While financial markets have been focused on European and US debt problems, the real issue is clearly global economic growth, which now appears to be faltering badly.
INVESTORS have been transfixed for the past few weeks, first on Europe as it belatedly introduced another package of measures to deal with its sovereign debt problem, and then the US, which in the nick of time agreed to increase its debt ceiling and thereby avoid a partial shutdown and default.
Markets enjoyed brief relief rallies in response to both, but subsequently weakened after the US lost its AAA credit rating.
The real issue has been the deteriorating global growth outlook, with the political bun fights in Europe and the US just making it worse.
US, European debt
The good news, of course, is well known. Europe has expanded its support for problem debt countries and the US, by raising its debt ceiling, has avoided a partial government shutdown, which would have almost certainly plunged the US back into recession.
However, the European debt problems have not gone away: the bailout fund (the EFSF) is not big enough; it’s unlikely Spain and Italy will be able to make their share of contributions to it; investors now worry they will be forced to share in the pain of bailing out other countries as they have with Greece; comments from political leaders have raised concerns about their commitment to the agreement; and intensifying fiscal austerity will make the debt problems worse.
Reflecting this, Italian bond yields have broken to new highs and Spanish bond yields are back to their mid July highs. Italy and Spain account for about 30 per cent of Euro-zone GDP and a third of its debt, so a spiral of ever-tougher fiscal austerity forced by rising bond yields in these two countries (as has occurred in Greece, Ireland and Portugal) would be a major concern.
Meanwhile, the intense political debate in the US has drawn worldwide attention to the scale of its debt problem, brought forward the timing of fiscal austerity and left the door wide open for the sovereign debt downgrade from ratings agency Standard & Poor’s.
Back in April, when S&P put the US’s AAA sovereign rating on negative outlook, it appeared to be giving it until 2013 to act to lower its deficit. In mid-July, it indicated the politics were such that if the US didn’t move now the odds of doing so later were low, indicating $US4 trillion in savings over 10 years would be expected. In fact, only $US2.4 trillion in savings at most have been agreed to.
S&P was true to its word and downgraded the US credit rating last week. The other ratings agencies, Moody’s and Fitch, have retained America’s AAA sovereign rating but have warned it could still be downgraded.
The biggest impact of the US ratings downgrade may actually be felt over time in the US dollar, which will remain under downward pressure to entice investors to invest in lower-rated US debt.
Potential beneficiaries are the currencies of other AAA-rated countries, notably Scandinavian countries, Switzerland, and commodity currencies such as the Canadian, Australian and New Zealand dollars.
The euro is unlikely to benefit given the debt problems facing the Mediterranean countries and the increasing obligations for core Euro-zone countries resulting from this.
The debt ceiling debate and credit downgrade have focused attention on America’s public debt problems and adversely affected business and consumer confidence.
The real problem
This brings us to the real problem – the recent slowing in the global economy. The soft patch in global, notably US, growth during the first six months of this year was largely due to adverse weather, Japanese supply chain disruptions and the surge in oil prices; it was expected that growth would pick up in the current half.
However, the recent deterioration in key economic indicators suggests more may be involved than temporary factors. While business conditions indicators (or PMIs) in Japan have recovered, the US and Europe have continued to deteriorate and PMIs in India, China and Brazil have also slowed.
While some sort of bounce is still likely in the US in the current half year as auto production returns to normal, it is looking softer than previously assumed.
Revisions to US GDP data and the soft first half of the year have also pushed US year-ended economic growth to just 1.6 per cent, which is below its so-called ‘stall speed’. In six of the past seven times US year ended GDP growth slipped below 2 per cent since 1970, it has kept falling into recession.
Our base case is that the global recovery will continue.
• The slowing in US growth increases the chance the US Federal Reserve will undertake another round of monetary stimulus via quantitative easing (ie QE3). While higher inflation means the hurdle to doing more quantitative easing is higher than it was a year ago, a further increase in unemployment is likely to spur the Fed into action. The European Central Bank may also at some stage be forced into quantitative easing.
• While growth in the emerging world is slowing from excessively strong levels, there is no evidence of a sharp decline indicative of recession and so overall it should remain reasonably strong. Emerging countries now account for more than 50 per cent of world economic activity. Japan also appears to have recovered.
• The fall back in global oil and food prices should help relieve household budgets.
However, with fiscal austerity starting to kick in next year in the US and set to knock up to 2 per cent from growth as GFC stimulus programs wind down, and fiscal austerity continuing in Europe, growth in advanced countries is likely to be pretty sluggish. In other words, it’s hard to see the 4 per cent or so global growth the IMF and others including the Reserve Bank of Australia have been assuming for this year and next.
Local implications
The global malaise affects Australia via three key channels: the direct impact on business and consumer confidence (both of which are depressed); financial markets (eg the loss of wealth as the share market falls); and trade. While demand for Australian exports remains strong, the risk is the weakness in Europe and the US adversely affects growth in China and Asia, which then reduces demand for Australian exports.
So far there is no clear evidence of this, but it is worth keeping an eye on. The bottom line, though, is the global outlook is softer than the RBA has been assuming and this, combined with a continuing run of very weak economic indicators in Australia, highlights why it would be a major mistake to raise interest rates any time soon. In fact, the case is steadily building that the next move in the cash rate will be down.
Investor implications
The fall in share markets has left shares cheap. Before this week’s falls the forward prices-to-earnings ratio for Australian and global shares had already fallen back to early 2009 levels.
However, just because shares are cheap doesn’t mean they can’t get any cheaper. The September quarter and into October is normally the weakest time of the year for shares, and ongoing worries about European debt, the slowdown in the US and uncertainty about whether China will have a hard landing could push shares even lower in the months ahead.
By year’s end, global shares are likely to be on the rise again, supported by attractive valuations, another round of US quantitative easing, greater certainty that China will avoid a hard landing, and improved confidence global growth will remain positive (albeit weak and fragile).
Of course, for longer-term investors this is all noise and they should stick to their agreed long strategy. But for shorter-term investors there is a case to remain cautious for the next few months.
• Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors.
