Caton's Corner - September 2013

The dominant influence on markets continued to be the likely tapering of quantitative easing by the US Federal Reserve. I discussed this last time, and suggested that there was no need for markets to fall when the tapering began (probably later this month). Given that markets are forward-looking, any likely effect has probably already happened. This is clearest in the bond market. Quantitative easing is designed to lower long-term interest rates. It certainly did this, with the 10-year bond rate reduced to a paltry 1.63% in early-May but back at 2.78% in recent days. The market is effectively doing the Fed’s work for it in its view, QE has already ended.

The tapering will probably begin on 18 September, after the next FOMC meeting. Expect some volatility in markets (what’s new) but there is no need for any depressant effect.

Bad economics

Did anyone else notice that there is an election campaign going on? At time of writing, the outcome seems clear. If the expected result eventuates then it is likely that business confidence will be lifted, which should be positive both for the economy and for financial markets.

We are told frequently that economic management is a (perhaps the) key issue in the election. What is interesting about this is that there is no clear evidence that one side is a more competent manager of the economy than the other. In recent times, the Coalition got to manage the commodity-price boom while the Labor government got to deal with the GFC. Who is to say that if the roles had been reversed the results would have looked very different?

The plain fact is that most of what determines how the Australian economy performs has little to do with the government. The rest of the world matters a lot, monetary policy is independent and the private sector goes about its business every day. In Hamlet’s words, there’s a divinity that shapes our ends, rough-hew them how we will. The Federal government does the rough-hewing.

This is not to argue that government makes no difference. Indeed, both sides should be given credit for the bipartisan approach to economic reform that dragged the Australian economy into the 20th century in the 1980s and 1990s. The days of bipartisanship are, unfortunately, long gone.

Election campaigns are frustrating for economist because they see their discipline misused time and time again. Here there is bipartisanship both sides are equally guilty.

One of the biggest distortions is this endless hammering away at the idea that Australia (or rather the Labor government) has amassed this huge pile of government debt that will, somehow or other, impoverish us or our children (or perhaps their children). The plain and simple truth is that, measured relative to the size of our economy, Federal debt is less than a quarter of the average for the developed world (I have a chart for those interested). One could legitimately argue that the Budget should be closer to balance, but not that it has left us with a major debt problem. The phobia about debt is not without consequence the day that a country succumbs to it is the day it begins to under-invest in infrastructure.

There is also an apparent assumption, on both sides and certainly in the media, that the state of the Budget is the most important indicator of the economy (and of the Government’s ability to manage). It is not the unemployment rate is a far better candidate. We have lost sight of the fact that the Budget is there to serve the purposes of the economy and not the other way around.

Economists (at least most of them) also find perplexing the sudden focus on foreign investment, particularly in agricultural land. For the past 200 years, Australia has benefitted hugely from the influx of foreign capital. We will continue to need the latter for as long as we don’t save enough domestically to finance our own capital needs. We already have a Foreign Investment Review Board whose job it is to assess large-scale purchases with an eye to the national interest, and there is no evidence that this process is broken. In addition, foreign investment in agriculture is relatively small less than 2% of the total. Finally, raising new barriers runs the risk of flouting our international obligations.

Then there is the carbon tax. If it is, as we have been told, “a great big tax on everything”, how can it be that scrapping it saves the Budget money because the compensation paid to business is more than the revenue collected by the tax?

Strange days indeed!

Elsewhere

The Australian dollar fell marginally in August, from 90.7 US cents to 89 cents (check). This leaves it above fair value. During the month, the Reserve Bank characterised it as still high, and I share that view. The downward move may not be over!

In early-August, the RBA cut the cash rate to a record low of 2.5%, a move that was “fully passed on” in mortgage rates. Financial markets remain convinced that there is a further cut out there. I’m less certain the RBA would probably like to think that it is finished. The key for a further cut is the unemployment rate. It’s currently 5.7%, which is relatively low by international standards. But it was 5% as recently as April last year and the trend is ominous. If it continues, unemployment will soon be higher than it was at the worst point of the GFC. If it hits 6%, expect a further rate cut.

I thought I made a mistake but I may have been wrong

In the previous Caton’s Corner, published on 21 June when the ASX200 stood at 4739, I cut my end-of-year forecast from 5300 to 5100. This after having raised it from 5100 to 5300 in early-March! Now, at end-August, either forecast looks equally plausible. Perhaps I should just settle for a range of 5100-5300!!

Trumpet-blowing

In July, the Fairfax press awarded me the “Palme d’Or” for being the most accurate forecaster (among economists!) of the share market for the financial year 2012/13. This was on the basis of a forecast I had made 12 months earlier when the share market was around 4100. I believed at the time that concerns about Europe (and particularly about a Greek exit from the Eurozone), were overstated, and hence that the market was clearly cheap. My forecast for 30 June this year, of 4750, actually turned out to be low, given that the market finished the year at 4803. Every lottery has a winner!

Chris Caton
Chief Economist

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