Global economic growth remains strong although concerns about weaker future growth are increasing with the Ukraine war adding to high inflation and central banks under increasing pressure to act more forcefully to contain inflation. Government bond yields are rising fast with bond markets starting to recognise that the prolonged period of disinflation is over, and that inflation will settle longer term at a higher annual rate than it has in recent decades at cycle low points. While business and consumer sentiment are weakening, strong past economic growth still has momentum reinforced by a build-up of household savings through the Covid pandemic that could be spent, as well as greater growth in government spending than is usual in strongly recovering economies.
Current economic strength and mounting concern about downside risks to that economic strength are on display in the United States. Data reports show a very strong economy. Q4 GDP rose at 7.0% annualised pace, more than double long term trend growth. February retail sales rose 0.3% m-o-m, consolidating a huge 4.4% m-o-m gain in January. February nonfarm payrolls rose by 678,000 and the unemployment rate fell to 3.8%, the lowest reading since February 2020 at the start of the Covid pandemic. Weekly initial jobless claims have pushed below 200,000 indicating that the unemployment rate will fall further. Wages are rising above 5% y-o-y.
Notwithstanding the considerable strength of US data reports, sentiment surveys are slipping, notably those relating to consumer sentiment. The Ukraine war has been unsettling and the additional upward pressure it has placed on energy and food prices is adding to and prolonging high US inflation. In February, US annual CPI inflation pushed up to a new 40-year high of 7.9% y-o-y with producer prices at 10% y-o-y. The March annual CPI and producer price readings will be higher with the Ukraine war boosting US gasoline prices. The escalating US inflation cycle peak and increasing risk that when inflation subsides the cycle low will not have a 2 handle but could have a 3, 4 or higher handle is driving up bond yields as well as the need for the Federal Reserve (Fed) to hike interest rates quickly and aggressively.
At the Fed’s policy meeting in March the Fed hiked the Funds rate by 25 basis points (bps) to 0.25-0.50% range. The hike, the first in the current cycle, was minimal given how high inflation has run and is likely to stay. The Fed is indicating that it will lift the Funds rate to 2.50% in 2023 and 3.00% beyond, but those projected interest rates seem inadequate to deal with high, persistent inflation. Rising US bond yields are likely to pressure the Fed to hike more aggressively than it indicated at the March meeting.
Turning to China, the influences on its growth prospects became mixed in March. The Government announced a GDP growth target of 5.5% for 2022 which would if achieved mark acceleration from growth nearer 4% y-o-y in Q4 2021. The Government plans to spend more, which will assist growth, but a hardline attitude to eliminating rather than living with Covid outbreaks, the lingering fallout from earlier policies containing excesses in particular sectors of the economy including the huge property development sector, and the risk of copping sanctions because of a too close relationship with Russia’s President Putin all present potential growth headwinds. Having said that, the most recent data points are promising with February readings stronger than expected including fixed asset investment spending, +12.2% y-o-y (previous +4.9%); industrial production, +7.5% y-o-y (previous +4.3%); and retail sales, +6.7% (previous +1.7%).
Europe remains most affected by the Ukraine war. It is accepting millions of refugees from the war. Economic sanctions on Russia including the thorny issue of how much to reduce imports of Russian gas are hitting hard. Growth prospects are suffering while inflation pressure is intensifying. The ZEW economic confidence survey for Europe collapsed in March to –38.7 from +48.6 in February. Economic readings that reflect earlier rapid economic growth remain strong. Europe’s unemployment rate fell to 6.8% in January, the lowest reading in more than 20 years. Inflation continues to escalate with the headline annual CPI inflation rate at 5.9% y-o-y in February and expected to push above 6% in March. Europe’s producer prices rose more than 30% y-o-y in January. The European Central Bank is indicating that it will start hiking rates (its Deposit Rate is still –0.50%) later this year. The Bank of England, facing similar inflation pressure to the ECB, hiked 25bps to 0.75% in March, its third hike in as many meetings and is heralding hikes every meeting this year.
Australia consolidated its position as one of the strongest growing advanced economies with strongest growth prospects in March. Q4 GDP rose more than expected by 3.4% q-o-q, 4.2% y-o-y. Growth was driven primarily by household consumption spending rebounding after the end of lockdowns in New South Wales and Victoria. Since Q4 retail spending has lifted further, up 1.8% m-o-m in January, and employment growth has been exceptionally strong, up 77,400 in February pushing the unemployment rate down to 4.0%. The Ukraine war has dented consumer sentiment, much as it has elsewhere around the world, but the lift in energy and commodity prices is also delivering a boost to Australian export and national income.
Before the latest escalation of the Ukraine war, high commodity prices were boosting Australian export income. In January, the value of exports lifted 8%, increasing the monthly trade surplus from $A8.4 billion in December to $A12.9 billion in January. The value of exports will lift much further in February and March boosting the profits of resource companies and company tax revenue for the Government.
On Tuesday the Federal Treasurer announces the 2022 Budget, the last before the Federal election in May. The 2021-22 underlying Budget Deficit was forecast at over $A100billion when the last Budget was announced in May last year. Since then, GDP and employment growth have been much stronger than forecast and unemployment lower than forecast. Commodity prices have also been much higher than forecast. The benefit to the Budget bottom line is considerable, reducing the 2021-22 Budget Deficit by more than $30 billion and more than $80 billion cumulatively for the 2021-22 through 2023-24 Budget deficits. Given how strongly the Australian economy is growing with building upward pressure on inflation, any unfunded use of the growth/ commodity price dividend to the Budget bottom line will serve to further overheat the economy. Yet various spending initiatives are planned in the Budget including compensation for cost-of-living pressure.
While inflation is lifting in Australia at a lesser pace than overseas so far, strong past growth and prospects plus a pre-election Budget add to the likelihood that Australian inflation will catch up with high inflation readings overseas before long. The RBA continues to rely on past slow wage growth to make a case for delaying interest rate hikes. Yet the rapidly tightening labour market all but ensures that wage growth will accelerate and more rapidly than in recent decades. At some point, the wage and inflation data will convince the RBA that inflation is not only running consistently within 2-3% target band but has escaped consistently above band. We expect a rate hike in June just after the Q1 CPI and wage price index releases. The June rate hike could be 40bps to 0.50%. We see a need for the cash rate to be no lower than 1.00% by the end of 2022 and no lower than 2.50% by the end of 2023.