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Where are we in the global investment cycle and what’s the risk of a 1987 style crash?

Posted On:Oct 18th, 2017     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

This month of October often creates apprehension amongst investors given its historic track record with the 1929 and 1987 share market crashes. And it was in October 2007 that US shares peaked ahead of 50% plus falls (in most share markets) through the Global Financial Crisis (GFC). From the post-GFC share market lows in March 2009, US shares are up

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This month of October often creates apprehension amongst investors given its historic track record with the 1929 and 1987 share market crashes. And it was in October 2007 that US shares peaked ahead of 50% plus falls (in most share markets) through the Global Financial Crisis (GFC). From the post-GFC share market lows in March 2009, US shares are up 278% and global shares are up 196% to new record highs and Australian shares are up 92%. After such strong gains it’s natural to wonder whether another major bear market is imminent. Aside from left field events triggering a crash, the key question remains where are we in the investment cycle? This note updates our analysis on this front from earlier this year (see http://bit.ly/2kPIlha) and also provides a comparison to 1987.

Second-longest US cyclical bull market since WW2

The cyclical bull market in US shares is eight and a half years old. It’s the second longest since World War Two and the second strongest in terms of gain. See the next table.

I have applied the definition that a cyclical bull market is a rising trend in shares that ends when shares have a 20% or more fall (ie, a cyclical bear market). Source: Bloomberg, AMP Capital.

At the same time, according to the US National Bureau of Economic Research the current US economic expansion is now 100 months old and compares to an average expansion of 70 months.  The concern is that with the US bull market and economic expansion both old, US shares are vulnerable to another bear market and, by implication, global and Australian shares are, too.

Still in the sweet spot in the investment cycle

First some context. The next chart is a stylised version of the investment cycle – the thick grey line is the economic cycle.

Source: AMP Capital

A typical cyclical bull market in shares has three phases: scepticism – when economic conditions are weak and confidence is poor, but smart investors see value in shares helped by ultra easy monetary conditions; optimism or the “sweet spot” – when profits and growth strengthen and investor scepticism gives way to optimism while monetary policy is still easy; euphoria – when investors become euphoric on strong economic and profit conditions, which pushes shares into clear overvalued territory and excesses appear forcing central banks to become tight, which combines with overvaluation and investors being fully invested to drive a new bear market.

Typically, the bull phase lasts five years. However, “bull markets do not die of old age but of exhaustion” – their length depends on how quickly recovery precedes, excess builds up, inflation rises and extremes of overvaluation and investor euphoria appear.

Our assessment is that we are still in the “sweet spot” phase, albeit more advanced now. Global economic indicators are strong, growth forecasts are being revised up as highlighted by the IMF and this is driving stronger profits. But thanks partly to the slow post GFC recovery, there are still few signs of the sort of excesses that characterise the “euphoria” phase that ultimately leads to the “exhaustion” of the cyclical bull market and the next bear market.

  • There is no overinvestment globally. While the US recovery is further advanced than most, even here business investment and housing investment (excesses in which preceded the tech wreck and GFC, respectively) are around or below long-term averages relative to GDP.

  • Overall private sector debt growth is modest in most countries.

  • After years of below trend growth globally, spare capacity still remains & this (along with technological innovation) has been constraining inflation. Wages growth remains weak and has only just started picking up in the US. Core inflation in major countries ranges between 0.2% in Japan to 1.3% in the US.


Source: Bloomberg, AMP Capital

  • As a result, global monetary conditions remain easy and without a surge in inflation look likely to remain so. The Fed is continuing to tighten but it’s “gradual” and from a very easy base and other central banks (including the RBA) are on hold. A shift to tight money that brings about a global economic downturn looks a fair way off.

  • Share market valuations are mostly okay. Measured against their own history, shares are no longer cheap. This is particularly so for US shares. But once allowance is made for low inflation and still-low bond yields, shares are fair value to cheap depending on the market (next chart).


Source: Bloomberg, AMP Capital

  • Finally, while short term investor sentiment bullish, long-term measures of positioning are not.  In the US, the huge investor flows into bond funds over the last few years have yet to reverse in favour of shares. In Australia, sentiment towards shares remains low. Still no euphoria here.

It may also be argued that major non-US share markets and Australian shares did have a bear market in both 2011 and 2015-16 so their cyclical bull markets are not old at all.

Overall, we are still not seeing the signs of excess, euphoria and exhaustion that typically come at cyclical economic and share market peaks ahead of recessions and deep bear markets. So barring some sort of external shock, the cyclical bull market in shares looks like it still has further to go.

What to watch?

The key to watch for the next big bear market is for signs of excess – eg, overinvestment in key areas, rapidly-rising inflation, aggressive tightening in monetary policy, clear overvaluation and investor euphoria. This would then set the scene for the next economic downswing and hence a more severe bear market (as opposed to a correction or short-term bear market like we saw in 2015-16). At the moment, it’s hard to see much excess but we do expect US inflation to start rising from here. One risk is that the longer things remain benign, the more investors will expect them to remain benign and this will result in excessive risk taking setting up the scene for a sharp fall in markets. But it’s only lately investors have started to get comfortable. So this may have further to go.

