The Road Ahead

An invitation to a super-select briefing at the Australian Davos Connection's Hayman Island Leadership Retreat has clarified my current concerns.

Summary: Another European downturn, rising US interest rates and a stubbornly strong Australian dollar all present near-term threats to investors, and could trigger a sharemarket correction.
Key take-out: Timing a correction is always difficult, but investors might want to lighten their equities load. But make sure you have some cash available for equities to take advantage of any correction.
Key beneficiaries: General investors. Category: Economics and Investment Strategy.

Each year, for the last 18 years, I have attended the Australian Davos Connection’s Hayman Island Leadership Retreat.

I go there not so much to enjoy the beauty of the island but to get the chance to meet people I wouldn’t otherwise encounter, particularly those from abroad. And, more importantly, I go there to take a step back and look at some of the forces that are emerging that will shape our investment scene in the coming 12 months. Almost every year I am surprised, and 2014 was no exception. So let me share with you some of the things I encountered.

1. Another European crisis?

The first and most dramatic was that there is a real possibility of a renewed European banking crisis. Most of us have assumed that Europe would struggle through, and even the problems in the Ukraine would not upset the gradual recovery process. But at Hayman a number of people shared with me the fact that there remain serious problems in the European banking system, and in the last three or four weeks Deutsche Bank shares have come under pressure despite the fact that it only recently completed an €8 billion capital raising. We will need to watch Deutsche Bank shares, because if they resume a downward path after this week’s European market recovery it will trigger a chain reaction. Usually events like this take longer than you think to erupt, but at Hayman there was a clear warning. If Deutsche or any other major bank in Europe needs a government-type rescue then it will shatter the European market and cause a global sharemarket correction. But I do not think there will be a collapse, because the United States does not have a banking problem and will continue on its recovery path.

2. Rising US interest rates

The second and related event is that, at some point, the US is going to end its quantitative easing process and start a process of interest rate increases. There are a wide variety of views as to when this is likely to happen. My guess is that it will start in the first half of 2015, although some think it might be earlier. But timing speculation really is a guess so, leaving it aside, when US interest rates do rise (and eventually it will happen) it will suck a lot of money into the US. That will cause problems in places like Europe, where they have been basking in the vast amounts of global liquidity created by quantitative easing. At Hayman some believed this event will be the trigger that brings on the banking crisis. Others say that the banking crisis will happen before that – perhaps when real stress testing is carried out later this year. Nevertheless, it is clear that one of the considerations Federal Reserve chief Janet Yellen needs to weigh up is the global consequences of American interest rate increases.

3. A strong Australian dollar

Thirdly, the weak iron ore and coal price are events that would normally trigger a lower Australian dollar. Such an event remains possible, but any major exodus of money out of Europe will see some of that money diverted into Australia, and indeed there is substantial Asian money currently coming our way. Without making a forecast, that means there is at least a clear scenario that sees the Australian dollar staying strong despite the terms of trade going against us. That is not a pleasant scenario for many industries.

4. The technology boom

We had a fascinating briefing about the technology boom in Israel. There is no doubt the Israelis have been very skilled in developing their technology research industry and linking it to the United States. The latest war in Gaza has not stopped further IPOs of Israeli technology ventures. In fact, it has had no affected them at all.

We can learn a lot from what the Israelis have done and, without taking anything away from these achievements, the global liquidity is causing enormous prices to be paid for the technology development. The technology price boom reminded me of past Australian mining booms, when all you needed to make a fortune was to peg an exploration lease near a nickel strike … and, at some point, the technology price boom market is going to crack. It will not end the Israeli technology innovation, but it will bring prices to more realistic levels.

5. A vision for Australia

Trade Minister Andrew Robb shared with those at Hayman the most amazing vision for our country. In opposition, Robb was the architect of much of the government spending cut programs. But when he was engineering the cuts he attached to them a vision for the future. Unfortunately Prime Minister Tony Abbott and Treasurer Joe Hockey have forgotten about the vision. Robb was at Hayman to remind us that we have the opportunity to enter a new phase of prosperity. And, in this age of Australian prosperity, we are going to see our sharemarket rise to much higher levels. That is not an immediate prediction, but it does mean that if and when a substantial correction takes place don’t be frightened to back Australia. The Robb vision is based on an explosion of the middle class in the countries to our north and particularly China. This will enable us to have a substantial market for upmarket clean food, and that market will enable Australia to transform agriculture in the north. And that transformation will create a construction boom of enormous magnitude, and for the benefits of the emerging Asian middle class to extend to Australian tourism, education and medical services. Robb has signed trade agreements with Japan and Korea and is attempting to negotiate one with China. At some point either the current government  -- or if they don’t have the skills -- the next government will embrace this vision. It is already creating great excitement in capital markets around the world. You can watch a video interview I conducted with Robb on his vision here.

6. A new outlet for gas

On the dark side, in the short term, there is no doubt we are going to see a gas crisis that will cost a lot of jobs. But out of it may come some common sense. Dow ’s chief executive, Andrew Liveris, explained to those at the ADC Leadership Retreat that Australia should reward farmers whose land is used to extract gas. We can develop a substantial gas industry from reserves we know exist and which will not necessarily be converted to LNG for export. He explained that if Australia does take this direction it will create an additional boom to that forecast by Robb. You can also watch the video interview I did with Liveris here.

7. Some strategies for investors

It is clear that a vast number of Australian companies are at last looking at their operations and devising ways to lower their cost bases, often using the new technologies. That means that we are going to see increases in profitability in the next two or three years that will not require big rises in revenue. However it will exacerbate the Australian unemployment problems. Combine that with the government expenditure restraints and we desperately need infrastructure investments. The good news is the projects are there, and the money is there. All that is required in political skills. At the moment common sense is rare in Canberra, but I think that will change. And so what are some of the investment strategies that come out of this? First, as the Australian sharemarket rises in the quest for yield, all investors need to be aware that there are international forces developing that could trigger an Australian sharemarket correction. Those that believe the European banking crisis will erupt before the end of 2014 and lead to instability in the euro are predicting the correction will come earlier than most expect.

One clear strategy is to lighten your equity load, and hope to buy in on the correction. But, as you know, such a strategy can come to grief because a correction usually takes longer to arrive than you expect.

Make sure you have some cash available for equities to take advantage of any correction. Be careful about your exposure to Europe in your investment strategies, and be aware that Australia has a great long-term future. And, if you are a longer-term investor and are prepared to ride through corrections, this is a good place to have your money because eventually we will get a set of politicians who will embrace the Robb and Liveris visions.

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