13 December 2007
The sub-prime fall-out and forecasts of slower US growth has cast black shadows over the world's economies. And experts are divided over its impact on Australia, which is caught between the two economies of the US and China.
The Economist Intelligence Unit (EIU) claims that over the last 25 years the US has accounted for 27 per cent of the global GDP. And in the first half of this decade demand from US consumers was critical to world growth.
But as Professor of Finance at Melbourne University Russell Kim Sawyer points out, while the US is still an engine of the global economy if only through consumption, technology, ideas and expectations, China is the engine of production.
In 2007, China's economy grew by 11.5 per cent, while India and Russia continued to grow. According to the IMF these three countries alone have accounted for one-half of global growth over the past year. On the other hand, US growth was more modest in the September quarter at around 3.9 per cent.
But the IMF in their October World Economic Outlook has reduced global growth projections by 0.5 per cent to 4.75 per cent and states, "financial market strains could deepen and trigger a more pronounced global slowdown".
In addition, they cite potential inflationary pressures, volatile oil markets, and the impact of strong foreign exchange inflows on emerging markets.
US slowdown almost definite
With all experts predicting a slowdown in the US economy, the issue remains as to whether the US will slide into recession, and what the impact will be on the world's economies, including Australia.
The former head of the US Federal Reserve, Alan Greenspan, has put high odds on the probability, pointing out that there is a one in two chance the US will slip into recession.
As AMP Capital Investor's Dr. Shane Oliver points out, the impact of a US recession will depend on its severity. If we have a technical recession of one or two quarters of small negative growth followed by a rebound, it won't be a major issue, he says.
"Australia could live with a minor recession in the US, but obviously it would create some uncertainty in financial markets,"
Simon Doyle of Schroders argues that the extent of the impact of a US recession on Asia, especially China, will ultimately determine the effect on Australia.
How far will the sub-prime fall-out go?
Melvyn Krauss, a senior fellow at the Hoover Institution at Stanford University, argues the US created "garbage debt" in the form of sub-prime mortgages and Europeans hungry for extra yield, and as reckless as the Americans - bought it. He says no one is sure who is holding it or hiding the junk.
A critic of 'decoupling', he says it's nonsense that a US recession will have no effect on Europe and Asia.
The IMF points to the volatility of the financial markets, and how uncertainty about further losses saw liquidity dry up in certain financial market segments.
The IMF adds that the sub-prime fallout has further to go, which will produce tighter credit conditions and weaker confidence in the US, and the rate of expansion will moderate in Japan.
Impact on emerging markets
The EIU says the emerging market economies have been the beneficiaries of the substantial liquidity in the world markets, however this is set to change.
The issue is whether the emerging markets can weather both the slowdown in the US and the increasing volatility in the financial markets.
The EIU argues that Latin America will be the first affected by the US slowdown but China, although exposed to the US economy, will continue to boom.
The World Bank argued in November in its semi-annual report that East Asia's economies are likely to weather the storm from any slowdown in the US. However it also cautioned that China needed to rein in inflation and contain its trade surplus.
According to a recent report on FT.com, China's Commerce Ministry warned that a slowdown in the US would trigger a drop in Chinese exports that would be a "turning point" for China's rapid economic growth.
In fact, the Chinese Government does not support the view that Asian growth has decoupled from the US.
The US receives a fifth of all Chinese exports, making it the second-largest destination for goods after the EU.
The Ministry said it would find it difficult to rein in soaring property and stock market prices, and inflation was running at its highest level in a decade.
It also noted that continuing global market turmoil would encourage greater capital inflows to China, and place further strain on the country's regulatory and financial system.
Another China Syndrome?
Experts are divided as to the degree of impact of a US slowdown in China and the flow-on effect in Australia. However, there is consensus that a slowdown in China will affect commodity prices and the broader Australian economy.
Professor Russell Kim Sawyer points out that Chinese equity markets are not mature. And there is some evidence they may still absorb the US (sub-prime) contagion.
"Whereas in August the Shanghai market was resilient to the sub-prime crisis, this month the Shanghai and Hong Kong markets are more highly correlated with the US market. That constitutes some evidence of contagion, which clearly represents a threat to Australian investors."
Mark Rider of UBS Global Asset Management argues that if a slowdown in China occurs - a clear negative for resource companies - commodity prices would fall sharply. Which would have a significantly adverse impact on the Australian economy.
AMP Capital Investor's Dr. Shane Oliver believes we will see a slowdown in China to around 10 per cent growth from 11.5 percent - but not a collapse.
However, he said there is not a need for an aggressive rise in interest rates in China because the Government has other means to slow the economy down.
Simon Doyle of Schroders says a US recession would have a detrimental impact on Australia, particularly through Asia and China, which would see softer commodity prices.
What next for the Bull Market?
Dr. Shane Oliver believes the bull market will continue until about 2010, though the risk of embarking on a bear market next year has gone up due to the issues in the US.
On a more positive note, he says that if the US pulls through there will be a lot more liquidity around and lower interest rates. And history tells us that if favourable market conditions go on for another few years, current high returns could continue as the euphoria builds.
UBS's Mark Rider expects to see more normal returns from the share market over the next three years, but also more volatility. Shane Oliver agrees, stating that logic dictates that double-digit returns will give way to single digit returns.
According to Simon Doyle, "Investors holding diversified portfolios have enjoyed double digit returns on the back of the resources boom and Asian economic expansion, but investors should be looking to gain exposure to assets that are not correlated to this theme". He also believes Australian Government Bonds is one asset to consider.
Mark Rider thinks that global equities will be the stand out assets in 2008. He says US equities, along with a number of smaller continental European markets and the UK, provide the most valuable valuations.
But Professor Russell Kim Sawyer believes investors should follow relatively defensive strategies, such as infrastructure assets, considering Australia will be pursuing a stronger infrastructure path in the next few years.
Shane Oliver adds that we will see more of the same, with Asia and the emerging markets being the stand out performers given that these markets will be the key beneficiaries of lower interest rates. He says Australian shares will also benefit.
He also believes that private equity and infrastructure will do well with direct property continuing to deliver good returns. But listed property will deliver returns slightly below Australian shares, and with interest rates where they are, cash will outperform bonds.
Whatever the strategy investors adopt, it is clear that more defensive strategies are needed to absorb the continuing volatility and economic slowdowns.