Olivers Insights

Three years after it first started raising interest rates in this cycle the Fed has increased rates for the ninth time, raising the Fed Funds rate another 0.25% to a target range of 2.25-2.5%. While this was largely anticipated by markets, the Fed was less dovish than expected and so shares sold off in response. That said it does appear that the Fed has got to a point where it can now pause or at least raise rates more slowly.

Fed hikes and market turmoil

After some initial ructions after the first Fed hike in December 2015 into early 2016, markets generally were not too fussed about Fed hikes in 2016 and 2017 as tightening was “gradual” and we were only going from very easy monetary policy to less easy. However, this year markets have become fearful that the Fed will go too far and push the US into recession. In fact, fears about the Fed were the main initial trigger for falls in shares back in February and more recently since October. Of course, lately they have combined with worries around trade, US technology stocks, slowing growth indicators globally, worries around President Trump and the Mueller inquiry and US politics to accentuate share market falls. This has all combined to push global shares down 14% from their September high and Australian shares down 13% from their August high.

The Fed blinks, but not enough yet

In raising the target range for the Fed Funds rate by another 0.25%, the Fed remains upbeat on the outlook for the US economy and noted the continuing strength in the US labour market and solid growth. However, it has added the word “some” in reference to “further gradual” increases in interest rates going forward. It has also indicated it’s monitoring global economic and financial developments. And it has lowered the “dot plot” median of Fed meeting participants interest rate expectations from three hikes next year to two – albeit it’s still above market expectations – and edged down the long run estimate for the Fed Funds rate to 2.75%. While it’s not enough to satisfy share markets just yet, the Fed is moving dovish.

Source: US Federal Reserve, AMP Capital

Basically, with the Fed Funds rate getting close to neutral, US core inflation stabilising around the 2% target, interest sensitive sectors like housing and autos slowing and various headwinds to the US economy next year the Fed can afford to pause or at least go more slowly in raising interest rates. Our base case is that the Fed will hold the Fed Funds rate flat during the first half of next year and only raise rates once in the second half. So, to the extent that fear of the Fed has been a big factor driving share markets lower and volatility up this year, a more cautious Fed next year should help start to allay the fears around it.

It could be a gummy, but is still unlikely to be a grizzly

As I have pointed out in recent notes, there are three types of significant share market falls:

• Corrections with falls around 10%;

• “gummy” bear markets with falls around 20% meeting the technical definition many apply for a bear market but where a year after falling 20% the market is up (like in 1998 in the US, 2011 and 2015-16 for Australian & global shares); and

• “grizzly” bear markets where shares fall 20% and then a year later are down another 20% or so (like in 1973-74, US and global shares through the tech wreck or the GFC).

Grizzly bears maul investors but gummy bears leave a nicer taste. Corrections are quite normal and healthy as they enable the sharemarket to let off steam. Excluding the present episode since 2012 there have been four corrections and one gummy bear market (2015-16) in global and Australian shares. Bear markets generally are a lot less common, but what we saw in 2015-16 was a gummy bear market.

Source: Bloomberg, AMP Capital

Gummy bear markets are shorter and see smaller declines than grizzly bear markets. And the deeper grizzly bear markets are invariably associated with recession, whereas the milder gummy bear markets including the 1987 share market crash tend not to be. (The Australian experience is discussed here.)

With uncertainty around trade, global growth and President Trump remaining high shares could still have more downside into early next year, particularly after having broken below their October/November lows. In other words the further break down in share markets seen in December may be signalling a shift from a simple correction to a gummy bear market. However, our view remains that a grizzly bear market is unlikely because a US, global or Australian recession is not imminent. Put simply:

• Monetary conditions are still not tight in the US and they are still very easy globally. While there has been much fretting about the US yield curve flattening and in some cases inverting (with long term bond yields falling below short-term interest rates) the two yield curves we have found most reliable are still positive albeit less so. The gap between the 10-year bond yield and the Fed Funds rate has flattened dramatically but is still positive at 39 basis points. And the gap between 2-year bond yields and the Fed Funds rate has also flattened a lot but is still positive. As can be seen in the next chart, prior to the last three US recessions both of these yield curves inverted – but there were several false signals and the gap between the initial inversion and recession can be around 15 months. So even if they both invert now recession may not occur until 2020 and yet historically share markets only precede recessions by around 3-6 months so it would be too far away for markets to anticipate. And past recessions in the US have also been preceded by the Fed Funds rate being well above inflation and nominal growth and it’s a long way from that.  

Source: Bloomberg, AMP Capital

• Fiscal stimulus will continue to boost US growth in 2019.

• We have not seen the sort of excesses – in terms of debt growth, overinvestment, capacity constraints and inflation – that normal precede recessions in the US or globally. While the housing downturn is an issue in Australia its negative impact on the economy is likely to be offset by business investment albeit growth will still be constrained.

A more dovish Fed, the US and China starting to work through their differences on trade and the positive impact of the 40% fall in oil prices since their October high (which is bad for energy producers but takes pressure off inflation and helps boost consumer spending) add to confidence that we are not heading towards a US/global recession. Which in turn would mean we are not heading into a grizzly bear market.

However, our expected road map for share looks like this: shares possibly have more downside into early next year into a gummy bear market (hopefully at least after a Santa rally!) as global growth indicators remain softish in the near term. This in turn is likely to prompt more stimulus in China, the ECB to provide more cheap bank funding and a bit of fiscal stimulus out of Europe (was Macron’s concession to the “yellow shirts” a sign of things to come for fiscal stimulus in Europe?) at a time when the Fed pauses. This combines with signs that US/China trade negotiations are making make progress. Shares then bottom around March. Economic data starts to improve, and it looks like 2015-16 all over again (albeit a bit more compressed in time). In this context a further leg down in shares turning the correction we have seen so far into a “gummy bear” market (down 20% or so from top to bottom but up a year later) is a high risk. But a grizzly bear market is unlikely.

