First published 22 December 2014.
A letter to investors. Outlook for 2015 by John Abernethy
In the past we have often stated that the longer term is much easier to forecast than the shorter term. Today it seems that this statement is even truer as we consider the outlook for Australia’s economy and therefore its investment markets in 2015.
At the outset we can observe some current trends that could dominate markets in the first half of 2015. These are:

    1. Australia’s sharply declining terms of trade and a deterioration in our balance of trade means we will record monthly trade deficits of between $1 billion and $2 billion for the foreseeable future;


    Figure 1. Terms of Trade*
    Sources. ABS; RBA

  1. The trade deterioration and the rapidly declining resource capital investment cycle will act to depress economic growth to well below our annual long term growth rate. Quarterly economic growth rates will likely fall below 0.5% (2.0% per annum) and therefore unemployment will rise;
  2. A weakening Australian dollar is certain but this will elevate inflation in contrast to the occurrence of deflation in much of the developed world; and
  3. Despite our relatively high inflation rate there will likely be both a cut in cash rates and a solid rally in our bond market such that Australian investors will suffer a period of negative real interest rates across the yield curve.
    The above may paint a confusing picture and indeed it could be suggested that the forecasts are inconsistent with each other. However our forecasts merely reflect the chaotic nature of the world economy and markets.


Figure 2. Gross Public Debt
Sources. G20 Study Centre, The Lowy Institute; theconversation.com; www.tradingeconomics.com
This chaos is most clearly presented in bond markets across the world where yields have plummeted despite a massive lift in sovereign debt. Six years of unrelenting supportive monetary policy settings in Europe, Japan and the US have created markets that struggle to appreciate or fairly price risk. Investors are therefore now confronted with the likelihood of low returns and possibly the loss of capital as the true long term effects of quantitative easing (QE) play out. The sustained maintenance of low cash rate settings has neither improved credit demand nor consumer confidence. Rather it has fed speculation.

Figure 3. Policy Interest Rates – G3
Source. Central Banks

Oil price declines add to the confusing outlook

The recent sharp decline in the oil price is surprising and therefore its outlook is difficult to forecast. The flow-on effects to consumer energy prices have added to the significant risk of deflation in Europe while further improving the competitiveness of the Chinese manufacturing sector. It may have a similar positive effect on the US manufacturing sector and on consumer spending but we believe the continued strengthening of the US dollar will have an offsetting effect on US exports. Lower petrol and energy costs would normally be positive for consumer activity in major developed economies but across most of Europe the effects of rapid population ageing and high youth unemployment will act to check these benefits. Indeed, lower oil prices will add to the downward pressure on interest rates meaning that savers or retirees will simply not generate enough income to maintain their standard of living.
On reflection it is now clear the monetary policy settings of major developed economies over the last six years have not resulted in sustained economic recovery. Importantly these policies have not even resulted in inflation or credit growth. Much of the developed world now has historically low yields on savings that act to stymie both retirement incomes and consumer confidence. Therefore much of the developed world (particularly Europe and Japan) in 2015 will remain in a low growth cycle and it is difficult to see how this will change over the remainder of this decade. Should deflation permeate around the world then it is possible similar pressures may confront Australia.

Predictions for the Australian asset markets

Over a year ago, we forecasted the weakening of the Australian dollar. Looking forward we see no reason why the dollar will not continue to depreciate against most major currencies in 2015. The exception will continue to be the Japanese yen, which is being debased by its massive QE policy settings. The Australian dollar depreciation will occur in direct response to the sustained weakening in commodity prices. Australia’s currency will therefore behave as it has done historically but the depreciation will help the Australian economy adjust to falling export income and per capita national income. A sustained weaker currency should act to protect the Australian economy from falling into recession.

Figure 4. Consumer Price Inflation
Sources. ABS; RBA
Given this view, we expect the Australian equity market will be constrained by flat to falling earnings, with limited chance of profit upgrades for domestic companies. Nevertheless, the search for yield will act to support those companies offering sustainable and fully franked dividends well in excess of the cash rate, such as the major banks, A-REITs and certain large companies, such as Telstra and Woolworths. Depending on its extent, the Australian dollar weakness will support our international companies but at this point we think these companies are already priced for a lower currency so there is limited value here. Rather, the opportunity for longer term investment returns remains with export companies that interface with the Chinese economic growth cycle and its developing consumerism. In our view, these companies predominantly appear in the US equity market with relatively slim pickings in Australia.
Meanwhile the interest rate markets present as historically peculiar. Across the world, including Australia, we have witnessed a compression of yield curves. Short term interest rates had very little distance to fall and most of the declines in fixed interest yields have been seen in long-term bond yields. Recently Australian 10-year bond yields fell below 2.7% per annum which are historic lows. The bond yield has fallen by 135 basis points over the last year and 35 points lower over the last month.

