Will the cycle beat the structural?

It's been a banner year for all asset classes except bonds. David Llewllyn-Smith of Macro Business explains why he thinks the cyclical upswing will continue.

Key Points

  • Cyclical upswing but a long way from healthy, sustainable growth
  • Opportunities abound from RBA forcing dollar lower
  • Emphasises the need for international exposure

This year, central banks triumphed as debt and deleveraging crises worldwide subsided, financial repression and liquidity reigned, and the great rotation from defensive assets to cyclical and risk plays dominated returns.

For the first time since 2008, stock markets began to anticipate a real recovery in the global economy. Even property markets in developed economies joined in. Indeed, returns in developed market asset classes have been so strong that many are asking if we’ve returned to our pre-crisis bubble condition.

That depends on whether we can expect high earnings growth to rationalise this year's higher valuations. There are two possible answers to that question, both of which are contradictory and both right. [Economics eh? You wouldn’t get away with a statement like that in physics – Ed].

The first answer is ‘yes’. In cyclical terms, the US, UK, European and Japanese economies are all better placed going into 2014 than they were 2013. The US especially may creep closer to a respectable 3% growth, at least for a little while. Europe and the UK are also clearly recovering, although not as strongly. Japan looks like a star at this point as its reflation policies kick in, although no-one knows if that will last.

The second is ‘no’. In structural terms, we are a long way from healthy, sustainable growth. The US has passed the low point of its private sector develeraging but in front of it stretches the near endless task of stabilising deep (but improving) budget deficits.

The UK has engineered a renewed housing and consumption surge that only proves it has nothing else to offer. Europe is worse still, with structural problems half resolved through a spaghetti bowl of cross-border agreements on bank and fiscal equalisation that makes the US political system look coherent.

Japan has engaged in a radical monetary policy experiment that has trashed its own currency and reinflated exports. Beyond that are deflationary pressures from emerging markets able to produce everything from sneakers to rockets at a fraction of Western prices.

Which of these two answers will hold sway next year? Will cyclical momentum or structural headwinds win out? My money, at least for 2014, is on the former.

The cycle wins

If cyclical momentum wins – and nothing is certain in these matters – the shift towards stocks from defensive asset classes will continue. That means cyclicals and growth stocks should perform well. 

But it won't be smooth. The major macro theme for the year ahead will be the challenge of ‘policy normalisation’. That is, central banks in the US, the UK and, to a lesser extent, in Europe and Japan, will toy with exits from extraordinary monetary support. Rising interest rates could easily threaten the recovery.

The key will be the US Treasury market, where falling prices have already pushed yields up on 30-year bonds to almost 4% from 2.5% in late 2012. Most US mortgages are fixed rate and benchmarked to this rate so prospective buyers of US housing have already faced the equivalent of six typical Australian rate hikes in a year. Not surprisingly, US housing is slowing and its prospects are one of my key risks in the year ahead.

If the Fed tapers its bond purchases then the 30-year yield will rise further, to around 4.5%. That’s probably too high to sustain US house price rises and the recovery may stall. Should that occur, the Fed will almost certainly act, either by slowing its tapering, reversing it altogether or perhaps resuming quantitative easing. For this reason, and with a nod and a wink to the Bernanke/Yellen ‘put’, I expect the S&P 500 to go higher over the next year.

Australia is different

That many not help Australia, though. For two years, Australian stocks have been diverging from the tearaway returns on Wall Street – a result of an over-weaning attachment to China, which is sliding as developed economies rise.

Domestic cyclical sectors have been enjoying stellar valuation improvements on interest rate cuts but the huge resources sector has been punished as China slows. The banks have straddled the divide, moving from a defensive yield play in difficult times to a growth play on a credit recovery.

There are three reasons why I believe this split between Australia and other developed market returns is likely to continue next year.

First, Australian growth faces a torrid time in 2014. The year will be dominated by falling mining and related investment, which is expected to tumble from 8% of GDP to probably 2%. That’s an enormous downdraft that may get stronger in 2015 when the LNG projects come to an end. We will go over the capital expenditure cliff next year and that will keep growth materially below trend.

The non-mining sectors won’t fill this business investment hole for the next two years and probably not in the third year either with Ford and Holden leaving, although public investment will kick in strongly in 2016 to make up the difference.

Mining boom's 'third phase'

Many analysts still anticipate respectable growth of 2–2.5%, largely due to the so-called ‘third phase’ of the mining boom, when construction turns to production. Net exports will be a potent growth driver just as they were this year, contributing 1.9% of 2.3% growth. But this won’t help employment at all. As unemployment rises, cyclical stocks will struggle to deliver high profit growth.

Second, the Reserve Bank's attempt to rebalance the economy away from the mining investment cliff is producing a Sydney property market boom without much of a growth dividend in return. Although the RBA is putting a brave face on its campaign to reinvigorate housing construction, outside of apartments it is largely failing. Instead, Sydney property is facing a speculative boom.

The RBA cannot and will not raise interest rates because it desperately needs a lower dollar, somewhere between 70 and 80 US cents, to stimulate investment in tradable sectors to fill the mining hole.

So next year we may see the RBA's incipient jawboning campaign replaced by a group of axe-wielding staff looking for carry traders in Martin Place, with property investors clutching cheques made out to the Office of State Revenue next in their sights. Anything, including loan-to-value ratio (LVR) speed limits and the like, to subdue Sydney's maniacs without hiking rates will be considered.

Huge deficit

Meanwhile, the new Liberal Government must address a huge deficit, so consumers are going to be pushed and pulled by authorities' efforts to control what they've unleashed.

The third reason Australian returns are likely to lag the US is that since the Chinese announced many liberalisation measures aimed at catapulting China out of the ‘middle income trap’, markets have been happy to give them the benefit of the doubt.

But with an economy heavily orientated to investment, unleashing the consumer will entail painful restructuring. There is no way around this. To boost household incomes, interest rates must rise. But raising interest rates exposes the bad debts that have funded so much dodgy infrastructure.

It’s a nasty quandary. This year's 2 trillion yuan stimulus is passing and Chinese growth is going to slow in the first half of next year as the infrastructure pipeline empties. If it isn’t replenished in an effort to move away from an investment-led economy, Australia is in trouble. Our iron ore supply builds to a crescendo in the second quarter of next year, so the pillar of Australian exports strength might crash right if the Chinese wind back demand.

Falling $A a better bet

Where does that leave us? A decent rally in Australian stocks is possible next year. The sell-side bulls that dominate commentary are pushing for an S&P/ASX 200 at 6,000, with housing and growth stocks leading the way.

The problem is that this view discounts the structural headwinds just described. A much better risk-reward equation lies in playing the Australian dollar. One way or another, the dollar must fall. Either the RBA will be able to muscle it down past 80 cents earlier, or the economy will remain weak enough that interest rate cuts will do it later.

The dollar would also fall materially if a shock hit global sharemarkets, so it's a built-in hedge for those investing offshore. If all goes well it will amplify capital gains as the currency falls.

Local investors should tread very carefully. Cyclical and growth stocks will be the play, as will dollar-exposed industrials (not miners). But so long as the capex cliff falls away beneath us, there is an unusually high risk of a real recession overtaking the Australian economy in the event of a shock.

 

David Llewellyn-Smith is the founding publisher and former global economy editor of The Diplomat magazine, Asia Pacific’s leading geo-politics and economics website. He is also the co-author of The Great Crash of 2008 with Ross Garnaut and a regular economics and markets contributor for Fairfax and the ABC. David is the editor-in-chief and publisher of MacroBusiness.

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