Worried about the ‘worry list’? It’s better than you thought
Shares have just topped two consecutive years of big losses. Such a slide has resulted in a long “worry list” for shares and other growth-oriented assets – indebted consumers, inflation off the back of ballooning budget deficits and central banks pumping money, worrying demographic trends, and so on.
Some investors are pessimistic: the temptation being to assume just more of the same. However, as we’ll see, the “worry list” might not be so worrying after all.
Don’t get carried away on the “worst ever” syndrome
Everything was pushed to extremes in the past year – we had the worst financial crisis since the 1930s, one of the worst bear markets ever, the worst global recession since the 1930s, the biggest fiscal and monetary easing since WWII. Then add some less-favourable demographic trends, and it is possible to paint an endless list of problems.
While it would be silly to ignore the risks, there is also a danger in getting carried away.
Let’s go through the investor’s worry list.
1. Household reluctance to take on more debt, and by banks to lend, will prevent economic recovery.
This is the most common worry, but note several points against it. Firstly, consumers are responding to fiscal stimulus and lower interest rates. This is certainly evident in Australia, where retail sales are up 7% year on year, car sales have seemingly turned the corner and various housing indicators have improved dramatically; these trends suggest consumers have not lost the inclination to consume.
In the US, retail sales have not collapsed – despite the unemployment rise – car sales are recovering and consumer sentiment is improving. While a more cautious attitude to debt will likely constrain the consumer-spending recovery, there is nothing to suggest consumers are solely focused on debt reduction.
Secondly, some indicators (such as car sales and housing starts) have fallen below the underlying demand level, so sooner or later they must spring back. In fact, the number of US new houses for sale has collapsed, which combined with record low housing starts, may lead to a housing shortage if construction doesn’t pick up soon.
Thirdly, the early 1990s’ experience indicates “debt deleveraging” won’t necessarily stop a recovery. For instance, the fall in private debt in the US didn’t prevent an economic and share market recovery.
In fact, private sector credit normally lags an economic recovery. This was evident in Australia then too.
(”Debt deleveraging” simply means “debt reduction”; it occurs several ways: borrowers using savings to gradually pay down debt; borrowers selling assets to pay down debt; or borrowers defaulting on a loan.)
2. The budget-deficit blow out is a major concern.
Right now the increase in budget deficits globally is appropriate, because without it we would be having a worse recession. Also, this is unlikely to be boosting interest rates yet, as less private sector borrowing is offsetting higher public borrowing.
That said, in several years time, once recovery has occurred, governments will have to unwind their borrowing and this could cause increased economic volatility.
3. “Easy money” means the US will be the next Zimbabwe.
In a nutshell, comparisons with Zimbabwe are ridiculous; that country has 250 million per cent inflation because it wiped out its productive potential, so the government turned to printing money to finance spending and pay public servants. Simply put: no goods plus lots of money meant prices surged. That is not the case in America.
Right now, the main concern in the US (and elsewhere) is actually deflation as the global recession is resulting in idle factories and rising unemployment queues putting downwards pressure on prices. In fact, consumer prices are already falling in the US, Japan and Europe where inflation is below zero and in Australia inflation is just 2.1%. While narrow money-supply measures have surged, this is because central bank easing has boosted bank reserves. Only when this feeds through to a broader increase in credit and economic activity returns to more normal levels, will inflation be a serious risk.
4. Double-dip recession.
Worries about a double dip are common near the end of most recessions. The main fear is that once the policy stimulus wears off, growth will collapse again.
One view is that it is too early to talk about a “double dip”, because we haven’t emerged from this recession yet.
However, given the impact of fiscal stimulus still to occur (particularly via infrastructure spending), and the likelihood that we will start to see a housing recovery in both the US and Australia next year, a double dip then appears unlikely.
5. The US dollar will crash, creating renewed financial panic.
This one gets an airing every time a government talks about diversifying reserves away from US dollars. However, while a further improvement in global confidence may result in more downwards pressure on USD, a collapse is unlikely, because the two most traded alternatives (the Yen and Euro) are no more attractive – and the Chinese won’t allow a sharp rise in the Renminbi (”Renminbi” loosely translates as “the people’s notes”, and is the official name of China’s currency; the more commonly used “yuan” is actually the principal unit).
6. Demographics is destiny.
Using demographics to predict the share market is back in the headlines following Harry Dent’s latest book “The Great Depression Ahead” in which he predicts America will enter a Great Depression in 2010, and shares will not bottom until 2012. Dent has based this largely on the back of demographic trends, that is, looking at the number of people in the “peak spending age” of 45 to 49.
Most analysts agree that Dent made a great call in the early 1990s. But there are dangers in relying on this approach too much, certainly to make big calls. First, the relationship between demographic variables and share markets is very rough and encompasses only a few big 30-40 year swings. It has given a bad decade-by-decade guide. Secondly, the combination of having children later, living longer and delaying retirement, all mean the relationship between demographics and economic and financial variables will change over time. Thirdly, demographics indicated that US shares should have boomed over the last decade. Dent’s book from a couple of years ago, “The Next Great Bubble Boom”, predicted the Dow Jones would reach 40,000 by 2010; but so far it has been a terrible decade (the Dow is now at 8,500, or at 1998 levels).
6. Shares are expensive after their rally.
No. Shares have gone from being very cheap at their March lows, but they are still not expensive – despite those strong gains. Forward price-to-earnings multiples (the ratio of share prices to year-ahead consensus earnings expectations) have increased from around 8 or 9 times at the March lows to around 14 times for both global and Australian shares. This is still below longer-term averages around 15 times.
Conclusion
Mainstream global equity markets will likely face a more volatile and constrained ride over the longer term, and shares may also have a rougher ride through the traditionally weak September quarter than was the case in the last quarter.
However, as per the above discussion, many of the current worries are overblown and certainly not enough to prevent solid gains in the year ahead. Shares are still cheap, and are attractive relative to low-yielding cash and bonds, plus, an economic recovery from later this year is likely to underpin an eventual profit improvement. Most investors are still underweight with shares, so there is a lot of cash sitting on the sidelines.
Source: “Oliver’s Insights: Just how worrying is the ‘worry list’ for investors?” by Dr Shane Oliver, Head of Investment Strategy and Chief Economist, AMP Capital Investors; “A Stubborn Mule’s Perspective: Deleveraging and Australian Property Prices”, July 22, 2009; and Wikipedia, “Renminbi Etymology”.
Tags: economic outlook