Outlook for 2012

Published in the Financial Planning Magazine, January 2012

With so much uncertainty in the investment climate, it is almost anyone’s guess how things will unfold over the coming year. Financial Planning asked some investment experts to make their predictions on the opportunities for growth, areas that will struggle, and how they might respond to some key market events.

Which asset class will see the most growth in 2012, and which will see the least growth (or the greatest contraction)? 

Kate Howitt: Since the major factors that will impact markets are so binary in nature – Euro consolidation or break-up, US recovery or reflation, Chinese tightening or reflation – it’s no wonder that macro crystal-ball gazing is even more error-prone than usual. Given this uncertainty, what do we know? Our read of the Reserve Bank of Australia (RBA) is that they remain comfortable with an ongoing gradual decline in real residential property values, so property is unlikely to be the stand-out asset class. Given the macro uncertainties, it is also hard to see cash returns trending up from here.

That leaves us with equities. Why would you possibly want to buy equities when the world is so grim? We know that the local equity market is offering close to a 5 per cent yield overall, with even higher yields from blue chip stocks such as the banks, Telstra and REITs. And we know that our banks are some of the strongest in the world, corporate gearing is at 30-year lows and earnings are generally below cycle peaks. In 2008 we all experienced the risk of holding equities, but now the market offers reasonable valuations, yield support, solid fundamentals and the potential for reflationary policy moves. These factors suggest it may not be too long until we are back to the situation in 2009, where there was a greater risk to not holding equities.

Dale Gillham: It is actually quite hard to say which asset class will rise. Investor confidence is very low and as such, I believe investors will continue to move funds into cash during 2012. Our economy is showing signs of weakness and Asia, especially China, is expected to slow, which will cause more jobs to be lost in Australia in the coming year. Given this, interest rates are likely to continue to fall and our share market will not be strong, in fact I believe 2012 is likely to be more bearish than bullish. That leaves property, and while falling interest rates will be somewhat of an incentive to buy, if job losses continue, I cannot see much upside in this sector. So what will see the most growth? Property, but growth will be patchy at best. What will see the least growth? The share market – I expect this will be the biggest asset class to fall in 2012.

Shane Oliver: 2012 will be a difficult year. I think Australian shares have the best potential next year, because they have had a terrible year in 2011. But the market is now incredibly cheap, dividend yields are extremely attractive, and it is likely to push high by year-end. The uncertainty though is that the European situation is continuing to spiral out of control. Therefore it could well be a year of two halves – where the first half is pretty terrible and things continue to worsen, and then we’ll see a really strong rebound at the end of the year as the gloom starts to lift.

We would be least comfortable with international bonds. The odds are that there will be upwards pressure on US bond yields next year, as the debt problems of Europe spread to America, or alternatively, growth will start to improve, which will also put upwards pressure on bond yields.

Joseph Brennan: We have studied a lot of variables – growth rates, interest rates, economic variables – to try to find factors that have some type of predictive relationship with future equity returns. Our empirical data suggests that the price an investor pays for growth is far more important than the level of expected growth. We recommend investors avoid chasing investments based on return expectations – rather, understand the risk and expected return characteristics of all the asset classes in their portfolio and rebalance back to policy weights when appropriate.

Philippa Sheehan: Whether an asset class grows or contracts in 2012, it is important to remember that diversification across asset classes remains the best possible means for investors to achieve their long-term goals.

We’re keeping our eye on emerging markets and watching for continued growth. It’s interesting that some developed countries are exhibiting the characteristics traditionally associated with emerging markets, and some emerging markets are proving to be more sustainable than traditionally thought.

This is because some emerging markets are beginning to exhibit gross domestic product growth well above that of some developed nations, and have balance sheets that indicate they are robust and well-managed compared with past efforts.

An asset class that we think will potentially underperform in 2012 is global equities, particularly in developed markets. The deleveraging necessary particularly in relation to sovereign debt issues will lead to little immediate comfort for investors.

What will be the most critical factors affecting the stability of financial markets over the coming year?

KH: There are four interconnected issues that will drive markets in 2012. First, it will become clear that ‘halfway house’ solutions for the Euro won’t work, so 2012 will either see a push towards European fiscal integration or the dismantling of the single currency in its current state. This European resolution, whichever way it goes, will have significant impacts for the rest of the global economy, so the second factor markets will grapple with is the ability of the US economy to maintain its current slight positive momentum. Election-year inertia means fiscal policy is unlikely to be a factor, either in stimulating the economy or in implementing the cuts required by the extension of the debt ceiling.

