Chris Caton weighs up the chances of a slowdown in China, a double-dip recession in the US and sovereign debt problems in Europe during 2011.
AT the end of 2010, the Australian share market was below the level at which it started the year. It is one of just four major markets in negative territory, with Japan, China and Brazil for company.
And the question is: Why?
After all, the global financial crisis (GFC) is over — but the hangover remains. The world economies have been growing for more than a year. It’s been slow growth, but even slow recoveries generate earnings growth, the lifeblood of share markets.
The answer, of course, is that nobody is quite convinced and markets continue to climb a wall of worry.
They worry about Eurozone debt, about a possible slowdown in China and about a double dip (ie, a return to full-blown recessionary conditions) in the United States.
The Eurozone issue appears to be getting worse. Ireland has been granted at least a temporary reprieve, with aid forthcoming from the International Monetary Fund and the European Union.
But others, particularly Portugal and Spain, remain in the crosshairs. Spain is by far the largest in economic size (close to 12 per cent of the total European economy and bigger than Greece, Ireland and Portugal combined) and hence the biggest potential risk.
Having said that, its public debt to gross domestic product (GDP) ratio is relatively low.
The Eurozone debt issue is clearly important for the European banking system, and if there is a default at any stage the banks will suffer.
But there are important differences from late 2008, when the full severity of the GFC struck.
Back then, no one knew who was holding what on their balance sheets, or what the ‘assets’ were worth.
Now at least, not only is the problem smaller but it is far more transparent. A default, full or partial, would hurt — but it would be a clearly survivable event.
Similarly, the other two market fears are almost certainly exaggerated. It’s true that China is trying to slow that economy because it has something of an inflation problem, but even if it were inadvertently to slow too much, the Chinese authorities have proved remarkably adept at getting it going again.
Paradoxically, the reason the US is not going to ‘double-dip’ is that everything that usually leads an economy into recession (eg, housing and business investment) is still so weak from the ‘Great Recession’ that it can’t possibly fall fast enough and far enough to cause overall negative growth.
These fears have weighed on share markets to such an extent that they are now demonstrably cheap. The price/earnings ratio for the Australian market, for example, is well below its long-run average.
Cheap markets can get cheaper, of course, but they don’t stay cheap forever. I anticipate that these concerns won’t go away quickly, but the worst fears won’t be realised, and hence markets can get some traction.
I see the ASX200 index at 5250 by the end of 2011, up by more than 10 per cent from its current level.
Meanwhile, the Australian economy has been doing very well. Employment has increased by 3.7 per cent in the past 12 months, and the mining investment boom still has a long way to run.
Given that we are starting from a low 5.2 per cent unemployment rate, this boom can be accommodated only if growth elsewhere is restrained.
The Reserve Bank of Australia (RBA) Governor, Glenn Stevens, has hinted strongly that the RBA still has a bias to raise rates further, but that it is in no hurry.
It would be prudent to assume perhaps two more rate increases in 2011.
Incidentally, the RBA is well aware that consumers and businesses do not borrow at the official cash rate. So when we get so-called ‘out-of-cycle’ increases in the variable mortgage rate, as occurred in early-November, what this almost certainly means is that the RBA will need to increase the cash rate one less time than it otherwise would.
And that leaves the exchange rate. Australia is caught up in a ‘currency skirmish’ going on around the world.
One of the aims of the skirmish is to get emerging markets (and China in particular) to raise their exchange rates so that global economic growth can be redistributed from the developing world to the developed world.
Currency volatility will go on for some time yet. But we all know that the Australian dollar is currently overvalued and is likely to come down at some stage.
By my reckoning, fair value is about 85 US cents, so that seems as good a forecast as any for end-2011.
At the moment, however, the rest of the world is on sale for Australians, be they travellers, online shoppers or investors.
Chris Caton is chief economist at BT Financial Group.
