The 2016 year is coming to a close and world markets have somehow become even more extraordinary than they were at the end of 2015
The US will end the year with only one rate increase, compared to four increases predicted by markets a year ago. The EU and Japan have extended their QE programs even further. China has continued with its extraordinary increase in state-owned corporate debt. And Australia’s inflation and wage growth have hit record lows and employment is trending even lower.
Financial markets are the instruments of minute to minute, day to day traders like hedge funds and banks. Over the longer term they will find fair value, but the distance travelled to get to that fair value is huge and stressful for real investors. The key is to understand where fair value, being the real value of investment assets will stop l and set your position accordingly. Then sit back and let financial markets bounce up and down. It is also useful to know when markets have travelled too far from reality and use those times to buy at great value or sell and take a profit.
So, the big question is what shape is the world in and where should long term investors, as opposed to day traders, be putting their money?
The 15 points below wrap up some of the views we have spoken about in The WIRE and in webinars and seminars in recent months, updated for the latest news where relevant. I’ve ordered them in terms of controversy, with the least controversial up front, so make sure you keep reading until the end.
- Australian economy weaker than headlines suggest, creating a growing underemployment problem. Next year will see conditions worsen as the construction sector slows, particularly in Brisbane and Melbourne.
- Weak Australian inflation will continue. Wage growth continues to weaken and is now just 1.9%pa, the lowest on record. Australian CPI is primarily driven by wage growth; factors such as the falling AUD or rising inflation globally have a much smaller impact.
- Australian interest rates to be weaker than expected due to weak employment and low inflation. The RBA’s job is to maximise employment without exceeding inflation targets. With inflation below the RBA’s 2-3%pa target rate and showing no signs of rising, they will be far more compelled to lower rates than to increase them in 2017.
- Meanwhile, the US economy will continue to strengthen. The US economy will likely see growth of more than 3%pa in the third quarter. Consumer spending, which accounts for 70% of its economy, is heading for a very strong Christmas period. Trump’s plans to spend heavily on infrastructure is a strong net positive, and any tax rate cuts are a positive for the next five to ten years before debt concerns arise again. The US economy is unlikely to experience high growth as Trump’s plans will be pared back by the thrifty Republicans. However, the US will continue to be the strongest major global economy.
- Credit conditions will be benign globally (except China) as employment conditions, interest rates and commodity prices remain relatively stable. Combined with the above, the outlook for returns on 3-7 year Australian, US or UK credits are strong. Yields at these current levels have priced in the most inflation possible from the Trump policy movement, so if anything yields will fall at these maturities.
- Europe and Japan will still be weak. Other than the US, the global economy is still very weak despite massive QE and easy credit conditions. If anything, it has been weakened by further leverage in China and political unrest in Europe. QE doesn’t seem to be making any meaningful impact in Europe or Japan, with the possible exception of Germany making the European unrest even worse. Bond investors are not getting paid enough to be taking EUR or JPY risk at the moment.
- US rates to rise, but slowly, because of global weakness. We ended 2015 with a Fed increase expected in December. Markets then started to price in 3-4 rate increases in 2016. We said at the time that we didn’t believe this would actually happen as the rest of the world was too weak. The year will end with just one rate rise and we think 2017 could be the same with just one rate increase, despite the strong economy, because of the global outlook. This time however we are in step with markets who also have a one increase assumption priced in.
- USD to strengthen as US rates rise while the rest of the world remains weak.
- Upside risk in US medium term bond prices While US inflation is on the rise due to rising wages, the market’s current bond yields suggest inflation will jump in the 3-5 year range, pricing in Trump’s infrastructure and tax cut policies. His success in getting these policies over the line is a long way from certain so there is downside risk on US bond yields in the 3-5 year range in the event that he isn’t as successful as markets expect.
- US yield curve to flatten, by increasing in the short end of the curve as the Fed slowly tightens but the long end falls if Trump’s inflationary policies don’t succeed.
- Downside risk for commodities and Australia if China crashes We still don’t think that a China hard landing is the most likely outcome, but the massive increase in debt particularly by state-owned enterprises in 2016 has increased a hard landing risk materially. Commodity prices, the AUD, Australian equities and, if severe enough, global equities will come under substantial pressure if the market gets nervous about a China-induced GFC 2.
- Commodities to fall slightly from current levels Commodity prices have been boosted in 2016 by unexpected leverage by the state-owned steel sector. This has left spot markets unbalanced and pushed up prices. Resources companies will increase supply in 2017 and prices will fall from current highs, but not dramatically. Oil will remain between US$40 and US$50 a barrel, with downside risk if a supply war breaks out between Saudi Arabia and the rest of OPEC or if Trump successfully opens up new exploration sites in the US.
- Equity markets to run out of excuses to rise In 2015, equity markets rose because interest rates were staying low. In 2016 they rose on the same news and then because of Trump’s promises of fiscal stimulus. In 2017, starting the year with Trump’s policies priced in and with very low interest rates priced in for the short-term, there are no more excuses to increase price/earnings ratios. That means that the only reason for share prices to rise is higher earnings than expected. As earnings growth forecasts are already very optimistic, priced for perfection in fact, and given that earnings has been flat globally now for two years, it is very hard to see what will change in 2017 to see equity markets rise further. The more likely scenario is that the bull market runs out of steam and a correction, albeit a small one, occurs.
- Volatility and gold to remain high More uncertainty lies ahead in 2017 as Trump takes office, Europe shifts closer to imploding, China’s stressed industrial sectors see higher defaults and equity prices struggle to justify their high valuations. Uncertainty drives volatility, which in turn pushes up the popularity of gold. USD gold mining corporate bonds are a strong hedge against these growing risks.
- Australian:US interest rate differential to narrow A very controversial forecast inside and outside FIIG, but my rationale here is simply that the Australian economy has weak employment growth prospects, meaning the RBA will prefer to let rates lag behind the US. At the moment, the differential is just 40bps; that is, the Australian 10 year government bond rate is 0.40%pa higher than the US equivalent. This is well below any historic averages, but that fact by itself does not mean it can’t go lower or even fall to zero. If conditions in Australia do not improve and if the US economy continues to strengthen over the next few years, there is no rule that says that the Australian bond yield can’t be lower than the US rate, no matter how disturbing that might be for bond traders!