Blips On Radar Point To Stormy Weather Ahead

Sun Herald

Sunday June 25, 2006

David Potts

Interest rates will set the mood, David Potts writes.

MY HOW the financial year has flown. It's hard to believe there was a booming sharemarket, the dollar was getting stronger, interest rates were going nowhere, the gold price was below $US450 an ounce, and you used to be able to get a decent cup of coffee.

Instead we have, um, this.

Oh well, volatility means money and I don't mean mood swings, either. Mind you, the new financial year will almost certainly be marked by prolonged periods of bad moods in the markets.

There are already blips on the radar that show either central banks are chasing shadows because they think inflation is rising, or it really is and they aren't doing enough to stop it.

Either way, there's a race around the world to lift interest rates. One that we're winning by the way. Not only did the Reserve Bank start first, it's also pushed higher.

The economy

These synchronised rate rises are already affecting the markets, interest rates and the dollar. If we're unlucky they could also hurt the economy.

Taken in isolation, it's all clear ahead. Economists are forecasting that the growth rate will pick up in the right spots - business investment and mining exports.

Productivity is "simply sensational", said Craig James, chief equities economist at CommSec, pointing to a growth rate of 4.7 per cent in the year to the March quarter, the best in eight years.

"Economic growth is good but far from spectacular and there is a nice balance between consumption and investment," he added.

But "conditions vary markedly across states and industries and the export sector is still not pulling its weight".

There's no sign of the end of the housing slump on the eastern seaboard, which will help interest rates, but spending is proving to be something of a dark horse.

Despite high and rising petrol prices, not to mention higher interest rates, we're back in the shops again - and there's always next week's tax cuts. Unless, that is, they've already been spent.

Anyway, left to its own devices the economy is fine.

But if the global rate rise does what it's supposed to, and let's be frank, that's to rein in growth, then we're in trouble.

For a start, commodities would come off the boil, just as the mining companies are investing big time so they can meet demand. If the demand leaves before the rendezvous, that'll set off a downward spiral of over-capacity.

It doesn't bear thinking about. So don't.

Besides, rising interest rates are mainly a problem for industrialised countries.

Sometime next year, the International Monetary Fund forecasts, the combined output from developing countries, which include China, will for the first time exceed that of what might loosely be called the West.

Spooky, in the words of Dame Edna, isn't it?

While other countries depend on the West for their markets, fortunately Germany and Japan are on an upswing anyway. In their cases interest rates are low to start with and there's nothing unusual to have increases as the economy picks up.

It's when rates rise as the economy is slowing that's the problem, which is what Wall Street is worrying about.

The sharemarket

The US Federal Reserve will almost certainly raise rates for the 17th time in a row when it meets on Thursday, so don't expect any sense from the markets before then.

A market adage says buy on rumour and sell on fact, which just goes to show how it gets over-excited before something happens.

In the case of central banks, make that sell on rumour and buy on fact.

Once the rate rise is out of the way, there's a good chance that Wall Street will bounce back.

Mind you, it'll look for something else to worry about; no doubt whether there'll be another rate rise after this one. Talk about neurotic.

The other problem is the price of oil, where there's no relief in sight.

On the contrary, the demand for oil is likely to rise as the developing economies accelerate. In the meantime, there's no chance of significantly boosting production within the next 12 months, either in more oil or refining capacity.

If there are any economists left who still claim that high oil prices are a passing fad, they certainly aren't employed by the central banks. As Macquarie chief economist Richard Gibbs points out, oil has doubled in real terms in just two years.

Still, high oil prices aren't necessarily bad for the resources-driven Australian sharemarket thanks to big hitters such as BHP Billiton and Woodside.

However, they are damaging to industry, not the least of which includes other mining companies, which are faced with high transport costs.

You'd also expect them to crimp retail spending, but never underestimate the resilience of the little Aussie bargain hunter.

"A raft of companies will benefit from buoyant investment conditions for at least the coming year, including Bradken, Skilled Group, WorleyParsons, Coates Hire and Crane Group," James said.

The fact that super has suddenly become more attractive is a bonus too. It has to find a home somewhere, most likely in the sharemarket.

Once you take into account what's happening everywhere else, a return of the bull market looks ever more likely.