What should investors do?

Of course, sharp market falls are stressful for investors as no one likes to see their wealth decline. I don’t have a perfect crystal ball so from the point of sensible long-term investing the following points are worth bearing in mind.

First, periodic sharp setbacks in share markets are healthy and normal. Shares literally climb a wall of worry over many years with numerous periodic setbacks, but with the long-term trend providing higher returns than other more stable assets.

Second, selling shares or switching to a more conservative strategy after a major fall just locks in a loss. The best way to guard against selling on the basis of emotion is to adopt a well thought out, long-term investment strategy and stick to it.

Third, when shares and growth assets fall they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities that pullbacks provide.

Fourth, while shares may have fallen in value the dividends from the market haven’t. So, the income flow you are receiving from a well-diversified portfolio of shares remains attractive.

Fifth, shares often bottom at the point of maximum bearishness. So, when everyone is warning of disaster it’s often time to buy.

Source: AMP Capital 20 December 2018

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) 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.

2019 is likely to be an interesting year for the Australian economy. Some of the big drags of recent years are receding but housing is turning down, uncertainty is high around the global outlook and it’s an election year, which will add to uncertainty. This note looks at the main issues around the housing downturn and what it means for the economy and investors.

Australian growth has slowed again

September quarter GDP growth was just 0.3% quarter on quarter or 2.8% year on year and was well below expectations. 

Source: ABS, AMP Capital

It was concerning for two reasons. Firstly, it suggests that the pickup in growth seen in the first half of the year was an aberration. And secondly it highlighted that the fears around consumer spending as housing slows may be starting to be realised as consumer spending was the big downside surprise.

Housing downturn…

For years we have felt that the combination of surging household debt and surging house prices was Australia’s Achilles heel in that it posed the greatest domestic threat to Australian growth should it all unravel. But we also felt that in the absence of a trigger it was hard to see it causing a major problem. However, over the last year a combination of factors have come together to turn the housing cycle down and create a perfect storm for house prices in Sydney and Melbourne.

These include: poor affordability; tight credit conditions; a surge in the supply of units; a collapse in foreign demand; borrowers switching from interest only to principle and interest loans; fears by investors now that changes to negative gearing and capital gains tax if there is a change of government (assuming Labor can get it through the Senate) will reduce future demand for their property investment; all of this is seeing the positive feedback loop of recent years (of rising prices > rising demand > rising prices etc) give way to a negative feedback loop (of falling prices > falling demand > falling prices etc). This could all be made worse if immigration levels are cut sharply.

Auction clearance rates have fallen to record lows (in terms of my records!) – which for Sydney and Melbourne are consistent with further price falls running around 8-10% pa – and housing credit continues to slow.

Source: Domain; AMP Capital

House prices in Sydney and Melbourne will likely have a top to bottom fall of around 20% (10% in 2019) and national average prices will likely have a top to bottom fall of around 10%.

…leading to a drag on growth

While not on the scale of the property crashes seen during the Global Financial Crisis (GFC) in the US and parts of Europe, the Australian property downturn will have a significant negative economic impact. The main impacts are expected to be:

• a direct detraction from growth as the housing construction cycle turns down. This is likely to amount to around 0.4 percentage points per annum (which was what it added on average during the construction boom).

Source: ABS, AMP Capital

• reduced demand for household equipment retail sales as dwelling completions top out and decline.

• a negative wealth effect on consumer spending of around 1% pa. Rising housing wealth helped drive decent growth in consumer spending in NSW and Victoria as households reduced the amount they saved as their housing wealth rose. This is now likely to go in reverse detracting around 0.6 percentage points from GDP growth.

• there could also be a feedback loop into further bank credit tightening if non-performing loans and defaults rise.

Taken together these could detract 1-1.2 percentage points from growth over the next year.

No recession, but constrained growth

Clearly a deeper slump in national property prices – say a 25% top to bottom fall rather than the 10% we are expecting – would cause severe economic damage but in the absence of much higher interest rates or unemployment causing mass defaults this is unlikely. Australia hasn’t seen the sort of deterioration in lending standards seen in the US prior to the GFC that saw people with “no income, no job, no assets (NINJA’s)” get loans and where the Fed raised rates 17 times over two years! And unlike in the US, Australian mortgages are full recourse loans so there is no “jingle mail”. So, a US GFC style surge in defaults adding to downwards pressure on prices is unlikely.
Barring a deeper property slump, a recession is unlikely:

• The drag on growth from slumping mining investment (which was averaging around 1.5 percentage points per annum) is fading as mining investment is getting close to the bottom.

• Surveys point to a recovery in non-mining investment. Business investment plans for this financial year are pointing to a 4% gain and 7% for non-mining investment.

Source: ABS, AMP Capital

• Public infrastructure spending is rising and has further to go.

• Net exports are likely to continue adding to growth, although the US/China trade war is a threat here. 

• And there are even a couple of positives for consumer spending in the form of lower petrol prices (saving around $10 a week for a typical household) and likely pre-election tax cuts or handouts although these may not kick in until July 2019. Under a Labor Government this looks likely to be more skewed to low and middle income earners with high income earners facing tax hikes.

Given the cross currents, our assessment is that growth is likely to be around 2.5-3% going forward. This is not the recession some fear but it’s well down from the 3.5% pace the RBA expects.