What about comparisons to 1987?

October 19 marks the 30th anniversary of the 1987 share market crash and as always comparisons are being wheeled out. While the bulk of the crash was concentrated in October 1987 (US shares fell 20% on October 19 and Australian shares fell 25% on October 20), US shares fell 34% over three months and Australian shares lost 50% over two months. The causes remain subject to debate – but the key appears to have been a 3% rise in US inflation, a 2% rise in US bond yields and Fed tightening hitting markets after a period of very strong gains. The following tables provide a brief comparison to today.

Source: Thomson Reuters, AMP Capital

Compared to 1987, the gains over the past 12 months have been more modest and while forward price to earnings ratios are higher (in the US) or the same, this should be the case given far lower inflation and bond yields and real dividend yields are far more attractive. It’s also noteworthy that share markets had already started to break down before the October 19 1987 crash whereas that has not happened now. As an aside, it’s worth noting that despite the 1987 crash, economic growth was barely impacted and so shares moved higher in 1988 and 1989.

Investment implications

First, corrections should be anticipated – with Trump, North Korea and the Fed being potential triggers – and the fickleness of investor confidence means we can’t rule out another crash like in 1987. But despite this we still appear to be a long way from the peak in the investment cycle.

Second, non-US share markets and economies are less advanced in their cycles and provide opportunities for investors.

Finally, it’s worth noting that several bad years (1987 and 1929) have given Octobers a bad wrap globally. While historically they have been a soft month in Australia (with shares down an average 0.3% since 1985 in October), they have actually been positive in the US (up 1% on average).

Source : AMP Capital 18th October 2017

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP: l is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: 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) 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.

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Will Australian House Prices Crash? five reasons why it’s more complicated than you think!

Posted On:Oct 11th, 2017     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

A common narrative on the Australian housing market is that it’s in a giant speculative bubble propelled by tax breaks, low interest rates and “liar loans” that have led to massive mortgage stress and that it’s all about to go bust, bringing down the banks and the economy with it. Recent signs of price falls – notably in Sydney –

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A common narrative on the Australian housing market is that it’s in a giant speculative bubble propelled by tax breaks, low interest rates and “liar loans” that have led to massive mortgage stress and that it’s all about to go bust, bringing down the banks and the economy with it. Recent signs of price falls – notably in Sydney – have added interest to such a view.

The trouble is we have been hearing the same for years. Calls for a property crash have been pumped out repeatedly since early last decade. In 2004, The Economist magazine described Australia as “America’s ugly sister” thanks in part to a “borrowing binge” and soaring property prices. At the time, the OECD estimated Australian housing was 51.8% overvalued. Property crash calls were wheeled out repeatedly after the Global Financial Crisis (GFC) with one commentator losing a high-profile bet that prices could fall up to 40% and having to walk to the summit of Mount Kosciuszko as a result. In 2010, a US newspaper, The Philadelphia Trumpet, warned “Pay close attention Australia. Los Angelification (referring to a 40% slump in LA home prices around the GFC) is coming to a city near you.” At the same time, a US fund manager was labelling Australian housing as a “time bomb”. Similar calls were made last year by a hedge fund researcher and a hedge fund: “The Australian property market is on the verge of blowing up on a spectacular scale…The feed-through effects will be immense… the economy will go into recession.” Over the years these crash calls have even made it on to 60 Minutes and Four Corners.

The basic facts on Australian property are well known:
 

  • It’s expensive relative to income, rents, its long-term trend (see the next chart) and by global standards.

  • Affordability is poor – price to income ratios are very high and it’s a lot harder to save a sufficient deposit.

  • The surge in prices has seen a surge in debt that has taken our household debt to income ratio to the high end of OECD countries, which exposes Australia to financial instability should households decide to cut their level of debt.

Source: ABS, AMP Capital

These things arguably make residential property Australia’s Achilles heel. But as I have learned over the last 15 years, it’s a lot more complicated than the crash calls suggest.

First, it’s dangerous to generalise

While it’s common to refer to “the Australian property market”, only Sydney and Melbourne have seen sustained and rapid price gains in recent years. On CoreLogic data over the last five years dwelling prices have risen at an average annualised rate of 11.4% per annum (pa) in Sydney and 9.4% pa in Melbourne but prices in Brisbane, Adelaide, Hobart and Canberra have risen by a benign 3 to 5% pa and prices have fallen in Perth and Darwin. Australian cites basically swing around the national average with prices in one or two cities surging for a few years and then underperforming as poor affordability forces demand into other cities. This can be seen in the next chart with Sydney leading the cycle over the last 20 years and Perth lagging.  

Source: CoreLogic, AMP Capital

Second, supply has not kept up with demand

Thanks mostly to an increase in net immigration, population growth since mid-last decade has averaged 368,000 people pa compared to 218,000 pa over the decade to 2005, which requires roughly an extra 55,000 homes per year.

