Our view on the Investment Landscape - April 2015 Blog article
The Investment Landscape – April 2015
It’s been a big 12 months for Australian economics, the Government and the Reserve Bank of Australia (RBA). Australian growth forecasts are continually being revised downwards, and this looks like it will continue as things are not improving. This has been driven primarily by the fall/collapse in commodity prices. Iron Ore has dropped from $112 to $48, oil has fallen from $100 to $50 and coal is sitting at decade lows. The economy has completely been turned on its head! This has implications for policy, interest rates and investment markets. It’s important to understand these as it shapes investment decision-making and portfolio construction.
To start, let’s look at government fiscal policy. The Australian government relies heavily, directly and indirectly, on tax revenue from the commodity sector to fund expenditure and promote economic growth. The aforementioned commodity price falls equate to a massive reduction in gov’t revenue, and given the oft mentioned fiscal deficit and the Liberal’s focus on restoring budget surplus, there will be NO help from the gov’t in stimulating growth through increased spending. In fact, you can expect the budget deficit to blow out significantly when the budget is announced in May, and I mean SIGNIFICANTLY!!
This is important as the government is effectively rendered useless in helping Australia turn around its flagging growth outlook. The other policy lever we have is via interest rates, which are controlled by the RBA. Simply, lower interest rates lead to increased spending and investment which is a positive for economic growth. You need look no further than the strength of property and share markets since the RBA dropped rates in January. Cheap credit encourages people to spend and changes valuation dynamics. The RBA will have to keep reducing rates for a variety of reasons, including reducing the value of the Aussie dollar - which is staying around the mid-high 70’s. Every one cent fall in the Aussie dollar is a tremendous benefit for Australian exporters, and thus economic growth. Currency devaluation is what just about every other country around the world is doing to stimulate its economy, and why not, it’s worked for the US.Unfortunately we are miles behind the eight ball and need to get cracking now!
Let’s spend a moment more on the currency devaluation theme, it’s the biggest thing in global markets at the moment. The US led the way with its QE program, which seems to have worked, and we’ve since seen Japan and now Europe (via the European Union) embark on similar programs. The performance of their respective sharemarkets over that period has been astonishing. The RBA is behind in this regard and it’s the reason our currency remains stubbornly high - relative to the rest of the world our interest rates are high. Essentially, low interest rates (resulting in low currency) are really good for sharemarkets!
So essentially we have 3 key themes – slowing economy, paralysed government and a high dollar. All roads lead to the RBA dropping rates. Over time this should result in a lower dollar, stronger asset markets (shares and property) and provide a base for economic growth.
Investment Strategy Implications
If recent history is any guide, the above scenario has clear investment implications.
Interest rates will fall, this is inevitable.
Cheaper credit has a strong correlation to the performance of share and property markets for a variety of reasons. With rates coming down, we expect a strong performance from the Australian sharemarket over the coming year. We also expect property will continue to be in demand. Let’s focus on financial shares for a moment - most investors hold directly or indirectly significant exposure to these (the Australian sharemarket index is nearly 50% financials!). There has been much debate over the valuation of these assets, which on virtually any valuation metric look expensive relative to history. Without going into the technicalities of valuation, essentially valuations are relative to interest rates. Don’t forget that we have never seen interest rates this low, so it should come as no surprise that we haven’t seen valuations this high. The lower rates go, the higher valuations will go. This will be driven by domestic and global money looking for a decent return, as you won’t be able to get it from cash!
Given the above, the Aussie Dollar will fall
If I had to pick one certainty this would be it. The RBA wants it lower, it will therefore go lower. It HAS to go lower. Given this, we want to be exposed to international shares on an unhedged basis. Every 1% the AUD falls is a 1% positive return for us. We wouldn’t be surprised to see the AUD in the 60’s so there is certainly return to be gained here. International shares aren’t a bad place to be either. The US is the only developed country with increasing growth forecasts, Asia is strong and Europe is starting a similar QE program that has delivered positive results in the US. Sharemarket performance in these markets reflects this optimism.
Be invested, but diversify!
Subject to your risk tolerance, share and property markets should continue to deliver positive returns in terms of both capital growth and income. Cash, whilst providing security, will not deliver any meaningful return. In terms of allocating money to specific sub sectors of a market, (i.e. banks, resources) we don’t think now is the time to go down this path. The key to maximising return whilst minimising risk is diversification!! The macro environment will deliver asset class returns and we do not need to be taking stock/sector specific risk .Aim for a diversified portfolio covering all regions.
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