Investors have endured volatile market conditions so far in 2015. While economic growth is improving in the US and UK, in other regions it has been more subdued.
On the whole, growth in Europe has been restrained, after achieving some momentum in early 2014. This led to the European Central Bank starting a quantitative easing (QE) program. After missing its growth forecast, China’s central bank also cut lending rates and its Reserve Requirement Ratio (RRR). In addition, central banks around the world, including Australia, have maintained an aggressive approach to monetary policy, reducing official cash rates in early 2015. It’s worth noting the Danish central bank cut rates on three separate occasions in January after the Swiss National Bank’s decision to break the Swiss franc/euro currency peg.
There has also been a sharp decline in commodity prices, reflecting a weaker global economic environment. Oil, iron ore, copper, gold and natural gas are some of the commodities whose values have fallen over the last 12 months. At the same time there has been an increase in supply from producers in an attempt to reduce the number of higher marginal cost competitors in the market. The challenge with this strategy is the extent to which producers can tolerate lower absolute prices in an environment where inventory levels are rising. While lower commodity prices have a positive effect on the broader global economy through cheaper input costs for businesses and cheaper goods for consumers, to date the impact has been minimal as consumers and business remain cautious.
There is also a mixed outlook for growth on a regional basis. The US and UK economies continue to maintain steady momentum. But the short-term growth outlook remains opaque for Europe, Asia – including China and Japan – and some emerging market economies such as Brazil. As a result the World Bank has reduced its growth forecast for 2015 to three per cent, the lower end of its range.
Overall, however, emerging market economies are set to drive growth this year. This should be positive for higher risk assets such as emerging market equities. But returns are likely to be volatile and investors should be prepared to hold positions for an extended period to achieve high values for assets in this category.
Financial markets have experienced gains stemming from higher liquidity as a result of central banks’ monetary easing policies. Bonds and equities did well throughout 2014. From a global perspective the fall in the Australian dollar has delivered additional returns for investors. We expect the Australian dollar will continue to trade lower through 2015. The ‘steady as she goes policy’ adopted by the Reserve Bank of Australia (RBA) since September 2013 has now changed, with the bank reducing the official cash rate by 0.25 per cent to 2.25 per cent in February, an all-time low. In its statement the RBA noted while the cash rate had remained steady for an extended period, based on updated forecasts of both domestic and global factors it felt a further reduction was appropriate.
Now having played its hand, the challenge for the RBA is that it will be difficult to stop at just one cut. In our view, the decision had much to do with other global central bank decisions in January and market perception as opposed to a real need. What is clear, however, is that the economy is moderating and the growth outlook remains muted. This has seen inflationary expectations drop below the RBA’s two per cent target level.
While low inflation numbers can be linked to a decline in commodity prices, lack of good governance and policy remains the sticking point. More needs to be done to encourage an environment in which businesses are prepared to invest and seek out growth opportunities. The unemployment rate has also steadily risen, putting further pressure on both policy makers and the RBA.
Overall, we believe the domestic economy will continue to slowdown. The level of political uncertainty across a range of areas is reducing the ability of the economy to transition from the mining boom. Lower cash rates can only be of limited use if they are not supported by proactive and constructive policy.
From a broader market perspective the near term fortunes of the economy will be linked to the global macro outlook, especially Chinese growth, as much as to domestic issues. Consequently the medium term outlook remains challenging.