The good news for stock investors first. The Jakarta Composite index rallied 46% last year, after soaring 87% in 2009, as investors chased stocks benefiting from an economy rejuvenated by reform. Since he was elected to power in 2004 (and re-elected in 2009), President Susilo Bambang Yudhoyono has implemented financial, tax, customs and capital market reforms and introduced stimulus measures to shepherd southeast Asia’s largest economy through the global recession.

The result was that Indonesia’s economy grew at an average annual pace of 5.5% in the past three years, a fair achievement during a global recession. Investors thought the world’s fourth most-populous country of 240 million people could maintain that growth rate in coming years.

But that thinking didn’t last too long into 2011. On January 3, the Central Bureau of Statistics said consumer prices in Indonesia jumped 6.96% in 2010. Stocks fell on a view that the central Bank Indonesia will need to raise the benchmark reference rate by 100 basis points over 2011, to slow the economy and lower consumer inflation to under 6%.

The slide in stock prices was exacerbated, almost perversely, on January 5 when Bank Indonesia at its monthly policy-setting meeting left the reference rate unchanged at 6.5% for a 17th consecutive month. Investors fretted that a larger overall rate increase would be needed in the long run if the central bank didn’t attack inflationary pressures quickly. Over the three trading days from January 7 to January 11, the market plunged more than 8%. For January, the index dropped 7.9%, a decline beaten only by India’s slump of 10.6%.

Stocks did better over February because the Bank Indonesia finally acted against inflation, raising the reference rate by a quarter point to 6.75% on February 4. The Jakarta Composite Index gained 1.8% in February, to be Asia’s third-best performer for the month, but still ended the month as Asia’s third-worst performer so far in 2011.

The main action Indonesian authorities took last year to curb inflation was to order banks to set aside more reserves. The central bank kept interest rates on hold because core inflation, at just 4.3% in 2010, is under its 5% target. The bank has been cautious about raising rates because it is concerned that higher rates will encourage speculative foreign inflows and expects the jump in food prices that is fanning inflation to be only temporary.

Heavy rains in recent months have disrupted food production across the archipelago and boosted the price of staples. Rice is reported to have risen about 10% recently, while the country’s favourite spice of chilli pepper has nearly trebled in price. Food comprises about 20% of the basket of goods used to calculate inflation in Indonesia.

An upbeat future

But hey – even if inflation and interest rates rise this year, optimism abounds about a country that fewer than 15 years ago almost collapsed politically and economically – even if it still has many challenges such as a lack of infrastructure and an abundance of red tape.

Politically the Muslim country is stable. After overthrowing 31 years of the Suharto dictatorship in 1998, the country has turned itself into a secular democracy and controlled extremist voices. So successful has this transformation been that the country is touted, along with Turkey, as a model for Muslim countries in North Africa that have overthrown autocratic regimes in recent weeks.

It’s not just investors who are upbeat about an economy that is posting a current-account surplus of around 1% of GDP, where the government’s finances are under control, and where inflation, while troublesome, is well below the double digits recorded as recently as 2002.

In December, the government articulated an economic vision for 2025 that sees Indonesia as one of the 10 largest economies in the world with a per capita GDP of US$12,800 to US$16,160, from about US$4,000 now. The IMF expects the economy to grow between 6% and 7% in the coming four years.

On February 25, Fitch Ratings raised its outlook on the country’s sovereign rating, to imply that Indonesia’s debt is soon to be classed as investment grade. Fitch at the moment rates Indonesian debt BB+, its highest non-investment-grade, or junk, rating.

In December, Moody’s Investors Service upgraded Indonesia’s sovereign rating one notch to Ba1, its highest non-investment-grade rating, because of the government’s improving debt position and the country’s build-up of foreign reserves, which stood at US$96.2 billion on December 31.

“The economic policy framework remains increasingly well positioned to deal with evolving macroeconomic challenges and potential shocks,” Moody’s said in a release, foreshadowing the upgrade.2

Including, stock investors take note, the challenge of inflation.

Jakarta Composite versus MSCI Asia ex-Japan Index since start of 2009

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• At 2.46pm on Friday March 11, an earthquake measuring 9.0 on the Richter scale occurred off the north east coast of Japan near Sendai, triggering a 10 metre tsunami that was felt across the Pacific Ocean. The earthquake has been ranked as the fifth largest in modern history and the biggest in Japan.

Main Developments

New agencies provide the most accurate and timely compilations of facts of major events. The situation following the great earthquake is clearly still evolving and the economic impact will be felt for years to come. The following report comes from Reuters:

• “Death toll expected to exceed 10,000 from the quake and tsunami, public broadcaster NHK says. About 2,000 bodies found on two shores of Miyagi prefecture, Kyodo reports.
• Japan battles to prevent nuclear catastrophe as there is a hydrogen explosion at the No. 3 reactor of the quakehit Fukushima Daiichi nuclear power plant, which is 240 km (150 miles) north of Tokyo.
• Chief Cabinet Secretary Yukio Edano says the core container at the reactor is intact after the fresh explosion which is unlikely to have led to a large escape of radioactivity.
• Edano says six people were injured after the explosion at the nuclear plant.
• Prime Minister Naoto Kan says the situation at the nuclear power plant remains worrisome and authorities are doing their utmost to prevent damage from spreading.
• Earlier, Tokyo Electric Power Company (TEPCO) said radiation levels at the Fukushima Daiichi nuclear power plant, which is 240 km (150 miles) north of Tokyo, had risen above the safety limit but this posed no “immediate threat” to human health. An explosion blew the roof off at reactor No. 1.
• International Atomic Energy Agency (IAEA) says the lowest state of emergency had been declared at a separate nuclear power plant north of the town of Sendai. But Japan’s nuclear safety agency says there has been a rise in radiation at the Onagawa facility due to leakage from the Fukushima plant and there was no problem with the cooling process there.

