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Where next for shares?

This article appeared in the March 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

The bulls are flying in the US and the bears are in hibernation - but bumps are ahead.

Photo of Alan Kohler By Alan Kohler, Eureka Report

There are just two ships investors need to keep an eye on 2011: SS China and the good ship QE2*. Perhaps add the sudden storm of bank competition sparked by NAB, and investing this year looks pretty straightforward. Get those things right and the rest should fall into place. (*Editor’s note: QE2 is the tag given to the US Federal Reserve’s second round of quantitative easing to boost the US money supply and help the economy.)

Money pouring out of emerging markets

Global funds are predicting a setback for emerging markets (EMs), especially in Asia. Money is now pouring out of the Third World and into the First World.

Emerging markets have had a huge run over the past couple of years and the big global players who went long in EM assets (had an over-allocation in their portfolio towards this asset class) in early 2009 have been handsome winners. The tide is now turning and institutions are rushing out of EM assets; as a result they are now under-performing developed-market assets.

If the big international funds are right and there is a setback coming for Asian markets and economies, it will hit both the Australian dollar and sharemarket. And China is at the top of the list of economies the markets are now saying look vulnerable this year.

Interest rates and inflation in China

There have been three official interest rate rises in China in three months, and late in February there was another lift in the banks' reserve ratio, further limiting how they can lend. A consultant who recently returned from western China told me the interest rate on property investment loans in some areas was as high as 42 per cent!

Despite that, monetary policy in China is still fairly loose compared to 2007, when inflation was roughly the same as it is now. And although headline inflation has eased recently, a surge in producer prices (wholesale inflation) to 6.6 per cent in January suggests tightening will continue, with more interest rate rises likely. (Editor’s note: Additional interest rate rises in China to quell inflation could slow its fast-growing economy and reduce demand for commodities.)

The evidence suggests that global funds will continue to shift out of EM assets in the months ahead. Sentiment has turned and this appears to have some way to run. So far the Australian sharemarket and dollar are holding up, albeit nervous and flat, but that will not last if there is a deterioration of market sentiment about China and other EM nations.

China exporting inflation

Economists at the Royal Bank of Canada made an interesting observation recently in their weekly note: "China has effectively turned into an exporter of inflation rather than disinflation in recent years." (Editor’s note: This means prices for exported Chinese goods are rising rather than falling and affecting prices in countries that buy these exports).

This is an important development and was confirmed by Launa Inman, the managing director of Target, when I interviewed her recently. Australian retailers are being hit by steep price rises every time they go on a buying trip to China.

A retail specialist with Ferrier Hodgson, James Stewart, says many retailers are being told that prices are up to 25 per cent higher in China at the point when goods are being loaded on to ships. Retailers have little choice but to pay, or face having no stock.

Another way China is exporting inflation is through higher commodity prices, especially for food and soft commodities such as cotton.

Remarkable Wall Street recovery

In the meantime, the US sharemarket has gone up in a straight line for six months. There was a story in February on Bloomberg that pointed out that you have to go back 40 years to see the last time Wall Street rose so much in six months with so little volatility and so few opportunities to buy the dips along the way.

It has been a truly remarkable performance, entirely due to Ben Bernanke and his QE2. In November the Federal Reserve chairman confirmed three months of speculation and announced the second round of bond buying by the Fed, worth US$600 billion.

Investor surveys now show historically high levels of enthusiasm for equities. The Wall Street Journal reported that this has been the fastest 100 per cent rebound in the S&P 500 since 1936. The latest Merrill Lynch-Bank of America survey showed that 67 per cent of portfolio managers are overweight in global equities, the highest since the survey began in 2001. Exposure to bonds is the lowest in five years and cash holdings are the lowest in nine years.

The bulls are flying in the US and the bears are in hibernation.

History tells us these are the most dangerous times to be an investor - when everyone thinks the market is going to new and greater heights. But the recent switch out of emerging market assets is reinforcing the bull market in developed-world sharemarkets and will probably mean the run will continue or a while yet.

Australia in the middle

What that means for the Australian sharemarket is probably more of the same: it will continue to produce returns somewhere between Wall Street and Shanghai. Since November 1, the US S&P 500 has gone up 13 per cent, the Shanghai composite has fallen 5 per cent, and the Australian All Ordinaries has gone up 5 per cent – almost smack in the middle.

If you were an optimist you might regard this as Goldilocks and the three bears: not too hot, not too cold, but just right. Maybe. But if the Chinese economy cracks, as the markets are predicting, and QE2 comes to an end as well, which it is due to do in June, the Australian market could be hit by a double whammy.

As for the banks, the outbreak of competition is good news, not bad. The “break up with each other”, as the NAB campaign puts it, will keep the regulators off their backs and perhaps even encourage a resumption of credit growth.

About the author

Alan Kohler is the publisher of Eureka Report, a leading investment newsletter.

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