Summary: The market is telling us about important trends for both the world and Australia. There are four assumptions it is making at the moment: That Greece won’t cause a collapse if it leaves the euro, that US interest rates will be low for longer, that Australian banks and industrials shares should be boosted amid lower yields and that China’s overheated share market is a significant threat to Australia.
Key take-out: As the world scrambles for yield in this tough environment, industrial stocks and Australian banks will look very attractive – as Warren Buffett has noticed.
Key beneficiaries: General investors Category: Economics and Investment strategy.
The market is telling us about important trends that are ahead for both the world and Australia. As we all know, markets can be wrong and when they are wrong there are dramatic adjustments. But with that important qualification let’s look at what the markets are telling us the world will be like in the next six months.
Right now all the noise is about Greece and we are seeing soft equity markets which will accelerate if Greece leaves the Euro. But there is no collapse so the markets are telling us that in the short term Greece will not make a huge difference to the whole market.
1. Greece won’t cause a collapse
If it stays in the euro and a deal is done (I still maintain that is about a 60 per cent chance) there will be a relief across markets. If it leaves the euro (and I rate that at 40 per cent) Greece is headed for a depression but the world has all the mechanisms in place to confine the major market fall out from that event to Greece itself. Longer term there will be problems with Greeks fleeing Greece and trying to enjoy a better life in northern European countries and I think Russia will take a bigger hand in Greece – increasing the likelihood of European conflict – but that will not take place initially.
And the above message is exactly what the markets are saying about Greece. We will certainly see a correction in the markets if Greece leaves the euro but there is no sign of a pending big collapse. I am much more concerned about China but I will come to that later.
2. US interest rates will be low for longer
The second message we get from the markets is that while American interest rates are going to rise later this year (and let’s not get hung up on the month) the interest rate increases are not going to be as big as the markets feared a short time ago. As a result the US ten-year bond yield has fallen from around 2.5 per cent to around 2.25 per cent – a quarter of a per cent drop in a short time is a trend setting event.
Similarly the ten-year Australian bond yield has fallen from around 3.25 per cent to 2.9 per cent. We were seeing an exodus of Australian money to take advantage of high US bond rates and the likelihood of higher US interest rates.
This interest rate expectation change is going to disappoint a lot of investment strategies that have been based on the market consensus that the US interest rates would rise markedly. The problem with higher interest rates in the US is there is no sign of significant inflation breaking out and while considerable employment has been generated as part of the economic improvement, a great many of the jobs are at the lower paid end of the spectrum.
That makes the Federal Reserve very nervous about undertaking an aggressive interest rate hike policy especially as, thanks to the automated spending cuts the US Congress had passed, government deficits are falling dramatically. Unlike Australia the US does not have a government driven economic stimulus.
3. Bank shares will continue to be attractive
Thirdly, back in Australia, the bank deposit interest rate war has virtually ended. The National Australia Bank’s electronic banking subsidiary Ubank has now lowered its one-year rate to 2.9 per cent, below the magical 3 per cent rate. Westpac has lowered its 12-month rate to 2.4 per cent. In other words, the banks are lifting their margins by giving their savers another belting around the head. And my guess is that there are probably more blows to come.
And so the markets are telling us that on the interest bearing securities front, yields are going to be low although there will be some rise in the US.
A combination of lower yields and the fact that banks are going to shift money from deposits to their share-holders will underpin and probably boost bank shares in Australia over the next few months. Indeed as the world scrambles for yield in this tough environment Australian bank and other industrial share yields will look very attractive. And of course Warren Buffet is looking around at our high yielding stocks.
I notice Citibank is forecasting the Australian S&P/ASX200 index will rise to around 6,000 and while I am not making any prediction the interest rates environment is very conducive to such an increase.
4. China’s the bigger threat to Australia
What is more dangerous to Australia is, of course, what is happening in Shanghai. The Chinese economy is still growing but the rate is slowing considerably; despite this the Chinese share market has skyrocketed this year because there has been a frenzy of lending to channel the Chinese love of gambling into margin share trading.
This was also designed to help Chinese banks raise much needed capital at reasonable equity levels. But in the last week or so the Shanghai market has fallen 13 per cent. At this stage that is a reasonable correction after such a big rise. But if the fall were to continue then the reverse would be quite severe. Any market that is based on high risk margin borrowing falls very sharply once sentiment goes the other way because the traders are forced out of the market and panic sets in.
At this stage a 13 per cent fall is a warning sign but it is not severe enough to rule out a recovery. Australia has a very big stake in what takes place in China. Our resource shares are very much linked to China and what makes the Chinese share market fall a little scarier is that it has been accompanied by a fall in most commodity prices, including iron ore and oil.
That is not good news for Australia. Combine that with the global campaign against coal and clearly Australian mineral exports are under threat. So what the markets are telling us is that while our high yielding shares may do well our mining shares may not. Somewhere in all that is the Australian dollar which is really holding its ground and is buffeted by these various forces.
When you step back you realise the market is giving us a very different message from what has been around for most of 2015. If the market is right longer term yield stocks and corporate bonds are going to return to favour.