• Authorities have set up a 20-km (12-mile) exclusion zone around the Fukushima Daiichi plant and a 10 km (6 miles) zone around another nuclear facility close by.
• Strong aftershocks persisting in the stricken area.
• About 300,000 people evacuated nationwide and almost 2 million households without power in the freezing north.
• The Bank of Japan offers to pump a record US$85 billion into the banking system to soothe market jitters.
• TEPCO says rolling blackout to affect 3 million customers, including large factories, buildings and households.
• Nuclear safety agency rates the incident a 4 on the 1 to 7 International Nuclear and Radiological Event Scale, less serious than Three Mile Island,which was a 5, and Chernobyl at 7.
• Quake triggered tsunami up to 10 metres (30 feet). Waves swept away homes, crops, vehicles and submerged farmland.
• Total insured loss could be up to $15 billion, equity analysts covering the industry say. Disaster-modelling company AIR Worldwide estimates the insured losses from the Japan earthquake at between $14.5 billion and $34.6 billion.”

Financial & economic effects

• The Bank of Japan will expand asset purchases from 35 trillion yen to 40 trillion yen in order to boost liquidity in the economy. The BoJ is
  worried about the impact of the earthquake on household and corporate sentiment.
• The Japanese yen has strengthened against the US dollar since the earthquake on expectation that foreign currency will need to be sold in exchange for Japanese yen to fund the massive rebuilding work. The Australian dollar fell from US100.25c to US99.65c initially after the earthquake. But it rose to US101.60c in US trade on Friday night before easing to US100.75c today.
• The Japanese sharemarket (Nikkei) fell 6.2 per cent on the expectation of weaker short-term prospects for manufacturing companies and the overall Japanese economy. In contrast, shares of construction companies have been well supported.
• Shares of food exporters in the Asian region have been supported on the expectation of higher demand (Sendai is a major food producing region of Japan).
• The Australian All Ordinaries index fell as much as 85 points before retracing to be down 24.6 points (0.5 per cent) to 4710.1 at the close. Uranium stocks fell from favor as investors feared reduced demand in reaction to the explosions at nuclear facilities in demand. In contrast, shares of thermal coal and natural gas producers rose on expectation of demand for alternative fuels following damage to Japanese nuclear facilities.
• Our commodity strategist said: “We expect that a prolonged shutdown of the Fukashima Daiichi power station will increase import demand for fuel oil, coal and LNG, putting upward pressure on coal and gas prices. The quantum of increased coal, LNG and fuel oil demand is hard to estimate and depends on the extent of nuclear outage. But the Fukashima Daiichi nuclear power plant’s capacity translates through to up to 14Mt of thermal coal equivalent – or ~1.5%-2% of world trade per year.”
• Similar to the natural disasters experienced in New Zealand and Australia, the Japanese economy will soften in the short term as production is constrained and consumer and business sentiment are negatively impacted. But activity will be boosted in the medium-term as rebuilding/repair/refurbishment work begins. The Japanese economy contracted by 0.3 per cent in the December quarter and a technical recession (two consecutive quarters of falling output) cannot be ruled out.
• In response to the Kobe earthquake (January 17 1995; magnitude 7.3; damage estimated at US$100 billion) industrial output fell 2.6 per cent in January before rebounding in the following three months.
• The Japanese economy had only been expected to add 0.14 percentage points to the 4.4 per cent global economic growth this year, so the ‘big picture’ impact will be modest.
• Despite high government debt levels (gross debt to GDP stands at 225.9 per cent), Japan should have few problems in securing foreign funding for rebuilding operations. Japan has consistently maintained a current account surplus, estimated at 3.1 per cent of GDP in 2010.

The post The Great Sendai Earthquake of 2011 appeared first on AdviserVoice.

Key points

• The Japanese earthquake has caused terrible human suffering. In terms of the economic impact, in the short term it will likely depress Japan’s economy as a result of damage to factories, power supply, transport infrastructure and confidence. However, by the second half of the year the rebuilding effort is likely to result in a boost to growth.
• While it has added to short term uncertainty in global investment markets, we don’t expect the earthquake to derail the global economic recovery or growth in Australia. In fact, increased commodity demand associated with rebuilding will ultimately provide a boost for Australia. We continue to see the recent pull back in share markets as a correction, and not the start of a new bear market.

Introduction

It seems the string of disasters in our part of the world this year is not letting up – the Australian floods, the New Zealand earthquake, and now a massive earthquake and tsunami in north east Japan. At this stage the full extent of the damage in Japan is unknown, but it is clear it has resulted in a terrible human tragedy. Right now the focus is on the rescue effort and our thoughts are with the Japanese people and all those affected. This note looks at the likely impact on economic activity, investment markets and Australia.

Economic impact

All natural disasters follow a similar pattern in terms of their economic impact and the Japanese earthquake is unlikely to be any different. The initial impact is negative as production is disrupted as a result of damage to factories, the power supply, transport infrastructure, confidence, and to homes which means workers are focussed simply on survival. This then gives way to recovery as rebuilding kicks in and production returns to normal.

