Macro (Re)view (30/9) | Leaving Q3 behind

A highly volatile Q3 for markets has drawn to a close leaving behind a deeply inverted US yield curve, stronger dollar and lower equities. The rapid regime shift away from ultra-low interest rates and asset purchases in response to high inflation is largely driving market volatility, but as developments in the UK gilt market have demonstrated there are also spillover effects coming into play. 

UK policy remains in the spotlight  

Concerns over the viability of the fiscal and monetary policy mix in the UK continue to amplify volatility in global markets. The government this week reaffirmed its intentions to press ahead with expansionary fiscal measures despite adding to the inflationary outlook, drawing the ire of the IMF. The repricing in the gilt market to much higher yields that came off the back of this uncovered insolvency risks in the UK's large pension fund sector, prompting intervention from the Bank of England. Daily gilt purchases (up to £5bn) directed at long-dated maturities (20yrs and above) are set to take place through to 14 October, effectively giving time for funds to reposition their exposures to account for higher interest rates going forward. All up, this implies a £65bn operation.  

Following the mini-budget, the UK's Debt Management Office announced the measures would require an additional £62bn of gilt issuance for the fiscal year. On top of that, the BoE had last week given the green light to start its gilt sales program, totalling around £40bn over a 12-month period. As part of this week's announcements, the BoE has said it will now delay gilt sales by 4 weeks until the end of October. However, the BoE is still formally targeting an £80bn reduction in its balance over the next 12 months, though those plans are now clouded by uncertainty. BoE Chief Economist Huw Pill said this week the MPC was not in favour of hiking rates over the inter-meeting period, but that a "significant monetary policy response" looks warranted at the November meeting in light of the government's fiscal stimulus plans.

US inflation reaccelerates 

After seeing some respite in July, US inflation pressures lifted in August as the Fed's preferred core PCE deflator rose from 4.7% to 4.9%yr, above the 4.7% pace expected. There was better news on the headline PCE measure, which has eased to its slowest since January at 6.2% reflecting declining gasoline prices. However, for the Fed, it is the core rate that is most influential for policy, and August's upside result supports the hawkish message from FOMC members during the week, including from the Vice Chair Lael Brainard in giving backing to restrictive monetary policy settings to return inflation to target.  

High inflation and the Fed's rapid hiking cycle have been headwinds to US consumers, but while demand has slowed since the beginning of the year it continues to hold up. Year-ended growth in personal consumption has moderated to 1.8%, an 18-month low. While that situation should help to ease inflation pressures, the composition of demand is now being driven entirely by services, a component in which inflation tends to be stickier than for goods. With the effects of the pandemic dissipating and consumption patterns continuing to rotate back to services, this may slow the pace at which inflation comes down. 

More signs of resilience from Australian households...  

The data points over the past week reaffirmed the resilience of the Australian economy to headwinds domestically and offshore. Retail sales posted their 8th consecutive month-on-month gain rising by 0.6% in August, an upside outcome on market expectations for 0.3%. The picture for discretionary spending was softer than the headline result as sales ex-food saw a 0.3%m/m rise, but that is against the trend of what has played out so far this year, with discretionary spending far outpacing headline retail sales. 

Although weak financial markets and falling property prices contributed to a reported 3.3% decline in aggregate household wealth in the June quarter, a strong labour market has been key in driving incomes and supporting spending. Job vacancies came in lower for the 3 months to August (-2.1%), but that looks consistent with other data that have indicated activity in the labour market slowed around the middle of the year due largely to seasonal factors and Covid disruptions. The key point remains that vacancies, both in absolute terms and as a share of the labour force, are very elevated, which points to a further tightening in the labour market via a lower unemployment rate. 

... could lead the RBA into another 50bps rate hike

The strength in the labour market and a very favourable terms of trade position on the back high commodity prices are key factors that narrowed the deficit in the Federal Budget for 2021/22 by $47.9bn from the earlier forecast to 1.4% of GDP. The RBA returns to the fold next week where markets lean to another 50bps hike in rates. My reading of the ABS's new inflation gauge suggests headline inflation is running around 7% in Q3, up from 6.1% in Q2 and is seemingly broadly consistent with the RBA's outlook for inflation to rise to the high 7s by the end of the year. The RBA has been openly discussing the idea of downshifting to hiking in 25bps increments, though the global backdrop of volatile markets and central bank credibility coming under pressure may make this difficult for the Board to pull off next week. 

Euro area inflation hits 10%

The euro area's deepening energy crisis drove stronger than expected inflation readings in September risking another 75bps rate hike from the ECB at the October meeting. Headline inflation lifted from 9.1% to 10%yr (vs 9.7% expected) and the core rate now stands at 4.8% (vs 4.7%) from 4.3% in August. The increase in energy prices over the year is almost 41%, pressures which are feeding through to push up prices of goods and services across the economy, seen in the core rate running well above the ECB's 2% target. Speaking before the European Parliament this week, ECB President Christine Lagarde said that rate hikes "over the next several meetings" are likely to be needed to guard against inflation expectations becoming deanchored.     

