Searching questions for Tony Abbott if turmoil on stock markets gets worse

August 26, 2015

25 August 2015

By Stephen Koukoulas

The savage market ructions of recent weeks and days are disconcerting. While not unprecedented, the quite staggering fall in share markets and commodity prices are threatening to undermine the global economy. For Australia, the news is particularly alarming. Australia’s stock market, the ASX, has not performed well in recent years, lagging well behind the other markets. If the market ructions translate to an extended period of weak global growth, Australia’s already dismal export performance will be hampered and the commodity price weakness will further undermine national incomes.

We are not there yet. There needs to be either further falls in stocks and commodities or an extended period where market weakness persists for there to be material damage to the Australian economy.

At levels under 4,900 points earlier today, the ASX 200 has fallen 19% from the levels in March, shaving around $325bn off the value of the market.

Perhaps more remarkably, the ASX is around 28% below the peak of October 2007, meaning that stocks have registered almost a decade of no capital growth. Even with today’s market turmoil, the US S&P 500 index is around 25% than the level of 2007.

Australia’s bigger picture economic concerns are shown up in the stock market performance. Within the ASX, there is a heavy concentration in banks and miners. The diversity of listed companies is very limited when the other big sector – retail – does not have any meaningful global presence.

As commodity prices fall, the ASX almost inevitably falls given the weight of mining and related companies. Banks, which are so tightly linked to the housing market, had been a star performer as the boom in house prices, investor demand and new construction underpinned their profits. Bank stocks have also fallen sharply. Investors are betting that the Australian housing boom is over which will see loan growth slow. Changes to regulations about bank capital requirements, which take effect next year, are also likely to inhibit bank profitability.

History shows that there is solid, if not strong, correlation between share prices and the performance of the economy. A sustained trend in stock prices up or down normally leads aggregate economic growth by two to four quarters. At the moment, the share price fall has been evident for a little less than six months.

If the market turmoil shows up in hard economic data in the months ahead, the big questions will be for policymakers. The Reserve Bank of Australia, which had been signaling to the market in its recent commentaries that the rate cutting cycle was probably over, would need to deliver further interest rate reductions. This would likely see renewed weakness of the Australian dollar which would help support the export sector and the domestic firms competing with importers. Indeed, one aspect of the market action in recent weeks has been Australian dollar weakness, especially against the Euro and British pound.

If the economy is particularly weak, fiscal policy stimulus would be necessary to support economic activity and employment levels. Economically, this is obvious and most prudent response. Politically, the Abbott government’s rhetoric against debt and deficit and the fiscal stimulus measures delivered by the Rudd government during the global financial crisis would make it difficult for it to deliver a fiscal response.

The market swings are difficult to interpret, which makes it impossible to see where the dust will settle. That said, the weaker markets are, the more worries there will be about the Australian economy. For now, the problems are not so severe to completely undermine growth but a further 10% or so fall in global stocks and it might be a very different picture.