Share markets began 2013 in fine fettle.

For the month of January, the US market, as measured by the S&P 500 index, advanced by 5%, to its highest monthly close since October 2007. In the past year, the S&P500 has risen by 13.1%. The US market is now up by 121.4% from its early-March 2009 trough. Over the past 50 years, when the January result has been positive, the year has turned out to be positive 83% of the time. The ASX 200 index rose by 4.9% in the month, to its highest monthly close since August 2008.

If one were looking for a reason for this continued strong performance, one could perhaps say that “nothing bad happened”. In the US, the earnings season began and so far it has been positive. As a general rule, more companies report earnings above expectations than below, in part because they “manage” expectations beforehand. This year, this “upside surprise” phenomenon has been more pronounced than usual.

In the US, there was one nasty piece of news GDP (the Nation’s output) actually fell in Q4 2012, something that happens very rarely outside of recessions. There were special factors, however, including hurricane Sandy.

The best news in the US in January was that the worst outcome was avoided in its fiscal mess. Early in the month, the “fiscal cliff” was avoided as Republicans and Democrats agreed on a medium-term deficit reduction package. In addition, the next instalment of the debt ceiling issue, which roiled markets in August 2011, was postponed for several months. It is tempting to think these problems have gone away completely. There are, however, still some rocks ahead.

Sequestration is currently due to begin on 1 March, and the current continuing budget resolution expires on 19 March. A further one must be passed by 27 March to enable the government to continue to run. Failing passage of a new resolution, there would be a shutdown. Shutdowns used not to be particularly unusual. There were fifteen between 1977 and 1995, lasting between 1 and 17 days. Since the Clinton/Gingrich shutdowns in 1996 (26 days in total), there have been none. Congress is likely to move fairly swiftly on a new resolution if this is not done by mid-April, the members of Congress won’t get paid! Debt limit issues need to be addressed by 19 May.

The other two international “flashpoints”, China and Europe, were remarkably quiet in the month. Long-term rates in Europe continue to decline, which is a good sign.

And in Australia

The two most important pieces of economic news in the month were the employment report and the CPI release. Both, in a sense, gave the RBA carte blanche to cut further should it so desire. Estimated employment fell by 5,500 in December, and shows a mediocre 1.3% growth in the past year. Meanwhile, the unemployment rate rose from 5.3% to 5.4%. Inflation remains low in the year to the December quarter, the headline CPI increased by just 2.2%.

Despite the soft labour market and benign inflation news, the RBA Board will probably elect to “leave well enough alone” at its meeting in early-February. The previous reductions in rates are still working their way through the system, and the RBA is probably less worried about the immediate risks to the Australian economy coming from abroad, and also about the effects of weaker commodity prices. The Bank would still be concerned about the ongoing high Australian dollar, but there’s not much it can do about it.

During January, much was made of the fact that the banks’ cost of funding has been reduced in recent months because of a decline in their wholesale costs. What this probably means is that any further cut in the cash rate will be matched point for point by declines in variable mortgage rates.

The Coming Election

Late in the month, the Prime Minister, Julia Gillard, delivered a major surprise in announcing that the next Federal election would be held on 14 September. We have never before known the date so far in advance. This led to immediate speculation that the current Government is now a “lame duck”. In fact, the Government will not go to “caretaker” mode until the election writs are issued in August.

I won’t be deciding my vote on economic-policy grounds, but the economic policies of the two protagonists will be a focus of the campaign.

It is worthwhile pointing out that the Australian economy is in much better shape than the rest of the developed world. Unemployment and inflation are both low, we have no public debt problem (despite what the shock jocks tell you), and we have had no house price crash. We avoided most of the effects of the GFC. The Government should have been able to take more credit for this performance than it has been able to do. Despite the relatively good showing, business and consumer confidence remain low. There appear to be two main reasons for this. One, the two-speededness of the economy means that many industries and regions are languishing, particularly those hurt by the high Australian dollar. Two, the fact that we have a minority government means that there is no policy certainty. Whichever way it goes, the election should at least end this state of affairs.

There will be much focus on responsible Budget policy in the campaign. I have said in the past that a rapid return to surplus is not good economic policy in fact it would be bad for the economy.

It will be interesting to see how much we hear about repeal of the carbon tax. This has rapidly become “part of the furniture” (as did the GST). It’s difficult to identify many harmful effects, in part because both low-income consumers and many industries were over-compensated. That said, the Gold Coast City Council remains firmly opposed to the tax. My suspicion is this issue may quietly go away, although Mr Abbott’s recent rhetoric suggest otherwise.

The two sides may both make noises about protection of manufacturing, and particularly of the car industry. The mercantilist viewpoint won’t go away. There is still a popular belief that “it’s not economic output if you can’t drop it on your foot”. The fact is, however, that for decades economic growth throughout the developed world has primarily taken place in the service sector. In the past 20 years, the number of jobs in Australia has increased by more than 4 million (more than 50%) with no contribution at all from manufacturing. There is no point in shoring up an inefficient industry in perpetuity the costs to Australian consumers of doing so far outweigh the gains to producers and workers. A case can, of course, be made for short-term protection, e.g. because an industry is in temporary difficulties because of the high level of the currency.

Perhaps the biggest economic issue facing Australia is productivity growth. I have written of this in the past. In recent years, much of our poor productivity performance has been camouflaged by real income gains coming from our rising terms of trade. That luxury is unlikely to be available to us in the immediate future. What can we do? Glenn Stevens had it right when he said “get the list” from the Productivity Commission, and do the things on the list. There is a myriad of things we can be doing better (reduction in red tape, better transportation policy etc).

Productivity can also be enhanced by “slow burners” things that will eventually make a lot of difference but will take some time to have an effect. Education and infrastructure (which may necessitate greater use of public debt!!) are two that stand out.

Where are we going?

Last month, I published an end-2013 forecast for the ASX 200 of 5100 points. I pointed out that this was much stronger than the mean forecast (4557) of a panel of equity analysts polled by the AFR. A month into the year, and already my top-of-the-market forecast is looking low. I will wait for a few months before adjusting it, however. I know at least one reader who is very unforgiving of changes to forecasts (you know who you are, Jeff)!

Chris Caton
Chief Economist - BT Investment Management

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

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