Unfortunately, the supply of dwellings did not keep pace with the surge in population growth (see the next chart) so a massive shortfall built up driving high home prices. Thanks to the recent surge in unit supply this is now being worked off. But there is no broad based oversupply problem.

Source: ABS, AMP Capital

Consistent with this, average capital city vacancy rates are around long-term average levels, are low in Sydney and are falling in Melbourne (helped by surging population growth).

Source: Real Estate Institute of Australia, AMP Capital

Third, lending standards have been improving

For all the talk about “liar loans”, Australia has not seen anything like the deterioration in lending standards other countries saw prior to the GFC. Interest-only loans had been growing excessively but are not comparable to so-called NINJA (no income, no job, no asset) sub-prime and low-doc loans that surged in the US prior to the GFC. Interest-only and high loan to valuation loans have also been falling lately. And much of the increase in debt has gone to older, wealthier Australians, who are better able to service their loans.

Source: APRA, AMP Capital

Yes, I know various surveys report high levels of mortgage stress. But we heard the same continuously last decade from the Fujitsu Mortgage Stress Survey and yet there was no crash. By contrast, RBA research shows that while getting into the housing market is hard “those who make it are doing ok” and bad debts and arrears are low. Finally, debt interest payments relative to income are running around 30% below 2008 peak levels thanks to low interest rates. Sure, rates will eventually start to rise again but they will need to rise by around 2% to take the debt interest to income ratio back to the 2008 high.

Fourth, the importance of tax breaks is exaggerated

A range of additional factors like tax breaks and foreign buyers have played a role but their importance is often exaggerated relative to the supply shortfall. While there is a case to reduce the capital gains tax discount (to remove a distortion in the tax system), negative gearing has long been a feature of the Australian tax system and if it’s the main driver of home price increases as some claim then what happened in Perth and Darwin? Similarly, foreign buying has been concentrated in certain areas and so cannot explain high prices generally, particularly with foreign buying restricted to new properties.

Finally, the conditions for a crash are not in place

To get a housing crash – say a 20% average fall or more – we probably need much higher unemployment, much higher interest rates and/or a big oversupply. But it’s hard to see these.

  • There is no sign of recession and jobs data remains strong.

  • The RBA is likely to start raising interest rates next year, but it knows households are now more sensitive to higher rates & will move only very gradually – like in the US – and won’t hike by more than it needs to to keep inflation on target.

  • Property oversupply will become a risk if the current construction boom continues for several years but with approvals to build new homes slowing this looks unlikely.

Don’t get me wrong, none of this is to say that excessive house prices and debt levels are not posing a risk for Australia. But it’s a lot more complicated than commonly portrayed.

So where are we now?

That said, we continue to expect a slowing in the Sydney and Melbourne property markets, with evidence mounting that APRA’s measures to slow lending to investors and interest-only buyers (along with other measures, eg to slow foreign buying) are impacting. This is particularly the case in Sydney where price growth has stalled and auction clearance rates have fallen to near 60%. Expect prices to fall 5-10% (maybe less in Melbourne given strong population growth) over the next two years. This is like what occurred around 2005, 2008-09 & 2012.  

Source: CoreLogic, AMP Capital

By contrast, Perth and Darwin home prices are likely close to the bottom as mining investment is near the bottom. Hobart and increasingly Brisbane and Adelaide are likely to benefit from flow on or “refugee” demand from Sydney and Melbourne having lagged for many years.  

Implications for investors

Housing has a long-term role to play in investment portfolios, but the combination of the strong gains in the last few years in Sydney and Melbourne, vulnerabilities around high household debt levels as official interest rates eventually start to rise and low net rental yields mean investors need to be careful. Sydney and Melbourne are least attractive in the short term. Best to focus on those cities and regional areas that have been left behind and where rental yields are higher.   

Source : AMP Capital 11 October 2017

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP: l is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: 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) 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.

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Where are we in the search for yield? Is it about to reverse as the Fed starts quantitative tightening?

Posted On:Sep 21st, 2017     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

For some time now, the investment world has been characterised by a search for decent yield paying investments. This “search for yield” actually started last decade but was interrupted by the Global Financial Crisis (GFC) and the Eurozone debt crisis before resuming again in earnest. 

When investment assets are in strong demand from investors, their price goes up relative to the

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For some time now, the investment world has been characterised by a search for decent yield paying investments. This “search for yield” actually started last decade but was interrupted by the Global Financial Crisis (GFC) and the Eurozone debt crisis before resuming again in earnest. 

When investment assets are in strong demand from investors, their price goes up relative to the cash flow (eg dividends, interest or rent) they provide pushing their yield down. This is evident in recent times in response to the “search for yield” with yields falling across the board as the next chart shows. 


Source: Bloomberg, REIA, RBA, AMP Capital

But everything goes in cycles. So has the “search for yield” gone too far? Will the US Federal Reserve’s shift to start reducing its bond holdings cause a reversal? 

