The Big Issues for 2010

First a recap

There’s no question that 2009 was the year of the GFC – global financial crisis. But interestingly, just as some were ready to declare that a new Depression was upon us, the global economy bounced back. We can thank the aggressive stimulus applied by Governments and Central Banks. We can also give thanks to China – the global rebound wouldn’t have occurred without China’s 4 trillion yuan stimulus package.

China has come from being an interesting sidelight to the subject of dinner party conversation. And this is just the start. The real question is when China will pass the US as the biggest economy in the world. It will happen in the next decade, but if China continues to expand at a near 10 per cent annual pace, it could happen much sooner.

Economic debate always tends to extremes – and 2009 was a case in point. Depression didn’t happen and neither did deflation. The point that seems to be lost on many analysts is the role that globalisation now plays. When the US turned down, across the rest of the globe – almost simultaneously and collectively – confidence levels dried up. People stopped spending, businesses stopped investing – the fear response.

But once US financial conditions stabilised, confidence in the rest of the world rebounded – especially in Asia, which was fundamentally in good health before the crisis. And that’s the rub. The US financial crisis became a global financial crisis because of globalisation and the fear response. Once the problem was isolated, then the rest of the world got on with business.

Moving into 2010 the chief risks relate to the US: high unemployment; its ability to grow without props provided by the Government and central bank; the commercial & residential property markets; the world’s preparedness to buy US debt; the path of the US dollar. And that’s just the top-level factors. For Europe and Japan it’s the absence of growth drivers that is the main concern. But for Asia and even Latin America, the outlook is more positive as emerging nations seek to bridge the gap with advanced nations. And that gap is indeed closing.
 
The Big Issues for 2010

The Shape of Economic Recovery

A few months ago the general assumption was that the global economy would recover in 2010, but it would be ‘U-shaped’. That is, the upturn would be slow, gradual or measured – there are various ways to express it, but a quick return to health wasn’t on the agenda.

But analysts are quickly revising that view. Some parts of the world – especially Asia – are experiencing ‘V-shaped’ recoveries. Of course that just leads the more gloomy economists to pronounce that the recoveries aren’t ‘V-shaped’, rather the start of ‘W-shaped’ recoveries. That is, the upturn will be short-lived; disappointment will follow in the form of another downturn.

There is no doubt that the US economy is at risk of a ‘W-shaped’ recovery. Europe and Japan are also at risk, especially as population growth is flat or negative in many countries and Chinese and Indian industrialisation doesn’t confer the same benefits as for other parts of the world, such as Asia and Latin America.

In Australia, the shape of recovery is expected to be ‘U-shaped’ to begin with, turning more into a ‘J-shaped’ expansion as the full benefits of Chinese and Indian industrialisation become realised.

One issue that goes hand in hand with the Shape of Economic Recovery is the Timing and speed of the withdrawal of economic stimulus. If central banks act too quickly in lifting rates, ‘V-shaped’ recoveries can quickly turn into ‘W-shaped’ economic growth paths.

So What?  US sharemarkets have more consolidation work ahead. Over 2010 sharemarkets are likely to experience periodic surges followed by periods of consolidation – more like two steps forward, two steps sideways.

China

China has featured on the ‘What’s In’ lists for the past few years, and it no doubt will feature again next year in the 2011 list. The world has never before witnessed an economy with 1.3 billion people going down the path of industrialisation. And many find it hard to visualise until they go to China, experience the pace of change. And even then, they are only scratching the surface.

China’s demand for resources will no doubt amaze some commentators over the next few years, but the demand is entirely understandable when you consider the size of its population. The greatest limiting factor on China’s growth will be its access to resources. And there is the very real prospect that commodity supply will again fall well short of demand, driving prices higher.

Based on IMF projections, China will pass the US to be the biggest global economy in the next 8-10 years.

So What? There is the risk of a new commodity boom; resources companies, mining services and engineering face strong prospects; and the Aussie dollar could head towards parity with the greenback.

India

When it comes to industrialisation and broader economic development, India is probably a decade behind China. India is effectively paying the price for restricting foreign investment in the 1990s and failing to invest in infrastructure.

But each year, India’s population grows by around 16 million people. And not only is India’s population growing but its people are getting richer, buying more of the consumer durables that we take for granted in Western nations.

So What? The solid pace of economic expansion in India further supports the view that mining, energy and resources-dependent companies – especially coal – will experience above trend growth in the short to medium term.

