The world economy is slowly recovering from the GFC. The US is healthy, albeit not expanding as fast as we would hope for. The EU’s massive quantitative easing program seems to be scoring some early wins, particularly in Germany. Japan remains stagnant, but with the US and EU building, the world economy is looking brighter than it has for years; except for one major risk - China
Data points to a gradual slowdown
China’s economy continued to decelerate in August. Factory output grew at 6.1% p.a. (up 6.1% for the year ending 31 August 2015), compared to its ten year average of 14% p.a. Fixed-asset investment, which is property and infrastructure spending, slowed to its weakest pace in 15 years at just 10.9% p.a. Both of these figures were below the market’s expectations.
The overhang of unsold properties continues to be a major drag on economic growth. Sales continue at a steady pace, but construction activity is rapidly declining. As a strong lead indicator, sales of earth excavators fell 33% in the year to August 2015.
There was one brighter note of data, but even then it lacked credibility. Official retail sales data showed a rise 10.8% p.a. in the year to August, but e-Commerce giant Alibaba lowered its sales forecasts and vehicle sales fell 3%, now down 25% since their peak in 2014.
This is on top of a very poor month of data out of China:
- Imports in August fell 13.8% from the previous year
- Exports fell 5.5% from the previous year
- Manufacturing prices fell 5.9%, marking 42 months of straight declines due to excess factory capacity
- Inflation jumped but not due to economic activity (which would be good news), but rather due to a shortage of pigs. Otherwise deflation remains a threat to Chinese corporates
All of this data points to a gradual, controlled slowdown in China’s economy. That’s the base case for Australian investors; expecting China to return to its previous economic growth of 7% p.a or above, is naive. In fact we would argue that it is naïve to expect China to achieve its target 7% p.a. growth this year.
A slower China means a slower Australia and lower global interest rates
This base case of a gradual slowdown will result in Australian GDP growth being below historic averages for the next 5 to 10 years at least, depending upon how we manage to transition our economy. At present, we are doing very little to give our economy genuine hope of finding a replacement for the mining investment boom.
A slower Australian economy will mean lower: earnings growth in equities and interest rates as the RBA tries to support growth. Lower rates also mean a lower AUD, in line with our view that the AUD will fall to 65 to 70 cents against the USD.
A slower China also means lower interest rates globally. The reason why: the currency wars. The EU, Japan and China are currently aggressively deflating their currencies in an attempt to improve their export competitiveness. If you can choose between the Japan and the EU to buy your imported goods, and the Euro falls in value, your price for the EU goods falls and therefore you will buy from Europe in preference to the Japan. Unless of course the Japanese Yen also falls, then it makes no difference. And that is the current situation; three of the four largest manufacturing economies in the world are pushing down their currencies, meaning they are gaining little competitiveness against each other.
They do however gain competitiveness against the US and UK, which are both expected to increase rates sometime in the next 12 months. And herein lies the reason for our forecast for lower rates for longer: the US and UK will be very cautious about raising rates while these aggressive tactics remain in place in Europe, Japan and China. The EU and Japan have both announced recently that they are likely to extend their Quantitative Easing programs, and with the rapidly deteriorating situation in China, we can expect lower rates there too.
This all adds to interest rates globally remaining very low for the next 5 to 10 years, at least.
The current long-term bond yields in the US, UK and Australia still reflect a recovery in interest rates to near ‘normal’ levels over the next 10 years.
We do not believe this to be the case and as such, see value in long duration bonds as long as:
a) The US 10 year Treasury rate is above 1.8% p.a.
b) UK 10 year yields above 1.5% p.a. or;
c) The Australian government 10 year bond yield is above 2.0% p.a.
The biggest risk to Australian investors
For those that have attended to our seminars lately or tuned into the Smart Income Investment Strategies webinar last week, you’ll know that we believe the biggest risk to Australian investors at the moment is the above slower China scenario. As this means investment returns will be much lower than we are used to. In this scenario, relying upon returns from term deposit for income to support your lifestyle is a high risk strategy. Interest rates will remain at or move lower than current levels for the long term.
Beyond that base case, the next biggest risk is a more rapid slowdown, or a “hard landing” in China. If China slips into a hard landing with GDP growth of less than 5% p.a., markets will react violently and bring down global equities.
Given the overpricing of US equities at present, a correction of more than 20% could follow. In particular, any market perceived to be dependent upon China will be hit harder, such as: Australia, New Zealand, Brazil, Indonesia, Malaysia, Canada and South Africa. Several of these economies are already in recession.
In this scenario, the AUD would rapidly fall below 60c and bond yields would also fall sharply. That’s the good news for those with money overseas and those with long duration bonds. For investors with a more pessimistic view regarding China, we have put together an investment strategy called the ‘Short China’ defensive portfolio. This strategy includes an investment portfolio with: infrastructure bonds to avoid the downturn in corporate profits and USD and GBP corporate bonds to provide the opportunity for profit if the AUD falls further.