The New York Stock Exchange opens and closes to the sound of a bell but as many share investors have lamented, no-one rings a bell at the top or the bottom of the market.
So far this month, Australia’s benchmark S&P/ASX200 index has slumped 11.7%, mostly on justifiable concerns about the ability of Europe and other developed nations to service their debts.
But investors have also been pondering a raft of other negatives.
Whether justified or not, there is a danger that the Resource Super Profit Tax (RSPT) will scare off overseas investors and will result in mining projects being shelved. There are also concerns that the Chinese regulatory authorities will not be able to dampen speculative activity in the housing sector without hurting the overall economy.
Likewise, most blue chip stocks in the local market are not cheap on key valuation yardsticks – a situation that might become worse if short-term interest rates rise another 0.75% over the next two years as the futures market is implying.
But perhaps the biggest problem is one of simple arithmetic: namely, that it’s impossible to keep piling up debt indefinitely. In economics, saving is often described as deferred consumption. It’s the portion of your income that you could spend now but have held back for future use. Debt, of course, is the other side of the coin. It allows you to spend more than your earn and to bring consumption forward from the future.
The sting in the tail with debt is that you have to allocate future income to meet your repayments. Greece and several other European are now barely able to do this and bondholders are staring at losses of potentially trillions of dollars. The usual solution to this kind of economic mess is to grow your way out of the problem – i.e. generate more income and pay down your debts. Unfortunately, Greece has little chance of doing this. Its three main industries are tourism, shipping and manufacturing – none of which have great upside. It will therefore have to cut future consumption for years, and possibly decades, to come. It’s a similar story for Portugal, Spain, Ireland, Italy and a host of other European countries who will struggle until the Euro sinks to a level that makes the region competitive again.
Questions for local investors
Of course, the critical question for local investors is: what does all this mean for us? The answer is probably not that much. Although the Europe accounts for 15.2% of world GDP, it only accounts for 6.8% of our exports. Australia’s biggest individual export market in Europe is the U.K. which has a 2.6% share. On a dollar basis, that makes it less important than Singapore and about the same as Thailand. The other G7 countries – France, Germany and Italy – collectively account for just 1.8% of Australia’s export sales. China, Japan, India and South Korea constitute nearly 58% of the total.
The reality is that Europe is a relatively minor contributor to Australia’s economic growth and has a limited presence in Asia. Any fallout from Europe in terms of weaker growth or sovereign debt defaults is unlikely to have a significant impact.
Worries about China need to be kept in perspective too. While there are legitimate concerns about speculative activity in the Chinese housing market and newly-announced curbs on lending, you need to bear in mind that 30 of China’s 32 biggest banks are state-owned. Twelve are owned directly by the central government and another 18 generally smaller lenders are owned by local governments. Unlike most Western countries, the Chinese regulatory authorities don’t have to cajole their commercial banks to rein in spending; they can instruct them what to do.
Moreover, the government has made it clear that it is targeting second homes and high-end properties in tier one and tier two cities, not the low-end real estate which dominates the industry. As long as inflation stays reasonably contained, the odds are that the residential property boom in China will deflate with a hiss not a bang.
With the Resource Super Profits Tax (RSPT), it’s hard to untangle the information and misinformation. According to Fortescue Metals CEO Andrew Forrest, the RSPT is “equivalent to the nationalisation of the mining industry.” Yet Treasury Secretary Dr Ken Henry argues that “the RSPT should have little impact on mining investment. Overall mining investment is encouraged in this package.” BHP has threatened to cut its dividend, Rio Tinto plans to ‘review’ all its projects, the Wall Street Journal says the tax will make Australia ‘one of the most burdensome places to mine in the world,’ there have been threats to target marginal seats in Western Australia during the Federal election and everyone is getting frustrated that others can’t see their point of view.
It is not hard to understand why mining companies and share investors don’t like the tax but they seem to be swimming against the tide. The wider business community is not rushing to back them up on the issue with most industrial and service sector CEOs expressing ambivalences or even guarded support for the RSPT, the Federal Government is not keen to negotiate a compromise and the weight of research is starting to confirm that the mining sector is not as heavily taxed as it was a decade ago.
It is hard to weight up these competing claims but perhaps the best arbiter is the stock market. Since the RSPT was announced, the ASX Metals & Mining Index has actually outperformed the All Ordinaries Index by 1.7%.
Not all bad news
With all the drama surrounding the RSPT, European debt and world growth, it’s easy to get caught up in the gloom of the moment. But to keep a balanced perspective, it’s important to be aware of other trends that just don’t fit the doomsday scenario.
- To begin with, most commodity prices are strong, especially in $A terms. This is surprising given that commodity prices and the US$ tend to move in opposite directions and world growth is supposedly at risk from an implosion in Europe.
- Mining stocks appear to have under-reacted to the weak $A. During the past month, gold shares have slumped 6% yet the A$ gold price has surged 14.8%. Since the collapse of Sons of Gwalia from hedging losses in 2004, most gold miners have steadily unwound their hedging arrangements so the higher $A bullion price should quickly flow through to their bottom line.
- Dry cargo shipping rates are up 28% so far this year which suggests that world trade is strong. While this is by no means a perfect indicator, it is useful because it is hard to fudge. No-one leases a 50,000 long ton ship just for the heck of it.
- ASX trading volumes are up 67% on last year. This must be making inroads into the supply of panic sellers in the stock market.
- While Australian corporate earnings are only expected to grow 1.7% this year, they are forecast to climb by 12.9% in FY11.
- The S&P/ASX 200 index is nearly 29.6% below its long-term trend.
- Job ads on seek.com.au and other online websites are continuing to grow strongly which indicates that labour demand and business trading conditions remain positive.
- Dividends plus franking credits are yielding more than short-term interest rates.
Conclusion
There will undoubtedly be plenty of turbulence on the financial road ahead but the local share market looks closer to a buy than a sell. While the fears about Europe’s fate are of concern, the punishment meted out to Australian equities and the $A over the past month is excessive.
Warning: While all care has been taken in the preparation of this document (using sources believed to be reliable and accurate), we do not accept responsibility for any loss suffered by any person arising from reliance on this information. This document is not financial product advice and does not take into account any individual’s objectives, financial situation or needs.
