The cover story of Time this week declares the end of what it describes as “cowboy diplomacy”.
While the large Stetson hat dwarfing the US president is meant to symbolize the limits of US-centric foreign policy, it might just as easily symbolize the limits for the world economy at large of a US-centric economic policy. The change that is now underway, where global growth will become less reliant on the US, has significant implications for investment strategy.
For the past three weeks, this space has sought to provide an update of the global economic landscape. From this analysis, three issues have become obvious. First, global growth is likely to be slower next year compared with this year. Second, the era of super-cheap credit is now past, with interest rates around the world on the rise. Third, with the outlook for policy less clear and global tensions still apparent, investment risk has risen.
From an investment strategy perspective, equities remain our most favoured asset class, particularly on a valuation basis since the May pull-back. The cold shower that markets have taken recently serves to inject some sensibility back into market valuations. Despite this view, gains will be harder to come by. A new, more risk-averse investment environment is now upon us.
This is an environment different from what we have known in the past three years. Capital gains will be harder to come by; the cost of not being diversified will be higher; and investors will require more adroit stock-picking skills. Investors will need to think more about how to manage their risk, than about how to manage their returns. In this regard, investors should favour large-cap stocks that have a long track record of earnings quality and balance-sheet strength.
In the near-term, the slower growth outlook penciled in for the US will dominate strategy. Defensive markets and sectors are likely to do better than cyclicals. In this regard, banks, media, utilities, listed properties, and telecommunications tend to be the most defensive sectors while Australian and US shares tend to be the most defensive markets. Interestingly, in terms of daily price movements that exceed plus or minus 1%, Australian shares have become more volatile this year than US shares.
We still favour Australian equities over US shares in the near-term, however. The US market is yet to digest fully the 425 basis points worth of interest-rate hikes, structural imbalances in trade and housing are still unwinding, and the most powerful man in the world, Ben Bernanke, is still a rookie, having been in the job just six months. History does not treat favourably new Fed Chairmen who want to exhibit their inflation-fighting credentials early. Miller in 1978, Volker in 1979 and Greenspan in 1987 were all greeted by weaker equity markets after aggressive rate hikes.
Add to this the allure of Australia’s dividend yield, and the fact that almost 70% of the US market capitalization is in cyclicals or financials, and Australia looks to be a pretty good place to be in the near term.
With central banks more concerned about inflation than growth in the current environment, interest rates are likely to continue to move higher in the near term, both in Australia and elsewhere (although Australia’s early-mover status means it has less to do). Yield curves are likely to flatten as a result, driven more by the short end of the curve than the long end.
The risk that the US falls into a mild recession in the next 6 to 12 months cannot be ruled out, given the extent to which US households are indebted and the bluntness of monetary policy as a tool for fine-tuning economic activity. If this were to occur, the Federal Reserve would quickly step in to lower interest rates, as it did to soften the blow of the 2001 recession. This would then bode well for a shift by investors back into a more aggressive growth strategy.
Such a scenario suggests that in the medium term, the investment environment would once again be favourable toward growth sectors and markets. Moreover, the sense that many of the global imbalances, such as the US trade deficit, the global housing bubble, and the US bond bubble, are starting to correct bodes well for the sustainability of the cycle further out. In this regard, mining and resources, oil and gas, industrials, and discretionary consumer goods sectors are the most cyclically- sensitive sectors, while Asia and Europe are the most growth-oriented markets.
In this environment, a reacceleration of global growth will see the yield curve once again steepen as long-dated bond yields move higher relative to the short end.
The world economy has moved into a transition period as it comes to rely less on the US consumer to power growth. In the near term, volatility in financial markets is likely to stay so investors should keep on the defensive. Further out, however, a global business cycle that is less US-centric is one that is more sustainable. Beyond the next twelve months, investors should feel comforted that the fundamentals underpinning global activity will have improved as a result of this rebalancing.
By Tracey McNaughton, senior economist, BT Financial Group.*