Only the US raises a question mark, and that's more an anxiety attack than fundamental problem. At worst, housing is slowing down to a soft landing. No crash there.

And there's still no sign of high oil prices biting. Nor will they if productivity rises and China continues to make cheap consumer goods.

There's just one nagging doubt. The US is running a current account deficit that is almost as bad as ours and which surplus countries such as China and Japan have been happy to finance.

After all, they get paid by American consumers for their products and can then bank their profits in the US at three times the return they can get at home.

It's a nice arrangement all round really. If Americans stop buying, the deficit shrinks, so no problem there either. But if the Chinese and Japanese decide there are better places to invest their money, all hell could break loose.

The dollar

Which reminds me of the dollar. Although less predictable than a soccer referee, at least it has its fans. They think that, because there's a record-breaking commodities boom, the dollar should be heading towards US80 cents rather than 70.

The trouble is we've been spending the proceeds of the boom, and then some. That's why our foreign debt is rising, something the markets turn a blind eye to from time to time but is still a long-term black mark - or perhaps red card.

And to be bullish on the Aussie dollar you have to be bearish about the US dollar.

While the US has the same balance of payments problems, it's big enough to write the rules. Until the surplus countries decide to look elsewhere for their investments, the US dollar will remain as the world's reserve currency.

The more the US lifts interest rates, the stronger the US dollar will become.

Interest rates

But Australian dollar fans point to the likelihood of our rates rising too.

Unless they rise by more than 0.25 per cent, it's hard to see why the Australian dollar would suddenly be more attractive to investors.

True, speculators and hedge funds might have some fun with it for a while and drive it, but eventually they'll move on.

The economists at BT say there's "close to a 50 per cent chance of a further rate rise in August or September". Hmm, so there's also just over a 50 per cent chance that there won't be.

Gibbs predicts a rate rise in the "third or fourth quarter".

Nobody is talking rate cuts though. Considering that the world's central banks are vigilant about inflation, and oil prices seem set to stay high, little wonder.

There's an outside chance rates might drop later next year, but don't bet the mortgage on it.

On second thoughts, maybe you should. You can switch from a standard variable home loan to a three-, four- or five-year fixed term and save almost 1 per cent in interest.

It might cost a bit more initially because of exit and re-entry fees, but over time you'll be better off.

Even if rates eventually drop, you will have saved heaps in the meantime. Besides, they'd have to drop five times before you were disadvantaged.

Every time you fill up the car will be a reminder that a rate drop isn't on the radar. And it would be nice to have the mortgage to help with these petrol prices.

You'll need to be quick though. Money market rates, the benchmark for fixed term mortgage rates, have been creeping up.

Property

Did I mention that Australia is running a dual economy: resources on one side and everything else on the other? I must have.

It's even more obvious in property, where Western Australia is going gangbusters and most other places are in the doldrums.

Even if rates stay where they are over the next year, the experts see little chance of a resurgence in residential property east of Kalgoorlie.

But it also means rental yields will continue to rise.

It's been 2 1/2 years since the slump in home prices in Sydney and Melbourne started which, incidentally, is the average length of a downturn.

This is also the first housing slump that didn't come with a recession. Or that started from such low interest rates.

Even so, Rod Cornish, head of property research at Macquarie Bank, predicts a "flat to moderate growth for two years" in residential prices. In Sydney make that a continued downturn until the end of this year, and a "stabilisation phase" in 2007.

"For land developers this is going to be a slow recovery," he said.

It'll be a long time before preselling is back in vogue.

With the possible exception of the west, where for the first time Perth housing is less affordable than Melbourne or Brisbane, and the top end areas in the capital cities, the more promising property investments are in office space and factories. Because of a global boom in leasing demand Cornish predicts Australian office space will be the property winner over the next 12 months.

In Melbourne returns on office space are the highest in 27 years, Brisbane and Perth 25 years and although Sydney is a laggard rents are expected to rise 13 per cent next year.

Industrial rents are also starting to rise. "Infrastructure is the main key," he said.

Still, there's one possibility that could kick residential property along.

As the sharemarket gets more tetchy, more investors will see property as a welcome haven.

© 2006 Sun Herald

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