It is an interesting predicament we find ourselves in today. On one hand our economy is the envy of the developed world, our sovereign debt is low, our interest rates are on hold, unemployment sits at an impressive 5%, real household incomes are rising, and we are in the midst of a China fuelled mining boom.
But despite this, we are all desperately gloomy and the industrial sectors in our economy are doing it tough. Consumer sentiment has fallen to a two year low this month as households continue to pay down debt expecting the worst. Furthermore discretionary spending has all but disappeared.
Only two months ago David Jones predicted second half earnings would rise 5%, but yesterday they announced that they expect second half profits to fall 9-12%. This will have flow on implications for other discretionary retailers on the market today.
So what’s really happening and why are we so gloomy?
There are a number of factors at play that are distracting Australians from the generally impressive fundamentals of our economy. It seems the media and politicians are our worst enemy at present. Newspaper readers wake every day to a feast of European debt, possible US sovereign ratings downgrades, and a good dose of anti-carbon tax rhetoric from the Federal Opposition claiming a price on carbon will be the country’s economic undoing.
In Australia much of the electorate remain sceptical about human induced climate change and many wonder about the impact of Australia’s adoption of a carbon price ahead of some of the world’s major emitters. Given roughly half of the votes go to the Coalition, this is creating considerable fear and uncertainty.
Whilst most Australians kept their jobs, enjoyed lower interest rates and maintained their household income levels during the GFC – the event was nonetheless deeply disturbing and many of us still bare some psychological and financial scars to this day. This is partly attributable to the fact that Australians carry high levels of household debt, primarily as a consequence of their large home mortgages which are tied to relatively expensive residential property market. Witnessing the property bubbles in the US, UK and Europe burst so spectacularly in 2008 has made us all terribly nervous.
Should we be as nervous as we are?
Our view is ‘probably not’. There is a considerable disconnect between what people think is happening and what the data shows is actually happening.
In Europe, the US, UK and Japan industrial production and factory orders have gradually picked up this year. And in China, policy makers are responsibly slowing growth to constrain inflation, but growth is still at an impressive 9.5%.
Sovereign debt concerns in Europe do pose a real risk, however Australia’s fortunes are far more closely tied to China and developing Asia than they are to the old developed economies of America and Western Europe.
Recent concerns that Chinese policy makers may inadvertently trigger a ‘hard landing’ for the Chinese economy have probably been overplayed. Inflation in China is currently running at around 6.4%, however, if you scratch a little deeper things probably aren’t as bad as most believe. If you strip out food price inflation (which is running at around 12%), underlying inflation is more like 3%. And so far the Chinese have managed to restrain growth in a controlled way. In the second quarter Chinese growth slowed to 9.5% from 9.7% in the first quarter, but retail sales and industrial output data showed activity remained strong despite the efforts to contain inflation.
A key concern for investors at the moment is the domino effect a Greek debt default may have on the weaker peripheral European nations (ie the PIIGS). This has highlighted the sense of uncertainty among investors and added volatility in credit markets, which has translated to equity markets.
Standard & Poor’s, the international ratings agency, has cut its rating of Greek debt to CCC, only two notches above default. Markets are expecting Greece to default and this has been reflected in prices with two-year Greek Government bonds yielding around 26%.
There is much debate between the IMF, EU and European Central Bank (ECB) on how to structure future bail outs of Greece. There is however a general understanding that preventing a Greek debt default and reducing the risk of contagion now, should reduce the cost of any bail out in the future. The EU, ECB, and IMF are working hard to achieve this. The bailout proposals have come in response to the difficulty Greece is having rolling over its maturing bonds. The ECB is maintaining that Greece has sufficient state-owned assets to cover their debts and reassure the financial markets that its problem is a matter of liquidity rather than solvency.
Some commentators have described a possible Greek default as representing the “Lehman” of sovereign debt. They have warned of contagion which could spread across Europe, causing Greek banks to implode and inflicting major damage on the big banks in France and Germany.
