The Australian Economy

Consumer Price Index	4.5% (year to June 2008)
Unemployment Rate	4.3% (as at 30 June 2008)
GDP Growth	2.74% (year to June 2008)
Exchange Rate (iUS$)	79.96 US Cents (as at Sept 30)
Source: www.rba.gov.au

The Australian economy has been through a golden period categorised by strong growth, high commodity prices, low unemployment and rising asset prices. It appears certain that we are entering a more difficult phase - however, in comparison to many of the World’s major economies we remain in a relatively good position.

The strong growth over the past decade resulted in higher interest rates and a large budget surplus. As a result, both the RBA via monetary policy (i.e. interest rates) and the Government via fiscal policy (i.e. Government spending) have significant capacity for providing stimulus to our economy and lessening the risks for a serious and sustained economic downturn

Monetary Policy - Interest Rates

The RBA acted beyond expectations when they cut the cash rate by a full 1%, following a previous 0.25% cut the previous month, in a bid to shore up the slowing economy. Their commentary to date can be summarised in that they are concerned about slowing world growth, tightening credit markets, slowing consumer demand and falling business confidence but are having to weigh these factors up against high inflation (brought about by a strong commodities market and a tight labour market). Expectations are for interest rates to continue to fall, the speed and extent of the cuts will be determined by how the domestic and global economies progress over time. Markets are currently pricing in a further 50 basis point cut when the RBA next meets on Melbourne Cup day.

Fiscal Policy - Government Intervention

On Tuesday the Government announced an additional $10.4 billion to be injected into the economy; some of this will have an immediate impact and others will take a longer time to implement and flow through the system. Some of the immediate initiatives include:

• Families receiving FTB Part A will receive $1,000 per children as a Christmas bonus, payable December 8th;

• Pensioners and carers to receive a lump sum payment, payable December 8th, $1,400 for single pensioners, $2,100 for pension couples and $1,000 for carers;

• A doubling of the first homebuyers grant to $14,000 for those buying an existing dwelling and $21,000 for those buying a newly built home. Payable immediately and for the rest of the 2008/09 financial year.

Inflation remains well above the RBA’s target range of 2-3% and, as the RBA has signalled, inflation is not expected to return to this range until 2010. Inflation must be managed effectively, and this is one crucial factor that could undermine both the RBA and the Governments ability to stimulate the economy further. Falling fuel costs, commodity prices and growth should ease the pressure on inflation, although this may be somewhat offset by the falling Australian dollar increasing the costs of imports.

Australian banks have held up well compared to many of their overseas counterparts, however a rising cost of credit has forced them to pass on the increased margins to customers. Finance remains relatively easy to obtain for residential borrowings, although corporate debt does appear to have become more restricted.

The Australian Currency The Aussie dollar has taken a hammering over the past few weeks, which hasn’t been fully highlighted in the below table. The AUD/USD exchange rate had gone excruciatingly close to reaching parity back in July this year, reaching a high of 97.86 cents, since that point it had dropped 33% to 65.51 cents on October 10.  There have been two (or three) primary reasons for this big turnaround in the AUD: A falling Australian Interest Rate Environment; Falling commodity prices; Hedge funds unwinding speculative positions in the market.

Index	30 September 2008	12 Month % move
$A/US	0.7996	-9.41%
$US/¥Yen	104.31	-9.41%
$US/UK£	0.5546	+12.11%
$US/Euro€	0.6960	-1.42%
$A/Euro€	0.5565	-10.70%
Source:www.rba.com.au

For a while the commodities story was expected to be the ‘stronger for longer’ story that would stay its course despite global uncertainty, underpinned by strong growth from China and other developing nations. It appears as though the market accepted that commodity prices had risen too far and that at the very least the emerging economies would feel some flow on effects from the slowing developed economies. 

The Global Economy World growth has slowed over the past twelve months as a result of the US led sub prime credit crisis, over leveraged developed economies, high levels of inflation and an environment of fear and suspicion. Expectations for future growth have also been revised downward.

Global Index Snapshot
	Aus	US	Japan	Euro	UK
GDP Growth (Year to June 08)	2.74%	2.17%	1.06%	1.41%	1.47%

Forecasts from the International Monetary Fund (IMF) still paint a relatively sound position with growth expected to slow in 2009 before regaining speed in 2010 and beyond. The accuracy of these projections will largely depend on how long the cloud of the credit crisis continues to hang over the heads of the Worlds economies. The latest estimates from economists are that the US economy shrunk by 0.2% in the third quarter and is expected to contract by a further 0.8% in the final quarter of 2008. Whilst there appears to be some debate within the US Federal Reserve as to whether the US economy is in a recession or not, there seems little argument that that is where they are headed.

