Olivers Insights

Eurozone recovery

Signs abound that the Eurozone has left the crisis behind.

• Thanks to austerity programs and more recently a return to economic growth, budget deficits are coming under control in the main crisis countries, viz, Italy, Spain, Portugal, Ireland and Greece. Spain is a laggard, but the average Budget deficit in these countries will be around 4% of GDP this year, down from 10% plus a few years ago. Greece, Italy and Portugal are on track to run primary budget surpluses (ie the budget excluding interest payments) this year. See the next chart.

   

• The decline in budget deficits in the crisis countries is set to see average gross public debt levels peak this year.

Source: IMF; AMP Capital

• Economic restructuring is starting to bear fruit. One guide is unit labour costs as it reflects both productivity growth and labour costs, so is a guide to competitiveness particularly across countries with a common currency as is the case in the Eurozone. Italy (and France) have been the laggards on the economic reform front with rising unit labour costs, but Spain and Portugal have made significant progress in reducing costs, particularly relative to Germany. See the next chart

Source: OECD; AMP Capital

• Reflecting the return of investor confidence, particularly once it became clear the ECB was not going to allow a break up in the Euro (and so bond holders would get paid back in Euro’s & not devalued new liras, pesos, etc), bond yields in the crisis countries have collapsed to precrisis levels or below. In fact Spanish and Italian 10 year bond yields have fallen to record or near record lows.

Source: Global Financial Data; AMP Capital

• Finally, confidence and business conditions have improved across the Eurozone and this has seen a return to growth. While the next chart has a lot of lines on it the key is that confidence is moving up across the Eurozone including in the crisis countries. In fact, the improvement in Greek confidence levels is quite astounding given where it was a couple of years ago.

Source: Bloomberg, AMP Capital

ECB moves again

However, Europe is not completely out of the woods yet. While confidence and business conditions have picked up nicely, growth remains gradual (at just 0.9% over the year to the March quarter), unemployment has only fallen slightly from its peak of 12% to now 11.7%, inflation is just 0.5% year on year, money supply is growing at just 0.8% year on year and bank lending contracted 1.8% over the year to April. This has led to concerns that the Eurozone might be sliding into a Japanese type scenario of low growth and deflation.

To head off this risk the ECB has unveiled another round of monetary stimulus. While much anticipated, as the ECB had been foreshadowing a move for some time, it did not disappoint. The key measures deployed include cutting its key interest rate to just 0.15%, cutting the rate of interest banks receive on excess deposits at the ECB to -0.10%, an extension of guidance as to how long rates will remain low, an extension of the commitment to supply unlimited short term funds to banks at the 0.15% interest rate, a new long term lending program to banks (called Targeted Long Term Refinancing Operations or TLTRO), an end to the sterilisation of the bonds held in its existing bond buying program (which it calls SMP) and preparation for a program to purchase asset backed securities (which would amount to a US style quantitative easing program). The highlight was probably the TLTRO program which is effectively a “funding for lending” program that will allow banks to borrow to fund their non-mortgage lending at just 0.25% interest for four years.

The latest ECB move is not as momentous as its efforts in 2011 and 2012 (the first LTRO, “whatever it takes” and the Outright Monetary Transactions program that backed it up) that ended the Eurozone crisis. It would also have been better to see a US style quantitative easing program straight away and there are doubts about how successful each of the measures announced by the ECB will individually be.

But the ECB has more than met market expectations as reflected in the 2.3% rally in Eurozone shares and the collapse in bond yields in Spain, Italy and Greece since the announcement. What’s more the scatter gun approach of deploying virtually everything at once adds to confidence that the whole should be worth more than the sum of the parts in terms of its impact on the economy. The ECBs broad based approach also adds to its own credibility and confidence that it is determined to get the economy on to a stronger path.

And the clear impression is that while interest rates have hit bottom it stands ready to do more if needed and this is likely to involve the purchase of private sector asset backed securities. Finally, there are signs that the wind down in bank lending in Europe that has occurred in the run-up to this year’s review of the quality of the banks’ assets and stress tests of their capital, has run its course. If so the ECB’s measures aimed partly at boosting bank lending have a good chance of succeeding.

Implications for Eurozone & global recoveries

The bottom line is that the ECB’s measures – and commitment to do more if needed – add to confidence that the Eurozone economic recovery will pick up pace over the year ahead and that deflation will be avoided. This in turn is good for global growth and since Europe is China’s biggest single export destination, also good news for China, which in turn of course is good news for Australia.

What it means for investors

There are several implications for investors.

First, the determination of the ECB to put Europe on to a stronger growth footing and the easier monetary environment in Europe is positive for Eurozone equities, which remain relatively cheap. The chart below shows a composite valuation measure for European shares that indicates they are still about 2 standard deviations (or about 20%) undervalued.

