Cliff Notes: Stuck in the Moment

Key insights from the week that was.

Our latest Westpac-MI Consumer Sentiment Survey proves the tense backdrop of elevated inflation, restrictive interest rates and heightened economic and political uncertainty is weighing heavily on the consumer mood. The headline index fell 2.9% to 80.6 in May, leaving sentiment stuck near pandemic-era lows. Cost-of-living pressures are the chief concern: ‘family finances vs a year ago’ and ‘family finances next 12 months’ down 7.5% and 8.5% respectively, reversing April’s reprieve and leaving both measures circa 20% below historical averages. This tone is hardly surprising given inflation expectations are holding around 5½%yr, 3ppts above the RBA’s target range mid-point.

It is notable that RBA Governor Bullock has characterised the three rate hikes delivered earlier this year as necessary to deal with the domestic inflation risks present before the Middle East conflict began, and that this “gives space” for the RBA to see how the conflict plays out. Markets are increasingly adopting a sanguine view on the conflict despite a run of military strikes, seeing Brent oil generally trade between US$90 and US$95 per barrel over the past week, with the lower limit of that range tested overnight after President Trump announced a deal would be signed in coming days (more below). While the RBA is set to pause in June, input cost inflation and the threat of broad-based passthrough still makes the case for further rate hikes in August and September.

Over two-thirds of respondents to the consumer sentiment survey also expect a further increase in mortgage rates over the next year. The threat of an additional squeeze on households’ real incomes makes for a pessimistic assessment on the near-term economic outlook amongst consumers, a viewpoint shared by business. The latest NAB business survey showed that business confidence remained very weak in May, though a moderation in cost pressures lifted the collective mood slightly. Business conditions are reportedly stalling as profit margins are squeezed by higher costs. This is consistent with our view for GDP growth to hold below the pace of population growth through 2026. Our detailed forecasts will be published later today in our June Market Outlook on WestpacIQ.

In the US, May non-farm payrolls materially beat expectations, gaining 172k against a circa 90k expectation, with 93k in back revisions to March and April. These results left the 3-month average at 188k, three times April’s initial 48k. The unemployment rate and participation rate were unchanged, however, at 4.3% and 61.8%. Average hourly earnings were also benign at 0.3%, 3.4%yr. Headline US CPI inflation then printed in line with expectations at an elevated 0.5% in May, principally due to a 3.9%mth jump in energy prices. But core inflation has printed at 0.2% for four of the past six months (including May), and the monthly average is 0.25%, suggesting underlying inflation in the US is only modestly above the 2.0%yr medium-term target. While the market has been flirting with the idea of impending rate hikes by the FOMC, these data points instead suggest the best course is for the Committee to remain on hold.

An extended period of on-hold policy is also likely to be seen in Canada. Having left the policy rate unchanged in June, the Bank of Canada highlighted that the Middle East conflict and US trade policy are lingering risks for inflation, but Canadian GDP is weak, having disappointed in Q1 at -0.1%, and employment stalled on a multi-month basis. A recovery in growth in coming quarters is still expected to leave Canada with excess supply, allowing the initial impacts of the current energy shock to be looked through, unless evidence of secondary effects materialise.

In contrast, the ECB is now officially back in tightening mode. The Governing Council delivered an expected 25bp increase at their June meeting. In the press conference, President Lagarde indicated that policymakers had little doubt about the need to tighten policy, with the decision taken unanimously and no alternative options considered. The policy statement was explicit that this shift is a response to inflationary pressures stemming from the war in the Middle East, which, looking ahead, will depend on “the intensity and duration of the energy price shock, as well as the scale of its indirect and second-round effects”.

The ECB’s new economic projections illustrated the range of possible effects the war could have on the economy. The baseline projects GDP growth of 0.8%yr this year and 1.2%yr next year, 0.1ppts lower than the last update. The adverse and severe stress scenarios instead point to materially weaker growth in the near term, with the economy slipping into a technical recession in both cases. On inflation, the baseline outlook now sees inflation peaking at 3.4%yr, up from 3.1%yr previously, and remaining elevated for longer. The adverse and severe scenarios showed headline HICP inflation peaking at 4.1%yr and 6.3%yr respectively, little changed from the March projections. Looking ahead, President Lagarde’s comments confirm that inflationary momentum is broadening, suggesting a single 25bp hike is unlikely to be sufficient. So, we expect another hike, most likely in September when the ECB will next update its projections.

In closing, it is worth highlighting the state of the Middle East conflict. The past week has been eventful to say the least. Last weekend, Iran and Israel hit one another with several barrages of missiles. The US requested the hostilities cease, and both Iran and Israel acquiesced. But an Iranian drone then hit a US Apache helicopter patrolling the Strait of Hormuz, seeing the US retaliate with force against numerous Iranian military assets. Iran then responded, and the US followed up with further attacks. A reported request from Iran to cease the attack saw President Trump cease fire on Thursday only to again threaten to hit Iran “VERY HARD” on Friday and to take control of Iran’s oil production facilities. Within hours though, President Trump announced that an agreement had been reached and would be signed off in coming days, leading to a re-opening of the Strait. Brent crude currently trades around US$90, having initially broke through that level. Participants are clearly hopeful this update will prove accurate and herald at least a temporary end to the conflict.