Business leaders and mums and dads alike need to prepare for a rocky road in the coming financial year. 
 
Story Melissa Wilkinson 
 
There’s no doubt that the last 12 months have delivered businesses and consumers a wild and rocky ride. The US sub-prime crisis in August last year was the standout event which sent global financial markets into turmoil. It has caused extensive damage to markets and institutions right at the core of the global financial system. It is estimated that the major global banks have been hit with losses of more than $US290 billion as a direct result of the collapse of the US sub-prime mortgage market. 
 
With declining US house prices and rising mortgage defaults, many predict that we still haven’t seen the end of it. ANZ economist Saul Eslake believes that more losses are expected to filter through over the next quarter, potentially reaching as much as $US500 billion. 
 
In a recent report he wrote: “Further substantial losses could result from a possible downgrading in the credit ratings of the so-called monoline bond insurers which would in turn undermine the credit ratings and hence the value of the $US2.5 trillion of municipal and other bonds which are enhanced by their guarantees. Losses could also stem from credit default swaps in the event of a rise in corporate borrowings. These swaps are derivatives which provide insurance against defaults on corporate borrowings.” 
 
The fallout from the sub-prime crisis is still causing major ructions around the world. Liquidity remains significantly impaired despite efforts from central banks to restore confidence. 
 
Lewis South, chief economist in Macquarie Bank’s Fund Management Group, says that risk is being totally repriced now. 
 
“The price of liquidity is now extremely elevated relative to historical norms. It is to be hoarded in the US and will continue to be hoarded for some time.” 
 
The risk of a serious global credit crunch is a key issue likely to keep many awake at night during the rest of the year. Lending standards are tightening around the world and some of the data already suggests that a broad credit squeeze is starting to emerge. 
 
The question on everyone’s lips is how far the US is away from a recession. As consumers primarily drive the country’s economic engine, how they respond to the slump in house prices will be the deciding factor. 
 
Since September 2007, the Federal Reserve has cut interest rates by 300 basis points and introduced a range of tax rebates to try and help the household sector. 
 
The challenge is that the household sector is still in severe debt, with estimates as high as 2 per cent of GDP. Analysts will continue to watch US consumers like hawks for any signs of scrimping, saving or cutbacks in spending. 
 
The International Monetary Fund believes that the US will inevitably slide into recession during the remainder of 2008. This will mean two or more quarters of negative growth before we start to see a moderate recovery during 2009. 
 
World Outlook 
While some economists argue that the rest of the world has essentially de-coupled itself from the US economy, a slowdown there is still predicted to have a significant impact on overall global growth predictions. A bleak forecast has emerged from the IMF in particular with statements like “the world economy has now entered new and precarious territory”. 
 
IMF economists have slashed their 2008 global growth predictions to 3.7 per cent, down from 4.9 per cent in 2007. Its economic team says that there is a 25 per cent chance that global growth will drop to 3 per cent or less in 2008 and 2009. This is technically equivalent to a global recession. 
 
The two key issues likely to cause major wobbles in the global economy in the short term include a slide in housing prices in developed economies outside the US and a fall in commodity prices. Research over the last 30 years shows that during major global slowdowns commodity prices tend to fall an average of 30 per cent. 
 
The good news is that while growth in emerging and developing economies such as China and India is expected to ease somewhat, it will remain robust going into 2009. 
 
Australian Outlook 
While slowing growth around the world and the global financial crisis are two themes regularly waved about by commentators as key issues for Australia, the reality is that the economy will slow because Australian policy makers want it to. 
 
The economy is now in its 17th year of economic expansion and, as a result, the inflation genie is well out of the bottle. 
 
Inflation is a natural by-product of strong global growth, and an economy with low levels of capacity and low unemployment. Over the year to the March 2008 quarter, core inflation in Australia increased to 4.25 per cent which is much higher than the Reserve Bank’s inflation target band of 2 to 3 per cent. According to ANZ research, this is the highest inflation rate since the RBA introduced inflation targeting in the early 1990s. 
 
Eight interest rate rises in the last three years will undoubtedly cause the economy to start decelerating during the remainder of 2008 and going into 2009. Inflation is expected to remain above 4 per cent during 2008 and then will fall back to 3.5 per cent by the end of 2009. What is worrying is that this figure is still above the RBA’s target of 2 to 3 per cent. The good news is that most economic pundits believe that the RBA has done the bulk of its heavy lifting and interest rates are set to stay on hold in the short term. 
 
The bad news is that there are some serious risks associated with the RBA’s inflation targeting approach. Policy makers may have been too heavy handed with their interest rate interventions which could cause the economy to start to falter instead of just cool off. 
 
Critics of active monetary policy believe that policy changes affect the economy with a lag and in the case of interest rates, the delay is typically about 12 to 18 months. They believe that because it’s so difficult to forecast future economic conditions, any attempts to stabilise the economy can ultimately end up being destabilising. While the Australian economy appears to be at a major turning point, it’s unlikely to head into recession next year as China’s continued strong appetite for raw materials will provide some support for a soft landing. The US and Europe are no longer the main game for Australian exporters. The US accounts for only 6 per cent of total merchandise exports and in contrast, China now represents 13 per cent. 
 
To date, Australia has benefited enormously from rising energy and raw material prices and this has significantly boosted our national income. Our terms of trade are forecast to rise in the near term and this will be largely driven by expected increases in coal and iron ore contract prices in mid 2008. 
 
