Over the weekend, the “austerity” coalition in Greece won a majority of seats in the Greek Parliament in the second election in six weeks. However, as we have said before, the very high probability is that Greece will eventually default on its debts. Its debt equals 130% of GDP, even after previous “restructurings”.
The euphoria, if any, is likely to quickly dissipate, as the markets turn their attention to Spain, which has had to ask for a $125 billion bailout for its banks, and where the interest rate on 10 year government bonds has crept up to a post-euro high. This matters, because if the ratio of government debt to GDP is high (in Spain it is now 72% of GDP and is expected to reach 80% by the end of the year) then a rise in interest rates causes a rise in the interest burden the government must pay which then ups the deficit which in turn increases the debt to GDP ratio, and so on. Once debt to GDP passes a certain point, just the belief that the government might default worsens the situation, leading to a doom-loop of rising debt and rising interest rates ending in default—unless a circuit breaker is created.
The Germans believe that the circuit-breaker is austerity: cutting spending and raising taxes so that the budget balances. The only problem with this approach is that austerity slows the economy, since tax increases reduce spending and budgets cuts reduce incomes. Everybody’s spending is someone else’s income, and if there is uncertainty and insecurity, this is compounded. So spending dries up, leading to falling employment and incomes which in turns leads to falling spending and so on and so on. In fact, since the biting austerity measures imposed on Greece, Italy, Spain, and Portugal, industrial production is down by between 20 and 30% in these countries, and of course, the budget deficits have blown out again. So, not in fact a very effective circuit-breaker.
Alternative suggestions for circuit-breakers involve various degrees of future budget-balancing measures (e.g, pay freezes for government employees, pension and unemployment benefit freezes, hiring freezes) with monetary ease (which will make it attractive for the banks to invest in government bonds, thus driving down their yields) as well as confidence-boosting measures such as central bank measures of support for banks and banking systems. Economic growth tends to reduce government deficits as tax revenue rises faster than nominal GDP. However, the ECB (European Central Bank) has refused to cut its discount rate below 1%, even as Europe slides into recession. By comparison, the Federal Reserve Bank in the United States has a discount rate of zero, the Bank of Japan a rate of 0.1%, and the Bank of England of 0.5%. Under its new head Mario Draghi, the ECB has it is true been actively supporting banks across the euro area, most recently by lending them one trillion Euro at 1%. But this isn’t enough. In the face of a double dip recession and inflation of only 2.5% you would think that the ECB would also have zero interest rates.
From the beginning of this crisis, European institutions have blundered. Each attempt to address the crisis has been a case of too little, too late. This has meant that the next rescue has had to be bigger, and each time a new rescue is announced, the market response is more jaded. And since the whole point is to create a circuit-breaker which drives down bond yields so that long-term reforms and budget-balancing initiatives can take effect, the situation has continued to deteriorate.
What does this mean for our markets? Europe and the US are a little over 20% each of the world economy. The BRIC countries (Brazil, Russia, India, China) are together about the same size as this. (Japan is just 6% of the world economy, now) And China is much more important to Australia in terms of exports than either the US or Europe. China has been squeezing its economy to slow inflation and stamp out a housing bubble. It’s been successful in both objectives, and has recently started to restimulate its economy. Of the BRIC countries, only India is unlikely to start growing fast again, because of political inertia and a reluctance to continue the very successful reform processes of the last decade.
The US has recently slowed a little. No one is quite sure whether this is “payback” for strong growth earlier this year when abnormally mild weather allowed construction activity to take place when pouring concrete is usually impossible because of the temperature. The “Fed” (Federal Reserve Bank) has inclined to this view but has also stated that it stands ready to pump more liquidity into the system if required. The US faces a “fiscal cliff” later this year, as previous tax cuts are reversed and spending is “sequestered”, and this is troubling. All the same, the probability is that when faced with the crisis, after the presidential and congressional elections, the politicians will cobble together a compromise.
Europe, however is in serious trouble. And though we keep on expecting rational responses from the European authorities to this crisis, it seems most probable, based on their behaviour so far, that they will fail. Europe faces a decade of zero growth, like the lost decades in Japan after the authorities there fumbled their response to the bursting of the Japanese property bubble.
In Australia, growth is strong (4.3% in March), unemployment low (around 5%), inflation under control …. a long list of excellent stats belies the negative sentiments of the public. The problem is that the south-eastern segment of the country where most of the population lives is barely growing, while less populated parts (WA and parts of Queensland) are where the boom is taking place. WA’s real growth in the year to March was over 14%, for example.
Despite the widespread gloom, it’s very hard to see that the Australian economy will collapse. Our fiscal positions, at Federal and state level, are sound, our banks are well capitalised, the RBA can cut interest rates much further if it needs to, the personal savings ratio is back at 9%, and our main export partner is restimulating its economy.
Our share market now yields 4.8% which equates to around 6.5% when franking credits are added back. The cash rate is just 3.5%. Ten year Commonwealth bonds yield just 3%. It’s very hard to argue that the share market as a whole is not very good value at current levels, though as usual, some sectors might be overvalued and others undervalued.
Hybrids (shares or corporate debt which have limited risk of capital loss and higher running yields) are also attractive in current conditions.
We are currently adjusting diversified and balanced portfolios to reflect these factors.
Short term, markets might still drop, if just because of sentiment. But longer term, the underlying likelihood of excellent income returns will support valuations into the future.
As ever, if you have any questions or would like to discuss your portfolios, please feel free to talk to us.