Source: Bloomberg, AMP Capital

Second, ECB actions are likely to maintain downwards pressure on peripheral country bond yields, but given they are historically low, particularly so given the still high debt levels in such countries, this trade is becoming risky.

Third, the ECBs actions provide further support for the global “carry trade” that involves borrowing cheaply in low yield countries like Europe and putting the proceeds into higher yielding countries and assets. As a result, the chase for yield looks like it has further to run. This is supportive of corporate debt and high dividend paying shares.

Fourth, and related to this, the reinvigoration of the carry trade risks delaying the next leg down in the value of the Australian dollar, as global demand for high yielding investments like those in Australia remains strong. Japanese interest in Australian bonds appears to be returning and Europe is likely to be a source of funding for carry trades. In the short term this could work against the downwards pressure on the $A coming from the weaker terms of trade and the need to rebalance the Australian economy.
Finally, the ECB’s latest monetary easing also provides a reminder that the global monetary policy back drop remains very supportive for growth assets like shares generally.

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

The saga over the budget in particular has been depressing with the 2013 Budget showing a run of deficits worse than those associated with the 1990s recession despite having the biggest boom in our history. And the community reaction to the latest Budget seems to have had the effect of refocusing the debate from the broad based need to reform the economy and get the budget back into surplus to a focus on equality. In other words rather than focusing on growing the national pie, the focus is back to how to divide it up.

The problems Australia faces are trivial compared to those seen in many other countries with more rapidly aging populations and far bigger public debt burdens. Talk of a budget emergency is over the top. But we do need to take our fiscal challenges seriously or else we could end up in the sort of mess several other countries have run into, where when luck ran out and things turned sour the IMF got called in and the choice became cut back or no bailout from the IMF. We are a long way from that but so too was Ireland in 2006 when its net debt to GDP ratio was the same as Australia's today but its boom turned to bust, house prices tumbled, banks had to be bailed out, public debt ballooned and lenders dried up necessitating IMF support.

After the biggest resources boom in our history, Australia’s public finances should be in far better shape. Norway is a good example. Realising that its North Sea oil reserves would not last forever it has been running big budget surpluses and putting the money into a sovereign wealth fund for use when the boom is over. As a result Norway’s net public debt is negative, ie it is owed way more than it owes.

Source: IMF, AMP Capital

I am optimistic we will get Australia and its fiscal finances back into shape, but we need to see much better from all in Canberra than we have seen lately for this to occur.

The Challenges

The structural challenges facing Australia are simple:

• The biggest boom in our history is now fading as lower commodity prices drive lower growth in national income.

• This has seen the boost to the budget from the resources boom go into reverse at a time when we have spent and continue to spend the proceeds whilst the demands on health and pension spending are set to accelerate from the ageing population. At the same time we are embarking on several major expenditure items at once – the National Disability Insurance Scheme, the Gonski education reforms and the new Paid Parental Leave scheme. All of these are desirable, but they are not really all affordable. The NDIS in particular could turn out to be very expensive over time.

• This is all occurring at a time when the boost to productivity growth from the economic reforms of the 1980s and 1990s that lasted into early last decade has faded. This is particularly evident in multifactor productivity (that looks at growth in output per unit of labour and capital), which has gone backwards over the last decade. This didn’t matter when national income was growing strongly through the commodity boom, but with it now slowing it matters a lot if we want to keep growing our living standards.

Source: ABS, AMP Capital

What to do – restart the reform agenda

To get back on track, Australia needs to do several things.

Put the Budget on to a sustainable path towards surplus. To not do so will leave us with little fiscal flexibility come the next downturn and leave us vulnerable should our luck turn against us resulting in extraordinary demands being placed on the Federal Government as occurred in Ireland. The Government’s Budget puts us in the right direction. To minimise the negative impact on confidence and to gain Senate passage some of the harsher aspects of the Budget are likely to require softening.

Reform the tax system. This is a big one. Put simply the current tax system suffers from a number of problems.

• It’s too complex – with over 120 taxes but just 10 of them raising 90% of the revenue.

• There is a heavy reliance on income tax (raising around 50% of revenue) as opposed to sales tax (raising nearly 30% of revenue) and this did not change with the GST. As a result, following the Budget Australia’s effective top marginal tax rate at 49% will be 15th highest globally and the highest in our region, viz NZ 33%, Singapore 20% and Hong Kong 15%. Sydney can forget about becoming a world financial centre – as why would individuals locate here and lose half their extra income? The end result is a disincentive for extra effort, increased demand for tax minimisation strategies and less incentive to save.

• The numerous taxes along with the GST exemptions for fresh food, health and education result in various distortions in the economic system.

Ideally, from an economic perspective the GST needs to be broadened and its rate increased and the proceeds used to fund the removal of numerous nuisance taxes and reduced income tax. Tax reform should occur with the aim of not increasing the overall tax burden on the economy. Once allowance is made for compulsory superannuation contributions in Australia and social security levies in other countries, the tax burden in Australia is already around the OECD country average. Taking it higher would only reduce incentive and Australia’s long term growth potential, as various high tax European countries have found.

