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Market Commentary - May 2012

by Brendan Gallagher

The benchmark S&P/ASX 200 hit a nine month high early in May, closing at 4,429.5 points after the Reserve Bank of Australia cut interest rates by a larger than expected 50 basis points. Since then, renewed fear of a disorderly Greek default and exit from the Euro has been a major driver of a flight to safety and subsequent falls in global share markets.

Such is the media saturation, these events are difficult to ignore.

In Greece, parliamentary elections were held but the result was inconclusive and new elections will now be held on June 17. The fear that Greece may exit the Euro has been exaggerated of late, as unconfirmed support for the leftist Syriza party swells – they are an anti-austerity party. After issuing a protest vote in the first attempt elections, the Greek people may wish to consider the long term consequences of a Greek exit and the option to undertake structural change and stay in the Euro. If Greece was to leave the euro zone it (Greece) would be at risk of experiencing a painful deep recession and perhaps civil unrest. The rest of the world would however, survive a Greek exit!

Greece is not necessarily the problem. The real risk to the Eurozone would come via contagion to other member countries. If Greece exits, fears would undoubtedly grow that others will follow. This would in turn pose a threat to bond yields for those countries under threat. This might well place upward pressure to bond yields, which would then push up borrowing costs, which in turn could see deposit holders make a run on the banks to secure their cash. In France, President elect, Francois Hollande took on the hot seat, which was a welcome sign to the fragile French economy at the time, with their share market rising on the day. Hollande, a socialist, came into power on a platform of growth as opposed to austerity – he will now enter into what can only be described as ‘interesting’ discussions with his counterpart in Germany, who favours austerity reforms that might deliver growth down the road. Herein lies the problem with monetary union.

Unfortunately, there is not a lot of great news coming out of Spain either, as she suffers downgrades on the back of her deteriorating public finances and concerns that the country will face sizable payments to support their banking sector.

The fear from souring confidence in the euro zone, is the onset of a deep recession, which would impact the rest of the world via trade, the world’s financial system and global confidence. The Eurozone takes approximately 25% of US exports and 20% of Chinese exports (indirect impact back to the Australian economy right there). If the Eurozone saw a contraction of say 5%, then this could wipe off 0.6% from US growth, up to 2% of OECD growth, 0.5% of Chinese growth and potentially 1.25% from Global growth.1

A further key recent event was the release of Chinese economic data. The figures showed an economy continuing to slow, but also one where inflation was under control. In response, the central bank cut the bank reserve requirement – the reserves that banks need to hold at the central bank. This easing of monetary policy is a positive development for China and in these uncertain times, a solid sign for the rest of world economy.

Favourably, the US recovery remains on track with retail sales growing solidly, consumer sentiment at 2007 levels, bank lending on the rise and housing activity indicators well off their lows. The US is not without risk, as they move towards their Presidential election in November this year. The US Federal reserve has released a slightly more upbeat assessment of economic growth, but given high unemployment and low inflation, extreme policy settings remain in place. We cannot discount a third quantitative easing or QE3!

On the home front, the recent high for the Australian dollar was observed on April 30 when the currency stood at US104.53c. Since that time, the dollar has fallen around 6%. The Australian dollar is perceived as a “fair weather friend”, in that it tends to do well when there is optimism across the global economy. This perception is tied to Australia’s commodity reliance. In the current environment, the dollar is weakening in line with other “commodity currencies” while safe-haven currencies (those generally less dependent on global economic conditions) such as the Japanese yen and Swiss franc are favoured. With the Eurozone under fire, the Franc has lost appeal simply due to its proximity to the region – such is the contagion. The US dollar is also favoured in volatile times, but more on the fact that it is the most liquid currency in the world.

While many online consumers and travellers may well bemoan the fall in the Australian dollar, this drop is a major positive for our business community. Not only will business benefit, but so will home loan borrowers with a drop in fixed-term lending rates to new lows. The good news is that we can contemplate a rate cut because inflation is under control and there is no material growth in the near future. In addition, softness in the non-mining sectors, caution about the carbon tax, (again) the “troubles” in Europe and slower Chinese economic activity, these are all factors adding to the easing bias of the Reserve Bank – they also have to play ‘catch up’ to the yield curve and cut rates further.

A further drop to cash rates will be a positive signal for Australian equities, particularly those with high fully franked dividend streams, as retail investors will look to switch out of unfranked cash holdings in search of higher returns.

The Australian job market remains relatively healthy, wages are rising (and inflation is low) – purchasing power therefore remains even. Housing demand is visible as evidenced by tight rental markets but developers haven’t got the confidence or incentives to advance new projects at this time.

Australian banks continue to punch above their weight, with all four listed in the top 25 global financial firms – a comforting statistic when you consider the problems European banks are suffering presently.

While the fears are understandable, investors would be better served keeping their eyes on the big picture. China, India and emerging nations more generally are the major drivers of the global economy. While the Chinese economy has definitely slowed, authorities have shown by the recent cut in bank reserve requirements that they are well positioned to start stimulating growth again. From Australia’s perspective, the latest Euro crisis has actually thrown up a number of positives as discussed above.

While the word is maybe overused, investors need to ensure that their portfolios remain well diversified until it becomes clear that the Euro crisis has truly passed. Diversification will ensure that strength in defensive stocks is balanced against softness in growth-focussed areas such as resources.

As we have experienced in the past, whenever there is a mass rush to the exits, to raise cash at any cost, NO stocks or sectors are spared. This happened in 2008 and 2011, and looks like happening again. However as we also experienced with these past episodes, it pays not to panic, as eventually the fundamentals take over and shares rise again to reflect their true value.

 

May 2, 2012
 

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