• This was seen in terms of the Kobe earthquake in Japan in January 1995, which claimed 6,434 lives. Japanese industrial production fell 2.6% that month only to be followed by gains of 2.2% and 1% respectively in the subsequent months. In fact it’s worth noting while Japan’s GDP fell 0.7% in the December quarter 2004, it actually rose 0.8% in the March quarter 2005 when the quake hit and rose another 0.8% and 1% in the June and September quarters respectively.
• It was also seen in the Boxing Day Tsunami in Asia of 2004, with initial negative economic consequences in the areas affected followed by a strong rebound. In fact it was barely a blip in the Asian growth story at the time.
• The initial negative effects from recent floods are now being felt in Australia, but there is good reason to expect a rebound in growth from the June quarter.

The areas most affected by the earthquake account for around 8% of Japan’s GDP. It is a centre for auto production with Toyota, Nissan and Honda plants being shut down. Electronics plants have also been affected and damage to fishing and agricultural production is likely to be immense.  That said, given the area directly affected by the earthquake is a smaller part of the Japanese economy than the area affected by the Kobe earthquake in January 1995 it’s possible the economic affect may be smaller this time. According to Bank of America Merrill Lynch the three worst hit prefectures in the Kobe earthquake accounted for around 12% of Japan’s GDP.

However, it is still very early days in assessing the damage and there are some reasons to be a bit more concerned this time around. First, it’s the tsunami which has caused most damage this time, wiping away whole towns and parts of cities, as opposed to just earthquake damage to buildings, roads, etc. This also means the rescue operation may be more involved as will be the clean up before rebuilding can commence. Some areas may now even be unliveable given the shift in land and sea levels. Second, as a result of problems at nuclear power stations, the interruption to power supply may be greater and longer than was the case in 1995. Third, the loss of life this time around is likely to be much greater. This will have a potentially bigger impact on confidence than was the case in 1995. Finally, there is a risk of a serious nuclear catastrophe this time around, which if it occurred would result in a far more disastrous impact.

The most likely outcome would seem to be a set back in activity over the next few months – perhaps 2% or so knocked off industrial production – before rebuilding kicks in boosting growth again during the second half of the year. Post the Kobe quake the rebuilding effort was very quick and efficient and the same is likely this time. The Bank of Japan has already committed to a “massive” liquidity injection into the Japanese banking system. This has initially taken the form of increased short term cash injections, but should also include more quantitative easing (ie using printed money to buy government bonds and foreign exchange). Fiscal stimulus is also likely to be announced soon.

There are three bigger issues for Japan though. Firstly, Japan’s recovery since the GFC has been the most fragile of the G3, ie the US, Europe and Japan. This was highlighted by the fall in Japanese GDP in the December quarter and much weaker levels for consumer and business confidence. See the next chart. The earthquake will likely only add to Japan’s fragility.

More fundamentally is the impact on longer term confidence. The Kobe earthquake arguably damaged Japan’s national confidence in the 1990s adding to the malaise of the last two decades. The latest quake may only add to this sense of longer term malaise.

Finally, while price deflation means Japan has plenty of potential for further monetary easing, further fiscal stimulus will add to already very high public debt levels. Japan’s budget deficit is already 8% of GDP and public debt is around 200% of GDP. This is way above levels at the time of the Kobe quake and is even far worse than Greece. Short term it’s easy to finance as the private sector in Japan is a net lender. Longer term it is more problematic as a rapidly aging population will mean households will likely become net sellers of Japanese public bonds.

What about the global economic recovery?

The Japanese earthquake is unlikely to derail the global recovery. Apart from the likelihood that the negative impact on Japan will be mainly short term, Japan’s importance globally has slipped in recent times. At only 6% of world GDP, Japan only accounted for 0.16 percentage points of the 4.5% or so increase in world GDP last year.

Australian impact

Japan is Australia’s second largest trading partner, but its share of Australian exports has slipped from 25% at the time of the Kobe earthquake to 15% today. Short term economic disruption in Japan could cause a decline in orders for coal, iron ore and other commodities in the next few months. However, this is likely to be no more than a blip as the broader impact is likely to be positive as rebuilding will add to strong global demand for raw materials. Problems with nuclear power stations as a result of the quake, and any resultant rethink of the relative attractiveness of nuclear power globally, will likely be negative for uranium demand but positive for gas and coal demand. There may also be increased demand for food stuffs as the area affected is important in Japanese agricultural production.

It is noteworthy that even though the value of Australian exports to Japan fell in the March quarter of 1995 when the Kobe quake hit, they rose solidly in total – up 13.8% in the March quarter and up 22.2% in 1995 as a whole.

Finally, imports of cars, electronic goods and other manufactured goods from Japan may see a short term disruption but this is unlikely to last long, with other global producers also likely to step into the breach given still significant global manufacturing spare capacity.
At this stage we see no reason to alter our Australian economic forecasts which see year average growth this year of 2.8% and 3.8% in 2012 and the cash rate rising to 5.25% by year end.

Financial market implications

For Japan, the earthquake is negative for shares on the back of worries about the short term economic impact, positive for bonds on “safe haven” demand and probably positive for the Yen as Japan repatriates funds, particularly by Japanese insurance companies. This is pretty much how it played out immediately after the Kobe quake. So far it appears to be playing out this way as well, particularly for the share market which has fallen sharply.

However, after the initial reaction, which the post Kobe experience suggests may last several months, expect the Japanese share market to rebound as rebuilding kicks in and production returns to normal. There is a bit more uncertainty around the Yen – past experience suggests it will strengthen initially but this could be short circuited if the Bank of Japan intervenes (as it should) to help exporters.

