So far, so good (part 4)

April was yet another positive month for the Australian share market. The ASX 200 rose by 1.4% in the month, to bring the increase to 8.4% for the year to date. Unusually for recent times, the Australian market out-performed its US counterpart in the month. The S&P500 index fell by 0.8% in April, its first negative month this year. Nevertheless, it has increased by 11.1% so far this year.

What’s Changed?

As was the case last month, one cannot attribute the further gains in the market to good economic news. In Australia it is true that we got a solid labour-market report, but all the other signs pointed to a continued sluggish economy outside of mining.

Abroad, there was at least an absence of bad news about Europe. It’s true that Spanish debt was downgraded by a major ratings agency, but it had already experienced a de facto downgrade by financial markets. Market ructions caused by the French Presidential election were less than some had feared.

China’s first-quarter GDP report confirmed that economy has slowed, but it is still a long way from a screeching halt. The United States economy also seems to have struck a soft patch, typified best by a rising level of jobless claims (people filing for unemployment benefits) in the month. The United Kingdom recorded its second successive quarter of negative GDP growth, thus “double-dipping” for the first time in close to 40 years. On the other hand, the International Monetary Fund actually increased its expectation for global economic growth this year, for the first time in several years.

A month ago, rising oil prices were vexing many. They are less of a worry now.

And so to May

May is, of course, Budget month in Australia. This year, the usual preamble of leaks and breathless media coverage has been somewhat pre-empted by the unfortunate political shenanigans and the “dark cloud” hanging over Parliament.

The Government has committed to budgeting for a surplus in 2012/13, the financial year that begins in a few weeks. Given that a substantial deficit will be recorded this year, this will be a massive fiscal turnaround if achieved. Not only would it be unprecedented in Australia, it would have rarely happened elsewhere. At present, probably only Greece and New Zealand are engaging in fiscal tightening of the same magnitude.

This rapid return to surplus has been typified as sound economics. It is not. Among other things we have been told that it will permit more interest rate cuts than would otherwise occur. While there may be some truth to this at the margin, monetary and fiscal policy are not perfectly interchangeable. To attempt to offset fiscal tightening by monetary loosening is roughly equivalent to advocating that one drive with one foot firmly on the brake and the other on the accelerator at the same time. Put it another way: suppose that, hypothetically, spending on aged care is cut by $2 billion by how much do interest rates have to be lowered to offset this?

Incidentally, the US is facing some similar issues, albeit starting from a far worse position than Australia is. The automatic expiration of some tax cuts at the end of this year have created what is known there as a “fiscal cliff”—a dramatic tightening of fiscal policy. The Chairman of the Federal Reserve, Dr Ben Bernanke, has already stated that it would be simply impossible to offset the effects of this cliff by loosening monetary policy (of course, with official rates already close to zero, the Fed has less room to move than the RBA does).

While it is true that the Budget should be pointed in the direction of eventual balance, to endeavour to get there in one year, given the current softness of the non-mining economy, is likely to be counter-productive.

Of course, we know that even if a surplus is achieved, some of it will be means of “smoke and mirrors”. To take one example the initial compensation for the carbon tax will be paid out this year, thus increasing the starting-point deficit, while the revenue will be collected next year, thus increasing the size of the fiscal “turnaround”. But this is actually a virtue rather than a criticism. Given the shaky economic case for a quick return to surplus, if it is partly achieved by means other than genuine tightening so much the better!

The Interest Rate Decision— Who’s in Control?

Of course, before we even get to the Budget, the Reserve Bank has shown its hand, cutting the cash rate by 50 basis points on 1 May. It signaled in early-April that it was disposed to cut the cash rate, in part because it had under-estimated the extent of the slowdown in the non-mining sector of the economy, but that it intended to wait until May because it wanted to see the latest inflation news, in the form of the March quarter CPI, first. At the time, I thought that there was simply no way that the inflation news was going to be bad enough to forestall a cut, and this turned out to be true in spades.

There was no surprise that the RBA cut. There was some surprise that it cut by so much. Like Pavlov’s dogs, financial markets have been trained to expect 25-point moves except when events have changed quickly and thus mandate more dramatic action. That hasn’t happened on this occasion. The Bank nevertheless made it very clear why it thought a “super-size” cut was necessary anyway. In its judgment, financial conditions (lending rates) should “now be easier than those which had prevailed in December”. Given that the variable mortgage rate has crept up since December, this would not have been achieved by a quarter-percent cut.

My suspicion is that most of the cut (perhaps 35-40 basis points) will be passed along quickly to borrowers, although one of the Big Four will take up to ten days if it sticks to its schedule. As I have written before, the banks’ argument that their cost of funds is not solely driven by the cash rate is unquestionably correct, but this only means that the Reserve Bank’s monetary policy lever is inexact, not that it doesn’t work at all. I think about it this way: at any one time, lending rates are probably within 15-20 basis points of where the RBA would like them to be if they weren’t then the RBA would move the cash rate, and keep moving it, until they were. That is what they did today, and the banks will unquestionably follow.

The Bottom Line

Four months into 2012, I see no reason (yet!) to change my end-of-year forecast of 4700 for the ASX 200. If I do have to change it, I will be moving it up, and it’s a few years since I had to do that!

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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