Last year was a tumultuous one in many ways, with serious economic and political challenges keeping financial markets on edge for much of the year. It was only the actions of central banks to inject enormous liquidity that ultimately calmed market nerves and delivered strong investment returns in 2012.
High levels of private sector debt and policy-makers’ inability to stimulate growth, particularly in Europe, hampered global growth. Interest rates remained very low, and the US Federal Reserve, Bank of Japan and Bank of England implemented further quantitative easing measures.
Anaemic US recovery
Among major developed economies, only the US ended 2012 with any momentum, although its recovery remains one of the weakest on record. Although fiscal policy detracted from US growth, consumer spending continued to grow, supported by modest growth in employment and incomes. By the end of the year, there were signs of recovery in housing activity, manufacturing and services.
Late in 2012, attention turned to the impending fiscal cliff – the massive tightening of fiscal policy due in January 2013. After protracted negotiations, much of the tightening was avoided, but US budget developments are likely to cause continuing uncertainty in financial markets.
The eurozone still struggled
At the end of 2012, much of the eurozone remained in recession and economic conditions on the European periphery were still catastrophic. Austerity measures in the eurozone and the UK designed to rein in fiscal deficits and stabilise public debt have achieved neither aim: tighter fiscal policy has tended to worsen economic conditions and further undermine public finances.
However, as 2012 progressed, financial markets became more hopeful of a resolution to the eurozone crisis. Markets greeted positively the massive injection of liquidity into the European banking system by the European Central Bank and, later, its announcement that it would buy European government debt.
Growth continues in China
China’s economy has slowed over the past two years, from an annual growth rate of 11.9 per cent in the first quarter of 2010 to 7.7 per cent for the third quarter of 2012. Still, China’s reported growth remains spectacular.
Concerns about future growth in Australia
Australia’s economy slowed during 2012, but still posted a respectable 3.1-per-cent growth in output for the year to September. Although still historically high, Australia’s terms of trade fell by around 14 per cent from its recent peak as prices for our key resource exports declined. These declines, and the uncertain global environment, meant capital spending plans were wound back. The mining investment boom is expected to peak sooner, and lower, than previously thought.
The Australian dollar continued to trade at very high levels against major currencies. This has helped keep inflation low and spread the benefits of the mining boom to consumers, but has put considerable pressure on non-mining exporters and industries that compete with imports.
With concerns about Australia’s growth prospects and the difficult global environment, the Reserve Bank of Australia reduced official interest rates to 3 per cent.
What lies ahead?
The outlook for the world economy and financial markets remains highly uncertain. The range of paths the world economy could take is much wider range than normal. Overall, it’s likely that the world will continue to muddle through – that decisions on the most difficult economic issues will keep being deferred and central bankers will keep implementing extraordinary measures to maintain some semblance of economic and financial health.
However, the risk of another sharp downturn in global activity and further instability remains higher than usual. The potential concerns go beyond economic issues; geopolitical risks (such as developments in the Middle East, political transition in China and its relations with its near neighbours) could also cause market instability. Perhaps most worrying is how much the evolution of the world economy depends on policy makers’ ability to make sensible decisions, as it is far from clear that they will.
In the US, political negotiations about fiscal policy will continue to be a drag on US growth in 2013 and pose a significant risk to the outlook.
The eurozone crisis is far from resolved, and there is a significant risk that forecasts for a eurozone economic recovery in the next year or two won’t be met. Public debt levels in much of Europe are unsustainably high, and further defaults and debt restructurings are likely.
Australia’s economic performance during and since the GFC has been impressive. However, the picture is very mixed across the economy and there are still risks to the outlook. We’re heavily exposed to developments in China. A more severe adjustment in Chinese growth would have significant implications for Australian exports, investment, employment and the financial markets.
If such a shock occurs, it’s likely the Australian dollar will fall substantially and policy makers will respond to soften the economic impact. However, if our dollar doesn’t fall far or fast enough, or policy makers don’t act, there’s a risk our economy could stall.
The MLC response to uncertainty
In such an uncertain environment, diversification and risk management are even more critical than usual. At MLC, we’ve long argued that economic and financial forecasts are unreliable even at the best of times and that investment decisions based solely on these forecasts are also unreliable.
The essence of our leading-edge scenarios-based approach to asset allocation is that rather than attempting to forecast what will happen, we carefully consider what could happen. We explore the paths economies and markets could take, identify both risks and opportunities, and position our portfolios to manage the risks and capture the potential returns.
Brian Parker is a senior investment strategist at MLC Investment Management.
