Expect elevated levels of financial market volatility in 2015

Financial market volatility, which has increased over the last few months from unusually low levels, should remain elevated during 2015 as macro-economic inflection points are reached.

Commenting on Novare Investments’ economic report for the fourth quarter of 2014, Francois van der Merwe, Head of Macro Research said: “Now in its sixth year, the equity bull market is getting old, but at the same time, bond yields are at record low levels in many countries.

“Falling oil prices are a game changer that will boost global GDP. Deflation fears are hence unwarranted and should recede as consumer spending picks up. Global GDP, despite being low, is improving and central banks will remain accommodative in the wake of broad-based commodity price declines.”

He added that the benefits that accrue to oil users as a result of the price decline far exceed the cost to producers in terms of overall economic impact. The price fall is also undermining central banks’ efforts to lift inflation and will prompt further stimulus action from those that have inflation targets as their sole mandate.

“The US is set to again assume the title of global growth engine, with the durable recovery leading to a pick-up in global exports during 2015. The Fed has a mandate for both employment and inflation, and with unemployment falling back into the target zone, the Fed should start hiking interest rates later this year. However, low inflation will allow patience before doing so,” said van der Merwe.

A surprise might arise if consumer spending accelerates, pushing up inflation. This would put the Fed behind the curve resulting in faster rate increases than are being priced in.

In an effort to beat deflation, European and Japanese central bank expansion will offset unwinding accommodative monetary policy in the US. Eurozone growth slowed towards the end of 2014, but euro depreciation, low borrowing costs, the weaker oil price and diminished fiscal drag from unwinding austerity measures should bolster the region’s growth prospects.

Said van der Merwe: “US equity valuations are somewhat rich, but consistent with high levels of corporate profitability and supported by low interest rates. European and Japanese equities are attractively valued and will benefit from continued monetary stimulus and more competitive exchange rates.

“The earnings expectation bar has also been lowered substantially for these two regions. Future equity returns will rely more on company fundamentals and profitability than on an equity market re-rating. The global earnings cycle is in an uptrend in response to the economic recovery and should head higher. We do not expect an equity bear market and believe that equities should deliver positive, albeit lower-than-average returns over the next year. We expect global equities to outperform global bonds.”

The South African economic outlook remains tainted by structural constraints that will inhibit growth, as will the unwillingness of policymakers to accelerate reforms. The near term economic outlook will largely be determined by the oil price decline and electricity supply, which are contrary to one another in terms of impact.

The decrease in the oil price will bring relief to indebted consumers by increasing disposable incomes and reducing inflation, while the fall in consumer inflation will allow the Reserve Bank to delay monetary policy normalisation. And, finally, lower oil prices will help trim the wide current account deficit as the oil import component is reduced. The large current account deficit will, however, remain a headache given South Africa’s dependence on foreign funding, any reversal of which could cause currency depreciation.

The weak domestic macro-economic backdrop will make it difficult for local share prices to maintain their high valuations. To sustain the market’s rating, company earnings growth will have to beat expectations.

“Macro-economic risks have diminished and should have a reduced impact on financial markets during 2015. Instead, the greater risks could be geopolitical as social instability increases, resulting in financial market volatility that is difficult to predict. For South African investors, offshore portfolio diversification is important to take advantage of potential rand weakness that stems from such turmoil and more attractively valued opportunities,” said van der Merwe.