Provision Newsletter

Introduction

After sharp share market falls when headlines scream about the billions wiped off the market the usual questions are: what caused the fall? what’s the outlook? and what does it mean for superannuation? The correct answer to the latter should be something like “nothing really, as super is a long-term investment and share market volatility is normal.” But that often sounds like marketing spin. However, the reality is that – except for those who are into trading or are at, or close to, retirement – shares and super really are long-term investments. Here’s why.

Super funds and shares

Superannuation is aimed (within reason) at providing maximum (risk-adjusted) funds for use in retirement. So typical Australian super funds have a bias towards shares and other growth assets, particularly for younger members, and some exposure to defensive assets like bonds and cash in order to avoid excessive short-term volatility in returns.

The power of compound interest

These approaches seek to take maximum advantage of the power of compound interest. The next chart shows the value of a $100 investment in each of Australian cash, bonds, shares, and residential property from 1926 assuming any interest, dividends and rents are reinvested along the way. As return series for commercial property and infrastructure only go back a few decades I have used residential property as a proxy.

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Source: ABS, REIA, Global Financial Data, AMP Capital

Because shares and property provide higher returns over long periods the value of an investment in them compounds to a much higher amount over long periods. So, it makes sense to have a decent exposure to them when saving for retirement. The higher return from shares and growth assets reflects compensation for the greater risk in investing in them – in terms of capital loss, volatility and illiquidity – relative to cash & bonds.

But investors don’t have 90 years?

Of course, we don’t have ninety odd years to save for retirement. In fact, our natural tendency is to think very short term. And this is where the problem starts. On a day to day basis shares are down almost as much as they are up. See the next chart. So, day to day, it’s pretty much a coin toss as to whether you will get good news or bad. So, it’s understandable that many are skeptical of them. But if you just look monthly and allow for dividends, the historical experience tells us you will only get bad news around a third of the time. If you go out to once a decade, positive returns have been seen 100% of the time for Australian shares and 82% for US shares.

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Daily & mthly data from 1995,yrs & decades from 1900. GFD, AMP Capital

This can also be demonstrated in the following charts. On a rolling 12 month ended basis the returns from shares bounce around all over the place relative to cash and bonds.

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Source: Global Financial Data, AMP Capital

However, over rolling ten-year periods, shares have invariably done better, although there have been some periods where returns from bonds and cash have done better, albeit briefly.

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Source: Global Financial Data, AMP Capital

Pushing the horizon out to rolling 20-year returns has almost always seen shares do even better, although a surge in cash and bond returns from the 1970s/1980s (after high inflation pushed interest rates up) has seen the gap narrow.

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Source: Global Financial Data, AMP Capital

Over rolling 40-year periods – the working years of a typical person – shares have always done better.

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Source: Global Financial Data, AMP Capital

This is all consistent with the basic proposition that higher short-term volatility from shares (often reflecting exposure to periods of falling profits and a risk that companies go bust) is rewarded over the long term with higher returns.

But why not try and time short-term market moves?

The temptation to do this is immense. With the benefit of hindsight many swings in markets like the tech boom and bust and the GFC look inevitable and hence forecastable and so it’s natural to think “why not give it a go?” by switching between say cash and shares within your super to anticipate market moves. Fair enough if you have a process and put the effort in. But without a tried and tested market timing process, trying to time the market is difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 9.7% pa (with dividends but not allowing for franking credits, tax and fees).

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Source: Bloomberg, AMP Capital

If by trying to time the market you avoided the 10 worst days (yellow bars), you would have boosted your return to 12.4% pa. And if you avoided the 40 worst days, it would have been boosted to 17.3% pa! But this is very hard, and many investors only get out after the bad returns have occurred, just in time to miss some of the best days. For example, if by trying to time the market you miss the 10 best days (blue bars), the return falls to 7.6% pa. If you miss the 40 best days, it drops to just 3.6% pa.

The following chart shows the difficulties of short-term timing in another way. It shows the cumulative return of two portfolios.

• A fixed balanced mix of 70 per cent Australian equities, 25 per cent bonds and five per cent cash;

• A “switching portfolio” which starts off with the above but moves 100 per cent into cash after any negative calendar year in the balanced portfolio and doesn’t move back until after the balanced portfolio has a calendar year of positive returns. We have assumed a two-month lag.

