Sell in May!

The share market had its first negative month so far this year. The ASX 200 fell by 7.3%, the worst month in two years, and is now up by just 0.5% for the year to date. The US market, as measured by the S&P500 index fell by 6.3% in May, to be up by 4.2% since the start of the year. Meanwhile, both US and Australian long-term bonds fell to record lows, which at least means that bond-holders had a good month.

It’s all about Greece

The share market weakness in the month was entirely due to increasing concerns about Greece in particular and Europe in general. The first attempt to elect a new Government was inconclusive, and there will be a second-round election on 17 June. Greece has a proportional-representation system, which virtually guarantees that there will be a Coalition government. The question is: will that be a Centre-Right coalition (New Democracy and PASOK) or a coalition of the left (likely dominated by the Syriza party). Recent opinion polls put the Centre-Right in the lead.

Importantly, neither of the likely winners wants to take Greece out of the Euro. The difference is that the Centre-Right parties appear happy to abide by the current austerity/debt repayment plan agreed with the Troika (the ECB, the European Commission and the IMF) while the Left parties want to renegotiate, slowing down the austerity plan. Given that the Greek economy has contracted every year since 2008, one can sympathise with their view that the Greeks have suffered enough.

The issue is that, at some stage during any such renegotiations, the two sides reach an impasse. This could then lead to a cutoff of bailout money from the Troika. This, in turn, would lead to increasing speculation of a Greek exit from the Euro and a run on the Greek banking system as depositors try to move their euros elsewhere before they are converted into drachmas. To stop this run, the Greek government would be likely to impose capital controls, which would mean that a euro inside Greece would no longer be the same as one outside, so Greece has then, effectively (and primarily accidentally), left the common currency. (It should be pointed out that deposits in the Greek banking system have already declined by a third since the crisis began three years ago).

There would probably follow a significant depreciation of the replacement currency and thus an outburst of inflation. Exiting the currency would inevitably lead to Greece defaulting on its Euro-denominated debt, which would seriously undermine its ability to borrow new money!

This would be an unholy mess for the Greeks, but does it really matter for the rest of the world? After all, the Greek economy is very small these days smaller indeed than the economy of the city of Philadelphia. Since Greece left the Ottoman Empire in 1832, it has been in default or restructuring after default more than 50% of the time. And other nations such as Argentina frequently default. Why is this such a big deal?

The answer is that it may not be. But the increasing interconnectedness of the financial system, and of the European economies, means that it might be. A Greek exit from the Eurozone will lead to speculation of other exits, such as by Ireland and Portugal, and hence possibly to runs on banks in those countries. Again, this is no big deal these are also small economies. The real risk is a spread to the Spanish or Italian banking systems. The ECB could endeavour to stop such contagion by making it clear that all Euro deposits are guaranteed, but would such a guarantee still be in effect for an exiting country? During bank runs, rationality is also often in short supply. There was a run on the Northern Rock bank in the United Kingdom in late-2008 despite the fact that deposits were guaranteed up by 50,000 pounds sterling. Bank runs are pernicious things and the best way to stop them is before they start. But it is not always clear how to do this.

It is not the inevitability of a bad end that argues against a Greek exit from the Eurozone it is, rather, the small possibility of a very bad end. Because of this, my view is that the other European nations will do “whatever it takes” to keep Greece inside the tent. This may include a slower approach to austerity, or the issue of Eurobonds, which would lower borrowing costs for most countries. If a Greek exit does occur, then it would be better if it were not done too hastily. A prepared exit would increase the period of uncertainty, it is true, but it would also allow time for “ring-fencing” to prevent contagion.

Of course, even if Greece remains in the common currency, the issue will not go away. Greece is massively uncompetitive, mainly because its nominal wages have risen faster than in other European nations, particularly Germany. It will take years to fix this. If Greece remains in, it has been estimated that its economic size in 2016 could still be 20% smaller than it was in 2007! There is no easy way out. One thing is for sure June 18 will be a very interesting (and volatile) day on world financial markets.

Budgets come and Budgets go

Every year an enormous fuss is made about our national Budget, and every year, it seems, something else happens immediately afterwards to knock it off the front pages. One can look at the Budget in several ways, including as a statement of our national priorities and as a tool of economic management. Suffice it to say that this year’s edition isn’t nearly as good as the Government would have us believe, nor as bad as the Opposition depicts it. In the view of this macro-economist, while it is correct to aim the Budget in the direction of surplus, it is simply unnecessary to aim for a surplus in the coming fiscal year. Only three other OECD nations (Cyprus, Greece and New Zealand) are planning a fiscal contraction as rapid as ours. While much of the fiscal tightening is cosmetic rather than real, the change in our fiscal position is probably set to subtract 0.5 to 1 percentage point from GDP growth over the next year. Is now a good time to be doing that?

One other point about the Budget. The following chart is borrowed from Treasury Secretary Martin Parkinson’s post-Budget address. It makes the point that Australia has never had a government debt problem. Beware of shock jocks and other false prophets preaching otherwise!

Average OECD and Australian gross government debt since the 1970's

Interest rates

I wrote about the early-May “double cut” last month. Financial markets are convinced that there will be another cut in June (next week) and more than a full percent of cuts over the next year. I am not so sure. It could happen, of course, if the international situation worsens and thus poses a threat to the Australian economy, or if the recent cuts (and the fall in the exchange rate) fail to provide a boost to the beleaguered non-mining 80% of the economy. Put me down for one more cut in the cash rate.

The Bottom Line

Five months into 2012, I see no reason (yet!) to change my end-of-year forecast of 4700 for the ASX 200. While there could be a nasty outcome in Europe, this is by no means inevitable and a lot of bad news is already priced in.

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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