Short of a nuclear catastrophe, we don’t see the Japanese earthquake derailing the global economic recovery and nor do we see it derailing the cyclical recovery in global share markets. However, it has come at time when the worry list for investors has suddenly expanded again – to include unrest in the Middle East and oil prices, renewed concerns about European debt and Asian tightening – and so only adds to short tem uncertainty. In this sense it’s too early to say whether the correction in shares that began last month is over or not.

The same applies for Australian shares. The initial reaction in the Australian share market has been negative, but any negative economic impact on Australia is likely to be minor and short lived and Australia is likely to be a key beneficiary of increased raw material demand as Japan rebuilds. With the Australian share market now trading on a forward price to earnings multiple below 12 times, Australian shares are well placed to rebound once the correction in global shares has run its course.

In terms of sector specific impacts the earthquake is likely to be negative for insurers and uranium producers, but positive for gas and thermal coal producers. It should ultimately be positive for commodity producers more broadly as rebuilding demand kicks in.

So far the Japanese quake has taken pressure off oil prices, on the assumption refinery closures in Japan may reduce oil demand. This may be true short term but ultimately it will mean Japan may import more refined fuel. So overall the impact on the oil price is ambiguous, with events in the Middle East likely more important.

Concluding comment

The events in Japan are heartbreaking. However, like all natural disasters the negative short term economic impact should hopefully be less than feared and will give way later this year to rebuilding which will help boost growth.

The post The likely economic/financial impact of Japan’s earthquake appeared first on AdviserVoice.

• Ireland has gone from financial market darling to a challenging credit in the space of three years. With a similar concentrated banking system that has a high exposure to the property market, could Australia become another Ireland?
• The rapid rating decline of Ireland has various lessons for investors: not to rely on ratings; and that state support for banks is not necessarily a panacea.
• Sovereign guarantees to banks may defend them to an extent but ultimately it may only transfer the risk from the banking system to the sovereign.
• While Ireland’s problems could be partly mirrored in Australia, various factors should mitigate some of the causes that were central in Ireland.
• Ireland should provide a salutary lesson to Australian investors that relying upon the status quo is unwise.
• Australia did weather the financial crisis effectively due to a variety of factors, but if these factors reverse, Australia’s safe haven status could be dented.

Introduction

Ireland has rapidly deteriorated from financial market darling to a challenging credit needing a bail-out. The extent of the turnaround is such that the factors that caused this need to be considered in regards to other economies. In particular, could this happen in Australia? The Australian economy is considerably more robust and diversified than Ireland’s but the systemic exposure to banking has noticeable parallels, suggesting that complacency about Australia’s economic strength may need to be challenged.

Of the European states that have so far experienced severe challenges and much public consideration, Ireland stands out to Australians because of a greater similarity in banking systems, with both having a small set of major banks which are very focused on the domestic market. It is therefore informative to compare the situations of the two nations and more particularly the banking systems.

To do this, we first examine the events in Ireland and then compare them with Australia so as to determine if there are lessons for Australian investors.

The Irish situation

Ireland has been in the headlines in the last few months for all the wrong reasons. A bail-out by the European Union (EU) and International Monetary Fund (IMF) is now in progress and the creditworthiness of the state is continually deteriorating. Four years ago, it all seemed so different: prior to the GFC, Ireland was a shining star, attracting financial institutions around the world to the new financial hub of Dublin. Low taxation, a knowledge-based culture and a convenient location made Ireland a hive of activity.

What went wrong?

Ireland was badly affected by the financial crisis of 2007 and 2008. Many of the institutions operating there contracted in size and often the Irish operations were scaled back or closed. The Irish economy had transitioned from being primarily an agricultural exporter to being a ’knowledge centre’ but unfortunately this ’knowledge’ was often centred on more innovative products such as Structured Investment Vehicles (SIVs) which were the most vulnerable to the liquidity squeeze caused by the global financial crisis (GFC).

To meet the rapid growth up to 2006, Irish property was in strong demand from genuine and speculative buyers, causing house prices to more than double between 2000 and 2006 (as shown in chart 1). Commercial property was squeezed and developers borrowed heavily to meet the increased demand.

When growth stopped, the banks were left with large books of commercial and residential real estate and extensive loans to developers. Since 2006, house prices have fallen nearly 40%. Commercial property has been performing even worse with Investment Property Databank Ltd. estimating a 60% slump in the values of shops, offices and warehouses in the three years to September 2010.

The Irish banking system

Four main banks operate in the Republic of Ireland: Bank of Ireland, Allied Irish bank, Anglo Irish bank and the Ulster Bank. Ulster Bank is a subsidiary of Royal Bank of Scotland (RBS). On the night of 29-30 September 2008, two weeks after the collapse of Lehman Brothers, the Irish Government issued a guarantee of Allied Irish, Anglo Irish Bank, Bank of Ireland and three building societies. To address European Commission concerns, the guarantee was extended on 9 October 2008 to Ulster Bank and five other institutions which had non-Irish sponsors.
In January 2009, the Irish government nationalised Anglo Irish Bank. At the time of writing, it appears quite likely that Bank of Ireland and Allied Irish will also be nationalised.

Recent developments in Ireland

The population of the Republic of Ireland is about 4.5 million people. Unemployment has risen from a low of 4.4% in November 2006 to the current level of 13.6% (as shown in chart 2). With limited prospects of improvement, the size of the bank debt problem has, despite political resistance, forced the EU and IMF to intervene. Effectively an €€85 billion package has been established of which between €€35 and €€50 billion will be used to prop up the banks with the remainder to support the Irish state.