The third major factor will be the outcome of the current policy debate in China between reformers who would like to see a faster rebalancing of the Chinese economy towards consumption by continuing the squeeze on investment, and the provincial authorities who are supportive of reflationary policy moves. The outcome here has obvious implications for China’s demand for raw materials and hence Australia’s terms of trade.

Fourth, the net outcome of these situations will be seen in the currency markets. Further ‘money printing’ stimulus by the Fed would, in isolation, weaken the US dollar. But with risks to the Euro in its current form, the US dollar is reinforced in its role as the world’s reserve currency. In turn, the Australian dollar will respond: a stronger US dollar and ongoing restrictive Chinese policies would weaken the Australian dollar, while significant reflationary moves by either the Fed or the Chinese authorities could see the Australian dollar sustained back above parity for much of the year.

DG: I expect 2012 to be the year of ‘show and tell’ where governments finally deal with the issues at hand rather than avoiding them as they have been doing, and this will allow world economies to readjust to a new paradigm. Initially this will bring instability to our markets, however it will lead to stability and the start of a new prosperous period for Australia by the end of 2012 that will run up to at least 2020.

SO: The resolution of the European problem and how that unfolds is the big issue. I think it is going to cause continued volatility in markets for some time to come, but is most likely to be resolved in the middle or second half of next year, and then the stabilisation could start to become a strength. Basically the uncertainty is whether Europe has a mild recession or a deep one, and the degree to which that affects the US, China and Australia.

JB: The most impactful macro issues that the market is currently grappling with are the pace and breadth of the US recovery – given high unemployment, weak housing, weak consumer spending, and fiscal drag; Euro contagion, in terms of fiscal health and associated banking sector issues; the price of oil; and China’s growth and the potential for faster yuan appreciation.

Of these issues the market’s concern over Europe’s financial system issues is contributing the most to recent volatility and is probably the most critical issue for the coming year.

PS: The continued uncertainty surrounding the state of play in Europe is the most critical factor. It is looking more likely that the EU’s attempt (or lack thereof) to solve Europe’s monetary crisis will result in a double dip recession.

What is the outlook for interest rates in Australia in 2012?

KH: Highly efficient monetary policy transmission is one of the key structural advantages of the Australian economy, but makes predicting RBA-moves well in advance a much harder game! It seems clear that the RBA doesn’t want to see house prices grow to any meaningful extent, in the interest of restraining household debt levels. Conversely, we know that the RBA will be responsive to any further weakening in the economic outlook for Australia.

DG: The outlook has to be down, and I would think that we would go back to rates that we saw in 2008/09. In essence, if rates do not fall, we will see increased defaults on housing loans, and neither the banks nor the government want that. 

SO: They will be going down, probably another 75 basis points from here to 3.75 per cent. It all depends on the situation in Europe – if they have a milder recession, we might even see one or two more rate hikes, but if it is a deep recession and that flows through to China and the US, and therefore our own growth, we will see greater cuts. The backdrop locally is that the mining boom is continuing, and inflation worries over the last year seem to be receding.

JB: While Australia’s economy has been amazingly resilient throughout the past few years, our outlook is still closely tied to overseas conditions and events, particularly in Asia and Europe. The RBA has been in an enviable position compared to other developed country banks, as it has been able to adopt monetary policy that has balanced its view of future inflation and price stability with economic growth. The RBA, at its November 2011 board meeting, stated that a more mixed approach to managing cash rates (combining its usual inflationary band and with increased emphasis on monitoring Australian unemployment levels) will likely prevail in the short-term.

PS: It is anticipated that interest rates will initially fall in 2012 as the RBA attempts to address the issues associated with a two-speed economy, with rate rises likely towards the end of the year as wages pressures brought on by industrial action feed through into inflation.

Hypothetical: If the Australian equity market dropped 20 per cent tomorrow, how would you respond?

KH: Use cash to buy stocks with solid business models, sound balance sheets and good yields. Macquarie Airports Limited, Wesfarmers Limited, Suncorp Group Limited, Commonwealth Bank of Australia, Rio Tinto Limited, Iluka Resources Limited and Oil Search Limited look attractive.

