Markets had a mixed month

It was a confusing month for markets. The ASX200 fell for just the second time in eight months, by 0.3%, closing at 4823. I made the point last month that April is usually a good month, but this turned out not to be the case. By contrast, the US share market, as measured by the S&P index, rose by 2.8% in the month, to bring its gain since early-March 2009 to a phenomenal 101.6%.  The comparison between here and there was at its most stark in the final week of the month. The US market rose by 2% while the Australian market fell by about 2% in just three days. It’s clear what the current major concern of the market is: the incredible levitating Australian dollar.

In the past year, the Australian market has risen by just 0.3%, being easily outpaced by the US market (up 13%). For 2010 to date, the difference is 1.6% compared with 8.4%.  At first glance, this is puzzling given that the Australian economy has been doing so much better than is the US.  But its growth rather than levels that causes markets to improve and earnings growth in the US has been better than in Australia.

The incredible rising $A

One thing holding earnings back in Australia is the (by now) super-natural strength of the Australian dollar, which is worth $US 1.097 as I type. This is clearly making it tough for all Australian businesses with international exposure.  I have made the point before that the $A is overvalued, with its “fair value” probably just above 90 cents, but there’s no way to know when it will stop levitating.

This fair value has risen by more than 10 cents in the past year for one very simple reason; the US dollar has fallen. Put another way, close to half of the strength of the $A in recent months has in fact been weakness of the US dollar. Thus, for example, we have actually fallen (slightly) against the euro since the start of the year.

US concerns

Why is the US dollar weak? For a myriad of reasons. It began to fall systematically in late-August 2010, when Fed chairman Ben Bernanke announced the Federal Reserve’s intention to engage in quantitative easing (QE2)—that is to purchase long-dated US government securities and hence add to private-sector liquidity. The kneejerk reaction has been that this will increase the supply of US dollars, and hence make them worth less, so the US exchange rate falls. Far be it from anyone to point out that, in fact, the supply of US dollars has not been growing unusually quickly. QE2 is due to end on 30 June; many analysts have suggested that a good deal of paper will hit the fan at that time, but for me it’s just another day.  (Forgive me for being stylistic).

The end of quantitative easing reminds many that the next move in interest rates in the US is up, and there is speculation that it may now happen this year. Once again, knees tend to jerk. Rising interest rates, it is said, are bad for share markets. In fact, on the last eight occasions that the US has begun to raise rates the share market has averaged gains of more than 8% in the following year.

One further US concern arose in April. The S&P rating agency reaffirmed the AAA status of US government debt but downgraded the long-term outlook from stable to negative because of concerns about the US’s ability to come to grips with its long-term deficit issues. The agency estimated that the chance of a downgrade within two years was about 1 in 3. The real chance must be less than this. The current ratio of US marketable debt to GDP is about 70%. Downgrades from AAA typically tend to occur when this ratio gets close to 100%. While the rate of growth of government debt has to be curtailed in the future, there is no precipice out there in the future.

Of far more potential importance to markets in the short term is the looming debt ceiling. In the absence of Congressional action, the US government will lose the ability to issue more debt sometime between mid-May and early July. Unless something is done, this will require a drastic curtailment of Federal spending. Something will be done (as always) but not before a few displays of brinkmanship.

Other International Concerns

Of course, it’s not only US debt that is an issue. In the month, Eurozone debt concerns increased, particularly in Portugal and Greece. The chance of a (partial) default in one or both of those countries is now quite high. Is this the end of the world? Unquestionably no. It’s a big issue for the countries concerned, but the combined size of the Greece, Portuguese and Irish economies is less than that of Florida. Can you imagine becoming concerned about possible debt issues in the Panhandle State?

An International Bright Spot

Several years ago, a firm in London, Consensus Economics, had a good idea to make some money. It co-opts numerous economists in various countries around the world to provide their forecasts of GDP growth, inflation etc. I’m on the Australian panel. Then Consensus Economics averages the forecasts and sells these averages back to the contributing economists! Who said ingenuity was dead? The forecasts usually cover the next year or so, but every six months we provide long-range projections for the next decade. The update in April had one remarkable feature; for the first time this century, the major country thought likely to grow most rapidly in the next 10 years is not China but India. This doesn’t mean that India is yet the fastest grower, only that it is thought likely to become so some time in the next 10 years.

This was always going to happen eventually. India has far stronger labour force-growth than China because of its very different demographics, and it’s poorer, so it can play “catch-up” for longer. And it’s not as if China has suddenly waned. Indeed, the latest International Monetary Fund (IMF) forecasts suggest that, by one mode of measurement, the size of the Chinese economy will exceed that of the US within five years.

And so to Oz

The most important domestic economic news in the month was the CPI for the March quarter. This showed a large rise, of 1.6%, in prices paid by consumers. Petrol prices have risen through no fault of our own, while the January floods and cyclone pushed up the cost of fruit and vegetables. In addition, electricity rates were raised in several States and there were other seasonal influences on the cost of education and health services. A high inflation report quickly begets talk of higher interest rates. At least one rate rise is likely, probably after mid-year, but not because of this CPI report. There is no endemic inflation problem in Australia, but the economy is close to full employment and we need to be able to accommodate strong growth in mining investment and in re-construction spending. Were it not for the spate of natural disasters and the strong exchange rate (which is doing some of the work of slowing the economy) the RBA would probably have raised rates already this year.

Finally, it’s early-May, so the Budget is looming. As usual, the ground is being laid for a “tough Budget”. After the first 20 years, this kind of pre-talk tends to become a little jading. The Government has recently acknowledged that the 2010-11 deficit may be close to $50 billion, rather than the $41.5 billion it forecast last November. Despite the strength of the economy, revenue growth has been lagging. The large deficit is a hangover from the quite appropriate fiscal response to the GFC, but one would have liked to have seen more progress in winding it back since then, given that the economy has returned quickly to something close to full employment. The Government is still committed to returning the Budget to surplus by 2012-13, but it wouldn’t be a surprise to see this target slip by a year on 10 May when the Budget is delivered. And bear in mind that the expected outcome for the current year is more than $8 billion different from what was expected less than six months ago, so how much faith should one put in figures for a year or two ahead?

Chris Caton

Chief Economist

The views expressed in this article are the author’s alone. They should not be otherwise attributed.