Drivers of the search for yield

Interest in yield based investing is not new and is in fact a normal part of investing. Particularly when investors are a bit wary about going for growth. In fact, in Japan it’s become pretty much the norm as interest rates have been stuck at zero for years. In the 1950s, yield focussed investing was the norm in the US and Australia. The search for yield also became apparent last decade and played a role in the GFC itself (as investors piled into yield based investments underpinned by “sub-prime” mortgages, oblivious of the risks). There are three main drivers of the “search for yield” in recent years:

  • First, low interest rates and bond yields and the flow on to bank deposit rates due to low inflation and sub-par growth have encouraged investors to search for higher yielding investments. Central banks buying up bonds and displacing investors into other assets have accentuated this.

  • Second, reduced fear of economic meltdown (as the GFC and subsequently the Eurozone public debt crisis subsided) has helped investors feel comfortable in taking on the greater risk that this entails. 

  • Finally, aging populations in developed countries is seeing baby boomers move into pre-retirement and retirement, driving a demand for less volatile investments paying income. Normally, this demand would go to bonds and bank deposits but as their yields are so low some of this demand has gone into other yield paying investments.

Demand for yield from aging populations has further to go as populations age. For example, in Australia the share of the population aged 65 and over is projected to rise from 15% now to 22% by 2061. However, the second driver is cyclical and will reverse next time there is a sustained bout of risk aversion – just as it did in the GFC. 

The first driver is a mix of structural and cyclical influences, though, and it’s probably been the main driver of the search for yield. Bond yields and interest rates have been trending down for 30 years or so and this is structural reflecting a downtrend in inflation, which resulted in a long-term super cycle bull market in bonds. But falls this decade also contain a big cyclical element reflecting the sub-par global growth and deflation seen after the GFC. This accentuated the super cycle bull market in bonds and put the search for yield on steroids. This is where the greatest risk of a reversal in the search for yield trade lies.

The logic of falling yields 

The search for yield is understandable and can be seen in relation to Australian commercial property ie office, retail and industrial property. The next chart shows average commercial property yields and 10-year bond yields. While average commercial property yields have fallen since the early 1980s from an average of 8.3% to around 5.5%, the yield on bonds has crashed. The longer the decline in bond yields has persisted, the more investors have expected it to continue, driving rising demand for higher yielding assets like property.


Source: Bloomberg, AMP Capital

With Australian 10-year bonds yielding 2.8%, it’s little wonder investors might find commercial property on an average yield of around 5.5% more attractive particularly once capital growth of, say, 2.5% pa (ie inflation) for a total return of 8%, is allowed for. The property risk premium – the return potential property provides over bonds – at 5.2% remains high & well above early 1990s and pre-GFC levels that caused problems for property.


Source: Bloomberg, AMP Capital

The same logic applies to investment in assets such as unlisted infrastructure, listed variants of both commercial property and infrastructure, shares and corporate debt.

But are we getting close to a reversal?

Has it gone too far? The greatest risks are around corporate debt where the gap between US investment grade and junk bond yields and US government bond yields has narrowed sharply to around levels that prevailed prior to the tech wreck and again prior to the GFC. But as we saw in the mid-1990s and mid-2000s, spreads can remain low for a while before trouble arises, which is usually when the economy turns down and there is no sign of that just yet. 

For equities the gap between the forward earnings yield on shares and bond yields has narrowed in recent years. But this gap – which is a guide to the risk premium shares offer over bonds – still remains relatively wide by pre GFC standards.


Source: Thomson Reuters, Bloomberg, AMP Capital

And finally for real assets, using commercial property as a guide, as indicated earlier the risk premium offered by commercial property relative to bonds remains wide, albeit it has narrowed as property yields have fallen and bond yields have risen (a bit). Overall, it’s hard to argue the search for yield has gone too far given how low bond yields still are. That said, corrections like what we saw in shares and corporate debt during 2015-16 are healthy in ensuring this remains the case.

But what about the risk of an upswing in bond yields, particularly with the Fed moving to quantitative tightening? This is the biggest risk and our view is that the super cycle bull market in bonds is over. See “The end of the super cycle bull market in bonds?” which can be found at http://bit.ly/2fLoTNw. There are several reason for this:

  • First, global growth is looking stronger as evident in strong business conditions indicators across most countries. Global growth is improving and becoming more synchronised globally. Nearly 75% of the 45 countries tracked by the OECD are seeing accelerating growth, the highest it’s been since the initial bounce out of the GFC in 2010.

  • Part of the reason for this is that the “muscle memory” from the GFC, which commenced a decade ago, is fading and this is contributing to stronger confidence.

  • The risk of deflation is receding and giving way to the risk of a rise in inflation as capital and labour utilisation is on the rise globally & productivity growth is poor, reflecting: low levels of investment; increasing levels of populist regulation in some countries; and as older workers retire. While the impact of technological innovation (the Amazon effect, artificial intelligence) will keep this gradual there will still be a cycle in inflation and the risks are gradually pointing up.  

