Market Forecast: On the road to recovery in 2009

AS the curtain lifts on 2009, consensus forecast for G7 economies is for a recession similar to that seen in the early 1980s.

Along with falling commodity prices, concerns are set to rise over potential deflation and the possible emergence of a liquidity trap in the global economy similar to that experienced in Japan throughout the 1990s.

I believe these concerns are likely to prove ill-founded. In the same way the rapid increase in energy prices in the past two years was not a threat to inflation because it was a relative rather than generalised rise in prices, the current cyclical pullback should not be deflationary.

The current situation contrasts sharply with Japan where structural problems and poor policy frameworks resulted in persistent oversupply, dragging broader consumer prices lower for a sustained period.

Ultimately it’s important that business and household expectations for inflation remain positive.

Globally, policies pursued by authorities combined with existing institutional frameworks, including inflation-targeting frameworks, should help anchor expectations as they did when commodity prices were rising.

Authorities should be successful in stabilising financial and economic conditions, with clear signs already emerging that recent policy efforts are gaining traction.

The rapid fall in interest rates during late 2008 should improve conditions as 2009 progresses, while fiscal expansion is likely to play an increasing role supporting activity.

Further, central banks have significant ammunition to boost activity beyond lowering cash rates to zero, as the US Federal Reserve is demonstrating.

With the National Bureau of Economic Research, which dates business cycles in the US, recently confirming that the US economy has been in recession for the past 12 months, many of the excesses in the economy have already been worked off.

Consumers have made significant inroads into repairing their balance sheets, aided by falling energy prices, while new housing activity is running at less than half its underlying requirement. As excess supply of new housing is reduced, the prospect for a stabilisation in house prices mid-year is increasing.

In light of these views, it is reasonable to expect a recovery in economic activity in the second half of 2009.

While credit availability is set to remain constrained, with housing affordability at its highest level since 1973, a return to potential growth could be quicker than markets now expect.

For a small, open economy like Australia, whose recent performance has been tied to the strength in commodity prices, the knock-on effects of global weakness could prove challenging.

While a prolonged period of sub-trend growth is likely, I do not foresee Australia entering the sort of deep recession being experienced elsewhere. Household balance sheets are in better shape than their US counterparts, while the domestic banking sector is comparatively stronger.

Moreover, all the main arms of policy are providing significant support to demand, with additional cuts in interest rates and government infrastructure spending set to provide further support as the year progresses.

Looking further ahead, Australia’s fortunes are likely to remain tied to Chinese economic prospects. With Chinese authorities abandoning the loan quotas used previously to slow the economy, and a significant fiscal expansion in train, we expect a fairly rapid recovery in China.

Ultimately, the Chinese economy is in the midst of a long-run period of strong growth tied to the urbanisation and industrialisation of the country’s still largely rural population.

This structural story should begin to support commodity demand and prices as we head into 2010, and will continue to provide support to the Australian economy for many years to come.

Lewis South is chief economist at Macquarie Funds Management Group.