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Source: Global Financial Data, AMP Capital

Over the long run the switching portfolio produces an average return of 8.8% pa versus 10.2% pa for the balanced mix. From a $100 investment in 1928 the switching portfolio would have grown to $218,040 compared to $705,497 for the constant mix.

Key messages

First, while shares and other growth assets go through periods of short-term underperformance relative to bonds and cash they provide superior returns over the long term. As such it makes sense that superannuation has a high exposure to them.

Second, switching to cash after a bad patch is not the best strategy for maximising wealth over time.

Third, the less you look at your investments the less you will be disappointed. This reduces the chance of selling at the wrong time or adopting an overly cautious stance.

The best approach is to simply recognise that super and investing in shares is a long-term investment. The exceptions to this are if you are really into putting in the effort to getting short-term trading right and/or you are close to, or in, retirement.

Source: AMP Capital 14th November 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

In today’s environment of low interest rates, many investors are chasing income by moving into lower-quality high-yield bonds, but are they ignoring the downside risks?

While an overweight to high-yield credit may be an efficient way to boost a portfolio’s yield, investors need to be mindful of the additional risks they are taking on and how those risks will interact with other parts of their investment portfolio.

For example, for retirees seeking a stable income-generating portfolio, the addition of less-liquid bonds that have an increased risk of capital volatility might not be the right investment option, despite the income they produce.

Here, we explore the different types of fixed income securities and their associated risks.

Types of fixed income securities 

The types of fixed income securities investors can choose from include both publicly-traded debt securities (such as corporate bonds, sovereign and non-sovereign government bonds, supranational bonds, and commercial paper) and privately-traded instruments (such as loans and privately placed securities). The credit market also includes structured financial instruments, such as mortgage-backed securities, asset-backed securities, and collateralized debt obligations, which tend to exhibit higher yields (and lower liquidity) as the complexity increases.

Within corporate bonds, there are several classes of debt, ranging from senior bonds to preferred securities. Senior bonds have greater security in the issuer’s capital structure than subordinated debt and preferred securities. In the event the issuer goes bankrupt, senior debt must be repaid before other creditors receive any payment. Senior debt is often secured by collateral on which the lender has put in place a ‘first lien’ or legal right to secure the payment of debt. The further down the capital structure a security is, the higher the risk of ultimate loss.

The importance of quality bonds

A bond issuer’s ability to pay its debts (i.e. to make all interest and principal payments in full and on schedule) is a critical concern for investors. Most corporate bonds are evaluated for credit quality by credit rating agencies, such as Standard & Poor’s, Fitch Ratings and Moody’s Investors Service, and result in a rating on a standard scale that can be compared across issuers. These ratings scales are broadly split into two categories to reflect safer securities – referred to as “investment-grade” – and riskier securities – referred to as either “speculative-grade” or “high-yield”.

The financial health of the company or government entity issuing a bond affects the bond’s yield and subsequently the price investors are willing to pay. If the issuer is financially strong and investors are confident that the issuer will be capable of paying the interest on the bond and pay off the bond at maturity, then the yield will be lower as the perceived risks are lower.

High-yield corporate bonds on the other hand have lower, speculative-grade credit ratings than their investment-grade brethren. The greater risk of loss implied by these lower ratings, leads to higher yields compared with those seen within investment-grade corporate bonds. This is because there is a higher probability that a borrower defaults or fails to meet its obligation to make full and timely payments of principal and interest. Historically, speculative-grade companies experience higher default rates throughout economic cycles – and particularly so during recessions – resulting in potentially significant losses to investors when these occur.

Liquidity and volatility

High-yield bond funds tend to invest in loans, corporate bonds and structured credit which are at the riskier end of the investment universe. These types of securities can be difficult to buy or sell as they do not trade frequently, making them less liquid than investment-grade bonds. Bond funds where the underlying investments are investment-grade rated typically provide investors with daily liquidity as the market for these assets is larger, better-known and therefore more liquid. This is most prevalent when markets are volatile and investors are searching for “safer” assets, and when market pricing tends to be very reactive to liquidity and volatility risks.