Inflation to stay lower for longer

Growth around 2.5-3% won’t be enough to further eat into spare labour market capacity so the decline in unemployment is likely to stall (job vacancies appear to be slowing) and underemployment is likely to remain high at 8.3%. This in turn points to wages growth remaining weak. Meanwhile, it’s hard to see much uptick in other sources of inflationary pressure: competition and pressure for price discounting remains intense and commodity prices have fallen this year with the oil price falling over 30% from its recent high feeding through to lower petrol prices and the link between moves in the $A and inflation has been weak for years now. The latest Melbourne Institute Inflation Gauge points to a further fall in inflation into this quarter with its trimmed mean measure of underlying inflation up just 1.3% year on year in November.

Source: ABS, Melbourne Institute, AMP Capital

RBA to cut in 2019

Against the backdrop of falling house prices, tight credit conditions and constrained growth, which will keep wages growth weak and inflation below target for longer we see the next move by the RBA being a rate cut. However, it will take a while to change the RBA’s thinking, so we don’t see rates being cut until second half next year but won’t rule out an earlier move if things are weaker earlier than we are expecting. By end 2019 the cash rate is likely to have fallen to 1%.

Rate cuts won’t be aimed at reinflating the property market but supporting households with a mortgage to offset the negative wealth impact on spending. A 0.25% rate cut roughly saves a household with a $400,000 mortgage $1000 a year in interest costs. And banks will likely have no choice to pass the cuts on given the bad publicity not passing them on will generate.

Implications for investors

There are several implications for Australian investors.

First, bank deposits rates will remain poor.

Second, with the RBA likely to cut rates and the Fed hiking (albeit slowing) the $A is likely to fall into the high $US0.60s.

Third, Australian bonds are likely to outperform global bonds.

Finally, while Australian shares are still great for income, global shares are likely to remain outperformers for capital growth. The housing downturn will weigh on retailers, retail property, banks and building material stocks.

Source: AMP Capital 12 December 2018

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) 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.

2018 – a lot weaker than expected

After the relatively low volatility and solid returns of 2017, the past year has seen almost the complete opposite with high volatility and poor returns. It started strongly in January but started to get messy from February. At a big picture level things were fine: global growth looks to have held solid at around 3.7%, inflation rose in the US but only to target and it remained low elsewhere, the Fed raised interest rates but rates generally remain low and profits rose solidly. But it was the risks below the surface that came together to give a rough ride. There were five big negatives:

• Fear of the Fed. The Fed provided no real surprises and nor did US inflation, but investors became increasingly nervous that Fed hikes would crush US growth and profits.

• US dollar strength. While the US dollar did not rise above its 2016 high it caused problems in the emerging world where US dollar denominated debt is high.

• President Trump’s trade war. This was always a high risk for 2018 and once it got underway it weighed on share markets. While the initial focus seemed to be the US versus everyone it morphed into fears of a new Cold War with China adding to fears about growth and profits.

• China slowdown. This was as expected to around 6.5% as a result of credit tightening but fears that it will combine with the trade war and get worse added to global growth angst.

• Global desynchronisation. US growth was strong, but it slowed in Europe, Japan, China and the emerging world.

Australia saw growth around trend and made it through 27 years without a recession, as infrastructure spending, improving business investment and strong exports helped support growth and this in turn drove strong employment growth, a fall in unemployment and the Federal budget closer to a surplus. Against this though credit conditions tightened significantly with the Royal Commission adding to regulatory pressure on the banks, house prices fell, wages growth edged up but remained weak and inflation remained below target, all of which saw the RBA leave rates on hold.

Overall this drove a volatile and messy investment environment.

Investment returns for major asset classes

* Yr to date to Nov. Source: Thomson Reuters, Morningstar, REIA, AMP Capital

• Global shares saw weak returns in local currency terms with significant corrections around February and October. But this masked positive returns from US shares but weakness elsewhere. Global share returns were boosted on and unhedged basis because the $A fell. 

• Asian and emerging market shares paid the price for being star performers in 2017 with losses thanks to a rising $US causing debt servicing fears, the US trade war posing a threat to growth and political problems in some countries. 

• Australian shares were hit by worries about the banks, consumer spending in the face of falling house prices and weakness in yield-sensitive telcos and utilities offsetting okay profit growth and low interest rates. 

• Government bonds yet again had mediocre returns reflecting low yields and capital losses from rising yields in the US as the Fed hiked. Australian bonds outperformed. 

• Real estate investment trusts remained constrained on the back of Fed tightening and higher bond yields.

• Unlisted commercial property and infrastructure continued to do well as investors sought their still relatively high yields.

• Commodity prices were weak on global growth worries and the oil price had a roller coaster ride, first surging ahead of US sanctions on Iran then crashing as demand fell. 

• Australian house prices fell led by Sydney and Melbourne. 

• Cash and bank term deposit returns were poor reflecting record low RBA interest rates. 

• Reflecting US dollar strength, the $A fell not helped by a falling interest rate differential and lower commodity prices. 

• Reflecting soft returns from most assets, balanced superannuation fund returns were soft.

2019 – better, but volatility to remain high

In a big picture sense, the global economy looks to be going through a mini slowdown like we saw around 2011-12 and 2015-16. This is most evident in business conditions indicators that have slowed but remain okay. See the next chart.  

