November 2014
Key Points
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2014: global financial markets in review – a bumper year for investors
An end to the commodity super cycle?
Will the Australian economy improve into 2015?
Will the RBA cut rates in 2015?
International economies
2014: global financial markets in review – a bumper year for investors so far
To date, 2014 has proven to be a bumper year for investors. Driven by central bank injections of over US$1 trillion of
liquidity into global financial markets, almost all asset classes in nearly every major market rallied throughout the year.
Globally: equity prices rallied by 9.0%, (as measured by the MSCI World Index, local currency); bond prices in major
markets were up, with yields on 10-year sovereign bonds down between 31 basis points (bps) in Japan and 118 bps in
Germany; and with other major asset classes such as real estate and infrastructure also enjoying strong gains during the
year. Market volatility fell over the year, with the VIX index of US equity market risk falling by 9.1%, with markets quickly
shrugging off spikes in risk associated with capital flight from Turkey and Argentina (February, August), Russia/Ukraine
tensions (March), Russian sanctions (August), conflicts in Gaza and Iraq (August), and concerns over European and
Japanese growth and inflation (October).
While asset prices rose, on average, over the year, there was a wide distribution in returns across countries. In equity
markets, the US and Japanese were the strongest of the major developed markets, with the S&P 500 up around 12% and
the Nikkei up by 10%. The US market benefited from robust growth in the second and third quarters, following weather
impacted weakness in the first quarter, and strong growth in company earnings throughout the year. The Japanese
equity market, which is heavily weighted to export-oriented companies, has benefited from a 12% devaluation of the
Yen against the US dollar. In contrast, the Australian and UK markets underperformed, with prices broadly flat over the
year. In both cases, equity market performance has been adversely affected by poor performance of resource sector
companies, that have been hit by the fall in commodity prices. Similarly, there has been a significant variation among
equity indices of emerging markets. In our region, the Chinese and Indian markets have performed strongly (+30%, local
currencies), while the Korean market has underperformed (flat).
Ten year government bond yields fell sharply across all major markets this year. Yields in Germany, UK and Australia all
fell by around one percentage point. Bond yields have responded to the sharp fall in the price of energy commodities
and ongoing excess capacity in Europe and Japan, which has placed downward pressure on global inflation over the
course of the year. Downward pressure on bond yields has occurred despite the US Federal Reserve (Fed) drawing its
asset purchase programme to a close in October. Offsetting the end of liquidity injections by the Fed have been asset
purchases by the European Central Bank (ECB) and the Bank of Japan (BoJ), which have continued to supply global
financial markets with funds. In anticipation of a significant programme of asset purchases by the ECB, German yields
fell by over one percentage point in the year. UK bond yields also fell in excess of one percentage point as the weaker
outlook for Europe, the UK’s main trading partner, coupled with downward pressure on UK inflation, led investors to
push back the timing of the monetary tightening by the Bank of England. Australian yields also fell in excess of one
percentage point, as positive yield spreads to other major markets continued to attract foreign investor demand and as
the fall in the prices of Australia’s bulk commodity exports led investors to downgrade the economic outlook and the
expected pace of Reserve Bank of Australia’s (RBA) tightening cycle.
As mentioned, the fall in prices of the energy complex placed significant downward pressure on global inflation over the
year. Oil prices fell by around 30%, thermal coal prices by 47% and hard coking coal by around 17%. A combination of
greater-than-expected production and less-than-expected demand, particularly from China, resulted in the dramatic
drop in prices. As Chinese authorities move to cool the local housing market slowed the pace of economic activity,
China’s rate of steel production slowed over the year, slowing China’s demand for iron ore. This slowing in demand
coincided with the rise in productive capacity of the three major iron ore exporters, leading to the sharp drop in iron ore
prices.
An end to the commodity super cycle?
While a faltering global economy is one reason behind the fall in commodity prices, it is now becoming clear that a
deeper reason is a dramatic increase in supply. The sharp run-up in prices in the decade to 2008, and again in 2010/11,
encouraged significant exploration and development of resources. Coupled with technological break-throughs enabling
the access of shale and coal seam gas reserves, major resources companies ignited a significant resources investment
boom to satisfy growing demand from emerging markets. Not surprisingly, now that this supply is coming on-stream,
commodity prices have started to fall. How much further could prices fall? Estimates from the IEA suggest that around
2.6 million barrels of oil per day face a breakeven price above US$80 per barrel. However, breakeven prices (which is the
price required to achieve a positive return over the life of the asset) are higher than producers marginal cost, due to the
latter not taking into account previous capital expenditure decisions. Anecdotal reports from OPEC suggest their
members would be willing to tolerate a floor of around US$60-$70 per barrel in order to slowdown exploration and
developments in the US with the end goal of OPEC maintaining global market share and an oil price above US$80 per
barrel.
