Economic Update – January 2015

The Big Picture

Anyone expecting – at the start of December – a quiet run-in to New Year’s Eve would have been very disappointed. Oil price falls and guess-work over what the US Federal Reserve might say about interest rates caused a severe bout of jitters on markets earlier in December. However, all’s well that ends well.

Wall Street reached new highs in the last days of the year and our market bounced back strongly. Perhaps, like last year, our market might continue its ‘Santa rally’ into January. We have the fair value of the ASX 200 estimated to be 5,550. The market finished the year at 5,411 – up +1.1% on the year and +1.8% on the month.

The big talk at home has centred on our official interest rate. Will they cut, or will they hike? The mood changed over the month but little can reasonably happen before March given past statements by the Reserve Bank.

In spite of pessimism recorded in various confidence surveys, forecasts for Australian economic growth and employment are not bad. Retail sales were up a creditable +0.4% in November.

Overseas, the US and United Kingdom (UK) economies continue to strengthen, the European economy continues to struggle and China still has a managed slow-down to sustainable growth in place. However, Russia is a different story. It was already struggling with the Ukraine conflict and the consequent sanctions placed on Russia. With oil prices almost halving over 2014, Russian exports have taken a massive blow and a serious recession is very likely to follow.

What happens in the Russian economy does not usually affect us much but this time it could be different. President Vladimir Putin is already forced into a corner over Ukraine. If the pressure increases further one might ask if he could over-react. An alliance between China and Russia changes the balance of power in the world and the demand-supply conditions for world resources.

Looking forward to 2015, lower oil (and petrol) prices could make a big difference to consumers at home and abroad leaving more to spend on other goods and services. Even a gentle rise from around $55 per barrel now to $80 per barrel would still leave consumers so much better off than at the start of 2014 when oil was around $100 per barrel. No one is predicting big improvements in oil prices but OPEC must react at some point. As in most situations stability in commodity prices and currencies is worth having to pay a premium for.

It is a relatively safe bet to say that the US economy will strengthen and Wall Street with it – at least, that is, until the US official interest rate rises significantly – probably in 2016.

It is also a fairly safe bet that our economy will not be as strong as that of the US. However, moderate gains on our stock market are consistent with broker forecasts and we expect the ASX 200 to peak during 2015 to somewhere near 6,200. We do not expect the ASX 200 to stay above 6,000 for an extended period of time until late in 2015 or early 2016.

So by expecting capital gains of about 9% on the ASX 200 and 8% on the S&P 500, there is a strong case for some investors to consider diversifying across both asset classes. Dividends on the ASX 200 should be about 4.8% with franking credits on top. Of course investors in overseas share markets need to consider currency risk which might amplify returns or detract from them.

Asset Classes

Australian Equities

With a +1.8% bounce in December, our market finished the year just in front of where it started.  While +1.1% for the year might not seem much, it translates into about +7% when dividends and franking credits are taken into account (and before tax). And that is much better than having been in cash!

There was an unusual divergence in the returns of the Top 20 stocks over 2014. Most resources companies did quite badly while some companies in other sectors did extremely well. Those who favoured the high yielding sectors of Financials (+9.8%), Property (+27.0%), Telcos (+20.8%) and Utilities (+16.1%) should have done very well indeed. As it turns out the defensive Health sector (+24.4%) did particularly well over 2014.

With rates on hold in the US at least for the first half of 2015, the so-called ‘yield play’ seems likely to outperform resource plays in the near term. However, there were some encouraging signs at the very end of 2014 that resources stocks had been over-sold and a bounce might be expected in early 2015. As always there is more expected risk attached to resource stocks over high-yield stocks.

At last there is a reasonable chance that the ASX 200 will exceed 6,000 for a little while in the second half of 2015. It is quite common that investors take profits when big psychological levels, such as 6,000 are breached. If the market does end 2015 at 5,900 or thereabouts as we predict, investors should be very happy, especially because of the relatively high yield and franking credits in Australia.

Volatility is ever-present and increased volatility might occur when the US Fed starts raising rates.

Foreign Equities

Wall Street continued to make new highs in December and the Dow Jones index crossed 18,000 for the first time. Both the Dow Jones and S&P 500 indexes lost a little steam in the last few days but the S&P 500 was up +11.3% on the year. The world index was up only +3.6% over the same period.

The big question for local investors holding US stocks is the impact of our currency. The Governor of the Reserve Bank of Australia is trying to talk the dollar down. If he is successful, the S&P 500 returns in $A (Australian dollar) would be amplified. But if it goes the other way, Australian investors would be getting lower returns than their US counterparts.

Bonds

With the US QE programme well behind us, and a clear period of stable official rates ahead, bonds should have a stable future in the near term. But when rates do start to rise in the US, bond yields will rise eroding the expected total returns for bonds.

If the European Central Bank finds a way to purchase government bonds from its member nations as it is trying, some optimism should sweep across Europe in early 2015.

Interest Rates

There were big changes in interest rate expectations in both Australia and the US during December. Analysts switched from forecasting hikes to cuts in 2015 for Australia. The market is pricing in one and a half cuts (to 2.125% from 2.5%) next year but the Governor of the Reserve Bank continues to focus on stability in monetary policy.

We see no need to cut rates as that would have limited impact on the economy. There are better ways to stimulate the economy through fiscal policy from the government – but it does not seem close to moving in that direction yet.

The US Federal Reserve has given strong hints that it will not raise its official rate anytime soon – possibly even after 2015 ends! More than likely there will be one or two very gentle increases in the second half of 2015.

