What do the equity markets know that the politicians do not?

 Much has been said (by politicians and economic commentators alike regarding the performance and resilience of the Australian economy throughout the turmoil of the global financial crisis and subsequent European sovereign debt crises. In particular, the relatively low level of unemployment experienced in Australia and the fact the Australian economy did not officially reach recession status at any stage over the past four years (a recession being two quarters of consecutive negative GDP growth).

While politicians continue to tell us that Australia is the envy of the western world when it comes to economic performance and management, it would seem the performance of the Australian share market throughout the same period tells a different story.

As a general theory, the share market should reflect the state of the economy given share market performance is broadly based upon the profit expectations of the companies that form the share market. Companies tend to make larger profits through economic good times and lower profits through economic downturns.  Therefore the higher the expectations for future company profits (due to the expected performance of the economy), the higher the markets should push.

Let’s look at the performance of the US equity market versus the Australian equity market over the past five years. To assess the performance of the Australian market we will use the ASX200 index which tracks the movement of the top 200 companies of the Australian share market.  For the US market we will use the S&P500 which tracks the movement of the top 500 companies of the US share market.

Chart 1 details the dramatic drop (52% decline) in the share market from October 2007 to March 2009, as well as the subsequent rally to March 2010.  Using the monthly closing price for analysis, the chart reveals that the Australian market has rallied 50% off its March 2009 low. The equivalent rally of the S&P500 has been 86%, a significant out performance when compared to the Australian market.

Chart 1: S&P/ASX – Monthly Line Chart

Chart 2: S&P 500 Cash – Monthly Line Chart (Close)

Why is there a large variation in equity performance despite the strong performance of the Australian economy when compared to the US economy?

A key reason is the relative performance of the Australian dollar when compared to the US dollar. A strong Aussie dollar makes it harder for Australian companies to compete overseas placing a drag on profit and share price performance.  The US has worked extremely hard at depreciating their dollar against other key currencies (very low interest rates coupled with increased money printing helps keep the dollar down) in order to prop up the competitiveness of their domestic companies so as to support jobs growth. To date, this strategy has proved effective when considering share market performance however the flow on impact to jobs growth is only starting to have some traction.

The equity markets know a consistently strong Aussie dollar is not positive for the performance and sustainability of corporate profits. As a result we are starting to see Australian companies cut Australian jobs in order to manage costs and endeavour to maintain their competitiveness against overseas companies.  Politicians (and the RBA) should therefore start directing more of their energy at ways to depreciate the Aussie dollar to help our local battlers compete on a more level playing field with their global competitors which is much easier said than done.

Luke Havelberg is the Manager of Treasury Balance Sheet.

Filed under: Finance