Twenty years ago, when the 1980’s “greed is good” bubble burst, Australia followed the US in a long slide into recession. Indeed, when Wall Street slumps and the US economy wobbles, Australia has invariably spiralled downward also. It happened in the mid-1970s on the back of the OPEC shock, and it happened in 1929 with the Great Crash. And we weren’t immune from the pain of the dot.com crash six years ago.
Right now, Wall Street is looking wobbly again. The US economy is facing a triple threat: tighter credit as institutions reverse their past loose lending practices, a housing market in crisis from the sub-prime mortgage disaster, and record high oil prices. As a result, US consumer confidence has dived, the greenback remains weak and the economy is sick. Indeed, US Federal Reserve chairman Ben Bernanke told Congress that the outlook is gloomy, warning of a worsening economy and no inflation relief. There are fears that the Fed may not continue easing monetary policy for fear of stoking inflation which is already being fuelled by the oil spike (looking to top $US100 a barrel) and higher food prices.
As one US analyst put it, there is “a whiff of stagflation” in the air, where rising prices occur in an environment of declining asset values, little or no growth, and rising unemployment – all signposts of a slide into recession.
The sub-prime mortgage crisis has been triggered by higher variable interest rates on home loans after the US housing bubble peaked in early 2006 which left many borrowers unable to meet repayments and lenders unable to fully recoup their funds due to falling property values. It has begun to crunch some of Wall Street’s bluest investment institutions.
In the September quarter Bank of America wrote down $US3 billion. Merrill Lynch lost $US 2.24 billion- the largest quarterly loss in its history – after having to make write-downs of almost $US 8 billion. Its chief executive officer Stan O’Neil departed (albeit walking away with a $US161 million package). There’s an expectation of further write-downs of up to $US4 billion to be made in the current quarter.
Citibank wrote down up to $US11 billion from its mortgage exposure and, like O’Neil, its chief executive Charles Prince quit. Morgan Stanley wrote down $US3.7 billion and Wachovia $US1.1 billion. Swiss group UBS reported its first quarterly loss in five years: $US716 million. The stock price of US broker E*Trade is down 84% over the year mostly on fears of its exposure to the mortgage crisis and Reuters reports that there is talk it is teetering on bankruptcy if it cannot retain its clients.
And it’s not over. More institutions, both US and foreign, are likely to be sucked into the sub-prime mud and forced to make multi-million dollar write-downs in the current quarter and into calendar 2008. It’s estimated that total write-downs will total at least $US64 billion.
In response to this crisis as well as to the other worsening economic conditions, the US Federal Reserve’s Open Markets Committee cut official interest rates by a quarter of a percentage point to 4.5% on October 31. The Bank of England has signalled it will cut rates due to a worsening outlook for economic growth and inflation.
For Australian investors now is a time of caution. After 10 consecutive interest rates rises, our official cash rate now stands at 6.75% with the Reserve Bank of Australia concerned about rising inflation and warning of the need for more rate rises in 2008. If the US continues to cut interest rates to address its concerns, the gap between US rates and Australian rates will power the Australian dollar higher still, making life tough for Australian exporting manufacturers and resource companies.
But unlike past sneezes on Wall Street, Australia may be inoculated by the significant transformation in our economy. Much of our current economic health is due to demand from China. China may well insulate us from the crises besetting the US at the moment, although with half the world’s share investments invested in the US stockmarket, any gyrations there will send shockwaves across the Pacific regardless of how well we are performing.
The Australian economy is therefore delicately poised. Depending on how we are hurt by rising prices, and higher petrol costs and the drought are already putting a fire under inflation, and whether China’s need for our product continues despite the economic declines elsewhere in the world which would reduce demand for its manufactured goods, Australia may ride out the current turmoil in good shape.
Australian investors must be cautious. We are not immune from what is going on in overseas markets – indeed with China as our biggest customer we are just as dependent as ever. But, if we are lucky, the crisis in the US may wash over us without too much damage. The coming six months will be key in signalling whether we merely shiver or catch a cold.