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Finance - Outlook improves but risks abound |
What a difference a year makes.
Just 12 months ago prospects for the world economy looked bleak. The US was still struggling to recover from the dot.com collapse and the September 11, 2001 terrorist attack. For a while the US actually dipped into a recession. The war drums that were sounding ahead of the invasion of Iraq did not help.
Fortunately the downturn was mild but it could have been a lot worse. Japan was still a basket case, the SARS epidemic was spreading with unpredictable consequences and Europe was struggling with a recession of its own. One of the biggest fears was the threat of deflation – an economic phenomenon with which we have had no recent experience.
While things were not too bad back home, we felt vulnerable and were well aware that any major crisis offshore would reverberate here. But the SARS scare came to nothing much - at least on a global scale - the threat of terrorism receded, and Japan and Europe started to recover - as did share markets around the world. Superannuation funds in Australia actually posted positive returns.
A big part of the reason we survived it all was the action by world central banks to cut interest rates to near record lows by pumping money into the economy. This, combined with tax cuts in the US saw consumers soldier on, spending all their income and borrowing where necessary to fund larger purchases. House prices in many parts of the world rocketed, spurred by investors looking for alternatives to the share market.
The threat of deflation – falling consumer prices that force employers to match price falls and cut costs - is still lurking in the background but is now not taken too seriously as an immediate threat.
China, which is rapidly becoming the factory of the world, is helping to keep prices down, in part because of its cheap labour and in part because it has linked its currency to the US dollar - which of course has been falling. This makes China’s exports even cheaper.
As we enter 2004, the outlook for continued growth looks good, although there are of course the risk factors that never go away.
In the US and Australia there will be Federal elections that will cloud the economic waters and make sensible decision making harder. Central banks will be struggling to find the right balance with interest rates, especially if tax cuts are promised.
Tax cuts will give a boost to consumer spending, which will put additional upward pressure on interest rates.
The problem for the central banks however is that while low interest rates kept the economy afloat, it also saw consumers take on high levels of debt. High debt levels make the economy vulnerable to any shocks. An upsurge in inflation, higher interest rates, drought, an economic downturn offshore can all play havoc with those heavily in debt.
The worst-case scenario is a rise in unemployment that could prove particularly difficult for those in debt. And of course there is always the ‘X’ factor – the unexpected event that can disrupt even the most stable economies.
One to watch for of course is the Asian bird flu. The SARS incident showed how a health scare can lead to a drastic fall in overseas travel with the immediate effects felt by the airline and tourism industries. If it is severe and lasts long enough, the effects flow on.
The housing industry is another one to watch. Housing construction and house prices have been the real engine for growth in the Australian economy for the past two years. Almost half the buying has been done by investors, or more accurately, speculators. They are pouring $7 billion a month into this sector and many are vulnerable because of the big licks of investment capital tied up in one area – the eggs and basket scenario.
Many punters have thrown fundamental investment principles away in the race to join in the fun and what they perceive as easy money. But it is the rental returns on property, just as it is profits in the corporate sector, which determine the value of an investment. When speculation takes over, bubbles develop which in turn can lead to either a bust or a slow deflation.
So given all this, what is in store for the major investment markets this year?
Given all the risk factors, this is not an easy one. However in the absence of any surprises, the housing sector looks as though it will go into a gradual decline. Housing starts are expected to fall. So too is investment spending on housing. But with only small interest rate rises predicted, house prices are likely to plateau rather than fall. Already there is anecdotal evidence that developers are pulling the plug on some projects and auction clearances are down.
The share market should be positive although few are expecting double-digit returns. Share prices both here and in the US are not cheap in relation to corporate earnings so the upside, from an investor’s viewpoint, is limited. A lot however will depend on the strength of the recovery in the US. If profits start rising rapidly then the market could take off.
In the fixed interest area, returns will probably fall as interest rates go up. The dollar will play its part here. If the dollar rises in value there will be a dampening effect on the economy as exporters struggle to be competitive. This will reduce the need for interest rate hikes.
All in all, not too bad a year. But you never can tell.
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