Ratings downgrades

Since the crisis started, the ratings of Ireland have deteriorated rapidly. For over seven years up to March 2009, Ireland was a solid triple-A rated state with ratings as good, or in some cases, better than Australia’s1. Now Moody’s and Fitch have lowered the sovereign into the triple-B rating grade and at A (Negative Watch), S&P is expected to follow shortly.

Bank ratings have been even more adversely impacted. The Irish banks are all rated in the triple-B range or below and subordinated bank debt has now been downgraded into the weaker end of sub-investment grade if not to default.

An Australian perspective

Effect on investments

For Australian investors, Ireland seems a long way away and direct exposure to Irish entities is likely to be limited for most.

The contagion effect to other challenged European sovereigns may possibly increase the significance of Ireland’s problems for investors, and portfolios need to be monitored to control the extent of impact.

Loss of faith in governments and banks

Perhaps the most significant contagion effect is a loss of faith in the creditworthiness of major banks – even when strongly supported by the government. Although the Irish government has indicated that senior bank paper is ‘money good’, some commentators are questioning whether it is possible to achieve this. Certainly, any hope that Tier 2 paper is very resilient has been dimmed, if not extinguished, by the action of Irish authorities on their banks’ subordinated debt as well as by ECB legislation that is intent on clarifying and ensuring the loss protection purpose of all subordinated debt.

The rapid rating decline of Ireland has various lessons for investors. The first of which (if not already learnt) is not to rely on ratings. The next lesson is that state support for banks is not necessarily a panacea. It might appear that the Irish state has been weakened by the explicit guarantees that it gave for the banks, but probably the more pertinent point is that these guarantees were forced upon the Irish government, since without them the collapse of the banking system may well have been much earlier.
Australia was fast to follow Ireland into guaranteeing bank debt. This action was not a casual decision and emphasises the systemic importance of the banks within Australia. The subsequent events in Ireland highlight that sovereign guarantees do not eliminate the risk but instead transfer it from the banking system to the sovereign.

Could it happen here?

This raises the more intriguing question for Australians: could it happen here especially with a similar concentration of key banks, all of which have high exposure to the property market? It should, however, be noted that the four major banks are serving a country with about five times the population of Ireland.

Australia has had a relatively gentle GFC compared with the US and Europe and the banking system has remained largely unscathed especially when considering the major banks. The cost of funds has increased for all banks, but the competitive landscape has eased with many of the smaller competitors being squeezed out. The reduction in competition has allowed the major banks to protect their margins, especially in the mortgage and small and medium enterprise (SME) markets.

This protection of margins has helped maintain the credit quality of the major banks but it has created political problems, as borrowers see their interest rates being increased by more than the official Reserve Bank of Australia rate rises.

The four major banks have increased their balance sheets over the last few years substantially as competing lenders have gone by the wayside – although the growth has not reached the level predicted in early 2009.

Australian banks have always had a heavy property focus and in the early 1990s some banks nearly collapsed due to their exposures. Since the advent of the GFC, the banks have been steadily managing down the more challenging commercial property exposures and this sector should not impact Australian banks to nearly the same extent as the Irish banks, but residential mortgages remain a key exposure. Although Australian house prices increased slightly slower than Ireland’s before the financial crisis, they have continued to increase and convincing arguments can be made that prices are in a bubble. (Chart 3 emphasises the extent to which the Australian housing market has continued to perform.) Possibly, the biggest risk is if unemployment in Australia rises significantly as it did in the Republic of Ireland.

However, unlike Irish banks, Australian banks have had a broader range of assets with much of corporate Australia traditionally relying on bank loans as their main, and often only borrowing avenue. With the banks’ increased borrowing costs and investment money beginning to build up both domestically and offshore, corporate bond markets are now competing with relatively attractive borrowing rates and issuers are being lured away from the banks.

Caution may be needed if the banks’ exposure to stronger Australian corporates continues to be eroded and the banks’ balance sheets become overwhelmingly focused on just SMEs and mortgages. That being said, there is a long way to go before we reach that situation.
Beyond the banking sector, other factors definitely distinguish the two countries. Unlike Ireland, Australia has its own currency which enables it to use more levers in controlling economic issues. However, the fact that Ireland shares the euro places a strong incentive upon other euro participants to find a solution and hence is not a complete negative.

Finally, the situations of Australia and Ireland are very different: Ireland is an agricultural producer that reinvented itself as a ’knowledge centre’. In Australia, although agriculture is a main export earner, commodities are a dominant earner and with the relative geographic advantage, in terms of proximity to Asia, Australia has been fortunate in continuing to find buyers of its exports, and while trying to become more of a focus in the financial world, it has not relied upon this.

For Ireland, the exposure was to a downturn in demand for ’innovation’ but Australia is much more exposed to a downturn in demand for agriculture and commodities. This important variation means that the causes of any Australian crisis will most likely be quite different from those of the Irish crisis. However, the similarity of banking systems suggests that the banks, as a transmission mechanism for a crisis, may be similar even if the stronger nature of the Australian banks results in the end effects being less dire.

Conclusion

Australia is not Ireland and, as the discussion above suggests, while Ireland’s problems could be partly mirrored in Australia, various factors should mitigate some of the causes that were central in Ireland. However, with the corporate market attracting strong credit names away from their traditional bank markets, the banking system is moving towards the Irish in its concentration on property and this trend should be monitored.

