Volatility in the $A is one factor, but there are plenty of other matters that ensure the financial year 2015/16 has become a most difficult one to forecast. Consider the following occurrences over the last nine months:
- The collapse in oil prices and the inability of OPEC to control excess supply;
- The erratic adjustment of Chinese economic policies to counter slowing growth;
- International currency manipulation as central banks run out of tools to effect economic growth;
- The collapse (and now recovery) in iron ore prices; plus
- The reticence of central banks to adjust interest rates so that they at least match inflation.
The result has been an elevated level of market price volatility. Therefore, with short term predictions difficult to make and with no end in sight for price volatility, we continue to recommend that an active investment strategy be adopted. In effect, we suggest that portfolios have a “sub-portfolio” for trading positions and that short term profits be regularly banked.
We suggest that investors not concern themselves with predicting market bottoms, or market tops, or even contemplating whether a strategic turning point has been reached. Markets are traversing a heightened period of chaos caused by extraordinary economic policy settings across the world, paralysing logical thought and asset pricing. While investors should maintain a long-term focus on investment returns, it seems clear that trading profits will be an important short-term ingredient as we wait for risk-free returns (i.e. bond yields) to exceed inflation expectations.
What are the key issues likely to impact markets?
We expect the following will be important:
1. The direction and the level of the oil price will be significant. Over the last twelve months, the developed world has received a significant economic benefit from lower oil and energy prices. The decrease in energy input costs has held down inflation and added to deflationary pressures. Lower petroleum prices have been beneficial to households and consumers who have more discretionary income at their disposal. While lower energy prices have been beneficial for consumers, the effects across producer countries have been severe, as has the fallout for those banks over-exposed to energy companies. For the remainder of this year, we expect oil and energy prices to rise moderately checked by abundant supply. Rapid oil price rises could occur if supply is disrupted – most likely because of a major geo-political event.
Figure 2. An Unprecedented Oil Bear
2. Central banks in Europe, Japan and the US are likely to remain steadfast with their policies to hold cash rates at extremely low levels. We suspect that this will lead to increased commentary that the world economy has moved into a “new normal” characterised by exceptionally low yields and low investment returns. We dispute the new normal view because the world is in a contrived cycle and not one driven by the proper functioning of markets. We believe that central banks are unwittingly suppressing growth by imprudent policy settings. Longer term, the way out of this cycle is difficult to fathom or forecast. For the remainder of 2016, we expect no significant policy changes by central banks.
Central bankers painting themselves into a corner
3. The United Kingdom is headed for a general vote in late June to determine whether it remains inside the European Union. The so-called “Brexit”, if it becomes a reality, may cause concerns in currency, equity and bond markets across Europe, and particularly in the UK, but we foresee little impact on our markets. Brexit will concern the European Union because it sets a precedent for other disenchanted member countries to follow. Brexit will also ignite the rivalry between Germany (Frankfurt) and the UK (London) in claiming the financial centre of Europe. We have long held the view that Germany has the ambition to move Europe’s financial centre away from London. Brexit would allow London to independently regulate and tax institutions away from German influence. Indeed, London will fiercely protect its status because financial markets are its life blood. In passing, we suspect that the pound will rally on either result.
Source. International New York Times
4. The US will move into a full election mode setting from July onwards. More than any prior election year, the risks of a market scare stemming from policy pronouncements seems acutely high. In particular, we perceive a growing tension between US and Chinese trade relations. Neither of the Presidential front-runners (Clinton and Trump) appears to have overwhelmingly widespread support. Indeed the US, like other advanced democracies, may well endure a protest vote against the status quo. If the younger generation turns out to vote in greater numbers than normal, then who could confidently forecast how they will vote? While Hillary is certainly the favourite to win, the US election remains a wild card for world markets.
5. Prior to the US election, the economic performance (reported or real) of China remains the major external influence for the Australian economy. The implementation of China’s economic policy (both fiscal and monetary) by authorities will continue to drive commodity markets and influence the flow of Chinese capital into Australia. Already in 2016, we have witnessed shifts in Chinese policy settings that have influenced confidence levels in the Australian economy. It is our view that the elevated $A makes Australia even more exposed to China. This is because Australia remains highly dependent on commodity and energy prices for national income. China buys one third of our exports and we therefore cannot avoid the consequences of a slowdown in China. Further we need to monitor the outbreaks of rampant debt-fuelled speculation that is reported to be occurring in China. The recent rise in iron ore is a case in point. Time will tell if it is merely another example of poor credit management.