Inflation and the Nation: A Global Recession’s Potential Effects on the Australian Economy

The OECD has warned of a pervasive global economic slowdown. The IMF has punctuated its latest World Economic Outlook with inflation and uncertainty. So firstly, how did the world get here? And secondly, what does it mean for Australian businesses and conditions?

To answer the first question, lingering unfavourable trading conditions stemming from the COVID-19 pandemic, compounded by geopolitical instability abroad, have contributed to inflationary pressures and a global cost-of-living crisis.

These conditions and responsive policy measures have weighed on global economic projections, leading the World Bank to suggest that ‘the world may be edging toward a global recession in 2023’.

The second question requires further examination.

Australia’s circumstances and likely response

Australia’s economic track record during previous global recessions bodes well for the country’s economy. Unlike many other developed countries, Australia did not experience large economic downturns during the global financial crisis (GFC) in 2008. Instead, Australia benefited from its significant resource trade with China, as the Chinese economy recovered relatively quickly from the GFC’s initial effects. Moreover, strong policy responses, including lowered interest rates and expansive stimulus packages, supported businesses and growth. Australia’s policy responses to the economic effects of the COVID-19 pandemic included similar measures.

However, it’s unlikely that strategies from previous periods of economic turmoil will remedy the current economic situation in Australia, as this time the cause is significant inflationary pressures. Therefore, the Government may consider differing policy responses, such as rate rises and limited public sector expenditure.

Australia remains better placed than other countries to weather a potential global recession. While the economic fallout from the Russia-Ukraine conflict is likely to affect Australia, it is anticipated to cause spikes in energy and commodity prices that may benefit many domestic operators. In addition, Australian economic pressures are relatively muted compared with other countries. The RBA has space to slow the pace of rate hikes, improving its prospects of containing inflation as it has the scope to raise rates at a feasible speed.

Repercussions for industries, businesses and individuals

A potential global recession is likely to reverberate through the Australian economy with varying effects for many businesses and individuals. Subdued demand across the board is likely to place downward pressure on total business profit. Fluctuating and uncertain trading conditions are likely to encourage operational changes for many businesses, including:

• Adjusting profit margin expectations.
• Limiting exposure to foreign markets and reliance on imports.
• Implementing decentralised decision-making to adapt to rapidly changing environments.
• Engaging in debt minimisation tactics.
• Tightening spending on non-essential business items.
• Strengthening relations with their core client base.
• Procuring the services of financial planning and investment advice firms, as well as market research and statistical services professionals.

Regardless of the pace of rises, heightened interest rates are likely to have significant ramifications for businesses across Australia, due to increased borrowing costs and corresponding downward pressure on business confidence. Businesses that can maintain the flexibility to absorb price increases are likely to remain competitive in the market.

Firms in the finance and real estate services sectors are acutely exposed to movements in interest rates. Due to heightened interest rates, growth in both residential housing prices and the All Ordinaries index is forecast to be sluggish over the next year, likely weighing on the profitability and performance of these firms.

Inflationary pressures are likely to continue increasing expenditure on necessary household items, such as food and transport, eroding income available for discretionary spending and dampening real household discretionary incomes for Australian consumers. Complementary price and wage increases run the risk of initiating a wage-price spiral, which would exacerbate inflationary pressures. A potentially cooling Australian economy would likely dictate unemployment and underemployment rates as business and public sector expansion slows.

The cash rate drives standard variable home loan interest rates as it determines funding costs for banks. Macroprudential policies, which are designed to limit inflationary pressures, are likely to flow through to individuals in the form of higher residential housing loan rates. This rise leads to increasing downward pressure on mortgage affordability for many Australians. Moreover, rising interest rates are anticipated to raise the value of current debt repayments and drive the household debt to assets ratio in the current year. Elevated debt repayments may result in more mortgage defaults nationally.

International trade and foreign investment

Continued solid demand for many Australian commodities is projected to support the strength of the Australian dollar. The Australian dollar may also benefit from the RBA’s ability to decouple from the United States Federal Reserve’s fiscal policy at its discretion.

Moreover, some of Australia’s leading importing partners are currently experiencing economic headwinds, strengthening the Australian dollar in contrast. For example, Australia’s largest importing partner, China, is currently grappling with sluggish economic growth tied to stringent lockdown measures and slowed real estate investment and construction activity. Domestic operators may choose to purchase higher volumes of goods from countries such as China to enhance their margins before markets stabilise.

Import-reliant industries, such as motor vehicle wholesaling, pharmaceutical retailing and water freight transport, are likely to benefit from a strong Australian dollar due to the relative affordability of foreign goods.

 China is a key export destination for many Australian industries and a projected slowdown in the country’s economic growth is anticipated to limit demand for a range of Australian goods. Firms that are typically supported by exports to China can benefit from diversification of their trading partners and re-evaluation of their business models.

Subdued global economic activity and the strong Australian dollar are likely to constrain trade volumes for export-reliant industries. Firms that minimise the threat of substitutes in the market and ensure that their products remain high quality can infer that if the price becomes less favourable their export volumes are less likely to decrease substantially.

Projected spikes in commodity prices have the potential to offset the effect of subdued trade volumes on turnover for commodity-based operators. Prices for commodities typically benefit due to their use as hedges against inflation. Therefore, commodity price increases tend to favour firms in export-heavy industries, such as iron ore mining, coal mining, grain growing, and beef cattle farming.

Foreign direct investment (FDI) in Australia is likely to contract in response to a global recession caused by a prolonged period of rising inflation. Based on statistics published by the ABS, the mining, real estate, finance and manufacturing sectors all contribute more than 10% of the total amount of FDI in Australia.

A global recession may impact the mining sector less due to commodity prices. In contrast, the real estate, finance and manufacturing sectors could be significantly impacted. For example, lower FDI flows may result in less developments, particularly in the Multi-Unit Apartment and Townhouse Construction industry. The value of certain securities may fall in response to deteriorated investment conditions, reducing assets for firms in a range of finance industries. Manufacturing may also be taken off shore to countries with better financial conditions to ensure that the ROI remains beneficial for investors.

Long term effects

A global recession has the potential to cause permanent shifts in international trading priorities and sources of foreign investment. The length and severity of a potential global recession is ultimately down to the effectiveness of appropriate macroprudential policies designed to ensure the stability of the world’s financial systems.

The RBA has indicated its willingness to continue raising the cash rate until inflation rates stabilise. However, it has also indicated its willingness to reach its inflation target range over time so as not to cause undue economic harm. If mismanaged, the long-term consequences of consistent inflation could include eroded purchasing power for many Australians and prolonged periods of subdued consumer sentiment.

Globally, many economies are likely to consider heavier investment in renewable energies, as opposed to reliance on imported fossil fuels. This strategy allows them to futureproof their energy infrastructure against supply chain disruptions, such as those caused by the COVID-19 pandemic and the Russia-Ukraine conflict, and safeguard against inflationary pressures tied to cost-of-living pressures.

Australian operators that can fund investment in new developments while ensuring supply is unaffected are likely to benefit the most from trends in renewables. Grant availability and imports of easily implementable technology are likely to support an expansion of Australia's renewable energy industries moving forward, including:

• Hydro-Electricity Generation.
• Wind and Other Electricity Generation.
• Solar Electricity Generation.

Domestic firms that can adapt their business models and tactics in response to a potential global recession are likely to reap the benefits as conditions eventually stabilise and they get opportunities to expand their market share.