High-yield bond funds can often have returns that behave similarly to equity markets; in other words, their returns often move in the same direction as equity markets. This is due to the capital price impacts of movements wider in credit spreads; namely the size of the bond yield margin above a risk-free asset yield which compensates investors for the associated credit risk. Typically, a credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity.¹

When credit spreads widen, this is a reflection that the market for those securities is requiring higher compensation for the underlying risk of holding those securities – for instance, for a higher risk of default, or more compensation for liquidity risk.

In times of heightened volatility, these dynamics can become self-reinforcing, given the right conditions. For instance, investors observing the capital value of their investment falling (as risks are increasing) may attempt to sell their exposure. If enough investors attempt to sell the same assets into a liquidity-constrained environment, this can exacerbate the issue, causing further losses – and in extreme circumstances, can cause a fund to “lock-up”, or result in capital being unable to be returned to investors in a timely fashion.

All investors have a different risk-return appetite; however, investors need to be mindful that economic growth has been reasonably solid for much of the past decade, and an environment where yields have been pushing progressively lower creates an environment where liquidity and volatility risks may not be appropriately priced in some markets. Funds with larger exposures to credit investments of lower-quality or greater complexity are likely to exhibit a higher likelihood of drawdowns on capital, and the potential for negative returns.

The final word

The ‘lower-for-longer’ interest rate theme continues to dominate markets, and low yields are likely to see low returns from bonds for a period of time. Investors moving into lower-quality high-yield bonds, should consider whether the additional yields on such bonds adequately offset the higher capital volatility and liquidity risks that come with them.

A retiree, or someone heading into retirement typically needs an investment strategy designed to provide a predictable and reliable income stream throughout their retirement years so if you’re not comfortable with capital volatility, lack of liquidity and you require a regular reliable monthly income stream, then a high-yield bond fund may not be the best choice for you.

There are many options along the risk curve when it comes to fixed income, with cash at the least risky end and instruments such as hybrids that also have equity characteristics at the other end. In other words, there is a wide spectrum of fixed income investments and it pays to understand what these are, the risks they have and how they can help meet set goals when building the fixed income component of a portfolio.

¹ https://www.investopedia.com/terms/c/creditspread.asp

Author:  Nathan Boon, Sydney, Australia

Source: AMP Capital 12th Nov 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

There are mechanisms to maximise returns in this lower-for-longer environment, and a green alpha strategy in real estate investment is one option on the table.

Against a global backdrop of lower interest rates, falling government bond yields and bank term deposit returns at or below 2 per cent, achieving higher, low risk returns is becoming more challenging for investors.

With the lower for longer trend seemingly entrenched as global economic uncertainty rises, investors are turning to green alpha strategies as one way to maximise returns, whilst improving the sustainability performance of Australia’s built environment at the same time.

How does this apply to real estate?

From a real estate perspective, maximising the returns you can generate in a portfolio is primarily linked to boosting the rental income and keeping operational costs down. Reducing the outgoings of an asset by cutting energy costs is an important, and relatively simple method to boost income yields and according to market evidence and international studies into green buildings, can make significant differences to the return an asset delivers over its life.

Asset valuations and returns are already starting to reflect a growing divergence between high-standard green buildings and their less green peers that can add as much as 50bps per annum to a total return.

For example, according to the MSCI Green Property Investment Digest, over the past three years, Prime CBD Office buildings with a NABERS star rating higher than four stars (the maximum is six) have delivered a total return to their investors of 13.4%, versus 12.9% for all other assets in this category.

Source: NABERS.gov.au

Looking at a cities level, investors chasing green returns might do well to focus on the Melbourne market, which had the highest total returns for prime office buildings with a 4-6 star NABERS rating at 15% in the year to June 2019.

After Melbourne, investors in Canberra benefitted from the highest ‘green alpha’ with a 200 basis point boost in total returns, versus the average for the prime office market there. Government tenants in this market place a high priority on green credentials when leasing space, driving better income return outcomes for landlords who can offer 5 star plus opportunities in that market.

