Ongoing good news in the US and the start of the European Central Banks (ECB) bond buying program are underpinning a global economic recovery. As a consequence, global share markets have been generally positive over the past quarter with the global share indices for the developed world and the emerging world up 2.4% and 2.2% respectively.
However, markets have become more volatile as a result of uncertainty surrounding the Greek debt issues and the spike in bond yields, the latter flagging potentially higher global interest rates in the long term.
From a valuation perspective we see the US share market as being stretched whereas Europe and Emerging Markets remain fairly priced for the long term.
Greek crisis causing short term havoc in global share markets
The major news story at the moment is the Greek situation which appears to be reaching a crescendo at the time of writing. The uncertainty around Greece has created higher volatility in global share markets as investors react to news, good and bad, on an almost daily basis.
The very recent increase in volatility has been driven by concerns that Greece would default on its scheduled debt repayments on 30 June. The IMF confirmed Wednesday morning 1 July that they had not received a payment from Greece and therefore Greece is in default.
Greece did make a last minute request to access a further 30 billion euro from the European Stability Mechanism (ESM) for bridging finance for a further two years to enable them to restructure existing debt. Their major creditor rejected this application.
The Greek Government has called a snap referendum on Sunday 5 July to seek input from the Greek public as to which course of action to pursue. Their choice is either voting ‘Yes’ to accept the austerity measures required by its creditors or ‘No’ to not accept the austerity terms.
Voting ‘Yes’ has the possible implication of increasing the already high level of financial stress the Greek people are already experiencing. However, Greece’s creditors assess this as necessary for Greece to be in a position to begin repaying its debts. The upside is that its creditors will view this favourably and it will most likely ensure that Greece remains in the Euro zone and continue to receive the benefits of membership such as access to jobs in Europe.
Voting ‘No’ has the possible implication of a Greek default resulting in an exit from the Eurozone with potentially dire economic consequences for Greek citizens. This would likely see a reintroduction of the Drachma (Greece’s pre EU membership currency) which would likely result in the significant devaluation of assets such as cash, possibly bank failures, restricted access to the Eurozone for Greek workers and a host of other detriments.
It appears the Greek people are being asked to choose which scenario is going to hurt less because, regardless, the economic pain level for its citizens is going to rise.
At this stage, no one knows how this will play out (hence the high level of share market volatility). And it is likely to be some time before it is resolved either way.
Questions abound such as:
• Will the Greek government make good on its threat to take the rest of Europe to court if they are thrown out of the European Union?
• How would the rest of Europe respond if Greece isn’t forced to leave the Eurozone… or if it is?
• Will the European Central Banks (ECB) provide the necessary capital to mitigate the impact on the European financial system should it occur?
• Will the Greeks default on further scheduled debt repayments?
• Could a Greek tragedy cause a domino effect in Europe, with other countries, like Italy and Portugal for example, suffering similar problems due to the inability of their economies to service their debts to the satisfaction of their creditors as has been the case with Greece?
What impact will the Greek crisis have on the longer term performance of global economies and share markets?
It’s likely to be minimal. Greece is a very small economy and their debt level is not huge in the scheme of things, so the longer term impact of the problems surrounding Greece should not be too onerous on the rest of the world.
And, with so much good news elsewhere in the world, it’s likely that the crisis in Greece will not be sufficient to stem the rising tide of global economic growth for long, if at all.
The US Economy continues building a head of steam
In the US, unemployment is declining, inflation is low and overall economic growth, while soft, at 2.7% p.a. is trending positively. In addition, US consumer sentiment has held up after the gains achieved in 2014, and is currently running at a five month high. In keeping with this theme Americans have borrowed more money than they have for some time, indicating more confidence in personal incomes and job stability.
There has been a pick-up in average hourly earnings, indicating that conditions are right for all-important wages growth to occur. Wages growth is a critical factor as it feeds through to consumer confidence. Confident workers increase consumption at the expense of savings – and this is good for economic growth.
If the current trajectory of US economic data is maintained then the much expected start of increases to the US official interest rate is likely to occur in the second half of 2015.
The ongoing recovery in the US is good news for the global economy because the US is one of the world’s largest economies and biggest consumers. As US demand rises, growth improves not only for the US but also for all those countries that export to the US. This has the knock on effect that leads to stronger growth in many other countries and contributes to improving global growth.
Nonetheless, we believe the US share market is now fully priced and generally does not represent good value for investors over the long term. This is not surprising as often the share market can lead the real economy by six to nine months. The market sees the green shoots of recovery and prices this in much faster than it takes the economy to deliver on these expectations.