We do not entirely share this view. While the collapse of Lehman wasn’t widely predicted by the market, a Greek default has been factored in and is reflected in current prices. Lehman also had a larger balance sheet than Greece and one that was also far more complex due to its exposure to derivatives.
Willem Buiter, the chief economist at Citibank, is regarded as an expert on financial crises. He predicted that the ECB has sufficient reserves to get Greece, Portugal, Ireland and Spain out of trouble. He further labelled as ‘scaremongering’ comparisons by the ECB of Greece to Lehman Brothers.
We do not suggest that Buiter’s forecasts will necessarily come true, but it is a considered response amongst the sea of media headlines today.
US federal debt is projected to reach approximately 95% of Gross Domestic Product (GDP) by the end of the year, the highest percentage since just after World War II. That figure compares with a debt level of 40% of GDP at the end of 2008, which compares favourably with the 40-year average of 37%. In contrast, Greece’s debt is around 150% of GDP.
In the U.S, a two tiered approach to addressing the debt problem is underway. This will involve a down payment of debt initially, followed by a longer-term agreement. The focus in the U.S is on a corporate tax overhaul, a weak US Dollar to accelerate exports and other measures to encourage new investment.
Looking at the current pricing of Australian and U.S Government debt, the market actually believes that Australia is more likely to default on its debt than the U.S.
Aussie House Prices
It is true that Australian house prices are high relative to the US, UK, and Western Europe. These high prices are a vulnerability for the Australian economy, however we don’t think the housing market is the “bubble” that some commentators would suggest.
Other than “value”, the residential property market has none of the typical characteristics of a “bubble”. House prices haven’t risen sharply in recent years, loan to value ratios aren’t excessive, and supply remains relatively tight. Furthermore, we have very little in the way of “sub-prime” lending in Australia. Further protection is afforded by the fact that Australia is close to full employment and delinquencies (the rate of people defaulting on their home loans) are low. Whist we can’t see property prices running away from here, we think it unlikely that we will see a wholesale collapse in prices.
What happens if a country defaults on its debt obligations?
While government debt default is a rare thing it can and does happen. In August 1998 the Russian stock, bond and currency markets collapsed and inflation was at 84%. This was a country of 140 million people, compared to just 11 million in Greece. The IMF provided loans to Russia at the time, similar to what they’re doing in Greece today.
Most of the decline in the Russian stock market occurred leading up to the default, as shown in the graph below. Then, after the default, markets started to gradually recover.
Another example was when Argentina defaulted in 2002. Argentina is home to 40 million people. Despite the defaults, in U.S dollars, its stock market has returned 10.9% pa since the default. This compares to around 7.8% pa in Australia over the same period.
It is important to remember that economic growth is not directly linked to bond or stock market performance.
The Russian and Argentinian examples demonstrate that markets are continually adjusting prices to reflect expectations, and a Government defaulting on its debts is not necessarily destructive to investment opportunities.
Ian Macfarlane, the former Governor of the Reserve Bank (RBA), thinks Australians get too much news about the economy, and this surfeit actually worsens the decisions we make about investments. Over the past couple of decades the public has been inundated with economic statistics, he says.
”The newspapers and magazines are full of economic news, television reporting is saturated with it, there are special radio and television programs devoted to it.”
And there is a strong bias towards sensationalism and hype. Greece is in “chaos” and could endure a “financial catastrophe”. Interest rates don’t merely rise, they ”soar”, the exchange rate ”dives” or ”plunges” and budgets ”blow out”. It’s the nature of the news cycle and sectors of the media industry.
Macfarlane says a broad range of information is better than a narrower one, but more frequent information about a particular thing may stop us seeing the forest for the trees. As evidenced by the Russian and Argentinian examples above, none of the problems in the world today are new – they are just variations on a theme.
At junctures such as these, when equity markets are soft and media reports are highly negative, investors are better to focus more on getting their long term portfolio construction methodology and philosophy right and less on deciding whether to “buy or sell”. As investors we need to concentrate on things which we can control, and where possible base our decisions on academic research rather than guessing where the markets will go next.