Evaluating the world risk factors for Australian financial markets for 2013

With Christmas and New Year cheer and optimism still bubbling away for most of us we now need to turn our attention to the major risk factors that are likely to impact upon the Australian economy and financial markets during 2013.

Whilst Australia has enjoyed such a remarkable escape from the doom and gloom that has blighted other countries in its league, there are certainly signs that the economy is exposed to both critical domestic and international risk factors which will determine Australia’s route through these unchartered global economic waters.

At the end of the day the global stock market has been in a secular bear market for over a decade and we are now at the juncture of ascertaining whether the bear will have its final growl in 2013 or we will enter a new market phase. The economic fundamentals are very strong for Australia, however a number of world risk factors prevail that could upset Australia’s economic stability. We should not become complacent.

The world risk sources emanate from the northern hemisphere but these can wreak havoc elsewhere, including Australia. Europe is still a major issue in terms of world economic fortunes and 2013 will be a make or break year for them in terms of the single currency that necessitates closer banking and political union. Already, the UK is hinting on the need for a tiered system of membership to exist which although critics describe as a ‘two speed EU’ would allow banking, monetary and political union to move forward at a faster progressive pace. For would-be contenders on the European continent this could boost the viability of the Eurozone, whilst keeping the rationale of a strong Europe intact and expand the free trade area without leaving anybody out. This consensus has been gathering momentum in recent months and would certainly fortify the global institutional framework and contribute to more stable world economic growth.

If Europe is unable to sort out its banking and monetary union in 2013 and if some member states were to leave the Euro then this will have severe repercussions in the world’s markets and will impact on Australia because of the involvement of European banks in Australian financial markets, as well as Australia’s interconnectivity to the world economic community.

Another major risk emanating from both domestic policy and international factors is the strength of the Australian dollar. The Australian dollar over the past 2 years has been viewed as a ‘risk on-risk off’ currency and if it remains high due to this status then this will be extremely damaging to the real economy, particularly manufacturing which is struggling at present, relative to the resources sector.

 Nevertheless, in times of crisis, global investors seek safe havens such as precious metals, US and UK government treasury bonds and the perception of the Australian currency being ‘risk on-off’ is probably going to prove to be a passing fad, so we may see a major depreciation occurring which could unravel into capital flow instability and impact the real economy as well as make the financial sector volatile.

With regard to the Australian dollar, an interesting fact is that the price of Iron Ore has maintained an extremely close relationship with the Australian dollar [an association of 70%] between 2005 to 2011, whereas beyond the middle of 2011 this percentage association has been 10% [in other words, they have moved out of step].  Coupled with other perceptions that the Australian dollar is overvalued relative to other developed economies signifies that potentially it may lose about 15%-20% this year which could be a disturbing shock to the Australian economy. We are also simply too dependent upon China for our exports of commodities as well. This could trigger a downward spiral of ‘hot’ capital outflow and could set off a wave of panic which would precipitate into the Australian equity and bond market. Given Australia’s high degree of openness with regard to the capital account there could be a seismic shift in the underlying macroeconomic parameters like inflation and interest rates when the imbalance associated with the exchange rate is eventually rectified.

This process could begin in 2013. Whether you look at ‘fast food’ indicators like the Big Mac currency valuation produced by the Economist magazine or a more detailed analysis of the spike in Australia’s Terms of Trade [that research shows is mean reverting] or long-run relative purchasing power parity, the Aussie is probably overvalued by between 25%-30%.

 It has been argued that the Reserve Bank of Australia has been engaging in its own brand of Quantitative Easing [QE], reflected in a surge of Australia’s foreign currency reserves by printing Australian dollars for foreign central banks and this has been ineffective in driving down the value the dollar. This indirect and dirty form of market intervention by the RBA [if proven correct] could end in tears if overseas central banks like Russia, amongst at least 20 others,  become the trigger for capital outflow from Australia by reversing their decision to hold Australian dollars. This could happen in 2013. If this is not the trigger, then the pricking of Australia’s real estate bubble may instigate a downward spiral. In addition, QEs by UK, US and other major central banks have artificially inflated the global bond market and reduced yields to historic lows. If and when US GDP starts to return to its normal trajectory there will be movement of capital from the bond market to the equity markets which could cause a world market bond rout. Australia would not be immune from this because of the strong relationships that exist in global financial asset markets and exchange rates. This could be amplified by a high degree of foreign ownership of the Australian bond market. However, the collapse of the global bond market may dramatically end the secular bear market we are currently in.

The United States will continue to lurch between the hospital wards of economic recuperation throughout 2013 and we are expecting to see quite dramatic volatility in the markets due to this factor alone which will spill over into Australia. VIX, the future uncertainty indicator is currently climbing and is certainly a key indicator to look at to gauge investors’  global risk expectations throughout 2013, and one that is prone to unexpected spikes. Another key indicator is the Baltic Dry Index [BDI]  which measures freight rates for bulk cargo across 40 major shipping lanes in the world and which proxies for world trade. Despite some encouraging manufacturing statistics coming out from old dragon economy China, the BDI has remained bouncing along the bottom of the harbour since the onset of the global financial crisis.