Ring out the old

Few investors will be sad to see the end of 2011. It was a very difficult year, which promised quite a bit early on and then disappointed badly. The Australian share market, as measured by the ASX200, fell by 14.5%. This was its second consecutive yearly fall, and the third in four years. The last time that the share market fell for two years in a row was 1981-82.

The market rose in the first three months, by a grand total of less than 2%, but it then fell in eight of next nine months, and ended about where it was for the first time some seven years ago. No wonder so many are disillusioned with “growth assets”, which seem only to shrink! The US share market did better, with the S&P500 index flat for the year and the Dow up by 5.5%. The US share market thus managed (just) to hang on to one enviable record in the post-war period it has never fallen in the third year of a presidential term.

Of course, investors should have done a little better than these numbers suggest because they also benefit from dividend payments. My Australian share fund money was down by 7.6% (through to 28 December) and my balanced fund was up by about 0.5%.

In the last Caton’s Corner that I wrote before the start of 2011, I highlighted the issues that were weighing on markets, and hence causing them to be fundamentally cheap. These issues were eurozone debt, the chance of a serious slowdown in China and the possibility of a double-dip recession in the United States. These concerns never went away all year, although I continue to think that the US economy is doing a lot better than it gets credit for. I got tired of writing about these issues, so I imagine it was very boring to have to read about them every month.

It was not just these ever-present concerns that weighed on markets in 2011. It was also a year of more “shocks” than usual. Early in the year, in part because of the “Arab spring”, oil prices rose sharply. Then there was the spate of natural disasters, with the Japanese earthquake/tsunami and the Thailand floods having the most widespread economic ramifications via their effects on global supply chains. Finally, US politicians inflicted on that country the debt-ceiling fiasco, which led to the downgrade of US government debt.

What, then, of 2012? It’s clear that the eurozone debt issue will hang around for a long time, but in my view it is unlikely to become the catastrophe that many fear. There is no question that Europe will experience a (mild) recession, with the peripheral economies more severely affected, and that the effects of this will be transmitted elsewhere. Nevertheless, the global economy is likely to experience another year of (tepid) growth. It’s not just Europe that will contribute to this lukewarm outlook the United States, for example, will almost inevitably tighten fiscal policy substantially in 2012. Despite the negative effects on growth is the short term, this has to be done because of long-run budgetary concerns.

When I made the point in late-2010 that the Australian share market was fundamentally cheap, I meant that the price/earnings ratio was significantly below its long-run average. The continued poor performance in 2011 of the market was not because Australian companies did badly, but because the market has been further de-rated. That is, the already low P/E ratio fell even further over the course of the year. It is now so low that the market could improve by 40% from its current level and it would not look expensive given the earnings of the listed companies. Markets get this cheap because they are driven by fear these fears have only to stabilise and the cheap market can (finally) get some traction.

My end-of-2011 target for the ASX200 is 4700, a gain of about 16% over the course of the year. This, sadly, only undoes the damage done in 2011. Until recently, I had a significantly higher target, and I still think there is more upside risk to this forecast than downside. But I have to admit that I thought the share market would shake off its lethargy twelve months ago, and I got that very wrong.

The Australian Economy

The domestic economy also had a disappointing year, with GDP growing by a little less than 2%, compared with expectations of about 3% at the start of the year. The biggest reasons for the shortfall were, of course, the natural disasters early in the year, and the slow recovery in coal exports thereafter. The best indicator of the change in our economic fortunes in 2011 was the performance of the labour market. Over the course of 2010, employment increased by 360,000 and the unemployment rate fell from 5.5% to 5%. In 2011, by end-November, the economy had added just 45,000 jobs, and the unemployment rate had risen back to 5.3%. It may drift slightly higher in 2012, but the suggestion by at least one tabloid that the Australian labour market is on the verge of some kind of crisis is simply laughable. I have always found the best use of that tabloid is in cleaning the barbecue!

The Outlook for Interest Rates

When 2011 began, it was clear that the RBA still had a bias to raise rates further. Indeed, as late as August the RBA board gave some thought to raising rates. But increasing concerns about global growth, and diminished concerns about Australian inflation, led to a remarkable turnaround in a very short time. The official cash rate fell in both November and December, and will almost certainly fall again in February. Financial markets have even more cuts priced in beyond February, but my view is that precipitous cuts require an overly pessimistic view of both the global and Australian economies. Nevertheless, it’s not going to be easy to earn a decent return on cash. The one thing in investors’ favour is that overseas credit conditions are causing the banks to look more to the domestic depositor to provide funds hence deposit rates remain relatively attractive.

It remains to be seen how the policy of at least one bank of dissociating its rate changes from changes in the official cash rate will work. My suspicion is that it will be largely cosmetic. It is true, as the banks have insisted, that there is no one-to-one relationship between the official cash rate and their cost of funds, but it is also true that there is some relationship, and that the RBA is aware that it is borrowing rates that are important rather than the official rate. As a consequence, if the banks don’t “pass on” rate cuts fully, the RBA will simply keep cutting rates until lending rates are low enough to suit the purposes of monetary policy.

The Exchange Rate

The $A began the year at US$1.025, and ended it at US$1.021. The casual observer might thus think that nothing much happened. But in fact the currency traded a 16-cent range, from $1.10 to 94 cents and, on an average day, it traded through a range more than twice as wide as it did for the year as a whole. The currency continues to be too strong in my view, and could fall by up to 10 cents over the course of 2012. So shop early!

Chris Caton
Chief Economist

The views expressed in this article are the author’s alone. They should not be otherwise attributed.

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