Source: MSCI/IPD, AMPCI RE Research

Thinking long term, and looking beyond cost savings, sustainability initiatives such as integrated solar in commercial assets can provide long term downside protection against spikes in electricity costs. These sort of initiatives could reduce the outgoings of an asset, a competitive advantage at a time where electricity prices have risen by over 20% in the past two years.¹

Green alpha and the boost it provides to total returns has become a bigger part of an asset manager’s toolkit in maximising returns. Greener buildings, apart from delivering superior returns, tend to offer investors lower systemic risk with a more stable income profile, lower incentives and enhanced tenant “stickiness” which can reduce the vacancy of a portfolio.

The bottom line is, environmentally sustainable buildings offer both financial and environmental benefits to investors for the long term. In an increasingly challenging lower for longer returns environment, green alpha is a pathway to get ahead of the pack.

¹ https://www.nabers.gov.au/publications/annual-report

Author: Luke Dixon, Head of Real Estate Research – Real Estate Sydney, Australia

Source: AMP Capital 28th Oct 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

Investors may be surprised to learn about the patterns which have formed in the small caps market since the Global Financial Crisis. Here, we take a closer look at recent data, and what is driving earnings and valuations.

Overview

Australian small cap stocks have failed to live up to their potential in recent times. By definition, small cap companies are generally at an earlier stage of their life cycle with good growth opportunities ahead, and in an environment of record low interest rates and freely available money for companies to expand their operations, it would be expected that they are growing strongly and generating good returns. Some are doing just that, however it may surprise investors that the aggregate level of earnings generated by companies in the ASX Small Ordinaries Index has consistently declined since 2008 when the Global Financial Crisis (GFC) hit.

Source: AMP Capital, FactSet (2001-2019)

Earnings under pressure

There have been a few different factors driving the underperformance of earnings:

• The end of the resources capex boom in 2012-13 resulted in large earnings downgrades in mining and mining services related stocks, which were significant components of the index at the time.

• The domestic environment has been challenging for large parts of the economy with cyclical and structural factors affecting the earnings base of both consumer (subdued consumer confidence, e-commerce) and housing (new start declines, rising power prices) related companies.

• A number of technology and other high growth stocks have gone through a significant cost investment program – investing heavily in sales, marketing, product development and offshore growth to capitalise on new market opportunities. This has the potential to raise the earnings profile in outer years but has resulted in downgraded earnings forecasts in the near term.

The overall market has delivered muted growth since 2014, which has reflected a stronger period of earnings growth in mining companies (notably gold stocks), while earnings for industrial companies have flat lined and are virtually unchanged since post-GFC lows 10 years ago.

Small caps versus large caps

The factors highlighted above go a long way to explaining the underperformance of small caps stocks compared to their large cap counterparts over this time period. In fact, since small cap earnings bottomed after the GFC in September 2009, the Small Ordinaries Accumulation Index has underperformed the ASX 200 Accumulation Index by 70% in aggregate. It’s interesting that an index dominated by banks and diversified miners has substantially outperformed an index which has contained material exposure to stocks which have captured investor’s attention over the past few years including technology, Chinese consumer consumption (e.g. infant formula and vitamins), electric vehicles and gold.

Source: AMP Capital, FactSet (2009-2019)

Follow the earnings

The research we have undertaken into small cap returns and our experience in the market shows that earnings drive share prices. Valuation is an important consideration, however it is mean reverting and hard to predict, so we focus on our core strength – forecasting earnings. An earnings-based approach to valuing a stock is resilient to valuation changes and its serially correlated nature makes it more predictable.

Since 2001, the ability to pick a portfolio of stocks that has actually delivered the highest level of earnings growth in the small caps market would have delivered a compound 14% annual return, or a cumulative return of 828% over this period. This compares to an index return of 1% per annum. Obviously forecasting earnings with perfect foresight is impossible, but this illustrates the potential opportunity for active managers in the space who can spend time undertaking detailed fundamental research on a company and get an edge on the market.

Source: AMP Capital, FactSet

The above chart also shows that sell side analysts have added very little value when picking earnings over this period and investing by following consensus earnings leads to underperformance. In fact, since 2001 a portfolio of small cap stocks with the highest growth forecast by consensus has provided a return of -2% per annum, or -29% in aggregate. This isn’t a huge surprise given sell-side analyst forecasts are typically a lagging indicator. This is further exacerbated by the number and quality of earnings estimates in the Australian small cap market falling dramatically over the past few years. 

