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What to expect for the Australian and global economies and sharemarkets.
By Jon Reilly, Implemented Portfolios
For several years now, the investing environment around portfolios has been more about defensive characteristics and increasingly less to do with the returns generated. The official cash rate in Australia remained at 2.5 per cent throughout 2014 and as another year approached, most analysts expected that to persist well into 2015.
Although this rate is the lowest on record, defensive investors have for several years been able to take advantage of historically high margins on safe investments such as term deposits from Australian banks. However, now that banks have been able to significantly increase their domestic sources of funding, the once very attractive term deposits have steadily drifted lower over the past few years.
What also occurred in late 2014 was a weaker-than-expected Gross Domestic Product result. It led many commentators to predict the Reserve Bank of Australia would need to make at least one cut as early as its February 2015 meeting to support a weakening economy.
At the end of 2014, traditionally safe long-term government debt was yielding less than 3 per cent, and even the extra margin on riskier debt compressed over the course of the year, making the returns unattractive for the risk being assumed by investors.
In such a low-return environment, and indeed one in which returns may fall further, it can be increasingly difficult to avoid taking on more risk in your portfolio just to maintain the returns to which you have become accustomed.
An appropriate asset allocation plan, especially one reinforced by a trusted adviser, will ensure your portfolio maintains the defence it needs even when returns are lower than you would like.
2014 a tough year for share investors
It was a challenging year for Australian equities investors as the long-predicted correction in several key commodities hit the resources sector, and the financials sector dealt with the uncertainty of the Financial System Inquiry.
We have seen iron ore prices halve and oil prices fall by nearly the same amount, which is either good or bad news depending on whether you are a producer or consumer of commodities. Importantly, the largest mining companies are expected to be able to maintain their dividends, which look increasingly attractive given the sharp price falls late in the year.
If you can withstand the potential for more short-term volatility, which cannot be ruled out, then gross dividends of around 6 per cent or better should, in time, attract enough support to stabilise prices, at least in the medium term.
It was no surprise that the Financial System Inquiry recommended the major banks need to hold more capital and also increase the risk weighting applied to their mortgage lending. Over many years the big banks have enjoyed a comparative advantage over their smaller counterparts by increasing their leverage ratios, meaning they can earn a higher return on their equity.
Bank share prices have certainly reflected that over the past couple of years, leading the Australian sharemarket with annual returns of 21 per cent and 28 per cent for the index over 2012 and 2013 respectively, before dividends.
It would seem reasonable, given the changes likely to come, that investors should moderate their expectations for continued price appreciation and place more focus on the steady tax-advantaged dividend income paid by the banks.
The importance of policy settings
It is worth noting that the Federal Government has now discovered first-hand just how pernicious an effect a significant decline in terms of trade can have on budget and deficit estimates.
We should hope that over 2015, fiscal and monetary policy remains supportive as Australia's economy continues to transition from the capital investment phase of the mining boom. That looks to be increasingly difficult in the political and media environment but as is often the case, the Government would benefit from taking at least a medium-term view, if only it were able to do so.
Borrowing costs are currently very low, so the urgency to step on the fiscal brakes should be tempered while the economy continues to expand at less than long-term trend growth. Responsible fiscal policy should be a complement to monetary policy, although sadly we have seen many examples overseas of what happens when they have been deployed in opposition to each other.
So far the Reserve Bank has been remarkably effective at talking the currency lower, again with winners and losers in that outcome. Most recently the falling dollar has reflected not only lower commodity prices but also the stronger US dollar as America's economy continues to recover.
No doubt the RBA would be pleased to have seen our dollar fall to the low 80-cents range without having to cut rates, although it still sees it as somewhat overvalued. However, having a monetary policy response still available to stimulate in the face of weakness, stands Australia in relatively good stead and should provide some measure of comfort to equity investors.
Recovery in the US and a battle of minds in Europe
That the US economy is recovering is undeniable. Economic growth has been strong, with but one weather-related exception in the first quarter of 2014. Consistent jobs growth has brought the unemployment rate down to below 6 per cent.
All eyes are on the Federal Reserve, which, having completed the taper of its extraordinary policy support, is expected to increase rates in 2015 above zero per cent for the first time in more than six years. Anecdotally, the key statistic seems to be wage inflation, which, despite the strong jobs growth, remains stubbornly low.
US equity investors need to answer two questions: how much of the economic recovery is already priced into markets, which have risen by more than 200 per cent while rates have been at zero, and what will happen when rates are no longer at zero?
Across the Atlantic, the structural flaws in the European Union are highlighted by a battle of wills between Mario Draghi, the head of the European Central Bank, and Jens Weidmann, the head of the Bundesbank.
Draghi wants to deliver on his "we will do whatever it takes" rhetoric and the Germans are resisting based on their belief that such a program will remove the imperative to fiscal reform imposed on former profligate nations.
If Draghi can prevail, which means the ECB expands its balance sheet and purchases sovereign bonds, stimulating long-moribund economies and staving off deflation, then there may well be good medium to longer-term returns to be had for investors. A patient and incremental approach is probably the prudent one in this instance.
Political machinations in Japan and China
As for developed markets, Japan has had some upheaval recently after it entered recession and Prime Minister Abe called fresh elections. President Abe received a renewed mandate for continued implementation of the reforms collectively known as Abenomics, Japan is worthy of investors' attention, notwithstanding recent strong performance.
In emerging markets the best opportunities again look to be in Asia and specifically China. The Chinese Government has undertaken its own stimulus recently, and early signs are that the economy is responding. For much of 2014 the leadership's focus was on an anti-corruption drive, including the Fourth Plenum in October, which focused on justice and the rule of law.
That no one was immune to this crackdown was shown recently with the arrest of a former member of the Politburo Standing Committee and head of China's security and law enforcement institutions. Not surprisingly, this has led to stagnation at a local government level, where authorities thought it safer to do nothing to pursue investment and development opportunities, lest they be inadvertently caught in the anti-corruption net.
With the recent rate cuts, clearly there is still an important focus on economic growth and a focus on policy reforms. It is also fair to say that many of the longer-term reforms, such as changes to the system of urban migrant registration and even the one-child policy, are yet to take effect.
Signs of a maturing Chinese economy
We should expect and even welcome that China will soon start to report GDP growth below 7 per cent as an inevitable fact of an economy that will shortly surpass US$10 trillion. Looking further out, a welcome sign of a mature economy will be the abandonment of formal growth target announcements, as is the case with other major economies.
For investors, valuations still appear reasonable if not as attractive as in years past, although that is due to recent relatively strong performance. Of note is also the potential for increased foreign buying support in mainland Chinese equities following developments to connect the Hong Kong and Shanghai exchanges.
About the author
Jon Reilly is chief investment officer of Implemented Portfolios, a leading portfolio construction and investment management company.
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