The past 12 months have brought about significant change to the international and local economies, creating a degree of global uncertainty, says Patrick Noble.
A lot has happened for little reward in a year where equity markets have struggled to find higher ground. Indeed as it currently stands, it looks as though the Australian market will finish this calendar year in the red.
Meanwhile global markets, despite the turmoil, look set to eke out small gains, though the ascent of the Australian dollar has conspired against unhedged Australian investors.
The mostly sideways movement of equity markets did experience rapid shifts in investor sentiment, with the major factor being whether the prevailing winds were either ‘risk on’ or ‘risk off’.
The cause?
A number of seemingly recurring themes; sovereign debt issues in Europe; credit rationing in China; deflationary and double-dip fears in the US; and locally, a resilient economy, but with some sectors feeling the pinch of rising interest rates.
Perhaps the portents were in place in late 2009. As markets were rallying to their yearly highs, optimism was tested with the massive debt issues confronting Dubai World.
The problems were quickly shrugged aside, though the bears were quick to point to similar issues facing some peripheral Eurozone members.
No doubt 2010 will long be remembered as the year the ‘PIIGS’ (Portugal, Italy, Ireland, Greece and Spain) roiled global markets, though it also featured a number of other significant events. The global re-regulation of financials, election outcomes (including a hung parliament in Australia for the first time in 68 years) and a yet to be resolved Minerals Resource Rent Tax (MRRT) will all play their part in financial markets through 2011 and beyond.
Europe: Sovereign debt and contagion remains a threat
It’s an oldie but a goodie and in the case of Europe it really was a year of déjà vu. First Greece, then Ireland and a number of other ‘club med’ countries still remain firmly in the market’s sights.
Policy makers were initially slow to act, though they did manage to come up with a creative mechanism to circumvent the Treaty of Maastricht.
While Germany continues to press for bondholders to take some of the pain it is the economic strangle of austerity measures that is creating unrest in the region. Much reform is required, as is a steady hand, as political will remains the glue holding a fragile and polarised European experiment together.
China: Reigning in credit, currency pressures
A wall of credit inundated the Chinese economy to push it through the global financial crisis. The policy was perhaps too successful as China is now actively taking steps to reign in credit and ease inflationary pressures.
A series of five increases in the Reserve Ratio Requirement were undertaken throughout the year with additional lending policies applying to the rampant housing market. But with inflation hitting 4.4 per cent, official interest rates were also hiked for the first time in three years.
Policy makers have a delicate balancing act ahead of them. Engineering a soft landing and moving successfully from an export to consumption driven economy in the years ahead will be no mean feat.
A lower growth rate may be the order of 2011. Rising tensions with the US over currency policy will also need to be managed.
US: Fighting deflation, double-dip fears fade
China’s policy of pegging/gradual appreciation to the US dollar has been a bone of contention as America tries to grow its economy via the export market.
Some parts of Washington are aggressively pushing for action to be taken against what is seen as unfair currency manipulation, though a second round of quantitative easing (QE2) has taken its toll on the strength of the greenback. Hopefully cool heads will prevail.
While the Federal Reserve continues to wage its war against deflation with QE2, a more recent run of good economic data suggests that the double dip has been avoided and economic growth is resuming.
Nevertheless, a lot still needs to be done with unemployment hovering too close to 10 per cent.
If the housing market does indeed stabilise, ample liquidity, low interest rates and the now confirmed extension of tax cuts could see the US surprise over the next 12 months.
Australia: Two-speed economy, one monetary policy
Our economy remains heavily reliant on the growth of our Asian neighbours.
Their ongoing strength is assumed in both budgetary forecasts and pending bottlenecks, which are seen by the Reserve Bank of Australia (RBA) as future inflationary hotspots. In response, domestic rates have risen by a full 1 per cent over the past 12 months.
Now that rates are at a level the RBA may consider ‘neutral’, some parts of the economy are showing signs of stress.
The steam is coming out of the housing market, hit by a double whammy of rising utility bills and mortgage rate increases in excess of the official increase.
Furthermore, unemployment has unexpectedly shot up and even the latest retail figures from October (before the November rate hike) suggest that consumers are pulling in their expenditures.
Retailers are struggling, as too are other interest rate-sensitive sectors.
The appreciation of the Australian dollar has also affected a number of sectors, creating both winners and losers. And despite the initial market reaction to the MRRT, commodities have been a clear winner from both ongoing demand and the weakness in the US dollar.
Against the macro backdrop, equities have shown resilience over 2010.
Financials have passed perhaps lenient stress tests, however more trying announcements such as clauses in the Dodd-Frank Bill on powers to deal with ‘too big to fail’ banks have been taken in the market’s stride — as have pending BASEL III regulations.
Regulation has also featured heavily in Australia. Along with the proposed MRRT, telecommunications have been affected by the National Broadband Network.
Also, in light of recent interest rate moves, politicians are fuelling debate in the financials sector (to put it mildly).
Certainly one positive was the changes announced in superannuation, taking the minimum superannuation guarantee to 12 per cent by 2019-2020 — but it will be a slow journey getting there.
The investment landscape does seem to lack clarity. Nevertheless, these are typically the times when markets offer opportunity.
Despite the unresolved issues, strong earnings and merger and acquisition activity have been features underpinning equities.
Companies with a solid track record, pricing power and who possess a distinct competitive advantage offer good long-term opportunities.
The ability to lift dividends and engage in other capital management programs may also be attractive in a more volatile environment.
And from a relative value argument, the current asking price for many high quality companies is compelling when compared to the lofty prices being paid for government bonds.
Put another way, who would you prefer to invest with — Sam or Bill?
Sam is highly indebted, has structural issues and will likely add more debt in coming years, and currently pays you a yield of around 0.5 per cent per annum on a two-year loan.
Bill on the other hand has very low levels of debt and generates large amounts of cash year in year out.
Bill has a long track record of making money in differing market conditions and pays you a yield of around 2.5 per cent at the moment.
Your answer may depend on whether you’re a believer in moral hazard and bottomless rescue packages, but just so you know, one is the issuer of government debt and the other is Bill Gates’ Microsoft.
Patrick Noble is senior investment specialist at Zurich Financial Services.
