Olivers Insights

The period August to October is a time for anniversaries of financial market crises – the 1929 share crash, the 1974 bear market low, the 1987 share crash, the Emerging market/LTCM crisis in 1998, and of course the worst of the Global Financial Crisis in 2008. The GFC started in 2007 but it was the collapse of Lehman Brothers on 15 September 2008 and the events around it which saw it turn into a major existential crisis for the global financial system. Naturally each anniversary begs the question of can it happen again and what are the key lessons. And so it is with the tenth anniversary of the worst of the GFC.

A brief history of the GFC

The events around the failure of Lehman Brothers and the GFC have been done to death. But here’s a brief history. It was the worst financial crisis since the Great Depression. It saw the freezing up of lending between banks, multiple financial institutions needing to be rescued, 50% plus share market falls and the worst post-war global economic contraction. Basically, the environment of low interest rates prior to the GFC saw too many loans made to US homebuyers that set off a housing boom that went bust when rates rose and supply surged.

• 40% or so of loans went to people with a poor ability to service them – sub-prime and low doc borrowers. And many were non-recourse loans – so borrowers could just hand over the keys to the house if its value fell – “jingle mail”!

• This was encouraged by public policy aimed at boosting home ownership and ending discrimination in lending. Some extolled the “democratisation of finance”!

• It was made possible by a huge easing in lending standards and financial innovation that packaged the sub-prime loans into securities, which were then given AAA ratings on the basis that while some loans may default the risk will be offset by the broad exposure. These securities were then leveraged, sold globally and given names like Collateralised Debt Obligations (CDOs). But after securitization there was no “bank manager” looking after the loans.

• This all came as banks were sourcing an increasing amount of the money they were lending from global money markets.

This stopped in 2006 when poor affordability, an oversupply of homes and 17 Fed interest rates hikes saw US house prices start to slide. This made it harder for sub-prime borrowers to refinance their loans after their initial “teaser” rates. So they started defaulting, causing losses for investors. This caught the attention of global investors in August 2007 after BNP froze redemptions from three funds because it couldn’t value the CDOs within them, triggering a credit crunch with sharp rises in the cost of funding for banks – evident in a surge in short term borrowing rates relative to official rates (see next chart) – and a reduction in its availability causing sharp falls in share markets.

Source: Bloomberg, AMP Capital

Shares rebounded but peaked around late October 2007 before commencing roughly 55% falls as the credit crunch worsened, the global economy fell into recession, mortgage defaults escalated, and many banks failed with a big one being Lehman.

The crisis went global as losses magnified by gearing mounted, forcing investment banks and hedge funds to sell sound investments to meet redemptions which spread the crisis to other assets. The wide global distribution of investors in US sub-prime debt led to greater worries about who was at risk, with the loss of trust resulting in a freezing up of lending between banks and sky-high borrowing costs (see the previous chart). All of which affected confidence and economic activity.

The cause of the GFC lay with home borrowers, the US Government, lenders, ratings agencies, regulators, investors and financial organisations for taking on too much risk. It ended in 2009 after massive monetary and fiscal stimulus along with government rescues of banks. But aftershocks continued for years with sub-par growth and low inflation into this decade. From an economic perspective the GFC highlighted that:

• Fiscal and monetary policy work. There is a role for government, central banks and global cooperation in putting free market economies back on track when they get into a downward spiral. (While some have argued that easy money just benefitted the rich, doing nothing would have likely ended with 20% plus unemployment and worse inequality.) Hopefully there will be the same common sense ‘do whatever it takes’ approach again if the need arises.

• The return to normal from major financial crises can take time – in fact a decade or so according to a study by Kenneth Rogoff and Carmen Reinhart – as the blow to confidence depresses lending and borrowing and hence consumer spending and investment for years afterwards. The key is to allow for this and not turn off the policy stimulus prematurely, but also to avoid thinking it is permanent as the muscle memory does eventually fade.

• “Stuff happens” – while after each economic crisis there is a desire to “make sure it never happens again”, history tells us that manias, panics and crashes are part and parcel of the process of “creative destruction” that has led to an exponential increase in material prosperity in capitalist countries. The trick is to ensure that the regulation of financial markets minimises the economic fallout that can occur when free markets go astray but doesn’t stop the dynamism necessary for economic prosperity.

Will it happen again?

History is replete with bubbles and crashes and tells us it’s inevitable that they will happen again as each generation forgets and must relearn the lessons of the past through another bubble based on collective euphoria about some new innovation. Often the seeds for each bubble are sown in the ashes of the former. Fortunately, in the post-GFC environment seen so far there has been an absence of broad-based bubbles on the scale of the tech boom or US housing/credit boom. There was a brief surge in gold and some commodity prices early this decade but it did not get that big before bursting. Bitcoin and other cryptos were another example but they blew up before sucking in enough investors to have a meaningful global impact. E-commerce stocks like Facebook and Amazon are candidates for the next bust but they have seen nowhere near the gains or infinite PEs seen in the late 1990s tech boom.

