An update from Chris Caton – December 2010

So, you know, why are we down? After all, the GFC is over. The Australian economy has done very well - witness the strong labour market news we got recently - and the answer is of course that people still aren’t buying the story. They’ve got this wall of worries. They’re worried about - I used to say Greek debt, but now I have to say Euro zone debt. They’re worried about the possibility of a slow down in China and they’re worried about a double-dip recession in what is still the largest economy of them all - the United States.

Briefly, I think all three of these worries are overstated. The - believe it or not, if you add up Greek debt, Portuguese debt, Irish debt, that’s less than sub-prime mortgage debt was - and the thing is, the government debt now all has a value and everybody knows who’s holding what, and that makes it very different from the GFC.

Now of course, if there were a default of any kind, then yes, some banks in Europe would be hit. But this is a clearly survivable event.

The slow down in China

Slow down in China - yes, Australia’s a lot more wedded to China now so it becomes more and more important. They are trying to slow that economy. They’ve got an inflation issue. They’ve got a couple of property bubbles, but early last year does show that when it does - China does slow, perhaps too rapidly - sorry, slows too much - which is the fear - when that does happen the authorities there are pretty good at turning it around and getting it going again.  So even though it did slow too much - temporary.

Double-dip recession in the United States - somewhat paradoxically the single biggest reason why this is not going to happen is because everything that leads you into recession - such as housing, business capital spending - is still so weak from the first one that it can’t possibly fall far enough and fast enough to get you overall negative economic growth.

So I think these worries are overstated and there is no question the Australian share market is cheap right now. Just look at the PE ratio - and if you’re cheap because you’re worried about stuff that isn’t going to happen, that says to me the Australian market can make some significant progress.

I’ve got an ASX 200 forecast by the end of next year of 5250.

Interest rates

Now elsewhere - interest rates. The Australian economy is doing very well. We’re very close to full employment. We’ve got one sector - mining - that wants to grow and grow and we want to let it, and the only way you can accommodate that supernormal growth without overheating the whole thing is to raise rates. We’ve done that already. The Reserve Bank doesn’t have to hurry because we don’t have an inflation issue in Australia, and so there probably will be further rate rises next year, but I’ve got two priced in.

Incidentally on this - the Reserve Bank is not stupid - so when you do have episodes, such as in November when there were out of cycle rate rises by the banks, the Reserve Bank knows that people don’t borrow at the cash rate. They borrow at the variable mortgage rate or at the small business lending rate and so when you get these out of cycle rate rises the Reserve Bank’s response probably is, well that’s one fewer time I have to raise the cash rate.

At the end of the day they’re moving the mortgage rate and the lending - and the borrowing rate to where - to what they think is the right answer for optimal control of the economy right now.

So what that means for example is all this talk about increased competition in the banking sector may make it easier for people to switch, and that would be good. May make the banking system more efficient, but it is unlikely to mean that borrowing rates will suddenly drop significantly because the Reserve Bank wouldn’t let that happen.

Parity with the US dollar

Now, elsewhere of course, big story right now, the exchange rate still. I was a big believer we wouldn’t go through parity and I have no objection to it coming back below it. Fair value for the Australian dollar right now - $0.85 - by my calculations, and I think we will come down eventually.

But currency forecasts are very difficult. We’re caught up in a currency skirmish right now going on around the world, the ultimate aim of which is to get China and the other emerging markets to revalue their currencies. It will continue to be volatile, but I think eventually come down.

But you can say this about the currency - right now the rest of the world is on sale for Australian travellers, online shoppers and investors - the rest of the world is on sale right now.

So that’s a quick look at share markets, interest rates, and the exchange rate. The Australian economy - I mentioned already - doing quite well, and yeah the retailers have a bit of an issue at the moment, in part because rates have risen, also in part because there aren’t as many tourists shopping in stores in Australia as there usually are, and there’s a lot of Australians shopping either online or just overseas anyway.

So yeah, retail trade is suffering.

House prices also - a bit of a question about them. Just very briefly, we’re not in a bubble, we’re a bit over-valued. I wouldn’t be looking for strong house price gains in 2011, but I wouldn’t be looking for a crash either.

So that, as I said, a brief summary.

Thank you for listening. Have a great holiday season and hopefully we’ll get to do this again in the New Year.