  • Reflecting this, central banks are gradually retreating from ultra easy policy. The Fed is the most advanced here as the US economic recovery is further advanced. As a result, the Fed is moving towards allowing its holding of government bonds and mortgage-backed securities to start declining. This will be achieved by the Fed not rolling over (ie not reinvesting) the bonds on its books as they mature so it won’t be as dramatic as actually selling bonds. But its holding of bonds will nevertheless decline and it will be sucking cash out of the US economy. In other words, it will be undertaking “quantitative tightening” to reverse the “quantitative easing” of a few years ago. This is good news and reflects the strength of the US economy much as its commencement of rate hikes did in 2015. Nevertheless, combined with continuing gradual Fed rate hikes, it will likely see a resumption of the upwards pressure on bond yields acting as a gradual dampener on the search for yield.

The upswing in bond yields is likely to be gradual – with periodic spurts higher then fall backs like over the last year – as the Fed will likely be gradual, other central banks including the Reserve Bank of Australia are well behind the Fed in being able to tighten and yield focussed demand from aging populations will act as a constraint. But the trend in bond yields is likely to be up unless there is an unexpected relapse in global growth.

What does it all mean for investors?

There are several implications for investors: expect lower returns from government bonds as yields gradually rise; the search for yield likely has further to go in relation to commercial property and infrastructure but it is likely to wane as bond yields rise; share markets are now more dependent on earnings growth for future gains (and the signs are positive) but cyclical sectors geared to higher earnings will likely be the outperformers and yield plays may be underperformers. That the Fed is moving to start reversing its post-GFC quantitative easing (money printing) is another sign the global economy is getting back to normal. This is good for investors.

 

Source: AMP Capital 21 September 2017

Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: 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) 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.

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The US Federal Reserve starts quantitative tightening

Posted On:Sep 21st, 2017     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

The US Federal Reserve provided few surprises following its September meeting. While it left interest rates on hold, it confirmed that it will begin what it calls “balance sheet normalisation” next month and continued to signal its expectation that it will raise interest rates again in December and in the years ahead. While projected interest rates increases were lowered slightly

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The US Federal Reserve provided few surprises following its September meeting. While it left interest rates on hold, it confirmed that it will begin what it calls “balance sheet normalisation” next month and continued to signal its expectation that it will raise interest rates again in December and in the years ahead. While projected interest rates increases were lowered slightly for 2019, the Fed was more confident in another rate hike this year than markets had expected. So while US shares were little changed overnight, bond yields and the US dollar rose slightly.

While well flagged and so no surprise, the Fed’s move to start balance sheet normalisation is a momentous shift and tells us just how much stronger the US economy has become in recent years. Balance sheet normalisation basically involves reducing the Fed’s balance sheet back to more normal levels after it was boosted by post Global Financial Crisis “quantitative easing” (QE) or bond buying using printed money.
 
Only a few years ago, there was talk of “QE forever” and how “the Fed will never be able to unwind it”!  Quantitative easing was never optimal to help recover from the Global Financial Crisis but after further fiscal policy stimulus was ruled out it was all the US had. And it worked. So now it’s time to start reversing it.

The Fed remains upbeat on the economic outlook continuing to see inflation heading back to its 2% target and seeing the negative impact on growth from recent hurricanes as temporary. It made only minor changes to its economic forecasts and sees the near-term risks to the outlook as balanced.

Quantitative tightening begins

The start to balance sheet reduction – or what is likely to become known as “quantitative tightening” (or QT) – was well flagged earlier this year and the Fed will follow the plan it laid out at its June meeting. The Fed’s balance sheet was boosted by the government bonds and mortgage-backed securities it purchased during its post GFC related quantitative easing programs. It reached around $US4.5 trillion when the Fed ended QE back in October 2014 and has been maintained at this level ever since as the Fed has been reinvesting (or rolling over) bonds as they mature. Going forward, the Fed will reduce its balance sheet not by selling bonds, but by slowing the reinvestment of maturing bonds. This will start at a maximum cap of $US6 billion a month for Treasury bonds and $US4 billion a month for mortgage-backed securities in the December quarter increasing over 12 months until it reaches $US30bn a month for Treasury bonds and $US20 billion a month for mortgage-backed securities in December quarter 2018 at which point it will continue until the balance sheet falls to no more than the level the Fed deems necessary to implement monetary policy (thought to be around $US2-3 trillion). At this rate, the Fed’s balance sheet will have fallen below $US3 trillion by early next decade.

Source: Bloomberg, Federal Reserve, AMP Capital

While this is not quite as radical as actually selling bonds, it is likely to result in some upwards pressure on bond yields over time (all other things being equal) as the Fed will be reducing its holdings of them. Note that since QE first started in second half 2008 to now, US bond yields have fallen from around 4% to 2.27% at present (having hit a low last year of 1.4%). Of course other factors helped drive this but Fed bond buying no doubt played a role. Looking forward then, it’s likely that some upwards pressure on bond yields is likely to result from the Fed running down its bond holdings albeit this will be at a slower rate (capped at $US50 billion a month) from late next year than the bond buying that occurred under the final round of quantitative easing (QE3), which ran at $US85 billion a month.

The Fed has indicated that the balance sheet reduction could be stopped if there is a material deterioration in the economic outlook, so as with interest rate hikes the Fed will not be on auto-pilot.

