Economic and housing predictions for 2012: Craig James

As we look back on 2011, Property Observer is republishing some of our most noteworthy stories of the year.

Murphy's Law states: Whatever can go wrong, will go wrong. And clearly 2011 could be best described as the year when Murphy's Law reigned.

First there were significant floods across eastern Australia as well as disruptive cyclones across northern Australia. Coal production in mid-north Queensland was hampered over much of the year while banana production was decimated again in north Queensland.

There were earthquakes in Japan and Christchurch, New Zealand. And it wasn't just an earthquake in Japan, but it precipitated a tsunami and nuclear disaster. Japanese production of cars and car parts was severely disrupted, only getting back to near normal late in 2011.

There were also volcanic eruptions in Chile that resulted in ash clouds moving across Australia, disrupting air traffic.

And it wasn't just natural disasters that dominated but fresh economic crises. The European Debt Crisis reigned over the second half of the year and political wrangling was also able to precipitate fresh problems for the US economy over the year, prompting one rating agency to downgrade the US credit rating.

Not only did Australian businesses, investors and consumers have to contend with overseas issues, there was also the uncertainty caused by proposed carbon and mining taxes. Is it any wonder then that Australian consumers refused to spend, that economic growth proved sub-standard, that the sharemarket failed to fire and that the Reserve Bank switched its focus from rate hikes to rate cuts?

Economic and financial forecasts miss targets

With the benefit of hindsight it is clear that our economic and financial forecasts were overly optimistic.

Economic growth was tipped at 3.5% in 2011, with unemployment seen at 4.5% by the end of 2011 with the cash rate at 5.5% and sharemarket at 5,400. In a 'normal' year without the European Debt Crisis and natural disasters these forecasts would have stood a good chance of success.

In fact around mid year they were still largely on track.

The economy may have expanded 2.75% in 2011 while unemployment will be nearer to 5.25%, the cash rate will be 4.25-4.50% and the sharemarket will be closer to 4,400 points.

The good news is that inflation will probably end 2011 near the forecast of 2.75%. But the Aussie dollar forecast of US92c will be exceeded with the currency near US102c. We had expected the US recovery to be underway with investors looking to higher US interest rates and thus underpinning a stronger greenback. Still it's worth noting that just a few days ago the Aussie was below US97c, and seemingly headed lower.

Forecasts for 2012

As always, it is not the numerical forecasts that matter most. Rather the importance lies in the assumptions taken, the likely direction for the variables and the risks.

We assume that the European Debt Crisis will still dominate over the first few months of 2012. Clearly the "end game" could take a number of forms include the collapse of the euro zone. We assume that self-interest will predominate and that the euro zone will remain intact. Countries will set about the task for reining in deficits and stabilising debt levels as a proportion of GDP.

We also expect that the US economic recovery will continue and China will ease monetary policy, thus boosting growth prospects. The Australian economy should remain in balance with strong investment spending weighed against "average" growth in consumer spending and housing activity.

Risks abound – and mostly to the downside. Political wrangling could lead to the collapse of the euro zone while politics may also stifle the US economic recovery. In Australia, there are also some upside risks. Rate cuts could cause Aussies to spend again and buy and build homes. As a result stronger consumer and housing activity may coincide with strong business investment, especially in mining regions.

We tip 3.6% economic growth over 2012 – above the norm of around 3-3.25%, but from a low base. Underlying inflation should drift up over the year but remain below 3%, thus allowing interest rates to remain low. Unemployment should hold in a 4.5-5.5% range over the year.

The Aussie dollar is expected to drift lower to around US95c in the first half of 2012 as weak European economic growth restrains global economic growth. But the Aussie is expected to again be near parity with the greenback in late 2012.

While we would like to be more positive about sharemarket prospects, we retain a "soft" target for the All Ordinaries of 4,650 at the end of 2012. Aussie investors are expected to only slowly embrace stocks again over 2012 while global economic uncertainty and a firmer Aussie dollar will also restrain enthusiasm of foreign investors for Australian stocks.

The big issues for 2012

What will be the "end game" in Europe?

Clearly if investors wanted an answer to one question, this would probably be it – the likely "end game" in Europe.

If you had utmost confidence that the euro zone would break up in the next few months, then no doubt you would be positioned for sharp falls in Australian interest rates, the Aussie dollar and the sharemarket.