As can be seen in the below table, World growth is largely reliant on the continued prosperity of the likes of China and the other emerging economies that are expected to provide the bulk of the World’s growth for the next year or two.

Global Index Snapshot - IMF Forecast
GDP Growth	Aus	US	UK	China	Emerging Economies	Developed Economies
2008	2.5%	1.6%	1.0%	9.7%	6.9%	1.5%
2009	2.2%	0.1%	-0.1%	9.3%	6.1%	0.5%
2010	3.1%	2.0%	2.2%	9.8%	6.7%	2.0%
2011	3.5%	3.1%	3.3%	10.0%	6.9%	2.9%
Source: IMF World Economic Outlook (October 2008)

Is the World in for a Slowdown … Recession … or, a Depression??

In past banking/financial crisis’ (think 30’s, 70’s, 80’s/90’s) the distinguishing factor regarding how deep and how long lasting the hangover continued, was determined largely by the speed with which the various government/s reacted. Accordingly, despite a relatively slow and ad hoc initial approach, several large and co-ordinated efforts have subsequently been made to ‘stop the rot’, including:

• US Federal Reserve:
• Assisted JP Morgan to take over US investment bank Bear Sterns;
• Took control of mortgage originators Freddie Mac and Fannie Mae;
• Allowed investment bank Lehman Brothers to go under;
• Took over AIG;

• US Government announced and eventually passed a $US700 billion rescue package, allowing the Fed to buy ‘toxic’ mortgage related assets;

• UK Government bought a stake in eight banks, worth ₤50 billion;

• Worlds central banks announced a co-ordinated reduction in interest rates;

• Majority of the World’s government subsequently announced a guarantee to bank deposits.

In summary, this crisis (as all previous credit crisis’s before it) has been categorised by a preceding era of greed, lax lending standing and too greater reliance on debt (not supported by income or profitability) and has resulted in an environment of fear and suspicion, tightening finance and failing large-scale institutions. In the past, these crises haven’t been resolved until the level of uncertainty in the banking sector was reduced, typically as a result of government intervention (the earlier the better).

Source: www.imf.org, www.axa.com.au, www.smh.com.au

The Australian Sharemarket

The Bear is Back!!!

All growth assets have incurred a negative result over the past twelve months and only the conservative asset classes of cash and fixed interest have proved to be positive investments over this timeframe. Anybody that has been sitting in cash for the past twelve months would be feeling pretty smug, having earned themselves a handy return and averted the negative returns in shares and listed property.

Australian Asset Class Performance Summary as at 30th Sept 2008
	%1 Month	%3 Months	% YOY
Australian Cash	0.70%	2.46%	7.96%
Australian Fixed Interest	1.09%	5.2%	8.22%
Australian Equities	(11.20%)	(13.16%)	(29.63%)
Australian Listed Property Trusts	(6.17%)	(2.93%)	(44.44%)
International Equities (unhedged)	(3.5%)	3.75%	(16.22%)
International Equities (hedged)	(11.2%)	(11.06%)	(23.04%)
Sources: as at 30/09/08, based on returns of Vanguard index funds and Yahoo finance

The above figures are only to the end of the quarter, but taking the All Ordinaries from its peak in November 2007 to ‘Black Friday’ 10th October, the market has fallen 42.7%. This is one of the largest falls in the Australian stock markets history, following closely behind the 1987 crash, where the market fell 47.9% from September 1987 through to the lowest point in February 1988.

The only sector on the Australian stock market that had held (or increased) its value over the past 12 months had been the Resources sector. However, the last quarter saw the end of that with both of the major minors, BHP and RIO falling 45% and 54% since their peaks in May.

Are we there yet?

In an attempt to get a picture of the ‘cheapness’ of the Australian market it is interesting to take a look at two often used measurements of value, the dividend yield and the price earnings ratio.

According to the RBA, dividend yields on ASX 200 as at the end of August 2008 were 4.66% and price earnings of 13.8 times. Based on some fairly rudimentary calculations on my behalf, and assuming that the dividends and earnings of the ASX 200 haven’t changed over the past six weeks, as a result of the falls in the price we have seen over the past 6 weeks, of 22.88%, as of Friday 10th there would have been a dividend yield of 6.04% and a PE ratio of 10.64 times.

If we compare these ratios to the long-term averages (since 1982) of a dividend yield of 4.02% and a Price Earnings Ratio of 18.7 times the market would appear to be undervalued. The unknown in these ratios is the actual profits that companies will earn and the dividends that companies will pay into the future both of which we might all agree are likely to come under some pressure.