Source: Bloomberg, IMF, AMP Capital

Like then, this has not been good for listed risk assets like shares but it’s unlikely to be signalling the start of a recession, baring a major external shock. Monetary conditions have tightened globally but they are far from tight unlike prior to the GFC and the normal excesses in the form of high inflation, rapid growth in debt or excessive investment that precede recessions in the US or globally are absent. In fact, to the extent that the softening in growth now underway takes pressure off inflation and results in easier monetary conditions than would otherwise have been the case it’s likely to extend the cycle, ie delay the next recession. The slump in oil prices is a key example of this in that it will take some pressure off inflation and provide a boost to consumer spending. Against this background the key global themes for the year ahead are likely to be:

• Global growth to stabilise and then resynchronise. Global growth is likely to average around 3.5% which is down from 2018 but this is likely to mask slower growth in the first half of the year ahead of some improvement in the second half as China provides a bit more policy stimulus, the Fed pauses in raising interest rates, the fall in currencies against the $US dollar provides a boost to growth outside the US and trade war fears settle down (hopefully). Overall, this should support reasonable global profit growth.

• Global inflation to remain low. With growth dipping back to around or just below trend in the short term and commodity prices down inflation is likely to remain low. The US remains most at risk of higher inflation due to its tight labour market, but various business surveys suggest that US inflation may have peaked for now at around 2%.

• Monetary policy to remain relatively easy. The Fed is likely to have a pause on rate hikes during the first half and maybe hike only twice in 2019 as it gets into the zone that it regards a neutral. Rate hikes from other central banks are a long way away. In fact, further monetary easing is likely in China and the European Central Bank may provide more cheap funding to its banks.

• Geopolitical risk will remain high causing bouts of volatility. The main focus is likely to remain on the US/China relationship and trade will likely be the big one. While Trump is likely to want to find a solution on the trade front before tariffs impact the US economy significantly & threaten his re-election in 2020, it’s not clear that this will occur before the March 1 deadline from the Trump/Xi meeting in Buenos Aires so expect more volatility on this issue. Wider issues including the South China Sea could also flare up along with negotiations around Italy’s budget.

In Australia, strength in infrastructure spending, business investment and export values will help keep the economy growing but it’s likely to be constrained to around 2.5-3% by the housing downturn and a negative wealth effect on consumer spending from falling house prices. This in turn will keep wages growth slow and inflation below target for longer. Against this backdrop the RBA is expected to cut the official cash rate to 1% with two cuts in the second half of 2019.

Implications for investors

With uncertainty likely to remain high around US interest rates, trade and growth, volatility is likely to remain high in 2019 but ultimately reasonable global growth & still easy global monetary policy should drive stronger overall returns than in 2018:

• Global shares could still make new lows early in 2019 (much as occurred in 2016) and volatility is likely to remain high but valuations are now improved and reasonable growth and profits should see a recovery through 2019. 

• Emerging markets are likely to outperform if the $US is more constrained as we expect.

• Australian shares are likely to do okay but with returns constrained to around 8% with moderate earnings growth. Expect the ASX 200 to reach around 6000 by end 2019.

• Low yields are likely to see low returns from bonds.

• Unlisted commercial property and infrastructure are likely to continue benefitting from the search for yield but it’s slowing. 

• National capital city house prices are expected to fall another 5% led again by 10% or so price falls in Sydney and Melbourne as tighter credit, rising supply, reduced foreign demand and potential tax changes under a Labor Government impact. 

• Cash and bank deposits are likely to provide poor returns.

• The $A is likely to see more downside into the high $US0.60s, as the gap between the RBA’s cash rate and the Fed Funds rate goes further into negative.

What to watch?

After the turmoil of 2018, the outlook for 2019 comes with greater than normal uncertainty. The main things to keep an eye on in 2019 are as follows:

• US inflation and the Fed – our base case is that US inflation stabilises around 2% enabling the Fed to pause/go slower, but if it accelerates then it will mean more aggressive tightening, a sharp rebound in bond yields and a much stronger $US which would be bad for emerging markets.

• The US trade war – while it may now be on hold thanks to negotiations with China, Europe and Japan these could go wrong and see it flare up again. US/China tensions generally pose a significant risk for markets.

• Global growth indicators – if we are right growth indicators like the PMI shown in the chart above need to stabilise in the next six months.

• Chinese growth – a continued slowing in China would be a major concern for global growth and commodity prices.

• The property price downturn in Australia – how deep it gets and whether non-mining investment, infrastructure spending and export earnings are able to offset the drag from housing construction and consumer spending.

Source: AMP Capital 6 December 2018

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) 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.

While global and Australian shares had a nice bounce from their late October lows – rallying about 5%, partly reversing their 10% or so top to bottom fall, they have since fallen back to their lows as the worries about US rates, bond yields, trade, tech stocks, etc, have morphed into broader concerns about global growth and profits. Fears of a credit crunch and falling home prices are probably not helping Australian shares either, which this week dipped below their October low. Our assessment remains that it’s too early to say we have seen the lows, but we remain of the view that it’s not the start of major bear market.

The three bears – correction, gummy & grizzly

Very simply there are 3 types of significant share market falls:

• corrections with falls around 10% (of course these aren’t really bear markets – but some might feel that they are!); 

• “gummy” bear markets with falls around 20% meeting the technical definition many apply for a bear market but where a year after falling 20% the market is up (like in 1998 in the US, 2011 and 2015-16 for Australian & global shares); and

• “grizzly” bear markets where falls are a lot deeper and usually longer lived (like in 1973-74, US and global shares through the tech wreck or the GFC).

I can’t claim the terms “gummy bear” and “grizzly bear” as I first saw them applied by stockbroker Credit Suisse a few years ago. But they are a good way to conceptualise them. Grizzly bears maul investors but gummy bears eventually leave a nicer taste (like the lollies). Corrections are quite normal and healthy as they enable the sharemarket to let off steam and not get too overheated. As can be seen in the next chart, excluding the present episode since 2012 there have been four corrections and one gummy bear market (2015-16) in global and Australian shares. Bear markets generally are a lot less common, but arguably what we saw in 2015-16 was a gummy bear market.

