Saturday, December 18, 2004

On balance, it looks as if we can afford a happy Christmas or two (Australia)

The Australian

December 18, 2004 MOST Australians should be feeling pretty relaxed this Christmas, not least equity investors, as the ASX 200 heads for 4000. Well don't be.

Stop spending immediately, even if it is Christmas. If you don't heed this warning and halt your reckless buying and borrowing we are heading for recession. At least some economists think we are. Fortunately for your peace of mind over Christmas, most don't.

Let's start with the world economy. The chart shows the forecasts by an international panel polled by Consensus Economics. You can see that 2004 looks like being the best year for three decades.

According to Reserve Bank deputy governor Glenn Stevens this week, even if 5 per cent growth proves optimistic, it is hard to see how the result will not be at least a full percentage point above the 30-year average.

And next year? According to the Consensus forecasts, growth will slow but still be well above average. This, too, may now prove a bit optimistic because of weaker recent figures in Japan, Euroland, Britain and emerging economies, and some slowing in China. But Stevens points out that even a marked downgrade would leave world growth at about average, a quite reasonable outcome.

He also offers an interesting analysis of oil prices and the behaviour of financial markets which is worth noting. High oil prices could pull growth back next year, but he points out financial markets appear pretty relaxed about this risk. Bond yields are low by the standards of earlier oil shocks, particularly against a background of rising official interest rates in the US.

This could be explained as bond markets assuming growth will be hit hard by higher oil prices, and hence inflation won't be a problem. But Stevens thinks it is more likely it reflects a view that neither growth nor inflation will be affected very much or for very long by oil prices.

His backstop for this view is that markets are demanding relatively little compensation for credit risk. If investors expected a significant weakening of growth in the industrial countries, they should also expect an adverse effect on emerging markets and on low-grade corporate issues.

That should mean higher risk on lending and widening risk spreads, as creditors prepare for the risk of default. Instead risk spreads are historically narrow. So both bond and credit risk markets look optimistic about global growth and inflation. They could be wrong, of course. Perhaps they are placing too much faith in the ability of central banks to keep inflation under control without too much pain.

As for Australia, next week Peter Costello will deliver the sort of Christmas present only a Treasurer could give - the "Mid-Year Economic and Fiscal Outlook". It is likely to show Treasury has cut its forecasts for growth. Costello has already said, after the election naturally, that he thought Treasury's pre-election forecasts were too optimistic. Mind you, the main reason he gave was higher oil prices, and if markets are right, he will be wrong.

Even so, the economy is slowing in its 14th year of growth, as strong domestic spending begins to run into capacity constraints, that is, demand is running ahead of domestic supply.

A lot of this spending has been on housing, financed by borrowing, and since investment in housing has run ahead of domestic savings, we have a large current account deficit. Sooner or later, we are told, this will bring us undone, as foreigners become unwilling to lend to us, at least at the exchange rate and/or going rate of interest. Would this really be such a bad thing? A combination of a lower exchange rate and higher interest rates sounds pretty good if the problem is too much domestic spending and not enough export earnings. Provided, of course, interest rates don't rise to levels that cause a recession.

The Reserve Bank is optimistic that it can manage that. Stevens said Australia had absorbed substantial exchange rate movements over the past decade without the economy being derailed. Growth around 3per cent in 2005 would be a respectable outcome. So enjoy Christmas, and even if the fall in housing prices makes you feel a bit less wealthy, so far the boom is not a bust. Happy New Year.


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