Europe benefiting from ECB’s big bonds buying program
In Europe, the European Central Bank (ECB) began its bond buying program where it will acquire 60 billion euros of government and semi-government bonds per month until September 2016, an amount totaling 1.1 trillion Euros.
The objective of this program is to make cheap capital readily available to business and consumers in an effort to kick start growth in the region’s economies. To date, while cheap capital has been in abundance Europeans have been reluctant to borrow and invest as they lacked the confidence that self sustaining growth would follow.
An added benefit of the bond buying program for European exporters has been a depreciation of the Euro, providing a further boost to the region’s fledgling recovery. The weaker currency makes their goods more competitive in foreign markets and foreign goods more expensive in Europe.
If the US is building a head of steam then Europe is stoking the furnace to heat the boiler with its bond buying program. The US economy is further along on the road to recovery but the European economy now looks to be getting some traction as well.
China is still growing but at a slower pace
In China, economic growth continues to slow from its high levels, albeit at a modest pace. We believe this is consistent with Premier Xi’s program to transition China from being heavily dependent on exports to an economy with a greater domestic consumption focus.
This process of transition has contributed to a reduction in China’s demand for resource commodities (such as iron ore and coal), which in turn has resulted in ongoing weakness in global commodity prices. To highlight this, we note China’s steel consumption is expected to fall for the first time in 25 years.
Australia – missing the mining boom
Unsurprisingly our economy has continued to experience slower growth as the resources boom unwinds. As noted above the weaker growth in China is seeing weaker demand for Australia’s resources exports.
The government is keenly aware of this and has responded with policy recommendations designed to favour, and hopefully stimulate, activity in small to medium sized businesses and the retail sector, all being major employers in the Australian economy.
With the local economy slowing, the Reserve Bank of Australia (RBA) reduced the cash rate further to a record low of 2.0% in the quarter. This is designed to help promote growth in the economy by reducing the cost of capital for businesses and households.
Recent falls in the Australian share market have resulted in slightly better valuations and relatively attractive entry points for long term investors, especially in the financial sector.
These attractive valuations are underpinned by the low interest rates, the relatively strong dividend yields on offer, unemployment declines, conservative corporate debt levels, small business tax cuts and a weakened Australia dollar.
Notwithstanding these positives for shares in the short term, Australian investors continue to be concerned about the impact of the Greek debt issues and slowing growth in China.
Term Deposits lose their lustre
Over the past seven or eight years, term deposits have paid much higher returns than cash and bonds. That has now changed. The rates on government bonds have risen, as have rates on corporate bonds, and both now offer as attractive returns as term deposits but with greater liquidity.
Another headwind facing term deposits is that the dividend yield of the large listed shares is significantly higher than the yield available from term deposits. Shares dividends are currently 5.7% p.a., including grossed up franking credits, versus about 3.4% on a 5 year term deposit, a meaningful difference of 2.3% p.a.
This is a further source of support for Australian shares as it is likely there will be some reallocation of capital currently invested in term deposits to be reinvested in the share market. It appears this transition has been occurring for some time and we expect it to continue due to the yield differential being at its greatest since the trend began is 2013 (see Chart 1 below).
Australian residential property prices, especially in the major cities of Sydney and Melbourne, remain very buoyant and were further fuelled by the RBA rate cut and the expectation of more to come as the bank adjusts its policy to support the broader economy.
This is causing angst from property buyers and politicians as housing affordability deteriorates.
The listed property trust (LPT) market has fallen in concert with the Australian share market in the short term. This demonstrates how the two can often perform quite similarly, a factor that needs to be considered when investing. The recent and modest decline in LPT prices has resulted in improved valuations and in LPTs generally being considered fair value.
For investors preferring a more direct property-like allocation, we favour select professionally managed open ended trusts/funds containing a range of quality property assets diversified by sector and location.
Presently there is a limited range of options in that space, but they do present superior valuations to LPTs and characteristically have much lower gearing levels. This helps ensure that their return profile is much more akin to direct property than that of equities. The drawback to these unlisted funds is that they can be a lot less liquid than LPTs but significantly more liquid than direct property.
Portfolio Positioning and Outlook
With the exception of a fully valued US share market, we see most share market and property market prices as being in the ‘attractive’ to ‘fair value’ range for the long term. This is evident in our tipping points table.
Our outlook for investment markets, therefore, remains generally positive with global economic growth continuing to recover albeit at a benign pace.