Source: Bloomberg, AMP Capital

The next table shows conventionally defined bear markets in Australian shares since 1900 – where a bear market is a 20% decline that is not fully reversed within 12 months. The first column shows bear markets, the second shows the duration of their falls and the third shows the size of the falls. The fourth shows the percentage change in share prices 12 months after the initial 20% decline. The final column shows whether they are associated with a recession in the US, Australia or both.

Bear markets in Australian shares since 1900 

Based on the All Ords, excepting the ASX 200 for 2015-16. I have defined a bear market as a 20% or greater fall in shares that is not fully reversed within 12 months. Source: Global Financial Data, Bloomberg, AMP Capital

If a gummy bear market is defined by a 20% decline after which the market is higher 12 months later whereas as grizzly bear market sees a continuing decline over the subsequent 12 months after the first 20% decline, then since 1900 there have been 12 gummy bear markets (these are highlighted in black) and there have been six grizzly bear markets (highlighted in red). Several points stand out. First, the gummy bear markets tend to be a bit shorter and see much smaller declines averaging 26% compared to 46% for the grizzly bear markets.

Second, the average rally over 12 months after the initial 20% fall is 15% for the gummy bear markets but it’s a 23% decline for the grizzly bear markets.

Finally, and perhaps most importantly the deeper grizzly bear markets are invariably associated with recession, whereas the milder gummy bear markets including the 1987 share market crash tend not to be. Five of the six grizzly bear markets saw either a US or Australian recession or both whereas less than half of the gummy bear markets saw recession.

It’s also the case that US share market falls are much deeper and longer when there is a US recession.

What’s it likely to be this time?
Our view remains that a grizzly bear market is unlikely because, short of some unforeseeable external shock, a US, global or Australian recession is not imminent. In relation to the US:

• Business and consumer confidence are very high.

• While US monetary conditions have tightened they are not tight and they are still very easy globally and in Australia (with monetary tightening still a fair way off in Europe, Japan and Australia). We are a long way from the sort of monetary tightening that leads into recession.

• Fiscal stimulus is continuing to boost US growth.

• We have not seen the excesses – in terms of debt growth, overinvestment, capacity constraints and inflation – that normally precede recessions in the US, globally or Australia.

Reflecting this, global earnings growth is likely to remain reasonable – albeit slower than it has been – providing underlying support for shares. In relation to Australia – yes housing is turning down and this will weigh on consumer spending, but it will be offset by a lessening drag from mining investment, strengthening non-mining investment, booming infrastructure spending and solid growth in export earnings. Growth is unlikely to be as strong as the RBA is assuming but it’s unlikely to slide into recession either.

So, for all these reasons it’s unlikely the current pull back in shares is the start of a grizzly bear market. However, we have already had a correction in mainstream global shares and Australian shares (with circa 10% falls) and with markets falling again it could turn into gummy bear market, where markets have another 10% or so leg down – a lot of technical damage was done by the October fall that has left investors nervous, the rebound from late October was not particularly convincing and many of the drivers of the October fall are yet to be resolved.

Some positives

However, there are three developments that help add to our conviction that we are not going into a grizzly bear market. First, recent comments by Fed Chair Powell and Vice Chair Clarida indicate that the Fed remains upbeat on the US economy and a December hike looks assured (for now), but it is aware of the risks to US growth from slowing global growth, declining fiscal stimulus next year, the lagged impact of eight interest rate hikes and stock market volatility and appears open to slowing the pace of interest rate hikes or pausing at some point next year. The stabilisation in core inflation around 2% seen lately may support this. Past gummy bear markets (1987, 1998, 2011, 2015-16) all saw some pause or relaxation by the Fed.

Second, while it’s messy after the US/China standoff at the recent APEC forum there have been some positive signs on trade. Talks between the US and China on trade have reportedly resumed ahead of a meeting between President Trump and President Xi at the G20 summit next week and President Trump has repeated that he is optimistic of a trade deal with China and that the US might put any further tariff increases on China on hold if there is progress. The US/China trade dispute is unlikely to be resolved quickly when Trump and Xi meet. Perhaps the best that can be hoped for is agreement to have formal trade talks with the aim of resolving the issues and the US agreeing to delay any further tariff increases. With Trump wanting to get re-elected I remain of the view that some sort of deal will be agreed before the tariffs cause too much damage to the US economy. Rising unemployment (as fiscal stimulus will turn to contraction next year if current and proposed tariffs/taxes on China go ahead) and higher prices at Walmart will sink Trump’s re-election prospects in 2020. Of course, investors are now highly sceptical of any progress on the trade front. So any breakthrough in the next six months could be a big positive.

Finally, while the 30% plunge in the oil price since its October high is a short-term negative for share markets via energy producers, it has the potential to extend the economic cycle as the 2014-16 oil price plunge did. The main drivers of the fall in the oil price are slower global demand growth, US waivers on Iranian sanctions allowing various countries to continue importing Iranian oil, rising US inventories, the rising $US and the cutting of long oil positions. While oil prices are unlikely to fall as much as in 2014-16 when they fell 75% (as OPEC spare capacity is less now) they may stay lower for longer. This is bad for energy companies but maybe not as bad for shale producers as in 2015 as they are now less indebted and their break-even oil price has already been pushed down to $50/barrel or less. It will depress headline inflation (monthly US inflation could be zero in November and December) and if oil stays down long enough it could dampen underlying inflation. All of which may keep rates lower for longer. And its good news for motorists who see rising spending power. For example, Australian petrol prices have plunged from over $1.60 a litre a few weeks ago to below $1.30 in some cities. That’s a saving in the average weekly household petrol bill of around $10.

