The economic outlook for 2006

The global boom seems set to continue in 2006, which means Australia’s resource boom will continue also. There are risks, to be sure, but overall it is not clear that the risks are rising. Indeed, there is the prospect that the world economy is in a “sweet spot” and that slower growth in, say, the US and China might be offset by faster growth in Japan and (more surprisingly) in Euroland.

The key to continued global boom is that various “imbalances” remain under control. Inflation is the most general imbalance, and rising inflation has brought other global boom times to an abrupt end. Despite large increases in the prices of oil, gold and other commodities, high productivity growth in the production of many finished goods has kept general indices of goods and service inflation stable. The world economy was awash with liquidity as the US Fed adopted an easy monetary policy during the US recession of 2001. But the Fed has steadily withdrawn the monetary stimulus in a “measured” way and in the process (and allowing for at least one more rise of 25 basis points) moved US monetary policy more nearly to neutral.

With the price of many goods and services pegged by rising productivity, the excess liquidity raised asset prices, including the prices of houses, commodities and shares, all cases in which strong demand has coincided with relatively fixed supply. This asset price inflation - especially house price inflation in the developed nations - is a major imbalance with the potential for a sharp reversal to induce recession. The logic here is simple - consumers have been spending more on the basis of growing wealth, particularly in the form of housing wealth, and if there were a sharp drop in the value of the housing stock, consumers could be expected to go into their shells. So far at least falls in house prices have been modest and consumption has continued to grow in the developed nations.

Share and commodity prices have in fact continued to rise in most countries - the US being a conspicuous exception in 2005. Strong share prices have maintained consumer confidence and also financed an expansion of business fixed investment (as well as share buy-backs which have increased the buying power of wealthier consumers). Increased business investment has included spending to enhance capacity (as well as growth by acquisition) by resource companies in particular. This process has boosted the economies of Australia, Canada, the US and other countries where mining looms large.

Recovery in Japan has been helped by growing demand for manufactured goods but also by the end of 15 years of deflation. The Japanese banks have improved their balance sheets and are able to finance business expansion. In 2005, the Japanese stock market was one of the world’s strongest, with the Nikki index rising by more than 40 per cent.

Euroland has also shown greater strength, led by what one expert called a “micro recovery” in Germany as numbers unemployed have fallen and consumer confidence has risen. Development in Europe will bear careful scrutiny as stronger growth there would add to the overall inflationary risk.

China has been, with the US, a major engine for global growth, with India having an especially strong effect in raising the demand for raw materials. The Chinese authorities have in fact been attempting to slow the overall pace of demand and to deal with severe environmental problems as well as tensions caused by rising inequalities as some Chinese citizens become quickly and obviously far wealthier. The possibility of environmental or political upheaval in China is real enough in the longer term, but most experts predict continued strong Chinese growth for the foreseeable future, with perhaps some slowing - for example, from annual growth of 10 per cent to 8 per cent - in 2006. (Note that China has just materially increased its estimates of both the level of Chinese GDP and the pace at which it has been growing.)

One of the points for debate is whether the US economy is set to slow dramatically during 2006 and therefore whether US interest rates are more likely to continue to rise or to fall. A slowdown is certainly possible but there is a lot of momentum built on the twin pillers of fiscal and monetary expansion and powerful forces raising productivity in many sectors.

My money is on only a slight slowing of growth in both the US and China; with Europe and (especially) Japan (along with India, Russia and several countries in Latin America) growing faster, the chances are strong of continued rises from already high levels in the prices of oil, gold and other important commodities. With commodity prices already at high levels, there will be plenty of room for nervousness and perhaps greater volatility in the prices of notoriously volatile resource equities and in the prices of shares in countries such as Japan that are heavy resource users.

Another point for debate concerns the likely path of global interest rates. 2005 saw a belated rise in US and in most other bond yields. If one expects continued strong global growth then there is plenty of room for global interest rates to rise further. Those in the strong US slowdown school will be more inclined to see stability in interest rates or even falls from current levels, but these are not in our view high probability outcomes.

Currencies will remain volatile, representing as they do a set of relatively free and highly liquid markets that often act as the safety valve for volatile expectations. The Chinese currency is on the first steps to relative freedom and should show a tendency to appreciate against most others. The large US current account deficit should induce a tendency for US dollar depreciation but many people of a similar view were confounded during 2005. During 2006, the likely slowing in the pace at which US interest rates increase (signalled with the release of US Fed minutes in early January) is likely to represent a weakening of one support for the US dollar. The yen should be strong as the Japanese economy strengthens and the Euro may surprise on the upside as the Euroland economy strengthens.

The wild cards for 2006 are not unlike those that threatened prosperity in 2005. Bird flu, major terrorist attacks, the resurgence of global inflation, big drops in commodity prices, a crisis in the Chinese economy are all examples of low probability events that could derail the generally positive outlook. The rumours that the US may be poised to attack Iran are particularly disturbing.

We must hope for the best but be cautious in our investment strategies in case one or more of the potential negative shocks occurs in 2006.