Interest Rates, Inflation Leading Australian Economy into Recession

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Some days you talk about record corporate earnings, breathtaking corporate fraud or exciting new technologies. Other days you have to talk about interest rates and inflation. Today is one of those days.

You’ve been warned in advance. We’re in one of those transition phases in global markets. In order to find out what’s driving global asset prices (and maybe what’s coming around the bend) you have to plunge your hands into the warm and sticky bowels of the economy to see what’s really going on. So how about a little hands-on action with interest rates and inflation? In we go…

The strange feature of the last four years is that the world’s been booming without soaring inflation, growing without overheating. This – along with a few other factors like the disinflation coming out of China – has kept global interest rates down. And these low rates, of course, have made cheap money available for anyone wishing to make a multi-billion dollar deal, buy an over-priced house, or binge on a new TV. It’s a positive feedback loop leading to ever-higher asset prices and ever-constant interest rates.

Last week all that seemed to change. Just like that. The yields on ten-year US Treasury notes went over 5%. And then they kept going. The yield closed at 5.29% in yesterday’s New York trading. Bonds yields are rising. Bond prices are falling. How will stock markets and emerging markets react?

So far, stock markets have shrugged in sympathy, without bolting for the door. But this is where we take careful hold of that large intestine of the world financial system – US Treasury bonds and notes – and feel around for anything squishy or suspicious. The rise in US bond yields could trigger a rise in other bond yields and a sell-off in emerging market assets. It could mean, dare we say it, the re-emergence of risk.

Yes, yes, we know. Risk is dead, or so the markets have been telling us for the last year. But Alan Greenspan is proving even more entertaining in the private sector than he was as the most powerful central banker in the world. Speaking at an event sponsored by the Commercial Mortgage Securities Association, Greenspan all but said that risk is back. Only he said it banking terms, implying that the low risk-premiums enjoyed by issuers of emerging market debt are a thing of the past.
 
“It ain’t going to continue that way,” Mr. Magoo added. “And indeed, all the spreads you are looking at, including your spreads relative to the 10- year, are going to start to open up and the 10-year is going to be moving as well.” The rise in emerging market yields (a rise in borrowing costs) would have an obvious and negative effect on emerging market assets.
 
Just what are emerging market assets? Good question. A popular catch-all term is BRICs (Brazil, Russia, India, and China). Notice there’s no “A” for Australia in BRICs. But Australia is a China-proxy. So are Australian stock prices at risk from rising interest rates in emerging markets?

The action on the ASX sure indicates that investors think Australian stocks have something to lose if global rates tighten. But Greenspan might have thrown a life-line out to Aussie investors. He also said: “What we’re now beginning to see, is affluence spread throughout what we used to call the third world and consumption is beginning to increase.”

Greenspan means that China’s growth – indeed the growth of much of the emerging world – will be driven more by consumption and less by exports to America. The former Fed Chairman didn’t say that domestic spending in China would be less resource intensive than export-driven growth. But that’s the question we need to keep in mind.

Maybe the more pressing question for Aussie investors is whether the Reserve Bank has to raise interest rates soon and whether the economy is within a hair’s breadth of overheating. “The economy’s lack of spare capacity will trigger inflation pressure at the same time that food and electricity prices spike owing to the drought, as petrol prices reach fresh highs,” says JPMorgan chief economist Stephen Walters.

Access Economics chimes in with this forecast, “With earlier investment in mining now increasingly coming on-stream as higher mineral exports, that combination spells a short-term outlook with rapidly lifting real rates of economic growth and continued buoyancy in profits-but with lingering interest rate risk.”

Our take? This economy is due for a recession. Official measures of inflation don’t capture the rising cost of living – especially housing – for millions of people. The mining industry has billions in new investment planned, but too few workers to execute the plan.

Finishing our run through the nation’s economic bowels, we don’t see the rise in global bond yields as bearish for Aussie stocks, correlated as they are to China’s growth (although property and retail stocks with large portfolios of US assets won’t like rising rates). The bigger threat is inflation – an economy with too little labour trying to meet too much demand.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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