Market Thinking - A view from the Equity Market

- A surprise cut by the Australian Central Bank looks to have achieved its likely purpose of driving the Australian currency lower as currency wars intensify. Everybody wants dollars, or dollar earners, nobody wants dollar debtors. This trend looks to extend.

- Fixed income has lost touch with fundamentals as a rules based system obsessed with volatility traps money in the asset class. This looks eerily similar to the obsession with benchmarking that drove the Nikkei and the Nasdaq, 25 years ago and 15 years ago respectively.

- We have now reached the absurdity of some corporate bonds trading at negative yields while their equity pays over 3%. Unconstrained investors should start to switch now.

Visiting Australia last week I was presented with the almost impossible task (for me at least) of giving a presentation on my view on the world in only 10 minutes. The occasion was a conference known as the Chief Economists' Forum held in January every year for the investment community in Sydney and Melbourne. Much of the background to my talk was set out in last week's weekly note. In fact I was grateful for the opportunity presented in the Q&A to introduce my favourite metaphor for the Chinese economy, the Rubik's cube. This was something I first wrote about a year or so ago when it occurred to me that the multi-dimensional, structural changes going on within the Chinese economy might leave an impression of an economy in a great stage of confusion, but if you believe, as I do, that the necessary structures are being put in place (equivalent to getting the base level and the corners right on a Rubik's cube) then with only a few more rotations the mess can suddenly , and surprisingly, be resolved into a completed puzzle.

There was of course some discussion about the Australian dollar (AUD) and general agreement that the Reserve Bank of Australia (RBA) did not need to cut interest rates as, certainly in my opinion, the currency was doing the job for them. But monetary policy around the world has long since lost touch with economic numbers and while the cut last week was therefore something of a surprise, in many senses the RBA were just moving with the central bank herd, and was I suspect more to do with pushing the AUD down still further. Competitive devaluation is the name of the game and the big risk in all this is that we find a liquidity crisis for those that have borrowed in appreciating US dollar (USD). It is important to remember that market crises are almost always liquidity rather than solvency driven and if a rising $ and a shrinking US current account deficit chokes off the supply of cheap USD that markets have gorged on over the last few years, there could be some severe indigestion. I would thus be wary of anyone short $s, effectively anyone who took advantage of booming credit markets to load up on US$ debt. Everybody wants to be long $s, whether the currency or a $ earnings stream. In the US domestic stocks are preferred over international earners, not least as the likes of Estee Lauder warn of lower overseas earnings, while in Europe and the UK, the big $ earners are preferred over domestics. It is also important to note that while markets such as Europe and Australia are now hitting new highs in domestic currency terms, they are approaching 3 year lows when converted back into USD. This will make an interesting challenge for the chartists….which chart is driving the market?

The key takeaway from conversations during the rest of the week is that investors, not only in Australia, but elsewhere too, need to recognise that China is now a developed economy not a developing one and its growth drivers and needs are much closer to Europe or the US than the previous resource intensive model. The point was reinforced by Apple's results highlighting China overtaking the US as the largest buyer of iPhones and the announcement last week by Shanghai that it is no longer setting a GDP target. This latter point is, in my view, an extremely positive development. Targeting GDP growth numbers was a key factor in the misallocation of investment capital in recent years. Greater emphasis on productivity and efficiency – total factor productivity rather than total factor utilisation – makes for more sustainable economic growth.

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