Rate hikes to continue gradually

On interest rates, the Fed’s so called median dot plot of (Fed committee members’) interest rate expectations continues to point to one more rate hike this year, which is likely to occur in December and the Fed still sees three more hikes in 2018. However, the expectation for 2019 was lowered from three hikes to two and the Fed lowered its longer run Fed Funds rate estimate to 2.75% from 3%. Again, the Fed continues to stress that increases in the Fed Funds rate will be “gradual” and conditional on economic data.

While the Fed’s dot plot has been lowered for 2019, market expectations for US interest rates remain well below the Fed’s. This is understandable to some degree given the ongoing lack of significant inflation pressures and past experience. However, the Fed is reasonable in our view to assume that the tight US labour market will flow through to faster wages growth and inflation at some point.

Source: Bloomberg, Federal Reserve, AMP Capital

Our view is that the Fed will on balance hike rates again in December assuming inflation picks up a bit from here, and that the subsequent path of rate hikes will be closer to the Fed’s dot plot than the market is assuming. The process will still remain very gradual, though, compared to the rate hike at every meeting that was seen during the last tightening cycle mid last decade, which ultimately saw 17 rate hikes in just over two years.

Implications for investors

There are several implications for investors from the Fed’s move to start quantitative tightening at the same time that it’s in the process of gradually raising rates.

First, expect lower returns from bonds as bond yields are likely resuming their gradual rising trend. Just as US quantitative easing over 2008 to 2014 helped boost US and global bond returns it’s hard to see its unwinding with quantitative tightening being positive for them too – all other things being equal.

Second, shares should be able to withstand the latest leg in Fed tightening just as they have since the end of QE in 2014 and the four rate hikes the Fed has undertaken since: shares are still cheap relative to bonds; the Fed is only tightening because growth is strong and this means higher profits; and Fed monetary policy is a long way from being tight to the extent that it will threaten US or global growth – QT is just beginning and the Fed Funds rate is only 1-1.25%.

Third, within share markets, bond-sensitive yield trades like listed property and listed infrastructure are likely to be relative underperformers but cyclical sectors geared to higher earnings are likely to be outperformers.

Fourth, the ongoing monetary tightening in the US with gradually rising official interest rates and now a gradual reduction in the supply of US dollars through quantitative tightening should help boost the US dollar after its fall so far this year at a time when sentiment toward it is poor.

Finally, this in turn should help reduce the rising pressure on the value of the Australian dollar, which in turn should be welcome news for the Reserve Bank of Australia, which would prefer to see a lower $A. 

Source :AMP 21 September 2017 

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP: l is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: 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) 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.

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Another five great charts on investing

Posted On:Sep 12th, 2017     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

New ways to access various investments, tax changes and new regulations, all with social media adding to the noise. But it’s really quite simple and this can be demonstrated in charts. This note continues our series that began with “Five great charts on investing”, which can be found here and looks at another five great charts – well, one is actually a

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New ways to access various investments, tax changes and new regulations, all with social media adding to the noise. But it’s really quite simple and this can be demonstrated in charts. This note continues our series that began with “Five great charts on investing”, which can be found here and looks at another five great charts – well, one is actually a table – on investing.

 

Chart #1 Time in versus timing

Without a tried and tested asset allocation process, trying to time the market, ie selling in anticipation of falls and buying in anticipation of gains, is very 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 11.3% per annum (including dividends but not allowing for franking credits, tax and fees). 

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 12.5% pa. If you avoided the 40 worst days, it would have been boosted to 17% pa. But this is very hard to do and many investors only get out after the bad returns have occurred, just in time to miss some of the best days and so end up damaging their returns. For example, if by trying to time the market you miss the 10 best days (blue bars), the return falls to 8% pa. If you miss the 40 best days, it drops to just 3.7% pa. Hence the old cliché that “it’s time in that matters, not timing”.

Key message: market timing is great if you can get it right, but without a process the risk of getting it wrong is very high and if so it can destroy your returns.

Chart #2 Look less

If you look at the daily movements in the share market, they are down almost as much as they are up, with only just over 50% of days seeing positive gains. See the next chart for Australian and US shares. So day by day, it’s pretty much a coin toss as to whether you will get good news or bad news. But if you only look monthly and allow for dividends, the historical experience tells us you will only get bad news around a third of the time. Looking out further on a calendar year basis, data back to 1900 indicates the probability of bad news in the form of a loss slides to just 20% in Australian shares and 26% for US shares. And if you go all the way out to once a decade, since 1900 positive returns have been seen 100% of the time for Australian shares and 82% for US shares. 

Daily and monthly data from 1995, data for years and decades from 1900. Source: Global Financial Data, AMP Capital


Key message: the less you look at your investments, the less you will be disappointed. This matters because the more you are disappointed, the greater the chance of selling at the wrong time.

