The stock market has had a jittery start to 2015 as investors fret about the raft of risks facing global economies and markets.
In terms of risk, the major question that investors should be asking as they position themselves for the New Year:
- Is something going to ‘break’ in 2015?
- Will an event occur that triggers a reassessment of bond yields and then a contagion effect that spills into other markets, including Australian equities?
As we look ahead, we see three major risks that we believe are crucial in 2015:
1. Oil price reflecting European weakness
The oil price fall came out of nowhere but it is still falling into this part of the year, which is concerning. We are in the midst of the Northern hemisphere winter, a traditionally stronger period for oil prices. The weak oil prices seem to reflect poor ongoing economic conditions in Europe.
As we have mentioned before, a falling oil price increases the risk of European deflation, hurts the oil sector, and also increases geopolitical risks of key oil producers in the Middle East, Russia and South America.
2. The potential for a 90s-type credit collapse
There is also the risk of a ‘1990s-style’ credit bond collapse in places like Russia and South America; we’re already seeing the Venezuelan economy hit hard by the oil price collapse.
There is the potential for some major correction in developing and emerging world credit markets caused by a default. That could trigger a ‘contagion’ effect where the negative shock spirals out into other markets and regions as we saw during the Asian crisis.
While Greece remains a risk, what is concerning is that larger economies such as Russia are now also at risk.
3. A bond market correction
Perhaps the biggest potential for ‘something to break’ is the bond market, particularly in the “sub-prime bonds” of Europe. Across Europe bonds in Italy, Ireland, France and Spain are priced and primed for quantitative easing being a certainty. There will be a major correction in Europe if the much-promised QE isn’t delivered – patience must surely be wearing thin!
Here in Australia, little attention has been paid to our bond market, but investors need to note that 10-year bond yields have fallen to 2.69 per cent with overseas investors seeking a safe haven from the euro and yen and amid falling oil prices.
The more bond prices rally (and yields fall), the more likely we will get a correction. Asset prices never head in one direction without a correction and European bonds have clearly rallied too far and for too long. The correction is likely to start in Europe, we believe, some time in the next six months. We estimate a 1 per cent move in 10-year bond yields across the world will translate to a 5 per cent impact on world share markets.
The next question for investors is what should they do?
Late last year we recommended that investors focus on yield stocks. There is still reasonable yield in Australia, particularly for high quality companies such as Telstra (ASX:TLS), Woolworths (ASX:WOW) and the big banks.
Investors should also continue to maintain cash, despite low yields, which will position them to re-enter the market should something ‘break’ and global markets experience an overdue painful shock.