Source: Thomson Reuters, Bloomberg, AMP Capital

Post a GFC related pull back, global debt has grown to an all-time high relative to global GDP posing an obvious concern. However, this alone does not mean another GFC is upon us. The ratio of global debt to GDP has been trending up forever, much of the growth in debt in developed countries post the GFC has been in public debt and debt interest burdens are low thanks to still low interest rates in contrast to the pre-GFC period. Furthermore, the other signs of excess that normally set the scene for recessions and associated deep bear markets in shares like that seen in the GFC are not yet present on a widespread basis. Inflation is low, monetary policy globally remains easy, there has been no widespread overinvestment in technology or housing, and bank lending standards have not been relaxed as much as prior to the GFC.

Source: IMF, Haver Analytics, BIS, Ned Davis Research, AMP Capital

Moreover, financial regulations have tightened with banks required to have higher capital ratios and get more funds from their depositors. Much of the surge in debt post the GFC has been in private emerging market debt rather than in developed countries suggesting emerging markets are at greater risk.

Another economic crisis is inevitable at some point, but it will likely be very different to the GFC.

Seven lessons for investors from the GFC

The key lessons for investors from the GFC are as follows:

1. There is always a cycle. Talk of a “great moderation” was all the rage prior to the GFC but the GFC reminded us that long periods of good growth, low inflation and great returns are invariably followed by something going wrong. If returns are too good to be sustainable they probably are. 

2. While each boom bust cycle is different, markets are pushed to extremes – with the asset at the centre of the upswing overvalued and over-loved at the top and undervalued and under-loved at the bottom, which for credit investments and shares was in first half 2009. This provides opportunities for patient contrarian investors to profit from.

3. High returns come with higher risk. While risk may not be apparent for years, at some point when everyone is totally relaxed it turns up with a vengeance as seen in the GFC. Backward-looking measures of volatility are no better than attempting to drive while just looking at the rear-view mirror. 

4. Be sceptical of financial engineering or hard-to-understand products. The biggest losses for investors in the GFC were generally in products that relied heavily on financial alchemy purporting to turn junk into AAA investments that no one understood. 

5. Avoid too much gearing and gearing or the wrong sort. Gearing is fine when all is well. But it magnifies losses when things reverse and can force the closure of positions at a loss when the lenders lose their confidence and refuse to roll over maturing debt or when a margin call occurs forcing an investor to sell just when they should be buying.

6. The importance of true diversification. While listed property trusts and hedge funds were popular alternatives to low-yielding government bonds prior to the GFC, through the crisis they ran into big trouble (in fact Australian Real Estate Investment Trusts (REITs) fell 79%), whereas government bonds were the star performers. In a crisis, “correlations go to one” – except for true safe havens.

7. The importance of asset allocation. The GFC reminded us that what matters most for your investments is your asset mix – shares, bonds, cash, property, etc. Exposure to particular shares or fund managers is second order.

Source: AMP Capital 12 September 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.

For years now, many have told us that Australia is heading for an imminent recession. By contrast official forecasts have long been looking for several years of above trend growth. In the event neither has happened and we don’t see them happening anytime soon. Against this backdrop there are five things you should know about the Australian economy.

First – the economy grew solidly over the last year

After several years of muddling along the Australian economy actually perked up over the last year with GDP growing a surprisingly strong 3.4% year on year, its fastest since 2012.

Source: ABS, AMP Capital

That growth has been able to range between just below 2% and just above 3% over the last six years despite a large drag on growth from the fall back in mining investment is actually pretty good. But it’s below the norm for Australia, which has averaged around 3% GDP growth per annum over the very long term. It should also be remembered that strong population growth has been one of the reasons for the relative resilience of Australia’s economy, but over the last year per capita GDP growth at 1.8% has been running below that in the US and in line with that in Europe.

Second – growth is likely to slow a bit from here

While economic growth averaged a strong 1% quarterly pace in the first half of the year it’s likely to slow going forward:

• The housing construction cycle is turning down as approvals trend down and the cranes come down. Falling alterations and additions won’t help. 

• Growth in consumer spending is likely to slow given weak wages growth, high levels of underemployment and slowing wealth gains as home prices fall. With falling home prices its unlikely that households will be prepared to keep running down the household saving rate – which is now at a 10 year low of just 1% – to make up for weak income growth.

• Business investment plans for the current financial year are still subdued pointing to roughly flat investment (if plans for this year are compared with those made a year ago) and political uncertainty could start to weigh ahead of a potential change in government.

Source: ABS, AMP Capital

• Drought could knock 0.5 percentage points off economic growth this year.

Source: ABS, Bureau of Meteorology, AMP Capital

• While agricultural production as a share of GDP is now just 2.5%, a 20% slump in farm production as seen in past droughts would still knock 0.5% off economic growth. If it turns into an El Nino phenomenon it could be worse.

Third – but it’s not going into recession

Despite these drags, recession will continue to be avoided just as it has been over the past 27 years:

• Over the past five years or so the slump in mining investment back to more normal levels has knocked around 1.5% per annum from GDP growth. However, mining investment is no longer 7% of the economy and it’s near the bottom so its drag on GDP growth is approaching zero.

Source: ABS, AMP Capital

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

• Net exports are likely to add to growth as the completion of resources projects boosts resources export volumes, although a US/China trade war is a threat here.

• Profits for listed companies are rising in contrast to the 2014-16 period. This is a positive for investment.

