So far, so good (part 2)

It perplexes many investors that the US market has outperformed the Australian market, which is up less than 40% from its March 2009 low. Suffice it to say that such comparisons always depend critically on the starting point. Measure both markets from 2000, for example, and we have outperformed by a street.

The Australian share market had a moderate month in February, advancing by 0.8%, to bring its gain for the year to date to 6.0%. The US share market once again did better, rising by 4.1%, as measured by the S&P index. This puts the year-to gain at 8.6%, with this measure of the market at its highest level since June 2008, and up by a remarkable 102% from its closing trough on 9 March 2009. It perplexes many investors that the US market has outperformed the Australian market, which is up less than 40% from its March 2009 low. Suffice it to say that such comparisons always depend critically on the starting point. Measure both markets from 2000, for example, and we have outperformed by a street.

The single biggest reason why the US market has done better in the past three years is that the earnings of US companies have increased faster than those of Australian companies. And there are two reasons for this. First, productivity growth has been faster in the US than in Australia, and second, the US dollar has fallen while the Australian dollar has risen. Since in both case the listed companies make a lot of money offshore, these currency movements have boosted US earnings but cut into Australian earnings.

All quiet on the European front

The European situation didn’t get any worse in the month indeed one can make the case that it improved. The chart shows long- and medium term-bond rates for various economies (not including Greece!). I think of long-term rates as a “trouble index”. When rates rise, the cost of issuing new debt, or rolling over existing debt, increases. These interest payments themselves add to the country’s debt and the whole situation tends to spiral. Financial markets have drawn a “line in the sand” at around 7%. Late last year, as can be seen, Italian bond rates crossed this line twice and Spanish bond rates came close. In late-2011, The European Central Bank announced its LTRO (Long-Term Refinancing Operation), which provides cheap money to the European banking system, thereby keeping it liquid. This, in turn, eases the pressure on the Government bond markets. As a result, the Italian long rate has fallen steadily for two months, and now sits at 5.4%. Italy held a successful bond auction on 28 February, suggesting that markets are now fairly relaxed about Italian debt.

This LTRO programme does not fix the problem it merely stabilises the situation and buys time for the affected countries to get their fiscal books in order. It may, of course, be too late for Greece. On 29 February, the ECB announced the size of the second tranche of the LTRO programme. Initial market reaction has been favourable.

The other favourable international development in February was that, for the first time since August last year, the consensus assessment of global economic growth for 2012 did not deteriorate. It may not be saying much that economic forecasters are no longer getting more pessimistic, but it is a start.

The Australian Scene

Last month I mentioned the dramatic slowdown in employment growth in Australia over the course of 2011. The news for January was somewhat better, but it still leaves employment up by just 46,000 in the past 13 months, a rate of increase little more than one-tenth as fast as in the previous 18 months. The unemployment rate, however, has scarcely risen, sitting at just 5.1%. The flat employment story has not been reflected in a faster rise in unemployment because the rate of growth of the working-age population has slowed dramatically, and the participation rate has declined. There have, naturally, been big winners and big losers in employment, despite the overall flat result. The chart shows jobs gains and losses over the year to November 2011. There is little by way of surprise here mining employment has risen, while jobs in manufacturing, construction and retail have all fallen. Manufacturing employment has, in fact, fallen by some 12% since 2008.

As is well-known, the Reserve Bank sprang a surprise in early-February by not taking a further step towards lower interest rates. This partly reflects the fact that it sees less of a threat from the European situation than it did two months earlier. It also believes that the Australian economy is continuing to grow at a reasonable, albeit unbalanced, overall rate. The subsequent hike in some lending rates by the banks was also something of a surprise.

I have written about this before. Briefly, the banks are correct when they say that their cost of funds is not determined solely by the cash rate, and that this cost has risen recently. But it is also correct that the cash rate does have some effect and that, if the RBA is unhappy with the current level of lending rates, it will move the cash rate to wherever is necessary to achieve lending rates that it is happy with.

Whether or not we have seen the last rate cut in this episode depends critically on the extent to which the RBA’s assessment of the Australian economy turns out to be correct. My suggestion would be to watch the unemployment rate. Any sign that it is headed to 5.5% or higher will probably bring forth another cut. Unemployment may be a lagging indicator, but it’s a reliable one!

The Bottom Line

Two months into 2012, I see no reason (yet!) to change my end-of-year forecast of 4700 for the ASX 200.

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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