Key takeaways:

• Australia economy faces a slowdown in the year ahead due to a number of headwinds

• Whether the country falls into a recession could be due to factors including but not limited to interest rate policy, the Australian dollar, and the looming mortgage cliff'

With a growing number of economists predicting the global economy may stutter into a recession this year, investors will be watching developments closely over the coming months.

On the one hand, inflation has shown signs of potentially peaking in the US. But at the same time, an aggressive commitment by central banks around the world to hike interest rates is expected to weigh on economic growth. 

Amid bleak predictions for corporate earnings, what does it all mean on home soil? Can Australia avoid a recession? Here are three factors that may determine if a recession takes place this year.

Interest Rate Policy

Although many analysts have the Reserve Bank of Australia hiking interest rates at least one more time, if not two or three more times in 2023, the central bank was effectively the first in the world to wind back the pace of its rate hike program.

This cautiousness reflects the bank awareness about the need to balance monetary tightening with local economic growth. However, if it does not do enough to lower inflation, there is a risk that it becomes entrenched in the economy. Inflation currently remains well above the RBA target range, but it is widely believed inflation peaked in the final quarter of 2022. 

Meanwhile, as foreign central banks continue to hike rates, and inflation seemingly responding to those hikes thus far, Australia could be a potential beneficiary. Given the interconnected nature of the global economy, slowing economic growth and moderating consumer prices abroad should indirectly put downward pressure on the local prices for some goods.

Elsewhere, wages growth in Australia has trended well below that in other countries where inflation has been stubbornly higher for a longer period of time. The extreme tightness of the labour market remains a key factor here, risking higher wages growth that can lead to inflation. Immigration has picked up momentum lately, and some observers believe this could resolve labour market tightness.

Whether the RBA decides to pause its rate hikes and assess their impact will go a long way towards the likelihood of a recession. If the RBA continues to hike, not only is it likely the odds of a recession increase, but there is a distinct possibility that monetary policy weighs on the ASX as it did last year. 

The Australian Dollar Response to Global Growth

If a global recession takes hold on the back of economic weakness out of the United States, or even China, commodity prices may face renewed pressure.

Last year ended with some of these factors coming into play, with energy prices dipping to their lowest levels since the war in Ukraine broke out. 

However, if another sharp fall in commodity prices eventuates, it could arrest the recent rally in the Australian dollar. This is because Australia economy is heavily connected to commodities, and China is a major trading partner. 

Nonetheless, while export earnings would be lower, a weaker Australian dollar would provide some upside for the Australian economy. In theory, commodity exports should become more affordable and competitive on a global level. This was a predominant factor that allowed Australia to largely avoid the worst of the Global Financial Crisis.

Should China economic growth pick up dramatically in 2023, and its demand for commodities provide underlying strength for international trade, this is another factor that could provide a benefit for global economic growth, including Australia.

Learn more about the warning signs of a recession.

The Looming Mortgage Cliff'

Historically, fixed-rate home loans represented around 15-20% of all mortgages across the nation. This figure is over 80% in the likes of the US, UK, and New Zealand.

During the pandemic, with interest rates at rock-bottom levels, the proportion of fixed-rate loans as a percentage of the entire mortgage market grew to around 35-40%. In monetary terms, this represents about $750 billion in loans.

The RBA estimates that around two-thirds of fixed-rate loans, or 23% of all mortgages, will roll over to variable-rate loans in the second half of 2023. 

However, with the official cash rate increasing three percentage points, and potentially even more by the end of the year, borrowers face an extraordinary test by way of higher mortgage repayments. These repayments could be up to 40% higher than the thresholds that lending institutions used to stress test' borrowers' ability to meet their financial obligations.

A number of economists have flagged the looming mortgage cliff' as posing major headwinds for the property market. However, it also raises substantial risks for spending across the Australian economy, with debt levels sitting at record highs, and the prospect of a surge in the number of borrowers struggling to meet repayments.

One favourable trend during the pandemic was that many borrowers managed to get ahead of their mortgage repayments, with anecdotal evidence pointing to strong household savings.

Final Thoughts

Other criteria like business investment, construction activity, and the Balance of Trade will all play a role in determining whether Australia avoids a recession. Arguably, the biggest risk may be the US falling into an official recession, where a slowdown in growth tends to spread across the world.

But as the RBA seeks to return inflation to its target range of 2-3%, interest rate policy, the Australian dollar, and the looming mortgage cliff' represent important challenges for the local economy that every investor should take into consideration.