Aussie and Asian Growth to Continue
Australian and Asian economic fundamentals and GDP growth remain in good shape and will underpin regional stockmarket recoveries. It's a stock picker's market and capital protection is growing in popularity as market volatility rises. Global markets benefit from aggressive US Fed rate reductions but are wary of the May 08 peak in sub-prime mortgage resets.
What a month January has been! Normally the time of vacation and relaxation, January 2008 has produced a global stockmarket downturn which, in Australian terms, has led to the largest falls in stock prices in over 20 years. The selling pressure has been linked to losses from sub-prime mortgage backed CDOs, and whilst these losses have certainly hurt investors and hedge funds around the world, there are a combination of factors which have driven markets to their lows.
The bottom of the Aussie market was on 22 January 2008 - and with the ASX 200 index touching 5100 points its clear that our market has fallen a long way from the highs of 6700 in July 2007. The market is slowly clawing its way back with a recovery by the end of January back up to 5800 for the ASX 200. Investors are increasingly comfortable with a focus on medium to long term fundamentals but many are still wondering what has caused the shock to our market. Some of the causes are relatively obvious but one of the big bogeys has come from a source which has so far escaped much attention.
The main causes of the stockmarket correction.
A lot of press coverage has been devoted to analysis of how major global banks have lost large sums from the exposure to the sub-prime mortgage market. This has led to a contraction of the money available to lend to businesses and consumers, and had a double whammy as banks and market participants have become increasingly wary of counterparty risk. This part of the economic malaise played out in December 2007 and was seen clearly in the 80% drop in the Centro share price – emblematic of the withdrawal of debt funding to financially engineered stocks (such as more recently, Allco, and Babcock and Brown).
This so called "liquidity" problem has been exacerbated by a number of causes. Hedge fund short selling has been aggressive and is now widespread and intensely focused on stocks with high leverage and complex balance sheets. Many stakeholders including the ASX are calling for tighter rules and disclosure of short sales. Short selling has a legitimate use – it is part of the hedging of derivative positions – but is also one of the last legal methods of market manipulation. The use of short selling is clear as soon as short "covering" takes place: stocks that yesterday were being called risky and weak will rise rapidly the following day, as short sellers close out their positions. But the distortion that short selling sends to the market is unwelcome and can cause financial distress for investors that have margin loans covering their positions.
But the biggest story is one that most media outlets have missed: the massive €6.8bn loss incurred by Societe Generale, arising from fraud by one of its traders, dwarfs the bank busting £600m fraud which Nic Leeson perpetrated to end the 350 year history of Baring Bros Bank. The Soc Gen fraud involved rolling up loss making stock and futures positions in most major global markets around the world. It is widely rumoured in financial markets that it was the forced and rapid unwind of these positions that led to the synchronized losses on Black Wednesday, 22 January 2008.
What are the economic fundamentals for 2008?
Short selling, sub-prime led liquidity problems, and the Soc Gen fraud are all "temporary" phenomenon which will be washed out by the system over the coming months. What are the economic fundamentals for the rest of the year and beyond?
We noted at the start of this analysis that the Australian economy is growing solidly and our GDP growth is the envy of most of the developed nations whose economies lag our own. ANZ Economics go so far as to say that:
"We expect Australian growth to motor on at or above trend for the next two years…overall, it is difficult to be pessimistic about the outlook for Australia, despite global woes" (ANZ Economics, 29 January 2008, p. 12)
It's true that estimates of US growth have been severely downgraded in the last few weeks, including by the IMF, but its also the case that economic data in the US is stronger in most key factors than in the lead up to the most recent US recession in 2001. And is fears of a US recession are driving global market concerns, perhaps it's also true that the fears are slightly overdone:
"While the US economy is clearly slowing, there are good reasons why we think it will avoid recession." (ANZ Economics, 29 January 2008, p 4)
As the charts below show, most US indicators are stronger than in 2000 – 2001:
This has led commentators to suggest that weak economic data will persist for the first half of 2008 in the US, but that this won't spill over to successive quarters of economic growth (the technical evidence of a recession). Concerns that high debt levels will also cause problems for US corporate also seem overdone, as interest cover ratios are currently at 18.5 times for the US corporate sector, compared to 4.5 times prior to the 2001 recession.
And with the current account surpluses and FX reserves that many developing nations are now running (especially those which are commodity exporters), it's less likely than ever that these nations will experience financial distress just as a result of a weaker US economy.
In the case of China, for example, of the 11% GDP growth experienced last year, 9.0% was driven by domestic demand as China gets its industrial revolution into full swing; with only 2.0% of that GDP growth driven by exports. Clearly, the fear of a global recession driven by a flagging China following the lead of a weaker US, is overdone. And the strength of China is a key factor in the ongoing economic strength of Australia. India's 8.75% GDP growth last year was fuelled by an even higher level of domestic demand than in the case of China. While China's economic growth is forecast to slow in the next few years, this is down from a massive 11.8% last year to 10.8% in the first half of 2008 and to 9.5% in the last half of this year (Source: ANZ Economics). Strong growth across the entire Asian region will help Australia maintain our high levels of growth.
The obvious near term fear in Australia is the impact of rising interest rates. Once again, close analysis shows these concerns are somewhat overdone; although rising rates will inevitably hurt many homeowners and margin account stockmarket investors. For example, even despite rapid rate rises last year, those rises have not yet surpassed the aggregate value of the tax cuts announced in last year's Budget and which take effect this year. Domestic savings have also now returned to positive levels, and business investment will remain strong for the next couple of years at least.
In summary, while the coming years won't be as trouble free as the last 3 years have been for Australian investors, for a number of reasons the economic fundamentals and stockmarket prospects will continue to be good (albeit volatile) for at least the next 2 years. Prudent stockmarket investing, with appropriate risk reduction mechanisms in place (such as those in Alpha POWER Shares) will reward smart investors.
Tony Rumble
