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Switzer's list

 An extraordinary list of potential risks are hovering around investment markets at a time when the major underpinning to our rising wealth is looking unbelievably rock solid. And while the threats can't be dismissed and need to be monitored, we at Switzer remain cautiously optimistic.

The one big scary unknown is all about the fall out from the sub-prime loans in the USA, which has rattled the foundations of some of the world's biggest name investment houses such as Bear Sterns and BNP Paribus. We also saw a run on the UK bank Northern Rock, which needed a $6.6 billion bail out from the Bank of England.
Switzer's List Chart - Switzer Financial Services
The chart above shows how the money markets reacted to the uncertainty. You can see how interest rates spiked as the world became more wary of borrowers and repriced the riskiness of many loans.
This has put pressure on non-bank lenders and has delivered a competitive advantage to the big banks. It explains why the share prices of our big four banks have been heading north.
The sub prime loans issue
The big question marks over these loans have raised doubts over the economic health of the US economy and some pundits are pulling out the 'R-word' for recession. This could undermine the really good forecasts for the world economy.
Thankfully, the US central bank is cutting interest rates aggressively and is likely to keep doing so until it thinks it has avoided a recession. Next year is a presidential election year and history says the Republicans have been good at dodging a recession when, as a government, they have gone to the polls.
The worst is behind us
The former Federal Reserve boss, Alan Greenspan says the worst of the sub-prime mess is behind global money markets and he suggests a US recession is now down to a 30% chance from 50%.
It still will be a close run thing with the American housing sector nosediving.
CommSec's Craig James says the central concern rests with the outlook for the US economy, but high oil prices, ongoing jitters on global financial markets and the bubble in the Chinese share market are also areas to watch.
"The US economy is likely to slow in coming months, dragged down by weak housing activity," he tipped. "However we expect that recession will be avoided. Not only is the economy in good shape outside the housing sector but also the Federal Reserve has shown a preparedness to cut interest rates and support activity."
The Aussie economy
I agree with his assessment that the Australian economy is far less sensitive to developments in the US, with China, India and Asia more generally driving global economic growth and demand for Australian resources.
"Any slowdown in the US would be felt more indirectly, such as US consumers buying less finished goods from Asia and Europe, in turn leading to reduced demand for raw materials from Australia."
The main game for our economy and our stock market is China followed by India and even Russia, which is in possession of plentiful oil supplies.
"While generally off the radar screen for most analysts, investors need to keep a close eye on developments in China, especially the Chinese share market," James warns. "Over the past year, the Shanghai Composite index has soared by 220%, but earnings have not kept pace, causing valuations to weaken markedly. Arguably a bubble has formed, although it is unsure what form the correction is likely to take."
Despite that, James is positive on the local stock market and his colleague, celebrated number cruncher Ron Bewley, who I worked with at the University of NSW years ago, in September speculated that the Aussie market would rise 14% for the year to September 2008. Adding 4% for dividend payments he saw an 18% rise!
James' view
"On the share market, we expect the All Ordinaries/ASX 200 to reach 7,000 points by the June quarter of 2008, underpinned by solid profit growth and favourable valuations. The path to 7,000 is unlikely to be smooth, with the likelihood of further volatility caused by credit market jitters and the downturn in the US housing sector."
The chief economist at Westpac, Bill Evans sees a modest rise in shares making me feel comfortable with a 10% increase in shares for the year. I like big blue chip stocks and particularly the companies in the top 20 stocks, though I might not like all of them but most of them.
James likes the materials sector, which means BHP-Billiton, Rio Tinto and the like. He also has a preference for the consumer discretionary sector, especially retailing with the potential for the higher Australian dollar likely to drive prices of imported goods down. This is good for stocks such as Harvey Norman and JB HiFi.
The inflation genie
The big local story ahead is inflation. We get the next reading on the Consumer Price Index on October 24 and if it's close to 0.9%, the Reserve Bank will think about raising interest rates.
Possibly the election and a lack of clarity on the final depth of the sub-prime problems, which could worsen the US slowdown, could put some restraint on the Big Bank.
On interest rates
Westpac's economics team sees one more 0.25% interest rate rise ahead in this cycle, while Citibank thinks they can see two rises because of the strength of the local economy and the commodity price boom. On the other hand, James thinks rates are on hold for 2007 but the next inflation number is a big watch for him.
Most economists are favourably disposed towards property despite the chance of interest rate rises, though two increases could challenge lots of stretched Aussie households.

Published on: Tuesday, October 09, 2007

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