Source: Bloomberg, MotorMouth, AMP Capital

Source: AMP Capital 22 November 2018

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) 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.

A few months ago Reserve Bank Governor Phillip Lowe provided four common sense points we should all keep in mind regarding borrowing to finance a home. (The Governor’s speech can be found here). I thought they made sense and so summarised them in a tweet to which someone replied that every checkout operator knows them. Which got me thinking that maybe many do know them, but a lot don’t, otherwise Australians would never have trouble with their finances. So I thought it would be useful to expand Governor Lowe’s list to cover broader financing and investment decisions we make. I have deliberately kept it simple and in many cases this draws on personal experience. I won’t tell you to have a budget though because that’s like telling you to suck eggs.

1. Shop around

We often shop around to get the best deal when it comes to consumer items but the same should apply to financial services. As Governor Lowe points out “don’t be shy to ask for a better deal whether for your mortgage, your electricity contract or your phone plan”. The same applies to your insurance, banking, superannuation, etc. It’s a highly-competitive world out there and financial companies want to get and keep your business. So when getting a new financial service it makes sense to look around. And when it comes time to renew a service – say your home and contents insurance – and you find that the annual charge has gone up way in excess of inflation (which is currently around 2%) it makes sense to call your provider to ask what gives. I have often done this to then be offered a better deal on the grounds that I am a long-term loyal customer.

2. Don’t take on too much debt

Debt is great, up too a point. It helps you have today what you would otherwise have to wait till tomorrow for. It enables you to spread the costs associated with long term “assets” like a home over the years you get the benefit of it and it enables you to enhance your underlying investment returns. But as with everything you can have too much of it. Someone wise once said “it’s not what you own that will send you bust but what you owe.” So always make sure that you don’t take on so much debt that it may force you to sell all your investments just at the time you should be adding to them or worse still potentially send you bust. Or to sell your house when it has fallen in value. A rough guide may be that when debt servicing costs exceed 30% of your income then maybe you have too much debt – but it depends on your income and expenses. A higher income person could manage a higher debt servicing to income ratio simply because living expenses take up less of their income.

3. Allow that interest rates can go up as well as down

Yeah, I know that it’s a long time since offical interest rates were last raised in Australia – in fact it was way back in 2010. So as Governor Lowe observes “many borrowers have never experienced a rise in official interest rates”. But don’t be fooled by the recent history of falling or low rates. My view is that an increase in rates is still a long way off (and they may even fall further first) – but that’s just a view and views can be wrong. History tells us that eventually the interest rate cycle will turn up. Just look at the US where after six years of near zero interest rates, official US interest rates have risen 2% over the last three years. So, the key is to make sure you can afford higher interest payments at some point. And when official rates move up the moves tend to be a lot larger than the small out of cycle moves from banks that have caused much angst lately.

4. Allow for rainy days

This is another one raised by Governor Lowe who said: “things don’t always turn out as we expect. So for most of us having a buffer against the unexpected makes a lot of sense.” The rainy day could come as a result of higher interest rates, job loss or an unexpected expense. This basically means not taking all the debt offered to you, trying to stay ahead of your payments and making sure that when you draw down your loan you can withstand at least a 2% rise in interest rates.

5. Credit cards are great, but they deserve respect

I love my credit cards. They provide me with free credit for up to around 6-7 weeks and they attract points that can really mount up (just convert the points into gift cards and they make optimal Christmas presents!). So, it makes sense to put as much of my expenses as I can on them. But they charge usurious interest rates of around 20-21% if I get a cash advance or don’t pay the full balance by the due date. So never get a cash advance unless it’s an absolute emergency and always pay by the due date. Sure the 20-21% rate sounds a rip-off but don’t forget that credit card debt is not secured by your house and at least the high rate provides that extra incentive to pay by the due date.

6. Use your mortgage for longer term debt

Credit cards are not for long term debt, but your mortgage is. And partly because it’s secured by your house, mortgage rates are low compared to other borrowing rates – at around 4-5% for most. So if you have any debt that may take longer than the due date on your credit card to pay off then it should be on your mortgage if you have one.

7. Start saving and investing early

If you want to build your wealth to get a deposit for a house or save for retirement the best way to do that is to take advantage of compound interest – where returns build on returns. Obviously, this works best with assets that provide high returns on average over long periods. But to make the most of it you have to start as early as possible. Which is why those piggy banks that banks periodically hand out to children have such merit in getting us into the habit of saving early.

Of course, this gives me an opportunity to again show my favourite chart on investing which tracks the value of $1 invested in Australian shares, bonds and cash since 1900 with dividends and interest reinvested along the way. Cash is safe but has low returns and that $1 will have only grown to $237 today. Shares are volatile (& so have rough periods highlighted by arrows) but if you can look through that they will grow your wealth and that $1 will have grown to $526,399 by today.

 

Source: Global Financial Data, AMP Capital

8. Allow that asset prices go up and down

It’s well known that the share market goes through rough patches. The volatility seen in the share market is the price we pay for higher returns than most other asset classes over the long term. But when it comes to property there seems to be an urban myth that it never goes down in value. Of course property prices will always be smoother than share prices because it’s not traded daily and so is not subject to daily swings in sentiment. But history tells home prices do go down as well as up. Japanese property prices fell for almost two decades after the 1980s bubble years, US and some European countries’ property values fell sharply in the GFC and the Australian residential property market has seen several episodes of falls over the years and of course we are going through one right now. So the key is to allow that asset prices don’t always go up – even when the population and the economy are growing.

