Economy: Envying the economic outlook Down Under

Our economies are similar, but Canada can only envy Australia's overall outlook.

It was the interest rate hike heard around the world — at least by stock and currency traders.

Citing a strengthening global economy, Australia’s central bank tightened its national money supply in early October, raising its key lending rate to 3.25% — the first increase in a developed economy since the onset of the global economic meltdown. Currency speculators then started betting on hikes in other nations, with Canada emerging as an early favourite. That helped push the value of the loonie above 95¢US. Stock market bulls, meanwhile, took the Australian move as a sign that the recovery is real and the dreaded double-dip recession is no longer a serious threat to equity values.

To which we say: not so fast, mates. Australia’s move actually says nothing long-term about the global economic picture, not to mention the Canadian economic landscape. But reaction to it does show just how much irrational optimism is in play today.

John Calverley, Standard Chartered Bank’s head of North America research, thinks people are nuts to suggest the Bank of Canada will hike rates this year and add fuel to the loonie’s upward flight. “BOC officials have said they won’t do anything until next July,” he says, “and they would lose long-term credibility if they reneged.” The economic data here, he adds, “do not support central bank action this year.”

Canada and Australia both have commodities-based economies, stable banks and a shared history of pre-crisis budget surpluses. But thanks to its trading relationship with China, where GDP is expected to grow 8% this year, Australia never went into recession. According to the International Monetary Fund, the Australian economy will grow 0.7% in 2009 and 2% next year.

If all goes well, the IMF saysCanadian GDP will rise 2.1% in 2010, but economic activity is expected to shrink 2.5% this year, and unlike in Australia, our jobless rate sits at an 11-year high of 8.7%. Furthermore, Canada sends more than 75% of its exports to the United States — where consumer spending is nowhere close to pre-crisis levels, and loan defaults linked to real estate and rising unemployment could yet create another major banking crisis.

The IMF forecasts U.S. economic growth of 1.5% in 2010 after a 2.7% decline this year. But Standard Chartered says there is “a growing risk that the U.S. recovery will look like a flash of lightning,” charged by “short-term stimulus.” Keep in mind that politicians around the world have been printing money and borrowing cash in massive amounts, hoping to try to jump-start economic growth. This can’t go on forever, especially not in the world’s largest economy. After all, the U.S. government is already expected to run annual deficits of more than US$1 trillion until the 2020s, when expenditures on Social Security and Medicare will skyrocket.

Nobody, of course, knows what will happen when stimulus programs are withdrawn. But demand in the global economy could crash like the U.S. auto sector after Uncle Sam’s cash-for-clunkers program expired.

When it comes to the financial health of Canada’s largest trading partner, the most bullish forecasters might be those at Bank of America Merrill Lynch. Shortly after third-quarter U.S. corporate results started rolling in with a bang (aluminum producer Alcoa got the ball rolling by reporting its first quarterly profit in 12 months), they predicted the world economy will grow 4.2% in 2010, with a 3% increase in American GDP.

Yet even B of A does not think Canada will follow Australia’s leadon interest rates before the second quarter of next year. As head of the bank’s Canadian research, Sheryl King notes: “The economic recovery is still too tentative to convince the Bank of Canada that policy stimulus needs to be pulled back earlier than that. Moreover, since the start of the downturn a startling 357,000 jobs have been lost even with 58,000 jobs created in the past two months.”

It is also important to note that plenty of threats to the global economy could force Australia to reverse course on interest rates before other developed nations start tightening their money supplies. China’s economic growth, for example, could trip over the nation’s brewing housing bubble. And thanks to Washington’s massive deficit spending, foreign reserve holders are diversifying away from the U.S. dollar; at best, this is forcing Canada and the rest of the non-American world to grapple with rising currencies, and, at worst, raises the prospect of a possible run on the greenback that would destabilize the global financial system — which is one reason gold prices sit at record heights.

Furthermore, as Texas wealth manager John Mauldin points out, European banks also pose a risk to the world economy because their leverage ratios remain in the danger zone that caused American failures.

In the words of independent Wall Street economist Robert Brusca, the global economic outlook is “cloudy with a chance of bad news.” And that’s why, instead of wondering when other central banks will increase rates, market players might soon be wondering how Canada and other countries will handle the next downturn (when rate cuts may not be an option).

Such talk might seem premature, given the average Canadian economic expansion period since 1980 has been 8.5 years. But Sal Guatieri, senior economist with BMO Capital Markets, warns the next retraction or system shock could come a lot sooner. And so he and other economists won’t even try to guessthe chances of Canada returning to budget surpluses or pre-crisis debt-to-GDP levels before the next round of intervention is needed. “I wouldn’t touch that question with a ten-foot pole,” Brusca says.

If more stimulus is required soon, Calverley argues central banks will probably have to print new money. And that, as any student of history knows, can lead to disaster.