March was another positive month for investors. The ASX200 rose by 5.1% and the S&P500 index by 4.9%. The Australian share market thus was effectively flat in the first quarter (up by 0.2%); not a bad result after a fall of more than 6% in January. The US market was up by 5.9% in the quarter and by more than 10% from its local low in early-February. The problems that bedevilled the market in January have not gone away, but they have not worsened either. China is still showing no signs of slowdown, and the Greek problem remains large for Greece, but a plan has been worked out with the latter’s Euro union partners to mitigate the effects. None of this should come as a surprise.

Nor should it be a surprise that a new set of issues has arisen. We may now have to think about the market effects of Obama’s health plan, pressure on China to raise the value of it’s currency and even the RBA governor’s jawboning (or was it TV-boning?) of the property market. In brief, none of these is likely to derail the world economic recovery, so none should stop the market rally.

Incidentally, I spent much of March touring the provinces giving a series of presentations with other funds managers. One of them referred persistently to the share market’s fluctuations as being caused by the “swings and arrows of outrageous fortune”. I guess that means that what you lose on the slings you gain on the roundabouts!

What about the latest set of issues catalogued above? The Obama health plan means that 95% of the (legal) US population will have health coverage, up from 83% now. But clearly this will cost money, so won’t it add to the US’s deficit and debt problems? And drive up the cost of hiring for business? The plan’s answer to the first question is “no”, since the costs will be met by an array of increased business taxes. But that only makes the second issue potentially worse. Any economic (and hence market) effects are unlikely to be felt before 2014, however.

There is another issue here. Twenty years ago, about 30% of all health costs in the US were government-funded. That share is now 45% and the Obama plan will take it to over 50%. This can only mean less market discipline in the sector.

As we are well aware in Australia, health is a tricky issue to get right. Everywhere else in our lives, technology tends to drive costs down; in the health sector it drives them up. Since there is an assumption that rich and poor alike are entitled to the best health care, it is a sector where costs tend to spiral. The recent Intergenerational Report again highlighted the critical role played by health costs in increasing total government spending faster than GDP. While society has a right to decide to pay more taxes to cover the costs of health care (all those in favour??), consider this. Per capita health costs are about twice as high in the United States as in Australia. Are Americans healthier than Australians?

The sudden increase in attention paid to the Chinese currency by the US is an annual phenomenon. When the cherry blossoms bloom in Washington, a young Congressperson’s fancy lightly turns to bashing the Chinese, in the hope that the US Treasury will name China as a “currency manipulator”. Presumably this plays well in Peoria.

It is true that the yuan should be stronger in some fundamental sense, but it is unclear why this is so important to the US. A recent study suggested that the yuan was undervalued by 20-40% and that, if it were revalued accordingly, US employment would rise by about 600,000. Note that this would be enough to reduce the current unemployment rate from 9.7% to 9.3%; a help, but hardly a panacea.

A case could even be mounted that this jobs effect is overstated. After all, almost everything that the US imports from China is no longer made domestically. So a stronger Chinese currency would either drive up the cost of China’s imports to the US, without greatly affecting their amount, or else the source of those imports would shift to a new cheap manufacturer, e.g India, Laos or Thailand. Of course, it’s not all about imports. US exports to China (there are some!) would become cheaper, and the quantity demanded therefore could go up.

In the long run, the Chinese currency is almost certain to rise if only because it’s the right answer for the Chinese. A stronger currency makes Chinese citizens richer in the world. But it’s clear that China is not in a hurry, and doesn’t like to be leaned on. So far, the renewed attention to the currency has had little impact on markets, and it may well stay that way.

House prices through the roof?

Which brings us to house prices in Australia, and the Governor’s view. Let’s just say that central bank officials around the world no longer cling to the view (expressed in seminal paper more than 10 years ago by some bloke named Ben Bernanke) that there is little or nothing they can or should do about asset price “bubbles”. The paper argued that central bankers could never be sure when a price rise was a bubble rather than a fundamental repricing, and in any case raising interest rates to burst a bubble may do more damage than waiting for the bubble to deflate and then using the tools of monetary policy to “clean up afterwards”. One of the proximate causes of the global financial crisis was the US house-price bubble that formed in 2005 and 2006. So we now have a clearer understanding about just what “cleaning up afterwards” can mean. There has to be a better way.

The Reserve Bank of Australia “leant against” the rapid rises in house prices in 2003, and now, a little more than 6 years later, we’re looking again at house prices rising too rapidly. What’s the RBA to do? Well it’s recent rhetoric suggests that 15% per year house price rises don’t bother it per se, but it will worry if credit growth becomes too rapid, lending standards begin to slip, and people begin to leverage up to “get in the game”. Note that Governor Stevens used that key word, “leverage” in his recent foray into breakfast TV.

Just as the rate cuts last year stopped a significant fall in house prices, so the rate rises already undertaken, and those in prospect, should moderate the rate of house price inflation. If they do not, then the RBA may just keep raising rates until they do.

But let me end on a cheerier note. April has been the month that has shown the strongest average gains on the Australian share market in the past twenty years.

Chris Caton
Chief Economist