This year started badly for financial markets, with an escalation of uncertainty related to the fallout from the sub-prime crisis, compounded by an increased probability of US recession.
Uncertainty is not good for financial markets. Both debt and equity markets switched operating mode from greed to fear, with their actions driven by a major shift in perceived risk.
Debt markets earn marginal interest income, so that their growth comes from building their loan books, yet they remain the equity of last resort. Last year the focus was on profits. Now, the heightened perception of risk has led to caution on lending, raising risk margins on debt and, in some cases, withdrawal of funding.
In equity markets, the flight from risk caused substantial falls in affected companies’ prices.
This is a financial phenomenon rather than a real-side phenomenon, and, almost certainly, an over-reaction. My suspicion is that risk has been mis-priced, and that’s not unusual, opening up opportunities for (brave) investment. The problem is that there will be real side consequences, though probably not as severe as financial markets think, and we should explore them carefully.
Threat of recession
How will it all pan out? Bad news on the US economy has highlighted the threat of US recession as the sub-prime crisis spreads from the housing market. Despite the prospect of further lowering of the federal funds rate and despite the government’s attempts to limit the impact on mortgages, rising risk margins have played havoc with commercial securities and will contain consumers’ ability and willingness to raise further debt funding.
For companies, lending caution and higher interest rates will cause problems with debt funding. They may delay some projects, they mean a review of gearing and, in an environment in which equity funding has become difficult and expensive, affected companies may have to sell assets into a weak asset market. The result will be a setback both to real and financial investment markets.
The key to the US economy will be the behaviour of consumers. The question is the impact on confidence and hence on consumption expenditure. Will demand soften and by how much? The housing boom has already collapsed – how low can it go? Will the US go into recession mid-year as some investment banks are suggesting? And even if it does, what impact on the rest of the world?
To my mind, we are certainly seeing a setback to the US economy, but it’s still too early to call a recession.
For Australia, now more dependent on Asia than the US, the question is the impact on the world economy in general and China in particular.
Meanwhile in Australia, the minerals boom is driving investment, employment, incomes, consumer expenditure and output growth. The economy is running above sustainable growth levels, and starting to experience demand-inflationary pressure. And the promised tax cuts this year will boost income and consumption, making it worse. For the last five years, a strongly rising Australian dollar has given us a free ride on inflation, offsetting much of the inflationary pressure and delaying the need for interest rate rises. But this year should see inflation running above 3 per cent, at the same time as employment growth leads to a further tightening of the labour market, in particular skilled labour, pressure on wages and further pressure on inflation.
The question is not whether we will see interest rate rises, but how many interest rate rises will be required to contain inflationary pressure through this period of strength.
Recession in the US and the setback to world growth would have a negative impact on Australia but would be more than offset by the current momentum and strength associated with the minerals investment boom.
The net outcome would still be strong growth. More serious for Australia would be an outcome which affected world demand for minerals and commodity prices, but that would take time to impact on growth. Strong growth this year is in the bag.
Certainly, rising risk margins on debt are having an impact, both in financial markets and on the real side of the economy. And commercial property markets have had a dose of this disease, initially in listed equity markets but now spreading to difficulty in funding projects, reassessment of gearing, and sales of assets into a buyers’ market.
The first half of this year should be interesting – expect some softening of yields and project delays. But this will turn out to be an overreaction on the ‘fear’ side of the equation.
In a strong demand market facing limited supply, the real side impacts will be transient. Rising rents will underpin recovery. Once the risk panic is over, risk margins will settle and confidence will return. Banks and investors will come back to what is an attractive ongoing business. Yields will firm and property values have yet to see their peak. Indeed, once we get through the current setback, the next two years will exhibit strong growth.
For the last few years, indeed up to only a few months ago, Australian property fund managers were complaining that there weren’t enough properties in Australia to place the quantum of funds available for property investment, so that they had to look overseas. Interestingly, the move overseas has been their undoing, particularly those highly geared and exposed to the weaker US and UK markets. But Australian property markets have remained strong, minimising the current damage.
The players have been complaining about the lack of good stock available in Australian markets. My suspicion is that the next few months will shake out opportunities not seen for some time. This is a time to get into the market, not out of it, both directly and indirectly.
Dr Frank Gelber is Director and Chief Economist of BIS Shrapnel.