Source: Goldman Sachs Global Investment Research, Factset

When analysing performance of the AMP Capital Australian Emerging Companies Fund since its inception in July 2014 to September 2019, the Small Ordinaries Index has been a solid performer despite the earnings headwinds, providing investors with a 8.9% per annum compound return (55.9% cumulative return). But when we dig into what has been driving this return, it’s clear this performance has been by dividends with muted earnings growth and a P/E multiple re-rate (or put simply, the stocks becoming more expensive). In a world of record low interest rates and rising asset values, the multiple re-rate is understandable and not out of sync with other asset classes, however it is unlikely to be sustainable unless investors start to see material earnings growth starting to come through in order to justify the higher valuations.

The AMP Capital Australian Emerging Companies Fund has returned 11.5% per annum (after-fees) over the same period (76.8% cumulative return), with earnings growth contributing the majority of returns, which is aligned to our investment philosophy and process. The ability to pick stocks which are growing earnings consistently has been the major driver of the Fund’s outperformance.

Past performance is not a reliable indicator of future performance Cumulative total returns from July 2014 to September 2019 are shown after fees and before tax

Bigger is better? Not necessarily…

Despite the relatively gloomy picture we have presented for small cap earnings, there is one major reason for optimism in small caps. The median small cap manager has significantly outperformed not only the ASX Small Ordinaries Index, but also the ASX 200 Index and the median large cap manager over a long time period. Investors who have trusted their money with even a middle of the pack small cap manager have seen excellent compound returns over this period. The Australian small caps market is inefficient and not well researched, providing good managers with the opportunity to find new information which gives them an edge in picking stocks.

Source: AMP Capital, Mercer, FactSet (2000-2019)

Key take-aways:

• An investment process which is focused on earnings can lead to significant outperformance.

• The need for investors to be benchmark unaware – why invest in a stock just because it is in an index? It’s much better to construct a high-quality portfolio of stocks from all the available options in the investable universe.

• The benefit of active management, especially in small caps, which have proven to generate excellent returns for investors over the long term.

Author: Matt Griffin, Co-portfolio Manager, Small Caps Sydney, Australia

Source: AMP Capital 8th Nov 2019

Important notes: AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMPCFM) is the responsible entity of the AMP Capital Australian Emerging Companies Fund (Fund) and the issuer of the units in the Fund. To invest in the Fund, investors will need to obtain the current Product Disclosure Statement (PDS) from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232 497) (AMP Capital). The PDS contains important information about investing in the Fund and it is important that investors read the PDS before making a decision about whether to acquire, or continue to hold or dispose of units in the Fund. Neither AMP Capital, AMPCFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this document. Past performance is not a reliable indicator of future performance. While every care has been taken in the preparation of this document, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to their objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

Bad meme

There is always someone telling us that there is some sort of economic/financial disaster coming our way. However, there does seem to be a higher level of hand wringing now about the global economic outlook than normal. These concerns basically go something like this:

• Global debt – both public and private – is at record levels relative to GDP and with public debt ratios so high there is no scope for fiscal stimulus should things go really bad.

Source: IMF, RBA, AMP Capital

• Years of quantitative easing and other unconventional monetary policies like negative interest rates by central banks in major advanced countries haven’t worked and seem to have no end.

• More and more debt globally is trading on negative interest rates – it’s now around $US14 trillion including around 25% of all government bonds – which is unnatural and causing distortions in valuing assets with risks of asset bubbles.

• Inequality (as measured by Gini coefficients) is rising – particularly in the US – which is driving a populist backlash against rationalist market-friendly economic policies of globalisation/free trade (as evident in Trump’s trade wars), deregulation and privatisation.

Source: OECD, Standardised World Income Inequality Database, AMP Capital

• This along with the relative decline of US economic and military power is contributing to geopolitical tensions as we move from a “unipolar world” (dominated by the US after the end of the Cold War) to a “multipolar world” as other countries (China, Russia, Iran/Saudi Arabia, etc) move in to fill the gap left by the US or even “challenge” the US.

This is all seen as being bad for global growth and hence growth assets, all of which is being heightened by the downturn in global growth seen over the last year or so.

Five reasons not to be too fussed.

