Back on track

Last month, I wrote about the Cyprus situation and suggested that it could turn out to be a one-month wonder. So far, that assessment has held up. But other international risks emerged during the month.

China reported disappointing GDP growth in the first quarter of the year. That economy grew by “only” 7.7% in the past year, and at an annualised rate of 6.6% in Q1. The most interesting point about the latter figure is that it is not usually published analysts usually have to back out an estimate of the current quarterly growth rate from the published annual data. 7.7% growth is hardly shabby, but it compares with a consensus forecast of 8.2% for 2013, a figure that now seems unlikely to be attained. The official view, on the other hand, has been that the economy would achieve about 7.5% growth, so this month’s news should perhaps not have been too surprising.

It’s not just China that reported slower growth. A number of indicators in the United States (March employment and retail sales for example) suggest some slowing there. Plus we know that sequestration (mandatory cuts in government spending) is already having an effect, which will intensify in the coming months. Government spending was a drag on the economy even before sequestration. In the past six months, it has declined at its fastest pace since the end of the Korean War in the mid-1950s, while since the economic recovery began in mid-2009, public-sector austerity has sliced about 1 percentage point per year from overall economic growth. The US reported growth at an annual rate of 2.5% in Q1 this is likely to slow to 2% or less in Q2.

What’s significant about this is that we’ve been here before. Indeed, in each of the past three years, the US economy has experienced something of a springtime swoon in growth. Like Pavlov’s dogs, economists and analysts are primed to expect it to happen again.

And where the economy goes, the share market tends to follow. For many years, there has been in mantra in the market: “sell in May and go away”. This refers to the statistical regularity that, on average over a long period of time, share markets around the world have tended to do worse in the six months beginning in May than they do in the other six months of the year. Note the words “on average” there is nothing inevitable about this.

Take one long-run average and overlay apparent cyclical weakness and what happens? The US share market has had a “local peak” in each of the past three Aprils, and has then fallen by an average of more than 10% in the next two months, as the following table shows. Furthermore, it has taken an average of almost seven months before the market has regained its April peak, although this period has been (artificially?) lengthened by the 2011 experience, when the market began to recover but then fell hard again in the second half of the year because of concerns about Europe.

This doesn’t have to happen again this year, and my belief is that it won’t, but the fact that it has happened in each of the past three years means that the level of uncertainty about the near-term direction of the market will remain high for some time. In particular, the flow of US economic data will remain under close scrutiny for any signs of slowing. Any subsequent weakness in the US market is likely to be translated to the Australian market, which is no longer fundamentally cheap. Message: expect significantly slower gains in the months ahead. I maintain my forecast for the ASX200 index of 5300 at the end of the calendar year, although the risk now appears to be to the upside.

The outlook for monetary policy has changed in Australia. In my view, the Reserve Bank is now likely to cut the cash rate again in either May or June. In the past month, we learned that the employment gain in February was indeed overstated (this should have surprised no-one). The March data show just a 0.9% increase in employment in the past year. More importantly, the unemployment rate now stands at 5.6%, up from 5.4% in February and 5% in April 2012. In addition, the March quarter CPI release showed that inflation continues to be remarkably low.

In the light of the upcoming election, the Budget, due on 14 May, should take on less importance than usual, but then how would we sell newspapers that week?

The case for the RBA to cut in May is that such a move follows news about inflation and can immediately be justified in the Bank’s quarterly Statement on Monetary Policy. The latter is likely to show lower growth and inflation forecasts than previously, thus making it difficult to justify inaction. On the other hand, the Bank may choose to wait for the details of the Budget, and also for more news about capital spending plans, in both the mining industry and elsewhere. This information will be published on 30 May.

Chris Caton
Chief Economist