Commodity boom

If we’re right with our view that China and India will continue to expand solidly in 2010, then this will translate into a pick-up in demand for commodities. Importantly it’s not just the expansion in China and India but also solid growth rates for economies across Asia and the commensurate expansion of the middle class and demand for consumer durables.

The key question is whether commodity supply can keep pace with demand. In 2006 and 2007 the scale of Asian expansion caught central banks and mining companies alike by surprise. The same could happen again – especially given that the GFC caused mining and energy companies to mothball facilities or curtail expansion plans.

So What? A sharp lift in commodity prices, or even a new boom, would lead to higher investment in the resources sector and greater demand for engineering services; the other risks include a revival of inflation and further appreciation of the Australian dollar. The real risk for Australian companies is that the Aussie dollar holds above US80c or US85c rather than returns to the long-term average of US72c.

Chinese yuan appreciation

The GFC served to silence calls for revaluation of the Chinese yuan (or renminbi). However Chinese authorities would only contemplate revaluation or further moves to free up the link to the greenback if they believed that it wouldn’t lead to a major shake-out in the export sector and disrupt overall economic expansion.

The US is certainly in no position to force the revaluation issue, well aware that it needs China to continue its regular purchases of US treasuries.

And China will want to be confident that the global economy is on a much firmer footing before even contemplating changes to its currency.

So What?  A stronger Chinese yuan would lift the purchasing power for Chinese commodity buyers, in turn, boosting the Aussie dollar.

Climate change

Countries across the globe will determine their responses to climate change in 2010. Given that there is no common agreement on the extent or severity of climate change – and never will be – there is unlikely to be uniformity on the approach taken to the issue. The climate has been changing for centuries, but there are few signs that the process is accelerating.

Some countries favour a tax on carbon emissions, others favour a market-based approach where carbon credits can be bought and sold.

The fundamental principle is that carbon emissions – like pollution – create negative externalities. That is, carbon emissions lead to problems or costs for consumers or businesses. If a price were put on emissions then it is assumed that affected businesses would seek ways to reduce the costs or perhaps pass on the costs to consumers.

So What? Eventually the Australian parliament will decide on measures to address climate change. And understandably there will be winners and losers. Some investors jumped too quickly, reacting to the Government’s proposed legislation on a carbon pollution reduction scheme. Other investors need to be careful not to fall into the same trap with any revised proposals. Any emission pricing scheme will be phased in over time – there can be costly mistakes for investors in trying to get ahead of the market.

Housing cost & supply

Just how tight is the housing market? Over the last year Australia’s population rose by 440,000 people – the biggest increase on record and the largest percentage increase in 40 years. The number of migrants increased by more than 285,000 people. But dwelling commencements only rose by just over 131,000. On this basis you would have expected more people to be on the streets and for the rental vacancy rate to approach zero. But it didn’t happen. In fact some Sydney landlords complained that they had to reduce rents or offer rent incentives.

CommSec found that Australia is building the biggest homes in the world, but at the same time there is new evidence that household size is increasing for the first time in at least a century, or perhaps since European settlement.

The debate about housing costs and supply will go on in 2010. There is no doubt that rising housing costs are causing children to stay longer with parents and for more young people to share accommodation. State and territory governments have to pay more attention to produce more land, reduce costs for developers and revisit zoning laws.

So What? CommSec expects home prices to rise by 8-10 per cent over 2010. Population continues to grow and not enough homes are being built. For investors, rising rents and home prices is an attractive combination.

Taxation

The review into Australia’s tax system – the Future Tax System Review – will report to the Government by the end of the year. Headed by Treasury Secretary Ken Henry, the review panel has taken over 1,000 submissions, but interestingly, there have been little in the way of leaks. The review will probably recommend a reduction in business tax and will likely recommend measures to create a more level playing field on the taxation of savings.

Could the review panel recommend a hike in the GST rate to fund other measures such as removal of state payroll tax? Certainly it’s a possibility. And while a lift in the GST rate makes a great deal of sense, the question is how the Government would respond with an election drawing near. Clearly both sides of politics will need to agree about the sensibility of a proposal to increase the GST rate for it to get through the political process.

It is uncertain when the Government will respond to the recommendations. The terms of reference states: “The Government will respond in a timely way to the tax review's recommendations as they are released.”

