The weak start to the year reflected market concerns about a couple of dominant themes. Firstly, the US Federal Reserve late last year commenced the process of normalising short term interest rates by increasing the Fed Funds cash rate by 0.25% following an extended period of effectively zero “emergency level” cash rates. A few months earlier they had also discontinued their Quantitative Easing or “QE” program designed to increase money supply to the economy by the Federal Reserve buying government bonds and mortgage backed securities and holding them on their balance sheet. At the time of the US rate hike, the market took this move as a sign of growing confidence in the strength and durability of the US economy, and the Fed framed market expectations to expect up to four further 0.25% increases over the course of the calendar year. In January, the market shifted focus and became concerned that the Fed may have acted prematurely by tightening policy and that future rate hikes would have a negative impact on the fragile growth outlook and perhaps drive the global economy into recession. With the growth outlook in Europe and Japan much more sluggish than the US, their respective Central Banks continue to implement expansive monetary policy programs to stimulate growth and head off potential deflationary forces.
The potential for a continued economic slowdown in China also came into renewed focus during January. This was a persistent theme though the course of 2015 and contributed to a hugely volatile Chinese stock market and weakness in commodity prices. In the second half of the year however, the market seemed to become more comfortable that Chinese authorities had taken sufficient policy action to arrest the slowdown in the pace of growth which they forecast to come in at around 6.5%. During January however, persistent devaluation of the the Yuan by the People’s Bank of China (PBOC) coupled with weak trade data, telegraphed to the market that perhaps the Chinese economy was not travelling as well as the market had anticipated warranting the additional stimulus provided by currency devaluation. As always, the market remains very suspicious of “official” published data by the Chinese government which seems to consistently print in line with the expectations they set. Following on from the boom years in China during the 2000’s where growth rates regularly exceeded 10% fuelling the global commodities boom, the Chinese government has tried to engineer a gradual slowdown to more sustainable growth levels and to concurrently change the mix of growth from more investment led (building and infrastructure) to be more consumption focussed. We need to remember that China is not a Western style open free market economy, the Government and PBOC exert direct control over critical economic levers such as interest rates, capital flows, lending standards, the exchange rate and investment spending and that are left to market forces in most other economies.
The slowdown in China has a critical influence on the Australian economy due to trade linkages primarily through the bulk commodity exports of iron ore and coal being raw material inputs to steel production. The slowdown in Chinese growth has contributed to precipitous falls in commodity prices which has both negatively affected our trade account and terms of trade and seen the value of the Australian dollar fall from around parity to the US dollar as recently as May 2013, to its current level of around 71 US cents. Weaker commodity prices have also seen sharp falls in the share prices of major mining companies and stifled their level of investment spending which was once a significant driver of economic growth. The Reserve Bank of Australia (RBA) is looking for non-mining sectors of the economy such as housing, retail trade, business investment and tourism to compensate for the slowdown in mining investment. While the housing sector has been strong in Sydney and Melbourne in particular, the other sectors of the economy have been sluggish prompting the RBA to ease cash rates last year to 2%, still very high by global standards. With inflation well contained, it is likely that the RBA will need to further reduce cash rates during the course of 2016 to provide additional stimulus to the economy and offset the contractionary impact of increases in lending rates imposed by most banks late last year following tighter APRA capital requirements. In terms of government policy, the Turnbull government is reviewing tax policy and formulating plans to wind back the budget deficit in advance of the Federal Budget in May.
Somewhat curiously, the oil price has now become a barometer for the health of the global economy and the key driver of global equity markets. Markets reacted negatively to the decline in the oil price during January which fell to below $30 per barrel after trading over $100 per barrel as recently as mid-2014. It should be noted however that the falling oil price reflects over supply rather than a slackening of demand which continues to grow consistent with modest global economic growth. OPEC countries and Russia have maintained output levels and with the ending of trade sanctions against Iran, they have now begun to add to global supply. Far from being negative for the global economy, lower oil prices are likely to boost personal consumption as lower petrol prices increase disposable income for consumers. Paradoxically, history tells us that it is sharply higher oil prices that are negative for the global economy as was the case during the oil shock in 1973 which led to a severe sharemarket correction and a deep global recession.
As has been the norm for the past few years, the near term direction of financial markets will largely be dictated by Central Bank policy. In the US, zero cash rates and three separate QE programs have been successful in driving bond yields lower and the US sharemarket higher. With the US now moving to gradually tighten policy, this tail wind has been removed and the fortunes of the US market will be dependant on corporate earnings growth. With constrained levels of economic growth of around 2% and the US Fed keen to gradually increase cash rates to pre-emptively prevent any emergence of inflation, the environment for profit growth is problematic especially given the impact of the strong $US on foreign sourced earnings. For this reason, Q4 2015 earnings results in the US will be closely scrutinised by the market. In Europe and Japan, signs of economic recovery are much less tangible than in the US and as a result are likely to continue with expansionary monetary policy settings including QE programs. With most major governments around the world running large budget deficits, it is difficult to see how government spending initiatives can assist in the process of economic recovery. While the US economy remains the dominant force in the global economy, the Chinese economy now has become the swing factor. To that end there will be close focus on the degree to which their economy slows further from here and how successful the Chinese authorities are in managing this process. With the world’s two largest economies, the US and China, still delivering positive growth however it is difficult to see the global economy moving into recession despite the difficulties evident in Europe and Japan. For this reason, the recent sharp pull back in equity prices should be considered to be an overreaction to fears that are unlikely to be realised.
Against this backdrop, the outlook for investment markets for 2016 still remains challenging. While the market correction in January has improved valuations to much more reasonable levels, gains from here will be dependant on the trajectory of earnings growth. As will always happen in financial markets, negative sentiment can result in sharp corrections. Over reaction in markets provides opportunities for long term investors than can look past short term weakness and buy good quality assets at cheaper prices. The very easy monetary policy that still persists globally, in addition to heightened levels of risk aversion have led to abnormally low yields on government bonds which continue to offer security but poor long term returns prospects. In summary, we believe the long term outlook for growth assets such as shares remains sound and offers better potential returns compared to more secure fixed interest assets such as government bonds. With yield becoming a scare commodity, investors will continue to look for alternative sources of income which will tend to support higher yielding sharemarkets such as Australia. Even factoring in the likelihood of modest reductions in dividends from mining companies, in a low earnings growth environment, the yield from Australian shares will become a key source of return. Most importantly , investors need to be patient, expect continued bouts of market volatility, and look forward to the longer term when conditions are likely to become more favourable to equity markets.
By Gary Burke
Chief Investment Officer