Source: UBS, AMP Capital

• While profit growth has slowed from 17% in 2016-17 to around 8% it’s positive and 77% of companies in the recent reporting season (the highest since the GFC) have seen rising profits with 86% of companies raising or maintaining their dividends indicating confidence in the outlook.

Source: AMP Capital

So while housing construction will slow and consumer spending is constrained, a lessening drag from mining investment and slightly stronger non-mining investment along with solid export growth provide an offset and are expected to see growth between 2.5-3% going forward. Down from over the last year and slower than the RBA expects, but stronger than many doomsters see.

Fourth – spare capacity will remain for a while yet

With the economy’s potential (or sustainable) growth rate running around 2.75% and actual economic growth likely to run around this spare capacity in the economy will be with us for a while yet. To use it up we really need a long period of above trend economic growth, but this looks unlikely. Spare capacity remains most obvious in the labour market where the underutilisation rate remains historically high at near 14%. With it likely to remain high for some time to come it’s hard to see much acceleration in wage growth or inflation in the economy.

Source: ABS, AMP Capital

Fifth – which means RBA rate hikes are a long way off

The RBA’s forecasts for continuing solid economic growth and a gradual rise in underlying inflation argue against a rate cut and support the case for an eventual hike. But our more constrained view on growth implying lower for longer wages growth and inflation along with the risks posed by likely further falls in Sydney and Melbourne home prices, tightening bank lending standards and the drought indicate a rate hike is unlikely to be justified any time soon. The next move in rates is probably still up but not until second half 2020 at the earliest and there is a risk that the next move will actually be down if falling home prices pose a significant threat to consumer spending and inflation starts falling again.

Implications for investors

There are several implications for Australian investors.

First, continuing growth should provide support for reasonable returns from Australian growth assets.

Second, bank deposits are likely to provide poor returns for investors for a while yet.

Third, while Australian shares are great for income, global shares are likely to remain outperformers for capital growth.

Finally, the outlook remains for a further fall in the $A. With the RBA comfortably on hold and the Fed raising rates every three months (with the next move coming this month), the interest rate gap between Australia and the US will go further into negative territory making it even more attractive to park money in the US and not Australia which will drag the $A down. Threats to global growth from a trade war and problems in emerging countries will also weigh on the $A.

Source: AMP Capital 6 September 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.

For the last two calendar years the Australian dollar has defied our expectations for weakness. But after hitting $US0.81 in January it’s been trending down as US interest rates fell below the Australian cash rate, the threat of a US-driven trade war increased and it recently broke below a short-term range around $US0.74 and fell as low as $US0.72 on fears of contagion to global growth from a crisis in Turkey. This note looks at outlook for the $A and why it makes sense for Australian-based investors to hold a decent exposure to foreign exchange.

What are the fundamental drivers of the $A?

The Australian dollar tends to move in line with relative price differentials over the long term. This is the theory of purchasing power parity (PPP) according to which exchange rates should equilibrate the price of a basket of goods and services across countries – see the next chart.

Source: RBA, ABS, AMP Capital

If over time Australian inflation and costs rise relative to the US, then the value of the $A should fall relative to the $US to maintain its real purchasing power and competitiveness. But in the short to medium term, swings in the $A are largely driven by swings in the prices of Australia’s key commodity exports and the terms of trade (when they go up the $A tends to rise and vice versa) and relative interest rates such that a rise in US rates relative to Australian rates makes it more attractive to park money in the US and hence pushes the $A down.

Why the $A is likely to fall further 

At current levels, the Australian dollar at around $US0.7350 is around where it should be on a long-term purchasing power parity basis – see the first chart. But the $A rarely spends much time at the purchasing power parity level and tends to be pushed to extremes above and below it. Our view remains that the downtrend in the $A that started in 2011 when the iron ore price peaked at over $US190/tonne has further to go. The main reason is the interest rate differential in favour of the $A is likely to go further into negative territory as the Fed continues to hike rates and the RBA remains on hold. This is making it relatively less attractive to park money in Australia putting downwards pressure on the $A. The Fed is on track to hike rates again next month as the US economy has continued to strengthen highlighted by a very tight jobs market. This will take the Fed Funds rate to a range of 2-2.25%. If the RBA leaves rates on hold at 1.5%, as is almost certain, then the gap between Australian and US official interest rates will fall to -0.5-0.75%, from a whopping +4.5% in 2011. Periods of a low and falling official interest rate differential between Australia and the US usually see a low and falling $A.

Source: Bloomberg, AMP Capital

While some think that the RBA just follows the Fed there has often been significant divergences. This has notably been the case lately with the RBA hiking in 2009 (as the mining boom returned) and the Fed holding and the RBA continuing to cut in 2016 even though the Fed had commenced a tightening cycle. While US growth is running well above potential and has largely used up spare capacity, Australian growth has been running below potential and there is plenty of spare capacity. This is evident in the combination of unemployment and underemployment in the US running about as low as it ever gets whereas in Australia it’s about as high as it ever gets.

Source: Bloomberg, AMP capital

While there are some positive signs in Australia with investment picking up, strong export volumes and strong employment growth, uncertainty remains high around the housing sector and consumer spending. Wages growth and inflation also remain very low so the RBA is likely to be on hold for a long while yet as the Fed continues to hike. Given falling home prices in Sydney and Melbourne a rate cut cannot be ruled out if it threatens overall growth and inflation.