9. Try and see big financial events in their long-term context

Hearing that $50bn was wiped off the share market in one day sounda scary – but it tells you little about how much the market actually fell and you have only lost something if you actually sell out after the fall. Scarier was the roughly 20% fall in share markets through 2015-16 and worse still the GFC that saw roughly 50% falls. But such events happen every so often in share markets – the 1987 crash saw a 50% in a few months & Australian shares fell 59% over 1973-74. And after each the market has gone back up. So, we have seen it all before even though the details may differ. The trick is to allow for periodic sharp falls in your investment strategy and when they do happen remind yourself that we have seen it all before and the market will find a base and resume its long-term rising trend.

10. Know your risk tolerance

When embarking on investing it’s worth thinking about how you might respond if you found out that market movements had just wiped 20% off the value of your investments. If your response is likely to be: “I don’t like it, but this sometimes happens in markets and history tells me that if I stick to my strategy I will see a recovery in time” then no problem. But if your response might be: “I can’t sleep at night because of this, get me out of here” then maybe you should rethink your strategy as you will just end up selling at market bottoms and buying tops. So try and match your investment strategy to your risk tolerance.

11. Make the most of the Mum and Dad bank

The housing boom in Australia that got underway in the mid-1990s and reached fever pitch in Sydney & Melbourne last year has left housing very unaffordable for many. This contributed to a huge wealth transfer from Millennials to Baby Boomers and some Gen Xers. Hopefully the current home price correction underway will help in starting to correct that. But for Millennials in the meantime, if you can it makes sense to make the most of the “Mum and Dad bank”. There are two ways to do this. First stay at home with Mum and Dad as long as you can and use the cheap rent to get a foot hold in the property market via a property investment and then using the benefits of being able to deduct interest costs from your income to reduce your tax bill to pay down your debt as quickly as you can so that you may be able to ultimately buy something you really want. (Of course, changes to negative gearing if there is a change to a Labor Government could affect this.) Second consider leaning on your parents for help with a deposit. Just don’t tell my kids this!

12. Be wary of what you hear at parties

A year ago Bitcoin was all the rage. Even my dog was asking about it – but piling in at around $US19,000 a coin just when everyone was talking about it back then would not have been wise (its now below $US6500) even though many saw it as the best thing since sliced bread. Often when the crowd is dead set on some investment it’s best to do the opposite.

13. There is no free lunch

When it comes to borrowing & investing there is no free lunch – if something looks too good to be true (whether it’s ultra-low fees or interest rates or investment products claiming ultra-high returns & low risk) then it probably is and it’s best to stay away.

Concluding comment

I have focussed here mainly on personal finance and investing at a very high level, as opposed to drilling into things like diversification and taking a long-term view to your investments. An earlier note entitled “Nine keys to successful investing” focussed in more detail on investing and can be found here.

Source: AMP Capital 15 November 2018

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) 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.

October was a bad month for shares with global shares losing 6.8% in local currency terms and Australian shares losing 6.1%. It’s possible that following top to bottom falls of 9% for global shares, 11% for Australian shares, 21% in emerging markets and 31% in Chinese shares we have now seen the low in the share market rout. Shares were due a bounce and from their October lows and Australian shares have risen around 4% since. But it’s impossible to be definitive and with the worry list around US interest rates, trade, politics, etc, there could still be another leg down. However, our view remains that recent turbulence in share markets is a correction or a mild bear market at worst (like 2015-16) rather than the start of a deep bear market like the global financial crisis. This note reviews the key recent worries for shares and why they are unlikely to be terminal.

US inflation & interest rates

The US economy is very strong as evidenced by consumer confidence at an 18-year high, unemployment at a 49-year low and strong economic growth. With spare capacity being used up wages growth is edging higher as shown in the next chart.

Source: Bloomberg, AMP Capital

Against this backdrop it makes sense for the Fed to continue the process of returning monetary policy and interest rates to something more normal. Naturally, the ongoing removal of monetary stimulus in the US creates consternation and has been periodically occurring ever since former Fed Chair Bernanke started talking about slowing or “tapering” quantitative easing in 2013. In short, investors continue to fear a return to the GFC and so any move to remove monetary support creates periodic bouts of fear. Several points are worth noting about this though. First, the Fed can afford to remain gradual in raising rates. Inflation is at the 2% target, wages growth is a long way from the 4% plus level that preceded past recessions and productivity growth is rising so this will keep growth in unit labour costs down. Meanwhile, intense competition and technological innovation are also continuing to help keep inflation constrained.

Second, on any measure US monetary policy is a long way from being tight. The Fed Funds rate is zero in real terms, it’s well below nominal growth and the yield curve is still positive.

Finally, a return to more normal interest rates is a good thing because it reflects a stronger, more normal economy.

In short, expect gradual 0.25% Fed rate hikes to continue, with the next hike coming in December, and this will cause bouts of market volatility but it’s a long way from crunching the economy in a way that would bring on a deep bear market in shares.

The US/China trade conflict

This issue has been periodically worrying markets since around March. It stepped up a notch after last month’s speech by US Vice President Mike Pence indicating that US gripes with China extend beyond trade which led many to talk of a new Cold War – the implication of which is less trade and occasional military tensions which implies lower economic growth and lower price to earnings multiples. However, it’s still not as bad as it looks.

First, so far only 12% of US imports have been subject to a tariff hike averaging 15%, which is equivalent to an average tariff hike of 1.8% across all imports. So it’s a non-event compared to 1930 which saw a 20% tariff hike on all imports.

