What might the next financial year hold for Australian companies managing risk?

It has been a turbulent few years, and businesses have had to navigate a very difficult backdrop. Unfortunately, it is doubtful that the operating environment will become much easier over the next year, with some recent underlying issues still in place and other fresh interconnected challenges likely to emerge. 

In the common fight against inflation, global central banks have tightened policy aggressively by raising interest rates rapidly. Over the past year, the Reserve Bank of Australia has increased the cash rate by a cumulative 375bps. This is the most abrupt RBA rate hiking cycle since at least the 1980s. The moves here, and abroad, are designed to constrain activity across the private sector with the aim of getting demand and supply into better alignment and bringing down inflation over time. 

Will it work? Time will tell on the inflation front; however, a “known known” is that such aggressive actions will generate a meaningful drag on the economy. Given monetary policy changes work with ‘long and variable’ lags, the negative economic consequences are only just now beginning to manifest. Studies by the RBA show that interest rate changes take ~4-6 quarters to have their full impact. 

Broadly speaking, based on historical experiences and the magnitude and speed of the rate rises that have been put through around the world, odds of a global recession over the next year appear quite high, in our view. Domestically, we expect growth momentum to slow materially as 2023 unfolds and the cumulative impacts from tighter credit conditions gain traction, the cashflow hit on indebted households intensifies as the large pool of COVID-era fixed loans are refinanced at much higher rates, and the world economy decelerates. An extended period of below average economic growth and weaker demand looks to be on the cards. In time, the slowdown is anticipated to spill over into the jobs market, with more sluggish growth and concerns about the outlook reducing labour demand and pushing up unemployment. This itself can feed back negatively into spending and investment trends. 

Importantly, while the softer economic conditions are intended to cool price pressures, this can take some time to materialise. For businesses, this timing mismatch can prove to be problematic as it may crimp profitability and squeeze margins. For instance, at the time demand, and in turn revenue, is starting to drop off, costs are likely to still be quite high. The labour market is a lagging indicator. Current labour market conditions generally reflect the state of play in the economy ~6-months ago. Hence, past tightness in the labour market, even if it looks like things should change course down the track, may continue to feed through to a business’s wage costs for some time. And, this looks set to be compounded by ongoing elevated costs in other areas such as utilities and rent. 

In addition to the direct effects outlined, businesses are also likely to face other, more difficult to judge, second round influences. In the past, very fast global rate hike cycles have exposed excesses that have built up across the system, with flaws also uncovered by macro amplifiers such as rising unemployment and high debt levels. This time should be no different; however, pinpointing when and where they could show up is quite difficult. This suggests volatility across markets (interest rates, equities, and foreign exchange) may be more elevated than what many have grown used to in the years after the global financial crisis (GFC), making hedging and investment decisions equally as tricky to make.