Australian Economic Outlook - Transcript

Hello and welcome to Strategic Alternatives, a podcast series with insights and outlooks from RBC capital markets. I'm Rob Thompson, macro rate strategist for RBC Capital Markets Australia. Thank you for joining us. Today's a special episode of Strategic Alternatives where I'll be welcome you through the factors influencing the economic outlook for Australia in 2024. I'll also be discussing some of the key questions posed by our clients to inform their decisions for the year ahead.


Our first theme is the long-term macroeconomic outlook. A long-term growth outlook for Australia is that activity will continue to soften as we move through the year with GDP growth likely to run well below trend recession is not our base case, but we'll be increasingly seeing pockets of stress crop up amongst lower income and highly indebted households and in rate sensitive sectors. The peak in inflation is likely behind us, but progress in getting towards the RBAs two to 3% inflation target is slower than amongst many peer countries.


We've been fielding many questions from clients on why Australia has been lagging in this inflationary cycle, both on the way up and the way down. One of the key reasons we've consistently pointed to is a significant degree of inertia in the Australian wage setting process. This plus embedded inflation and energy and rents are holding us back from calling the end of the RBA cutting cycle, even as other central banks appear to have reached their terminal rates. Monetary policy is now unambiguously restrictive with the RBA lifting the policy rate to 4.35% in November, but still only modestly. So there's also considerable disagreement amongst investors we speak to about where the RBA should set the cash rate. Many domestic investors tend to think 4.35% is already too high, thanks largely to the very powerful mortgage rate channel in Australia. While those overseas often tend to think 4.35% is too low, our base case is one further increase in the cash rate 4.60% terminal rate in February, followed by a lengthy on hold period until cuts begin in 2025.


It's a close call though and we acknowledge the RBA might be able to sneak through without having to tighten rates again. Our second theme is consumers, employment, and the housing market. Household spending is already falling in per capita terms and will slow materially further. High mortgage rates including the ongoing rollover of low COVID-19 year of fixed mortgage rates to variable, ongoing cost of living pressures, negative real household disposable income, and subdued consumer confidence will continue to squeeze consumer's ability to spend. In the conversations we've had, our clients are curious to understand the extent to which mounting headwinds to households will continue to be offset by positives, including surprisingly resilient labor markets and still sizable savings buffers. We note the labor market is starting from position of considerable strength heading towards 2024, including multi-decade lows, unemployment and highs in participation. But at this point is past peak tightness and with early signs of loosening, including declining vacancies, rising applications per job add, and an increasing rate of labor under utilization. We expect the unemployment rate to continue drifting higher to around 4.6% by end of ‘24.


This will add pockets of stress among some households, but at the aggregate level is still not far from NAIRU. One risk we've highlighted to investors need to watch out for is a fast deterioration in the labor market than our base case. If, for instance, the unemployment rate were to hit 5% next year with a trajectory including more listening to come, this could prompt a much quicker turn to rate cuts from the RBA. In conversations with clients, we've been trying to help them unpick.

So our third theme is fixed income markets. In conversations with clients, we've been trying to help them unpick what's ahead for fixed income and credit markets heading into next year. From a duration perspective, peak policy rates and moving beyond peak inflation across the G7 should provide a catalyst for decent bond market performance over 2024.


We expect two year yields to end the year around 3.7% in Australia and 10 year bond yields to end the year around 4.15%, both well below current levels. Benchmark 2s, 10s bond curves should ball steepen from early 2024. As markets grow comfortable, central banks are done hiking rates. We have found considerable support amongst clients for our broad views on curve and duration, but the major difficulties we keep hearing about in taking advantage of these are A, timing and B, navigating heightened volatility. We continue to advocate patience waiting for the right levels and appropriate position sizing as the best answers to these challenges. There are plenty of opportunities in markets at the moment and no need to rush into large positions in trades which aren't favorable at current levels.


Credit markets will face periodic challenges as central banks continue to withdraw liquidity and higher rates squeeze profitability through tougher refinancing tasks. Banks will have elevated funding needs as the remainder of the RBAs term funding facility rolls off in the second quarter of next year as well. If Australia can avoid recession as per our base case though, then credit should perform reasonably well. Spreads look tight relative to the last 18 months, but zoom a little further out and they're actually still quite attractive in broader historical terms. Highest superannuation fund allocations to fixed income in Australia will also continue to provide support, particularly if this broadens out from a current skewed to bank debt.


Our last theme for today is swing factors and destabilizing dynamics in terms of factors that could affect the Australian economy more broadly in the new year. These are four key things we're watching out for.


Inflation will we see smooth disinflation or a bumpier ride? There are both common international and uniquely Australian factors to consider here, and getting the answer right will be crucial to determining all asset class returns in 2024.


Second, the unequal distribution of rate hike pain, younger and poorer renters and more recent mortgages are suffering disproportionately and cutting spending whilst older debt free. Free and asset rich Australians are using higher rates to support strongest spending. The third theme is the fiscal impulse. Government spending has had a broadly neutral impact through 2023 to date in aggregate but remains too high and should be tied to better compliment monetary policy.


Stage 3 tax cuts due next year possible further household energy subsidies and a crowded state infrastructure task pipeline could add to the RBAs task by keeping aggregate demand too high and keeping inflation sticky. The fourth is the housing and immigration debate. The impact of surging migration on housing is an increasingly political issue with some commentators and politicians waiting to call for a temporary easing in some forms of migration. This might indeed ease housing pressures, but we will have upsetting ramifications on labor supply and therefore wages, especially with skill shortages also remaining a key business issue.


Our recessionary and inflation risks are receding, which should set the stage for a decent bond market performance swing factors, including a bumpy path to lower inflation, unequal rate, hike pain amongst households, fiscal stimulus, and the housing migration debate will still bear watching for investors.

Thank you all for joining me for our views on the economic crosswinds likely to impact markets in 2024. Stay tuned for more insights in future episodes of strategic alternatives.