News

Sell in May and go away!

So goes the adage. This year, as in 2010, we should have listened! The Australian share market had its worst month since June last year, falling by 2.4% while the United States market fell by 1.4%. This makes eight months out of the past nine that the US share market has outperformed the Australian market.

Oddly, the major concern overhanging markets came from elsewhere: the eurozone debt issue. I made the point last month that the economic size of the three countries most affected-- Greece, Ireland and Portugal—was smaller than the economy of the state of Florida. But their political links to the rest of Europe and the contagion issue gives them greater importance than this comparison would suggest. In the month, the issue moved on a little further. While the rest of Europe is prepared to do something to shore Greece up, it seems inevitable that Greece will eventually default on its debt, if only partially. Its public debt to GDP ratio is close to 150%. In the past two hundred years, no country with a debt ratio that high has managed to return it to an acceptable level (say 70%) without defaulting.

If Greece does default, what will happen next? We can be sure that financial markets will be roiled for some time, and there will be concerns that Ireland and Portugal will follow suit, which will drive up their borrowing costs. There is also concern that contagion could spread to both Spain and Italy. Were this to occur, things would start to get serious since they are both fairly large economies. But Spain has a relatively low debt/GDP ratio right now, and Italy’s is close to stable. Then there are the possible effects on the European banking system, particularly in Germany. A default would mean substantial losses for the banks, but the Fitch ratings agency has recently made the point that the loss would be manageable.

What seems to have been forgotten in all of this is that sovereigns default on their debt quite often. In Argentina, it’s a national sport. And life goes on, albeit with some volatility.

Meanwhile, the world economy appears to have been going through something of a soft spot. It’s still in recovery mode, but many global indicators, particularly relating to manufacturing, have softened. Some of this is, of course, due to the ongoing effects of the Japanese disaster. But the softness is unlikely to mean that the global recovery is about to die; rather, given the spare capacity in so much of the developed world, the best bet is that the recovery will be a long one.

Closer to home

It was an interesting month for both monetary and fiscal policy. In early May, the RBA published its Quarterly Statement on Monetary Policy, the best read going on the state of the global and domestic economies. In it, the RBA sent a clear signal that more rate rises are in the offing. What it said (in code, of course) was that financial markets had two more rate rises priced in during the next two years, and that this was unlikely to be enough to keep inflation under control. Translation: expect at least three rate rises! Once this clear tightening bias is revealed, the RBA may as well act on it, so there was immediate speculation that rates would rise in early-June (next week). This is most unlikely to happen. Almost as soon as the Statement was released, Murphy’s Law swung into action. Since then, in addition to the increased global worries outlined above, we’ve had weak news about lending for housing, about retail trade, about employment, and about consumer sentiment. In addition, we’ve found out that wage growth is still very modest. And to cap it all, as this opus goes to press, we find out that Australia’s economic output fell by 1.2% in Q1, the largest quarterly fall in 20 years. Of course, we all knew this fall was coming. It is due mainly to the effects of the January floods, particularly on coal exports.

The RBA is clearly planning further rate rises, in part to accommodate the extraordinarily strong growth still coming from mining investment in the next year or two without over-heating the entire economy. But it’s worth remembering that it’s a plan, not a schedule, and plans can change as we find out more about the ongoing state of the economy. Recall that last year, in early May, the RBA sent a similar message, although with less emphasis. In the past twelve months, the cash rate has risen just once.

Budgets come and budgets go

The 2011/12 Budget was released on 10 May. It showed a return to surplus in two years, despite a worse starting-point than was expected a year ago. The increased deficit in the year about to end ($49 billion compared with the previously expected $41 billion) was due mainly to the fact that the Australian economy has grown less rapidly than expected in the past twelve months and has hence generated less revenue. But growth is expected to pick up, and real spending growth is expected to be held below 2% per year, so the deficit disappears relatively quickly. Indeed, the plan has the deficit (measured as a share of GDP) declining in each of the next two years at a faster pace than in any one year in the past half-century. This is despite much explicit fiscal tightening in this Budget, but it’s tight because it’s not loose. For the first time in nine years, your tax rate won’t go up on 1 July; we have abandoned the policy of simply handing back the revenues of the mining boom.

So what will June bring?  

Only a brave person would hazard a guess. I doubt that the period of volatility is over, and at the end of the month the “quantitative easing” programme in the US comes to an end. Last month, I suggested this would be a non-event, and that is still my view. At the beginning of the financial year, I ventured a target of 5500 for the ASX200 by end-June this year. This was quite ambitious, since the index closed June 2010 at 4301. It will obviously fall significantly short of this level. I anticipated that the international worries, in particular, would be closer to resolution by now. I am, however, a great believer in recycling, so at the moment I am prepared to put forward the same forecast for June 2012 (although I will revisit this in next month’s missive).

Chris Caton

Chief Economist

The views expressed in this article are the author’s alone. They should not be otherwise attributed.