Headwinds cause markets to react

Matthew Sherwood, Perpetual’s Head of Investment Market Research examines the impact of slowing Chinese growth and elevated sovereign debt in the Northern Hemisphere on global sharemarkets. After reaching 18 month highs in mid-April, global sharemarkets have had both good and bad news – but investors have focused on the negative, dragging down market sentiment and share prices.

The tailwind: The global economy is recovering strongly
Global industrial production is currently running at 12% per annum and consumer spending is improving. Rising consumer spending in the US has boosted the recovery in the manufacturing sector which has spread to the broader US economy.

Meanwhile, households appear to be reducing debt, which creates opportunity for future spending growth. Businesses also remain in a position to lift spending following large capital raisings and high profits over the past 12 months.

The headwinds: European debt, China and the resource profits tax
Despite this good news, investors have focused on the headwinds challenging the economy and investor sentiment has deteriorated over the last month. Recent events, such as European debt concerns, a potential slowing in China and debate over the resources profits tax, have driven shares down.

However, markets have been discerning, with the pace of decline led by European markets where government debt stress is the most significant (see Chart 1).

1. European debt crisis
Over the past month, markets have been focused on the economic and financial market consequences of Greece’s government debt problems and the possibility of this spreading to other highly indebted members of the European Union (including Portugal, Spain, Ireland and Italy).

Could this become another financial crisis?
The European Central Bank and International Monetary Fund have developed a €750 billion stabilisation package designed to assist the highly indebted economies over next three years. So, this is unlikely to turn into another global financial crisis – the global economy (outside Europe) is expanding, interest rates are at record lows and the debt involved in these European economies is modest relative to that of the US housing market. Also, while the issues in Europe are different to those that triggered the US crisis in 2008, the European authorities appear to be getting ahead of the problems much earlier than the US did.

Despite these factors, investors are yet to be convinced that enough has been done in the European crisis. The lack of competitiveness and high production costs in the Greek economy mean that there is still a large risk of default after 2013 (when the rescue packages expire) and the country faces major resistance to policy change, suggesting it will need major assistance for a quite some time.

Nonetheless, the damage of the European debt crisis has to date been contained to Europe – unlike the US crisis which had more widespread effects.

2. China
China has been artificially inflated since 1997
Like Europe and the US, China is likely to experience softer growth over the next few years – but for different reasons. China has grown its economy at 10% per annum for the past 10, 20 and 30 years. While this is very impressive, its economy has been artificially inflated since the 1997 Asian financial crisis by interest rates that have been kept extremely and deliberately low. This cannot continue as these low rates have led to sharp spikes in property prices where a bubble may have developed, inflation and an unsustainable surge in investment.

Chinese property prices have surged over the last six years and the government is trying to boost supply to ease price pressures. If growth suddenly turns negative, this could cripple the fragile Chinese financial system, given the US$ 1 trillion worth of bank loans to the financing arms of local government authorities. These vehicles need rising property prices to contain solvency issues and it is an extremely delicate balancing act to take the heat out of the Chinese property market without causing enormous turmoil in the Chinese financial system.

Investment growth needs to slow
Chinese investment is simply growing too fast and the government has acknowledged that this needs to moderate. Investment is around half of Chinese economic growth, relative to 18% in Australia and 8% in the US. If the Chinese economy is to reduce investment’s contribution to growth, it could slow iron ore consumption and hurt mining exporters including Australia and Brazil. Such a slowdown in Chinese investment is not in Australia’s best interest.

3. Resources rent tax
The primary focus of the Australian Government’s response to the Henry Tax Review has been the super profits tax on the mining sector. Market analysts have estimated this tax would reduce the value of the mining sector by around 8%-15% (including the impact of a lower corporate tax rate) if implemented. Lower profits would naturally lead to lower investment and reduced dividend income for investors. This is most likely why Australian metals and mining stocks have experienced a larger decline than their global peers, since the policy announcement (see Chart 2).


Rarely has a government announcement had such a detrimental impact on shareholder wealth. The proposed arrangements would place the total tax paid by Australian mining companies at around 57% which is well in excess of the total taxes paid in other mining-based economies, for example Canada (23%), Chile (26%), China (30%), South Africa (33%), Brazil (38%) and the US (40%). This will make it more attractive for all Australian mining companies to invest overseas and is likely to reduce investment in Australian-based projects.

What do these headwinds mean for investors?
Growth in Europe, the US and China is likely to moderate. The Northern Hemisphere debt crisis is an issue that will plague markets for years to come and is likely to restrict economic growth in Europe, and the US and Japan (which have similar debt concerns). Meanwhile, a moderation in Chinese growth is likely to have investors nervous for a time and needs to be factored into market expectations. While analysts tend to label every major global headwind as ‘unprecedented’, all the crises over the years have eventually ended, growth resumed and sharemarkets recovered. The long-term rationale for remaining in shares remains at present – global economic growth is solid, earnings growth is recovering, interest rates are low and valuations appear to be attractive.

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