Macro (Re)view (23/9) | Relentless rise in rates

The Fed's relentless hiking cycle went up a notch this week as the FOMC signalled a more aggressive approach was required to curb inflation in the US. This pulled 4 other G10 central banks into delivering a total of 275bps of rate hikes this week, but those efforts were insufficient to 'out hawk' the Fed, sending the US dollar ever higher. Against the tide, the Bank of Japan continued to hold policy unchanged, but the situation prompted intervention in the FX market to defend the Yen for the first time since the late 1990s. Bond markets, already under pressure from rising rates, reacted poorly to the announcement of a significant fiscal stimulus package in the UK. Gilt yields soared in response, heaping more pressure on the Sterling, with markets also contending with the confirmation from the Bank of England that it will soon commence selling down its bond holdings.    

Fed presses on with rate hikes...

The Federal Reserve's FOMC ramped up its response to high inflation in the US, not only hiking rates by 75bps but also signalling a higher peak in the fed funds rate than expected by markets, some 125bps above its current level of 3 to 3.25%. Committee Chair Jerome Powell said in the post-meeting press conference the FOMC was "purposefully" raising rates to a "sufficiently restrictive" setting that will likely be needed "for some time" to lower inflation to its 2% target, with additional tightening to come from the reduction of its balance sheet that is now running at its top pace of $95bn/mth.   

Chair Powell said that with the strong labour market generating upward pressure on wages and prices, longer-term inflation expectations risked becoming unanchored from the Fed's target. Accordingly, a more aggressive approach from the FOMC was signalled, with its median projection for rates rising to 4.4% by the end of the year (up from 3.4% in June) and lifting further to peak at 4.6% in 2023 (3.8%). Although rates are seen on a falling trajectory from 2024, the updated projections indicate the fed funds rate is likely to remain in the restrictive zone until at least 2025. 

... but faces an increasing trade-off 

That is how long the FOMC sees it will take for inflation to return to target on both a headline (2.0%) and core (2.1%) basis. This comes after the inflation projections for 2022 and 2023 were revised higher. The trade-off is significant, with more rate hikes seeing the growth outlook slashed to 0.2% this year from 1.7% in June and then to 1.2% in 2023 (from 1.7%) and 1.7% in 2024 (from 1.9%). Growth running below potential for that sustained period—something Chair Powell said was needed to lower inflation—puts the unemployment rate on an upward path, rising from 3.8% by the end of the year to 4.4% by 2024.  

Bank of England hikes into a complex outlook  

The BoE hiked rates by 50bps to 2.25% as the UK's complex economic backdrop resulted in the first 3-way vote from the 9-member Monetary Policy Committee in over a decade. A majority of 5 votes sealed the decision over 3 members who voted for a larger 75bps hike. The incoming member on the MPC, Swati Dhingra (replacing Michael Saunders), cast a sole vote for a 25bps increase. The MPC also gave the green light to its earlier announced plan for balance sheet reduction, voting unanimously for an £80bn reduction over the 12 months to October 2023. This will include around £40bn of gilt sales, of which £8.7bn is planned for the first 3 months. 

At cross-purposes to the BoE hiking rates, the government announced around £160bn of fiscal stimulus measures to impact the economy through to 2025/26 under its Growth Plan 2022. This includes a provisional £60bn to cover the government's price cap on energy bills. In its decision, the MPC noted the energy price cap will likely lower the peak in inflation from 13% to 11% in Q4 and cut 5ppts from headline inflation in 2023. However, over a medium-term horizon, it would add to inflationary pressures as it will help support household demand. The Sterling deteriorated further and gilt yields surged on the back of this week's developments, reflecting rising inflation risks and concerns over UK public finances. 

Given the associated uncertainties, the guidance from the MPC remained that rates are "not on a pre-set path", pledging also to act "forcefully" to signs of inflation becoming entrenched into the price- and wage-setting process. The path for rates will depend heavily on the Bank's revised assessment of the economic outlook, taking into account the effects of the government's fiscal stimulus, to be published at the November meeting. 

RBA to weigh its options 

The minutes from the RBA's September Board meeting were notable in that they revealed the Board held a discussion over whether to hike rates by 25 or 50bps. Ultimately the Board decided on 50bps, but this is a significant development given speculation of a slowing in the pace of tightening only started after the meeting when Governor Lowe removed the reference to "normalising" rates in his statement. At last week's parliamentary testimony, Governor Lowe told members that as rates rise higher "...the need for big adjustments gets smaller" and that the same discussion over hiking by 25 and 50bps would take place in October. 

The overall impression is that the RBA is becoming more mindful of the risk of overdoing tightening, with the minutes noting the Board was "resolute" in the need to lower inflation to target but also needed to take into account the "risks to growth and employment". Adding to the sense of caution is the global economy where the effects of rising rates, the war in Ukraine and a slowdown in China due to Covid are presenting downside risk for Australia. As Governor Lowe noted in his address last week, a soft landing domestically would be harder to achieve if there was "further material bad news on the global economy". 

Macro (Re)view (16/9) | Inflation watch continues

An above consensus outcome on core inflation in the US drove an aggressive reaction in markets as expectations for more Fed tightening saw equities decline and the dollar rising. Yields at the front end in the US lifted sharply, leaving the 2-year yield at its highest since 2007. Next week, both the Fed and BoE have policy meetings. 

More work in front of the RBA 

At this week's appearance before the parliamentary Standing Committee on Economics, RBA Governor Philip Lowe reaffirmed the commitment to bring inflation back to the 2-3% target band while aiming to keep the economy "on an even keel". Governor Lowe said that with the cash rate now close to estimates of the neutral range, the Board has more optionality and will discuss whether to hike rates by 25 or 50bps at the October meeting. Further rate hikes are on the table with the RBA intent on ensuring high inflation does not become entrenched through the wage-setting process. Although there is little sign of that at the moment, Governor Lowe said the RBA would need to remain alert given the strength of the labour market.  

