Why markets are rising

The US economy appears to be back on track and that should flow through into higher interest rates in Australia. However, we need to keep a close eye on China.

It is important to understand why the US sharemarket is driving world markets higher and what can interrupt that rising trend.

Here in Australia, while we will follow the US trend, we have special factors, which will result in different developments.

As we saw at the weekend, growth is breaking out in the US due to a combination of much better technology; lower-cost, more carbon-efficient energy and a rise in asset prices caused by the liquidity created by quantitative easing. In turn, we are seeing employment increasing and, almost certainly, that will flow through into higher wages.

That’s a perfect combination for stock markets. But it does mean that interest rates will rise. My best guess as to what will happen is to follow our weekend economist, Westpac’s Bill Evans, who has good record. (Weekend Economist: Rates wait, November 1)

Evans does not expect the US to start raising rates until September next year but then there will be a half a percent rise in the final quarter. Then, in 2016, US interest rates will rise by a further 150 basis points (1.5 percentage points) -- a total of two per cent over the next two years. Whether Evans is right on the timing is academic, we are looking at a substantial rise in interest rates over the next two years. 

But given the low US starting point, American interest rates will still be low because corporate efficiencies driven by better technology and low-cost energy are keeping a lid on costs and inflation.

That means those who are investing purely for yield, like long-term bondholders, are going to lose money but the losses will not be catastrophic. What is the most dangerous force for markets is the likelihood of big periodic shocks -- like a European disaster, a major reversal in China, an oil production melt down in the middle east or a disease pandemic.

Here in Australia, our interest rates will rise because, one way or another, they are linked to US interest rates. I know there is a strong body of opinion backing a rate fall, but that will only happen if there is a substantial fall in commodities. However, a strong US will help underpin China and boost commodities.

The US stock market gets a big percentage of its momentum from growth and technology stocks. In Australia, we have a smaller proportion of growth and technology stocks, with yield stocks like banks dominating the ASX in a way that is rare in global markets. It’s certainly not the case in the US.

So, unless there is a big rise in commodities (unlikely), our market will not perform as well as the US, but, we will be better than Europe. Higher interest rates will affect our yield stocks.

On the other hand, if US demand can hold commodity prices, then the efficiencies now being driven by our miners will see a new era in profitability for BHP and Rio Tinto. For Australia, the big danger is China, nothing serious can go wrong there.

It is Chinese money that is driving so much of our economy as it pours into property and tourism. My Chinese friends tell me it’s going to increase further. While that continues, we will ride through the shocks of lower mining investment, motor cessation and higher interest rates.

If the Chinese economy declines, we will be hit hard, but our dollar will fall to cushion the blow. But there is also a hidden China danger -- the Abbott government keeps annoying China with pro-Japan and sometimes pro-US policies, such has the anti-Asian bank stance. China may decide to teach us “a lesson.”

As the Reserve Bank has warned, during this transition to higher interest rates, the world and Australia are going to go through periods of pessimism, with sharp corrections in various markets. We have just seen one, but there will be a lot more.

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