Our base case is that solid global growth will support commodity prices – particularly iron ore and coal – and that this will provide a floor for the $A in the high $US0.60s. However, history suggests we are still in a commodity price bear market after last decade’s surge in prices, the recent 20% or so plunge in metal prices is a warning of weakness and there are threats to emerging world growth from a rising $US, a potential contagion from Turkey, slower growth in China and from US trade policy.

Source: Global Financial Data, Bloomberg, AMP Capital

In the very short term the Australian dollar is oversold and this along with speculative short positions warns of a bounce higher. However, beyond this our assessment is that the $A has further to fall and will likely reach $US0.70 by year end.

What does it mean for investors?

With the risks skewed towards more downside in the value of the $A, there are several implications for investors.

First, there remains a strong case to maintain a decent exposure to offshore assets that are not hedged back to Australian dollars. A decline in the value of the $A boosts the value of an investment in offshore assets denominated in foreign currency by one for one. This can be seen in relation to international equity returns in the next table. The first column shows the return from global shares in local currency terms; the second shows the return in Australian dollars (if foreign currency exposures are not hedged back to Australian dollars); the third column shows the difference, which is the change in the $A on a weighted basis; and the final column shows the return to global shares if hedged back to Australian dollars.

Source: Thomson Reuters, AMP Capital Investors

When the $A rises as it did last year it reduces returns from international shares for an unhedged investor. But when the $A falls as was the case in 2005, 2008, 2013, 2014 and 2015 it boosts the value of global assets and hence the return from global shares for an unhedged investor.

Furthermore, when Australian interest rates are above global rates, investors are “paid” to hedge their foreign currency exposure back to Australian dollars. As can be seen in the last column the return from global shares when hedged back to Australian dollars has been higher than the local currency return because hedging investors receive the difference between Australian and foreign rates. However, with Australian rates falling versus global rates the incentive to hedge is falling.

Second, if the global outlook turns sour, having an exposure to foreign currency provides protection for Australian investors as the $A usually falls in response to threats to global growth. As can be seen in the next chart there is a rough positive correlation between changes in global shares in local currency terms and the $A. Major falls in global shares associated with the emerging market/LTCM crisis in 1998, the tech wreck into 2001, the GFC, the Eurozone crises and the 2015-16 global growth scare saw sharp falls in the $A. This has been evident this year with worries about a trade war and Turkey weighing on the $A. So being short the $A and long foreign exchange provides good protection against threats to the global outlook.

Source: Bloomberg, AMP Capital

Finally, continuing weakness in the $A will be positive for Australian sectors that compete internationally like tourism, higher education, manufacturing, agriculture and mining.

Source: AMP Capital 21 August 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.

Earlier this year the big fear was that inflation was going to surge led by the US and that this was going to drive aggressive interest rate hikes by the US Federal Reserve and much higher bond yields, which in turn would pressure other asset classes. Such fears saw a significant correction in global share markets with US shares falling 10%, global shares falling 9% and Australian shares falling 6%. Since then, inflation fears seem to have taken a back seat. While in most major countries 10-year bond yields are well up from their 2016 multi decade lows, US bond yields have struggled to stay above 3%, German bond yields are around 0.3%, Japanese bond yields are around 0.09% and Australian bond yields are around 2.58%, with most well below their highs seen earlier this year. So, what happened? Should we still worry about inflation?

What happened? 

A whole bunch of things have helped bond yields remain low and kept investors focused elsewhere:

• First, although US inflation has moved up it remains relatively benign with the core private final consumption deflator around 2% year on year which is the Fed’s inflation target. It seems every US jobs report has seen the same “Goldilocks” (not too hot/not too cold) combination of strong jobs growth and falling (now sub-4%) unemployment but low wages growth of around 2.7-2.8% year on year implying low inflation pressures. See the next chart.

Source: Bloomberg, AMP Capital

• While the Fed has continued its drip feed of rate hikes consistent with strong economic conditions, the lack of any inflation break-out has meant that they have been able to remain gradual, with one hike every three months and monetary policy remains very easy.

• Strong US earnings growth has helped distract share market investors. June quarter earnings results have seen 84% of companies surprise on the upside regarding earnings and 71% beat revenue expectations, both of which are above normal levels. Reflecting this, June quarter earnings growth has come in around 27% on a year ago, up from expectations for 20% earnings growth in early July.

Source: Bloomberg, AMP Capital

• The trade war threat has tended to dominate, leading to fears of a hit to global (and US) growth and safe haven demand for assets like bonds (which has helped keep their yields down).

• Worries about Italy’s new populist government blowing out its budget deficit and already high level of public debt, or worse still threatening to leave the Euro resulting in bond holders taking a hit on their investment in Italian bonds, have boosted demand for German bonds depressing their yields and helped extend expectations of easier for longer European Central Bank monetary policy.