After a temporary slowdown around the middle of the year, activity in the labour market rebounded in August leading to rises in employment (33.5k), participation (66.6%) and hours worked (0.8%). Increased participation saw the unemployment rate ticking up slightly, though at 3.5% it remains at lows going back to 1974. Underemployment (5.9%) and overall underutilisation (9.4%) also stand at historical lows. For my full review of the August Labour Force Survey see here.  

Consumer and business survey data was also in focus domestically this week. According to the Westpac-Melbourne Institute index, consumer sentiment saw its first rise in 10 months after lifting 3.9% in September but remains deeply pessimistic at an 84.4 reading. Despite this, household spending has been robust, highlighted in last week's national accounts. The backdrop of strong demand fed into an upbeat NAB Business Survey with confidence and conditions rising further above their long-run average levels in August.       

Core inflation rises in the US 

Although headline inflation in the US has come off its highs, a pick-up in the underlying pace saw expectations for the Fed's tightening cycle repriced higher, including speculation of a 100bps hike at next week's FOMC meeting (75bps expected). Inflation pressures had eased in July and although headline inflation was again subdued at 0.1% month-on-month and the annual pace slowed from 8.5% to 8.3%, the core rate went the other way rising by 0.6%m/m to 6.3%yr (from 5.9%). 

Headline inflation has been held down over the past couple of months mainly by falling gasoline prices, which were off 10.6% in August following a 7.7% decline in July. Beneath the surface, a key dynamic continues to play out with the contribution to inflation from services components remaining on the rise. As inflation started to accelerate in 2021, goods were the main driver due to strong demand associated with the pandemic colliding with constrained supply chains. With those effects now unwinding, stickier services categories are taking over in driving inflation. Shelter and rent costs are up sharply over the year (6.3%) and that has played a major part in elevated core inflation.   

Close call next week for the Bank of England 

Next week's BoE meeting shapes as a closely run thing with the MPC set to weigh up hiking Bank rate by 50 or 75bps. Inflation and labour market data released this week were stronger than expected on the key details and suggests the MPC could opt for 75bps, though a very weak retail sales report (-1.6%m/m in August) is a sign of the pressure households are under and could therefore argue for 50bps. Adding to the complexity is that the government has said there will be a 'fiscal event' the day after the meeting where it will unveil more of the details on the 2-year energy bill price freeze and other support measures.  

Headline CPI inflation on a 12-month basis softened a touch from 10.1% to 9.9% in August (vs 10.0% expected). However, the core rate showed its fastest month-on-month rise (0.8%) since March, firming the 12-month pace from 6.2% to 6.3% (vs 6.2%). Signs of broadening price pressures across the CPI basket come as an unwelcome development, particularly as average weekly earnings growth exceeded expectations at 5.5%yr in July. 

Rising wages reflect a tightening labour market in the UK where the unemployment rate fell to 3.6%, its lowest in 48 years. That has been driven by strong demand for labour - the most timely gauge of employment reported a 71k increase in August (vs 60k) - but also by a constrained supply of workers due to the pandemic. The inactivity rate lifted to its highest since 2016 (21.7%), driven largely by a significant rise in the number of people away from work due to long-term illness over the Covid period, now standing at 352k. 

Australian employment 33.5k in August; unemployment rate 3.5%

Activity in the Australian labour market rebounded from a temporary slowing in July with employment, participation and hours worked rising in August. Although the unemployment rate ticked up slightly to 3.5% it remains at half-century lows, indicative of the robust demand for labour that shows little sign of easing.  

Labour Force Survey — August | By the numbers

• Employment increased by a net 33.5k in August, broadly in line with consensus (35k) and mostly reversing July's 40.9k fall. 

• The unemployment rate came in a touch higher at 3.5% from 3.4% in July (3.4% expected), but remains at lows dating back to 1974. Underemployment eased to 5.9% from 6%, leaving total underutilisation steady (9.4%). 
• The participation rate rebounded to 66.6%, after falling to 66.4% in July.  

• Hours worked lifted by 0.8%m/m, overturning the 0.8% fall in July associated with seasonal factors and Covid and weather-related disruptions.  

Labour Force Survey — August | The details

August's Labour Force Survey broadly reversed the weakness that was reported in July when activity was hampered by disruptions from Covid-related absences, La Nina and winter school holidays. Total hours worked lifted by 0.8% month-over-month in August, rebounding from a 0.8% fall in July. This saw hours worked rising to 4.5% above their pre-Covid level. 

Driving the rise in hours worked was the return of workers from annual leave; the number of Australians working fewer hours than usual due to annual leave fell by 731k in the month (to 839k), a large fall that lines up with the return of schools from winter holidays. This was reflected in the rebound in full time hours worked, up 1.4%m/m from -1.2% in July.  

Covid-related absences lifted slightly over the month, causing 761k Australians to work reduced hours in August. Due to the winter spike in Covid cases and the return of schools, there was a 60k rise in the number working fewer hours than usual in August due to caregiving reasons (352k).   

