World Economic Update - 25 May 2010Dolfinwise Financial Planning

25 May 2010

World economic events have progressed rapidly over the last couple of weeks since my last update and I thought it timely to provide some of my thoughts regarding where we are now, having seen a fall in share markets over the last week emanating from fears the Greek debt crisis could spread to the rest of Europe.

As we anticipated the German government passed legislation on Friday effectively allowing the ECB to guarantee the Greek debt.  To facilitate this process France and Italy need to to pass similar legislation but we again expect they will as the consequences of not doing so would be too dire.

What commenced with a debt bubble that burst in the subprime mortgage space in America resulted in sovereign states around the world having to bail out the private sector. This effectively moved debt to national balance sheets. What we are seeing in Greece and Europe is the flow on effect where some countries were already too indebted themselves due to living beyond their means for too long. Now they are struggling in a tougher economic environment to make their payments and are being forced to make drastic cuts to spending and increase taxes to try to avoid defaulting.
For the weaker European countries being tied to the euro means the normal process of being able to devalue their currencies to improve their competitiveness and increase exports/decrease imports and thereby reduce their deficits is not available making the situation all the more difficult.

Due to the levels of debt in sovereign states many of these governments will need to look to the private sector (financial institutions, private sector savers, or quantitative easing (printing more money)) to refinance over the next few years as there is simply not enough countries with sufficient surpluses to fund those who will need to refinance or take on new debt.

The requirement to borrow from the private sector is likely to result in an increase in long term interest rates (yields on bonds) as this will be required to attract monies from private investors.  This means I will continue with my strategy of the last few years of remaining underweight in International bonds (until we believe the likely increase in credit spreads has occurred and has settled down) and avoid any overweight positions in property which is likely to be another asset class, badly affected by rising finance costs. Due to the need for cash by banks term deposits will continue to pay handsomely and are a great haven for defensive money.

Our current view on world share markets is as follows:
Markets will continue to be extremely volatile until more certainty emerges about the finer points of the rescue package for Europe’s weaker states. However it is likely that the package will stave off problems for another 3 years and allow time for credit markets to adjust.  Markets may bounce further to extend Friday’s rally if details of the package provide more certainty over the next few weeks.

Medium term, Europe as a whole will likely stagnate as it sorts out its credit issues. Germany may ironically benefit in the medium term by the current occurrences as its tie to the Euro makes it extremely competitive relative to the other member states with no ability for its currency to relatively appreciate.

I believe the US may surprise on the upside over the next 12 months. The problems in the US should not be taken lightly or be underestimated however the US banks are sitting on an unprecedented amount of liquidity that was injected by the Federal Reserve buying mortgage backed securities at the height of the Global financial crisis. This liquidity is likely (as credit losses now start to reduce for the banks) to be injected into small to medium size businesses and fund their expansion and growth. This expansion of money supply will provide significant stimulus to the US economy in the short term.  This may bode well for the share markets in the next 12 months. Caution though needs to be exercised as at some point this excess liquidity will need to be withdrawn or excess inflation will result and the US like much of the world has to reduce its deficits.

The other major world factor at the moment is China. China has retained its stellar growth through the GFC by building fixed assets at a far greater rate than they are being occupied.  This cannot go on forever without creating a massive asset bubble. As a result it is likely the Chinese government will slow its investment in this unprecedented building program. This will reduce the rate of China’s economic growth and reduce demand for our commodities (hence the drop in miners share prices recently and the depreciation of the Australian dollar). China’s greatest export market is Europe and so it may not be able to rely on a pick up of exports as much as it had hoped to.  So in the short term, commodities may be a very risky place to be, however, I have no doubt that a 5-10 year view still paints a very rosy picture for commodities companies and the Australian economy as a whole.

In summary in the short term it is still a time to be cautious, however it is not a time to panic and flee to completely defensive assets either. At times like this it is important to take a medium to long term view and accept that volatility can be uncomfortable but that a quality portfolio or well diversified assets over the long term will always perform.

This is general information only, if you have specific queries relating to your own circumstances please do not hesitate to contact the office.

Jason Bragger CFP DipFP BSC BA
Director - Dolfinwise
(07) 3831 5990