More importantly, however, than any similarities of the two countries, Ireland should provide a salutary lesson to Australian investors that relying upon the status quo is unwise. Australia did weather the financial crisis most effectively due to a variety of factors. But if these factors reverse (e.g. the Chinese market for commodities reduces) then Australia’s safe haven status could be dented. In such a case, the banks and their dominant position in Australia would become a core focus and they may be more vulnerable than currently thought.

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Key points

• Like the fires of two years ago the floods have wrought terrible tragedy in terms of loss of life and disruption to people’s lives. Beyond the human suffering there will also be significant implications for the Australian economy and investment markets.
• Expect the floods to knock around 1% (or $13bn on an annualised basis) off the Australian economy in the December and March quarters. Rebuilding should see 0.5% of this recouped by year end and a further modest boost to growth through 2012.
• Higher food prices – notably for fruit & vegetables – will add around 0.5% to 0.75% to inflation in the March quarter.
• In terms of damage to physical assets – property and infrastructure – the flood could cost $15bn with rebuilding likely to be spread over several years.
• The RBA is likely to look through the short term boost to inflation and focus more on the short term hit to growth, leaving rates on hold till around mid year. However, once production rebounds and rebuilding kicks in it is likely to return to raising rates from around mid year to head off an overheating in the economy.
• While the floods have led to earnings downgrades, the impact on markets overall should be minor, in part offset by higher coal prices. Australian shares are cheap, having lagged global markets over the last year, and we remain of the view that notwithstanding short term uncertainties they will head to around 5500 for the ASX 200 by year end.

Introduction

Two years ago it was fires ravaging parts of Australia with devastating consequences. Now it’s floods, with most states being affected. Even Tasmania, where I spent last week on holiday, was affected with Railton in the State’s north-west copping it a day or so after I passed through it. However, so far it’s Queensland that has been hit the hardest with an area the size of Germany and France going underwater and Brisbane seeing its worst flood since 1974. Unfortunately the crisis is not over with almost one third of Victoria now flood affected. Like the fires of two years ago the floods have wrought terrible tragedy in terms of loss of life and disruption to people’s lives.

Beyond the human suffering there will also be significant implications for the Australian economy and investment markets. There will be three key economic impacts from the floods: the obvious damage to wealth and associated repair and rebuilding costs; the impact on production or GDP growth; and the impact on inflation.

Damage from the floods

Getting a clear handle on the damage bill from the floods is obviously difficult with flooding continuing in many areas. However, there is no doubt that it will be immense:

• Assuming that 40,000 houses suffered partial or total inundation with an average repair cost of $50,000 implies a total repair bill for damaged housing of around $2bn;
• Damage to commercial property, mines, farming equipment etc could amount to another $2bn;
• Given the extent of the flooding, damage to public infrastructure such as roads, railways, bridges, electricity and water supply, etc, could easily top $10bn to repair. Eg, the Queensland Roads minister has already estimated $1.5bn worth of damage to state controlled roads. However given that the state only controls 20% of Queensland roads the total damage bill for Queensland roads will be well in excess of this. This suggests a total damage bill of around $15bn, which is similar to the damage caused by the 1989 Newcastle earthquake of around $13bn in today’s prices and Cyclone Tracy in Darwin in 1974 which caused around $15.5bn of damage in today’s prices.

As rebuilding and reconstruction commences it will provide a boost to economic activity, but this is unlikely to become evident until the June quarter at the earliest and it will be spread over several years.
Much of this repair bill will fall to Federal and state budgets and to a lesser degree insurance companies and individuals. Fortunately, Australia’s relatively low level of public debt means that Australian governments are well placed to cover the bill. Net public debt in Australia is near zero in contrast to many other OECD countries where it is at exorbitant levels. So even if Federal and State governments have to run up extra debt of $13bn or 1% of GDP, it is not a major financial concern.

A negative supply shock – the worst kind

Physical crises like floods initially amount to negative supply shocks as they cut into an economy’s ability to produce. This is the worst kind of shock as it reduces economic activity at the same time that it adds to inflation.

In terms of the impact on economic activity the major negative impact will come from the following:

• Lost coal production – Queensland normally exports about $2.8bn worth of coal a month. It’s estimated that $2.3bn of coal sales has already been lost. With only 15% of its coal mines operating at full capacity due to flooding or lack of transport and likely to take 3-6 weeks and possibly months in some cases to get back to normal it’s likely that coal exports will be reduced, possibly by around $5bn spread over December to February. This is equivalent to around 0.4% of annual GDP alone;
• Reduced agricultural production – particularly in terms of fruit and vegetable production, sugar cane, cotton and to a lesser extent wheat and meat. This could amount to another 0.1% to 0.2% knocked off GDP;
• Reduced activity mainly in tourism, transport and retailing due to disruption caused by the floods could easily knock another 0.4% off GDP. A 5.7% nationwide fall in consumer confidence in January, presumably largely due to the blanket coverage of the floods, suggests that the short term hit to retailing might extend beyond just flood affected areas;
• The disruptive effects associated with floods may also result in a delay to the start-up of some mining related projects.

So overall economic activity could be reduced by around 1% with a part of this showing up in the December quarter last year, but the bulk of the impact, around 0.8%, occurring in the current quarter. As such there is a chance that March quarter GDP growth could actually be negative.

