PORTFOLIO POINT: A resurgent private sector is driving the US recovery, while public spending remains weak. Given the political situation in Australia, we may see a similar trend develop here.
When the Dow index of US shares rose above 13,000 this week – and stayed there – it was a clear signal that fundamental changes have taken place in the United States.
With the help of veteran US economist Al Wojnilower, allow me to plot what I think is taking place in the land of the stars and stripes.
In Australia, we are familiar with two-speed economies and we are seeing very different economic outcomes from mining and non-mining areas.
In the US, they also have a two-speed economy – the private sector and the government sector. Spurred on by tax cuts and expansionary monetary policy, private sector demand is embarking on a textbook cyclical upswing.
Consumers are buying more new vehicles and electronic devices, and their incomes are growing. At the same time, credit is easier to obtain. Housing starts are creeping higher, rather than falling rapidly. Business is better, so capital spending continues to expand.
It would seem that some capital goods industries are producing at full capacity. Private employment is growing and joblessness is shrinking.
But this improved economic climate is not shared by those parts of the economy whose revenues come mainly from governments, rather than the private sector.
Federal outlays on goods and services – both military and civilian – are shrinking, as are state and local government expenditures. The current US growth rate of around 3% in real GDP might theoretically double if the sectors highly reliant on government customers were eliminated. It’s also important to understand that American companies have spent the past four years reducing their cost structures, so their profitability will rise.
Most international portfolios have a strong bias towards the US. Given the high Australian dollar, plus the stronger US economy, it makes a lot of sense to have an international component in your portfolio with such a bias.
What we are seeing is strength from a part of the world where we have come to expect weakness. One of the dangers for the US is that parts of its banking system may get embroiled in the European morass. In very simple terms, Europe is a duplication of the US sub-prime crisis, where the banking system poured good money into a series of worthless securities.
Over time, those worthless securities will have to be written down and this will cause great damage to the European banking system. But for the most part, the world has anticipated a good portion of this event, and if the European collapse can be confined to Greece, Portugal and perhaps Ireland, the US should be able to manage the fallout (although there will be great pain in Europe). If the problems in those countries spread to the substantial downgrading of Italy and Spain, then a more serious situation will take place.
Of course, for Australia, China is the most important country determining the fortunes of our mining industry. China’s trade will be affected by Europe and it is possible that in the coming presidential election campaign, there may be some anti-Chinese moves out of the US.
But overall, the likelihood of a major collapse in China appears to be diminishing. The country has lowered its growth rate to around 7.5%; it will keep a close eye on the property market to make sure it does not return to bubble conditions and, at the same time, it is trying to boost consumer demand and be a country less reliant on export revenue.
These changes will take time and we might have a few nervous periods, but the situation looks a lot better than it did towards the end of 2011. It’s hard to see commodity prices in this environment returning to boom demand, although we are constantly surprised at how long it takes to bring on new supply. Nevertheless, when the major projects being constructed do come on-stream, we will see softness.
It is always possible that the Middle East could blow up, due to the Iran situation becoming a great deal worse. At the moment, speculators are having a ball pushing oil prices higher, and so if there is a period of stability, we might see a fall in petrol prices in the next six to 12 months.
In summary, we have a US economy that is holding well and its robust private sector is leading the way. Europe at best will muddle through and China, at least to this point, looks solid. This is not an environment for a boom, but it is an environment where share prices are unlikely to fall out of bed.
Finally, a word about Australia in this context: we have a government dedicated to balancing the budget and an opposition with a similar dedication. State governments are cutting back their deficits. It seems likely that the task of balancing the budget is going to be much tougher than Treasurer Wayne Swan has believed. So there is a possibility that in Australia, we will duplicate the US pattern and see a restrained public sector but a much stronger private sector led, of course, by the mining industry.