A challenging year ahead ?

Share markets around the world have continued to be volatile in the past month. How many times has the Australian market opened up and finished down, and conversely? The volatility reflects the ongoing climate of uncertainty, and while some of this comes from the continued effects of the credit market issues, most of it relates to the US economy.

US recession - it's (almost) official

There is now general, if somewhat grudging, agreement that the US economy is probably already in recession. Much of the debate has shifted to just how bad the recession could be, with the general view being that it will be mild. If it does turn out to be mild, one could make the case that the 16.3% sell-off in the S&P 500 index between early October and 22 January may have been enough. That is to say, markets have probably already 'priced in' a mild recession. Indeed, a look at P/E ratios suggest that stocks may currently be cheap.

There are good reasons for thinking this episode will be mild. First, housing has been the main source of the slowdown in growth to date, but it is now so weak that it can’t possibly keep subtracting from growth at the pace it has done so far. Second, the Federal Reserve is on the job, having already cut the Federal funds rate (the equivalent of our cash rate) from 5.25% to 3%. Third, fiscal stimulus is on the way. Finally, the 'stock cycle' is very unlikely to play as large a role in this recession as it usually does.

Stock cycles are huge contributors to recessions. What happens is that, when demand drops away, it takes a while for producers to adjust their output and in the meantime unwanted stocks have run up on the shelves (or on the car dealers’ lots).  So production plans then get adjusted far enough in order to run this unwanted accumulation off. That is, production is cut to less than the level of demand. This switch from running stocks up to running them down is usually responsible for about 70% of the loss in output during a recession! Nowadays, of course, computerised controls and the increased importance of the service sector mean that the stock cycle is no longer as important as it used to be. And, at the moment, stock levels don’t appear to be excessive in the goods producing sector. So it is unlikely that the stock cycle will contribute as much as usual to this recession.

Mild, or worse?

Here’s the problem with the 'mild recession' view: once economists accept that recession has begun, they always forecast a mild one! And they are often wrong. Most analysts expecting a recession now foresee a peak-to-trough movement in GDP (the total output of the economy) of just 0.5%. The average post-war recession in the US economy has seen output fall by at least 1.5%. So it is clear in which direction the risk lies. If the recession turns out to be 'average', then equity markets have further to fall. Equities may be cheap right now, but they could get cheaper in the short term!

It’s important to point out that it’s not just the US that has experienced a slowdown in growth. There is speculation that the world’s second largest economy, Japan, is also on the verge of recession. Growth forecasts for Germany and the UK have been revised down significantly in recent months, and even forecasts for China have come down, which is a very rare event.

17-year inflation high

Meanwhile, the Reserve Bank has made it clear that it is on the warpath against inflation, so Australian investors (and borrowers) can look forward to still-higher rates. In the year to the December quarter 2007, CPI inflation came to 3%, but underlying inflation hit 3.6%, a 17-year high.

On three occasions in February, the RBA took pains to point out that inflation was likely to remain high unless rates are raised further. They judge the recent pace of growth (4.3%), and the unemployment rate of 4.1% to be simply unsustainable. The cash rate was raised to 7% in early February, and will almost certainly be raised again, to 7.25%, in March. That may not be the last increase; indeed there is speculation that the cash rate my hit 8%. Long before that, expect more cries of mortgage stress. And one has to think that the rate rises will eventually have an effect on potential house-buyers, which will take the wind out of the sails of house prices.

In part because monetary policy works with a lag, it's always difficult for a central bank to tell when it's done enough, and the risk always is that any attempt to slow growth eventually ends up succeeding all too well. So don't be surprised to see sharply lower growth by late this year.

All in all, 2008 is likely to be a challenging year for investors!

Chris Caton

Chief Economist

Dr Chris Caton writes a regular column providing topical financial commentaries, economic overviews, and assessment of investment issues. Investors can access Caton's previous columns by visiting Caton's Corner on the BT website.