Employment increased by 33.5k (on net) in August, mostly rebounding from the 40.9k decline in July. Full time employment posted a 58.8k rise (-86.9k in July) while part time employment fell by 25.3k (from +46.0k). Australian employment now stands at 13.592m, 4.5% higher than pre-Covid levels. 

As labour market activity picked up again from the July slowdown, participation in the labour force lifted. After falling from record highs (66.8%) to 66.4% in July, the participation rate lifted back to 66.6% in August. The share of Australians in work firmed to 64.3% after a small decline in July.  

The rise in participation equated to a 47.5k increase in the size of the labour force. As this larger than the lift in employment (33.5k), the unemployment rate came in a touch higher at 3.5% from 3.4% in July but remains at half-century lows. Underemployment was pushed lower to 5.9% (from 6%) due to the rise in hours worked. Overall, this left the rate of labour force underutilisation unchanged at 9.4%, its lowest since the early 1980s.   

Labour Force Survey — August | Insights

The August report confirmed the slowdown in hiring and overall activity in the labour market in July was caused by temporary seasonal factors and disruptions. Forward-looking indicators from job vacancies and this week's NAB Business Survey point to employment rising through the back half of the year. That supports the outlook for the unemployment rate to continue falling and for the labour market to keep tightening. That is the scenario expected by the RBA and so today's report should have few implications for the October meeting. With the report mostly printing in line with their expectations, it will also do little to dissuade markets from pricing in a reduction in the pace of the next hike to a 25bps increase from the 50bps hikes seen at the previous 4 meetings.     

Preview: Labour Force Survey — August

Australia's Labour Force Survey for August is due from the ABS at 11:30am (AEST) today. Employment is coming off a surprise fall in July, but underlying conditions in the labour market remain very robust. In today's report, employment is expected to rebound and hold the unemployment rate at its half-century low of 3.4%. 

As it stands | Labour Force Survey

Employment fell by 40.9k (on net) in July, surprising market expectations for an increase of 25k. This was the first decline in employment since the Delta wave lockdowns during winter and early spring of 2021. A sharp fall in full-time employment (-86.9k) was attenuated by an increase in part-time employment (46.0k). July's result looked to be driven by additional volatility around the end of financial year from high Covid-related absences, flooding in New South Wales and school holiday periods.

Despite the fall in employment, the unemployment rate came in lower at 3.4% from 3.5% in June. The driver was an easing in the participation rate off record highs (66.8%) to 66.4%. There were also declines in underemployment (6%) and underutilisation (9.4%) in July.

Total hours worked contracted by 0.8%m/m reflecting seasonal factors and Covid-related disruptions. All up, there were around 2.6 million Australians who reported working fewer hours than usual in July. Hours worked were 4.0% above pre-pandemic levels in July, broadly in line with the rise in employment over the period (4.3%).    

Market expectations | Labour Force Survey

The market expects employment to rebound in August and rise by 37.5k, though there is a wider than usual band of estimates from 10k on the low side to 110k on the high side. Though they provided a reliable guide to employment in July, the ABS noted in its latest release of the high-frequency payrolls data that firms' reporting patterns to the ATO can change around the end of financial year, making it difficult to obtain a clean read on conditions. Payrolls over the reference period for the August survey were around 1.5% lower. The unemployment rate is expected to hold at 3.4% (range: 3.2% to 3.6%).  

What to watch | Labour Force Survey

The underlying strength in the labour market should see July's fall in employment quickly reversed. In raising rates by 50bps last week, the RBA reaffirmed its data dependency and focus on the labour market. Markets are pricing in a downshift to a 25bps hike for the October meeting after Governor Lowe removed the reference to "normalisation" in the decision statement as the cash rate (now at 2.35%) moved closer to estimates of neutral in Australia. In a speech a couple of days later, the governor noted the case for slowing the pace of rate hikes was "stronger as the level of the cash rate rises". This comes as the outlook for the labour market remains robust, with the RBA expecting the unemployment rate to continue falling as job vacancies remain at very elevated levels.

Macro (Re)view (9/9) | Staying the course

Risk assets saw some respite with most equity markets advancing after falling heavily in recent weeks. Alongside this, strength in the US dollar strength came off slightly. The US yield curve became a little more inverted as Chair Powell reaffirmed the Fed's commitment to lower inflation. On that front, we saw the ECB and BoC both hiking rates by 75bps this week and in Australia, the RBA raised the cash rate by a further 50bps.    

Resilient household demand is driving the Australian economy...

The Australian economy expanded by 0.9% in the June quarter and 3.6% in year-ended terms, maintaining solid momentum against a backdrop of slowing growth offshore in G7 economies and a sharp contraction in China following the return of lockdowns. Domestically, household consumption lifted by 2.2%, contributing 1.1ppts to growth in Q2, a resilient outcome to headwinds that include high inflation and falling real incomes, the RBA's rate hiking cycle and weak sentiment. Also supporting growth was net exports (1ppt) as resources production rebounded from weather-related disruptions and inbound tourism picked up. Supply constraints weighed on growth affecting inventory rebuilding (-1.2ppts) and residential construction activity (-0.1ppt) due to materials and labour shortages. My in-depth review of the Q2 national accounts is available here.   

 

The strength in the labour market and accumulated savings are key factors that continue to support household spending. The full reopening of the international borders also provided a boost, with pent-up demand for travel and associated accommodation and hospitality services coming through. Reflecting this, services consumption advanced strongly (3.6%), continuing the rotation in demand away from goods categories (-0.1%). A 1.3% rise in July retail sales suggests the overall momentum in spending has continued into Q3 (see here). 

