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Nothing but blue sky ahead?
01/05/2008
Most investors would have felt some relief in April. For the first month in six, the ASX200 index rose as share markets around the world settled down somewhat. Credit markets also eased; the US Federal Reserve has been adding liquidity to the system, and it was joined in April by both the Bank of England and our own Reserve Bank. Their efforts appear to be bearing some fruit.
Does this mean that it’s all over, and that investors can assume that there is nothing but blue sky ahead? Unfortunately not. Despite the protestations of many, the US economy is in recession, and there may well be significantly worse news to come. If there is, it is still possible that markets have not yet reached their lows. If, on the other hand, the US recession turns out to be mild, as many believe, then equity markets may already have troughed (which is not to say that they can’t go down from current levels).
Par for the course, part of the cycle
Of course, we all know that investment is a long-term project, and the wise will be looking beyond the next 3 to 6 months. Just as share markets hate recessions, they love recoveries. Past performance is no guarantee of the future, of course, but the past performance of the US share market during recoveries has been remarkably impressive. First, the market usually turns before the recession ends. In 7 of the past 8 recessions, the market has “led” by between 3 and 5 months (call it 4!). The average recession in the post-war period has lasted for 10 months. I estimate that the business cycle peaked in December, so “par for the course”, if the recession is average (which is worse than mild!) would be that the market hits its low point in June. This isn’t a forecast – the market may already have turned (in March), or it may not turn until some months after June. But June is “par for the course”.
In its first 12 months of recovery during and after the past 8 recessions, the US share market has never gone up by less than 25%, and its average gain has been 33%. As has been said many times, they don’t ring a bell at the bottom, so the only way in which investors can be guaranteed their share of the recovery gains is to stay in, even if that costs them in the next few months.
A closer look at the Australian market
If and when the US market begins to do well, the
Australian market will undoubtedly follow. And it now appears unlikely that
interest rates will rise again in the near future. Make no mistake: Australia
has an inflation problem. In the year to the March quarter, the CPI rose by
4.2%, with “underlying” inflation about the same. This latter fact means that
current inflation cannot be dismissed as “it’s just food and petrol, so we
can’t and shouldn’t do anything about it”. As I have written before, the
Reserve Bank (RBA) is in a very difficult position. Since last August, it has
tightened monetary policy significantly in order to slow down the rate of
growth of the Australian economy, and thus “turn down the heat” under
inflation. The problem with using interest rates to slow growth is that they
work with a lag, so you never know if you’ve already done enough until the day
that you find that you’ve done too much—at least that is what usually happens.
Tightening too much causes problems, but so does not tightening enough— it’s a
lot easier to bring inflation down from 4% to 3% than to bring it down from 5%
to 3%.
While the labour market data continue to suggest that the Australian economy is
still strong there are some partial indicators—dwelling approvals, lending for
housing, retail sales and consumer and business confidence—that suggest that
growth has slowed. The RBA will thus take a calculated risk that it has already
done enough to bring inflation down. It will, however, keep monetary policy
tight until it is clear that this is so. Don’t expect any rate cuts soon!
A broad view of commodities
April saw some interesting developments in commodity prices. Oil prices surged again, and food prices are rising rapidly all over the world. Just why oil prices are so high is a mystery to me. I don’t think they can be justified by supply and demand considerations alone, and it is quite bizarre that prices continue to surge while US gasoline demand remains very soft. In the year to the March quarter, petrol prices in Australia rose by 19%. The chart shows how petrol prices have fared relative to the overall CPI .They are about one-third higher than their long-run average.
Food prices are soaring because of unfavourable
growing conditions in many parts of the world, because of increasing demand in
the developing economies, and also because supply of corn and soybeans, in
particular, have been diminished by diversion towards the production of
biofuels. World dairy prices have risen by close to 50% in the past year, and
soybean prices are up even further. Rice prices have increased enormously. Food
prices have become both an inflation and social issue in many developing
economies. A few months ago, I would have said that made no sense to be worried
about slow US growth and high inflation at the same time. Now I am not so
sure.
As in the case of oil, it appears that some of the price rise is due to
speculation, in which case prices should stabilise soon. In any case, it is
almost certainly too late for rational investors to be contemplating investing
in (soft) commodities!
And a word on the Budget
Finally, there’s the Budget to worry about. Budgets
are no longer the financial-market event that they used to be, and rightfully
so. As a general rule, an incoming government’s first Budget is often its best
budget. It’s a lot easier, for example, to cut your predecessor’s spending
programmes than to cut your own. Expect an aura of fiscal responsibility, a
relatively large projected surplus and, of course, the tax cuts as
promised.
Chris Caton
Chief Economist
| Dr Chris Caton writes a regular column providing topical financial commentaries, economic overviews, and assessment of investment issues. Investors can access Caton's previous columns by visiting Caton's Corner on the BT website. |