Economic Update: December Quarter 2010

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While the Australian share market tended to lag overseas markets during the year, the stronger Australian Dollar (which exceeded parity with the US Dollar for the first time since 1982) did detract significantly from unhedged global equity returns.

After a disappointing start to 2010, diversified fund investors enjoyed solid returns during the second half of the year, largely reflecting the strength in world share markets. While the Australian share market tended to lag overseas markets during the year, the stronger Australian Dollar (which exceeded parity with the US Dollar for the first time since 1982) did detract significantly from unhedged global equity returns. Over the year to December diversified funds posted lacklustre, but nevertheless positive returns.

Global investment grade bond yields fell over the year to December resulting in capital gains and solid returns. However, global Government bond yields rose sharply towards the end of the year, and investment grade debt securities posted a negative return for the December quarter. This rise in yields, which was likely due to more positive growth expectations, occurred despite an announcement by the US Federal Reserve that they would carry out another round of Quantitative easing – outright purchases of US Treasury securities on the open market. Official interest rates have been maintained at historic lows in most major economies (and close to zero in the US and Japan).

Major asset class returns for the periods leading up to the end of December 2010 are shown in the table below.

Economic and market developments

The disappointing performance of world equity markets during the first half of 2010 reflected a combination of factors. The sovereign risk crisis enveloping the peripheral European economies – Greece most notably, but also Portugal, Ireland, Spain, and to some extent Italy – dominated the financial news for much of the year to date, and added to existing concerns about the durability of the global economic recovery. Those global recovery concerns arose largely on the back of a range of economic data – from the US and elsewhere – that tended to fall short of market expectations, but nevertheless remained broadly consistent with continued economic growth.

However, in recent months some of the leading indicators that were previously pointing to quite a pronounced slowdown in growth – or even perhaps a renewed recession in the US and elsewhere – now seem to have turned up again. While economic conditions and prospects for peripheral European countries such as Greece and Ireland remain dire, elsewhere economic conditions have been reasonably favourable.

The US economy continues to grow and generate jobs, but not yet at a fast enough rate to bring unemployment down in any meaningful way. In a surprising development prospects for US growth were given a boost over the month by the Obama Administration and Congress agreeing on a useful package of budget measures, including cuts to payroll tax and the extension of the Bush-era tax cuts.

Germany continues to lead the way in Europe, posting growth of close to 4% for the year to September, with solid growth in both consumer spending and business investment.

After experiencing one of the earliest and deepest recessions during the aftermath of the Global Financial Crisis, Japan has enjoyed one of the most impressive rebounds and is likely to have grown the fastest of the major economies for 2010 as a whole. However, the recovery has heavily dependant on a rebound in exports and by a relatively large fiscal stimulus. Over the year ahead the fiscal stimulus is likely to fade, and it is unclear how much more export-led growth Japan can enjoy, especially given the effect of a very strong yen.

The major emerging economies have enjoyed a robust, decidedly V-shaped recovery. The charts below show the performance of industrial output and export volumes in the major emerging regions. Many of these economies have benefited not simply from the recovery in their key export markets, but also from the fact that they have been in considerably better financial health than the developed world. After some moderation in activity during the year, the key emerging markets seem to have ended 2010 with renewed momentum.

In particular, growth in China and India remains spectacular despite some slowdown in Chinese growth during 2010. The decision by the Chinese authorities to increase lending rates by 25 basis points on Christmas Day may signal a new determination by the Chinese to address their rising inflation, which could cloud growth expectations going forward.

Rapid growth rates in China and India have had and continue to have profound implications for the performance of the Australian economy. The economic data in Australia currently describe a two-speed
economy where the resource rich states enjoy the benefits of a massive boost to Australia’s terms of trade and an enormous surge in business investment (although the shorterterm impact of the disastrous flooding currently being experienced across much of Queensland is likely to be severe). Elsewhere though, the picture is mixed. Outside of resources, business investment growth has been lacklustre. Some of the leading indicators of housing activity that had weakened around mid-year have recovered somewhat but do not suggest a massive upswing in housing activity. Employment growth remains very strong. Over the year to November total employment grew by 3.7% – the fastest annual rate of jobs growth since August 2005. At the same time consumers remain somewhat cautious, preferring to save a much greater proportion of what has been very strong income growth despite also reporting a quite high level of confidence.

Prospects

We have argued consistently over the past year or more that the world economy and financial markets are facing an environment that is considerably more uncertain than anyone has seen for some time. We expect overall economic growth in the developed world to be reasonable, but decidedly unspectacular. While we do not foresee a renewed recession or double-dip in the US, or in the world economy more generally, the outlook is still highly uncertain. The improvement seen in the recent economic data have made us, and indeed many other observers, more confident in this view. For those countries on the European periphery, the outlook remains much worse. If we look at Greece and Ireland in particular, what those countries are facing is utterly dire.

When it comes to prospective returns for the major asset classes, we are still of the view that over the medium-term, equities seem to offer the best return prospects for investors, particularly because traditional safe haven assets, such as Government bonds appear to offer poor future returns, especially in overseas markets. Broadly speaking, equity markets look to be fairly valued. While share prices have risen of late, so too have corporate earnings, and the outlook for the global economy remains generally supportive for share markets.

A key headwind facing the world economy is the prospect that financial institutions and consumers in the US, UK, and elsewhere will need to make further progress in repairing particular, private sector employment growth has been weak, but nevertheless positive some months now, and core labour incomes (i.e. private sector wage and salary income) are rising, albeit modestly. While rising incomes ultimately allow at least modest spending growth, it is still the case that both the demand for and supply of credit is likely to be subdued for some time, even though survey data increasingly show that banks in the US in particular, are now much less unwilling to provide credit. Moreover, there are signs that while households may be reluctant borrowers at this point, the demand for credit on the part of businesses – again most notably in the US – may be rising.

A continued recovery in the fortunes of the world economy is our core view, but there are a range of paths that such a recovery could take. Moreover, as suggested earlier, there is a real risk of policy error threatening the world recovery. Policymakers will be required to exercise some extremely difficult judgements over the coming years to sustain growth and prevent a slide into a Japan-style deflation, while also guarding against an excessive, undesirable rise in either asset price or generalised inflation further down the track. They will also need to rein in excessive budget deficits over the medium to longer-term. Even without further action to rein in these deficits in the near-term, past fiscal stimulus measures are running their course, and the positive impact of those measures has been fading, and will continue to fade.

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