The run-up in commodity prices following the war in Ukraine and other supply pressures led to the terms of trade rising to a record high, boosting national income and keeping the current account surplus elevated at 3% of GDP in the June quarter (see here). A more recent retracement in prices, however, led to a sizeable pullback in the monthly trade surplus in July (see here). 

... as the RBA hiked rates by a further 50bps

The RBA Board hiked rates by 50bps to 2.35% at Tuesday's meeting, taking the amount of tightening delivered since May to 225bps (reviewed here). Governor Philip Lowe's decision statement noted rates were expected to be hiked further "over the months ahead". The reference to "normalisation" that has been used to characterise the earlier rate hikes was removed from the statement with rates approaching estimates of neutral in Australia. 

At a speech later in the week, Governor Lowe said the Board was conscious of the lags in the transmission of monetary policy to the economy and also recognised that the case for slowing the pace of hikes was "stronger as the level of the cash rate rises". The central message remained intact that higher rates were required to rebalance supply and demand in Australia and to keep a hold on inflation expectations, but it seems the Board will be open to a discussion in October to slowing the pace of hikes (likely to 25bps increments), dependent on the data flow. 

ECB moves to frontload its hiking cycle  

The speculation in the lead-up to this week's meeting proved well founded as the ECB hiked its key interest rates by 75bps following on from the 50bps hike in July. The Governing Council noted in its decision it had sped up the pace of tightening to "frontload" the withdrawal of accommodative rate settings given inflation was running "far too high" at 9.1% and was likely to stay elevated for "an extended period". With an updated set of economic projections raising the outlook for inflation materially to 8.1% this year (from 6.8%), 5.5% in 2023 (3.5%) and 2.3% in 2024 (2.1%), ECB President Christine Lagarde said in the post-meeting press conference the Governing Council was prepared to keep hiking rates into 2023.   

That tightening will come into a deteriorating economic outlook as Europe confronts a significant real income squeeze and an energy crisis. Forecast economic growth this year has been lowered from 3.1% to 2.8%, slowing sharply to 0.9% in 2023 (down from 2.1%) with a rebound seen in 2024 at 1.9% (from 2.1%). Although the base case is for Europe to avoid recession, President Lagarde said the risks to growth were to the downside and forecasts that used more pessimistic assumptions pointed to a downturn in 2023.  

Also of note, with the depo rate lifting off zero, the ECB has temporarily lifted the 0% cap attracted by government deposits held at the ECB. These deposits will now be remunerated in line with the depo rate (0.75%) through April 2023, the move intended to prevent deposits from flowing into the markets and pushing down short-term rates. 

Fed Chair Powell sticks to script

In a Q&A appearance, Fed Chair Jerome Powell reaffirmed the commitment emphasized in his recent Jackson Hole speech to prevent high inflation from becoming entrenched in the US. Chair Powell said it was imperative for the Committee to heed the lessons from the high inflationary episodes during the 1970s and 1980s by taking strong action with its policy tools and "keep at it until the job is done". In a similar vein, Fed Vice Chair Lael Brainard said in a speech that it will continue its fight against inflation "for as long as it takes". To have confidence that inflation is falling back to the 2% target, Brainard said restrictive monetary policy will be required for "some time". Next week, CPI data for August is due (13/9) with the market looking for a modest 0.1% fall in month-month inflation. 

Australian trade surplus retraces in July

Australia's trade surplus retraced from record highs to come in at $8.7bn in July. Exports fell for the first time since November 2021 as global commodity prices eased while import spending advanced strongly, partly reflecting global inflationary pressures as well as a resurgence in services spending with overseas travel recovering rapidly.   

International Trade — July | By the numbers

• Australia's trade surplus narrowed to $8.7bn in July from $17.1bn in June, sharply lower than anticipated by markets ($14.7bn). 

• Exports retraced from record highs falling by 9.9%m/m to $55.3bn, the level still 18.2% higher over the year. 
• Imports advanced by 5.2%m/m to $46.5bn, with annual growth in spending elevating to 40.8% from 34.3%. 

International Trade — July | The details

The nation's trade surplus reset to record highs in May ($14.6bn) and then in June ($17.1bn) before pulling back sharply in July ($8.7bn), still a very elevated level in a historical context. The narrowing in the trade surplus was driven by lower exports earnings and rising spending on imports. 

Exports increased for 8 months running between November and June, continually resetting to record highs over this period. That run came to an end in July, with exports retracing by 9.9%. In nominal terms, export earnings were $6.1bn lower than in June, coming in at $55.3bn. Non-rural goods fell by 11.9%, accounting for almost 90% of the monthly decline in exports. This came on the back of falls in iron ore (-14.9%m/m), coal (-17.4%m/m) and LNG (-4.4%), the result of falling prices and/or lower export volumes.  

Supporting exports were rural goods (3.5%) and the services sector (4.0%). Cereals surged by over 10% to lead rural goods higher, as production continued to recover from disruptions caused by heavy rainfall. The full reopening of the international border has seen the recovery in the services sector shift up a gear. Tourism-related earnings lifted by 7.3%m/m to be up by 74.6% over the year. 