There is no denying these concerns. Debt is at record levels globally. QE has been running in various iterations for more than a decade now in some countries. Inequality is up – albeit its mainly a US and emerging country issue. Support for market-friendly economic rationalist policies such as globalisation, deregulation and privatisation seems to have waned (except in France). And geopolitical risks are up. All these developments point to the risk of slower global growth and investment returns ahead and may figure in the next major bear market. But there is always something to worry about (otherwise shares would offer no return advantage over cash) and trying to time the next downturn is hard. Moreover, there are five reasons not to get too fussed about the global outlook.

1. Debt is more complicated than being at a record

History tells us that the next major crisis will involve debt problems of some sort. But what’s new – they all do! Just because global debt is at record levels does not mean that a crisis is imminent. There are several points to note here:

• debt has been trending up ever since it was invented;

• comparing debt to income (or GDP) is like comparing apples to oranges as debt is a stock and income is a flow – the key is to compare debt against assets and here the numbers are not so scary because debt and assets tend to rise together

• debt interest burdens are low thanks to low interest rates

• all of the rise in debt in developed countries since the GFC has come from public debt and the risk of default here is very low because governments can tax and print money.

While Modern Monetary Theory has its issues, it does remind us that as long as a government borrows in its own currency and inflation is not a problem, it has more flexibility to provide stimulus than high public debt to GDP ratios suggest.

2. QE’s end point is not necessarily negative

Quantitative easing and other unconventional monetary policies actually do appear to have helped. Since its high in 2013 unemployment in the Eurozone has fallen from 12% to 7.5% and in the US it fell from 9% in 2011 to 4% in 2017 enabling the Fed to start unwinding unconventional monetary policy. Inflation has not been returned to 2% targets, but wages growth has lifted and at the start of last year it looked like the global economy was getting back to normal. What kicked the global economy off the rails again was a combination of Trump’s trade wars, a debt squeeze in China and tougher auto emission controls. But this it wasn’t due to a failure of quantitative easing.

As to how quantitative easing is eventually unwound there is no easy answer, but there is no reason to believe that it will end with a calamity. First, in the absence of a surge in inflation necessitating a withdrawal of the money that has been pumped into the global economy there is no reason to withdraw it. And when inflation does start to rise it can be reversed gradually by central banks not replacing their bond holdings as they mature.

Second, the assets central banks purchased as part of QE have boosted the size of their balance sheets but the varied size of central bank balance sheets from one country to another as a share of their economy shows that there is no natural optimal level for them. In fact, the Fed is now resuming natural growth in its balance sheet as occurred prior to the GFC so its balance sheet may just stay high (as along as inflation is not a problem).

Finally, if push came to shove just consider what would happen if say the Bank of Japan told the Japanese government that it no longer expects payment at maturity for the 50% of Government bonds it holds? The BoJ would write down its bond holding and the Japanese Government would suffer a loss on its investment in the BoJ but that would be matched by a write down in its liabilities. Basically, nothing would happen except that Japanese government debt would fall dramatically!

3. Inflation and interest rates are low

The key thing that has caused many sceptics to miss out on good returns this decade is that they focussed on low inflation as reflecting low demand growth but missed out on the positive valuation boost to assets like shares and property that low inflation and low interest rates provides.

4. Rapid technological innovation and growth in middle income Asia is continuing

This is well known and has been done to death, so I won’t go over it suffice to say that there are still a lot of positives helping underpin the global outlook and these two remain big ones.

5. Global growth looks like it may pick up

While the slowdown in global growth over the last 18 months has been scary and associated with share market volatility, the conditions are not in place for a deeper slide into global recession like we saw at the time of the GFC – excesses like overspending, surging inflation, excessive monetary tightening are not present. In fact, various signs are pointing to a cyclical global pick up ahead:

• Bond yields are up from their lows & look to be trending up

• The US yield curve is now mostly positive – suggesting the inversion seen this year may have been another false recession signal like seen in 1996 and 1998

Source: NBER, Bloomberg, AMP Capital

• European, Japanese & emerging shares are looking better

• Cyclical sectors like consumer discretionary, industrials and banks are looking better

• The US dollar looks like it might have peaked; and

• Business conditions PMIs for the US, Europe & China were flattish in October & may be stabilising. This saw the global manufacturing PMI go sideways and a rise in the services PMI and both still look like the 2012 and 2016 slowdowns.

