A tale of two economies

How is 2012 looking so far?

It’s pleasing to say that 2012 is off to a better start than 2011 — it’s certainly looking better at this point. Generally, the world’s economy seems to be in better shape, or at least less shaky than it was last year, and there is more positive economic news, particularly coming out of the United States (US). Consequently, sharemarkets this year are up. That said, problems still persist, with the main economic issue on the horizon continuing to be high European debt levels.

How significant is the Greek debt problem?

Greece remains at centre stage, and continues to threaten European economic stability. While Greece decided to make significant cuts in order to qualify for the second bailout package from the European Union (EU), it’s nowhere near plain sailing ahead. We don’t think Greece can grow its way out of the severe economic malaise that it finds itself in. No matter what financial assistance the country gets in the short term, in the long term its underlying economic problems still remain, and this will bear down on markets for some time yet.

We believe that in the long run, Greece will need to leave the Eurozone, as its debt situation will make complying with EU membership rules impossible. Greece will then be left in the invidious position of no longer being able to go to the international markets and borrow at anything like the lower rates it was able to do so previously — simply, it will become very expensive for the country to borrow. This will prolong any kind of recovery by years, and could even prompt a slide into a depression. The rest of Europe — the German, Italian and French banks, and the EU itself, will all have to write off the Greek debt they hold. Someone has to pay, and it’s going to be the European financial system that comes under strain and stress as a result.

Will a Greek default bring down the European Union, or worse still, the world financial system?

Fortunately, the answer is no — it’s very unlikely to destroy either. The reasons are, firstly, that the EU has been reasonably proactive in trying to stabilise and boost the European financial system through the so-called LTRO (long term [debt] repurchase operation) activity that it is using to provide cheap money to financial institutions.

Secondly, we need to put the Greek situation in context. Remember that Germany, Italy and France together account for about 70% of the EU’s Gross Domestic Product (GDP). On the other hand, Greece, as well as Ireland and Portugal, are comparatively very small satellite economies which, from a European GDP point of view, are relatively insignificant. This means that a Greek exit from the Eurozone, while clearly serious, and which will make life very difficult for the Greek people, will not be of great enough magnitude to deal a death blow to the EU or the European economies.

Likewise, given the even smaller size and consequence of the Greek economy on a global scale, Greece’s problems have even lesser chance of bringing the entire international economy down. Regardless of whether Greece exits from the Eurozone or not, for the rest of the world, life and business will go on. The US and other countries, ourselves included, will still continue to export worldwide, including to Germany, France and Italy, and they in turn will continue to export their products worldwide. All this taken into account, while lots of people are worried, we don’t believe the issues in Greece are serious enough to bring on another Great Depression.

How is the US faring, and economically how does it compare to Europe?

The US outlook is brightening, which is very important because the US is the country to lead the world out of recession — and that actually appears to be happening. The US consumer, economically the most important in the world, is spending more. Manufacturing is expanding, domestic vehicle sales are trending upwards, unemployment rates are falling and the US sharemarket has really taken off since the beginning of the year — the S&P 500 was up about 11.5% from the start of January to the end of February, which was ahead of the rest of the world. Overall, the US economy seems to be on track to recover and grow again, which is very encouraging.

As mentioned, the European outlook is less cheery but that aside, the purchasing managers index (PMI) for Europe is hovering around 50 (out of 100), which indicates Europe overall is neither expanding nor contracting. However, when you take a closer look at the data, you find that only the German economy is expanding, and that others, Italy and France included, are contracting. Clearly, lots of European economies are still in trouble, and really not yet back on the growth path. Generally, in Europe, consumers aren’t spending — retail sales, no doubt crimped by austerity measures, are weak, and industrial production is down and quite disappointing.

What we see when comparing the US and Europe is a ‘tale of two economies’. The US — the world’s most powerful and important economy — is getting back on track, leading to what you could call a kind of grinding recovery. Europe, on the other hand, is experiencing some economies going backwards, and the introduction of austerity measures and budget cuts in some countries means any serious recovery will be delayed for some time.

What about Australia?

In Australia, the December quarter and Christmas retail figures were lacklustre; house prices year-on-year in many parts of the nation continue to fall, despite what may be a more recent lift in auction prices; inflation is reasonably in control at 2-3%, which is where the Reserve Bank of Australia (RBA) wants to keep it; and one more interest rate cut is likely this year. The RBA is being reasonably cautious and keeping a very keen eye on Europe, and if rates need to be cut again, they will be.

A positive outlook for investors

Fortunately, things appear to be getting better, not worse. We are looking at a world economy that’s generally growing, albeit below trend — but at least it is growing rather than contracting. This change is welcomed by share investors, because sharemarkets react positively to growth.

Many Australian companies are currently offering very attractive dividends and dividend yields. For the cautious investor moving into the Australian sharemarket, it makes sense to buy higher dividend yielding companies, as these will provide a return on dividends alone that’s at least comparable, if not better than the return from term deposits — but shares also include the potential for capital growth.

With international equities, I think investors should be cautiously looking to buy. At this stage, much of the uncertainty of last year is behind us, and headway is slowly being made. The Greek problem, while not gone, is more understandable now and many people have factored in a lot of very bad news on that front. Currently, there are some quite reasonable arguments to move back into international shares, particularly into quality US shares, followed by European shares.

A final word on the economic outlook

Overall, our economic outlook could be reasonably described as cautiously optimistic. While there’s bound to be a few road bumps along the way, there are more reasons to be cheerful about the state of the world economy than there were six months ago. Things are looking a bit brighter, and that’s got to be good for Australian investors who have had a rough ride in the last few years. There’s fair reason to believe this year and the next few ahead will be smoother.