Economics Report - November 2011

October finally brought some relief for investors. The Australian share market rose for the first time in seven months, by more than 7%, the strongest monthly gain since July 2009. This, however, only reversed the damage done in September. The US share market, measured by the S&P 500 index, rose by 10.8%, its best month in close to 20 years.

It’s clear why things improved. The two big worries overshadowing markets no longer appear to be as dire as they did a month ago. The US economy is clearly not in the throes of returning to recession, although the pessimists still see a big chance of that happening sometime in the future.

More importantly, the latest plan to stabilise Greece’s debt and to protect the European banking system was greeted with some relief. It doesn’t look to me to be a panacea, and the “plan” is something like the fourteenth unleashed in the past twenty months. So we shouldn’t be too optimistic, but, as I argued a month ago (and several times prior to that), nor should we be too pessimistic.

The plan is aimed at reducing Greece’s debt to GDP ratio from the current 160% to 120% by 2020. In fact, it achieves this long before that date, simply because private-sector debt-holders have “volunteered” to take a “haircut” of 50%. That is to say, the value of their outstanding debt is effectively halved immediately. A “voluntary” haircut has a big advantage over an official default, in which the Greek government would simply announce that it was not going to repay its bonds at face value. Such an action would constitute a “credit event”, which would trigger credit default swaps (essentially insurance that debt-holders had taken out against such an eventuality) and you don’t want to know where that path could lead!

Other measures include a plan to recapitalise the banks, with funding supplied, if necessary, by an expanded European Financial Stability Facility (EFSF).

There are so many questions still to be answered. In particular, what is to dissuade Ireland or Portugal from putting their hands up for such a debt-reduction strategy? And is there any risk in Italy or Spain? My answer to the latter question would be “no”. Neither Italy nor Spain appears to have a debt issue. Italy perennially runs a high debt/GDP ratio, but it has not worsened seriously in the past 15 years, and Spain’s ratio is extremely low. The problem is, however, that if financial markets decide you have a problem then you do, and Italy’s long bonds have been sold off heavily in recent days. It’s hard to see the EFSF being anywhere near big enough to withstand a concerted sell-off of government bonds by speculators. What would have been better is an open-ended commitment from the European Central Bank, an organisation with effectively unlimited firepower, to purchase government bonds.

In a nutshell, the European situation isn’t over it just isn’t as gloomy as it appeared a month ago.

Back in Oz

Meanwhile, on the home front, the planes are back in the air where they belong. I seem to be the only person I know who isn’t an expert on the rights and wrongs of that situation, so I will refrain from comment.

The data flow relating to the Australian economy appears to have held up reasonably well in the past month retail sales and building approvals rose, while the jobs market appears to be going sideways. House prices continue to subside. Inflation, as measured by the September quarter CPI, is low, which gave the RBA carte blanche for its Melbourne Cup Day rate cut. While one could argue that rate changes are like cockroaches, in that there is rarely just one of them, there is little reason to expect a prolonged series of cuts. Certain sectors of the economy (tourism and manufacturing most notably) are struggling, but overall growth is reasonable and the unemployment rate remains low. The RBA has said that it is prepared to ease further in order to support domestic activity should this be necessary, but interest rates are a blunt instrument.

Incidentally, the RBA must be tearing its hair out about the recent fluctuations in Australia’s inflation data. Having (very unusually) revised down its estimate of underlying inflation for the June quarter a month ago, the ABS undid almost all of that revision last week. I’m sure there were sound technical reasons, but this simply shouldn’t have been allowed to happen.

Two of the big four banks acted immediately, passing the cut in the cash rate through to the variable mortgage rate in full. This should not have surprised anyone. The other two will presumably follow within hours.

And then there’s the exchange rate. Long-time readers will know that I have been a firm believer that one day the $A has to fall. So when it did fall from $1.07 to 94 cents in little more than three weeks in September, I began to think that I was indeed a genius. And here it is back above $1.03! We are caught up in worldwide swings of “risk on, risk off” but I continue to think that gravity will eventually drag the currency down.

Chris Caton
Chief Economist

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