World markets are in for a rough ride in 2012, but Australia is well positioned to survive another potential global recession, according to Dr Shane Oliver.
Uncertainty hanging over Europe, and to a lesser degree the US and China, suggests a very uncertain outlook for the year ahead.
However, it’s worth noting, to borrow from Paul Keating, every pet shop galah is saying the same thing – Europe, Europe, Europe! So maybe it’s all factored in and perhaps after an initial messy period, it won’t be so bad.
There are several reasons for a bit of cautious optimism.
First, Europe appears to be heading towards a resolution of sorts, which is likely to involve much greater European Central Bank (ECB) intervention, helping to limit Europe’s growth contraction next year to around -1 per cent.
The task is beyond the scope of various bailout funds (which aren’t big enough and are under ratings pressure) and the International Monetary Fund does not have enough funds.
The only organisation that can bring the debt contagion under control is the ECB. Our assessment is that it is likely to move into top gear in the next six months – and buy bonds in troubled countries more aggressively.
A move towards fiscal union is likely to provide it with more confidence to act; the deepening European recession provides justification for aggressive monetary easing and bond buying in order to achieve price stability; and German opposition to a more aggressive ECB is likely to fade as its economy weakens too.
Second, the US economy looks like it will continue to simply muddle along, perhaps even with another “double dip” worry around mid year, but growth being held up around the 1.5 per cent level by more quantitative easing and solid profits supporting employment and business investment.
Third, China looks like it could slow further in the short term, possibly taking growth to a low point of 7 per cent year on year.
However, with the property market and inflation cooling and the authorities not willing to tolerate a hard landing, policy easing is likely to become aggressive, resulting in overall 2012 growth of 8 per cent in China.
This is pretty much the story in the emerging world as a whole: ie, short-term weakness but plenty of scope to provide policy easing as inflation subsides, which should support growth.
Pulling all this together suggests:
- Global growth somewhere around 2.5-3 per cent next year, composed of 0.75 per cent in advanced countries and around 5 per cent in emerging countries, albeit looking worse earlier in the year before improving in the second half;
- Falling inflation as commodity prices remain benign and spare capacity builds in advanced countries, leading to a bout of deflation in Europe;
- More monetary easing with falling interest rates in the emerging world and commodity countries, but aggressive quantitative easing in the US, UK and to a lesser degree Europe (ie, just enough);
- Intensifying currency wars as quantitative easing sees the US dollar, euro and sterling remain weak; and
- Constrained earnings growth reflecting the soft overall economic backdrop.
For Australia this means a difficult environment initially, before risks recede later in the year. Our base case is for 3 per cent growth over the next year – ie, better than 2011 which was affected by the drought, but it probably will require more monetary easing with the cash rate expected to fall to 3.75 per cent by the end of 2012 to help protect growth.
So what does this all mean for investors?
- In the short term it’s hard to feel confident about shares and related risk assets, as much uncertainty hangs around Europe and global growth could first get worse before it gets better.
However, against this, shares are now very cheap (particularly against bonds), monetary policy is easing further and everyone is bearish. So while shares may have a rough start to the year, there is good reason to expect them to be higher by year’s end. That a lot of bad news is factored into share markets is indicated by forward price to earnings (PE) multiples which are now 10.2 times for global shares compared to 12.4 times a year ago. In Australia, the forward PE is now 10.9 times compared to 13 times a year ago. In the emerging world and Europe, the forward PE is now just 8.5 to 9 times. - Share markets to focus on are those with strong fundamentals and monetary easing (Asia, emerging markets and Australia) or those with weak currencies and monetary easing (eg, the US, where monetary easing is likely to be more aggressive over Europe). We expect the Australian ASX 200 to rise to around 4800 by end 2012.
- Commodity prices are likely to rebound after a possible initial soft patch once it becomes clear the global economy is not going into free fall and as quantitative easing (QE) ramps up in advanced countries. Gold is likely to rise through $US2000 an ounce on QE.
- The Australian dollar is likely to have a few rough patches, but is likely to remain strong overall, ending higher in response to more QE in the US and Europe – Australia being one of the few countries with a stable AAA rating – and as investors start to anticipate better commodity prices.
- Cash and term deposits are likely to become less attractive as cash rates continue to fall, pulling down term deposit rates with them.
- Very low starting point bond yields suggest low returns from sovereign bonds, unless of course global recession looms. Australian bonds are more attractive than global bonds given higher yields and less risk if things fall apart. Corporate debt is a better bet, but favour investment grade if you are worried about equities.
- Unlisted commercial property returns are likely to remain reasonable, reflecting yields around 7 per cent and requiring only modest capital growth to generate a decent return.
- Australian house prices are likely to fall another 5 per cent or so in the first half as buyers hold back on economic uncertainty, before rate cuts reach a critical mass and greater confidence leads to a recovery in the second half.
What are the risks?
The main risk is that Europe does not act quickly enough to prevent a major financial meltdown and deep recession. If so, this would drag the global economy back into, or very close to, recession.
There is also a risk in China that the leadership transition and a desire to quash property speculation sees the authorities react too slowly to the slowing economy, allowing a move to a hard landing (ie, 6 per cent growth or less) to become entrenched.
If the world really does go back into recession, fortunately Australia has plenty of ammo to fight it off – rates have a long way to go to zero, the Australian dollar will fall if things fall apart globally, there is more room for fiscal stimulus if needed, the corporate sector is cashed up, the household sector has a strong savings buffer and mining projects impart a degree of resilience.
This would all suggest a 1-2 per cent growth locally, but not recession.
Conclusion
Expect a rough ride, with potential weakness in the first part of the year. Conditions are likely to improve as monetary authorities in Europe and the US step up to the plate. Overall, what many fear could be a disaster could turn out to be much better than expected.
Dr Shane Oliver is head of investment strategy and chief economist at AMP Capital.
