Global financial markets had a tumultuous December quarter driven largely by the United States Federal Reserve’s wavering over when it would finally raise official interest rates.

The quarter began after a heavy market slump in late August, with equity markets spooked by signs of a Chinese slowdown and hints that the Fed could raise rates at its mid-September meeting. Indeed, America’s S&P 500 index dropped 11 per cent in the week ending August 25.

As it happened, the Fed baulked at the opportunity to raise rates in September, and sensing this shift in sentiment, markets rose up until mid-month. But the Fed then turned what should have been a major supportive event into a negative one – by attributing its non-action to the very same negative signs in the global economy that shook markets back in August. Perversely, that led the market to suddenly get a lot more worried about the global economy than it probably needed to be – figuring ‘what does the Fed know that we don’t?’

As is the way with markets, the Fed’s reluctance to raise interest rates did eventually evolve into a good news story, as traders speculated on the prospect that US interest rates could remain on hold until well into 2016. Equity markets rallied, and even the Australian dollar enjoyed a brief rally. At one point in early October, the Aussie dollar reached a high of just over 73 US cents.

The drumbeat of positive US economic news more recently, however, has left markets in two minds. On the one hand, America’s recovery is no doubt positive for corporate earnings. On the other hand, it has increased fears that the Fed would therefore have to raise rates sooner rather than later. Indeed, hawkish comments from Fed chairperson Janet Yellen and another very strong US employment report have recently swung market sentiment to the view that a US rate hike in December is now more likely than not. In turn, global stock market weakness has returned.

One challenge for global equity markets is that outright price to earnings valuations now appear stretched compared to their long-run average levels – supported by continued unusually low global bond yields which are at risk of rising as the US Federal Reserve raises short-term interest rates. History suggests equity markets tend to experience a few months of weakness following the start of a Fed tightening cycle and this episode is shaping up to be little different.

That said, for largely commodity importing countries in the developed world – such as the United States, Europe and Japan – weaker commodity prices (particularly for oil) should continue to support real household incomes and economic growth. Weaker commodity prices are also helping keep inflation low, which is allowing central banks to retain an accommodative policy stance.

Closer to home, Australia’s exposure to the much-maligned resources sector and the weakening Australian dollar have seen the S&P/ASX 200 index continue to underperform global peers, especially on an unhedged currency basis. Local economic data has been mixed, with weak readings on overall economic growth but continued reasonably solid employment growth – which in turn, reflects the shift in the composition of growth toward labour intensive (but relatively low wage) sectors such as health, education and hospitality. The rise to power of recently-installed Prime Minister Malcolm Turnbull has had only a modest positive effect on business and consumer confidence.

One worry for the economy is that the upturn in housing construction – which has been an important and timely contributor to growth at a time of heavy falls in mining investment – appears to be reaching a peak. Another worry is the untimely prospect of another serious drought which could devastate farm incomes once again.

Meanwhile, further declines in mining investment – and mostly likely commodity prices – remain likely, the negative effects of which are being offset by an only very gradual transition to non-mining service-based activity. Thanks to continued low inflation – the September quarter consumer price index result was lower than expected – the RBA has again raised the possibility of lower interest rates in the new year if the economy remains sluggish.

Despite the risk of lower local interest rates, the Australian equity market also remains challenged by still relatively high outright price to earning valuations. What’s more, the market does not have the underlying earnings support that is evident in more robust economies, such as the United States, which is particularly enjoying its exposure to the high-growth technology sector. Against this sluggish market backdrop, local investors are likely to continue to seek the safety of yield – though whether many companies can sustain their high dividend payouts in the face of weak earnings is questionable. Another important local market theme is to seek out companies with good exposure to offshore earnings, if only because the weaker currency will effectively boost the Australian dollar value of these earnings.

The outlook in emerging markets is even more challenged than that in Australia. Commodity exporting nations such as Brazil face the weakness in commodity prices – as we do – together with potentially destabilising capital flight as interest rates rise in the United States. Non-commodity exporters such as Korea and Taiwan, moreover, are exposed to the slowdown in the Chinese economy. Weaker oil prices and Russia’s military adventurism is seriously undermining its own growth prospects. That said, while downside risks clearly remain, Chinese authorities still appear to be successfully managing an orderly transition to slower and less recourse-intensive economic growth.

David Bassanese, chief economist, BetaShares