So endeth a poor financial year!

Investors will look back on financial year 2011/2012 with chagrin. It was a year dominated by concerns about Europe. The first three months were the worst, with the ASX 200 slumping by 13%. After that it chopped for the entire 12-month period it recorded a decline of more than 11%. We have become used to the Australian market underperforming, and this happened again. The US share market rose by 3.1% in the twelve months to June. With the Australian dollar falling by some 7% over the course of the year, Australian investors with offshore holdings did better than this.

Just as the year was dominated by concerns about Europe, so too was the month of June. The second round of the Greek election resulted in the formation of a coalition government dominated by the New Democracy party, with support from PASOK and the Democratic Left party. These parties together hold 179 of the 300 Parliamentary seats. Ironically, the same three won enough seats to form a coalition after the first-round election on 6 May that they chose not to do so on that occasion merely added to uncertainty.

The Greek election result doesn’t change anything fundamental. All of the issues remain the new government will, for example, attempt to re-negotiate the austerity agreement with the Troika (the ECB, the European Commission and the IMF). What has been taken of the table is a “tail risk”—the small chance that, had the left-wing Syriza party achieved victory, there may have been a swift and chaotic exit from the Euro.

At the end of the month, the Euro nations held yet another summit aimed at fixing the European problem. The fact that this is the seventeenth summit devoted to resolution of the crisis says all that you need to know about the success of the previous ones. There is a familiar pattern markets get excited beforehand about what may be achieved and are usually disappointed. This time it was different there was little sense of belief beforehand that anything substantive would be achieved. Accordingly, while the communiqu� from the meeting was short on specifics, it was greeted favouravbly.

Other Matters

It is quite possible that you are as weary of reading about Europe as I am of writing about it. There are other matters of course. Last week saw the introduction of the carbon tax. I covered this in some detail in August last year, to mixed reviews. Let’s just say that no other Caton’s Corner has ever inspired a death threat! My expectation is that, like the GST, the carbon tax (sorry, price) will rapidly become part of the furniture, and that the worst fears, or scaremongering, will not be realised. The real danger is that this is so true that there is little or no change in behavior!

Then there are interest rates. At its meeting on 2 July, the RBA board opted to do nothing, and we now know that in early June it deliberated between a cut of 25 basis points and no change, rather than between 25 and 50. The statement accompanying the decision hinted that the RBA is disinclined to cut further. Given that financial markets expected another 1-1.5 % of rate cuts after the June meeting, some hasty repricing is in order.

Productivity

It is well known that productivity growth has slowed in recent years in Australia. There was an excellent article in the RBA’s June Bulletin on this topic. Among other things, this article confirmed the slowdown, with labour productivity growth declining from an average annual rate of 3.1% in the decade to 2003/4 to just 1.4% since that year. The article found that about one third of the slowdown in total factor productivity was accounted for by just two industries, utilities and mining, mainly because of the significant increase in capital spending—the fruits of which have not yet been fully seen—in those industries. In mining, also, the enormous increase in prices has inspired companies to “go after” the harder-to-extract deposits this is good for profits, and hence for Australia, at the same time that it is bad for measured productivity.

The article points out that labour productivity has slowed in 20 out of 26 OECD nations in the most recent decade, suggesting that there is some global explanation. The natural “suspect” is the (declining?) effect of advances in information and communication technology, but is it really believable that these had a bigger effect on productivity before 2000 than after that date? Interestingly, labour productivity growth in Greece in recent years has been faster than in both Australia and Germany!

Note that the timing of the slowdown in productivity, and the fact that much of the slowdown is global, makes one of the favoured explanations (recent changes to labour-market regulations) highly unlikely.

In the long run, there are only three major ways in which a Nation can advance the living standards of its citizens increased labour-force participation, productivity growth and increasing terms of trade (export prices relative to import prices). The slowdown in productivity growth in Australia has coincided with an offsetting surge in the terms of trade (this is not a complete coincidence—see the brief discussion of mining above). This is illustrated in the chart below. The slowdown in productivity growth is shown in a diminution in the rate of growth of real GDP per hour worked, but growth in real gross national income per hour worked has been hardly affected.

And there’s the problem. The terms of trade have already ceased to rise, and will almost certainly fall further in the immediate future (commodity prices are on the wane). Ergo, unless productivity growth is lifted, real income growth will moderate significantly in the next few years. How do we do this? The RBA Governor had some wise words on this recently. There is no magic pudding we just keep looking to improve the way we do a myriad of things, we listen to, and pursue, the recommendations of the Productivity Commission, and we stop doing things that directly hurt productivity (shoring up terminally inefficient industries, for example).

The Bottom Line

Six months into 2012, I have finally relented and changed my end-of-year forecast for the ASX 200, from 4700 to 4500. I continue to believe that the market is fundamentally cheap and can get some traction once the international worries stabilise.

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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