New decade, new challenges

Contrary to the expectations of the gloom and doomsters, 2010 turned out to be a positive year. The global economy expanded by around 4.5%, the world didn’t slip into recession and global sharemarkets generally rose.

Sure, the year wasn’t without its problems. Investors fretted about a double-dip recession in the US, European debt, and an over-heating of the Chinese economy. But worse case scenarios were avoided.

Australian interest rates rose over 2010 and probably will again in 2011.

At face value, the Australian sharemarket disappointed. But in large part that’s because the Aussie dollar soared – the second strongest currency in the world over the year. In US dollar terms, the Australian sharemarket actually out-performed the ‘world’ index.

A look at the big issues

In the end, 2010 didn’t turn out too bad after all. I suppose you may not totally agree if you live in Greece or Ireland, but taking a broader perspective, 2010 has turned out to be a useful period of consolidation. Certainly the global economy expanded by around 4.5% – above the longer-term average growth rate. And growth of the order of 4% is tipped for 2011.

In large part the solid performance of the global economy is due to developing or emerging market economies. And this is something that investors will need to get used to. Countries like China, India and Brazil will be driving the global economy from now on. The year 2010 will be noted for the fact that China became a dominant feature on investor radar screens across the globe. China became the second largest global economy and bets are being placed on when it will take top spot. Some are speculating on the year 2019. Certainly the release of monthly Chinese economic data is now a key event for analysts and investors.

In Europe and the United States, much of 2010 was spent focussing on high budget deficits, high debt levels and soggy economic growth. Many European economies are putting priority on tackling budget and debt issues through austerity measures. In the US, the aim is to achievable sustainable improvement in the economy first, and then deal with debt issues later. The jury is out on which approach will be successful, but the US strategy appears to have the best potential.

In Australia, the Reserve Bank was determined to lift interest rates to more ‘normal’ levels. It achieved this objective in May and then moved to tighter policy settings in November. The cash rate was lifted from 3.75% to 4.75% over the year but the bank mortgage rate rose by 1.5 percentage points to 7.80%.

Looking at the economy, the feature was a tug-o-war between domestic and external issues. The Reserve Bank continued to fret about the boost to our incomes from the “terms of trade” – ratio of export prices to import prices. Prices of our exports are soaring due to demand from China. Prices of imports are falling because of the higher Australian dollar. All this should mean we are richer. The good news is that we are choosing to save the proceeds rather than spend it.

While the mining and engineering sectors are benefiting from the China effect, other sectors aren’t doing as well. Consumers decided to close their wallets in 2010, hurting retailers. Both the manufacturing and services sectors are currently going backwards according to the latest surveys. Residential construction is slowing. And export sectors are facing the headwinds applied by the stronger Australian dollar. Clearly this tug-o-war will continue in 2011 and the Reserve Bank will need to carefully weigh up the competing forces.

The Aussie dollar did go from strength to strength over the year. It started 2010 around US89c and in US trade on December 31 the Aussie hit fresh 28-year highs above US$1.02. The Australian dollar also hit 25-year highs against Pound Sterling and 21-year highs against the Euro also on December 30. The Aussie owes it strength to Chinese export demand, a firm economy and the highest interest rates in the developed world.

For sharemarket investors the year started with promise. But then European debt concerns emerged. And the world started to fret about a double-dip recession in the US. And the rising Aussie dollar kept foreign investors away. Overall, the Aussie sharemarket ended the year slightly weaker after solid gains in 2009 (actually the best increase in 16 years).

Interestingly it was another year in which bonds and residential property fared better than shares. That situation may not continue into 2011.

So what lies ahead? Interest rates could rise by around three-quarters of a percentage point in 2011 but the Reserve Bank won’t be in a rush to lift rates. The sharemarket should keep clawing its way back towards the late 2007 peak, lifting around 15% to 5,400.

The jobless rate should end 2011 lower, around 4.50%. But, as always, the currency is the hard one to pick. Our CBA currency strategists are tipping the Aussie to ease over 2011 as the US economy recovers and interest rates are increased. The strategists tip a level around US90-95c by end year.

Our economy

The Australian economy continued to expand over 2010. The economy grew by 0.7% in the March quarter, 1.1% in the June quarter and 0.2% in the September quarter. Annual growth stands at 2.7%, and growth for the full year will be around the same magnitude.

This outcome is good, but not great. “Normal” economic growth is around 3.0-3.25%. But the important point is that the expansion is continuing. There hasn’t been a recession in Australia for over 19 years.