Macquarie Bank’s South believes that China’s growth will not slow down enough to hurt Australia’s economic prospects. “The IMF is predicting that China’s growth will fall to 9 per cent in 2008, down from 12 per cent in 2007. A growth rate of 9 per cent is still very strong but if it was to fall below 7 per cent then we’d be much more concerned about the implications for Australia. 
 
“Over the next five years Chinese demand is very likely to outstrip expectations. Twenty million people are moving from rural areas in China every 16 months, so this structural shift in China is not going to go away even with higher commodity markets.” 
 
Financial Markets 
While our economy may be officially decoupled from the US, our financial markets are not. 
 
Shane Oliver, head of investment strategy and chief economist at AMP Capital Partners, believes that our sharemarket won’t be immune to more US financial volatility. 
 
“Our sharemarket is still heavily linked to the US and we tend to follow its direction, albeit to a lesser degree. We’re also going to see pressure on domestic company profits and some earnings downgrades. It’s going to be a choppy period overall but I do expect sharemarkets to recover. 
 
“We have two big things in our favour. A lot of bad news is already factored into our market so it does provide a kind of buffer. The other issue is that a reduction in US interest rates should be positive for global sharemarkets as shares will look more attractive than cash. 
 
“Both the government and the Reserve Bank have a pretty difficult course ahead of them. They’re aware that they need to slow the economy down but there’s high household debt, emerging mortgage stress and a lot of uncertainty about the global outlook. 
 
“It still remains an uncertain environment for us and there are lots of storm clouds on the horizon – inflationary pressures, high oil prices, falling house prices and high debt levels. For example, the ratio of debt to household income is now about 160 per cent, compared with 40 per cent in 1990. This means that for each $100 of household income after tax, there is now $160 or more of debt instead of $40. 
 
“One of the other key risks is if oil becomes a favourite for speculators. This could push the oil price up beyond fundamentals. All these things could mean a fairly bumpy ride road ahead,” he says. As a veteran of the market, Oliver recommends that retail investors avoid trying to time the market over the next 12 months. 
 
“The best thing is for investors to use any weakness as an opportunity to average into the market. You can’t predict the turning point or the bottom. Nervous investors should stay in the market instead of running the risk of missing out on the upswing. “We saw the bottom in March this year and we’ll probably see the market lower again but above the March levels. The market will remain fairly interesting as we’re likely to see resource stocks power ahead and stocks like BHP go to new highs. The banks still have some recovering to do, telcos will do pretty well because they’re defensive but consumer-related stocks will struggle.” 
 
What’s Ahead For Super? 
Chief executive of independent super fund researcher SuperRatings, Jeff Bresnahan, believes many super funds may find if difficult to post positive returns for the 2007-08 financial year. 
 
“In the last 12 months, the average balanced super fund returned -2.88 per cent. With a range of +0.16 per cent to -10.83 per cent to the end of April, it is certain that some balanced options will be bearers of bad news come July. Despite the short-term red ink, three and five year returns continue to hold up with medium per annum returns of 10.3 per cent and 11.1 per cent, respectively.” 
 
Financial planner Craig Banning from Banning Financial Services says that investors will need to have more realistic expectations for their super fund returns in the future. 
 
“We’ve been through a period of high double digit returns and over the next 10 years this is likely to drop to single digits. Households definitely need to get a grip on their home loans and pull back their longerterm expectations for wealth creation. Hardly any clients can tell me how much money they need to run their lives and, as a result, expenditure is blowing out. 
 
“I’m seeing a lot of people redrawing from their mortgage which is now bigger than what it was three years ago. People have been spending more because of rising house prices and strong investment returns, but they’ll need to start changing their mindset quite quickly.” 
 
Revised Accounting Standards 
In addition to economic and financial market issues over the next 12 months, business leaders will also need to factor in how changes in accounting standards may affect their operations. 
 
According to the Institute, one of the most important changes is AASB 3 Business Combinations which will impact those companies preparing to embark on an acquisition-led growth strategy. While the revisions to the standard don’t come into force until 1 July 2009, the 2008-09 financial year will be the comparative period. Changes to the standard mean that the profitability of future acquisitions may be affected. 
 
Debbie Hankey, partner at Deloitte Touche Tohmatsu, says the biggest affect from changes to AASB 3 will be a much greater level of volatility in profit and loss statements for those companies who make acquisitions. 
 
“All acquisition-related transaction costs will now need to be expensed instead of capitalised and carried through to goodwill. There will be no fundamental change to cash flows. What it will do is really highlight how much it costs to put these deals together. The costs of corporate advisers and other experts will show up in the accounts for the period of the acquisition, so the acquirer will need to make sure that they’re going to deliver some value. 
 
“It really means that companies will need to clearly communicate to the market what has happened in the profit and loss statement,” she says. 
 
The other major revision to AASB 3 is a change in accounting for contingent consideration. 
 
Hankey says that this change will also cause more volatility and also impact on valuations. 
 
“A lot of deals are put together where it’s difficult to agree on fair value for the transaction. Under the old standard, you had to wait until you knew what the fair value was and then you capitalised it. Under the new standard, you determine fair value at the time of when you do the acquisition. “It’s going to cause some valuation issues and friction between auditors and directors. This is because it will create more subjectivity and therefore more volatility in the P&L. If fair value blows out too much and the profits don’t materialise, then there may be an impairment issue. This change is causing a lot of heart sore already.” 
 
Fingers Crossed 
Over the next six to 12 months, key indicators such as private consumption expenditure, business confidence surveys, labour market figures and household credit growth will be closely scrutinised for signs of deterioration. The deceleration of the Australian economy is likely to cause considerable pain for business and consumers. What is unknown is how people will respond in a significant downturn, given the robust conditions enjoyed over the last decade.