Figure 5. Australian Government Bond Yields
Sources. Bloomberg
Remarkably, these yields are far above the yields of poorly rated European bonds and also Japanese bond yields. The margin above US bond yields has also fallen to a historic low. Even with a lift in inflation in Australia in 2015, we forecast Australian bond yields will stay low for a sustained period or until European bonds yields rise.
The ultimate perverse effect of QE is playing out. There is no “money printing inflation” but rather an “asset bubble” inflationary cycle that is engulfing Australian assets as well. Concurrent with this cycle is the overflow of investment capital from China, India, Japan and Korea into hard assets in Australia. Low interest rates and intense foreign buying suggest quality Australian property assets will continue to perform but mainly through capital value rather than income growth.

The calls for 2015

  1. Australian equity market will likely play catch-up with the US market in the first half of 2015, reflecting the cut in interest rates and the decline in the Australian dollar. However, we think foreign buyers will not be tempted to re-enter the Australian equity market until the currency sustainably falls below US$0.75. This is important to understand because it is foreign buyers who at the margin will move the Australian equity market.
  2. We expect the Australian equity market index will trade around 5,500 to 6,000 points but could well finish 2015 higher than today’s levels should the currency fall to below US$0.75. However, the total market environment will be important to monitor and this forecast is based on our view iron ore, coal and energy prices will maintain current levels.
  3. Australian long-term bond yields will continue at historic lows despite rising inflation expectations. This yield will mainly be the result of the Japanese QE program as our market captures foreign capital desperate for a yield.
  4. Despite the above we forecast Australian short term inflation will remain elevated when compared to the deflation experienced in Europe, Japan and the US. An inflation reading of about 3% in the second half of 2015 suggests Australian real interest rates will be negative across the yield curve. This will become a unique period for Australia.
  5. The Reserve Bank of Australia may cut the cash rate to 2.00% by June 2015 in response to slowing economic growth and a rise in unemployment. We expect the cash rate will remain low throughout 2015.
  6. The world economic scene will be dominated by the geopolitical events that unfold from the sharp decline in the price of oil. There will be issues for many OPEC members and the US production market may seek US government support to maintain production growth momentum. However, Russia is the most seriously affected and the risk of economic disaster is high because it operates outside any trade or currency zone. Military tensions between East and West in Ukraine, and financial tensions around Greece and EU support for its debt re-scheduling and/or austerity programs, are likely to remain centre-stage.
  7. The economies of the US and China will remain solid in 2015 with both being beneficiaries of lower oil and energy prices. Unfortunately, some of the benefits to the US economy will be curtailed by a rising US$. We expect China’s competitiveness on world markets will be enhanced and lower commodity prices will aid the Chinese consumer. In any case, China maintains a tight grip on its currency and manages it for its economic benefit

In summary, despite a challenging environment for the Australian economy, the equity market could make some small advances in the first half of 2015 on the back of the appetite for high yield. In this cycle, the downturn has been magnified by an elevated currency and sharply weakening commodity export prices. Thus, it will be a weakening currency that will ultimately offset lost commodity income and cushion the Australian economy. It is interesting to note that the Australian dollar price of iron ore has actually risen in the last month despite a US$ spot price decline.
As the Australian economy and our investment markets adjust to the many confronting forces, we expect income-oriented investment will provide the best returns in early 2015. The likely performing sectors will be high-yielding solid Australian businesses, high-quality hybrids and some property or infrastructure securities. Investors seeking capital growth may be disappointed unless they think counter intuitively. The Australian dollar will give substantial relief to many major resource companies and this is where value is now appearing – but the gains may be a year or so away. In the meantime, an increased weighting to US exporters focused on the Asian growth cycle appears the sensible place to allocate capital so long as price does not already reflect the opportunity.
The above paints a challenging period ahead for Australian investors but it is important to present a realistic picture of the economic environment. No one should be approaching investment in this environment without accepting that investment risk is elevated.
It is a strange period where interest rates do not compensate for risk of failure or default. It is this observation that leads us to predict that many of today’s investors and/or retirees may in the not too distant future be forced to live from capital drawdowns. More so, if the correct asset allocation is not undertaken. The true effects of QE lie ahead and sustained low investment returns may be with us for the next few years.