Financial Markets-2007 in Review and What to Expect in 2008

It has been an eventful and volatile year for financial markets. There have been three significant share-market corrections, one of which is still underway. In addition, exchange-rate markets have been extremely volatile, with the biggest story being the chronic weakening of the US dollar. Gold has gone within a whisker of its all-time highs of 1980 and oil prices are currently flirting with what only a year ago seemed a remote possibility - US$100 a barrel.

The first two share-market corrections occurred because markets were overvalued. Overvalued markets do not have to fall, but while they are overvalued they are vulnerable to shocks, and these shocks can take surprising forms. At the beginning of the year, very few would have predicted that the two catalysts for share-market corrections would have been a fall in the Shanghai share market (which doesn't even matter all that much for the Chinese economy) and US sub-prime mortgages. The third correction, if that's what it is, appears due to continuing concern about the sub-prime issue, and the possible knock-on effects on the US economy, and hence on corporate earnings.

History, of course, teaches that one should buy the dips, but it's very difficult to apply that lesson optimally in real time as markets weaken.

The Australian market, as it always does, followed overseas markets down. Between mid-July and mid-August, the ASX 200 fell by about 13%, and then recovered so quickly that it hit a record high in October. While the Australian market will continue to react to overseas market developments, it also dances to its own tune these days, with commodity prices being an important consideration (see below). At time of writing, for example, the Australian market is up more than 10% year-to-date, while the US market has made no net gains at all.

A word of caution about the Australian market: we usually trade on a lower price/earnings (P/E) ratio than the rest of the world, mainly because of the relatively large size of both the financial and resource sectors. Right now, the Australian P/E ratio is higher than that for the world on average. This suggests that the Australian market is starting to look relatively expensive.

Commodities

Commodity prices continue to be strong. Forecasts show base metal prices remaining close to their current levels for some years. Meanwhile, iron ore and coal contract prices are expected to rise further over the next year, with ore contract prices expected to rise by 30% in April 2008.

This would suggest that there is still some potential upside to the resource sector. In particular, the recent takeover activity in the sector suggests that the players themselves remain optimistic.

What's going on with the extraordinarily strong Australian dollar? The chart shows something quite remarkable. The red line is the Australian dollar as a fraction of the US dollar (look to the right scale). The blue line is a trade-weighted index (TWI) of the $US, measured against the currencies of the developed world, with weights determined by the amount of trade done by the US with each country (look to the left-hand scale). That line is inverted, so that it goes down when the $US strengthens and up when it weakens.

The chart demonstrates that for most of the past seven years, the $US has been the principal driver of the $A. Since March of this year, the story has been somewhat different, with the $A first rising sharply, apparently because of strong commodity prices and because of the "carry trade," whereby money is borrowed in low-yielding currencies, such as the yen, and invested in high yielders, such as the $A or Kiwi. Then, in the flight from risk in mid-July, the $A fell again, to less than 80 cents. Order, it appeared, had been restored, but then the carry trade took flight again, and the currency was pushed to a 23-year high of 94 cents, albeit for a nanosecond. There was even some loose talk of parity. In recent weeks, the $A has been in retreat again, and now sits close to 87 cents. The chart suggests that "fair value" is around 85 cents, although fair value will rise should the $US continue to fall.

Investors probably worry too much about the currency. It's true that it may rise or fall by a few cents, which has implications for overseas holdings. But surely it is more important that it is strong right now, which means that the rest of the world is on sale for Australian investors!

Is there a bottom line to all of this? With markets reasonably fully valued, the Australian market relatively expensive, and US economic growth being a real concern, share-market gains in 2008 are likely to be far more modest than in recent years.

The views expressed in this article are those of the author, and should not be otherwise attributed.

Dr. Chris Caton is the Chief Economist of the BT Financial Group. He has been in that role since 1991. He is also a former head of the Economic Division of the Department of the Prime Minister and Cabinet.

BT Financial Group - http://www.bt.com.au/investors/