The Usual Suspects

Well at least the new financial year got off to a positive start. In July, the ASX200 index rose by 4.4%, while the US market, as represented by the S&P500 index rose by 1.3%. The Australian market has now risen in 6 of the 7 months of the calendar year, but a very poor May means that the overall gain has been limited to 5.4%. The US share market has done better, rising by 9.7% year to date.

The Usual Suspects

As is well-known, there are three international issues weighing on the Australian market. These are: the chance of a “double-dip” recession in the United States, a slowdown in China, and Eurozone debt. How have these issues changed in the past month?

The US published its GDP accounts for Q2. These showed mediocre growth of just 1.5% (annualised rate) in that quarter, and 2.2% in the past year. But there were impressive signs of continued recovery in the housing sector. The world’s largest economy is stuck in slow-growth mode, with little chance of escaping in the near future, but this is a long way from renewed recession. They do have a looming issue that the politicians have to address quickly: the inadvertent severe tightening of fiscal policy on 1 January 2013 caused, primarily but not solely, by the expiration of the Bush II tax cuts. All it takes to avert this is some co-operation between the Democrats and Republicans, but their attention is diverted by the fact that this is a Presidential election year.

In the month, it was announced that year-to Chinese GDP growth had slowed even further, to 7.6%, in the second quarter. That’s the bad news. The good news is that, if one “backs out” likely quarterly numbers from the annual figures, the slowdown probably reached its nadir in Q1. So growth should accelerate in the second half of the year. China will, of course, continue to be a major concern for the future profitability of the Australian resource sector.

In Europe, things got worse before they got better. The threat of a Greek exit from the Euro may have been diminished by the election result—discussed last month—but it has by no means been removed completely. But the main focus continues to be Spain. The Spanish long-bond rate reached an unsustainable 7.5% late in July, a record for the Euro era. By end July it had fallen back to 6.75%. Note that this rate was frequently higher in the pre-Euro era, and the world didn’t end then!

Source: JPMorgan

Late in the month, the head of the European Central Bank (ECB), Mario Draghi, made a very strong statement that the ECB was ready to do “whatever it takes to preserve the euro”. In case anyone missed the degree of determination he added: “and believe me it will be enough”. He thus set markets up either for a major show of strength, or for major disappointment. I lean towards the former. And it will happen quickly. This week, the FOMC meets on Wednesday in the US, while the ECB and the Bank of England meet on Thursday. It is an ideal setup for a co-ordinated policy response. In the US, that may be as simple as an announced extension of the commitment to keep the Federal fund rate low (perhaps to end-2014 or even 2015), or it may be an announcement of more quantitative easing.

In Europe, the ECB may announce a commitment to purchase Spanish or Italian bonds, and thus drive down borrowing costs in those countries. Germany has been opposed to such a measure, but it can be overridden. In the ordinary course of events, the ECB would not be allowed to buy these bonds, but it is allowed to do whatever is necessary to keep Spain and Italy inside the euro, so that would be how the purchase would be justified. Of course, it may only take the announcement of an intention to buy bonds to scare the “shorts” (those who have borrowed and sold bonds in the expectation that rates would rise). These players would then have to cover their short positions by buying bonds themselves, thus causing rates to fall—it is possible this is what is already happening. Alternatively, the ECB can cut its policy rate or engage in quantitative easing, so it still has a fair bit of ammunition that it can use.

The Domestic Situation

July saw the introduction of the carbon tax (sorry, price) and the world still exists. Even Whyalla is still standing. I suggested last month that it would become part of the economic landscape very quickly, and I see no need to resile from that position. This is not to deny that there will be adjustment issues for some industries.

Perhaps the major economic news was that of continued low inflation in Australia. In the year to the June quarter, the CPI rose by just 1.2%, and even the Reserve Bank’s underlying inflation measure, which strips out the influence of unusually volatile items, has risen by just 2% in the past year. This stands in stark contrast to the “spiraling cost of living” stories so beloved by the media and some politicians. These stories always focus on a conveniently small number of highly visible prices (electricity, water, and petrol when it suits the story, for example). While it is clear that many are “doing it tough”, this is more because their incomes are static and their housing and equity wealth have been hit, rather than because of inflation.

The fact is that, properly measured, inflation is low, indeed so low that the Reserve Bank simply doesn’t have to worry about it. Future interest rate cuts will come about if the RBA is concerned about the state of the Australian economy and the threat from abroad. It is very unlikely that there will be a further cut next week (7 August) and this is significant. The RBA prefers to move immediately after we get new inflation news (which also happens to be shortly before its quarterly Statement on Monetary Policy, in which it can justify at length its current thinking). So no move in such a month suggests that the hurdle for a further move is quite high.

There is one factor that is becoming progressively more important in monetary policy decisions. In the next two years (say), about one-third of all economic growth will come from mining investment and resource exports. Trees don’t grow to the sky, and the boom in mining investment will end. The day that happens, Australian economic growth will slow significantly. On such a day, the RBA will be far happier if the cash rate begins with a 4 than if it begins with a 2. What this means is that, from now on, any discussion about of a further cut will have to address the issue “would we be better off saving this cut for when we may need it more?”

The Bottom Line

Last month I somewhat reluctantly cut my end-year forecast for the ASX200 from 4700 to 4500. There is no further change this month.

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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