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Key Points:
- It’s a challenging business environment, with interest rates and fuel prices at the highest levels for some years, the AI investment boom driving technology and construction spending, while businesses and households are still absorbing the very large cost increases of the past five years.
- We believe the RBA will likely increase interest rates at its Board meeting next week. The more interesting question is whether a quick follow-up rate rise might be delivered before Christmas. This is likely to be required if the Board hopes to moderate inflation by the second half of 2027.
- The data centre build out is likely to be enormous over the next few years. While this is great news for parts of construction, it will likely increase pressure on residential construction by contributing to higher interest rates and diverting labour to these projects.
The AI investment boom continues even as oil prices remain high and interest rates rise further
Australian businesses continue to face a complex and, in many cases, very challenging business environment. This reflects the combination of very significant cost escalation over the past five years, elevated fuel prices (especially diesel), and the highest interest rates in many years. The AI investment boom is also driving a surge in technology spending and data centre construction.
This combination is creating pressure on many businesses and increasingly divergent performance across sectors. Sectors benefiting include technology, parts of construction, parts of mining, defence, renewables and firms providing services to these areas of the economy.
Firms and sectors likely to be experiencing greater pressures include those with significant debt as interest rates continue to rise and roll over at much higher rates than were available during the pandemic, firms where transport costs are a significant component or energy is a significant input to the production process, interest-sensitive sectors, and sectors exposed to discretionary spending. Structural change also continues in retail as shopping continues to migrate online in certain segments, exposing businesses to greater global competition, while the broader impacts of AI are yet to emerge.
Data centre build out to assist parts of construction but add pressure to residential building
The outlook for construction in these circumstances is likely quite nuanced. Some of the figures being discussed in relation to the data centre build-out in Australia over just the next few years are enormous. The value of non-residential construction approvals has already doubled over the past year, largely due to data centre approvals, with a $32bn facility announced in the past month for the Central Downs district in Queensland.
This clearly provides opportunities for the large firms that can build these centres, as well as the many small firms that will sub-contract to these larger projects. At the same time, however, the scale of the spending is both adding to inflationary pressures and likely to draw labour resources away from other parts of the construction sector. Along with higher oil prices, the resulting increase in interest rates will contribute to a likely cyclical slowing in residential construction through 2027, while also keeping demand for many building materials strong. That is likely to create a very challenging environment for residential construction firms.
Interest rate outlook
In our last update, we warned that both the US and Australian central banks were likely to increase interest rates before the end of the year as inflation remained above target and the AI investment boom added to near-term inflationary pressures. That was not a consensus view at the time, with all major Australian bank economists expecting that the next move in Australian interest rates would be cuts in 2027! However, the view was correct, and the recent associated repricing of US and Australian short-end interest rate expectations has contributed to a marked sell-off in 5-year swap rates, which have risen around 40bps in both countries over the past month.
The RBA’s August Board meeting contained a number of red flags pointing to a possible near-term interest rate rise, most importantly the warning that inflation risks were skewed to the upside. Historically, when the RBA has warned of upside (or downside) risks it has frequently adjusted policy within three months. In recent weeks, senior members of the Bank’s staff have warned that “some of these upside risks are materialising” with Deputy Governor Hauser also quite forcefully stating “that people are furious about inflation”.
The repeated warnings about a further deterioration in inflation in an economy still assessed to have some capacity constraints and a labour market that is still a little tight strongly suggest the Board may increase interest rates at its September Board Meeting next week. This is around 90% priced by the market. The bigger question seems to be the likelihood of either a larger increase at that meeting (not high) or a relatively quick follow-up increase at either the November or December Board meetings (much higher). Either is likely to be necessary to alter the trajectory of inflation such that price rises moderate toward 2.5% by the second half of 2027.
Ordinarily, I would interpret the much greater focus on lowering inflation evident in recent comments as a sign of not one, but two likely interest rate rises in coming months. I think that’s likely, though I also wonder if the RBA is simply making the case for the September tightening. Either way, in both the US and Australia, my base case remains the emergence of a long, slow tightening cycle, characteristic of many investment booms, with no early interest rate cuts on the horizon in either country. Australia’s economy, however, would not be well placed to handle more than two interest rate rises in the next six months.
What it means for your business
The combination of pressures and shocks hitting the economy at the present time is producing a very divergent outlook across sectors, providing opportunities for some businesses but increasing the challenges for many others.
In my opinion, businesses should allow for two further increases in interest rates in the next three months (the first to be delivered next week) as cost increases and price rises continue to run too quickly relative to the RBA’s inflation target. The RBA needs to constrain economic growth and loosen the labour market a little to sustainably deliver a lower rate of inflation.
Together with strong demand from AI data centre construction this is likely to create additional pressure on the residential construction industry and discretionary spending. Technology spending and associated construction, defence, renewables, parts of mining, and services to these areas of the economy remain the bright spots.