But clearly it is possible that European nations would elect for closer fiscal integration and a more active role for the European Central Bank. In the US and Australia there are significant differences in economic conditions and incomes across states, territories and regions. But there is still a common federal tax base in both countries together with a federal budget and debt position. A United States of Europe clearly needs to move to the next step of a more centralised fiscal position while the European Central Bank needs to have similar powers to the Reserve Bank or US Federal Reserve.

If the European Central Bank had a stated determination to buy Euro debt in unlimited quantities, then the crisis of confidence would end. Investors would have confidence that they would get their money back. But that ECB commitment would require individual countries to deal with deficit and debt problems, and presumably would need some central enforcement to ensure countries were meeting their commitments.

Self interest will play a strong role in keeping the euro zone together. Germans may decry the lack of fiscal discipline in southern Europe but if Germany left the euro and adopted the Deutschemark, exporters would no doubt have to contend with a far stronger currency.

And countries like Greece and Italy would clearly face far more difficult economic problems if they left the euro zone and didn't have access to the wider group's resources and support mechanisms.

But while the "end game" in Europe is the number one issue moving into 2012, we also need to keep it in perspective. The fundamental worry is one of contagion. That is, if Greece or another country defaults on its financial obligations then banks and other investors lose money and are forced to call in loans, liquidate assets and withdraw from financial markets. The knock-on effects will be felt across the globe.

But in terms of economic growth, China, India and other countries in Asia and the emerging nation grouping, still hold the whip hand. While on-going problems in Europe could restrain global economic growth, emerging nations would respond by stimulating activity. A raft of countries survived Global Financial Crisis Mark I and there's no reason why they can't deal with GFC II.

So what? Arguably this is the biggest issue for investors in the early months of 2012. Of course the seemingly impossible could happen and European nations could fundamentally deal with the issues over the next few weeks.

But the European "end game" will affect the trajectory of the global economy and may ultimately decide if investors stay in cash-based assets or move back into shares.

How real and sustainable is the US economic recovery?

Recent economic data has proved encouraging. Consumers are spending, jobs are being created, companies are still making money and are well cashed-up and housing markets appeared to have stabilised. The sharp fall in the unemployment rate from 9 per cent to a 21/2 year low of 8.6% is certainly encouraging.

Still, on the other hand there is still an over-supply of US homes, more foreclosed housing stock could be pushed onto the market as prices stabilise, the budget deficit remains high and 2012 is an election year – adding more uncertainty to financial markets, especially in the latter half of the year.

Economies are influenced by "fundamentals" like population growth, productivity and the supply demand balance in markets, such as labour and housing markets. But economies are also influenced by "animal spirits" or confidence. If the European Debt Crisis is resolved, China continues on the path of industrialisation and there are no new "crises" in the US, businesses and consumers will get greater confidence to spend, employ and invest again.

So what? If the US economic recovery proves sustainable and actually gathers pace, this may lead to a stronger US dollar and that would provide headwinds for the Aussie dollar. A pick-up in the US would also be positive for US-reliant stocks like Westfield, News Corp,
James Hardie, Billabong and CSL.

Is there some "X-factor" that will derail China?

When it comes to China, investors can't seem to win. If the Chinese economy is growing strongly then there are fears of "bubbles" developing, such as in property markets, as well as fears that the economy will 'overheat', leading to higher inflation.

And when authorities take the necessary steps to slow the pace of the economy, the concern is that they end up being too successful, causing momentum to stall. So investors can't win – either the economy is growing too quickly or too slowly.

However even excluding the polarisation of views on the economy, there are still other concerns. Some worry about social and political stability. And indeed authorities are mindful that they do need to keep the Chinese people happy in an economic sense, otherwise they will start to compare personal and social liberties with those of other countries. Authorities need to ensure that people have jobs, incomes are rising, and quality of life continues to improve.

Apart from social stability, other "X factors" include banking sector failures, failure of local or regional governments or other bodies due to scandal or financial crisis, ethnic violence or uprising or geopolitical disputes with foreign powers.

So what? China is the second largest global economy. It is also the biggest driver of the global economy and Australia's largest trading partner. Arguably a crisis in China that serves to derail economic momentum would prove more damaging for Australia that a break up of the euro zone.