Second, while initially the US seemed to be picking trade fights with all major countries it has since renegotiated trade agreements with South Korea and Canada/Mexico and is negotiating with Europe and Japan. This tells us Trump is not interested in trade wars with everyone and that he is not anti-trade per se but wants “fairer trade” for the US.

Third, while Trump has threatened more tariff hikes on China if it retaliates it’s noteworthy that China has not fully retaliated and has been cutting tariffs and announcing more protections for intellectual property. This may help defuse the tensions a bit.

Fourth, while Trump’s comments expressing optimism about a deal with China should be treated with scepticism as they came just before the US midterm elections, they do highlight cause for optimism that a deal will be reached eventually. At least Trump and Xi are talking and Trump’s optimistic comments ahead of the midterms effectively tells us that he is aware that the trade issue is harming the stock market and potentially the economy. The latter in turn suggests that he wants a deal well before he faces re-election in 2020. So, while it may be premature to expect a deal when Xi and Trump meet later this month, a deal is likely well ahead of the 2020 elections. With China already lowering tariffs, improving intellectual property protections and softening joint venture requirements the outlines of a deal are starting to become apparent and Chinese Vice President Wang has indicated China is ready to negotiate with the US.

The US midterm elections – no surprises

The US midterm elections saw the Democrats win control of the House and Republicans retain the Senate which was what had been indicated by the polls and betting markets. So, it provided no surprises – in contrast to Brexit and Trump’s 2016 win! While the Democrat House is likely to prevent Trump from cutting taxes any further it won’t be able wind back last year’s tax cuts, reverse Trump’s deregulation of the economy or change his trade policy. But there is some chance that Trump and the Democrats may agree on infrastructure spending. While the Democrat House will likely set up committees to investigate Trump and consider impeachment charges, it’s very unlikely to get the required 67 out of 100 senate votes to remove him from office unless he is shown to have done something really bad. All up, while there may be some skirmishes around shutdowns and debt ceilings, the midterm outcome could be positive because it means less policy uncertainty.

On average, US Presidents have lost 29 House seats in their first midterm election. Clinton lost 54 and Obama lost 63. Trump looks to have lost around 34 but only needed to lose 23 to lose control of the House so what has happened is not unusual. What’s more the Republicans look to have increased their Senate majority so it’s not all bad for Trump. More broadly, it should be noted that “divided government” is the norm in the US. Perhaps the biggest risk is that Trump takes it personally and ramps up the populism, but if he wants to get re-elected in 2020 (which he does) then he won’t want to do anything that damages the economy and amongst other things this points to cutting a deal with China and getting the tariffs removed. Since 1946 the US S&P 500 has risen in the 12 months after all midterm elections – probably because the president starts to focus on re-election and so tries to boost the economy.

Source: Bloomberg, AMP Capital

US tech stocks

Having accounted for a big chunk of US share market gains this year the US tech sector has corrected around 13%, but that still leaves it vulnerable to relatively high valuations (Nasdaq is on a PE of 42 times), sales growth slowing down for some of them and the prospect of increasing regulation. However, we have not seen anything like the tech boom euphoria of around 1999/2000 so a crash like back then is unlikely. Our base case is that the US share market will start to see a rotation from expensive tech to cheap cyclical stocks (with many trading on forward PE’s of less than ten times).

Eurozone worries – German and Italy

Fears that the Eurozone is about to blow apart causing financial mayhem and threatening global growth have been with us since the Eurozone crisis that started in 2010. Lately the fear is that populist governments will take countries out of the Euro. This started with Greece in 2015. It was an issue last year but then pro-Euro parties and candidates won in various elections. This year it’s been an issue with Italy particularly, as its populist government sought a wider budget deficit, and Germany with Angela Merkel indicating she will step down as Chancellor in 2021. In terms of Italy, there will no doubt be a conflict between the European Commission and Italy over the size of its planned budget deficit but don’t expect it to go too far as the deficit is not outlandish and German and France won’t want to embolden the Eurosceptics in Italy by pushing back too hard.

In terms of Germany, the poor performances of the governing German grand coalition parties the Christian Democratic Union (CDU), the Christian Social Union and the Social Democrat Party (SPD) at state elections do not signal a threat to the Euro. First, comments by SPD leader Nahles indicate the grand coalition is not under imminent threat. Second, Germany’s budget surplus and falling public debt indicate plenty of scope to provide fiscal stimulus, which would be positive for Germany and the Eurozone and provide an electoral boost for the grand coalition partners. Thirdly, German Euroscepticism is not on the rise. In fact, support for the Euro in Germany has risen to 83% and it was support for the pro-Euro Greens that surprised in Bavaria and Hesse, not support for the Alternative for Deutschland. Finally, a new election is unlikely as both the CDU and SPD have seen a loss of support, so they aren’t going to back an early election. So those looking for a breakup of the Euro can keep looking.

Oil prices – back down again

In early October world oil prices reached their highest since 2014 with West Texas Intermediate topping $US76/barrel with talk it was on its way to $US100 on the back of strong demand and supply threats including impending US sanctions on Iran. This in turn was adding to concerns about the impact on global economic growth and rising inflation. However, since then the oil price has fallen by nearly 19%. US sanctions on Iran have started but with little new impact as Iranian oil exports had already fallen and the US granted waivers to allow eight countries – including Japan, China, India, Taiwan and South Korea – to continuing importing Iranian oil. The Iranian export cutbacks at a time of threats to production from Venezuela and Libya leaves a now-tight global oil market at risk of higher prices, but for now the threat has receded a bit.

Source: AMP Capital 8 November 2018

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) 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.