FYI | Jun 21 2011
– Russell Investments remains cautious on investment outlook
– Global equities slightly cheap, better value relative to Australian shares
– Australian dollar remains overvalued
– Reversal in commodity markets still expected
By Chris Shaw
As Russell Investments points out, the recovery in global share markets is now more than two years old. This means the cycle is at the point where equity valuations and economic trends are not always clear, so the group's chief investment strategist Asia Pacific, Andrew Pease, has updated his views on the current investment environment.
At the start of the year Pease had a modest bias towards global equities. This was based on the expectation of modest growth in developed economies and somewhat attractive equity market valuations delivering moderate returns over the course of 2011.
Over the past few months there have been some factors emerging to challenge this view, Pease including among them rising energy costs, the end of QE2, the withdrawal of fiscal stimulus around the world and policy tightening in China.
Pease also points to a number of issues he is less confident in, including the mining boom versus weakness in the rest of the Australian economy, the growth and inflation trade-off in China and various scenarios surrounding the Euro zone debt crisis.
As well, Pease notes there are unclear implications from the end of QE2 and from the impact on global growth of oil prices of more than US$100 per barrel. Pease also sees some questions in relation to how much upside remains for global corporate earnings in the current environment.
He has formed the view there is downside risk to relatively bullish consensus estimates for the Australian economy. This reflects a combination of fiscal tightening, RBA rate hikes, the strong Australian dollar and the potential for weaker commodity prices.
Growth forecasts for China also have downside risk according to Pease, this thanks to the potential for inflation pressures to be persistent enough to require more aggressive policy tightening measures going forward.
With respect to QE2, Pease suggests the big question is how much is currently priced in in terms of the pending completion of the program. At present this should be a lot given the Fed has set a June 30 end date for the program, though Pease takes the view there may yet be a potential unwinding of positions in some markets leading up to this date.
Euro-zone debt issues continue to linger and a muddle through approach appears the most likely scenario, while a Lehman-like disaster appears unlikely, further market volatility is expected.
Pease sees higher oil prices as a downside risk to global economic growth. As a general rule of thumb, every 10% increase in the oil price reduces global GDP growth by 0.25%. This means if current prices are sustained around 0.5% would be knocked off global GDP growth.
The good news according to Pease is there is some scope for US corporate profits to be stronger than expected this year. This is despite some headwinds such as slowing labour productivity growth and a lack of pricing power.
Factoring in the developments of the last few months has seen little change to Pease's view, which means a continued bias towards global developed world equities and comfort towards the yield pick-up currently available in credit markets.
Pease prefers global to Australian equities given downside risks for commodity prices and the weakness in the non-mining sections of the Australian economy. The division between the sectors is becoming deeper, which Pease notes is creating significant challenges for forecasters.
While the mining boom should see the Australian economy strengthen through FY12, capacity constraints make it unlikely investment spending will increase by as much as expected. So while further hikes in interest rates are likely, Pease suggests these rises may be fewer and more gradual in nature than consensus forecasts suggest.
In China, Pease suggests the economy's long awaited slowdown now appears underway, with a range of indicators suggesting a loss of momentum. Food prices should ease in coming months, something Pease suggests will help bring inflation back under control.
The cost of maintaining an undervalued currency remains a longer-term issue for China, with Pease taking the view risks are now biased more towards a rapid appreciation in the yuan.
Russell Investments continues to take the position the Australian dollar is overvalued at current levels. Pease notes potential catalysts for a fall in the currency are a slowdown in China, risk aversion triggered by the European debt crisis and delays to further rate hikes by the Reserve Bank of Australia (RBA).
Overall, analysis by Russell Investments suggests a cautious view for the next few months is appropriate, until there is greater clarity on the extent of current downside risks. The central view remains one of moderate US economic growth and similarly modestly attractive share market value generating moderate global share market returns.
Using an approach combining earnings measures, price to book value and a Fed model that compares earnings yields with US 10-year Treasury yields, Pease estimates global developed world shares are around half a standard deviation cheap at present.
While Australian shares are similarly valued under the model, Pease retains a preference for global equities given the greater scope for earnings upside and the existing downside risks for the Australian economy.
Pease's strongest conviction remains the Australian dollar is over-valued at present, as near US110c the Australian currency appears to be approaching a market extreme. There has been a strong correlation between the USD/AUD and the inverse of the trade-weighted US dollar for many years, but Pease notes in real trade-weighted terms the US dollar is currently at its weakest level since at least 1974.
What also supports the view the Australian dollar is near a peak against the greenback is interest rate differentials between the two economies, which appear to have peaked. Pease suggests the risks are skewed towards more tightening from the Fed and less from the RBA, as the US continues a gradual expansion and large portions of the Australian economy struggle.
Russell Investments has been waiting for a reversal in commodity markets for around a year, as LME inventories for base metals are high relative to prices and financial demand has been growing in importance as a driver.
Pease suggests since early May there have been some signs of an unravelling from extreme highs in the industrial metals market. Any downturn in commodity prices would be another headwind for the Australian dollar.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
