Financial markets have once again been climbing a wall of worry.

In May, the S&P500 index fell by 8.2%, while the Australian index, the ASX200 fell by 7.8%, to record its worst May since 1984. Since the start of the year, these indexes are down by 2.3% and 9% respectively. Sell in May and go away indeed! The main concern recently has been sovereign debt, particularly in the Euro area. This concern began with the revelation by Greece earlier in the year that it was running a budget deficit three times the size of what was previously thought. That’s a lot of extra bonds to sell. Suddenly Greece had a major problem or rather two problems, since it is also massively uncompetitive with its fellow European Union members.

There is no doubt that these are big problems for the Greeks. At best, they are looking at years of fiscal austerity, years of slow economic growth and years of little or no wage growth. The question yet to be resolved is what this means elsewhere. Greece is a small economy these days; less than 3% of the total European economy. So the overall economic effects of the Greek problem are minor. The concern is the financial-market reaction, which has spread as far as Australia, and the belief in “contagion”, which could affect, for example, Portugal and Spain. In addition, there is concern that a default by Greece on its debt, or even a restructuring, could significantly harm the European financial system. After the GFC, one can forgive people for being nervous about such possibilities. That said, my belief is that the concerns about Europe are being exaggerated. If this is true, then the sell-off in share markets in the past few weeks has been overdone and will be reversed. In particular, the Australian market, measured by a conventional price/earnings ratio, is clearly cheap right now. We know two things about cheap share markets: first, they can get cheaper, but second, they don’t stay cheap forever.

The Australian dollar was caught up in the flight from risky assets, falling from 93 cents at the beginning of the month to less than 81 cents. I have thought for some time that the $A was over-valued, so a fall in its value does not surprise me, but I certainly wasn’t expecting a 10-cent fall in just two weeks. The $A had its sixth biggest weekly fall since its 1983 float in mid-May; three of the five larger ones all occurred in the chaos of late-2008. Given that the $A is now a lot closer to fair value, I can see no reason to expect it to return to more than 90 cents anytime soon.

The concern about Europe has obscured another global issue that may eventually become more important. China is trying to manage a property bubble. In the past year, house prices in Chinese cities have risen by about 14%, with many unofficial figures suggesting much more in Beijing and Shanghai. China has moved quickly to limit the ability of Chinese citizens to purchase a second or third home, and they have also restricted purchases from abroad. Overnight, this has cut the demand for new housing by 40% according to some estimates. This will almost certainly lead to a major fall in construction, which is, of course, very commodity-intensive. This situation bears watching, although let me say that we’re always worrying about a Chinese slowdown and it rarely happens.

Meanwhile, back in Oz, we’ve had a Budget. The general perception is that it was boring, and there is some truth to that, mainly because so much was announced (not just leaked!) beforehand. This left little for Treasurer Swan to do on the night except to boast about a return to surplus in 2012/13, three years earlier than previously expected. Note two things. First, the surplus is forecast to hit $1 billion in that year; this is much less than the margin for error. Second, all of the improvement in the Budget outlook from a year ago has come about because the economy has done better than expected, rather than from policy changes. Of course, the Government is entitled to claim some credit for the fact that Australia weathered the GFC as well as it did.

The most contentious issue arising from the Budget is, of course, the Resource Super Profits Tax (RSPT), which will take 40% of any profits that exceed a 6% (approximately) return on capital. Let me just say this: governments, on behalf of Australian citizens, have always charged the mining sector for the privilege of taking the stuff out of the ground. Most of these charges are in the form of royalties, which have increased much less rapidly than either the revenues or profits of the mining companies in recent years. As a result, the share of mining profits paid in taxes approximately halved during the commodity price boom from 2003/4 to 2008/9. Royalties are also a very inefficient form of tax. The RSPT is a means to ensure that the Australian people get a bigger share of the boom, and in a relatively efficient manner. In principle, it is a good move. Of course, one could argue that the 40% is too high, or that the 6% uplift factor is too low. These issues will get sorted out during discussions. The mining companies are protesting a little too much in my view. Their only real beef is that, yes, they will finish up paying more taxes. Their response reminds me of mine when my boss offered me a substantial pay raise. I turned it down because it would have pushed me into a higher tax bracket!

Chris Caton
Chief Economist