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Australia is widely regarded as having the most successful economy in the developed world, so shouldn't its share market be just as strong?
Australia’s relatively successful economy, it could be argued, should create greater scope for profitability for resident businesses and this should in turn be reflected in superior share price growth.
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However, the relative performance of share markets around the globe in recent times has not always been consistent with measures of relative economic health. Australian investors, for example, may wonder why their stock market showed no growth in 2010, yet the United States (the home of the GFC) experienced an increase of 13 per cent in its S&P 500 Index.
There has, however, been little measurable correlation between economic growth and share market performance over the past three years. There are a number of reasons as to why this may be the case. Importantly, share markets are forward looking and should react to changes in expectations for future growth, rather than the actual growth being recorded in the current period. The growth outlook for European and the United States economies deteriorated markedly from late 2007 onwards; however, their share markets have performed on a par with those of Australia and China, where strong growth expectations have been largely retained.
THE IMPORTANCE OF POLICY SETTINGS
Share markets, it would seem, are highly sensitive to changes in macro-economic policy settings of governments. When loose economic policy prevails, interest rates are low, governments inject demand into the local economy and exchange rates will often fall because of the lower interest rates. This creates an environment that is conducive to improved company earnings. In addition, loose policy is allowed to prevail by authorities when inflation is weak and therefore there will be minimal cost pressures on businesses. Hence whilst loose policy will typically be introduced when economic growth is weak, the environment created by the policy can be quite favourable for company earnings.
POLICY TIGHTENING
It has been those economies (such as Australia and several emerging markets) that have recorded healthy rates of economic growth, where authorities have been forced to commence a tightening of policy in order to assist with the management of expected inflation. Higher interest rates, exchange rate appreciation and an inflating cost base are some of the negative implications of stronger economic growth that companies residing in higher growth countries need to deal with.
These negative implications of stronger economic growth no doubt help explain some of the recent under performance of emerging markets and the Australian market.
A LONG TERM FOCUS IS REQUIRED
There is perhaps an element of short term focus in heavily penalising share markets impacted by policy tightening. Ultimately, the aim of tighter policy is to increase the sustainability of economic growth and avoid runaway inflation. Economies that are maintaining loose economic policy will eventually have to tighten and if this is done too late, the inflationary consequences would not be favourable for locally listed companies. In addition, as was evident in Australia through the GFC, an early tightening of policy provides the capacity for authorities to loosen policy in the future to manage an unforeseen shock or event. Hence, share markets of those economies already running tight policies (such as Australia) should therefore be seen by investors as carrying a lower cyclical risk for the future.