In 2009 the Reserve Bank and Federal Government stimulated the economy to keep it out of recession. In 2010 that stimulus was withdrawn. The private sector is attempting to take up the baton from the public sector, but with mixed success. Consumers are reluctant to spend. And, outside the mining sector, businesses are reluctant to invest.

But businesses are certainly hiring. The unemployment rate stood at 5.2% in November, down from 5.6% a year earlier. And the inflation rate also ended the year lower at 2.8%. Both headline and underlying inflation are currently in the Reserve Bank’s 2-3% target band.

Inflation and economic growth both eased in 2010 due to higher interest rates. In October 2009 the cash rate stood at a 49-year low of 3.00%. But then the RBA embarked on a process to remove the emergency stimulus, lifting the cash rate by a quarter of a percent in October, November and December 2009, and then in March, April, and May 2010 and following it up with the move in November, taking cash to 4.75%.

After growth of around 2.75% in 2010, the Australian economy is tipped to grow by 3.25-3.50% in 2011. Investment is tipped to drive the economy over the year and consumer spending will also probably lift modestly. Housing construction should be flat but commercial construction is tipped to recover.

International economies

The International Monetary Fund calls it a “two-speed” economy. But just like in Australia, the global economy is very much multi-speed. Small European economies are contacting, the UK is recovering but Germany and France are in better shape. Japan continues to muddle along. The US economy is improving, with recent data showing that claims for unemployment insurance are at two-year lows.

But it is the developing or emerging nations that led the way forward in 2010 and will continue to do so in 2011. China is driving the global economy, the main concern being whether the authorities will continue to be successful in keeping inflation low and growth at a solid, sustainable pace.

The International Monetary Fund currently estimates that the global economy expanded by 4.8% in 2010. But while advanced nations likely grew by 2.7%, emerging nations probably grew by 7.1%.

The IMF expects the global economy to grow by 4.2% in 2011 with advanced nations lifting by 2.2% and emerging nations expanding by 6.4%.

The Economist magazine regularly compiles forecasts by major institutions, covering 58 countries across the globe. On average forecasters tip the US economy to grow by 2.6% in 2011 after growing by 2.8% in 2010. The Euro area is expected to grow by a more modest 1.4% in 2011 after lifting 1.7% in 2010. And Japan is tipped to grow 1.3% in 2011 after expanding by a surprisingly strong 3.2% in 2010.

Forecasters believe that China will grow by 8.9% in 2011 after growth of 10.2% in 2010. And the Australian economy is tipped to grow by 3.5% in 2011.

Currency and commodity markets

The US dollar moved into and out of favour over 2010 depending on the predominant theme at the time. When the European debt crisis raged over April and May, the greenback lifted. But when optimism returned, the US dollar lost favour to currencies that are more dependent on China and overall global economic growth.

Of the 120 currencies monitored by CommSec, the Mongolian tugrik was the strongest currency against the greenback over 2010, up 14%. Next strongest was the Australian dollar, up 11.7%, followed by the Japanese yen, up 11.6%. What do the currencies have in common? All benefit from a strong Chinese economy. Similarly the fourth-placed South African rand. Asian currencies dominate the top positions of the currency leader-board with currencies from Malaysia, Thailand, Taiwan and Singapore all posting firm gains.

At the other end of the scale, African and eastern European currencies have fallen most against the greenback over 2010. The Ethiopian birr slid just over 30% against the US dollar in 2010 with the Uganda shilling down 22%. The Euro was the 11th weakest against the greenback in 2010, down 9%.

It may seem like the Aussie dollar had a volatile time over 2010. But actually the year was far from extraordinary and certainly significantly less volatile than the past two years. It’s worth noting that the Aussie tracked over a range of around US38 cents against the greenback in 2008 and a near US32 cent range in 2009. In 2010, the range in 2010 was just over US21 cents. The Aussie hit lows of US80.65c on May 25 in the midst of the European debt crisis, before scaling peaks of US$1.02 on December 31. Certainly the ‘red letter’ day for the Aussie was October 15 when it cracked parity with the greenback for the first time in 28 years.

Across the asset classes, once again commodities posted strong gains in 2010. The CRB futures index lifted by 17.4% after a 23% gain in 2009. Among the strongest commodities was cotton, up 124%, with palladium up 97%, silver up 83%, thermal coal up 50%, wheat up 47%, iron ore up 45% and beef up 38%. Interestingly gold rose by ‘just’ 29.7% with oil up 15%.