• Other geopolitical events like the crisis in Turkey have kept investors on edge for deflationary shocks. The latest worries about contagion from Turkey as its currency plunged anew are likely overdone. Yes, there will be some impact on Eurozone banks that are exposed to Turkish debt (which will keep the ECB cautious), but it’s unlikely to be economically significant. More fundamentally, Turkey is not indicative of the bulk of emerging countries. Its currency has crashed 40% or so this year because of current account and budget deficit blowouts, surging inflation, political interference in its central bank and populist economic mismanagement generally. In addition, political tensions with the US following the imprisonment of an American pastor resulting in US sanctions on Turkey including tariff hikes on steel and aluminium have made things even worse. The crisis is now being intensified by Turkish PM Erdogan’s rejection of higher interest rates and an international bailout. While Brazil, Argentina and South Africa also have particular problems, most of the rest of the emerging world is in far better shape. That said, emerging markets will remain vulnerable until the US dollar stops rising (as a rising $US boosts US dollar denominated debt servicing costs for emerging countries that have high foreign debt), the global trade threat ends and uncertainty regarding Chinese growth fades. And upwards pressure on the US dollar is likely to continue as the Fed is unlikely to stop its process of gradual rate hikes anytime soon.

Source: IMF, AMP Capital

• Finally, while growth in the US has accelerated this year, in other major countries it looks to have slowed. So, while there was talk of the Bank of Japan, the European Central Bank and even the Reserve Bank of Australia following the US into tightening this has been pushed out further. Similarly, some signs of a softening in growth in China and the tariff threat have seen the PBOC (China’s central bank) move towards monetary easing.

Implications – another extension to the cycle?

These considerations have combined to help fade the inflation/Fed tightening fears of earlier this year with the result that bond yields have been contained and most share markets have been able to recover from their February inflation-scare lows. In some ways it’s more of the same because the whole post global financial crisis (GFC) experience has been one of two or three steps forward towards stronger global growth followed by one or two steps back (with eg the Eurozone debt crisis, the 2015 growth scare and various deflation fears along the way). What we have seen this year is effectively a continuation of that.

By delaying or slowing monetary tightening this has all helped extend the economic and investment cycle. The implications have been:

• A continuation of low returns from cash and low bank deposit rates.

• Yield-sensitive share market listed investments like real estate investment trusts have been able to rebound.

• Unlisted assets like infrastructure and commercial property have continued to benefit from a search for yield by investors.

With global monetary conditions remaining easy and US recession warning indicators still not flashing red (although the yield curve is worth keeping an eye on) our assessment remains that the investment cycle has more upside and that a US recession remains a way off yet. However, the main risks around this relate to the threat of a global trade war should the tariff threat from the US continue to escalate.

But should we still worry about inflation?

However, while the investment cycle has been extended it would be wrong for investors to dismiss the inflation threat – particularly in relation to the US:

• First, while it has taken a long time to get there resulting in numerous deflation scares along the way, spare capacity in the US economy has been mostly used up.

• Second, numerous indicators point to a very tight labour market in the US – with more vacancies than there are unemployed, very high hiring and quits rates, companies nominating finding suitable labour as a bigger problem than weak demand – suggesting that sooner or later wages growth will start to pick up more significantly.

• Third, inflation is well known to be a lagging indicator and it often appears as a problem after the pace of economic growth has peaked.

• Finally, from a longer-term perspective there is a risk that the lessons of the break out in inflation from the late 1960s into the 1970s are being forgotten and that populist politicians will seek to weaken the institution of an independent central bank targeting low inflation. President Trump’s tweets critical of the Fed raising interest rates are concerning in this regard. 

As a result, we remain of the view that (absent a full-blown global trade war) the drip feed of Fed rates hikes will continue well into next year, that the 35 year bull market in bonds that began in the early 1980s is over and that the risks to US and by implication global bond yields into next year are still on the upside. This suggests investors need to be a little more wary of yield-sensitive globally-exposed investments that don’t offer inflation protection (like inflation-linked bonds do and the potential for rising rents do in the case of commercial property and infrastructure) than was the case a few years ago when there was still plenty of spare capacity in the US. Ongoing Fed rate hikes also point to ongoing upwards pressure on the US dollar which in turn suggests that investors should remain cautious in relation to emerging market shares.

The upside risks for bond yields is less in Australia given much higher unemployment and underemployment and that the RBA is likely to remain well behind the US in raising interest rates. With the Fed hiking and the RBA holding, this is all consistent with ongoing downwards pressure on the Australian dollar which we still see falling to around $US0.70, having recently broken below $US0.73.

Source: AMP Capital 14 August 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.

In the rough and tumble of investment markets its very easy to get distracted: by talk of the next best thing that will make you rich, by the ever-present predictions of an imminent crash, by the worry list that constantly surrounds investment markets relating to growth, profits, interest rates, politics, etc.

The investment world is far from neat and predictable. The well known advocate of value investing, Benjamin Graham, coined the term “Mr Market” in 1949 as a metaphor to explain the share market, but it also applies to most other investment markets. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from euphoria to pessimism. Mr Market is highly seductive – sucking investors in during the good times with dreams of riches and spitting them out during the bad times when all hope seems lost.

This is particularly the case at present where noise around President Trump – often set off by a late night tweet – can set off market volatility and where this can be magnified by digital media in which it seems everyone is vying for attention leaving the impression we are in a constant state of crisis and volatility.

