Below Long Term Median Growth, Volatility & Interest Rates Cuts

Whilst equity markets around the world continue to experience volatility in the short term, the longer term view for economic growth remains positive.

The Chinese share market and currency stabilised a bit on Friday and US jobs data was positive, investor nervousness remained, pushing Eurozone shares down another 1.7% and the US S&P 500 down another 1.1%. As a result of the poor global lead, the Australian Stock Exchange (ASX) 200 futures fell 80 points on Friday. Yesterday the ASX200 was up 1.27% which was the first positive trading day for 2016!

The poor start 2016 send a warning that global growth concerns remain, that commodity prices are still under downwards pressure and that volatility in investment markets will likely remain high.

What’s behind the Volatility?

Many of the same worries from 2015 have triggered a poor start to the year for shares, including a sharp fall in Chinese shares. This in turn has caused renewed concern about the Chinese economy and has led to more commodity price weakness and fears of an emerging market crisis. Soft US manufacturing data and geopolitical risks – this time regarding Saudi Arabia/Iran tensions and North Korea – have also contributed to share market declines (with US shares falling -6%, Eurozone shares -7.2%, Japanese shares -7.0%, Chinese shares -9.7% and Australian shares -5.8%).

Commodity prices have also fallen, with the oil price now at its lowest since 2009 and bonds rallying with safe haven buying.

However, it is worth putting these developments in some perspective:

The latest fall in Chinese shares may have a bit further to go but looks to have been exaggerated, driven mostly by fears and regulatory issues around the share market and currency. The main drivers were:

• concerns about new share supply after a scheduled ban on selling by major shareholders commenced – Chinese regulators have since announced a restrictive limit on the size of stakes that major investors can sell.

• a new share market circuit breaker that commenced on Monday encouraged investors to bring forward selling in an effort to beat the shutdown – the circuit breaker has now been suspended and after 6% plus depreciation in the value of the RMB since July, the People’s Bank of China is now likely to step up efforts to try and stabilise it again.

• While the US ISM manufacturing index has been softer lately and is a concern, most US data points to stable underlying growth of around 2% or so.

• Signs that global growth remains fragile and constrained will have the effect of ensuring that global monetary policy remains easy this year, with the US Federal Reserve tightening likely to be gradual with perhaps just two 0.25% rate hikes, Japan and Europe continuing with quantitative easing and China continuing to cut interest rates. The continuing global weakness also adds to the case for the RBA to cut interest rates again.

• Tensions between Sunni Saudi Arabia and Shia Iran have been building for some time and partly flow from the shift that occurred in the US away from military focus in the Middle East. However, while they will continue to show up in wars in the region, e.g in Syria and Iraq, which will serve to keep oil prices low (or lower) for now, they are unlikely to result in outright direct conflict in a way that dramatically pushes up oil prices. In fact, in the short term the tension ensures that OPEC will remain paralysed

• North Korea’s H bomb test is a big concern, but there is some question as to whether it was really an H bomb and North Korea has already had three nuclear tests since 2006.

Implications for Australia

Australian economic data releases over the past two weeks were mostly soft. November retail sales were solid and the trade deficit fell slightly, but remains high. Meanwhile, the services sector PMI softened significantly in December, building approvals for November provided further evidence that the contribution to economic growth from home construction will slow this year, December home prices showed a further loss of momentum, and lending to investors continued to slow in November.

Our view remains that with global growth remaining fragile, commodity prices weak, mining investment still falling and housing’s contribution to growth set to slow and that the RBA will have to cut interest rates further this year. Now is great time not to fix your home loan unless you really need to!

Outlook

Worries about China and the US Federal Reserve are likely to drive continued volatility in the short term until some stability returns to the RMB and US dollar, and hence in commodity prices.

Beyond the short term, we still see shares trending higher helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth. However, volatility is expected to remain high.

Very low bond yields point to a soft medium-term return potential from sovereign bonds, but it’s hard to get too bearish in a world of fragile growth, spare capacity and low inflation.

Commercial property and infrastructure are likely to continue benefiting from the ongoing search by investors for yield. National capital city residential property price gains are expected to slow to around 2% this year, as the heat comes out of the Sydney and Melbourne markets. Prices are likely to continue to fall in Perth and Darwin, but growth is likely to pick up in Brisbane which is likely to be the best performing capital city market for 2016.

Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2% and the RBA expected to cut the cash rate to 1.75%.

The downtrend in the Australian dollar is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the Australian dollar undertakes its usual undershoot of fair value. Expect a fall to around US $0.60 later in the year with similar adjustments downwards with most currencies. This will mean you pay more for your overseas holiday, import car and TV. The flip side will be more competitive exports that will assist our primary producers and miners.

Summary

Volatility is likely to remain high and further corrections are likely, we see little risk of a recession in Australia at this point in time. What we have is a sharp adjustment of market sentiment and extreme fear without a real change in the underlying economic backdrop.

We expect the Chinese government will support economic growth through strong monetary policy easing and other measures which, in turn, should help support growth in China and the broader emerging markets. We will continue to watch and monitor the market, and will advise any changes to your portfolios if the situation evolves and requires action.

It’s worth noting that equity market falls boost the medium-term return potential from shares – simply because they make shares cheaper – and once markets bottom they are invariably followed by a strong rebound. Which was reflected in yesterday’s 1.27% rebound in the ASX200.