Beware of any nasty little surprises

Short-term economic forecasting is often brought undone by unpredicted events that end up having a major impact on growth and returns. Economist Shane Oliver outlines seven possible “surprise” outcomes for Australia’s economy this year and the likely effects of each.

The dawn of a new year creates excitement and speculation in economic circles. And with the introduction of the euro in Europe, the possible impeachment of the US President and the likelihood of tax reform in Australia, 1999 is certainly no exception.

What lies ahead for the economy in 1999?

The outlook for the first half of the year will continue to be clouded by the fall-out from Asia and emerging markets. However, the global economy should start to look a little healthier in the second half as lower global interest rates kick in and the Asian economies start to pick up.

While a slowdown in growth in the US, Europe and Australia is likely, it should be just that rather than a full-blown recession. By the second half of 1999, signs of a modest global recovery or at least a stabilisation should be evident. Signs that Asia, particularly Japan, are already beginning to recover should usher in modest growth and Australian exporters should start to benefit from the regional improvement by late 1999.

Leading Australian growth indicators such as dwelling approvals should bottom out during the second half, pointing to somewhat stronger growth in 2000. The decline in global interest rates should also have a positive effect on leading indicators in the US and Europe.

But watch out for surprises

History has shown with unerring regularity that unforseen factors emerge every year which push economic movements into a different and often surprising directions. Looking ahead, we have outlined seven possible surprises for 1999. Whilst none represent our central view, all are plausible and we'll be watching closely just in case.

1. Growth in the US, European and Australian economies fails to slow.

This scenario is actually not that far-fetched. Over the past year both Australia and the US have recorded far stronger growth than was expected given the Asian crisis, whereas economic indicators in both suggested a slowdown.

If growth held up in the short term, equity markets would likely continue to move higher as profit expectations were revised up.

However, the euphoria may be short-lived as central banks would probably return to a neutral bias under the risk that short-term interest rates might start to move back up. This would harm equity and bond markets during the second half of 1999, but property and unlisted/direct investments would be clear winners.

2. Inflation continues to surprise on the downside, with price deflation intensifying.

This would clearly be positive for bonds and would probably see yields breach 4 per cent in Australia and the US. It would also allow central banks to keep cutting interest rates - possibly even more aggressively than to date.

From a valuation perspective, lower inflation would be good news but deflation may actually contribute to falling profits. The best possible outcome for equities would be a combination of this and the previous surprise, since strong growth would be good for profits but lower-than-expected inflation would still permit falls in interest rates.

3. China devalues its currency.

This would have adverse consequences throughout the Asian region.

Such a move would reduce the competitiveness of other Asian economies at a time when they are struggling to boost exports, and could renew weakness in Asian currencies and share-markets generally.

4. The Australian dollar rebounds.

Although it is not a widely-held view, the Australian dollar could rebound back above $US0.70 this year. This would be likely only if global growth and commodity prices improve. However, such an environment would be positive for Australian resource stocks and would probably see the Australian equity market outperform global equities.

5. Iraq unleashes chemical weapons on Kuwait and Israel.

So far Iraq has taken its hits and laid low, with the result that equity markets globally have been free to continue rising. Retaliation by Iraq, on the other hand, would renew uncertainty and that could be harmful for stocks, particularly now that the US equity market is back around new highs.

6. President Clinton is forced to step down.

Such an eventuality is unlikely to cause enormous economic upheaval, since the importance of the presidency to both the US and global economy is often exaggerated. Federal Reserve chairman Alan Greenspan is actually a more significant figure, while markets would have no problems with Al Gore as President. However, a conviction would definitely add to uncertainty and may damage America's national psyche, with adverse consequences for its equity market. Nevertheless, we would regard the impact as short-lived and even providing a useful buying point for investors.

7. Australian equities outperform the US

Although this is our central view, on the Australian share-market's past record relative to the US share-market, it would certainly be a surprise. A range of factors suggest that Australian equities may outperform international equity markets over the next year, particularly market anticipation of an improvement in commodity prices and the low Australian dollar, which makes our market attractive to foreign investors. This would require investors to re-weight towards Australia after several years of underperformance against global equities.

Shane Oliver is chief economist, AMP Funds Management.