However, how much would profits and dividends need to fall to bring back these ratios in line with their long-term average? Even if the profitability of businesses on average were to fall 44% and dividends were to be cut by 33% the Australian market would still appear to be fairly valued in an historical context.

When is the Market Cheap?
GDP Growth	PE Ratio	Dividend Yield
10th October 08	10.64 times¹	6.04%¹
After the 1987 Crash	12.0 times	4.49%
Long-term Average	18.7 times	4.02%
¹Calculated based on adjusting the RBA's August figures for the change in Price from August 30 to October 10, 2008

“Even if the profitability of businesses on average were to fall 44%, and dividends were to be cut by 33%, the Australian market would still appear to be fairly valued”

Another interesting comparison to make is with the 1987 crash. Prior to the crash we had a price earnings ratio of 21.3 times and a dividend yield of 2.49%, which clearly demonstrates how overvalued the market was at this time. Following the crash, the market had a price earnings ratio of 12.0 times and 4.49% after the crash.

Stock markets are partially valued based on the underlying fundamentals of the market and partially based on people’s expectations. It is quiet obvious from the above that the ‘average investor’ expects both profits and dividends to be cut savagely over the coming year or two and hence are discounting shares to account for this.

The Global Sharemarket

Global Index Snapshot
Index	30 June 2008	30 Sept 2008	3 mth % move	28 Sept 2007	12 mth % move
S&P/ASX 200	5,215.3	4,600.5	(11.79%)	6,567.8	(29.95%)
All Ordinaries	5,332.9	4,631.3	(13.16%)	6,580.90	(29.63%)
NASDAQ (US)	2,292.98	2,091.88	(8.77%)	2,701.5	(22.57%)
Dow Jones Industrial (US)	11,350.01	10,850.66	(4.40%)	13,895.6	(21.91%)
S&P 500 (US)	1,280.00	1,164.74	(9.00%)	1,526.8	(31.09%)
FTSE 100 (UK)	5,625.90	4,902.50	(12.86%)	6,466.8	(24.29%)
Hang Seng (HK)	22,102.01	18,016.21	(18.49%)	27,142.5	(33.62%)
Nikkei 225 (Japan)	13,481.38	11,259.86	(16.48%)	16,785.7	(49.07%)
Source - Yahoo Finance as at 30th Sept 2008

The global credit crisis has impacted all of the world’s economies and in turn has resulted in negative returns on all of the World’s major stock markets. Even the rising giant of China couldn’t shrug off the impacts, with China’s Shanghai Composite index falling 142% over the past twelve months, although this does only bring it back to the levels of November 2006.

Capital City Property Markets

This asset class has been the star performer over the past twelve months, particularly in Brisbane, Adelaide and Melbourne. However, over the past six months the Australian property market has been more subdued, as a lack of consumer confidence, increased global uncertainties and high interest rates gave purchases a reason to sit on their hands and adopt a wait and see approach.

	Change in median House Prices March Qtr 2008 to June Qtr 2008	Annual Change in house prices June Qtr 07 to June Qtr 08
Sydney	-2.1%	1.8%
Melbourne	4.9%	8.7%
Brisbane	0.1%	14.7%
Adelaide	0.3%	17.0%
Perth	-3.7%	-2.6%
Hobart	-3.0%	4.8%
Darwin	0.8%	7.2%
Canberra	-3.2%	5.5%
National Average	-0.1%	6.0%
Source: Real Estate Insitute of Australia

With signs of a slowing property market, are we coming to the end of a golden era for property investment - will property follow in the wake of the share market?

Will Residential Property be the last Domino to Fall?

In light of the collapse in property prices in the US and Australia’s high level of debt per household, questions have been raised over Australia’s property market and how resilient it will prove to be. 

High Debt Levels

There can be no argument that Australians are significantly higher in debt than they have ever been in the past. In 1990 our level of housing debt to housing assets was 10%, this has now risen to 27.5% as of June 2008. Whilst this is a comparatively high level of debt it does also show that on average households have equity in their homes of 72.5%.

In addition, from 1994 our interest payments as a percentage of disposable income have risen from 5.5% to 14.4%. This figure has no doubt been assisted by the rising interest rate environment and may improve with interest rates expected to fall. 

Another figure that is concerning is our Debt to Disposable Income figure that has risen consistently from 35% in 1977 to 158% in 2008. Many of the economies that are now seeing falling house prices have had similar increases in debt and had reached a similar level of gearing.

What will Support Property Prices?

There would appear to be several strong supporting arguments for Australian property that Hudsons believe will allow property prices to remain relatively stable in the medium term and to provide the prospect for greater growth in the longer term. 

