Rudi's View | Apr 10 2008
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck, editor FNArena
The fact that the Australian share market has significantly underperformed US markets has caught my curiosity since the start of calendar 2008. Similar to other market watchers, experts and media commentators I have asked myself numerous times: Why is it that Australian shares have suffered much worse while US shares, financials excluded, actually haven’t performed so badly at all?
The Australian economy is in a healthy shape. The US economy is in recession. How many times have I now read these two sentences? I lost count. But I’ve read it so many times, it nearly gave me the impression the Australian economy had become invincible; carried, pushed, pulled and dragged along by the mighty Chinese while the US was rapidly falling off a cliff, experiencing the end of an almighty era.
Who’s in recession again? Many commentators tend to use this sarcastic open question in close connection with the fact that Australian shares have lost so much more compared to US shares. We all know the answer, that’s not the point. It’s about the underlying message, which is one of sheer unbelief: it’s their housing market crisis, their subprime mortgages excesses, it’s their Bear Stearns, their leveraged products that no longer can be valued; all opposed to our banks which are strong and well-managed, our resources companies that have no problems in finding buyers for their products and our Australian dollar which trades at multi-year highs against the US dollar – how come we are feeling so much more pain?
Many commentators have tried to provide the answer, and I have read many, but I haven’t seen one single explanation that felt completely satisfactory, including the suggestion that financials in the US already peaked in February, while Australian banks powered to new highs into October; if one compares from both peaks the losses are actually quite similar.
I still don’t buy it, even though I readily admit this is the most plausible explanation I have come across. Let’s be clear about this: US financials have crumbled, their balance sheets are shot to pieces, their reputations tarnished for at least a decade. Compared with that battlefield of what turned out to be vulnerable houses of cards, Australian banks are solid brick fortresses, having endured but a dent here and there – at the most.
I say the difference in performances of both markets is linked to the opposing direction of interest rates in the US and in Australia.
When I look at the prospects of an individual company I always keep an eye open for the underlying trend. Is 8% prospective earnings growth good? I’d say that 8% looks a lot better when it compares with a previous 4% forecast instead of being an adjustment from a previous forecast of 12% growth. Similarly, if a company is rated Buy six times out of ten, is that good? Depends whether it used to be eight out of ten, or four.
I am not going to make myself look smarter than I am. Two weeks ago someone made the observation that share markets in countries where reserve banks are tightening (or had a tightening bias) had underperformed markets in countries where interest rates are falling. That kept me thinking: could this be the explanation we’re all looking for?
The more I thought about this, the more logical -and simple- the issue became. Investors are supposed to look forward. Financial markets are a reflection of this. Yes, the Australian economy is in a healthy shape, while the US economy is in recession. But what do we see when we look forward?
Unfortunately, the answer to this question is negative for Australia. Inflation will hit 4% this quarter, which is 100 basis points (1%) above the Reserve Bank’s comfort level. About three quarters of the underlying stimulative factors are outside the direct influence of the Reserve Bank. Think property rents for instance, banking services and child care fees. The only way to pull inflation back from its elevated levels is by inflicting pain on the Australian consumer, or through a significant fall in international growth. It doesn’t seem like the latter is an option at the moment, so it had to be option number one.
In layman’s language this means that while the Australian economy is in a far better shape than many other economies around the world, the trend is nevertheless negative. As such it would seem but logical that the Australian share market is already reflecting this. And if recent data are any indication, the overall health of the Australian economy appears to be deteriorating at a rapid pace.
On Tuesday, National Australia Bank published its monthly business survey for March, revealing the lowest forward reading for the Australian economy since December 2002. The index has now fallen 10 points in three months, a pace of decline which even shocked the economists at the bank. Equally remarkable: all sector readings fell.
Now compare this with the US where doom and gloom in housing and the financial sector has put authorities, central bankers, investors and the rest of the world on red alert, in the highest state of action, but ultimately filled with hope that all this will lead to a much improved environment later this year. Now that’s something to look forward to! (It may yet turn out that investors are being too optimistic, but we won’t know this until later).
The key difference is that in Australia investors have to weigh up how bad things will turn out ultimately. Will there be a recession? We don’t know for sure, but we hope not. In the US the recession is already a fact, now investors can start looking forward to when the economic recovery will begin. (I noticed a growing number of market strategists is nominating the US stock market as their most preferred place to invest).
What does this mean for Australia going forward? If we apply the logic of the interest rate direction, this would imply that the Australian share market will remain an underperformer until the RBA will start cutting interest rates. According to a growing number of economists this could be happening as early as the fourth quarter of 2008. However, what this also means is that things will first rapidly deteriorate much further in the months ahead.
According to other economists, inflation will remain much higher for much longer in Australia. This will force the RBA to keep interest rates at the current 7.25% for much longer. Under this scenario economic growth in Australia doesn’t have to fall off a cliff (but it might), but there won’t be any relief from the Reserve Bank either.
Instinctively we would all feel more attracted to the second scenario, with a relatively healthier economy. In practice, however, the first scenario would probably turn out much better for the prospects of the Australian share market.