So What? The tax recommendations will have far reaching implications for the economy. If a more favourable tax treatment were given to bank deposits then investors would require both higher returns and greater certainty of returns from alternative investments such as property and shares. Still, it is also entirely possible that the review could come up with proposals affecting dividend payments by companies. Unlike climate change the Government would need to make changes on taxation with immediate effect.

Superannuation

The Super System Review has three parts: Governance; Operation & efficiency; and Structure. Headed by Jeremy Cooper, the review is due to release preliminary recommendations on Governance shortly. Recommendations on Operation & efficiency aren’t due until March-April 2010. An Issues Paper dealing with the Structure of the Superannuation system is due on December 14. A final report is due by June 30 2010.

What could the review come up with? Almost anything. But expect vigorous debate by industry bodies, fund managers and the Government. Clearly though Superannuation is an issue for 2010.

So What? Just like the Climate Change issue it’s a case of watching the debate but not over-acting. Recommendations will need to be vigorously debated before the Government announces decisions, and lengthy phase-in periods are likely for any changes.

Federal Election

A Federal Election must be held by April 16 2011. And the earliest date for a simultaneous half-Senate and House of Representatives election is August 7 2010. But there is the risk of an early poll given that the trigger for a double dissolution of both chambers exists – the carbon pollution reduction scheme bill being twice rejected by the Senate.

On current opinion polls the Federal Government would easily be returned to power. The key issues to be debated by the major parties will be climate change, industrial relations and the size of the government economic stimulus measures. Taxation and superannuation may also emerge as key issues for debate.

There are also state elections scheduled in South Australia, Tasmania and Victoria in 2010.

So What? Financial markets hate uncertainty so expect sharemarkets to trend sideways and perhaps under-perform other global markets once a poll is called.

What’s out for 2010

Recessions have already ended in a number of major economies and we expect more countries to emerge from intensive care and move into the recovery ward in 2010. As we noted above, the path of recovery will be uneven – with emerging nations in Asia and Latin America offering best prospects.

While the US is expected to experience a ‘U-shaped’ recovery, there is always the potential for surprises, as shown in the latest employment result. Once jobs start growing again, this will translate into increased confidence and consumer spending, creating momentum for the economy.

Certainly we are likely to see fewer references to the GFC or global financial crisis. The GFC came as a major shock to companies and consumers across the globe, but now with the healing process underway, people are gradually getting back to business.

With the GFC receding into the background, investors will have less need to be pre-occupied with all things US. The US really did dominate attention in 2009, its financial crisis spreading across the globe, causing sharemarkets to move in lock step with the US Dow Jones and S&P 500 indexes. Now investors can pay more attention to what’s happening in their own backyards. As a result the tight correlations that existed between major share indexes and US share gauges should ease markedly.

While the correlation ratio between the All Ordinaries and US Dow Jones was regularly near 0.95 in 2009 (where a perfect relationship would equal 1.0) it’s important to remember that back in 2005 that ratio was around 0.50.

With recessions ending and recoveries taking hold, clearly there will be fewer references to rate cuts or super-low interest rates. But here is where it becomes interesting – central banks must gradually lift interest rates and sell assets without derailing fledgling recoveries. Clearly the process is not without significant risks.

One change that has already happened as a result of the GFC is that consumers and businesses are re-assessing their views on debt. It’s not that debt will be shunned in 2010, rather people have long memories – companies will tend to favour equity over debt. Consumers will use their own funds rather than credit cards for regular purchases. It takes a shock for the GFC to change behaviours, and it will take some time before debt is regarded more positively.

Arguably more settled financial markets might lead to less volatility. But clearly this can’t be predicted with any great certainty. All it needs is something new from left field such a new geopolitical crisis and volatility will return with a vengeance. Still, there has already been a sharp drop in the number of days that the All Ordinaries rises or falls by more than 1 per cent.

One of the interesting developments that has followed from the GFC is even greater labour market flexibility. Companies have become more accustomed to using a mix of full-time and part-time staff. And they have also become more amenable to changes in work-hours and workweeks.

There are numerous anecdotes suggesting that those employees that have been forced to work fewer hours or different work hours like the change. While all this doesn’t spell the death of the 9-5 work-day or perhaps 8-5 work-day, employers recognise that different practices can prove more successful, reduce worker turnover and improve flexibility and productivity. The ageing population will require employers to adopt different practices with more senior workers requiring part-time rather than full-time positions.

Source Craig James, Chief Economist, CommSec

Source: Source Craig James, Chief Economist, CommSec

Comments by Richard Johnston