So far, so good

January was a good month for equity markets. The ASX200 rose by 5.1%, its strongest performance since last October (and, before that, September 2009). This is the best start to the calendar year since 1994. The US market, as measured by the S&P500 index, advanced by 4.4%, the best January result since 1997.

A strong start to the year in the US is by no means unusual. In the past 111 years, the increase in the S&P500 has averaged 1.2% in January, more than twice the 0.5% gains averaged in the other eleven months of the year.

Why has the year begun relatively well? The single biggest reason is that there has been no further deterioration in the European situation. It’s true that Europe will fall into recession this year (it’s probably there already), but that’s not new information. Indeed, long-term interest rates in the most troubled countries have fallen in the month, suggesting some moderation in the pessimism felt about the Continent.

This may come as a surprise to those who follow the action only through the media. During the month we were bombarded with the news that the World Bank was forecasting a global recession worse than the GFC, and the International Monetary Fund also chimed in with a dramatic lowering of global growth prospects, and with the memorable quote that the “current environment” provided “fertile ground for self-perpetuating pessimism”. How on earth could share markets simply ignore this news from two such august and respected institutions?

Because there was no news. The World Bank didn’t forecast another global recession. It simply warned that it could happen in the worst possible case, making the valid point that a further recession would be difficult to counteract because both fiscal and monetary policy are already very loose in most economies. The chief of the IMF sounded an equally dire warning of the downside risks. Such negative rhetoric is not really intended to inform it is designed to increase the pressure on policymakers, particularly in Europe, to get on with job of finding a solution.

The quantitative downward revisions to expected global growth by both the World Bank and the IMF simply isn’t news. These two bodies, rightly, issue updated forecasts only every six months. But markets don’t sit around thumb-twiddling and waiting for these reassessments. They react in real time to the ongoing flow of news. Last July, before the latest round of European paper hit the fan, the consensus view for global growth this year, as measured by Consensus Economics, was 3.6%. By January, that forecast had been reduced progressively by a full percentage point, to 2.6%. The World Bank’s forecast, at 2.5%, was simply catching up with the view of global growth already incorporated in the share market’s thinking. For more on this, Ross Gittins’ column in the SMH and elsewhere on 30 January is an excellent read.

Of course, the European situation remains a concern. That will be true for years. But so much bad news is already factored in to the current level of markets that they don’t have to fall further, and indeed, in my view, are more likely eventually to get some traction. There remains, of course, a very small probability of a much worse result.

What else did we learn in the month? The US economy continues to make forward progress. Its unemployment rate remains high, but over the course of 2011 it fell from 9.4% to 8.5%. Growth this year is likely to be somewhat better than though a few months ago, in part because the withdrawal of fiscal stimulus will be less rapid than thought then. And the Federal Reserve has made it clear that it is likely to keep interest rates very low for at least two more years! This alone is an indication that the (global) economy is not expected to heal quickly. The US also, belatedly, joined the ranks of inflation-targeting economies henceforth, the Federal Reserve will aim to keep the inflation rate for personal consumer spending close to 2%.

The Domestic Scene

The January news about the Australian labour market was concerning. Over the course of 2011, in net terms, employment increased not at all, after averaging monthly gains of 31,000 in 2010. Even during the GFC, we never went for a year without any jobs growth whatsoever. How did this happen? One possible answer is a changed attitude by employers. The GFC came after several years in which the unemployment rate had been falling, and new skilled workers had been hard to find. Having worked hard to hire, employers tended to hang on to their existing workers, but did cut their hours. In 2012, uncertain about the economy’s prospects, particularly outside of mining, employers were reluctant to hire, but obtained more labour input by increasing the hours of those already employed. The other measure of the labour market, the unemployment rate, told a somewhat better tale. It rose from 4.9% in December 2010 to 5.2% a year later. It is likely to rise further, but should remain handily below 6% all this year.

The current consensus forecast for Australian GDP growth for 2012 is about 3.4%, which is very close to trend. Growth will, however, continue to be unbalanced. Manufacturing and tourism, in particular, will continue to be held back by the exchange rate, while retail’s problems should alleviate slightly the consumer will remain cautious but is unlikely to keep getting more cautious. Mining investment is set to grow strongly, however. Indeed, the 3.5% overall growth could break down into 15% for mining and mining-related, and just 1% elsewhere.

It may be this two-speededness that accounts for the extremely negative mood about the Australian economy right now. Sometimes we need to remind ourselves that we haven’t had an official recession for two decades, that our banking system survived the GFC well, that house prices have not collapsed (except in some areas), that we have no public debt problem and that unemployment is far lower than in the rest of the developed world (except for Japan)!

Meanwhile, inflation in Australia remained quiescent. The CPI was flat in December, due mainly to falling prices of fruit (think bananas) and pharmaceuticals. In the past year, it has increased by 3.1%, but so-called “underlying” inflation remains at just 2.6%, a level unlikely to disturb the Reserve Bank. As a result, the Bank can continue to focus on growth in the Australian economy and on the possible risks (which are not as great as many believe) to the domestic economy from a European recession. As a result, the cash rate is odds-on to be cut again in next week, but that could be the last reduction for a while.

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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