However, the net impact on GDP from the floods is likely to be less because rebuilding and reconstruction will start to provide a boost to economic activity from the June quarter. By year end it’s likely rebuilding and reconstruction will have resulted in a 0.5% boost to GDP, and as a result the net impact on GDP growth this year will be of the order of minus 0.5%. In other words rather than 3.5% GDP growth through the course of 2011 as we had originally assumed, this will now likely be around 3%, with much if not all of this growth concentrated in the second half of the year.

An additional factor which will help reduce the negative impact on economic activity is that the disruption to the production of coal and some agricultural commodities will be partly offset by higher prices received for those who are still producing. Eg spot coal prices are up more than 20% from their December quarter average and wheat prices are up 14% from their December quarter average. The associated boost to national incomes may help reduce the short term negative impact on economic activity.

Inflation is also likely to see a short term boost in the March quarter, possibly of the order of +0.5% to 0.75%, mainly due to higher prices for fruit & vegetables and cereals and bread. Fruit and vegetable prices are likely to have been boosted by 20% or more.

Implications for economic policy

Just as it did with the surge in banana prices resulting from Cyclone Larry in 2006, we expect the Reserve Bank to look through the short term boost to inflation from higher food prices associated with the floods. The Reserve is likely to focus in the short term more on the negative impact on economic growth and the pressure this will take off productive capacity in the economy. As a result we expect the RBA to leave interest rates on hold out to May at least.

Thereafter we expect the RBA to resume tightening and still see the cash rate rising to around 5.5% by year end. While the near term concern may be a lack of economic growth, from mid year onwards there is a risk that the economy will start to overheat as reconstruction following the floods and a boost in replacement spending by consumers combines with a continuing surge in mining investment. There is in fact a serious risk that demand for skilled construction and engineering workers to help in the rebuilding activity at the same time that the mining boom is taking off will boost wages and add to inflationary pressures. The TD Securities/Melbourne Institutes’ Inflation Gauge for December highlights that even before the floods hit in earnest, inflation was a bit of a problem.

Obviously, the costs associated with the floods will put pressure on State and Federal budgets. While the impact on public debt is not a major concern given the low level of public debt in Australia and a short term blow out in the budget deficit is understandable reflecting one-off short term payments to victims, the Federal Government should ideally seek to offset increased spending associated with rebuilding from the floods by cutting back or delaying spending in other areas (such as infrastructure or the “cash for clunkers” program). Failure to do so could risk adding to skill shortages and wages pressures later this year.

Implications for Australian shares

So far this year worries about the impact of the floods on the Australian economy and profits have seen the Australian share market underperform global shares. This comes on the back of underperformance last year which appears to reflect worries about the impact of rising interest rates locally, the strong Australian dollar and Chinese tightening. However, while the floods still have the potential to add to short term uncertainty, we see no reason to alter our view that the Australian ASX 200 share market index will rise to around 5500 by year end.

• Australian shares are not expensive – trading on a forward price to earnings multiple of 13 times, compared to 15 times a year ago and an average of 14.5 times over the last 15 years.
• The profit implications from the flood are likely to be less than feared reflecting the benefit of higher prices particularly for coal. As a result profit growth is still likely to be solid this year at around 10-15%.
• A pause in the interest rate tightening cycle is likely to be positive for consumer spending, housing construction activity and credit growth helping retailers, builders and banks in the short term once the flood is over.
• Building material, construction and engineering companies and ultimately retailers could be key beneficiaries of the rebuilding after the floods.

Concluding comments

The floods have had a devastating and heartbreaking impact. However, as with all natural disasters there is a danger in exaggerating the economic impact. While the initial effect is certainly negative, rebuilding ultimately results in a boost to growth. And to the extent that the floods underline the ending of the long running drought in Australia and the arrival of a La Nina weather pattern, they should usher in better growing conditions for farmers in the years ahead.

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Many investors are cautiously bullish about the coming year, particularly following confirmation of extension of the Bush tax cuts and the surprise 2% cut in payroll tax. This is expected to boost US growth by 1% plus, which may take it to above potential levels and start to lower unemployment.

The chart below highlights the stark difference in the performance between the 1930s and current financial crises – these two episodes are circled on the left and right hand sides of the chart respectively. While US growth was flat in 2008 and dipped into negative territory (-2.6%) in 2009, last year saw a significant rebound (the 2010 figures in the chart are for periods to end September 2010). This is in stark contrast to the 1930s experience when growth averaged -9.4% during 1930-32. The other interesting difference lies in what happened to savings behaviour. In both cases total net savings (relative to GDP) declined but the extent of public sector dis-saving is today on a scale not seen in the 30s. It is this fiscal stimulus, together with the dramatic monetary policy response, which allowed the economy to expand last year.

The public sector stepped in to take up the slack as households increased savings, thus avoiding the paradox of thrift (in which more savings reduces demand and hence incomes which ends up increasing  debt). The difficulty with this strategy is, of course, spiralling public sector debt. For a time policy makers have to promise fiscal austerity while carrying on spending until the recovery becomes self sustaining…which hopefully occurs before bond holders lose confidence and grow wary of lending governments more money. Even if bond holders keep their nerve, policy makers know that as debt levels rise the risk is that GDP will slow down as the debt service burden grows. The US public sector debt is now US$14 trillion(!) and above the 90% of GDP threshold believed significant for growth rates.

US policy makers know they are in for a multi-year consumer deleveraging process, that will constrain growth unless there is an offset…hence they are chancing further fiscal stimulus, hoping that it will keep things going until the recovery is self sustaining. However, it’s not clear that the fiscal stimulus is being targeted in the right way. To fix a structural employment problem they likely need public sector infrastructure programs aimed at job creation (i.e. investment as opposed to short term boosts to consumption). All fiscal stimulus of course increases debt, the reverse of what eventually must happen. It is a difficult trade-off – is more shorter term growth worth more than longer term austerity? It is if there is sufficient risk of a Japanese style liquidity trap.