To help investors avoid being seduced by Mr Market there are nine key things to bear in mind. I haven’t written on this for a while but here is my list of the nine keys to successful investing.

• Make the most of the power of compound interest. One dollar invested in Australian cash in 1900 would today be worth $236, but if it had been invested in bonds it would be worth $877 and if it was allocated to Australian shares it would be worth $559,281. Although the average annual return on Australian shares (11.8% pa) is just double that on Australian bonds (5.9% pa) over the last 118 years, the magic of compounding higher returns over long periods leads to a substantially higher balance over long periods. Of course the price for the higher returns from shares is higher volatility – evident in rough patches like the Great Depression, 1973-74 after Elvis appeared via satellite from Hawaii to when The Brady Bunch was canned, 1987 and the GFC – but the impact of compounding at a higher long term return is huge over long periods of time. The same applies to other growth related assets such as property. So one of the best ways to build wealth is to take advantage of the power of compound interest and this means making sure you have the right asset mix in your investment strategy. (Speaking of The Brady Bunch – their house in Studio City LA was recently “sold” for over $US2m by the one family who bought it in 1973 for $US61,000. NSYNC bass singer Lance Bass offered “WAY over” the asking price of $US1.9m and was accepted but then got gazumped by a Corporate Buyer (likely a studio) who wanted the house at any price. Assuming the sale price is $US2.1m which is conservative and there was a net rental yield of 3.5% along the way this implies a compound annual return of 11.7%pa!)

Source: Global Financial Data, AMP Capital

• Be aware of the cycle. Investment markets – bonds, shares, property, infrastructure, whatever – constantly go through cyclical phases of good times and bad. Some are short term, such as occasional corrections. Some are medium term, such as those that relate to the 3 to 5 year business cycle. Some are longer, such as the secular swings seen over 10 to 20 year periods in shares. Some are even longer like the 35 odd year bull market in bonds since the early 1980s. But all eventually set up their own reversal. The trouble is that cycles can throw investors out of a well thought out investment strategy that aims to take advantage of long term returns and can cause problems for investors in or close to retirement. But they also create opportunities.

• Invest for the long term. One of the best articles on investing I ever read was by a US investment guy named Charles Ellis in the 1970s who observed that for most of us investing is a loser’s game. A loser’s game is a game where bad play by the loser determines the victor. Amateur tennis is an example, where the trick is to avoid stupid mistakes and win by not losing. The best way for most investors to avoid losing is to invest for the long term. Get a long term plan that suits your level of wealth, age, tolerance of volatility, etc, and stick to it. This may involve a high exposure to shares and property when you are young or have plenty of funds to invest when you are in retirement and still have your day to day needs covered. Alternatively, if you can’t afford to take a long-term approach or can’t tolerate short term volatility then it is worth considering investing in funds that target a particular goal.

• Diversify. Don’t put all your eggs in one basket. A common approach in SMSF funds has been to have one or two high yielding popular shares and a term deposit. This could leave an investor exposed to a very low return or if something goes wrong in the share. Through last decade many Australian investors wondered why hold global shares as Australian shares were doing so well. But this decade global shares have been the place to be reflecting stronger growth and the fall in the $A which enhances the value of offshore investments. Trying to get such swings precisely right can be hard so the trick is to have a diversified mix. But also, don’t over diversify as this will just complicate for no benefit.

• Turn down the noise. After having worked out a strategy thats right for you, it’s important to turn down the noise on the information flow surrounding investment markets and stay focussed. The trouble is that the digital world we now live in is seeing an explosion in information and opinions about economies and investments. But much of this information and opinion is of poor quality. As “bad news sells” there has always been pressure on editors to put the most sensationalised negative news on the front page of newspapers but there was hopefully some balance in the rest of the paper. But in a digital world each story can be tracked via clicks so the pressure to run with sensationalised and often bad news stories has been magnified. Hence click bait and all the talk about fake news. President Trump’s tweets are adding to the noise with markets sometimes jumping in response. He recently tweeted that “Tariffs are the greatest!” only to tweet 12 hours later in relation to the European Union that “I have an idea for them. Both the US and EU drop all tariffs.” Now I kind of get what he is saying and much of his utterances are bluster designed to get what he wants, but such gyrations cause confusion for investors. 

  Of course, economists like to say more is preferred to less but when it comes to information and opinion around investment markets this is not necessarily the case. There is little evidence that the ramped-up news flow is helping investors make better decisions and hence earn better returns. We seem to lurch from worrying about one crisis to another. This year is seeing the usual worry list with worries about: US inflation, Fed tightening, global trade, Trump and the Mueller inquiry, the US mid-term elections, Chinese debt, Italy, the emerging world, increasing tension with Iran, tech stocks, etc. Investing now seems like a daily soap opera – as we go from worrying about one thing after another. This is all leading to heightened uncertainty and shorter investment horizons which in turn can add to the risk that you could be thrown off well thought out investment strategies. The key is to turn down the volume on all the noise. This also means keeping your investment strategy relatively simple. Don’t waste too much time on individual shares or funds as it’s your high-level asset allocation that will mainly drive the return and volatility you will get.

