Global and local economies are expected to remain relatively strong, but liquidity conditions and investor confidence are vulnerable to the prospect of higher interest rates.
• Next 2-3 months likely to see elevated volatility and market weakness, especially with uncertainty surrounding the US election and the timing of expected interest rate moves by the Federal Reserve.
• Growth in China is continuing to moderate but a “hard landing” remains unlikely. Key risk areas lie with the Chinese corporate debt and property sectors but local authorities appear positioned to manage these risks over the short to medium term.
• Europe faces a period of heightened political risk, with looming Italian referendum likely to be a trigger for heightened market volatility
• We will not be making any adjustments to Six Park’s asset allocations at this stage.
The first few months of FY2017 have passed without major incident for investors. For many, this was unexpected - partly because of the volatility which has plagued markets for the last year and partly given the historical tendency for August-October to be a period of sharemarket weakness (if not just for psychological reasons). While we are hopeful that the upcoming quarter is similarly benign, a return to elevated volatility and market weakness is more likely given the range of upcoming political and economic events which have the potential to unnerve investors.
• Despite a rollercoaster ride of recent news, our expectation remains for a Clinton Presidency. That said, a surprise public backing for Trump cannot be entirely ruled out, particularly in light of the re-opening of the Clinton email investigation. Dislike of and distrust for Clinton remains high. Many Americans are also dissatisfied with where the country is heading and are disillusioned with its global free market policies. The power of a populist politician like Trump (even with his many flaws) should not be underestimated.
• As the Brexit vote showed, polls can be notoriously unreliable. Many Trump voters may be reluctant to reveal their true support to pollsters, understating his popularity. The voluntary nature of the US election system also adds further unpredictability. With neither candidate well liked, voter turnout could be low and in different proportions to those surveyed.
• The uncertainty of the election result is likely to weigh on markets until the election on Nov 8 – and may spill over for a longer period in the event of an unexpected Trump victory, especially given the unfunded nature of his spending plans, the uncertainty that his victory would bring to the world economy and the potential risk of retaliatory actions by other countries if he executed his trade barriers plans.
• Regardless, we do not intend to position our portfolios differently in advance of any particular result. Given the difficulty of predicting the ramifications of any one outcome, our approach is to focus on long term, fundamental shifts in market conditions, rather than specific events.
• We note that the policies of both candidates favour fiscal expansion and therefore either result should ultimately boost US growth (which will be ultimately beneficial for the world economy). It is also likely that the US Congress would rein in any excessive plans of either candidate. We are also reminded of research by groups such as Vanguard which have shown that Presidential elections typically do not have long-term effects on market performance.
US INTEREST RATES:
• Presidential election matters aside, the other near-term focus in the U.S. context will be on the actions of the Federal Reserve. As the central bank of the world’s largest economy, actions by the Fed are always heavily scrutinised. This is particularly so in the current environment, where traders are anxiously trying to take cues about when and how quickly the Board will move to “normalise” interest rate policy (having taken rates to near zero since the GFC and only raised them once since).
• With the global economy continuing to grapple with low growth and fragile investor confidence, we expect markets will be particularly volatile over the coming months as investors seek to predict and react to moves by the Fed. While a 25 bps rise in December will likely be seen as a further sign of US recovery, others may view it as being “too soon” and a risk to economic growth.
• Although the board of the Federal Reserve next meets on 1 November, we think it is unlikely to act so near to the election. The general consensus is therefore for a December rate rise – with the Fed having signalled recently that the case for raising rates by year-end has strengthened and 3 (of 10) board members favouring a rate rise at its last meeting. We tend to agree with this view, especially given the continuing flow of positive US macroeconomic data, and suspect the Fed (in the absence of intervening events) will most likely seek to raise rates gradually over the coming 12 months.
• That said, interest rate moves by central banks are notoriously difficult to predict and even harder to consistently prepare and position for. Even officials of the Federal Reserve have been poor predictors of rate hikes in the past. Even the Federal Reserve Board’s own December 2015 economic forecasts (released 16 December 2015) showed that its members expected four 25bps increases during 2016. They have approved none so far.
• Again we see little benefit in positioning our portfolios in advance of any particular move by the Federal Reserve. We do, however, remain encouraged by the ongoing positive indications for US household spending, employment and industrial production which confirm ongoing (albeit modest) strengthening in the US economy’s underlying fundamentals.
• With the underlying pace of growth in China continuing to moderate, the health of the world’s second-largest economy remains another area of concern. Last month the Bank of International Settlements published data suggesting that Chinese banks were facing mounting risks of a banking crisis. Recent trade statistics also showed a sharp decline in Chinese exports in September. However, other indicators paint a more positive picture. Recent PPI statistics showed factory gate pricing had risen for the first time in four years, a positive sign for local manufacturers who have been battered by price deflation historically. Auto sales also grew at their fastest rate in 3 years.
