Australia 'out of luck'; odds of recession rise in 2015

"Australia has run out of luck."

That is the blunt assessment of one of world's leading market strategists, Gerard Minack.

Mr Minack - the former global head of developed market strategy for Wall Street giant Morgan Stanley - says, with Australia's once-in-a-century commodity boom (unsurprisingly) reversing, there is a serious risk of a recession in 2015.

Now running his own boutique advisory firm for large global institutional investors, Mr Minack puts the chance of an Australian recession at around 40 per cent, although it becomes his base case scenario if the leading indicators of employment deteriorate.

"Under almost any scenario the outlook is for a lower Australian dollar, lower interest rates and under-performing equities," he argued.

"If there is a recession expect sharp outright losses in equities, notably banks, and significant falls in house prices."

Mr Minack has a pretty impressive track record in making big calls.

Famously, in early 2007 as investors continued on their rollicking pre-financial crisis bull run, Mr Minack warned that the layers of leverage being built up in the financial system meant that markets could halve in value by 2010.

The All Ordinaries fell from 6,421 in July 2007 to 3,145 in March 2009.

2014: The year of living anxiously

This time last year, the animal spirits on the Australian stock market were enjoying a period of effervescence.

In the last three weeks of 2013 the market merrily rallied 6 per cent, with All Ordinaries pushing through 5,000 points towards 5,400 early in the New Year.

This year the spirits are in retreat, beaten up by the anxieties of tumbling commodity prices, sullen consumer sentiment and a bleak view of the global recovery.

Globally speaking, in 2014 the Australian market is very much among the laggards, losing about 4 per cent of its value.

In the US, the S&P 500 put on about 8 per cent.

In China - where the economy is supposedly faltering - the Shanghai Composite is up around 40 per cent.

Even in Europe - the developed markets' most vexed region - the broad-based Eurostoxx 600 is up 4 per cent over the year.

Tumbling commodity prices in the second half of the year that are punishing resources stocks are an important part of the decline, but not the whole story.

Chief investment officer at Escala Partners, Giselle Roux, said there has been growing doubt that stronger consumer spending will come to the market's rescue.

"The bottom line is that, for the past couple of years, those with a positive view of the economy have said consumer spending will improve ... the saving rate is relatively high, the wealth effect of higher property values and super balances is good and unemployment is not high," she said.

"I'm sceptical. If it (stronger consumer spending) hasn't arrived before, why in the world will it now?

"There has been very little top line growth."

She said big corporate sectors target revenue growth of GDP plus inflation (around 5 per cent) as a minimum and "things have been well below what they would have liked."

For investors in Australian shares it has been a tough year.

"A lot of funds wouldn't have seen a positive capital return, although the income return has been much better than other asset classes," Ms Roux argued.

Fund manager at 2MG Asset Management, Mike Mangan, said that, while central banks have propped up markets with their bond buying programs and zero interest rates around the world, investors are losing confidence and becoming scared.

"The collapse of iron ore, oil and soft commodities are down; they're indicative of a fundamental weakness," he said.

"Central banks are papering over the issues with variants of printing money.

"There's plenty of scope to do this for years - there's too much debt and too many derivatives to just let it go."

Since the onset of the Global Financial Crisis, G4 central banks - The Fed, the Bank of England, European Central Bank and Bank of Japan - have expanded their balance sheets from $US4 trillion to more than $US10 trillion.

While the US called time on its $US4.5 trillion quantitative easing (QE) program in October, monetary policy remains extremely loose with official interest rates hovering between 0 and 0.25 per cent.

As well, Japan has expanded its QE program to $US712 billion a year and the ECB is expected to start a large-scale government bond buying program - tipped to be around 1 trillion euro or $US1.25 trillion - next year.

Mr Mangan warned that, eventually, the debt could spiral out of control.

"It took years for Lehman (the bank collapse that sparked the GFC) to evolve," he noted.

2015: The bull is running out of puff

Gerard Minack has observed that, after two years of broad-based gains, the bull market started to age through 2014.

"Modestly better economic growth in 2015 may lead to moderate returns for equities outside the US, although there are clear, but unpredictable, risks," he said.

Falling oil prices should stimulate European and Asian economies, although Mr Minack argued it is more important that policy makers have recognised that austerity is not necessarily the best policy.

"Japan may delay another growth killing consumption tax hike, while Europe should take the foot off the fiscal brake; perhaps even tap the accelerator," he added.

While growth looks most assured in the US, Mr Minack said equities there may struggle there as margins flat-line, the Federal Reserve starts tightening policy and the strengthening greenback crimps foreign earnings.

There are three big global risks according to Mr Minack:

• Credit markets start to deteriorate. Transactional liquidity appears to have dried up, and credit markets have seen at least pockets of zero-rate-inspired investing recklessness.

• US dollar strength causes significant financing stress, most likely in some emerging markets.

• Europe returns to crisis. Economics will cause the crisis, but politics will be the catalyst. Europe faces an election landmine over the next 18 months; almost any could be disruptive for markets.

What now?

With the commodities cycle rolling over and Australia's terms of trade and national income tumbling, the big economic driver is likely to be a depreciating dollar coupled with the increasing likelihood of an interest rate cut or two.

Giselle Roux said the impact of a lower dollar is unlikely to be felt until the second half of 2015.

"It takes a while to feed into sectors like tourism and education," she explained.

That increased activity could see a pick-up in wages in the services sector, particularly in low income jobs often tied to tourism, health and education.

The falling dollar should also benefit companies with global focus that can deliver growth overseas.

Ms Roux said that, while the banks' need for more capital may eat into returns down the line, they should remain solid.

"The big challenge for the banks is unemployment, although unemployment needs to get to around 8 per cent before they have difficulty with the bad debt cycle," she predicted.

"At some stage the resource sector will be a great buy, it's just nobody has any idea when."

As for retail stocks, Ms Roux said, "You may as well throw them out with your media sector stuff."

Mike Mangan said investors are looking for protection and are likely to keep "hiding" in defensive stocks such as Telstra and Amcor.

"Anything with balance sheet issues - such as Santos or the iron ore producers - has problems," he cautioned.

From Gerard Minack's perspective, within the domestic equity market, safe yield plays and beneficiaries of Australian dollar weakness - both areas that have done well this year - will continue to be relatively strong.

"If recession eventuates, then the most of these trends will become more pronounced, with the additional likelihood of declines in bank shares and domestic house prices," he added.

There are already some worrying signs developing.

Domestic demand is weak and corporate sales are still sluggish, Mr Minack pointed out.

Mining investment is in decline and that trend will only accelerate from here.

That coupled with a manufacturing sector still under pressure - the already announced job losses at the three big car makers will start soon - and a shrinking public service is not exactly a guarantee that unemployment will not rise further.