The Perfect Storm?

The phrase “the perfect storm” has often been used to describe events that have come together in a most unexpected and devastating way. The effects of the simultaneous occurrences are far more powerful than if they had occurred independently.

In our August newsletter we raised concerns about the anticipated fallout from the credit crisis in global markets. The article provided a few key warning signs that companies should be aware of as the uncertainty in the economy grows stronger.

Additional recent events in the world financial and commodity markets have now led some to believe that we are heading for a ‘perfect storm’. What are the triggers? And what are the likely impacts on the Australian economy?

First though some recent headlines from the major newswires:

“Greenspan 50/50 on Recession” – Reuters 08/10/07
“Crisis was “accident waiting to happen" Greenspan” – Reuters 21/10/07
“Bernanke: Housing Woes to Slow Growth” - yahoo 15/10/07
“Credit turmoil could mean turning point for growth” – Reuters 22/10/07
“U S Home Foreclosures Double” – Foreclosures Daily 17/10/07
“Greenspan Says `State of Fear' in Credit Markets” - Bloomberg 23/10/07
“173 US mortgage companies have imploded in the past 12 months” – The Mortgage Lender 23/10/07
“Alarm bells ring ahead of CPI release” - AFR 23/10/07
“Banks warn on higher loan rates” - AFR 23/10/07
US credit crisis
The housing and credit crisis in the US has greatly impacted world credit markets causing a dramatic reduction in liquidity. The market has improved slightly but we are now seeing higher pricing of risk across the board and a re-rating of risk by the major credit agencies. The net result is that debt is becoming harder to source and more expensive for existing and prospective borrowers.

The effects of this are starting to be felt locally, as we are already seeing the emergence of tighter credit policy and higher pricing. This will impact negatively on those businesses that operate on high volume, low margin models and those businesses that are already highly exposed to debt.

The US real estate crash is still unwinding with similar concerns now being expressed about the UK market. As a high proportion of small to medium business owners in Australia have used their properties to finance their businesses, any reduction in Australian property prices will have a dramatic effect on their ability to raise additional finance which will slow their growth or lead many to experience a cash flow crisis.

Oil price
Oil has increased by approx. 50% this year to a high of US$87 of late prompting some analysts to speculate that a price of $100 is now possible. The upward pressure is due to a number of factors including the continuing unrest in the Middle East, increasing demand from China and India, a weak US dollar and an all time low in excess production capacity.

The issue of real concern for Australia’s debt laden families and small to medium businesses is that every 12% increase in oil is equivalent to a .25% increase in interest rates. Therefore, we have actually had 6 interest rate increases this year (2 normal plus 4 equivalent).

High cost of labour
The latest figures released on Friday show that Australia now has the lowest unemployment levels in 33 years at 4.2%. This has further strengthened the belief that interest rates will be increased again towards the end of this year and into next year.

Employers currently find their business activities constrained by a lack of available and skilled staff and the additional high costs of luring new staff or even keeping their own staff in the business. This problem is unlikely to go away even if there is a slowdown in economic activity. These issues are proving both disruptive and costly for most small to medium businesses as they struggle to perform in volatile labour markets.

Interest rate rises
The Reserve Bank has an often stated policy of keeping inflation within 2 – 3 % per annum. Recent events are testing the limits of this policy and therefore require the RBA to use the interest rates to curtail this. The effects of a buoyant economy, low unemployment, growth in real wages, increased food prices (because of the drought) and increased fuel prices all lead to the need for the Reserve Bank to raise interest rates further to keep the lid on an overheating economy.

Given the record levels of individual and small business debt, an increase in interest rates will result in a reduction in discretionary spending and slow economic growth.

High Australian Dollar
In recent years and in particular over the past few months, the strong economy and interest rate differentials between its major trading partners and Australia has placed upward pressure on the currency. The currency is currently trading at around 90 cents with some analysts anticipating it going as high as 92.5 cents by the end of this year and 95 cents by mid 2008.

This is having a significant impact on non mining related exporters. For those companies relying heavily on exports they may be finding it difficult to remain competitive so either margins or sale volumes will come under pressure.

The high Aussie dollar is great news for importers though who find their goods being very well priced and an opportunity for greater profits. The concern is that too much of this sector is towards the non essential or luxury market. The Reserve Bank finds itself having to consider the long term effects of raising or leaving current interest rates as they are. Any increase in rates will lead to more inflows from foreign buyers of the dollar and will lead further upward pressure of the currency.

Faced with so many divergent pressures, business owners need to be thinking very strategically in the coming months to ensure that their business can weather any upcoming economic downturn.

For more information please feel free to contact one of the team at Vantage Performance.

Regards


Michael Fingland
Managing Director

Vantage Performance
Turnaround Management Specialists

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