Australia’s homegrown problems seen in margin spiral

Turning our attention to Australia today, it's frustrating but not surprising to see the Australian economy still in contraction with persistent cost and inflation pressures.

The rate of decline in the manufacturing and construction indexes (PMI and PCI) as well as industrial and sales activity all eased in June, but all remain in contraction and in pronounced downtrends.

Leading indicators like new orders are sick, and the RBA’s monetary policy still hasn’t had its intended effect on reducing prices, so it’s likely things will get worse before they get better. But hey, that’s why it’s called a business cycle.

Here’s a chart that sums it up nicely, shown in both macro and micro views. It comes from the AI Group and illustrates a big squeeze in industrial sector margins caused by higher input costs, higher average wages (yup, you heard right), and lower sales prices.

To understand it better, imagine the blue lines (sales prices/trend) above the other lines (input prices and average wages and trends), and what you'll get is a narrowing of the gap, representing the big squeeze on industrial margins.

Trend indicates more pain before gain

The trends say a lot and are consistent with declining Chinese industrial activity:

• Sales prices have been declining since May 2022, when interest rate hikes began, and the downtrend remains pronounced. It looks like we’re heading back to COVID levels.

• Input prices remain sustainably high and not yet improving, since January 2023.

• Wages have been coming back up since COVID and have been in a sideways channel ever since, although pointing up to the right as population ages and capacity utilisation continues to fall.

Sure, interest rate hikes have destroyed some demand (as intended) but unfortunately, wage and non-tradeable costs (i.e., items predominantly influenced by domestic factors/policies) remain far too high.

Why? Our economic cost base is too rich. Why? Too much government intervention and barriers to productivity, lack of low-cost reliable energy platforms, and a lack of technology development incentivisation for far too long. We have a massive opportunity to value add our natural resources by adopting nuclear robots to alleviate the pressures caused by ageing population and creative destruction, but we’re not there yet.

On top of that, we are behind most of the rest of the world in terms of cost right-sizing.

Here’s a close-up showing lower sale prices + higher input prices = margin squeeze.

Again, to see the squeeze, imagine the blue lines on top of the others.

And let’s be clear - industrial sales prices HAVE collapsed.

What now?

Margin compression usually happens towards the end of the cycle, and typically leads to lower corporate earnings, job layoffs, rising unemployment and in time, interest rate cuts from the relevant central bank, and hey presto - the new business cycle starts!

The critical questions now are:

• Is this the last chance for the RBA to deliver on its stable currency mandate with more rate hikes, even though that would risk more non-inclusive wealth effect for savers (savers/seniors are out to dinner every weekend because they’re getting 5% with Macquarie and 6% in fixed income), hurt the mortgage belt, and potentially stoke CPI?

• On the other hand, will the RBA buckle under political pressure and deliver premature rate cuts in the hope of avoiding an ‘F’ on each of its full employment and economic prosperity mandates, and risk exacerbating inflation?

Summary

Industrial sales prices are falling in Australia, while average wages and input costs are rising, leading to a margin squeeze spiral that needs to be addressed.

Inflation is embedded in the Australian domestic economy, with pressures likely to remain regardless of whether the RBA’s next move is a hike, pause, or cut. This is because almost all inflation is driven by items influenced by domestic factors (non-tradables) under highly interventionist governments, making it sticky. Meanwhile, other economies are at or near their preferred inflation target ranges.

The RBA faces critical decisions before its next meeting. Will they hike rates to get inflation back to target quicker but risk stimulating saver wealth effects, pause again to make a future cut more impactful/needed, or opt for a cut to support economic growth?

Let’s see what happens.

Until then, see you in the market.

Mike