For imports, spending lifted for a 3rd consecutive month with a 5.2% rise posted in July, partly driven by inflationary effects. Consumption goods made the largest contribution, rising by 9.1%m/m. Spending on new vehicles (15.4%) and clothing and footwear (16.7%) lifted strongly. Capital goods (5.0%) and intermediate goods (2.0%) strengthened in July. However, the story for imports centres on the services sector; spending was up by a further 8.1% in the month to be 91.7% higher over the year. Tourism-related spending is rising rapidly with overseas travel now occurring more widely, though it is still 32% below pre-pandemic levels.  

International Trade — July | Insights

Falling commodity prices contributed to a sizeable pullback in the trade surplus in July. Following an acceleration in prices in response to the war in Ukraine, prices for many commodities have eased more recently. Yesterday's national accounts reported the terms of trade had lifted to a record high level in Q2, driving a surge in national income. Activity in services trade is seeing a strong recovery with travel restrictions recently removed, particularly on the import side. 

In review: Australian Q2 GDP: Household spending drives growth

Resilient household demand to headwinds from high inflation, falling real incomes and the withdrawal of fiscal and monetary stimulus has continued to drive the Australian economy. Real GDP expanded by 0.9% in the June quarter and by 3.6% through the year. 

Australian GDP is now close to returning to its pre-pandemic trend, having risen to be 5.5% above its level from Q4 2019. Momentum in the first half of 2022 was solid as activity lifted by 1.6%; this was despite significant disruptions associated with La Nina and Covid-related absences, though the full reopening of the international border boosted activity.

 

Offshore, growth slowed in most advanced economies over the first half of the year. High inflation drove declines in real incomes and the withdrawal of fiscal and monetary stimulus led to consumer demand moderating. A return to lockdowns in China following Covid outbreaks saw output contracting there sharply in Q2.       

Global inflationary pressures continued to remain elevated. The Russian invasion of Ukraine led to an acceleration in commodity prices, driving up food and energy prices in particular. Ongoing strains in global supply chains were contributing to high goods inflation. Rising core inflation indicated price pressures were broad based. Labour markets were tightening in many countries, leading to rising wage pressures and higher inflation in the services sector.   

These global factors were contributing to rising inflation in Australia, with the June quarter national accounts reporting the GDP deflator lifted to 8.3%Y/Y. Meanwhile, strong conditions in the domestic labour market were leading to rising labour costs as growth in non-farm hourly earnings lifted to a 5.0%Y/Y pace. 

Employment in Australia increased strongly over the June quarter rising by 150k, lowering the national unemployment rate to 50-year lows at 3.5%. Following an easing of weather and Covid-related disruptions, hours worked in the economy rebounded by 2.9% in Q2. This saw the rate of underemployment falling to lows last seen in 2008 while total underutilisation in the labour force has been reduced to a 40-year low.  

The strong labour market, accumulated savings and the easing of remaining Covid restrictions on travel offset a further squeeze on real incomes, rising interest rates and weak sentiment. Household consumption lifted by 2.2%, contributing 1.1ppts to quarterly GDP. Net exports also supported growth in the quarter (+1ppt), with exports rising on the easing of weather-related disruptions that had weighed on production in the resources and agricultural sectors in Q1, while inbound tourism picked up on eased border restrictions. Elevated commodity prices have reset the nation's terms to a record high level, underpinning a 4.3%q/q surge in nominal GDP. A pause in inventory rebuilding (-1.2ppts) and capacity constraints in the residential construction sector (-0.1ppt) weighed on growth in the quarter.    

The RBA's tightening cycle has now delivered 225bps of rate hikes since May. Following the September meeting, the Board noted it will be watching closely the resilience of household spending and signs of inflation pressures feeding through to the wage-setting process. The June quarter national accounts are likely to confirm the Board's guidance that further hikes are required to return inflation to the 2-3% target, though the pace may be set to slow to 25bps increments from 50bps next month.   

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National Accounts — Q2 | Expenditure: GDP (E) 0.8%q/q, 3.4%Y/Y

Household consumption (2.2%q/q, 6.0%Y/Y) — Australian household demand remained resilient, continuing to rise despite real incomes falling in response to high inflation, the RBA hiking rates and weak sentiment. A strong labour market, accumulated savings and the easing of remaining Covid restrictions have helped to defy these headwinds, lifting household consumption to a 2.2% rise in the quarter and by 6% in year-ended terms. 

Consumption growth was driven by services categories (3.6%) as spending patterns continued to rotate back from goods (-0.1%). Although this rotation is occurring at pace, goods consumption (9.9%) remains substantially more elevated than services (3.3%) relative to their respective pre-Covid levels.  

The reopening of the international border and increased travel domestically drove transport services to a 37.3% rise in the quarter, which led to an associated boost in spending at hotels, cafes and restaurants (8.8%q/q). Larger attendances at public events and increased gambling activity pushed up recreation services by a further 3.6%q/q. Consistent with Australians going out and about more often, demand for clothing and footwear continues to lift (3.7%q/q) and is up by more than 20% over the year, going against the broader rotation in spending away from goods. 

Household incomes continue to be supported by the strong labour market. Wage incomes lifted by 2.3% in the quarter, driving a 1%q/q rise in household disposable income. However, given rising inflation real disposable income continued to fall, down 0.6% in Q2 following declines of 0.5% and 1.2% in the previous two quarters. Real disposable income is still higher over the year (2.2%), but it will continue to come under pressure with inflation set to rise further in the quarters ahead. 