• Buy low, sell high. What you pay for an investment matters a lot in terms of the return you will get. The cheaper you buy an asset (or the higher its yield), the higher its prospective return will likely be and vice versa, all other things being equal of course. So if you do buy or sell try to buy when markets are down and sell when they are up. Unfortunately, many do the opposite which explains the old saying that “flows follow returns”! Inflows to investment funds or markets are strongest after periods of strong returns and outflows are strongest after weak returns’ which is the wrong way around.

• Beware the crowd at extremes. At various points in time the crowd can be right and being in a crowd can feel safe. However, at extremes the crowd is invariably wrong. Whether it’s lemmings running off a cliff, or investors piling into Japanese shares at the end of the 1980s, Asian shares into the mid 1990s, IT stocks in the late 1990s, US housing and dodgy credit in the mid-2000s or most recently with Bitcoin which peaked last December just when everyone was talking about it. The problem with crowds is that eventually everyone who wants to buy will do so and then the only way is down (and vice versa during crowd panics). As Warren Buffet once said the key is to “be fearful when others are greedy and greedy when others are fearful”.

Source: Bloomberg, AMP Capital

• Focus on investments offering sustainable cash flow. Lots of investments have been sold on promises of high returns or low risk but were underpinned by hope based on hot air (eg, many dot com stocks in the 1990s) or financial alchemy (eg sub-prime CDOs). But if it looks dodgy, hard to understand or has to be based on obscure valuation measures to stack up then it’s best to stay away. There is no such thing as a free lunch in investing – if an investment looks too good to be true then it probably is. By contrast, assets that generate sustainable cash flows (profits, rents, interest) and don’t rely on excessive gearing or financial engineering are more likely to deliver.|

• Seek advice. Given the psychological traps we are all susceptible too (like the tendency to over-react to the current state of investment markets) and the fact that it is not easy, a good approach is to seek advice via an investment service or a coach such as a financial adviser, in much the same way you might use a specialist to look after other aspects of your life like the plumbing or your medical needs. As with plumbers and doctors it pays to shop around to find a service or adviser you are comfortable with and can trust. But its worth it in the end. Even I have a financial adviser to help deal with the complexity of investing.

Source: AMP Capital 7 August 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.

Since Donald Trump was elected President back on November 8, 2016 we have focussed on whether we will see Trump the rabble-rousing populist or Trump the business-friendly pragmatist. Despite lots of noise – particularly via Trump’s frequent tweets – for the most part Trump the pragmatist has dominated so far. But we have clearly seen a swing to Trump the populist this year – raising risks for investors.

So far Trump has been good for markets

In the period since his election US shares are up 34%, global shares are up 28% and Australian shares are up 21%. While the strength in share markets would have occurred anyway given stronger global growth, US tax reform, fiscal stimulus and deregulation have clearly helped and contributed to the US share market’s outperformance. While US tax reform and tax cuts have received much focus, the Trump administration’s focus on deregulation is equally as significant with the US under Trump seeing the least amount of new economically significant regulation since the Reagan Administration in the early 1980s.

Source: George Washington University, WSJ, AMP Capital

In terms of tax reform and deregulation the Trump Administration has much in common with Reaganomics.

Populism starting to dominate pragmatism

This year though the balance has shifted towards a greater emphasis on populist policies – notably protectionism and criticism of China, the return to sanctions on Iran and arguably recent criticism of the Fed for raising interest rates and pushing up the US dollar. There are several reasons for this shift in emphasis: the pro-business element of Trump’s policies were mainly completed last year; it’s a mid-term election year so Trump is back in campaign mode; Trump’s approval rating has improved despite this year’s controversial policies suggesting firm support for them from his Republican party base; and the strength of the US economy has also emboldened him. In fact, it could be argued that last year was all about bolstering the US economy ahead of this year’s more controversial policies.

The main risks around President Trump centre around five key issues: the rising risk of a full-blown trade war; the expanding budget deficit; the risk of interference in the Fed; the return of sanctions on Iranian oil exports threatening wider Middle East conflict; and the risk Trump ultimately comes into trouble with the Mueller inquiry. We will now look at each of these in turn.

Rising trade war risks

This issue has been done to death but won’t go away. So far the tariff increases actually implemented amount to just 3% of total US imports. While this has been met with proportional retaliation by other countries it’s a long way from a full-blown global trade war. However, the issue is what happens next. Another $US16bn of Chinese imports will likely be hit with a 25% tariff soon and the US is readying a 10% tariff on another $US200bn. Trump is also threatening to raise tariffs on all $US550bn of Chinese imports. China is threatening to retaliate proportionally although it will have to be with other means as it only imports $US130bn from the US. Trump is also threatening to put tariffs on auto imports and looking at Uranium.

News of a deal between the US and the EU to work towards zero tariffs on industrial goods is good news in terms of heading of a full-blown trade war between the two, but negotiations have a long way to go. There was hope of a deal with China in May – with Trump initially crowing about a May 20 trade deal, but since then both China and the US have dug in with Trump tapping popular support for protectionism and anti-Chinese sentiment. So, the trade threat could get still worse before it gets better which means it risks taking the edge off economic growth. Modelling by Citigroup of a 10% tariff hike by the US, China and Europe showed a 2% hit to global GDP after a year. Of course, we are not seeing a tariff hike on all goods but the impact could still be significant if negotiations with the EU and China fail and all the tariffs being talked about are implemented.
There are a few offsetting factors. First, China is moving to provide stimulus to support growth. Second, much of Trump’s approach still looks designed to apply “maximum pressure” to reach a negotiated outcome – and so far so good in relation to Europe. And Trump knows that the costs to US workers (from soybean farmers to Harley Davidson workers) and consumers will escalate as more tariffs are imposed. So, our base case remains that some form of negotiated solution will be reached, but in relation to China this may not occur until next year.

