Australia is one of the world’s most expensive places to live, but perhaps that’s not surprising as its population is amongst the world’s wealthiest. We are not a nation like the United States or China, where a massive population can generate sufficient demand to drive the local economy. We need to trade with the world to generate the wealth we need to grow, and when you look about the globe today, it contains many risks.

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

While much of the world is putting the pandemic behind it, China is ratcheting up its lockdowns to try and 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 couple of months as major Chinese capitals go into lockdown.

Domestically, the rising cost of living and the threat of a rapid series of interest rate hikes to stem inflation is creating daily headlines about tougher times ahead. While that may be true, the Australian economy remains resilient with record low unemployment, muted inflation pressure compared to many leading western nations, and strong terms-of-trade, the latter giving the government revenue to explore cost of living abatement measures.

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

The International Monetary Fund in its most recent report titled “War sets back the global economy” is projecting global growth to slow from an estimated 6.1% in 2021 to 3.6% in 2022. This is 0.8% lower from what it projected in January this year and is mainly attributed to the Russia/Ukraine’s war’s direct global spillovers.

That projected growth remains under pressure for further downgrades. If we look at major regions of importance, the European Union is between a rock and a hard place due its high dependence on Russian energy and the cost to rapidly try and expand alternative supply options. Meanwhile, inflation in the United States accelerated to 8.5% in March, including a 32% jump in fuel process and an 8.8% hike in food prices, the largest rise since 1981, according to economic data analytics group Trading Economics.

Australia’s own outlook took a bit of a battering in late April when it was revealed the inflation rate for March at 2.1% 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.

While the cost of living and inflation will continue to dominate headlines throughout the remainder of the year, there remains many reasons for optimism about the economic outlook.

Commodities

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

The increase in key export commodities boosts Australia’s income and growth. GDP is expected to grow by 4.25% in 2021-22 and by 3.5% in 2022-23 in real terms (inflation-adjusted), according to ABS data.

Inflation

The cost of living has recently picked up sharply in Australia, reaching 5.1%. However, this level is low compared the most recent US record reading of 8.5% and UK’s inflation rate of 7%. This offers an advantage to Australia in terms of how much and how quickly the central bank needs to move to keep prices under control. Additionally, after 2022, as oil prices are expected to gradually start falling and supply chain pressures will ease, inflation is also expected to moderate.

Labor market

The unemployment rate has dropped to 4% and it is expected to drop further to 3.75% by the end of the year, according to government data. Wages are also growing at an annual rate of 2.75% so far this year, which is a trend that is expected to continue. This compares to an average of 3.1% between 1998 to 2021, according to Trading Economics.

In addition, labor force participation is at high levels, which means a larger percentage of the working-age population are now either working or looking for work. On the other hand, the recent Queensland and New South Wales floods caused major disruption and had a direct impact to total number of hours worked. People simply worked fewer hours due to extreme weather conditions.

Business and consumer confidence

Collected data from several industry sources indicate that surveyed firms see the glass half-full. The focus has been more on positive news as mobility and economic conditions improve, rather than negative news from offshore. Australia’s tourism sector is one of the main areas for an improvement in business conditions, which have been stronger than pre-Covid-19 levels.

On the other hand, consumers are not as confident as businesses. Consumer sentiment has recently declined which is mainly attributed to expectations for higher interest rates and deteriorating financial conditions. Apart from expected interest rate increases, consumers also worry more than businesses about the implications of domestic natural disasters and the effect of the Russian-Ukrainian war to the local economy and daily life.

Interest rates

Set by Reserve Bank of Australia (RBA), the official interest rate sat at a historical low of 0.1%. That changed on May 3 when the RBA increased the rate by 0.25% to 0.35%. It is the first of what is expected to be a series of rate hikes this year. Other central banks had already started hiking policy rates. The Bank of England has increased rates three times since December last year 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 the interest rate expectations have shifted to the upside, and this is reflected in the current prices of the bond and futures markets. In other words, while the RBA’s 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 happened – as traded markets are forward looking. Remarkably, the market implied rate for end of 2022 is at 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. Increased interest rates also contribute to higher public sector debt payments over the medium term. However, according to a report by The Secretary to the Treasury and The Secretary to the Department of Finance, the budget deficit is expected to narrow down 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 commodities exporter helped Australia minimize the effect of the Russian-Ukrainian war to the local economy. At the same time, strong labor market and less extreme levels of inflation have put Australia in a good position from a monetary policy point of view. The full re-opening of the economy and international borders could be a positive catalyst for Australia, as migrant inflows could accelerate working-age population growth and increase domestic demand.

Panos Mamolis is an Investment Specialist for Citi, a sponsor of Firstlinks. Any advice is general advice only. It was 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 you make a decision about any financial product. Investors are advised to obtain independent legal, financial, and taxation advice prior to investing. Past performance is not an indicator of future performance.