While the US has plenty of problems (at least the growth outlook for 2011 is encouraging. Elsewhere policy makers have opted for fiscal austerity. Consequently, growth potential in the UK, Euroland and Japan is likely to be sub 2% in 2011.

The Eurozone, a coalition of illsuited and (some) dysfunctional partners, is scrambling to avert a new crisis. Economic conditions are not uniform. The core countries are doing okay, partly because they benefit from a lower exchange rate due to the influence of the risky Euro periphery. In contrast the periphery suffers from too high an exchange rate, increasing pain for the real economy. This increases the need for more fiscal stimulus, except that this is difficult since it’s already clear that many Euro periphery bond holders will suffer a hair cut on outstanding sovereign bonds and would be reluctant to invest more. Hence the stronger core is left to finance the weaker periphery.

The problems here look like going on and on. It is unclear how Spanish problems will be resolved, it is both too big to fail and too expensive to save. Policy responses to date have been reactive, and aimed at muddling through rather than finding a final solution. The German voters are impatient and its policy makers have been accused of dithering and acting at the last minute when forced to avert a new crisis.
However, the German economy is doing well and there is some acceptance of the need to change behaviour and support weaker members. This suggests that despite all the problems the Euro may survive.

Clearly policy makers face a range of highly unpleasant risks.Identifying the best policy stance is extremely difficult. The path forward is still very uncertain and policy makers will continue to be forced to react to emerging conditions. An added danger is the fracturing of the post crisis policy coordination, and increased focus on beggar-thyneighbour policies. Protectionism will result in a poor outcome for all.

It is clear that in the near term the global economy is highly dependent on the US and the emerging world, particularly China. Unfortunately China also has issues. It is struggling with the flow on effects of an
inflexible exchange rate, in particular spill-over from the loose US monetary policy. This increases excess liquidity, boosts short term growth but also creates instabilities…in particular what may be a bubble in the (vast) property market. The challenge for policy makers is to reduce the bubble risks without derailing economic growth.

Stellar Chinese growth is also creating labour shortages and wages are rising rapidly (over 20% in 2010). Commodity prices too have risen strongly following the most extraordinarily massive Chinese fiscal stimulus. Oil is around $90 a barrel and many soft commodities are up by around 25% over the past six months. (Note that China is no longer a source of disinflation for the rest of the world…this is not an issue now, but will be later.) With inflation picking up (particularly food prices, which can have implications for social stability) there is concern that policy makers are acting too slowly. They may be overly worried about a property market decline, this is a planned economy and the impact on the real economy may be limited by strong infrastructure spending.

While China is trying to engineer a soft landing, more fundamentally it also needs to increase the consumption share of GDP and rebalance a highly skewed economy.However with China getting ready for a handover of power to a new generation of leaders, change is likely to be cautious.

It is worth mentioning China specific positives. A large surplus reserve exists that can be used to offset economic downturns and this provides policy flexibility. Centralised policy making potentially allows the focus to be on longer term solutions and the use of multiple tools/solutions (be it taxes, lending/trading restrictions, rate-setting, etc) that may not be available to other policy makers.

What are the implications for markets? This is a complex and confusing environment. There is the potential for a range of both positive and negative surprises. It is possible that the US manages to pull off a sustainable recovery, which is critical to the global economy. Also very much on the positive side, many US and other companies are cashed up and strong, and as confidence grows capex and (perhaps) labour hiring could both surprise. A wave of M&A activity is perhaps more likely in the near term, and that could bode well (at least selectively) for equity returns.

Returns depend not only on what happens but also on what’s priced in. At the moment there is a bit more optimism about the outlook which tends to push future returns down (because the good news is already in the price), but there is still an historically high yield gap, or risk premium, between US forward equity earnings yields and the 10yr bond rate. That highlights how deeply unattractive US bonds are. In general, the combination of a highly uncertain environment and somewhat complacent market pricing would suggest a move into more defensive assets. However, today traditional defensive assets (nominal bonds) look very expensive and hence risky.

MLC became wary last year and we switched our global sovereign debt mandate to a cash benchmark. This reflects the risks of spiralling public sector debt, but also recognises that yields will rise as confidence grows in a self sustaining recovery (the December quarter 0.8% rise in the US 10 year Treasury yield was likely mainly due to higher confidence in the sustainability of the growth cycle).

Given typical time horizons and real return objectives, most investors need a significant allocation to equities. We think that a key to future returns is the quality of the stock selection – likely dispersion in individual stock performance implies high alpha potential. On the asset allocation side we are highlighting the need for a sufficient foreign currency exposure in portfolios. One of the biggest valuation anomalies is in the current level of the Australian dollar and, unusually, it may be vulnerable in both a return to risk aversion and more positive global growth scenarios.

The Australian dollar has benefited from what seems like unshakeable confidence, supported by stellar Chinese growth. But an improving US may reduce the focus on China and Australia has an Achilles heel – extraordinarily high private sector debt which is very negative for growth potential. The high private sector debt burden that Australia carries is largely funded from offshore savers via our banking sector, which is highly reliant on offshore wholesale financing. This is a low probability tail risk but we all know what can happen when foreign lenders lose confidence and pull the plug: Iceland, Ireland, Greece, Portugal, Spain.

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