Other Assets

Iron ore prices fell a little further in December but they appeared to stabilise and they even rose back above $70 per tonne at the end of the year. The share prices for BHP and RIO gained later in the month from their 2014 lows.

Oil prices also fell further in December but the share prices of the major Australian energy producers bounced back after, apparently, being oversold.

Gold prices continued to fluctuate near $1,200 in December. Our dollar lost nearly 4% in December to finish the year at $0.8171, after starting 2014 at $0.8948.

Regional Analysis

Australia

The call for rate hikes in Australia changed to a call for cuts during early December. Westpac even went for two rate cuts starting very early in 2015. There were plenty of ‘soft’ data to question the current monetary policy stance but a cut is far from inevitable.

The falling currency and oil prices make parts of the economy potentially much better off. There were +41,800 new jobs created in November but unemployment stands at 6.3%. Full-time employment actually fell by  1,800.

The Reserve Bank did not change rates in December and it does not meet in January. It is also doubtful if they would cut in February without some prior hint so March seems the earliest for us. However, a lot can happen between now and March making a cut unnecessary.

The Treasurer released MYEFO (Mid-year Economic and Fiscal Outlook). The unemployment forecast peak in Q2 2015 has risen from 6.25% to 6.5%. Currently unemployment is 6.3%. The forecast deficit has climbed from $30bn to $40bn and debt is expected to peak at half a trillion dollars. We do have a debt problem.

Clearly the current government is not making any great inroads into economic reform and the Prime Minister’s popularity continues to decline. But economic growth is still forecast to be +2.5% this year and +3.0% next – which is just a fraction below trend.

China

China’s Purchasing Managers’ Index (PMI) for manufacturing came in on the 1st December at 50.3 and down from the previous month. The January 1st read was 50.1 for the month of December – spot on expectations. Both numbers are above the ‘50’ that divides expansion from contraction. The sequence is gliding towards a stable ‘50’. China is on a stable growth path but quite a few other data releases disappointed in December. It is likely that China will continue with targeted stimulus packages.

China’s consumer price inflation is below target at 1.4% and producer price inflation remains negative at  1.6%. It is unlikely; therefore, that China will just sit on its hands.

U.S.A.

US GDP growth for Q3 was revised upwards from +3.5% to +3.9% in November and its final revision in December lifted growth to +5.0% for Q3!

Non-farm payrolls (employment) data came in at a massive +321,000 – making it the 10th month in a row to beat the psychological level of +200,000 – with the unemployment rate standing at 5.8%.

The all-important Federal Reserve Meeting reinforced that it will be ‘patient’ in waiting for the right time to lift the official rate. The Fed now predicts the rate will be 1.125% at the end of 2015 from 0% – 0.25% at the moment. At the previous meeting, the End of Year (e-o-y) forecast rate was higher at 1.35%. The e o y unemployment forecast is 5.2% and the Fed expects more people to join the workforce in search of jobs to counteract the booming employment numbers.

The Fed also stressed that it will be at least two more meetings before it signals any interest rate rise, making the earliest time for a hike to be June 2015.

US shale oil explorers are reportedly cutting back on their investment in new projects. This behaviour is exactly what OPEC was after when it failed to support oil prices by not restricting supply. Perhaps OPEC will soon reverse the price decline. It has the power to do so.

Europe

The European economies continue to struggle but the European Central Bank did not cut rates at its December meeting. However, there is increasing speculation that the Bank’s president is working on a solution to bring in a full stimulus package very early in 2015.

With political uncertainty forcing an election in Greece on January 25th – three days after the European Central Bank meets – the party that wants to exit the European Union may gain control. However, that is not the same as leaving the euro.

But more importantly, when this situation last arose in 2010 and 2011, people feared a knock-on effect to Spain, Italy and Portugal. Those countries are in much better shape now and bond yields are much lower. There is little to fear from Greece these days. Argentina defaulted last June but hardly anyone outside of that country noticed.

Rest of the World

The sliding price of oil has particularly affected Russia’s economy. It is so dependent on oil exports that the price of oil – along with the Ukraine conflict and the sanctions it has generated – looks likely to launch Russia into a full blown recession in 2015.

China has offered economic support to Russia but such an alliance could make it more difficult for Australia if a Sino-Russian relationship strengthens. Russia is rich in resources – just like Australia.

Russia was forced to increase its key interest rate from 10.5% to 17.0% in one go to help support its crumbling currency, the rouble!

Japan Prime Minister Shinzo Abe was re-elected in December with a very large majority. Already he has announced a $29bn stimulus package to help those who were hurt by the April increase in sales tax. Japan’s Q3 GDP growth was revised down to  1.9% from  1.6%.

The Hong Kong protest against how its politicians are elected ended quietly without any concessions having being won.

After 50 years, the US has at last lifted restrictions on US citizens travelling to Cuba. Obama acknowledged that the restrictions had no discernible impact on Cuba. Cuba welcomed the change but asserted that it will remain Communist!

*Ron Bewley(PhD,FASSA)– Director, Woodhall Investment Research

Important information

This information is the opinion of Infocus Securities Australia Pty Ltd ABN 47 097 797 049 AFSL and Australian Credit Licence No. 236523 trading as Infocus Wealth Management and may contain general advice that does not take into account the investment objectives, financial situation or needs of any person. Before making an investment decision, readers need to consider whether this information is appropriate to their circumstances.