The Australian economy finds itself in an interesting position, characterized by a mixture of softening activity indicators and a remarkably tight labour market.

This situation bears some resemblance to the economic conditions in the United States. However, unlike the US, Australia has not witnessed significant evidence of declining inflation pressures.

Recent concerns regarding wage growth have emerged following the minimum wage decision, leading to a belated hawkish stance from the Reserve Bank of Australia (RBA) and a substantial reassessment by the market of the peak cash rate. Consequently, fears have arisen regarding the potential for the RBA to push the economy towards a tipping point, as it tries to navigate a narrow path between increasing interest rates to fight inflation, without pushing Australia into recession.

The RBA gained significant attention as the first major central bank among developed economies to pause its rate hikes during the April meeting. This move was widely celebrated as a sign that other central banks might follow suit with a pause, to then be followed by rate cuts within months rather than years. However, those hopes diminished when they delivered another 25 basis point (bps) increase during the May meeting.

Against a market leaning towards another pause, the RBA raised the cash rate once again to 4.1% at the recent June meeting, pushing the rate to its highest point since April 2012, while hinting at further potential hikes.

The RBA appears to have become more impatient in waiting for inflation to slow and has de-emphasised the argument about the lagged impact of interest rate hikes, which was the argument used to keep the cash rate steady at the April meeting.

In response to the RBA’s new-found hawkishness, there has been a fairly dramatic repricing of the peak cash rate. In the futures market, the implied year-end rate rose to 4.65% from around 3.40% at the end of Q1 and 3.80% in the middle of May. However, the meeting minutes released last week struck a more dovish tone, revealing the bank considered the arguments for and against hiking were “finely balanced”, which saw expectations for the peak rate fall to 4.5%.

Admittedly, the macro data has been very erratic. But this has not been helped by official guidance, which has not been very consistent.

Consumer spending prospects, in the face of high inflation and sharply higher interest rates, would be even weaker were it not for the substantial savings buffer that households accumulated during the pandemic and the strong starting point for jobs. Both these supportive variables are likely to gradually wane over the course of the next 12 months but should cushion the extent of the consumer slowdown.

Recent surveys of consumers’ confidence from Westpac and ANZ suggest sentiment remains at or near levels usually seen during periods of economic downturns such the global financial crisis, when Australia dodged a “technical” recession. However, this sentiment has not fully translated into consumer behaviour and actual spending in aggregate. The challenge is that the impact of the rate rises has not hit the economy fully.

Goods spending is beginning to downshift from a very elevated level. In contrast, services spending slumped to depressed levels during the pandemic but has been recovering rapidly of late. So, against a broad trend of a softer consumer we expect the story of a goods spending recession to come sharply into focus in the near term. Services spending will likely take longer to slow, and the slowdown will likely be a lot less dramatic. May retail sales (due 29 June) will be closely watched, especially given listed companies are increasingly reporting that consumption 'fell off a cliff', particularly after the RBA hiked in June.

The current peak in fixed-rate home loan expiration suggests an imminent rise in mortgage stress on the horizon. Additionally, it is worth noting that a significant portion (~30%) of fixed-rate loans is still set to transition to much higher floating rates (increases generally from 2% to 5.5–6.0%) in the back half of the year, which will lead to a dampening effect on consumer cash flow, further impacting spending patterns.

With the RBA’s rate increases from May, June, and at least one more hike as currently priced also being passed on, the average mortgage rate over the next year will rise by at least 150 basis points.

Businesses are not as downbeat as consumers but business confidence has turned, according to the closely watched NAB business survey. The fall in business conditions now appears to be gathering momentum, and while they remain close to their long-run average, they are well below the levels we saw in early 2023. Forward orders – typically the best measure of economic activity - posted a sharp decline in the past month. If orders persist at these levels, we could well see ongoing sharp falls in business conditions, highlighting the risks around economic growth through the balance of this year.

The consumer exposed sectors appear to have pulled back the most. Forward orders in both retail and wholesale fell very sharply and are now the weakest of all industries. Historically, there have been very few periods of negative orders outside of downturns in the economy. The business sector may well hold the key in gauging the extent of the economic slowdown, with credit conditions and financial stability likely to be key swing factors in determining the extent of the downturn over and above a softening consumer. Whether a moderating trend continues will be confirmed on 11 July by the next monthly release of the NAB survey.

The Australian economy still has a degree of underlying resilience, as evidenced by ongoing labour market strength, strong migration flows and robust terms of trade position, so a recession is not our central case. However, risks of a policy misstep are rising and, by association, the rising risk of a significant slowdown, which was relatively low at the start of the year, is increasingly dragging on the Australian equity market.

The RBA's monetary policy decisions will be crucial in determining the path ahead, as they balance the need to address inflationary pressures while sustaining economic growth. The labour market remains tight, but inflation concerns persist. Consumer spending prospects face challenges, and business indicators point to a looming slowdown.

Although the case for believing the cash rate may have already peaked is weakening, the market expectation for a further 50bps of tightening feels overdone. We lean towards the view of limiting any further increase to 25bps, with the most likely timing being August, post the Q2 CPI release.

Australia’s sector mix and our belatedly hawkish central bank pose challenges for performance of Australian shares, at least in the near term. The focus on resilient earnings should intensify in coming months as growth slows.

Domestic fixed interest looks increasingly attractive as a portfolio diversifier. Yields have edged up above our fair value area (~3.5%) with 10-year yields at 4%. With official cash rates above 4% and looking likely to push higher, high quality floating rate credit also represents an attractive source of income with yields above 5% on offer.