AFR article
David Uren | March 7, 2008
THE economy is headed for recession next year, with a 50 per cent plunge in share values and a double-digit drop in house prices.
Do I have your attention?
While the Reserve Bank takes a largely benign view of the unfolding credit crisis, believing China's growth will insulate us from its worst consequences, others are less sanguine.
Morgan Stanley's chief market strategist Gerard Minack introduced a brief to clients last week saying, "I'm bearish - really bearish."
He argues that Australia will be dragged into recession by a slowing world economy, the tightening grip of the credit crisis, and the effects of the Reserve Bank's succession of interest rate hikes.
Economists are often trapped by the inertia of the moment, failing to see the magnitude of both booms and busts and being forced into constant revisions of their forecasts. This makes Minack, who takes a long view, worth listening to.
He argues that the market is coming to the end of its fifth bull run since the beginning of the 20th century.
As the chart (which adjusts the all-ordinaries index for inflation) shows, the bear markets that followed, produced falls in the region of 50 per cent and lasted for two to three years.
The problem is not that the market is overvalued, relative to earnings, but rather that earnings are themselves inflated and headed for a fall.
Based on profit figures back to 1970, earnings are 44 per cent above their long-term trend.
In the three recessions since then, real earnings per share fell by between 36 and 65 per cent from peak to trough.
"You've got to argue that earnings do revert to their mean. On almost every measure we've got for earnings, be it profit share of GDP, return on assets or margins, it looks unsustainable," he says.
Earnings have been inflated by spendthrift households running down their savings. While the Reserve Bank has argued that fears about housing debt are without foundation because household balance sheets are strong, Minack says the picture looks a lot worse when you look instead at household cash flow.
The latest annual national accounts show the household sector remains cashflow negative, with the deficit of 3.75 per cent of GDP accounting for half the current- account deficit.
Besides, he says, household balance sheets also looked fantastic in Japan in 1990, before its lost a decade of economic growth.
Minack is not persuaded by the proposition that Australia's housing market is somehow immune from the excesses of the US.
Australians have more leverage, are as reliant upon equity extraction and base their household balance sheet on a housing stock that is far more expensive than their American equivalents.
The household sector vulnerable to any reversal in fortune. The moment unemployment starts to rise, people will start defaulting on their housing loans.
The view that Australia will be saved by China and the resources boom underestimates the magnitude of the forces ranged against us.
China's growth may continue to require large flows of commodities, but commodity markets at present are being driven by speculative money that can flee as quickly as it came.
Base metals prices could fall by 40 per cent and bulk commodities by 15 per cent without heralding the end of the Chinese driven "super-cycle".
Commodity markets are facing not only the prospect of a recession in the US, but also the possibility of recessions in Japan and Britain, with a slowdown in Europe.
The long-awaited rise in the volume of mining exports will not save us, with Minack calculating it will raise GDP by, at most, 0.1 or 0.2 percentage points. The terms of trade, by contrast, has lifted GDP by about 9 per cent, while the increase in business investment caused by the resources boom has added about 3.5 percentage points.
"People react as though there is some injustice. Here we are with the market down 20 per cent, when our economy looks strong and China keeps growing," he says. "People miss the point that we're hugely wrapped up in the global credit crunch because we are one of the world's largest issuers of capital, with the most over-priced finance sector in the developed world and a rickety housing sector.
"People think we're Teflon coated because of links to China. I don't think that's true."
Hmmm - food for thought. I thought he was being negative when I read this last month, especially as all of our major banks are saying that they have little exposure.
Then ANZ announced $1bn in provision for bad debt last night - by any standards, that is an enormous provision and a sign that things are not what they seem with our banks.
AND - it's only on their half year results!
Time to revisit the mattress?
I'm sitting tight waiting for the falling interest rates to start and then it will create an environment where my increased yields mean that upon completion my multi-unit construction will be strongly cashflow positive. If I build it today I'm neutral, but I want more certainty before I turn the dirt.
