A recession by degrees

Construction companies, consumer spending and office property are all showing strain. The slowdown should broaden and deepen this year and more sectors feature in the headlines.

"The key reason a deep recession is unlikely is the financial balance sheet vulnerabilities required for such an outcome are not as prevalent this cycle.”

The ANZ-Indeed Australian Job Ads series suggests the unemployment rate is likely to rise above 4 per cent. None of these, however, suggest a recession is imminent.

What they do suggest is the Reserve Bank of Australia is close to an extended pause in its hiking cycle. After twelve near-consecutive rate hikes, there are sufficient signs of moderation in both demand and inflation that the RBA can afford to take some time to assess the full impact of the tightening delivered so far.

Beyond that, there are scenarios in either direction for interest rates in 2024.

For clarity, the degrees of recession matter. New Zealand and Europe are currently in technical recession, but unemployment has risen by less than half a percentage point in New Zealand and declined to new cyclical lows in Europe.

If this is the sort of recession resulting from the largest global inflation surprise in half a century, that would count as a much better outcome than some have feared. These are not the sort of recessions I am counselling against in Australia.

But what if? There are a range of reasons to expect even in the unlikely event Australia has a recession, it is likely to be relatively brief and mild.

It’s difficult to have a deep recession when the population is growing at 2 per cent.
Any recession at all, in fact, obviously implies a per-capita recession nastier than 2 per cent. The 1983 and 1991 recessions were both proper recessions and per-capita recessions. Though in both cases, population growth was less than 1.5 per cent.

Investors are already very conservatively positioned, limiting the ability of markets to weaken sharply and amplify the impact of higher interest rates.

Defensive stance

ANZ Research’s analysis of allocation to over 1,300 exchange traded funds (ETFs) suggests investor positions are the most defensive relative to growth fundamentals in the entire period post the global financial crisis.

Even locally, Australian super funds’ holdings of cash, at $213 billion, are well up on the pre-pandemic level of $183 billion, itself a then near-record.

While it may seem counterintuitive, higher inflation can also buffer incomes
in a downturn. In recent decades, downturns have been both real and nominal events: real activity has fallen and prices have flirted with deflation.

But it is nominal activity that most closely links to income growth across the economy. Were a real recession to occur this time it is unlikely to be associated with deflationary trends and the impact on incomes is therefore likely to be much milder.

Even if population growth, conservative investor positioning and the income benefits of inflation aren’t sufficient, there is a more concrete backstop. Central banks have rebuilt policy room. There are 400 basis points between the RBA cash rate and zero. That’s plenty of firepower to deploy against unexpected economic weakness.

These contingencies are underappreciated, but I also expect them to be unnecessary. The key reason a deep recession is unlikely is the financial balance sheet vulnerabilities required for such an outcome are not as prevalent this cycle.

Robust health

The net asset position of the household sector has deteriorated over the past
18 months, but it is still higher than at any time before 2020. The household sector’s ability to pay debt out of current financial assets has noticeably improved through this hiking cycle, to the strongest in 25 years.

The corporate sector in aggregate is also in robust health, with corporate debt as a share of gross domestic product the lowest since 1998.

The quality of the banking sector is also stronger. In 2017, about 7 per cent of ANZ’s lending was in sectors that traditionally had the highest delinquency rates – personal loans, asset finance and credit cards. That has fallen to 3 per cent. The debt in the economy seems to be in stronger hands.

This means demand is likely to wilt in the face of monetary tightening, as we are seeing, before financial stresses escalate in a way that threaten a deep recession. High interest rates are financially stressing some businesses and households, but these challenges do not seem to be broad-based enough to imperil the entire economy.

This balance sheet situation is not limited to Australia. The mild economic response
in the US following the collapse of Silicon Valley Bank reflects similar fundamentals. While surveys suggest US banks have become more hesitant to lend, the impact on the US economy so far has been extremely mild.

While any recession is best avoided, and is likely to be, the reality is degrees matter.
It is a deep recession that causes the most damage and leaves the deepest scars.
Such an outcome is unlikely for Australia in 2023.

Richard Yetsenga is Chief Economist with ANZ

A version of this article appeared in The Australian Financial Review on 1 August 2023.