Chart #3 Risk and return

This chart is basic to investing. Each asset class has its own risk (in terms of volatility and risk of loss) and return characteristics. Put simply: the higher the risk of an asset, the higher the return you will likely achieve over the long term and vice versa. The next chart shows a stylised version of this. Starting with cash (and bank deposits), it’s well known that they are very low risk but so is their return potential. Government bonds usually offer higher returns but their value can move around a bit in the short term (although major developed countries have not defaulted on their bonds). Corporate debt has a higher return potential again but a higher risk of default – particularly for junk bonds. Corporate debt is basically a hybrid between equities & government bonds. Unlisted or directly held commercial property and infrastructure offer a higher return again but they come with higher risk and are less liquid and can be less able to be diversified (although this can be remedied by investing via a managed fund). Equities can offer another step up in return but this is because they come with higher risk as they are subject to share market volatility and individual companies can go bankrupt wiping out share holder capital. Beyond this, private equity entails more risk again and so tends to command an even higher return premium. Each step up involves more risk and this is compensated for with more return.

 

 

Source: AMP Capital Key message: Investors need to allow for the risk (and liquidity) and return characteristics of each asset. Those who don’t mind short-term risk (and illiquidity in the case of unlisted assets) can take advantage of the higher returns growth assets offer over long periods. The key is that there is no free lunch.

Chart #4 Diversification

But this not the end of the story. The next table shows the best and worst performing asset class in each year over the last 15. 


Best and worst performing major asset class 
 

Year Best Asset Class Worst Asset Class 

2001

Aust listed property

Global equities unhedged

2002

Unlisted infrastructure 

Global equities unhedged

2003

Global listed property 

Global equities unhedged

2004

Global listed property 

Cash

2005

Aust equities Cash

Cash

2006

Global listed property

Aust bonds

2007

Aust equities 

Global listed property

2008

Aust bonds 

Aust listed property

2009

Aust equities 

Unlisted property

2010

Global listed property 

Global equities unhedged

2011

Unlisted infrastructure 

Aust equities

2012

Aust listed property 

Cash

2013

Global equities unhedged 

Australian bonds

2014

Global listed property 

Cash

2015

Unlisted infrastructure 

Cash

2016

Unlisted infrastructure 

Cash


Note: refers to the major asset classes. Source: Thomson Reuters, AMP Capital 

It can be seen that the best performing asset each year can vary dramatically and that last year’s top performer is no guide to the year ahead. For example, those who loaded up on listed property after their strong pre-Global Financial Crisis (GFC) performances were badly hurt as they were amongst the worst performing assets through the GFC. So it makes sense to have a combination of asset classes in your portfolio. This particularly applies to assets that are lowly correlated ie that don’t just move in lock step with each other. For example, global and Australian shares tend to move together during extreme events. But bonds and shares tend to diverge when crises hit – as we saw in the GFC when shares fell sharply but bonds rallied. And so there is a case to have bonds in a portfolio to help stabilise returns.

Key message: diversification is also a bit like the magic of compound interest. Having a well-diversified exposure means your portfolio won’t be as volatile. And this can help you stick to your strategy when the going gets rough.

Chart #5 Residential property has a role 

Chart #1 in the first edition in this Five Charts series highlighted the power of compound interest, with a comparison showing the value of $1 invested in various Australian asset classes back in 1900 and what it would be worth today. Unfortunately, I do not have monthly data for Australian residential property returns back that far but I do have them on an annual basis back to 1926 and this is shown in the next chart starting with a $100 investment. (Commercial property return series only really go back a few decades.)

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

Again it can be seen that over very long periods the power of compounding works wonders for shares compared to bonds and cash. But it can also be seen to work well for Australian residential property with an average total return (capital growth plus net rental income) of 11% pa, which is similar to that for shares. All of which highlights, along with the diversification benefits of a real asset like property, the case to have it in a well-diversified portfolio along with listed assets like shares, bonds and cash. The key is to allow for the different “risks” experienced by property versus shares. Property prices are less volatile than share prices as they are not traded on share markets and so are not as subject to the whims of investors and movements in their values tend to relate more to movements in the real economy. But residential property takes longer to buy and sell and it’s harder to diversify as you can’t easily have exposure to hundreds or thousands of properties exposed to different sectors and countries like you can with shares. So there are trade-offs between residential property and shares.

Key message: given their long-term returns and diversification benefits, there is a key role for residential property in your investment portfolio (putting aside issues of current valuations).

Source: AMP Capital 11 September 2017 

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note:

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) 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.

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The Australian economy bounces back – five reasons why some further pick up is likely

Posted On:Sep 06th, 2017     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
Growth bounces back (again) After another (weather related) soft patch in the March quarter, Australian economic growth bounced back in the June quarter with quarterly growth of 0.8%, up from 0.3%. However, annual growth is still subdued at 1.8% year on year, which is well below potential of around 2.75%. In the quarter, growth was helped by a pick-up in consumer

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Growth bounces back (again)

After another (weather related) soft patch in the March quarter, Australian economic growth bounced back in the June quarter with quarterly growth of 0.8%, up from 0.3%. However, annual growth is still subdued at 1.8% year on year, which is well below potential of around 2.75%. In the quarter, growth was helped by a pick-up in consumer spending and business investment, strong public investment and a contribution from net exports after a detraction in the March quarter.


