Another good year - but what lies ahead?

The Australian share market proved remarkably resilient to the rise in global market volatility throughout 2007, posting yet another year of strong returns. But where to from here? BT’s Chief Economist, Dr Chris Caton, looks at what investors might expect in 2008.

The Australian share market did reasonably well in 2007, although not as well as in recent years. This was despite three ‘corrections’ — in late February, July–August and November–December. Over the course of the year, the Australian market rose by 16%, while the US market was up by just 3.5%, and global markets in general by about 4%.

The corrections in the Australian market, as always, began offshore. The catalysts were the Shanghai share market, and the sub-prime mortgage issue in the United States, which precipitated both the second and the third corrections.

Of course, whether or not an Australian investor has done well this year depends critically on his/her exposure to BHP Billiton and Rio Tinto. These two stocks accounted for much of the rise in the S&P/ ASX 200 Accumulation Index in 2007.

So what happens next?

Given that the performance of the Australian market is so dependent on the rest of the world, particularly the United States, it is unlikely that 2008 will be as good a year again. In the past three months, the consensus forecasts for 2008 GDP growth in the United States, Japan, Europe and even China have all been cut, although not slashed. The strength of the world economy has been the main reason for the strength of share markets since 2003; it will not contribute as much support next year. And this leaves aside the ongoing open question as to whether the United States economy avoids recession.

In addition, the price/earnings ratio for the Australian market is now, very unusually, above that of the rest of the world, suggesting that our domestic market is relatively expensive. My view is that the domestic market will grow by 7-10% in 2008 provided that the consensus view is correct and the US skirts recession.

There is one thing that Australian investors probably will not have to worry about. Despite the sabre-rattling by the Reserve Bank of Australia (RBA) after the November rate rise, it now seems unlikely that the official cash rate will rise again in February, unless the CPI inflation news announced on 24 January is bad.

Every silver lining has a cloud, however, and one of the reasons for doubting that official rates will rise again is that short-term credit markets have already effectively done the RBA’s job for it. The 30-day bank bill, for example, is now almost half a percentage point higher than it would ‘usually’ be given the level of the official cash rate. This has driven up the cost of funds for lending institutions, and we have already seen the major banks pass some of this on in their lending rates.

Will we be better off under Labor?

On 24 November 2007, the Australian electorate voted for change, electing Labor and Kevin Rudd after 11½ years of Coalition rule. During the campaign, the Coalition made much of its superior credentials for economic management. In my opinion, this argument was always deeply flawed; there is no proof that Labor would be any better or worse at short-run management of the economy. That said, there will be some economic effects of the change in government. The abolition of Work Choices runs the risk of leading to higher wage inflation, given the current tightness of labour markets. On the other hand, there is reason to believe that fiscal policy may be more responsible under Labor. This may seem like an extraordinary thing to say, so let me justify it.

Both parties behaved like drunken sailors in the run-up to the election, giving away tens of billions of dollars in tax cuts and spending promises. Labor did promise somewhat less it is true, but that’s not where its advantage comes from. Labor has indicated that it will look hard for areas of spending that can be cut to offset (partially) its largesse elsewhere. It’s always going to be easier for a new Government to find areas of (the previous government’s) spending to cut!

There are likely to be economic differences as a result of the two sides’ different degree of enthusiasm for climate change policies. Labor has indicated that it will quickly ratify the Kyoto Protocol. Figuring out the effects of policies designed to slow down climate change is a very new sport, so there is a good deal of uncertainty about magnitudes. But it seems clear that any such policies will tend to reduce growth and increase inflation in the short-term, being the price we have to pay to improve the environment, and hence the economy, in the long-term.

At a sectoral level, climate change policies will clearly be positive for companies involved with renewable energy, and negative for the rest of the energy sector, since the cost of energy will surely rise.

As a general rule, there is no significant effect on financial markets from election results, or changes in government, and there is no reason to expect any exception to this rule in 2008.

Dr Chris Caton writes a regular column providing topical financial commentaries, economic overviews, and assessment of investment issues. Advisers can access Caton's previous columns by visiting Caton's Corner on the BT website.