Will Australia plunge into a recession?

With inflation raging and central banks playing catch-up with interest rate hikes, there's just one question on everyone's lips.

Is a recession coming?

The Reserve Bank of Australia (RBA) raised its cash rate by 75 basis points over the past few weeks and is expected to continue pushing it up until at least spring.

The worry is that by hiking rates so fast to stamp out inflation, the RBA might slow the economy so much that it actually goes backwards.

The traditional definition of a recession is when the gross domestic product contracts for two consecutive quarters.

And a recession would be pretty lousy for ASX shares. Demand for goods and services from listed companies would plummet, causing earnings to decline.

So will it happen?

AMP Ltd (ASX: AMP) economist Diana Mousina took a stab at answering this.

Signs are bad for a US recession

In the long run, inflation is poison to economic growth, which is why central banks are so keen to stamp it out.

But in the short term, the rate rises will slow down activity.

Mousina's team has revised its global growth expectations downwards multiple times this year.

"We expect global growth of around 3% in 2022 (in purchasing power parity terms) and just under 3% in 2023," she said on the AMP blog.

"This is a big downgrade to expectations, given that global growth was expected to be over 4% at the start of the year."

The typical indicators for a recession seem to be flashing red for the US.

The government bond yield curve has inverted over there and US stocks are in a bear market after crashing 24% since the early-year highs.

"Usually bear markets — when shares fall by 20% and keep falling — tend to be accompanied by recessions," said Mousina.

"The odds of a recession are larger in 2023 than in 2022 because central banks will need to take interest rates higher (and potentially too high) to get on top of elevated inflation which could cause the downturn."

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What about in Australia though?

"The 75 basis points worth of interest rate hikes so far have already started to dampen economic activity, with further declines in home prices, a fall in consumer sentiment and some slowing in weekly consumer credit card spending," said Mousina.

"The high inflation environment — especially on essentials like electricity, gas, petrol and food — is also adding to weakness in consumer spending."

In light of more interest rate rises over the next six months, the AMP team has further downgraded Australia's growth forecast.

"We now expect GDP growth to rise by ~2.7% over the year to December 2022 (well down from ~4% expected early this year) and 2.5% year on year to December 2023," said Mousina.

"We see the unemployment rate rising back over 4% in late 2023, after bottoming at 3.5% later this year."

However, the good news is that Mousina sees enough positives for Australia to stay out of recession territory.

"Consumers have a buffer of accumulated savings from the last 2.5 years of fiscal and monetary stimulus and low spending on services (worth $250bn)," she said.

"The pipeline of residential construction work still to be done is ~40% above pre-COVID levels which will add to economic growth, the business investment outlook is the best that it's been at for years with mining investment set to rise by +16% in 2023 and non-mining by +17%."

Mousina also noted both federal and state governments are implementing "growth-friendly policies" such as infrastructure and childcare spending. 

"And the outlook for exports — especially for commodities — is solid given the current commodity supply issues."

ASX shares are yet to fall into a bear market, according to Mousina, losing just 15% since their early-year peak.

She warns more pain could come for investors in the coming few months. But, once inflation is under control, ASX shares will be the place to be.

"We remain more optimistic on Australian shares versus US or Europe because of the higher exposure to commodities in our sharemarket, which remain in an uptrend, and less tech shares, which tend to perform worse as interest rates/bond yields rise."