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Investors may be in dangerous territory

Nicki Bourlioufas  |  09 Jul 2019Text size  Decrease  Increase  |  
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Australia’s economy is taking a tumble and the share market could follow, with analysts suggesting that even RBA interest rate cuts may not stave off the threat.

On the one hand, the economic outlook is not bright.

Long-term government bond yields have fallen to record lows in several countries. In Australia, the yield on the 10-year government bonds has recently fallen to an all-time low of 1.26 per cent, more than a percentage point below its January 2019 level.

Analysts expect yields to keep moving lower, heralding gloomier times for the domestic economy as household consumption slows amidst low wages growth and very high household debt levels.

Peter Warnes, the head of equities research at Morningstar, says as the economy stalls, the share market could stage a sharp pullback in the market in the second half of 2019.

“The more I think about it, at least from a scenario and analysis point of view, I would suggest there's a greater possibility of that happening than not,” says Warnes.

He says global equities could fall 20 per cent or more in the next 12 months given their overvaluation. Australian shares would inevitably be caught in the fall.

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“Never in my 50 years' experience in the markets have I observed central banks easing and aggressively easing when bond and equity markets are at peaks. And I think that investors are in high altitude and in dangerous territory. And the descent is as dangerous as the ascent,” says Warnes.

A triple-L environment

Commonwealth Bank Group economists predict the 10-year bond rate could fall as low as 1 per cent in March 2020, descending as economic activity slows.

“We anticipate a range of 1 per cent to 1.35 per cent over the period through to December 2020,” says Craig James, chief economist for Commsec.

"It is possible that yields could fall below 1 per cent … The world is in a 'triple L' environment of low inflation, low interest rates and low unemployment and a key reason is the ability to buy goods or hire workers globally,” he says.

“Central banks and governments will continue to respond with easier monetary and fiscal policies.”

Commsec’s James tips the All Ordinaries Index will end the year at between 6700-7000 points, compared to its current levels around 6,800. “After impressive first half gains, some consolidation can be expected,” he says.

'Cratering the economy'

Stephen Miller, an adviser at Grant Samuel Funds Management, says the Australian economy faces considerable risk – even though shares and bonds may keep rallying over the short term.

“Bond markets seem to be warning of potentially recessionary conditions ahead, while corporate spreads and equities seem to be reflecting a more relaxed environment ahead.

“Corporate spreads and equities appear more at risk, but it seems it would take the ‘crystallisation’ of some of those downside risks to manifest an actual downdraft in the price of riskier assets,” says Miller.

For term deposit investors, falling interest rates is bad news. Lower official interest rates and bond yields will inevitably push down term deposit rates to levels where it is no longer worth investing money, with returns sitting close to zero.

Forager Funds Management analyst Jeffrey Tse predicts low interest rates will persist.
“Interest rates on deposits, already woefully low, are likely to be at or near zero within a few years.

“We have one of the highest debt-to-income ratios in the world, mountains of mortgage debt and a dearth of fundamental reform in the past two decades. It is hard to imagine a scenario where rates go back up without cratering the economy,” he says.

Given the prospect of ongoing low interest rates, the case for investing in strong businesses with reasonable dividend yields and the ability to withstand an economic downturn remains compelling, says Tse.

is a Morningstar contributor.

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