So far, so good (part 3)

March was yet another positive month for share markets. The ASX 200 rose by 0.9% in the month, to record an increase of 6.9% for the first quarter of the year. The US share market did even better, with the S&P500 index up by 3.1% in the month and by 12% in the quarter. This is the best start to a calendar year since 1998.

The continued rise in markets cannot be attributed to good economic news in the month. Probably the best description of the news from Europe and the United States is that “nothing bad happened’. There were fewer positive surprises in the US data than has been the case recently, although the labour market continued to improve. Greece negotiated a deal with its private-sector debt holders without too many ructions.

Meanwhile, concern about a slowdown in China intensified. The Government downgraded its 2012 forecast to just 7.5% GDP growth, which should not have caused too much alarm. First, this number is broadly consistent with the previously-announced 5-year plan. Second, the economy almost always does better than this official forecast. Indeed, the private-sector consensus forecast for Chinese GDP growth this year stands at 8.4%.

The current state of the Chinese economy is difficult to interpret. But even if it were to slow, what happened in 2009 suggests that the authorities are quite adept at getting it going again. The risk to Australia is not so much that China will slow, but that the nature of its growth will change. China has been a magnificent story for Australia not just because of its size and its pace of growth, but also because it has been so commodity-intensive, due to the heavy volume of construction and infrastructure spending. By one calculation, per unit of GDP, China uses more than four times as much steel as the global average. That requires a fair bit of iron ore! In the future, China’s growth will come more from consumer spending, so its commodity-intensity will slow. The chart below shows various possible paths that China’s demand for commodities could follow. It’s clear that the greater risk is the shifting mix of growth rather than an overall secular slowdown.

Oil (and petrol) prices also became a topic du jour during March. The oil price has risen in part because of increased demand, particularly from emerging markets, and in part because of Middle East tensions, mainly involving Iran. Exports from the latter have been cut, in part because of sanctions imposed by some European nations, and tensions between Iran and Israel have increased. This is something of a re-run of last year, when the focus was on Libya. Libya exports more oil than Iran does so, to date, this has not been as severe an episode. In the United States, the spectre of $4 gasoline (a little over $1 per litre!) has been raised, and it’s close to becoming a serious political issue.

We worry too much about petrol prices. They are, of course, highly visible. Most people are reminded of the price several times a day. According to the detail in the CPI, petrol accounts for about 3.5% of the average consumer’s total spending. The chart below shows a somewhat broader concept, since it includes all the other running costs of a car. But petrol is the biggest part by far. What the chart shows is that, despite the fact that petrol prices have risen systematically faster than overall prices (by 2-3% more per year in recent times), the relative cost of operating a vehicle is quite low by the standards of history. How can this be?

There are a couple of answers. First, cars have become more fuel-efficient over time, so we drive further per litre on average. Second, kilometres driven have increased less rapidly than real incomes over time. It is often objected that rising petrol prices are particularly concerning because transportation costs “get into everything”. While this assertion is obviously correct, it remains the case that the whole economy is more energy-efficient than it used to be. Oil prices are simply less important than they used to be and, short of a Mid-East blowup, this episode is likely to pass quietly into history.

A third hot topic in March was the emergence of a debate about bonds versus equities. The former head of the Treasury, Dr Ken Henry, expressed the view that Australian investors tend to be over-exposed to the equity market and under-exposed to bonds and other fixed-interest instruments. Let me say that I have the greatest respect for Dr Henry, both as an economist and as a public servant.

On the face of it, Dr Henry’s view has a good deal of merit. I remember writing recently that the return on US long-term government bonds had been greater than on the US equity market not just in recent years, but on average over the past 30 years! Why, then, would anyone bother with the relative riskiness of shares? At the time, I also wrote that bonds would not out-perform shares over the next 30 years. I stand by this, and will willingly hand in my economist’s union card in 2042 if this turns out not to have been the case. Paradoxically, the reason why bonds have done so well historically is exactly the reason why they are unlikely to continue to out-perform.

Without going into all the details, bondholders make capital gains when interest rates fall. In the mid-1980s, the long-term bond rate was in the mid-teens. In January this year, it hit 3.7%. Obviously, along the way, there were significant capital gains. But how much further can rates fall? Indeed, today the rate stands at 4.1%, and there are many who believe it has further to rise. Of course, there are other forms of income-earning investments such as time deposits. Meanwhile, while there are always risks, it is not too hard to convince oneself that the share market’s under-performance has now left it cheap.

Dr Henry still has a point of course. A sensible diversification strategy mandates exposure to both “growth” assets and income-earning assets, and investors, particularly those in or near retirement, may have been too far along towards the risky (potentially higher return) end of the spectrum. Certainly Australian investors have been more exposed to the vicissitudes of shares than investors elsewhere in the world, and this has cost them significantly in recent years.

The Bottom Line

Three 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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