Falling Interest Rates – the US property market came unstuck following a period of extremely low interest rates, combined with aggressive lending practices to subprime borrowers. In contrast the Australian market has experienced significantly higher interest rates and has a much greater capacity to reduce interest rates (as the RBA has recently proved it is willing to do) in order to stimulate the economy and ease the pressure on households. As interest rates fall and rents rise, it will make it increasingly attractive for both homeowners and investors to buy into the market.

More Conservative Lending Practices – Australian banks have been more conservative in their lending practices and have largely avoided the issue within the US whereby borrowers had negative equity in their property from the outset, ensuring that as soon as prices fell there was little reason to continue to make loan repayments. As discussed above, the average Australian home owner has equity in their home of 72.5%.

In addition, the US subprime mortgage market constitutes 15% of the total US mortgage market, in Australia the closest thing we have to subprime only makes up 1% of the mortgage market. Furthermore, the next level of loans, the low-doc and no-doc loans within Australia make up 7% of our market compared with the comparative US ‘Alt-A’ market that makes up 15-20% of the loan market.

Shortage of Housing – according to property research group Matusik, there is an existing undersupply of housing in Australia of approximately 75,000 houses. This shortage is expected to worsen to 120,000 by 2010 as a result of greater demand (primarily from immigration) and insufficient supply (partly due to a reluctance of developers to release properties into a market low on confidence). It is difficult to imagine property prices falling whilst such a large shortfall of property exists.

Record Low Vacancy Rates and Rising Rental Yields – as demonstrated in the table below vacancy rates remain low (anything less than 2% is expected to put upward pressure on rents) and rents have been rising strongly in response to the tight property market.

Capital City	Quarterly % Vacancy Rate	3 b/r House rents		2 b/r other dwelling rents
		Annual % Change	Gross Annual Yield %	Annual % Change	Gross Annual Yield %
Sydney	1.1	17.9	3.1	15.2	5.4
Melbourne¹	1.0¹	12.0¹	3.4¹	13.5¹	4.1¹
Brisbane	2.2	12.1	4.0	14.3	4.6
Adelaide	1.5	8.0	3.9	15.0	4.4
Perth	2.8	16.7	4.1	16.4	4.5
Canberra	2.0	8.6	4.4	19	5.5
Hobart	2.4	7.4	4.6	26.7	5.0
Darwin	0.3	29.1	6.3	12.1	6.0
Source: Real Estate Institute of Australia, Data as at March 31 2008
¹Due to unavailablity of information, figures for Melbourne are for year March 07 to March 08

Whilst rents have risen substantially, the rental yields are not considered high (either in a historical context or compared with global property markets) for this reason it is likely that property prices will remain constrained until rental yields improve further (and interest rates fall further).

Government Assistance – as evidenced by this weeks announcement from the Rudd Government, the current Government continues to support the housing market with additional increases to the first home owners grant. In addition, as previously discussed the ability of the Government to bolster the economy using the current budget surplus should lessen the severity of any economic downturn.

Source: www.rba.gov.au; Real Estate Institute of Australia (REIA), Global Property Guide, ANZ Economic Update

Summary

The current economic issues were brought about by lax lending standards, a rapid expansion of debt in combination with the development of complicated, multi layered financial products that apparently dispensed the risk of these loans by breaking them up, repackaging them and on-selling them to unsuspecting financial institutions and investors. Uncertainty and fear are expected to linger until greater clarification comes to light as to how much exposure financial institutions have to worthless or subprime assets and what follow on impacts this will have to the rest of the World Economy.

The Australian and World economies are expected to slow and a period of below average growth appears to be a certainty. Continued volatility in the sharemarket is guaranteed although opportunities are likely to present themselves. The Australian property market is supported by several key underlying fundamentals, however prices may remain subdued in the short term until greater clarity comes to light regarding where the economy is headed, until rents rise further and interest rates are lower.

There are several possible saviours that may help ease the length and depth of any potential slow down, including:

• The continued growth of the Emerging economies;

• The large and decisive action taken by the World’s central banks;

• The flexibility within the Australian economy to stimulate the economy with fiscal and monetary policy.

We are not experiencing anything that we haven’t seen before (to varying degrees), we have had financial/banking crises in the past, the severity and length of which have varied. We won’t know how the current crisis will pan out until we are well past the other side, although it is important to remember that:

Want to know more?
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READ OUR GENERAL ADVICE WARNING

Want to know more?
Book a consultation with your Hudson Financial Adviser by calling
free call 1800 804 296 or book online.
READ OUR GENERAL ADVICE WARNING

Interested in shares?
Book a consultation with your Hudson Financial Adviser by calling
free call 1800 804 296 or book online
READ OUR GENERAL ADVICE WARNING