US economy still the biggest show in town

Events in Europe are not as critical for investors as the worrying signs from the United States, writes Matthew Kidman.

Events in Europe are not as critical for investors as the worrying signs from the United States, writes Matthew Kidman.

The French would have collectively pumped out their chests with pride last week, as the old-world darling took centre stage for a scintilla. It has been a long time since the global community thought about France's importance to the plight of the world economy. At the same time Greeks must have felt like jilted lovers following a torrid two-year on-and-off affair with financial markets. Not to be outdone by the French, the Greeks dolled themselves up and strode back on the world stage by botching their general election.

The events in these two European nations have drained the confidence of investors at a time when sentiment was on the mend. The US sharemarket had risen 30 per cent since the start of October last year while the Australian bourse had managed a 15 per cent gain. If the Greeks do end up leaving the European Union and the French prove recalcitrant by standing up to the Germans, then volatility in global financial markets will persist. These concerns will be magnified if recent political machinations lead to a dismantling of the euro. However, for local investors this should not be the focal point.

The tripwire for the last week's sell-off in global equities was not solely European political events but economic data in the US. Investors had been suspicious of a slowing US economy but were shaken by a weak April employment number. This followed a discouraging March jobs report and is the latest in a series of data below investor expectations. While a lack of jobs growth would seem to have taken investors by surprise, the writing has been on the wall for some months.

An index of surprise lead economic indicators taken by the US bank Citi turned down sharply in late January and early February. Inspired by the high oil price, these indicators have continued to head south. The Citi index has been a fabulous warning siren for investors in recent times. In April last year the index spun on its heel and turned down at a rapid clip. Sharemarket investors, star-struck by the prospects of more quantitative easing by central banks around the world, merrily ignored the economic reality. History tells us that four months later investors panicked, pushing all the major sharemarket indexes down by about 20 per cent.

Make no mistake, volatility and sentiment have shifted dramatically in the last few weeks and most of this stems from the US. The US sharemarket still accounts for about 30 per cent of world equity markets. It must also be remembered that US capital is the lifeblood for global equities with its tentacles in virtually every corner of the earth.

If investors want to worry about a single aspect of the world, it would be wise to concentrate on those lead economic indicators in the US before being too upset whether a socialist government has been elected in France for the first time in 17 years. With US interest rates next to zero, significant excess labour capacity and the great recession three years past, the US economy should be growing by 5 per cent to 6 per cent per annum. The fact growth has stagnated at between 1.5 per cent and 3 per cent keeps investors sensitive to bad news. If the US economy were notching up numbers like 5 per cent growth, investors would only give the European woes a cursory glance.

Just as importantly, Australian investors should be aware of the reality that we are still travelling through a secular bear market at home. This is characterised by many short, sharp rallies that all eventually fail. While the reduction of official interest rates should eventually break this cycle, we are seemingly not at that stage yet. This does not mean we should totally discount what is happening in Europe. A slowdown in European economic growth or even a contraction has major knock-on effects around the globe. The first that comes to mind is less demand for Chinese manufactured goods, which in turn dials down the demand for Australian commodities. One has only to look at the sell-off of Australian resource and mining services stocks in the last few weeks to understand how nervous investors get about the plight of Europe.

Following last Monday's 2 per cent sell-off on the ASX, 79 companies hit 12-month lows, of which 60 were mining or mining-related companies. In other words Europe is important but does not deserve top ranking despite all the political turmoil.

The overall direction of the Australian sharemarket will always depend more on the events in the US. If the US lead economic indicators continue to decline, then stay well away from the equity market. If they turn up like they did last August, then raid the savings account and jump into the equity market. The next time this happens, fingers crossed it is the beginning of a secular bull market.

The Herald accepts no responsibility for stock recommendations. Readers should contact a licensed financial adviser.

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