Tuesday, November 25

Australian market wrap

Against a backdrop of modest declining business profits, combined with a marked slowdown in global production and falling sales, economic forecasters are becoming more and more bearish and dire as each day passes. However as individuals and corporate save more, the slack in investment can be ameliorated to some degree by increased spending from reserves by the government sector on any number of very worthwhile investment projects which will have beneficial multiplier impact on their local communities. Hence it is in an excellent position to ensure large scale initiatives start to make some impact in countering the daily swag of negative thinking. The purpose of this posting is to examine the current state of play in the Australian economy and its effect on sentiment in our markets.

Risk of a housing price collapse

One identified risk relates to the relatively high level of private and consumer debt (linked to existing high house prices) and the adverse effects of a severe diminution or collapse in house prices on the solvency of our lending institutions. Lending by our instructions has for the most part been responsible and our defaulting provisions allow mortgagors in bankruptcy (unlike the USA where mortgagees are only linked to the property which was the subject of the mortgage) to pursue all defaulter assets in any recovery action. Hence mortgagees are much more likely to try and keep their homes during periods of economic hardship. Mortgages are also predominantly written on the basis of variable type interest rates which are currently declining rapidly. The risk of higher unemployment will cause concerns of course but there is also a severe shortage of housing stock supply which ensures any increase in stocks can comfortably remain below underlying sustainable demand.

It’s much more likely there is a softening in house prices in the order of say an annual decline of 5%. If that was to continue over the next 5-10 years it would be ideal (although unlikely) to ensure housing affordability was restored to more sensible sustainable levels.

Risk of a Business Lending collapse

The danger on the business front would be if banks shut off existing lending for investment projects to the extent such action might turn a recession into a depression. At the moment considerable press coverage is devoted to concerns about whether companies or individuals will continue to be financed. This is despite the fact our banks remain in good shape and are rated amongst the top in the world. The fear about lending being terminated or cut back is not borne out by any data or reported by any viable companies, but rather it is all about why it might happen.

Central bank governor Glenn Stevens summed it up well in a speech last Wednesday night in his relatively upbeat assessment of Australia's economic prospects ………….."Given that we have that scope, and given the underlying strengths of the economy, about the biggest mistake we could make would be to talk ourselves into unnecessary economic weakness,"

What’s causing our market downturn to mirror the USA?

Share markets in Australia continue to plunge. Australian shares have fallen nearly 50% from its peak last year without corresponding falls in profits. Many large Fund Managers see the nexus between reduced demand from the USA (confirmed to be in the middle of a very deep recession expected to last at least until the 3rd quarter of 2009) and the flow on effect to the Asian region including very adverse effects for Australia.

There seems little appreciation of the fact that in many of our service, manufacturing and exporting industries price contracts with customers are negotiated either on a yearly basis or even over several years and hence the dire predictions are simply not possible within the short periods anticipated. Asian economies such as Japan and Honk Kong are currently in recession whilst others are in decline which has not helped sentiment about the Australian economy.

Nevertheless I think it’s been just one factor amongst many that has caused Fund mangers outside Australian to dump Australian stock indiscriminately across the board. We represent only a small proportion of the total world market and hence it’s relatively easy for it to be oversold within a simplistic regional response to risk.

Listed below are other factors weighing against the Australia market.

Effect of an Aussie weakening dollar-The situation is also not helped by the weaker Aussie dollar, (historically it has always been linked to commodity prices and hence rises and falls with commodity price movements ) acting as a temporary catalyst to defer overseas investors investing in stocks here, until such time as the currency confidently stabilizes. Although we have seen commodity prices collapse the lower Aussie dollar also translates into much larger export receipts which offset what otherwise would translate into reduced export earnings.

Further reductions in interest rates- Australia will be further reducing our interest rates which puts a floor under any currency movement to the upside. This reduces buyer interest in our stock, fuelled by unsubstantiated fears of offsetting currency deterioration. If the currency was to temporarily reduce to below the rate of 60cents US than the Reserve Bank has already indicated its intention to become buyer until such time as it regains its value.

