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By Tim Farrelly – CEO of Farrelly’s, and asset allocation consultant to Australian Unity Personal Financial Services

Compared with a year ago the world economy is in much better shape; the US has slowly grown back to full employment, China continues to roar ahead and the European and Japanese economies have started to grow again.

All good news that should be, and is, comforting to investors.

As long-term investors we think about two main things: what sort of returns should we get from markets and what shocks or surprises could cause returns to be much lower than our expectations. Over the past year our expectations for future returns have moderated slightly as prices have risen, while our assessment of risk has fallen. We should still be fully invested.

The way ahead under President Trump has become much clearer

A year ago we were concerned by the United States of America initiating trade wars, and not just with China, and the possibility of a genuine war with North Korea and/or in the Middle East. We were worried about who would replace Janet Yellen as the chair of the US Federal Reserve and what would be the implication for interest rates and currencies if the new chair favoured aggressive increases in interest rates.

We also wondered who would be the winners and losers from the proposed company tax policies.

Today, all talk of trade wars has disappeared, China appears to be the new best friend of the US and is helping to manage the situation with North Korea. Tensions remain, but for now, seem more under control.

More good news is the appointment of Jerome Powell as the new chair of the US Federal Reserve. Powell is a moderate cautious individual who is likely to be in favour of raising rates very slowly. Another risk off the table.

The cuts to US company taxes now seem to be a certainty and will boost company profits across the board. Rather than winners and losers, the question seems to be more a matter of which companies will benefit the most.

Risks to the US economy and company earnings appear low. Good news.

Our only issue is how much you have to pay to buy those earnings. US shares have generally risen strongly to the point we question how much we have to pay for all this good news. We are cautious as to the long term outlook for US equities, even though the short term outlook appears rosy.

In our opinion, sharemarket valuations are more attractive in other parts of the world.

Euro economic fears have abated for now; equities are attractive

A year ago, following Brexit, fears abounded for a disorderly break-up of the Euro project and the implications for the highly indebted countries such as Spain, Italy and France. Today it is much calmer. Brexit seems to be turning ugly and other members of the Euro now have little enthusiasm to follow Britain in leaving the European Union.

For the first time in eight years, most of Europe is back into economic growth mode. Confidence and profits are up and, better still, European shares appear to be attractively priced.

Japan starting to grow again

For some time, we have marveled at the ever increasing mountain of Japanese government debt.

Many economists believe that economic growth slows when government debt hits 100% of GDP (i.e. gross domestic product, being the market value of all goods and services produced). Japan now has government debt at 230% of GDP and everything seems to be just fine.

Corporate profits have continued to grow and Japanese GDP per capita (surely a better measure of economic health than GDP) has grown about the same pace as US GDP per capita over the past 15 years.

One day the Japanese government will need to reign in its deficits and debt, but right now that still seems many years away.

Japanese equities are also attractively priced. We also like this market for investors looking for diversity outside of Australia.

China and Emerging Markets going through a transition

Emerging markets have seen many years of rapid GDP growth funded by ever increasing government and corporate debt. We believe that the debt-fuelled growth model may be reaching its limits and will come to an end over the next decade.

China continues to defy the doomsayers, maintaining its debt-driven growth model. The big question is when that model reaches its limits, will it be in a controlled fashion or by crisis? Here the potential for a shock is real and ongoing, though it might be years before realisation.

On a positive note, recent experience in India and South Korea suggests that economies can move away from the debt/growth model in a controlled way without causing a dramatic disruption to the economy or company profits. This is good news for the emerging market economies and, potentially, for the Chinese economy.

We have few short-term fears for Chinese and emerging economies’ sharemarkets, but continue to monitor the situation closely.

In short, we believe Asian stocks remain reasonably priced.

The UK is vulnerable

All signs are that Brexit will not go well for the UK economy. But how bad will it be for UK company profits is hard to tell. Our expectation is that it will be quite damaging and has the potential to permanently lower profits of UK companies by around 10% compared to where they would have been if the UK remained in the European Union. Hence, the UK is the one major economy that appears vulnerable to a major shock in the short term. We suggest caution in the UK sharemarket.

The Australian economy continues to grow and the sharemarket remains attractive

Over the past few years some of the investment media has been full of doom and gloom about the Australian economy; a collapse in residential property prices and building activity, the end of the mining boom, a collapse in the Australian dollar, a collapse in China our major export partner and catastrophic losses by the banks have all been in the headlines.

The mining boom has indeed ended, the Australian dollar has fallen, residential construction has slowed and yet, despite those difficulties, the economy has continued to grow, albeit slowly.

Today, mining investment has stabilised, residential building activity is moving to more sustainable levels in Melbourne and Sydney at least – Brisbane and Perth remain problematic – and interest rates remain low and are likely to stay relatively low for many years yet.

Australian banks have reduced the risk in their lending books and have raised more capital, and as a result they appear to be stronger than they have been for many years.

Furthermore, Australian shares generally remain reasonably priced and should produce returns well in excess of term deposits over the next decade.

Caution: Volatility is not dead

None of the above is to suggest that share markets are immune from future bouts of volatility.

There will be surprises in the years to come that we have not anticipated – that is the nature of surprises.  When they arise they will cause market volatility.

Nonetheless, most global sharemarkets are sufficiently attractively priced that, even with unpleasant surprises, share investments should comfortably outperform term deposits in the long term for investors who hold their nerve. We suggest investors remain fully invested for now.

This article was originally prepared and issued by Tim Farrelly, principal of Farrelly Research & Management Pty Ltd (‘Farrelly’s) ABN 63 272 849 277. It is reproduced without amendment in this publication with the permission of Farrelly’s and the extent to which it may contain the copyright material of another party, it is otherwise reproduced under the fair dealing provisions as applicable and contained in the relevant Australian statute.  Disclaimer: This article is not legal or personal financial advice and should not be relied on as such. Any advice in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. You should obtain financial advice relevant to your circumstances before making investment decisions. Where a particular financial product is mentioned you should consider the Product Disclosure Statement before making any decisions in relation to the product. Whilst every reasonable care has been taken in distributing this article, Australian Unity Personal Financial Services Ltd does not guarantee the accuracy or completeness of the information contained within it. Any views expressed are those of the author(s) and do not represent the views of Australian Unity Personal Financial Services Ltd. Australian Unity Personal Financial Services Ltd does not guarantee any particular outcome or future performance. Australian Unity Personal Financial Services Ltd is a registered tax (financial) adviser. If you intend to rely on any tax advice in this document you should seek advice from a tax professional. Australian Unity Personal Financial Services Ltd ABN 26 098 725 145, AFSL & Australian Credit Licence No. 234459, 114 Albert Road, South Melbourne, VIC 3205. This document produced in December 2017. © Copyright 2017