The rising cost of living was added to by the RBA commencing its rate hiking cycle. The cash rate was lifted by 75bps over May and June, leading to a 9.8% rise in interest expenses in the quarter, the sharpest rise in 10 years. These factors contributed to the household saving ratio declining from 11.1% to 8.7%, though this is still elevated compared to pre-pandemic trends. This equated to a $7.6bn reduction in saving by households compared to Q1, largely accounting for the rise in nominal consumption over the quarter ($10.8bn). 

Dwelling investment (-2.9%q/q, -4.6%Y/Y) — Residential construction activity contracted for the third quarter running, falling by 2.9% in Q2 to be down by 4.6% through the year. Ongoing capacity constraints from shortages of labour and materials and disruptions from wet weather hampered activity in the June quarter. 

New home building fell by 3.8%q/q and has been in decline since the June quarter of last year. Policy stimulus from low interest rates and government construction subsidies drove an upturn in activity from late 2020 through the first half of 2021. Since then, the sector's progress in working through a very substantial residential pipeline has been significantly delayed by capacity constraints, Covid-related disruptions and heavy rainfall down the east coast caused by La Nina. Despite there being more than 100k new detached homes currently under construction, activity in new home building is 7.6% lower than a year ago. 

Alteration work declined by 1.6% in the quarter but remains at elevated levels, up almost 19% since the end of 2019. The support of the federal government's HomeBuilder scheme, a preference shift for more space emerging since the onset of the pandemic and the run-up in housing prices are all factors that have led to alterations rising to this materially higher level. 

Reflecting cooling conditions in the housing market, most notably in the Sydney and Melbourne markets, ownership transfer costs — fees associated with real estate transactions — fell by 2.4% in the quarter (-3.7%Y/Y).  

Business investment (0.6%q/q, 1.4%Y/Y) — The post-Covid expansion in business investment remains intact, but the momentum has slowed as supply constraints, rising inflation and uncertainty around global developments have come into focus. Business investment was 0.6% firmer in the June quarter and was 4.4% above pre-Covid levels. 

Business investment is being driven by equipment spending, which has regained momentum after faltering over the back half of 2021 on global supply chain pressures. Equipment spending lifted by 3.9% in Q2 and was more than 7% higher through the first half of the year. Firms have responded to strong domestic demand by investing in new equipment, encouraged by government tax incentives and accommodative financing conditions. In contrast, non-dwelling construction has come under pressure falling by 2.8% over the first half of this year (-1.9% in Q2) as escalating costs and capacity constraints in the construction sector have weighed on demand.    

Forward-looking investment plans continue to remain upbeat, with the recent ABS capital expenditure survey implying a year-to-year rise in investment spending of almost 15% compared to the 2021/22 financial year. This investment will be needed to help resolve the capacity pressures in the domestic economy.  

Public demand (0.0%q/q, 6.0%Y/Y) — Public demand has been a strong support to the economy throughout the Covid period and has contributed 1.6ppts to activity over the past year. In the June quarter, growth in public demand consolidated. Consumption spending declined by 0.8%q/q following a sharp rise in Q1 (2.5%) that was associated with support for the recovery effort for the east coast floods. Growth in underlying investment lifted by 3.3% over the quarter as state governments continue to work through an expansive infrastructure pipeline. 

Inventories (-1.2ppts in Q2, -0.2ppt yr) — Subtracted a substantial 1ppt from activity in Q2 as a strong rebuilding effort to replenish inventories from depleted levels paused. Wholesaler and retail inventories declined, in part reflecting pressures in global supply chains but also the rotation in demand from goods to services categories.

Net exports (+1.0ppt in Q2, -0.9ppt yr) — Net exports made a sizeable contribution to quarterly GDP of 1ppt. Exports rebounded from recent weakness (5.5%q/q) but are still 8.9% lower than pre-Covid levels as the services sector remains in recovery. Export volumes were supported by resources and rural goods after production was hampered by weather-related disruptions earlier in the year. Growth in import volumes slowed to a 0.7%q/q rise in Q2 to be 4.4% higher than at the end of 2019, reflecting the strength of domestic demand over the Covid period. Services imports surged (14.3%) as restrictions on offshore travel eased. The rotation of consumption patterns back to services categories weighed on goods imports (-1.6%).    

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National Accounts — Q2 | Incomes: GDP (I) 0.8%q/q, 3.6%Y/Y

The June quarter's income estimate for real GDP came in at 0.8%q/q and 3.6% in year-ended terms. With prices across the global commodities complex rising sharply following the war in Ukraine and other supply disruptions, Australia's status as a commodity exporter has led to a surge in national income. Nominal GDP lifted by a further 4.3% in Q2, taking year-ended growth to 12.1% — a remarkable rate of increase relative to the 3.6% rise in output. 

On the back of the commodity price tailwinds, export prices advanced by 8.8% in the quarter, outpacing import prices at 3.9%q/q. As a result, the nation's terms of trade reset to a new record high level, which has risen by a stunning 12.5% over the first half of the year alone.  

