What’s Ahead?

Geo-political risk is high – events in the Middle East create ongoing volatility and significant tension remains between China and the West. Meanwhile, European unity is being tested by refugee inflow and the possibility that Britain might leave the EU. Short term global stock market volatility is due to uncertainty about falling oil prices and its effect on global banks as well as the severity of the slowdown in China and in emerging markets. China’s slowing construction and industrial sectors are a problem for Australia, as we supply them. Unfortunately, China’s overcapacity will take time to absorb and this will keep downward pressure on commodity demand as China struggles to stimulate and control its economy. Global trade has also slowed as China’s weakness affects its Asian trading partners and emerging markets – sapping the manufacturing sector’s health.

The US is less affected by China than export-oriented economies and the US is slowly recovering, despite uncertainty as its interest rates rise from near zero with gradual rises ahead. Though a stronger US$ affects its exports, the US recovery continues as consumption and especially housing lead modest growth improvements. Low growth is lingering for Japan and Europe, so they are still stimulating it with easier money policies. The emerging economies are experiencing tougher conditions, as their debts are often written in the rising US currency. Slow global growth, especially in China and the prospect of more US rates rises, puts downward pressure on emerging markets.

Despite gradual US rate tightening, the low yield there will make holding cash unappealing for a couple of years. In Europe and Japan, holding cash is particularly unappealing. In Australia, we have the stimulus of low rates, a low A$, less headwind from Budget repairs now and our interest rates are unlikely to rise until next year. This should help underpin our stock market as cash and deposits are also unappealing here unless for capital certainty. But it is this uncertainty that has made cash and property the preferred investment for most Australians. So it is a good time to be contrarian, as other Australian assets with reliable yield are looking cheap. Though confidence is improving, this may not yet help lift company profits overall because improving parts of the market are offset by those that are not.  So patience is required.

Australia’s outlook is for weak income growth as our mining investment boom unwinds and our terms of trade decline. Our interest rates are expected to stay at historic lows despite subdued growth and inflation, with slender prospect of rates easing further. It is a difficult time for Australia but the more progressive Federal leadership stance may eventually pull us out of this low growth phase to benefit from our proximity to Asia’s longer term growth. The continued arrival of new Australians of working age should help.

We don’t think recent poor market performance indicates a year of despair ahead. Markets now expect very conservative earnings and it’s hard to envisage upward surprises. Without this, markets remain volatile as the hunt for earnings certainty drives large valuation swings. Major miners have experienced brutal profit downgrades, production cuts are likely and may come quickly. But some energy exposure can hedge portfolios against Middle East geo-political risk. If China and commodities keep deteriorating, it would create a mini-crisis for Australia – our A$ would fall further and investments with offshore exposure would benefit. The golden age for the major banks has ended, so reducing these when better options arise is also worth considering.

Overall, we expect continued episodes of volatility due to global uncertainties and future investment returns that are lower than before, likewise inflation. The critical task is to prudently manage risk. Our stock market offers good long term value but slow growth in the short term. Sluggish global growth outlook may linger for years, so low interest rates will probably also take years to rise. As always, success comes from careful asset selection and patience.