• These mixed economic signals suggest China continues to face a difficult structural transition away from its traditional dependence on exports and heavy industry to an economy driven by local consumption and services. Local authorities also face a delicate balancing act of supporting growth through fiscal stimulus whilst controlling debt sustainability.
• Two key risk areas lie with the Chinese corporate and property sectors. From a corporate perspective, overall debt levels remain very high (company debt now exceeds 169% of GDP) and fixed asset and private investment levels remain depressed. In the property sector, easy credit and limited investment options have also spurred a property-buying frenzy across China's major cities and reignited “property price bubble” fears, particularly in China’s regional centres.
• While both these sectors remain a concern, the government continues to implement initiatives to address the issues, including measures to reduce corporate debt (including preferential tax treatment to encourage debt-to-equity swaps and mergers/acquisitions) and temper property prices (e.g. increased restrictions on home purchases and borrowing).
• On balance, we still do not forecast a “hard landing” to China’s growth trajectory over the shorter term. Given the country’s low government debt levels (22% of GDP) and unique administrative structure, we believe China still has the means to manage its short-term economic challenges.
• Europe faces a period of heightened political risk over the coming year, with the Italian referendum on 4th December and three general elections (Netherlands, France and Germany) in 2017.
• The referendum in Italy will see the country vote on a number of key reforms to its constitution. These changes propose a drastic dilution of the powers of the senate1 and a rebalancing of power away from Italy’s regions to the central government.
• The referendum is a potentially significant event. If approved, the constitutional changes would underpin a more streamlined, predictable and efficient government. If rejected, it has the potential to trigger political disarray for Italy and further uncertainty for the EU.
• Matteo Renzi, the Italian PM, had originally pledged to resign if his constitutional changes are not approved – although he has backed down on this promise more recently. A departure by Renzi (if it occurred) would likely trigger an early election. It may also allow the populist Five Star Movement to gain power and push for a referendum on Italy abandoning the Euro currency.
• Recent opinion polls indicate the “Yes” and “No” camps are running roughly equal, with a large proportion of voters still undecided. At this stage, it is difficult to assess the likely outcome and ramifications of Italy’s referendum. Some observers (including prominent economist Joseph Stiglitz) have suggested it could be a “cataclysmic event” that could lead to an eventual collapse of the EU. Others have argued the consequences will be far more muted, particularly if Renzi’s stays on in government (either because he chooses not to resign or is re-appointed as a head of a caretaker government) and delays a general election. At this stage, we suspect the latter outcome is more likely – although the prevailing uncertainty and speculation will likely manifest itself in heightened market volatility as the referendum date draws near.
1Italy is unusual in that both its houses of parliament serve the same function. This often causes political gridlocks.
• We expect the Australian economy will remain relatively strong. Although not immune from global headwinds, the country’s fundamentals remain sound. Measures of household consumption and business sentiment remain above average, labour market indicators are encouraging and inflation remains well below the RBA’s target.
• Key concerns (other than the flow-on effects of from any global tremors) include (i) the potential overheating within the property market (in pockets of the residential apartments sector) and (ii) the vulnerability of liquidity conditions and investor confidence to the prospect of higher US interest rates.
• The prospective loss of Australia’s AAA rating is a lingering risk. Some observers suggest that rating agency S&P may move to downgrade Australia’s rating as early as December when the government releases its mid-year fiscal update. S&P has already flagged a potential downgrade in July, noting its concerns about government debt levels and the challenges faced by Turnbull in being able to pass meaningful budget measures through parliament. While the loss of AAA status – if it occurs - would naturally unnerve markets and increase the cost of funds (especially for the banks and corporate sector), we suspect the longer term impact on markets will be relatively muted. The increase in funding costs would likely be quite small (especially in the context of the persisting “global search for yield” by investors), interest rates remain low and any funding cost rise could also be overshadowed by a cut to the RBA’s cash rate (if that was required).
• Overall, we expect the global economy to continue growing, albeit at a moderate pace.
• Monetary policy conditions remain highly accommodative and many countries (e.g. the US, UK, Europe and Japan) are beginning to revert towards expansionary fiscal policies (in the forms of lower taxes, increased government spending and infrastructure funding) to promote ongoing growth.
• While there are early signs that global inflationary pressures are starting to build (commodity prices and other input prices are rising, labour markets are tightening), these pressures are not yet significant.
• With valuation levels of most asset classes having been supported by the current low interest rate environment, the expected (albeit gradual) return to higher interest rates will inevitably reverse this trend (particularly across higher risk asset classes like equities). We already have started to see this play out in the Australian property trust sector, which has experienced price weakness in recent weeks on the back of lower sector yield expectations.
• Despite the near-term risks outlined above, we will not be making any adjustments to Six Park’s asset allocations at this stage.
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