Handling the headwinds

Part 2: Economic outlook

After a rapid rebound, directors have to deal with a tricky local and global economy. Rapidly growing expense lines and interest rate rises will challenge financial sustainability and growth.

The Australian economy grew 0.8 per cent in the March quarter and 3.3 per cent in the 12 months to March, according to the latest National Accounts data from the ABS. However, Pradeep Philip, lead partner at Deloitte Access Economics, notes that growth is being propped up by inventories, consumption and government spending.

“The Australian economy faces headwinds because inflation and interest rates are still rising,” he says. “Supply chains remain broken, the energy shock of the Russian invasion of Ukraine is still reverberating and geopolitical tensions are still rising. That bounce-back of the economy from COVID-19 does not equal recovery, because the world is dynamic and it’s moved on. There is a fragility that we observe in the economy.”

Low productivity and the lack of economic reform to regulations, competition and tax were problems for the economy before the pandemic, and remain problems as we emerge. Australia’s improvement in living standards since federation is largely explained by productivity growth, the Productivity Commission notes, but adds that compared with other developed economies, Australian productivity growth has slowed in recent decades and is now “middling”.

Recent data from the Productivity Commission (Productivity Insights 2021) reveals that multifactor productivity — the overall efficiency with which labour and capital inputs are used together in the production process — fell for the first time in nearly a decade (0.68 per cent). Labour productivity increased 0.5 per cent across the economy and 0.56 per cent in the market sector. The commission is currently holding an inquiry on issues and reforms that would be most likely to enhance productivity growth. In its call for submissions earlier this year, it wrote, “Lifting productivity growth rates is the only sustainable way to ensure Australians experience income growth similar to that of the past few decades.”

Investment, skills and innovation are the three key ingredients needed to improve productivity, warns Philip, and increased business investment needs to be accompanied by government infrastructure investment — such as in the energy grid to facilitate the shift to renewable energy. “If we can lift the investment effort in the economy, then we will start to have a positive impact on productivity,” he says.

Skills also need a lift, so they can drive changes such as the decarbonisation of the economy and not be a laggard. Finally, the innovation effort in the economy needs to lift. “We see globally, in every market, disruption taking place, and the only way you stay true to customers and consumers is by ensuring you are at the knowledge frontier,” says Philip, who believes Australia’s ability to innovate and adopt new technology is nowhere near as good as it should be.

While the economy is doing well and is expected to continue to do well, it could be knocked off course by external shocks from the Chinese, European or US economies over the next six to 12 months. China is still battling COVID-19 outbreaks, Europe is suffering from an energy shock, and the US is contending with structural issues in its economy as it unwinds fiscal and monetary stimulus.

“We need to watch very carefully what the fiscal and the monetary authorities do [in the US] because we want to make sure that they don’t go too far,” says Philip. “That is always the risk for us.”

Fiscal policy

On the inflation outlook, Philip says the economy is finely balanced and the Reserve Bank of Australia (RBA) and government need to work in sync. While monetary policy is being used to keep inflation at bay, fiscal policy needs to “do its bit” to drive the underlying structural changes in the economy. The government needs to ensure it doesn’t overstimulate the economy and targets spending on driving productivity.

Inflation hit 5.1 per cent in the March quarter and is currently being driven by broken supply chains and surging energy prices — not by rampant demand. The RBA started raising interest rates for the first time since 2010 this year, with a 25 basis point hike in May followed by a 50bp point hike in June, when it said inflation has “increased significantly”. On 5 July, the central bank again increased the cash rate target by 50bp, taking it up to 1.35 per cent, its highest level since May 2019. More interest rate rises will undoubtedly follow.

There is also more fiscal stimulus to come. The new federal government has yet to hand down a budget, but Prime Minister Anthony Albanese has said it will go ahead with tax cuts legislated by the previous government, despite concerns they could further stoke inflation. The tax cuts, legislated to begin on 1 July 2024, will cost an estimated $137b through to the end of the decade.

Additionally, with unemployment at 50-year lows, wage pressures are starting to emerge. Once again, the key is productivity. “If wages reflect productive effort, then the cost side of the equation is looked after,” says Philip. “If we don’t look after wages, you get the situation where people can’t afford to make ends meet, and that means demand will be suboptimal in the economy and there are other social and economic consequences that flow from a distribution problem.”

The government needs a concerted effort around its skilled migration program to ensure the system is efficient and effective. Many businesses could operate at higher levels of output if they had the right skills and the right people.

For directors, Philip says the current economic outlook requires them to keep an eye on the medium and long term, and to consider the investments they need to make for that time frame. An understanding of how the market they operate in is shifting is also important — but is it shifting structurally or just cyclically? Directors also need to consider their costs, not just incrementally, but can they use technology to change the cost structure over the medium and long term?

“This is the time to be thinking about all of these things,” says Philip. “And if you put them together with an investment framework, then things will make sense for directors because they’re then exercising their duties about being strategic for the companies they work with.”