Interference in the Fed and US dollar

Trump’s recent comments criticising Europe, China and others for helping drive the US dollar up and the Fed for raising interest rates naturally raises concerns that he will intervene in foreign exchange markets and interfere with the Fed. The comments lack economic logic – if “making America great again” means stronger US economic growth then it also means higher US interest rates and a higher US dollar – and maybe the Fed came in for a serve after Fed Chair Powell observed that “countries that have gone in a more protectionist direction have done worse”! Trump’s annoyance may have been triggered by the slide in the value of the Chinese Renminbi. While this looks to be mainly a strong $US story (as the $US is up around 7% against its low earlier this year against a range of currencies compared to an 8% gain against the Renminbi) the Chinese authorities seem quite content to let it fall for now and this will obviously offset Trump’s tariffs on Chinese goods.

Source: Bloomberg, AMP Capital

Despite all this it’s unlikely in the short term that Trump will act on his opinions on rates and the $US. US Treasury Secretary Mnuchin said the administration would “not interfere with the decisions of the Fed or move to manipulate the value of the dollar.” Trump is well known to be a high debt/low interest rate guy so it’s no surprise he is not happy with rising rates. But the Fed answers to Congress, has a mandate to keep inflation down and will do what it sees best – which with strong growth and at target inflation means returning interest rates to more normal levels. However, longer term there is a risk that Trump will weaken the institution of an independent central bank targeting low inflation and may also seek to return to a more interventionist approach regarding the US dollar, particularly if America’s trade deficit refuses to fall. Based on past experience such political intervention would risk much higher inflation which would be a big negative for investment assets as the revaluation that occurred as we moved from high inflation to low inflation would reverse. Fortunately, we are not there yet.

The expanding US budget deficit

It’s been the norm for the US budget deficit to blow out when unemployment rises (as tax revenue falls and jobless claims go up) and decline when unemployment falls. Thanks to Trump’s fiscal stimulus it’s now blowing out when unemployment is collapsing and looks to be on its way to 5% of GDP. This raises three risks. First, it may mean higher than otherwise interest rates and bond yields as the Fed may have to raise rates more than would otherwise be the case to stop the economy overheating and the Government’s competition for funds results in higher bond yields. So far there is not a lot of evidence of this with US bond yields remaining relatively low – presumably held down by low global bond yields and trade war fears – but its still a risk as US inflationary pressures rise.

Source: Bloomberg, AMP Capital

Second and more fundamentally it begs the question of debt sustainability when the next recession arrives given US public debt is already around 100% of US GDP. Finally, US fiscal stimulus by adding to the US savings-investment imbalance is adding to the US trade deficit and so is completely inconsistent with his trade policies. Even if there was a completely level playing field on world trade America will still have a trade deficit!

The return to sanctions on, and tensions with, Iran

Perhaps a big surprise this year for some has been that President Trump looks to have swapped a half decent deal with Iran for a dodgy one with North Korea. While the latter holds out the hope of (maybe) reducing the threat of a nuclear attack on the US, the return to sanctions and tensions with Iran risks higher oil prices. Since the lows of 2015 oil prices have increased by 70% reflecting increased demand and OPEC’s 2016 cutback. Global stockpiles and spare capacity have been rundown and supply from Libya and Venezuela is uncertain. Our base case is that demand growth will be more constrained from here and that a ramp up in US shale oil production will help contain oil prices around $US70-75 a barrel. The risk though is that the loss of around 800,000 barrels a day of Iranian oil exports and the renewed risk of wider conflict in the Middle East associated with Iran (eg, if Iran closes the Strait of Hormuz through which 20% of global oil supply moves in retaliation against US sanctions) results in higher prices.

The Mueller inquiry into Russian links

Our view in relation to the Mueller inquiry remains that unless Trump has done something very wrong the Republican controlled House will not move to impeach him and even if a Democrat controlled House post the mid-terms did, the Senate will not have the necessary two thirds of votes to remove him from office. However, his sensitivity over the issue, along with his comments seemingly favouring Russian President Putin’s word over US security agencies does remind a bit of Nixon in relation to Watergate. So his removal cannot be ruled out. But this would just mean VP Mike Pence would take over with basically the same economic policies (but with less tweet noise) and economic conditions are stronger than in 1974.

Trump tweet noise

The risks around Trump are real and need to be watched carefully. But Trump generates a lot of noise and much of it is contradictory and confusing – in the last week Trump tweeted “Tariffs are the greatest” only to tweet 12 hours later that “I have an idea for them. Both the US and EU drop all tariffs” – and often reflects bluster ahead of negotiations – recall his “fire, fury and frankly power” threat to North Korea. So the best approach for investors in relation to Trump is to turn down the noise.

Source: AMP Capital 26 July 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.