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Investment Market Update

Feb 04, 2015

Australia

Falling commodity prices have made the outlook for Australia more challenging. The price of iron ore (our largest export) averaged around $US90 in 2014, but towards the end of December was trading around $US70, the lowest since 2009. Price weakness is also impacting the federal budget. In fact, the government recently slashed its price forecast for iron ore in 2015 by a third to $US63 a tonne from $US94 in September. At 6.3% in November, the unemployment rate is expected to head higher. Interest rates are expected to remain on hold in the New Year with an increasing possibility of a rate cut. Consumer sentiment remains well below ten year averages.

The above factors have been major contributors to the decline in the Australian dollar. A weak dollar should make Australia more competitive (specifically exports). However, other segments of exports will not make up for lower commodity prices. The $A dollar is expected to weaken further. 

United States

Third quarter US economic growth has surprised on the upside. Gross Domestic Product (GDP) was revised to a very healthy 5% on an annualised basis, its highest growth rate since 2003. Growth was derived from a number of sources including consumer spending (which is critical for US growth and the largest contributor to the economy), business investment, housing and government spending. Increased exports added nearly 20% to the GDP figure, this will be difficult to maintain in the face of a rising $US. Unemployment continues to improve, currently 5.8% compared to 7% a year ago.

Taking into account 3rd quarter GDP, strong employment trends and early signs of wage growth, the Federal Reserve can be expected to increase interest rates over the coming months. Interestingly, the US appears to be enjoying economic growth, buoyant share markets and low long term interest rates (all at the same time). US economic strength has resulted in a resurgent $US - most currencies having been weaker against the $US, including the Euro. This will have some impact on US corporate earnings that are sourced from overseas and rising long term US interest rates will eventually impact profit margins.

The dramatic decline in oil prices towards year end will have consequences just as rising geopolitical tensions. More specifically for the US consumer, the event is cash flow positive as they pay less for fuel. Effectively, their spending power has increased. This is also true of China, India and other oil importing nations. Overall, lower oil prices are a net positive for the US economy. Increased supply coupled with slowing European and Chinese demand may see prices remain relatively low for some time.

2015 will be challenging for the US market given the probability of rising long term treasury rates, $US strength and recent cuts to the earnings outlook. Further, it is most unlikely that third quarter US GDP will be sustained. 2015 may well be a case of a strong US economy already having been factored into equity valuations.

China

There is no doubt the economy is slowing. However, the Chinese share market staged a significant rally in the latter half of the year from undervalued levels in early 2014. This rally was influenced by recent Chinese policy initiatives - official interest rates were unexpectedly cut and the government allowed foreigners to purchase mainland China A shares. Further, with house prices having weakened in China, there may be new funds directed toward non housing related growth assets in China and abroad.

China can be expected to be a beneficiary of lower oil prices, although an end to the residential construction boom is being felt across the economy with the growth rate again expected to slow. This was recognised when China reduced official borrowing rates in November 2014. 

Europe

European economic growth remains anaemic with the prospects of deflation very real. However, regardless of the negatives, the German market is near record highs, not so the French market which is still well below its June 2007 highs. With Germany being the largest economy in Europe and also the largest exporter (29% of European exports), corporates will get some relief from the weakening Euro versus the $US (partially offset by Russian embargoes).

The European Central Bank (ECB) has been providing stimulus in Europe for some time. While the stimulus may have been positive for markets, it has failed to have a meaningful, positive impact on the economy. In early 2015 announcements are expected about government bond purchases – this will allow banks to undertake more lending, a missing ingredient to the European economic recovery thus far – and about infrastructure funding and possibly about a major line of funding to be provided for relevant European countries. To keep Europe in perspective, banks that place funds with the ECB do so with a negative interest rate.

While lower oil prices should benefit large parts of Europe, they will also add to the deflationary concerns. Greece is again in the headlines due to political unrest, and concerns that Greece will not continue to comply with European bailout obligations. Concerns are again being reflected in the yields of Greek bonds.

Japan

Abenomics is yet to prove successful. Japan's economy has again been in a technical recession after GDP shrank an annualised 1.6% in the September 2014 quarter, expectations were for growth. Underlying inflation is also tracking well below the Bank of Japan's target levels. The Yen reached an eight year low in December and on 27 December the government launched a new $29 billion round of stimulus targeting largely the household. 

Other Emerging Markets

Countries that rely heavily on oil exports have seen major movements in their currencies and negative revisions to GDP. Russia is the more obvious example. The Russian Ruble fell 50% against the $US in the 2nd half of 2014 and interest rates rose to 17%. Russia is understood to have spent over $21 billion defending its currency. Interestingly, while $US oil prices have plunged, they have actually been offset by the fall in the Ruble.

The weaker oil price coupled with sanctions against Russia is placing a strain on the Russian banking sector to the extent that a Russian debt default is not out of the question should current factors prevail throughout 2015. Similarly, Venezuela will almost certainly default in March 2015. 

Equities

The US is trading on a forward price earnings ratio of around 16 times, which is above historical averages. At these levels the market is factoring in strong earnings growth due largely to strength in the US economy. This valuation is viewed as being on the high side and a more subdued performance from the US market is anticipated in 2015.  However, a weakening $A would be an additional source of returns for Australian investors.

The Australian share market is trading on a forward price earnings multiple of 14.4 times and a current dividend yield of 4.5%. Australian market performance has been heavily influenced by energy (oil stocks) and commodities (resource stocks) and some of this underperformance may partially reverse in 2015.

Investment Outlook

The investment environment for 2015 is one of contrasting scenarios.  Just as the fall in the oil price and other commodities may adversely impact emerging countries, it also brings major benefits to consumers and businesses around the world fuelling economic recoveries.  Along with the continued slowing of China’s economy, appreciation of the US dollar and geopolitical risks in Europe, there is reason to continue with a prudent and cautious approach to investment whilst constantly monitoring the market for potential investment opportunities. 

Prepared by 

craig a. hewett  CFP DipFP JP

ashton campbell financial services pty ltd

authorised representative

consultum financial advisers pty ltd

australian financial services licence 230323



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