI index this year have still been quite fast. Looked at it from the perspective of the annualised rates of 3m and 6m inflation (what we refer to as the 'run-rate'), which is less influenced by what happened 12 months ago, and tells us more about what inflation is doing right now, it is clear that the inflation run-rate has not dropped very much.

Moreover, unless it does so, and soon, given the much less favourable series of base comparisons from August to October, there is a very good chance that the annual inflation rate will begin to move higher again, not lower during the third/fourth quarter of 2023. Even the July print, where the last high base comparison should make progress possible, we have large electricity tariff hikes to incorporate, so the bad news may come even earlier.

The Australian dollar has been the worst-performing G10 currency in the past month, as it faced a combination of external headwinds coming from another round of Chinese growth repricing and the recent risk-off environment, as the two holds by the RBA cooling off domestic rate expectations.

Much of the outlook for an ultra-sensitive currency to global risk sentiment like AUD remains strictly tied to external developments. As shown below, AUD/USD is the second most sensitive USD-cross in G10 to swings in global equity-related risk sentiment, while its correlation with US back-end rates is not higher than other cyclical currencies like NZD, EUR and GBP.

The recent rally in global equities (MSCI World up 7% in the past six months) clearly hasn’t been reflected in AUD price action. Our short-term fair value model – where MSCI World index performance is a variable – has been displaying an obvious tendency in AUD/USD to overshoot on the undervaluation side, which likely reflects the risk premium related to China’s re-rating of growth expectations. The persistence of that risk premium suggests that the Chinese growth disappointment factor is now largely priced into AUD, which could ultimately limit the scope for further downside. Incidentally, we estimate that AUD/USD remains around 18% undervalued in the medium term, according to our real BEER model mis-valuation results.