Matt Drennan examines the outlook for international investors in the year ahead.
Now that Christmas has come and gone it’s time to see what presents Santa left us to play with in 2011.
Unfortunately, it looks like the sleigh ran into turbulence over Asia and most of the goodies rained down on that region with precious little left for the rest of the world.
Never fear – Bernanke is here
The second round of quantitative easing (QE) was designed to flood the US banks with liquidity, drive down interest rates and encourage credit growth.
Ultimately, this is supposed to generate growth in employment. The problem faced by the US is that despite sufficient liquidity, banks don’t want to lend and consumers don’t want to borrow.
Therefore, the fundamental goal of the QE program is unlikely to be achieved.
Because this excess liquidity is not being used for real investment, the danger is it may simply inflate asset prices. It has the potential to cause the next bubble and bust, exacerbating an already ugly situation.
As most soft (wheat, rice) and hard commodities (iron ore, coal) are priced in US dollars, debasing the currency can in fact behave like an additional tax on imports for the very consumers the QE program is designed to help.
A popular argument is that a weaker dollar increases US international competitiveness and leads to stronger export numbers that will support the economy.
This works in theory — but not if your major export partners also have weak currencies.
Some of these currencies are being kept low through artificial measures — such as China’s RMB being pegged to the US dollar, or the quantitative easing measures being pursued by the UK.
Other currencies, such as the euro, remain weak due to the European sovereign debt crisis. Either way, it stymies the ability of a ‘weaker’ US dollar to stimulate exports.
My expectation for 2011 is that US unemployment will remain stubbornly close to double digits, while consumers will continue to shun most non-essential spending and rebuild their savings.
The US dollar will remain under pressure as a result of QE. Ironically, the amount of liquidity sloshing around the system may see surprisingly good returns from global equity markets in the year ahead.
European disunity
Austerity measures in Ireland, Greece, the UK and other European countries will take many years to restore the health of public finances. In the meantime, economic growth will remain sluggish and unemployment will remain a burden.
Germany is the exception, but there are clear signs that its citizens are fed up with repairing the damage caused by other peoples’ folly.
To my mind this puts the whole Euro zone at risk.
Highly indebted countries were able to run up these debts because they could borrow in Euros. Now they need their own currency so that devaluations can assist the rebuilding phase.
Much like the US debt problem, something has to give here. It may not happen in 2011, but it is inevitable.
The ‘lucky country’
Softer inflation, GDP and employment data appears to have eased the pressure on the Reserve Bank of Australia (RBA) for further near term rate rises.
But the ongoing issues associated with setting one monetary policy for a two-speed economy will continue to pose a challenge for the RBA.
Unemployment should remain low at around 5 per cent and economic growth at 3.5 per cent, fuelled by strong export growth, with inflation largely in check. Within these aggregates, there will be huge variations both between industries and geographically.
Mining and related industries will continue to boom, with China’s measured slowdown adding to its longevity rather than putting it at risk.
The best of the price hikes for key commodities are likely behind us given a softer global economic environment and a gradual reduction in supply bottlenecks.
There is still much work to be done here and projects such as the National Broadband Network will undoubtedly bring some productivity benefits — although ports, rail and road projects are being largely ignored. It is difficult to transport a tonne of coal through a fibre optic network.
Australian equities still offer attractive prospects when dividends are considered. A strong pickup in mergers and acquisitions activity as corporates become more confident about operating conditions could well drive the next leg up in equity markets.
Currency
The main drivers contributing to the Australian dollar’s remarkable appreciation over the past 18 months have been the interest rate differential, the use of the Australian dollar as a proxy for risk, QE measures in major developed world nations and strong resource prices.
The interest rate differential is now fully priced in by the market.
The ‘risk on’ trade may still have some way to go, however, the Irish banking crisis remains as a timely reminder of just how quickly market sentiment can change.
Quantitative easing continues to put some pressure on the US dollar, however this too is now essentially priced into the market. All this would suggest that the recent drivers of the Australian dollar strength are unlikely to provide further appreciation pressures in coming months.
On almost all metrics the Australian dollar appears at least fully priced, if not overvalued.
The largest single risk for 2011
Excess liquidity from the US and the UK may continue to flow offshore in search of yield or capital returns rather than finding its way into constructive investment opportunities in their domestic markets. If this happens on a very large scale it has the potential to create the next great asset bubble.
There is already speculation that this may be occurring in some Asian property markets.
However, the incredibly favourable long-term urbanisation and industrialisation story leads us to believe we are still a long way from a bubble-like situation in the vast majority of these markets.
Matthew Drennan is the general manager of Zurich Investments.
