Instability set to hit global markets

01:33, Sep 02 2014

Australia's largest asset manager, Colonial First State, says global markets could be set for a period of instability as a major policy divide emerges between the world's major central banks.

Stephen Halmarick, the head of economic and market research at Colonial First State, believes the US Federal Reserve will raise interest rates for the first time in nearly seven years next June.

By this time, he said, the US unemployment rate will be below the 6 per cent level, while the country's inflation rate will be closer to 2 per cent.

In contrast, he says, the European Central Bank and the Bank of Japan have little choice but to opt for even more monetary stimulus.

"So we're going to have this policy division in the next six to 12 months, and that is very different to the post-financial crisis period where all of the world's major central banks pushed interest rates close to zero and then added more monetary stimulus through quantitative easing," he said.

"In the next six to 12 months, this will change quite dramatically. The Reserve Bank of New Zealand has already raised interest rates four times, and I expect the Bank of England will push interest rates higher in the next six months.


"The US Federal Reserve will put rates up in June, and the Reserve Bank of Australia will put rates up around the same time. And the Reserve Bank of Canada will put rates up shortly after that.

"So that means that all the 'dollar-block' countries will see increases in interest rates and policy normalisation. But at the other end of the spectrum, the European Central Bank will amp up its monetary stimulus, as will the Bank of Japan."

The divergence in monetary policy between the world's major central banks will have major implications for global markets.

"Global volatility risks will rise substantially," he predicted. "The US dollar will strengthen quite significantly, particularly against the euro and the yen.

"And the Australian dollar should also come down against the US dollar - it's more likely to be in the US85 cents to US90 cents range than between US90 cents to US95 cents range."

End of the bonds bull market

At the same time, Halmarick argues that investors will have to contend with the end of the long-term bull market in bonds.

"US bond yields are too low. Bond yields will rise and as short-term rates increase, the yield curve (which measures the gap between short-term and long-term rates) will flatten."

"There's been a cyclical bull rally in the bond market for a long time. That's going to recede as yields move higher."

At present levels, he argues, global bond yields fail to reflect the level of risks in the global economy.

"Bond yields are at extremely low levels. In the US, yields on 10 year bonds are trading around 2.4 per cent, while German 10 year bond yields are below 1 per cent.

"That worries me. There are substantial risks in the global economy - with quite a long list of major geopolitical risks.

"And at the same time we're about to see a major policy divide between Europe and Japan, on the one hand, and the dollar block, which is about to start raising interest rates.

"Over time, investors will realise that interest rates in those countries are rising because their economies are strengthening - which is a positive for equities. But they may initially struggle with the division in policy, and with the higher interest rates."

Further Wall St gain ahead 

Halmarick believes there's some potential for the US share market, which is already trading at a record high, to move higher in coming months.

"Usually the US equity market peaks about four months before the first interest rate hike. Now the first rate hike is likely to be mid-2015, which suggests that the market will peak in early 2015.

"That suggests that we might have three to four months - or maybe even as long as six months - of performance ahead of us. And although the S&P500 is already trading at record highs, it's possible it could continue to move higher."

But, he says, markets could become more vulnerable as the US rate hike looms closer, and the US central bank makes it clear that it intends to start tightening monetary policy.

In addition, investors could become impatient if companies start to boost their investment spending and buy new equipment.

"In terms of the US economy, we need to see an increase in companies increasing their capital spending. But from an investor perspective, that means less money for dividends and less money for share buy-backs," he said.

"So the big question is whether senior management - the chief executives and chairman of these companies - think about the long-term outlook for their companies, or whether they focus on the quarter-by-quarter performance.

"At the moment, the market is rewarding companies that deliver income. But as companies start to spend more on capital investment, this could result in some short-term negative for their share prices, even through in the medium-term it's better for their businesses and for the overall economy."

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