Since October 2009 our market has trended sideways. There have been some corrections and some rallies but in the end we are more or less exactly at the same level on the All Ords index now as we were at the end of September 2009. They say that bull markets climb a wall of worry. Well, this bull market isn’t climbing anything!

But as we have said before, the overall indices are misleading because of the huge divergence between the exporting sectors and those companies which sell to them and the rest of the economy. So, materials are up 20.6% since 30th September 2009, the metals & minerals index is up 23.9%, the overall resources index 17.7%, RIO 35.4%, and BHP 16.8%. On the other hand, for the most part, the rest of the market is down. Industrials are down 4.8%, banks 7.4%, and property trusts 10.6%.

This degree of divergence is unusual. What’s happening?

First, the RBA is determined not to allow the resources boom to spread to the rest of the economy. Previous commodity price booms (remember Poseidon?) have led to high inflation and soaring house prices, and when the booms ended, difficult periods of adjustment and retrenchment. The RBA is determined that this time, the surge in the export sectors (both mining and farming) will be offset by weakness in the rest of the economy. So it has raised interest rates (we have the highest cash rate in the developed world) and kept policy very tight. This has resulted in slowing mortgage demand, falling house prices, sluggish retail sales, and (combined with the jump in commodity prices) a soaring Aussie dollar. So, resource profits and share prices continue to trend up in response to the global commodity boom, while practically every other sector struggles.

In fact, our overall stock market is increasingly correlated with the Chinese stock market. Up until just a few years ago, this wasn’t so. We followed Wall Street. What happened overnight on the American stock market was usually duplicated here. But that’s no longer true. It sometimes looks as if our market
leads America and Europe. Well, no. Not really. We follow China, and so do they. As the chart shows, over the last four years our share market has followed China’s quite closely. In fact China appears to lead our market, bottoming in November 2008 when we only reached our low point in March 2009.

The economies of the BRIC countries (Brazil, Russia, India, and China) turned up before the “old” developed world. China now leads the world, economically, even though it’s still only the second largest economy. The recovery in Germany and other capital-goods producing economies has been on the back of sales to China.

So the question then becomes: where’s China heading?

Many commentators have insisted that China can’t grow if the west doesn’t. We think they’re wrong. China is at that stage of economic development where growth can be very high for decades. Japan GDP grew at near 10% per annum (industrial production doing 20%) for nearly three decades. Wages in China are growing at 20 to 30% per annum, off a very low base. Workers are enjoying rapidly rising living standards, and while they still have high savings rates, they are also spending, with retail sales growing at 18-20% each year. Low paid workers aren’t buying classy foreign imports as their standard of living rises (though those sales are booming) but local manufactures, thus adding to domestic demand, in a strong virtuous cycle. Chinese consumers don’t have much debt; they buy their houses with 30% plus cash deposits; the government has sound finances; and China has the world’s largest gold and foreign exchange reserves, and could easily fund a trade deficit for many years if it had to. Moreover the Chinese government knows it has to shift demand to internal sources. It has permitted the Yuan to rise by 6% against the US dollar over the last year, which helps hold down internal inflation but also encourages imports.

Contrast this with the situation in the US and the peripheral European economies, where personal finances are weak, the public sector runs large budget deficits, and outstanding government debt is nearly as large as or even exceeds GDP. Yet despite this positive longer-term background, over the last one and a half years, the Chinese stock market has drifted sideways. Why? The Chinese government saw what happened during and after the housing bubble in the US. It is determined not to let that happen in China. That’s actually quite hard, because sharply rising standards of living and high savings would even without monetary stimulus generate rising house prices. And a steady rise in asset prices can easily morph into a bubble as market participants come to believe that it will last for ever. So over the last 18+ months, the Bank of China has been tightening monetary policy, not so much by raising interest rates (though it has done that) but by tightening lending controls and increasing bank liquid asset ratios. By increasing the percentage banks must hold in liquid assets (mostly short-dated government stock) it reduces the amount which can be lent out. This has also had an effect on the stock market.

If Chinese growth slows more than planned, it will be easy for the Chinese government to reverse these policies. When an emerging economy is straining at the bit, the problem is to reduce growth not stimulate it. It’s easy for growth to get out of hand, for asset bubbles to emerge, for credit growth to explode. In the past, unrestrained growth has damaged many emerging economies. On the other hand, the weakened heavily indebted western economies have the opposite problem: how to stimulate growth without increasing already high debt levels.

So recent moderate tightening in China to prevent a housing bubble has led to a soggy stock market. We have no doubt that this is just a pause in Chinese growth. Already there are some signs that policy is being loosened a little: credit controls in rural areas have been made less stringent. The rise in Chinese inflation is mostly due to food prices, but the government has also allowed the Yuan to rise, as we mentioned above. The modest slowdown in the economy will also help keep inflation from getting out of control. Mind you, it tells you something when industrial production growth of around 14% per annum can be described as “a slowdown”.

We believe that Chinese growth will continue, and that even if GDP growth slips from 10% per annum to 8%, because it’s coming off a rapidly expanding base, its effect on the world economy and on demand for commodities will remain substantial.

This is key. It means that despite short-term weakness in commodity prices the longer-term picture remains very strong. Which means that resource shares will continue to outperform, and industrials will continue to underperform. It would not be wise to hold 100% of a portfolio in resource shares, because diversification is vital to reduce risk. However an overweight position needs to be maintained even through short term corrections, which we believe this is.

A final word. It seems inevitable that Greece will default on its debt, and it’s possible that other fringe European countries might also have to restructure their government obligations. Part of the weakness in markets has been due to this. However, a year ago when this happened, the market response was much more negative (and also soon reversed, it is important to remember). This time round, the response has been more muted, suggesting both that the market has accepted the reality of a Greek default (even though it hasn’t yet been officially announced) and that growth elsewhere is much more soundly based than it was a year ago.

We follow not just the behaviour of the Australian shares we hold on your behalf but also global share market indices, currencies, commodities and bonds, as well as (obviously) global economic trends. This is because if Australia ever was an economic island, it is one no longer, and the key to what happens in our share market lies abroad.

As usual, we are happy to discuss your needs and your portfolios with you should you wish it.