Source: Markit, Bloomberg, AMP Capital

These could be pointers to global monetary easing getting traction. Of course, much depends on what happens to geopolitical risks. The US election next year will be a big one to keep an eye on and beyond that US/China tensions look likely to be with us for years. But there is reason to expect some respite in the short term on the geopolitical front:

First, the economic slowdown in both China and the US is pressuring both to defuse the trade dispute in the short term. This pressure is greater now as Trump wants to get re-elected next year and knows that he won’t if he lets the US slide into recession or unemployment rise. China may prefer to wait till after the election but is more likely to opt for the devil it knows.

Second, Trump’s avoidance of retaliation after the attack on Saudi’s oil production facilities in September shows a desire to avoid getting into military conflict in the Middle East.
Third, Brexit risks are on the back burner for now (although they could still come up again next year).

Concluding comment

There is good reason to expect the global economic cycle to turn up in the year ahead just as it did after the growth in 2012 and 2016. This should be positive for growth assets like shares. Finally, for those worried that more and more debt will trade at negative interest rates our view is that this is unlikely: many countries have already sworn off using rates including the US and RBA Governor Lowe says it’s extremely unlikely in Australia. And if growth picks up as we expect the proportion of global debt on negative rates will decline as it did after 2016.

Source: AMP Capital 7th November 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

In a rural Spanish town, wolves outnumber children.

In the United States, carmakers are testing automated vehicles not in Silicon Valley, but in a Florida retirement community.

Closer to home, in Castlemaine, Victoria, a gym is encouraging people to lift weights to maintain muscle mass and prevent infirmity in later life.

These seemingly different stories spring from the same source: Around the world, populations are ageing.

Growing numbers of older people are dramatically reshaping places, cultures and economies.

Between 2015 and 2045, the number of people over 65 is expected to nearly double, to a record 15 per cent globally.

The increasing average age has generated concerns that global economic growth will slow and that share prices will fall significantly as retirees draw down their portfolios.

In Australia, most people understand the effect the baby boomers had on school construction in the 1970s, on household spending habits in the 1980s and on the sea-change impact in the 2000s. And with many of them entering retirement, how will they reshape our economy?

Recent Vanguard research, The Economics of a Graying World, has some positive, or at least counterintuitive, news about these investor concerns. Many of the assumptions about the impact of an ageing population don’t hold up to analysis:

• Older people don’t spend less than younger people. They devote less of their budget to categories such as clothing and leisure and more to health care and housing.

• A trend toward increasing the age required to receive retirement benefits will prompt many people to work longer.

• A shrinking workforce will provide incentives for investments to offset higher labour costs, which may boost productivity.

• A growing ageing population does not necessarily lead to lower investment returns.

The research reinforces the wisdom of diversifying portfolios globally to reduce the risk of exposure to downturns in a single country or region. The percentage of older people will be much higher in some of the world’s largest economies. In Australia, about 20 per cent of residents will be older than 65 by 2045, according to the Australian Institute of Health and Welfare. In Japan, as many as one in three residents will be older than 65 by then.

That doesn’t mean that you should reduce investments in countries that are ageing more quickly. Instead, it provides yet another reason to avoid over-concentrating your portfolio in the shares of a single country.

Home-country bias, a tendency to invest in the securities of the country where you live, often causes this over-concentration and creates unnecessary portfolio risk. A low-cost, globally diversified portfolio provides the best chance of investment success through exposure to a variety of growth and demographic outlooks.

Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.

Source : Vanguard 

Reproduced with permission of Vanguard Investments Australia Ltd

Vanguard Investments Australia Ltd (ABN 72 072 881 086 / AFS Licence 227263) is the product issuer. We have not taken yours and your clients’ circumstances into account when preparing this material so it may not be applicable to the particular situation you are considering. You should consider your circumstances and our Product Disclosure Statement (PDS) or Prospectus before making any investment decision. You can access our PDS or Prospectus online or by calling us. This material was prepared in good faith and we accept no liability for any errors or omissions. Past performance is not an indication of future performance.

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