DG: I believe the probability is there, and we could see a 20 to 30 per cent drop in the share market in 2012. I am an active investor and so firstly I am not fully invested in shares for either myself or my clients, and secondly, I would move to 100 per cent cash very quickly if required. When I am teaching people to invest and trade, I stress that it is not what you make that is important, but what you do not lose, and this means preserving capital. On the flip side, I believe that next year is the last time we will see volatile markets for a while, and so anyone with a ‘buy and hold’ strategy with at least a five-year horizon could simply ride out the turmoil and not really be affected too much.

SO: A 20 per cent drop would almost take us back to the lows we saw in the GFC, in late 2008 and early 2009. It would take the price/earnings multiple on Australian shares, which is currently around 10 times, to around eight times, which is historically what you see at market bottoms. It would push the dividend yield, currently 5 or 6 per cent, to 8 per cent in Australian shares. It would therefore establish tremendous value in the Australian share market, so I would put more money into the market.

JB: Rebalancing is an important component of any long-term plan. A 20 per cent change in the value of a portion of an investor’s portfolio should, all else being equal, trigger a rebalancing opportunity to return the portfolio back to its intended long-term asset allocation. This would generally entail buying more of the asset classes that have declined in value and potentially selling those that have appreciated – a tough approach that challenges behavioural biases. As difficult as this may be, we urge investors to stick to a sound long-term investment plan. This has generally proven to be the best course of action, regardless of what’s happening in the markets.

PS: Large daily fluctuations in equity markets have become a regular occurrence. This noise often diverts clients from their medium- to long-term goals. We’ve all seen equity markets drop, as well as recover. History shows us the same. It’s trying to time the recovery that may lead to missing out.

So we would reiterate that any amendment to an investor’s long-term strategy should not be made for reactionary or emotional reasons – it should be made deliberately to keep on track to achieve objectives.

Hypothetical: If there was finally a resolution of the Eurozone debt crisis, what would you expect to see from the market and what would your response be? 

KH: Markets tend to ‘climb the wall of worry’. So even though Europe is unlikely to be ‘solved’ in any quick way, an end to the uncertainty would give rise to a relief rally. We would sit back and wait for hot money flows back into the equity market to push valuations back to a level that better reflects the resilience of underlying cashflows. 

DG: Firstly I expect a dip in the market or a final ‘flushing out’, so to speak, which is quite normal. At this time, investor confidence will be at an extreme low and so I would not expect investors to be even looking at entering the market, but rather astute fund managers will be. Therefore, I would expect that we would get a slight upward burst in price before the market settles into a long-term sustainable trend. My response would be to get into the market, and look to increase my exposure to it the more the uptrend unfolds. In my opinion, the resolution would signal an end to the volatility we have been seeing. After all, when everyone who was ever going to exit the market has exited, then it will rise. Given this, any last flushing out of sellers that occurs will signal a market bottom and so trigger the start of the investing cycle again. 

SO: If you go back to October, we saw decent gains in the share markets around the world on expectations the Europeans were likely to get their act together. I think getting Europe under control would mean the European Central Bank acting as bond buyer of last resort for all the troubled countries in Europe.

This would have two effects – it would help to stabilise bond markets and inject a massive amount of liquidity into the European economy, which will help ameliorate recessionary pressures. That type of response would result in a huge rebound in markets. The initial response from the Australian market could be 5 to 8 per cent, and then over the next six months, it could easily be up 20 to 25 per cent. Australia could then go back to focusing on the strengths in our trading partners, Asia, and investing, rather than worrying about the politics in Europe.

JB: Since the market pretty efficiently discounts the future, by the time news is fully public, it is generally already reflected in the price of assets. Most likely, by the time a truly credible resolution became public, the market would have already discounted the news and the reaction would be muted.

PS: The Eurozone debt crisis is only one aspect of the overall need to deleverage economies. This process will not occur overnight and we look forward to supressed returns over the medium- to long-term.

It’s an interesting hypothetical because an argument could be made that the effect of this crisis has become so widespread, a resolution would potentially mean resolving a whole range of other issues. If that were the case, we could potentially expect a lesser degree of volatility in the markets caused by the Eurozone.

Whether the crisis is solved or not, our response would be the same as it’s always been – diversify your investments, invest with the appropriate amount of risk, and get holistic financial advice. 

Our experts 

  • Kate Howitt, portfolio manager, Australian equities, Fidelity Worldwide Investment 
  • Dale Gillham, chief analyst, Wealth Within 
  • Dr Shane Oliver, chief economist and head of investment strategy, AMP Capital Investors 
  • Joseph Brennan, principal, chief investment officer – Asia Pacific region, Vanguard Investments Australia 
  • Philippa Sheehan, managing director, My Adviser

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