NewsHub

State of Economic Markets

May 2010

After a stellar year on equity markets in 2009 that brought us back to near pre- Global Financial Crisis (GFC) levels, financial markets have become much more sensitive to unfavourable news¹.

As government stimulus continues to be withdrawn, the world is critically watching to see how it will survive without its financial life support. With different economies at various stages in their recovery, there are some countries in better shape than others.

As has been identified by the Reserve Bank of Australia (RBA), the global recovery is occurring at two different paces. The Group of Seven (G7) countries are experiencing negative growth, whilst Asian countries have experienced more of a V-shaped recovery². This can be seen in the graph below.

What is dragging the G7 growth? There are a number of forces that are impeding economic growth for G7 countries and other developed economies. The GFC evolved from irresponsible borrowing and lending practices by investors, homeowners and businesses around the world. As global policymakers moved to open their wallets to save the world from quite possibly financial collapse, they effectively transferred some of the debt from private to public (government) balance sheets. At the time, this transfer of debt was essential. But the consequence of the GFC hangover is that this debt still needs to be paid back. Efforts by governments to reign in budget deficits to erase debt will come at a cost, and act as a drag on growth. Quite simply they will need to increase their revenues (i.e. personal and business taxes), and /or decrease their spending (i.e. social security, roads and schools).

Some governments have had more difficulty than others in reigning in debt levels.

After Dubai’s debt problems in late 2009, the spotlight has been turned on Europe in 2010. Greece is having particular problems in raising funds to meet debt obligations, whilst Portugal, Italy, Ireland and Spain (to make up the acronym nickname the “PIIGS”) are also suffering from high debt-to-GDP levels.

The government debt problem has been magnified recently by governments facing higher long-term borrowing costs – in particular by the US.

The combination of markets struggling to absorb the enormous amounts of issued debt and increased sovereign risk has left investors demanding higher returns on debt. This means higher rates of borrowing for governments and a slower recovery.

What is assisting Asian growth? Asian economies have long focused on exports to drive economic growth, which has worked given the demand developed economies have had for their goods. With anaemic growth predicted for developed economies however, many Asian countries are changing their focus to promoting domestic demand for local products & services. China provides a good example. Described by one commentator as the “Asian growth model on steroids”3 – there is an increased focus on structural reforms to increase the share of consumption domestically, and promote urbanisation. Urbanisation refers to the movement of people from rural to urban areas. Their heavy focus on fixed asset investment in 2009 was a step towards improving their infrastructure to promote future domestic growth. To put it in perspective, two-thirds of China’s stimulus spending last year went towards infrastructure development.

How is Australia placed?

Australia has reaped the benefits of China’s rapid infrastructure development. The strong demand for Australian resources has helped shield the “lucky country” from the worst of the downturn, and left it in fairly good shape.

The economic data this calendar year has been solid.

Employment growth has been positive, business and consumer confidence remains high, the housing market has been strong, and business deleveraging is making way for an improving outlook for business investment.

Despite the positive outlook for Australia, there still remain headwinds that may impede the recovery:

• The removal of most of the government stimulus will leave households with less cash in their pockets this year compared to last
• The expected increases in interest rates will also eat into consumer spending and potentially affect consumer confidence
• Labour and capital constraints have been highlighted by the RBA (especially in the resource sector) which may create bottlenecks if not addressed.

Despite these headwinds, the Australian economy remains relatively well positioned. Contagion risk from the global government debt problems remains low, our government debt levels are manageable, and the majority of our major export partners are in the fast lane in the RBA-described two-speed world of GDP growth.

Whether this translates to local share market growth and assists our super account balances – with the ASX 200 grinding sideways during the March quarter (+0.1%) – is another question.

¹The ASX 200 returned 31% over the 2009 calendar year.
²Speech by Philip Lowe – Assistant Governor (Economics) at The Reserve Bank of Australia on 25 March 2010 at the Australian Industry Group’s 10th Annual Economic Forum, http://www.rba.gov.au/speeches/2010/
³Michael Pettis, April 25, 2009, mpettis.com