Yet another positive month for share markets

It’s clear what the main market-movers were in the month. On 6 September, the European Central Bank (ECB) announced the details of OMT (Outright Monetary Transactions), while a week later the US Federal Reserve committed to “QE3”—more unconventional policy easing.

OMT involves large-scale purchases by the ECB of long-term government bonds of those countries (think Italy and Spain most importantly) prepared to sign up to certain conditions to get their fiscal books under control. Importantly, there is no limit to the amount of bonds that may be bought this is the first time that the ECB has made such an open-ended commitment. The intent of the policy is to stabilise and then reduce borrowing costs in those countries, and hence to slow the upward spiral in debt as interest payments add to the existing level. So far, it’s working. Since the president of the ECB, Mario Draghi, first hinted at such a policy on 29 July, the Spanish long-term bond rate has fallen from 7.50% to 5.94%, while the Italian bond rate has fallen from 6.66% (my ex-wife’s phone number) to 5.09%. This policy does not solve the European debt problem, and pessimists will point out that a previous attempt to get long-term borrowing costs down late last year was only temporarily successful. What it does do is buy time for fiscal repair.

Source: JP Morgan

A week later, the Federal Reserve let fire with both barrels. It extended the time horizon of its commitment to keep the Federal funds rate close to zero from some time in 2014 to mid-2015. In addition, it announced an open-ended commitment to purchase $40 billion of mortgage-backed securities per month, in order to drive long-term interest rates down. This is in addition to the previously announced extension of Operation Twist, under which it will purchase $45 billion of government securities per month for the rest of this calendar year.

Markets interpreted these measures as an indication that central banks will do “whatever it takes” to get growth going, and made the judgment that such policies will have some success. As a result, on the days after each of these announcements, the ASX200 rose by a total of 85 points more than the total rise (71 points) for the month as a whole.

Of course, there are still international concerns. Analysts continue to speculate about the possible dire consequences of the “fiscal cliff” in the United States, and the slowdown in China continues to cause concern.

I have written earlier about the fiscal cliff. This is the name, coined apparently by Dr Bernanke, given to the possibly massive fiscal tightening—equivalent to about 5% of GDP-- slated to take place in the US early next year if lawmakers do nothing. The cliff comes about because of possible mandated spending cuts to bring the Federal deficit down, as well as because of the expiration of the Bush tax cuts, a payroll tax cut and extended unemployment benefits. If nothing is done, this tightening would unquestionably push the US back into recession, with nasty consequences for the rest of the world. One has to think, however, that sanity will prevail. Washington won’t get around to addressing this issue until after the Presidential election (Congress has already left town!), and it may not be fully resolved until sometime in the New Year. This means a continuing period of (completely unnecessary) uncertainty. No matter what, fiscal policy will almost certainly be tightened next year, thus keeping the recovery subdued. But the question is: will the tightening be close to 1.5% of GDP (if sanity prevails) or close to 5% (if partisanship rears its ugly head).

China continues to be an enigma. In September, the consensus forecast for GDP growth for this calendar year was cut again, from 7.9% to 7.7%. It was 8.4% as recently as April. Growth is then expected to pick up to 8.1% (down from 8.6% in March) next year. History suggests that these forecasts may yet be trimmed further. But steel production seems to have stopped falling and, as a consequence, spot iron ore prices have improved significantly since early-September. It is now accepted that commodity prices have passed their peak, and that mining investment in Australia may not be as strong as thought earlier, but it will still be strong. I have made the point before that Australia would have to get used to doing without a boost to real incomes every year just from rising commodity prices.

One consequence of the weakness of commodity prices has been increased speculation that the much-hyped surplus in the Federal budget in the current fiscal year won’t be achieved. In fact, a significant deficit is now likely. What should policymakers do? Absolutely nothing. The Budget bottom line is extraordinarily sensitive to commodity prices and offsetting the loss in revenue from lower prices by means of tightening elsewhere would only magnify any damage to the economy.

The Australian Economic Landscape

In the month, we learned that growth is still doing “OK but not great”. GDP increased by 0.6% in the June quarter, to show year-to growth of 3.7%, down from 4.4% in the year to the March quarter. The labour market continues to track sideways estimated employment has shown no net increase in the past four months and has risen by just 0.5% in the past year. But the unemployment rate remains at a comfortably low 5.1%.

Also in the month, the RBA indicated that it was monitoring the international situation carefully, and that it stood ready to cut the cash rate again if required. If history is any guide, expect a cut on Melbourne Cup Day, although a reduction in early-October (this week!) cannot be ruled out. Financial markets have four more rate cuts, totaling a full percentage point, priced in by mid-2013. I continue to think that this is overly aggressive.

Productivity Revisited—Australia Post could lift its game!

I wrote about Australia’s apparent poor productivity performance two months ago. I suggested that there was no “magic pudding” that would guarantee a better future performance, but I did suggest that one way to improvement was to do a myriad of (small) things better. I have a real-life example.

My wife and were away from home from 27 August until the evening of 19 September. A kind neighbour picked up our mail in that time. A package arrived on the very first day we were away, or rather a note was left that a package (possibly two) was available for collection any time in the next 5 days. Quick-thinking neighbour called Australia Post, with the information that we would not be returning until late on the 19th. That would be no problem he was told. On 21 September, I fronted the counter to pick up the package only to be told that it (or them) had been returned to sender on the morning of the 20th. When I asked why they bothered to hold the package the whole time we were away only to send it back as soon as we returned I was told “that’s our policy”! I enquired as to whether they could tell me the identity of the sender. “No”, said the counter-person, adding helpfully that “it was wine”. So, if you sent me wine in August and it has been returned, please resend. Only an extreme cynic would jump to the conclusion that it brightened the evening of a postal employee.

The Bottom Line

In early-July 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.