Aggregate company profits expanded by 10% over the quarter, accelerating by almost 25% over the year. Profits from non-financial corporations led the way posting a rise of 11.2% in Q2. This outcome was boosted by the mining sector benefitting from high prices for coal and LNG. Financial corporations profits advanced at a comparatively more sedate pace of 3.6% in Q2; however, that was the fastest quarterly rise that sector has seen in more than 7 years following the commencement of the RBA's rate hiking cycle, lifting net interest margins.  

Strong conditions in the domestic labour market have driven the unemployment rate down to half-century lows, falling to 3.4% in July. Employment continued to rise in Q2 (0.9%) and hours worked rebounded from weather and Covid-related disruptions (2.9%). Rising employment and hours worked drove the compensation of employees measure to a 2.4% increase in the quarter (7%Y/Y); on a per employee basis, average compensation was up 1.4% in the quarter (3.4%Y/Y).  

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National Accounts — Q2 | Production: GDP (P) 1.1%q/q, 3.8%Y/Y

The production estimate for real GDP was 1.1%q/q, 0.3ppt stronger than both the expenditure and income estimates, taking annual growth to 3.8%. The rotation in demand patterns led to gross value added (GVA) by the services sector coming in at 2% in the quarter compared to a 0.7% rise for the goods sector.  

Looking at the services sector, household services saw a 2.8% rise in quarterly production, stepping up after a disrupted Q1 (0.3%). The hospitality sector was a major contributor (10.7%) following the wider resumption of travel for business and tourism and strong demand for dining out and attending entertainment venues. Healthcare was boosted by the recommencement of elective surgeries after a Covid-related pause in Q1. Business services saw production expand by 1.1% in the quarter. This included a 1.6% rise in professional services on strong demand for consulting services and a 1% lift in the rental industry as demand for car hiring lifted due to increased tourism.

For the goods sector, production from goods distribution led the way with a 2% rise coming through in Q2. This was driven by the transport industry (7.5%), reflecting the boost to travel from the full reopening of the international border. Further support came from road and rail freight after weather-related disruptions in Q1. The wholesale industry weighed (-2.2%) due to supply chain pressures holding up deliveries of motor vehicles. GVA from goods production was broadly flat in the quarter (0.1%). Utilities advanced (4.1%) as cold weather saw demand for electricity and gas rise, though wet weather saw water consumption decline. The manufacturing industry weighed (-1.1%) as demand moderated following a strong first quarter.  

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National Accounts — Q2 | Prices

Inflationary pressures in the Australian economy picked up and broadened over the first half of the year. Global supply constraints have fed through to higher food and energy prices in Australia, contributing also to rising materials costs for construction. The GDP deflator lifted by 3.3% in the June quarter and by 8.3% over the year. 

Domestic factors are also generating rising inflation, highlighted by the domestic demand deflator rising to 4.9%Y/Y, its fastest since 1990. The gross national expenditure (1.6%) and household consumption deflators (1.5%) recorded similarly strong increases to those seen in Q1, to be running at 5.2% and 4.1% in year-ended terms respectively. Headline inflation lifted to a 6.1% pace over the year to Q2. 

Inflation according to the household consumption deflator (4.1%Y/Y) has been more moderate than the CPI has reported (6.1%Y/Y). Whereas the CPI calculates price changes for a fixed basket of good and services, the household consumption deflator moves with actual consumption. This suggests that as inflation has risen, Australian households have been price conscious with their purchases.

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National Accounts — Q2 | States 

State demand in New South Wales was solid in Q2 rising by 1.9%, advancing to 7.8% above pre-Covid levels. Household consumption growth posted a 2.5% increase in the quarter, led by rising spending at hotels and restaurants (10.9%) and on transport services (35.6%) as tourism picked up following the easing of border restrictions. Business investment rebounded in the quarter but was unchanged over the year (-0.1%). Wet weather and supply constraints saw residential construction activity slow sharply in Q2 (-0.1%).  

In Victoria, state demand was 1% higher in the June quarter and up 7.7% since the end of 2019. Household consumption increased by 2.3%q/q reflecting the boost from increased tourism in the state. Business investment was also supportive rising by 2.4%q/q to be up by 5.2%Y/Y. Equipment spending has been strong over the year (8.5%), underpinned by new vehicles and agricultural equipment in Q2. Activity in residential construction contracted sharply in the quarter (-3.8%) due to materials and labour shortages.   

Across the other states, state demand in Queensland was now 8.8% above pre-Covid levels following a 1% rise in Q2. The state's large tourism sector saw activity pick up on the full reopening of the international border, driving household consumption to a 2.2% increase. Capacity constraints and wet weather have caused significant headwinds to home building, with activity contracting by 14% through the year.  

State demand in Western Australia was broadly unchanged in the quarter (0.1%) but is more than 9% higher than prior to the pandemic. Household consumption advanced solidly (1.4%) as the state's borders were reopened. That support was offset by falls across business investment (-1.2%), residential construction (-1.2%) and public demand (-1.4%). South Australia saw state demand rise 1.5%q/q to be up by 9.3% since the end of 2019. This occured on broad-based rises including for household consumption (1.5%) and residential construction (3.2%), the latter defying capacity pressures seen in the other states. In Tasmania, state demand lifted by 0.6%q/q, partly rebounding from declines in the past two quarters. This leaves state demand 7.9% higher than pre-Covid. Services spending advanced on the back of increased tourism, with household consumption up 1.4%q/q. Residential construction work is unwinding and is close to returning to pre-pandemic levels (-14.9%Y/Y) after surging in response to policy stimulus.