Source:
ABS, AMP Capital

Australia continues to defy the doomsters’ endless recession calls. Against this, economic and underlying profit growth is lagging that seen in major economies. However, there are some positives pointing to a pick-up in growth.

Threats, risks and worries

Putting global threats aside, Australia’s worry list is well known:
 
  • Housing construction is starting to slow with falling approvals pointing to a further slowing (see next chart).


Source:
ABS, AMP Capital

  • Related to this, there is the risk of a house price crash “as seen” on Four Corners. However, there have been endless property crash calls since around 2004. In the absence of a stronger supply surge, the Reserve Bank of Australia (RBA) making a mistake and raising rates too high and/or unemployment surging, our view is that a slowdown in Sydney and Melbourne is likely, but not a crash.

  • Consumer spending is constrained by record low wages growth and high levels of underemployment. While consumer spending has been running faster than income growth, as rising wealth has allowed consumers to run down household savings (to now just 4.6%) this is unlikely to continue as the wealth effects flowing from property price gains in Sydney and Melbourne slow. Rapid power cost increases and high debt are also not helping. All of which is driving low consumer confidence.

  • Mining investment is still falling with business investment intentions pointing to another 22% fall this financial year.

  • The Australian dollar is up 16% from last year’s low and at around $US0.80 (and threatening to go higher) it is at risk of slowing growth (and investment) in trade-exposed sectors like tourism, agriculture and manufacturing.  

  • Underlying inflation is too low and risks staying below target for longer due to record low wages growth, a rising $A, competitive pressures & weak rents as new supply hits.

  • Our political leaders seem collectively unable to undertake productivity-enhancing economic reforms and take decisive action (eg, on energy policy). With the citizenship crisis threatening an early election, it’s unlikely we will see an improvement any time soon.

Five reasons to expect growth to improve

These worries are well known and despite them we remain of the view that recession will be avoided and growth will pick up over the year ahead: First, the growth drag from falling mining investment is nearly over. Mining investment peaked at nearly 7% of GDP four years ago and has since been falling at around 25% per annum (pa), knocking around 1.5% pa from GDP growth. At around 2% of GDP now, its weight in the economy has collapsed reducing its growth drag to around 0.4% this year and it’s near the bottom (see next chart). 


Source:
ABS, AMP Capital

  • Second, non-mining investment is likely to rise this year. Comparing corporate investment plans for this financial year with those made a year ago points to a decline in business investment this year of around 3.5% (see next chart). But this is the best it’s been since 2013 and once mining investment is excluded this turns into an 8% gain for non-mining investment.


Source:
ABS, AMP Capital

  • Third, public investment is rising strongly, up 14.7% over the last year, reflecting state infrastructure spending.

  • Fourthly, net exports are likely to continue adding to growth as the completion of resources projects boosts mining and energy export volumes and services sectors like tourism and higher education remain strong.

  • Finally, profits for listed companies are rising again after two years of falls. This is a positive for investment and the flow of dividends helps household incomes.


Source:
UBS, AMP Capital

These considerations should ensure that the Australian economy continues to avoid recession and that growth should pick up to around a 2.5% to 3% pace over the year ahead. This should be enough to head off further cuts in the cash rate. But with growth still a bit below RBA forecasts, wages growth likely to pick up only slowly, inflation likely to remain subdued abstracting from higher electricity prices, and the RBA likely wanting to avoid pushing the $A higher, our view remains that the RBA will keep the cash rate unchanged at 1.5% out to the December quarter 2018 at least before starting to raise rates.

Implications for investors

There are several implications for Australian based investors.

First, a return to reasonable growth is positive for growth assets. Australian shares are vulnerable to a short term US-led share market correction – given North Korean and Trump risks – but we remain of the view that it will be higher by year end.

Second, bank deposits are likely to provide poor returns for investors for a while yet, highlighting the case for yield-focussed investors to continue to look for superior sources of yield. The yield gap between Australian shares and bank deposits remains wide, driving a strong source of demand for shares. After Telstra cut its dividend, just make sure you get a well-diversified portfolio of stocks paying decent dividends though.


Source:
RBA, AMP Capital

Third, while Australian shares are great for income, global shares are likely to remain outperformers for capital growth. In fact, global shares have been outperforming Australian shares since October 2009. This reflects relatively tighter monetary policy in Australia, the commodity slump, the lagged impact of the rise in the $A above parity in 2010, and a mean reversion of the 2000 to 2009 outperformance by Australian shares. And of course, abstracting from volatile resource company earnings, underlying profit growth at around 5-6% in Australia is well below that in the US (at around 11%) and Europe and Japan (at around 20-30%) so the underperformance of Australian shares may have a while to go yet. Which all argues for a continuing decent exposure to global shares relative to Australian shares.


Source: Thomson Reuters, AMP Capital

If you would like to discuss anything in this article, please call us on |PHONE|.

 

Source: AMP Capital 06 September 2017

About the Author
Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: 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) 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.

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