Inflation and the danger of stagflation -Our annual inflation was five per cent in the September quarter and will remain high because of our falling dollar which has reduced from a high of 98.49 US cents in mid-July to a 5 year low to around 62 to 64 US cents. Consequently this means lower fuel prices arising from the reduced cost of oil will not be fully passed on at the bowser price. Also that reduction will be offset by increased food and imported price rises as consequence of the exchange rate. Hence the danger for stagflation is zero.

In a nutshell the fall in the USA mirrors adverse economic developments whilst those same falls (in terms of magnitude) on the Australian market are largely anticipatory. The danger is what is anticipated may turn out to be a self fulfilling prophesies.

Margin selling –The market is also being held down by a surge in margin calls (Margin lending refers to loans to buy stock where the loan is not to exceed certain percentage of the current value of the stock – usually the loan is to be a maximum of 60/70%) in good quality stocks when there is insufficient confidence for the bargain hunters to enter the market and buy up those stocks at bargain basement prices. Paradoxically it is the better quality companies who have sustainable responsible operations which were subject to the initial margin lending proposals which perversely, by virtue if that strength now bear the brunt of indiscriminate forced selling.

So in conclusion I return to the statement by our Reserve bank governor, which I fully endorse ‘"Given that we have that scope, and given the underlying strengths of the economy, about the biggest mistake we could make would be to talk ourselves into unnecessary economic weakness,"

Notwithstanding I think (as a consequence of the recent considerable financial wealth destruction, combined with falls in commodity prices flowing from recessionary impacts in the USA, Europe and Asia ) it maybe difficult to avoid a very short recession in Australia but it need not be anywhere near as bad as is feared. In the meantime we could still see further weakness in our share market driven largely by anticipatory fears until there is a return of confidence and a return to uncommon common sense.

There is also an irrational view that successful businesses and sustainability depends upon continual growth for any prosperity, similar to that other equally perverse idea that you have to populate or you will perish. Nothing could be further from the truth.

If I have only learnt one thing in business it is this; success is not dependant upon size or growth or coups or cleverness but has more to do with being in the right place at the right time. When your not there your success is contingent on being able to hard peddle and adapt to both changing circumstances and the environment whilst understanding what your core competences are and how they are attractive to customers. In fact that has always been the case and in essence it is not that much different to nature which we attempt to mimic in many different subtle ways.

We are going through a deleveraging period to return us eventually to a more sustainable economic position which means we will be less reliant on credit and more on investing from a savings pool, not a borrowed one.

Within that context companies and individuals can prosper just as markets will finally mirror that prospect.


Cart said...

Housing affordability seems to me to be part of the overall cost of living package and the perceptions of value within that. Value I this sense being what portion of income they are willing to accept as cost of a roof over their heads.
Here in Port Macquarie I’m watching both purchase and rental asking prices drift higher than pre-crisis while disposable incomes are reducing. That reduction can be put down to rapidly rising grocery and produce, fuel and other living costs. That bubble must have a bursting point.
Just as business had a role to play in creating an economic crisis it seems they are going to continue their negative role. Our Reserve bank governor asked that business stay active and positive, instead we are seeing reduction in activity and job loss, both of which deepen the crisis.
Again, from out here in the regions, I’m seeing mall businesses having contracts which meant ongoing work being cancelled. I’m seeing major businesses reducing or cutting local activity. I’m also seeing some of those major companies hurting local confidence and still living high on the hog at HQ.
The corporates must develop a real sense of community responsibility or be penalised. Cutting activity and jobs will simply drive us into a downward spiral.

Seraphine said...

excellent thoughts lindsay.
american banks have already written off about $750 billion of bad mortgage assets and derivatives. the guesstimate is they have another trillion dollars to go. as they delever, they need to raise tier-one capital. the falling markets are forcing them (and other financial companies, including insurance companies) to sell their stocks and bonds to raise cash. all this selling is causing a vicious circle of additional selling. each round presents further challenges to an already difficult situation.
the scary part is the united states government is spending money it can ill afford to prop up the financial system. as lender of last resort, it might bankrupt us all if people lose confidence in the ability of america to repay its debts.

susan said...

If the government in the US took the same route as the British then the banks would be truly nationalized and under the rule of a committee mandated to operate in a fair and open manner. It could mean a generally positive change.