The domestic equities outlook presents a highly complex set of moving parts for local investors in 2008.
The outlook for some cyclical sectors in the Australian economy has deteriorated noticeably, placing strong focus on how the Reserve Bank of Australia (RBA) slows inflation without overly stressing the leveraged household sector. The improving rural sector and buoyant resources sector will make the RBA’s job more difficult. At the same time, evidence of some slowing in Chinese economic growth may not be such a bad thing, although a coincidentally weaker Australian dollar would add to inflation problems.
As a result of domestic developments, it seems quite likely that offshore equity returns will outstrip Australian returns over the next 12 to 18 months in local currency terms. Australian resource stocks should do reasonably well as will defensives, however, we expect the construction sector, banks and retailers to struggle.
Provided the US Federal Reserve and the European Central Bank don’t botch the ongoing management of interest rates, we should see solid recoveries in global equity markets. During the 1998 market shake out following an earlier mid-cycle economic slowdown, the equity markets recovered their previous highs in two to three months and then rose further throughout 1999. If the Fed cuts rates another 50-100 basis points (bp) as the futures curve is suggesting, underlying conditions will be very supportive for equities on a 12-month view.
Economic drivers
The latest inflation data for Australia was well above market expectations, driving the annual rate to 3.0 per cent. Of more concern was the very strong core consumer price index annual rate of 3.6 per cent, the highest since 1991 — an outcome well above the RBA’s 3.25 per cent forecast and the RBA target band of 2.0 per cent to 3.0 per cent on average through the cycle. For some time now we have felt the RBA was behind the curve — the latest data is now suggesting the need for another two 25bp rate rises, probably before June 30.
In the current situation, we believe the RBA probably needs to lift the level of real interest rates to around 4.0 per cent in the next few months. This implies cash rates of 7.5 per cent. In New Zealand, the real cash rate is over 4.7 per cent and core inflation is about 3.1 per cent and reasonably stable. The equivalent real cash rate in Australia is now 3.6 per cent, where inflation is 3.4 per cent and rising.
Apart from the inflation data, the other worrying trend can be seen in the growth of Australian credit aggregates. Typically, nominal credit growth should run 3.0 per cent to 4.0 per cent above nominal gross domestic product (GDP) growth. At present, credit growth is 17 per cent per annum and nominal GDP growth is about 7.25 per cent (4.25 per cent real + 3.0 per cent headline inflation). The driver of this excessive credit growth is primarily business credit at present, although housing credit was previously a significant contributor.
The latest inflation and credit developments have materially increased the risks for Australian economic activity. Potential ongoing volatility is now markedly higher. Much will depend on the run of data and how the RBA manages its responsibilities. As events in the US have recently demonstrated, central bankers are not omnipotent. Whilst Australia’s new Labor Government is seeking to reduce fiscal stimulus and, therefore, inflationary pressures, its surplus target of 1.5 per cent of GDP is far too low and we fear it will take too long to have an effect.
Global influences
We see significant parallels in recent developments in global markets with the events of the third quarter of 1998 — and believe the full extent of the credit losses from the sub-prime crisis will not come in for at least another three to six months. The losses are unlikely however to exceed US$400 billion, or about 3.0 per cent of US GDP. This puts it in line with the Savings and Loans crisis but well below the 20 per cent of GDP consumed by the Japanese banking collapse (1991-2003).
Financial stock prices have typically fallen 25 per cent to 50 per cent in response to the current crisis.
The Long Term Capital Management (LTCM) crisis in 1998 saw ultimate losses of only US$4.5billion (realised after the sell-off concluded) although all positions at the time of the collapse well exceeded US$1 trillion. The coincident Russian crises (bonds/FX) saw losses of some US$100 billion. US financials saw share prices fall about 50 per cent at the time.
In both situations (1998 and 2007) the Fed was attempting to engineer a mid-cycle slow down and had already hiked rates in response to earlier inflationary pressures. The resulting fallout was primarily driven by credit markets.
> In 1998 it was LTCM and repudiated Russian bonds. In 2007-08 it is repudiated sub-prime lending.
> In 1998 equity markets fell 19 per cent over three months and the Fed cut rates 75bp (to a real rate of 2.6 per cent) before the volatility settled. In 2007-08 the Fed has already cut rates 225bp (to a real rate of -0.4 per cent) and equity markets have declined about 10 per cent.
> In 1998 long bond yields declined 95bp to about 4.6 per cent whereas in 2007-08 they have fallen 132bp to 3.6 per cent.
> During the 1998 event the USD/JPY exchange rate fell about 15 per cent, whereas in 2007-08 it has fallen 10 per cent. The US dollar has also depreciated against the Chinese yuan recently.
> In 1998 US GDP growth was quite robust (4.0 per cent year-end) and core inflation was 2.5 per cent leading into the crisis, whereas in 2007 GDP growth had already slowed materially (to 3.0 per cent) but inflation hadn’t (headline 4.3 per cent).
> Finally, in 2007-08 the decoupling effect (i.e, continuing economic strength in Brazil, Russia, India, China [BRIC]) is relevant in perhaps ameliorating the global effect of a US slowdown given the much greater relative size of the emerging market economy.
In summary, US GDP growth was weaker in 2007 than 1998 when the volatility phase started, whereas core inflation was about the same. The stimulus that resulted from the depreciating USD and falling long bond rates was also about the same. The key difference between the two periods is that in 2007-08 the Fed Funds real rate is much lower now than in 1998 and the US equity markets have not fallen as far. Overall, the economic stimulus being provided this time is much greater than in 1998, with the Fed Funds real rate currently being about 270bp below the equilibrium real rate.
We feel it is more likely that the US economy will experience a soft landing than a recession in the first half of 2008. Indeed, at the time of writing equity markets are discounting a recession.
From their current oversold levels, global equity markets including Australia are expected to recover in the coming months, but as we move into the second half of 2008 rising interest rates in Australia will make it generally more difficult for Australian equities to post the solid gains that many local investors are used to.
