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 MARKET REPORTS |
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Economics
The Recession we don’t have to have
January 16, 2008
Clifford Bennett, Chief Economist, Sonray Capital Markets
Former Australian Prime Minister Paul Keating famously described one economic down-turn as, the recession we had to have. While many commentators are citing the “R” word for the US, a brief look at history shows how quickly US slow-downs have previously spread to Australia.
It seems highly unlikely perhaps, but it always does at the top. This time things are different, but nevertheless the second half of 2008 could see a surprising risk of recession, one we do not have to have.
The immediate response of most readers I suspect, in Australian parlance, is “why the hell are we talking about a Recession?”
Australian economic data is strong across the board, Asian demand for our commodities continues to grow, new car sales are at record levels, and the supportive data continues across the country like a road train, suggesting the Reserve Bank of Australia will have to raise rates to stop it from over-heating. That would be on the Nulabor plain however, in Western Australia.
In eastern Australia the first cracks are appearing that suggest a historically repetitive following of the US economy toward flat to negative growth cannot be ruled out.
Australian equity markets are sharply lower this year. This is of course mainly due to the falls on Wall Street, yet last week we saw an ominous development in Australian valuations that had not been there before.
When the US markets rallied quite strongly on Thursday, instead of following suit as usual on Friday, the Australian market had another down day. While there were local stories of weakness, this was still a very weak performance in light of the US market rally. It suggests a domestic equity market that has become over-valued, at least in the short term, or does it highlight the cautiousness Australian investors can quickly develop when there are clear indications of a severe US slow down, as is now the case.
Australian property prices, at least east coast prices, are as vulnerable as they have ever been. Many would argue against this view on the basis of the very strong, even double digit, price gains seen in prime suburbs over the last year. We will not use the term sub-prime, but the less wealthy suburbs of the east coast, particularly of Sydney, have fallen in value over the last
year. In some cases by as much as 7%. That is a big number, and suggests tightening credit pressures on the domestic banks to increase mortgage rates could have an amplified impact in those less wealthy suburbs. The key to the concern here, is what has happened in the US. There, home values are negative across the entire country, but values first began falling in the less affluent suburbs, and have only recently reached even the East Hamptons.
The American experience over the last 1-2 years suggests for Australia that one cannot be complacent about strong home prices in the wealthier suburbs. It can be the case that weakness in the so called western suburbs of the east coast, are a sign of trouble ahead for the eastern suburbs as well.
The Reserve Bank of Australia concerned with inflationary pressures, driven by near full employment, capacity constraints, and high oil prices, is likely to lift interest rates further, perhaps at the next meeting. While some of us may feel that this is inappropriate, and even as I do that inflation is controlled by true competitive pressures in the modern era rather than central banks in, the fact remains that the RBA itself still thinks it has the dominate role, and given inflation is likely to spike higher immediately, the RBA can be expected to hike by 25 points at the next meeting. This is regardless of the independent lifting of mortgage rates by domestic banks, as it should be, as such moves are not broad in their immediate impact on the economy, as are RBA rate hikes.
So how the hell could there be a recession in Australia later this year? How about equity market declines, property market declines, and higher interest rates. Sure the export economy may well remain strong, but what of the domestic economy on its own. Exports will add to GDP, especially as infrastructure bottlenecks continue to be cleared, but non-trade GDP could be in trouble in the second half of the year.
Given all the negative headlines about at the moment, it is likely retail sales have peaked in November and
December, and may well consolidate through the first half of 2008. Investors will be increasingly cautious given the experience of Centro, the on-going sub-prime crisis, and in some suburbs at least, severe home value weakness.
This would still not be enough to create an Australian recession, but there is one ingredient that has the capacity to push the Australian economy over the edge. The mere reality of the historical linkage of the Australian economic cycle to that of the US, could be enough to send the same level of psychological fear across the Australian business community as is already prevalent in the US. In other words, justified or not, Australian businesses and investors could begin to “fear” a recession here in Australia. It only takes the fear of a recession, to create one.
The good news is that this is a recession Australia does not have to have, due to the tectonic shift of economic and in some cases political power away from the US and toward China. The majority of Australian exports go to Asia, and recent China trade data points to increases in exports to Europe and other regions and not just to the US. The world is not as US dependent as it once was. Strong regional growth across the globe means intra-regional trade, rather than the US centric trade patterns of old, now prevail.
Subsequently stagnant US growth will have only a marginal impact of 0.3% to 0.5% on global GDP. The rest of the world should continue to grow strongly.
The real risk for the Australian economy is that Australian businesses and investors perceive a greater “old world” level of risk, and act in accordance with that fear, instead of seeing the world for what it is today, one of broad based regional economies increasingly feeding one another’s growth.
The risks to the Australian economy are real, being equity and property market weakness combined with higher interest rates, but the current strength of Asia in general, and the Australian economy itself, can deal with these challenges. The problem is the risk of businesses following an old pattern of
behaviour, following what US companies are doing, based on history and strong cultural links, and reigning in fresh investment and spending?
As long as business and investors view the economic strength in Asia as having displaced the US as the main driver of the domestic economy, then Australian economic growth will remain robust through 2008.
In effect it is not enough that Australia is in reality no longer as dependent on the US as it once was, and that our major economic partners in Asia and elsewhere in the world will continue to grow strongly. Australian businesses and investors have to see this as being the case, and then act appropriately to this new global economic environment.
Key Forecasts:
- Fed will cut three times by 25 points in 2008.
- US economy will flirt with negative growth Q1, Q2.
- US equity markets remain at risk near term.
- China to remain a powerhouse.
- Global economy to remain firm.
- Commodities volatile but bullish.
- Gold target at US$495, US$800 achieved, US$1100 next.
- US dollar to continue accelerated collapse over next 6 months.
- Carry trade is old news and over, USD/YEN to decline to 103, 97.
- RBA to raise rates to 7.25% in H1 2008.
- Australian dollar will continue to climb, 93 cent target achieved,
next parity $1.00, but in 2008, then 1.08 1.12 in following year.
- Global equity markets may suffer minor drag from US market
weakness occasionally, but remain strong.
- Australian equities increasingly aligned to global growth. 6,900 7,350 in 2008.
More articles from this edition of CompareShares:
Stocks: Uranium stock picks for 2008
Investing: Stocks to hold in turbulent times
Resident Trader: Making typos when inputting trades can cost you big time
CFDs: How do margin calls work on CFD trading?
Analysis: The Recession we don't have to have
Smart Investing: Taxation of super savings upon death
US: Citigroup has $10b loss, US markets dive
Commodities: China coal shortage to continue
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