Interest rate forecast (%)
Level at
5-Dec-14
Mar-15
QIC Forecasts
Jun-15
Dec-15
2.50
2.50
2.50
3.00
0.00 - 0.25
0.00 - 0.25
0.00 - 0.25
0.50 - 0.75
Canada
1.00
1.00
1.00
1.50
Europe
0.05
0.05
0.05
0.05
UK
0.50
0.50
0.50
1.00
0.00 - 0.10
0.00 - 0.10
0.00 - 0.10
0.00 - 0.10
Australia
US
Japan
Source: Central Banks, QIC.
Australian economy
Will the Australian economy improve into 2015?
The recent performance of the Australian economy has been disappointing. Real GDP growth in the September quarter
was a meagre 0.3%, less than half the expected rate of 0.7%. This has cast doubt over the ability of the Australian
economy to sustain economic recovery over 2015 and has led a number of commentators to reverse direction and begin
to call for RBA rate cuts in the New Year. While weak GDP growth in the June quarter was partly blamed on a tough May
Budget, broader headwinds evident in the September quarter numbers cast doubt over whether the economy can
significantly improve into 2015. We still expect the Australian economy to improve. Indicators for December quarter
remain encouraging. In October: dwelling approvals jumped 11% to be back near cyclical highs, suggesting investment
will resume an upward trend; retail trade rose further, having surged in September; and a further narrowing in the trade
deficit points to another strong net exports contribution. However, our bottom-up analysis of capex plans by mining
project and State and Federal Budget spending points to an acceleration in the decline in mining capex and fiscal
consolidation. As a result, growth is likely to only slowly improve and remain sub par until mid-2015. We see growth
only reaching trend in 2H 2015, supported by a surge in LNG exports and as an improving global economy (led by the US)
and a lower AUD bolster non-mining capex and service exports. This would see unemployment drift down in the second
half of next year, which, along with lower fuel prices, should support growth in disposable incomes and spending.
Will the RBA cut rates in 2015?
The view that growth will improve, albeit slowly through 2015, is consistent with the RBA remaining on the sidelines;
particularly given its concerns over low rates fuelling a house price bubble. While predating the September GDP release,
the RBA on Tuesday highlighted its reluctance to cut rates, maintaining its forward guidance that ‘the most prudent
course is a period of stability in interest rates’ and leaving the cash rate unchanged at 2.5%. However, financial markets
are more pessimistic, moving to price a rate cut by August 2015 and trading the Australian dollar (AUD) to below
US$0.84; a four year low. Six out of 22 economists in the latest Bloomberg survey now expect a rate cut by mid-2015.
What would cause the RBA to cut rates? We see five potential triggers.
i.
ii.
The Australian dollar. The RBA outlined that, ‘A lower exchange rate is likely to be needed to achieve balanced
growth’. A stronger dollar (potentially due to additional QE in Japan) would slow the non-mining recovery.
House prices. With or without macro-prudential measures, a slowing in house price growth could temper RBA
concerns over a housing bubble.
iii.
iv.
China. If Chinese authorities tolerate a further slowing in industrial activity to tackle credit risks and pollution,
then Chinese demand for out bulk commodity exports will fall placing further downward pressure on iron ore,
coal and gas prices. Lower prices for our bulk commodity exports would lead to a further drop in national
income as the profitability of resource companies drops leading to lower equity prices and dividends and lower
ming royalties and taxes to State and Federal governments.
Budget policy. A smooth recovery needs an approach to public financies that supports consumer and business
confidence. We estimate that the Government’s mid-year update (released later this month) will show a blowout of $40 billion over the next four years, due to blocked savings and softer revenues. The return to surplus
will inevitably be pushed out a few years; the correct course of action for below-par growth. However, if 2015
sees a repeat of 2014, where unpopular revenue-raising and expenditure-cutting policies are blocked by a
hostile Senate, consumer and business confidence are likely to sour once again.
As an example of these risks, we modelled a scenario where iron ore prices fell to US$60/t in the first half of 2015 and
the AUD traced back to US$0.87. This results in a rise in the unemployment to 6.5% and to entrenched inflation at the
bottom half of the RBA target band. In this scenario, we would expect the RBA to embark on two 25 basis point rate cuts
in 2015.
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