Next Stop Recession?


At the beginning of this week I rated the Reserve Bank of Australia, under its saturnine head Glenn Stevens, one of the best performing central banks in the world. Australia, it seemed, would be able to ride out the financial storm that was spreading from US sub-prime mortgages to London and all the way to Iceland, Russia and Belgium.

So far, Australia has managed to avoid the worst recesses of the current crisis. No Australian bank has got serious trouble, and the Australian financial system is in surprisingly sound health. Australian growth is still robust. Although the shareholder wealth of a few highly leveraged firms like MFS, Centro, Allco, Babcock and Brown and ABC Learning has been demolished, this has looked like the normal creative destruction of a market correction, not the systemic risk witnessed on Wall Street and the European bourses.

Today, I’m not so sure about the Reserve Bank. The shock decision to lower rates by a full 1 per cent left nearly every analyst, trader and broker gobsmacked — at least until they started to cheer. This "bold" action of Glenn Stevens stemmed losses on the ASX for half a day — an aeon in the current environment — and even prompted advances in the price of some heavily discounted financial stocks.

In normal times, a move like this would signal a turning point and the market would roar back into bullish mode. But these are not normal times.

After the party, the hangover. Overnight, stocks on Wall Street fell another 5 per cent, adding up to cumulative losses on the Dow Index of 13 per cent over the last five days. US financial stocks are trading at 1997 levels — in other words, they have now lost a stunning 11 years of value. Meanwhile the UK Government has announced a ₤50 billion bailout of its own financial sector after the share prices of the biggest banks — like HBOS and the Royal Bank of Scotland — collapsed. Meanwhile, Iceland has shut its stock exchange and the entire banking system of Iceland looks to be insolvent.

Australian stocks opened lower and kept falling, wiping out all of yesterday’s gains. The ASX is heading below 4400 and no-one knows where the bottom will be.

"People are just throwing up their arms in despair," Alex Moffatt, director at Joseph Palmer & Sons, told Fairfax. "We’re seeing pretty close to capitulation selling."

In the current environment, there was always a chance that even a massive cut like this latest from the RBA would have only a minimal effect. The US Federal Reserve cut interest rates aggressively after the Bear Sterns collapse, but the effect was only transitory. With everything that is happening in Europe, it now seems unlikely that an interest rate cut of any magnitude will restore confidence in a banking sector haemorrhaging shareholder value, even one that is essentially sound and well capitalised like Australia’s.

Even without dramatic collapses or bank runs, the credit crisis is remaking the Australian banking sector. Smaller Australian banks and mortgage lenders are now disappearing into the maw of their larger competitors at a rapid clip. Westpac gobbled up RAMS Home Loans last year after that company’s funding sources completely dried up. It then moved first to takeover St George, for a price that now seems optimistic. Today, Commonwealth Bank of Australia announced it would buy BankWest from huge British bank HBOS, which is grave danger of going under after its shares were pummelled on the UK stock exchange earlier this week. Suncorp is in play with several banks sizing it up for a takeover.

The real concern about the 1 per cent cut is what it tells us about the RBA’s thinking. Frankly, they must now be expecting a downturn. Remember that the RBA hiked up rates last year to contain inflation, which is in fact still running at 5 per cent. But now any thought of fighting inflation seems to have been abandoned: to quote the RBA’s statement, "The recent deterioration in prospects for global growth, together with much more difficult market conditions even for creditworthy borrowers, now present the risk that demand and output could be significantly weaker than earlier expected. Should that occur, inflation would most likely fall faster than earlier forecast."

Translation: the RBA is now worried about the prospects of a global recession. Very worried. So should we all be. Today’s release of consumer confidence figures shows how the global financial crisis, which has gripped the international business media with understandable fascination, is affecting domestic consumers. Unsurprisingly, consumers are putting their wallets back in their pockets. In the last few days I’ve had several friends ask me if their bank savings are safe.

And some of the biggest falls on the ASX lately have been among mining stocks. Why? Because commodity prices are tanking. Only a year ago, commentators and mining executives were talking about a 30 year "supercycle" for commodity prices which would buoy the earnings of mining companies almost indefinitely. That kind of euphoria now looks as outdated as the much-vaunted "Macquarie model." Macquarie’s shares have been fallen through the week.

The elephant in the room is Australian housing prices. These are now grossly over-valued in comparison to markets like Ireland, the UK, and US, which have all experienced crushing asset price deflations as their house price bubbles have deflated. In western Sydney, many mortgagees are already "underwater" — in other words, the mortgage is worth more than the house. This is precisely the problem that is now ravaging US consumer spending. If Australian house prices fall at anything like the rate seen overseas, there will be widespread pain.

It’s just as well Australia has high interest rates and a big surplus. We’re soon going to need to spend money aggressively — and the Reserve Bank will need to cut rates again.

Ben Eltham is New Matilda's National Affairs Correspondent.