Caton's Corner: Sitting, waiting, wishing - but for how long?

Waiting for improvement in financial markets is like waiting for Godot although I remain convinced that, unlike Godot, improvement will eventually arrive. As I write, the US share market has hit a 12-year low, and the ASX200 is very close to its cyclical low. For the month of February, the S&P500 index fell by 11%, bringing its year-to-date drop to 18.6%. In the past year, it has fallen by more than 45%.

It dawned on me how bad the situation is a few weeks ago when I turned on the TV in a hotel room one morning to catch up on the US market. I'd forgotten that the previous day was a public holiday in the US, so the market was closed. When I realised this, my initial reaction was "thank god for that". It really is the case now that no news is good news!

Economic news around the world continues to be grim. Having said that, one can see some signs of hope; China, for example, may no longer be slowing and the pace of decline of Western countries may no longer be accelerating. This may be a second derivative, but it’s a start.

The clouds gather over Australia

Meanwhile, in Australia, almost all of our major trading partners are growing significantly below trend. This has already led to lower prices and lower quantities exported – take iron ore, for example. Given the commodity price boom was a huge force driving economic growth in recent years, the slump in prices will subtract from growth for some time to come. We’re in the worst international economic environment in memory. This is what makes recession in Australia inevitable.

And we've certainly done our best to avoid it. My mind goes back to early-November 1990 when the then-Treasurer Paul Keating announced at a press conference that Australia was in a recession "that we had to have". On that day, the words "fiscal" and "package" had never been used in the same sentence and the cash rate, believe it or not, was still 13%.

This time around, we have not (yet) declared recession, but there have already been two substantial fiscal packages and massive reductions in the cash rate. These reductions should eventually reduce the share of disposable income that goes to pay interest by as much as seven percentage points. That’s a lot of extra income, and some of it will be spent.

The Caton view on recessions and stimulus packages

Incidentally, Keating's words were responding to an announcement by the Australian Bureau of Statistics that Australia had just recorded its second successive quarter of negative GDP growth. This is a popular definition of recession but, in my opinion, a very bad one. First, it doesn't work between countries. If China, for example, grew by less than 5%, one would have to call that a recession. Second, GDP data gets revised, sometimes substantially, so previous recessions can be revised away and then years later re-emerge – from memory, that happened with the 1990-1991 episode.

For me, one should measure recessions in terms of job loss. If one did, then the Government has already admitted we're in recession – it just hasn't admitted that it's admitted it. Why do I say this? When the fiscal package was brought down in early February, the accompanying economic forecast suggested that GDP growth would be very small, but nevertheless positive, for the next two years. But it also projected the unemployment rate to be 7% by mid-2010. It’s currently 4.8%, and it was 3.9% in early 2008. How can we not call that a recession?

Incidentally, the second fiscal package satisfies the IMF 'criteria' for emergency fiscal measures – the measures in the package are timely, targeted and temporary. The argument that it will create Federal debt is specious – at worst, we may finish with government debt equal to 10% of one year's GDP, a very small number by international standards. There are, of course, those who will argue that the $900 payments to taxpayers may be used to reduce personal debt rather than to increase spending. That's true, but so what? Given what debt costs on credit cards, it's quite sensible to use the payment to reduce debt. And those who do that are in a better position to spend later.

Where do financial markets stand?

There is a lot of pessimism still out there and there is unquestionably more bad economic news to come, but I cling to my beliefs that markets have a lot of bad news priced in already, and eventually they will start to price in economic recovery, as they always do.

The Australian market is down more than 50% from its peak in late-2007. On average, in 'bear' markets it falls by a third. At the peak, it didn’t appear to be particularly overvalued, so such a big fall seems to imply that a lot of bad news is 'n the price'. This view is substantiated by price/earnings ratios.

Not a bad rate of return from here

But let's not compare this with average bear markets – let’s compare it with the really big ones which include 1987, 1929, and the OPEC episode in 1973. By doing so, what we find is after big bear markets, it has never taken more than six and a half years to regain the peak. That's a pretty poor return starting from the peak, but starting from where we are now, it is not unreasonable to expect the market at least to double in the next five years. That's certainly not a bad rate of return.

Of course, there is the usual caveat that past performance may not be a good guide to the future. But while we are hearing that “this time is different”, let me just point out the same thing was said in at least three of the four previous 'big bears'.

One cannot rule out a further low in share markets. But eventually, and in the not too distant future, there should, in my opinion, be a sustainable recovery.

Chris Caton Chief Economist

BT Financial Group

News home

Disclaimer and Disclosure This publication has been prepared and issued by BT Financial Group Limited ACN 002916458. While the information contained in this document has been prepared with all reasonable care no responsibility or liability is accepted for any errors or omissions or misstatement however caused. All forecasts and estimates are based on certain assumptions which may change. If those assumptions change, our forecasts and estimates may also change.