The month of August was remarkably similar to July. Once again, markets did well, and once again the view intensified that the world economy was improving. Japan, Germany and France all reported positive GDP growth for the second quarter of 2009, and the US economy will report significant growth for Q3. The “never-ending” recessions have ended, and optimism about world economic growth in 2010 is growing.

This is a very positive environment for equity markets, which have thus continued to surge ahead. The S&P 500 index is up by close to 50% from its 9 March closing low, and the ASX200 index is up six months in a row, to make its gain to date an impressive 42%. It rose by 5.5% in August after a 7.3% gain in July. Two months ago, I suggested that this index could reach 4500 by the end of this financial year. It’s been perilously close to that level already, in just two months, and a target of 5000 now appears more reasonable.

Of course, there are still the naysayers, who observe the problems still evident in financial sectors, and note the deleveraging that the US consumer still has to go through. They conclude from this and other concerns that the global recovery will be at best slow, and at worst ephemeral. There is no question that there are still problems to be resolved--somewhat ironically, rapid growth would be the best way to resolve many of these. But a rising tide tends to lift all of the boats, and the recovery will feed upon itself. I continue to believe that the biggest economic “risk” out there is that world growth will be surprisingly strong for the next year or so. This is certainly the way that forecasts have been moving in recent weeks.

Of course, as I write, share markets both here and abroad are “backing and filling”. The US share market fell by about 2% on 1 September, and we followed suit. The irony of this is that September has traditionally been the worst month for the US share market; it is the only one that has recorded negative returns, on average, in the past 80 years. I don’t see this weakening as a “calendar” effect; it is more likely simply to reflect the belief that markets have come a long way in a short period of time. In my view, moments of weakness constitute buying opportunities.

Meanwhile, back in Oz

Last month I highlighted the fact that the Reserve Bank no longer had a “bias to ease”, and that it was signaling that the next move in interest rates would be up. Briefly, if we had known that the Australian economy would emerge with as little damage as it apparently has sustained, then we never would have cut the official cash rate to 3% in the first place; hence the need to undo the emergency setting of monetary policy. In the past month, the news from the rest of the world has continued to improve, and we now know that the Australian economy showed reasonable positive growth in the June quarter. I still call this a recession, mainly because of the 2% rise (to date) in the unemployment rate, but just as the 1990-1991 episode was the “recession we had to have”, this one has proved to be the “recession we hardly had”.

There is considerable market chatter that the first rate rise may come as early as October. I still think that’s early, but there’s usually fire to go with the smoke when the chatter is as loud as it is at the moment. And recall, as I have said before, that when rates do rise they usually go up further and for longer than generally expected.

Keeping something in reserve

One issue that has raised its ugly head several times in recent months is the status of the US dollar as a “reserve currency”. I have written about this at greater length elsewhere. The nub of the issue is that the GFC has damaged the US’s reputation as a purveyor of high-quality financial assets, with the result that other countries’ appetite for US dollardenominated assets is fading just as the US has a lot of debt to sell because of the parlous state of its Budget. The Chinese, in particular, have expressed concern about the size of its dollar holdings on several occasions.

If other countries were to flee the US dollar, then the value of the latter would fall precipitously, with manifold consequences both for the US and for the countries seeking to wean themselves from the dollar.

While the extent of the GFC should have taught all economists to be suitably humble about their forecasting ability, it’s difficult to see this issue roiling financial markets, if
only because, like Richard Gere in An Officer and a Gentleman, there’s no place else to go. What would replace the US dollar as a reserve currency? The euro? The renmimbi? At worst, the relative importance of the US dollar will decline over time.

Chris Caton
Chief Economist