Embark on another round of privatisation. Private operators can invariably run businesses better than governments and the proceeds from asset sales can be used to pay down debt and/or recycle into new infrastructure spending. Privatisation of infrastructure assets also provides investment opportunities for Australian superannuation funds. The Federal and Victorian Governments went down this path significantly in the 1990s and there are still significant utility assets in other states that can be privatised.

Boost infrastructure spending. This is essential if we are to boost productivity and income levels. The Federal/state agreement to privatise assets and use the proceeds to invest in infrastructure is a move in the right direction. Queensland has announced a move down this path, but it won’t start till after next year’s election.

Reduce regulation. Excessive regulation is slowing business and investment. The Federal Government looks to be taking this on.

Reduce remaining protection. Industry protection has been substantially reduced but remains significant with various protection measures remaining such as bans on book imports, restrictions on pharmacies and the licensing arrangements of doctors and lawyers. The Government has at least made a start on this front by not chasing various failing businesses lately with blank cheques.

Get our education system producing better outcomes. As various studies have shown our education system is lagging other OECD countries in some areas. But as the debate around the Gonski reforms highlights, fixing it probably requires more funding, a solution to which likely involves greater deregulation, greater private sector involvement and higher fees.

Of course there is much more, but these are the main areas needed to be looked at to boost productivity growth.

What does it mean for investors?

Economic policies can have a significant long term impact on growth and hence asset market returns. Australian shares outperformed global shares significantly last decade. A lot of this owed to the resources boom and our absence of tech stocks which meant the Australian market largely missed the tech wreck. But the boost to productivity and profitability from the economic reforms of the 1980s and 1990s also helped.

Since 2009 though, the relative performance of Australian shares has slipped. While several key global share markets have made new highs including the US share market and just recently global shares generally, the Australian share market remains 20% below its November 2007 high

Source: Bloomberg, AMP Capital

Why the recent underperformance? A combination of factors have played a role including tighter monetary policy, the strong $A, weakness in China, and the fact Australian shares reached a much higher high in 2007. It’s also worth noting that if the reinvestment of dividends is allowed for then Australian shares are above their 2007 high. But the lack of recent growth enhancing reforms and the productivity growth slowdown have likely also played a role in the relative underperformance of Australian shares in recent years.

Concluding comments

Don’t get me wrong. I am not bearish on Australia. The economy can rebalance as the mining investment boom continues to fade – as it has been doing over the last year. But if we want strong sustainable economic growth that underpins a relatively strong performance from Australian asset classes we do need to seriously reinvigorate the economic reform process in Australia. Getting lost in endless debate about how to divide up the national cake or denial about the need to get the budget under control will only take us back to the poor economic performance of the 1970s.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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

The Indian share market has, not surprisingly, taken this very positively having risen 3.5% since the election and being up 15% year to date, making it one of the world’s strongest share markets this year as investors moved to position for a BJP win. But has it gone too far in the short term? What does the change of Government mean over the long term? And what does it mean for commodities and Australian exports?

India's growth potential is very high…

India’s growth potential is well known. Its population is still growing rapidly, unlike say China’s. By 2050 its population will likely exceed that of China. It has a highly educated workforce which has helped fuel growth in its services sector. Its urbanisation rate is low and has the potential to rise much further. Similarly its starting point of low per capita income (about one third of China’s) also means plenty of potential. And being a relatively closed economy it’s not as vulnerable as say Brazil to slower growth in China.

Through much of last decade this potential started to be unleashed as a result of economic reforms of the 1990s that de-regulated the economy and opened it up to investment. As a result the Indian economy performed spectacularly well, with growth averaging nearly 9% per annum over the five years to 2007 and increasing confidence that it was following in China’s footsteps.

…but yet to be fully realised

However, starting late last decade it seemed the wheels started to fall of the Indian economy. As can be seen in the next chart, for the last five years inflation has pushed higher while growth has slowed leading to a significant deterioration in the growth/inflation trade-off.

At the same time, the budget has remained in chronic deficit and is currently 5% of GDP and the current account has also remained in deficit.

Essentially the supply side of the economy did not keep pace with demand resulting in rising inflation and trade imbalances. Perhaps the biggest problem was that the Indian Government, run by the Congress Party, for various reasons failed to continue with the reform agenda in a meaningful way. As a result, privatisation has been slow, protection of domestic industries has been high, its labour market lacks flexibility and business is mired in red tape. It takes more than twice as long to start a business in India than it does in China. Compared to China, India also saves less and invests less in infrastructure.

As a result of its poor recent performance along with its dependence on foreign capital, India only a few months ago was being described as being one of the “Fragile Five” countries along with Turkey, Brazil, South Africa and Indonesia in terms of their vulnerability to the end of quantitative easing in the US.

Another round of reforms

However, the resounding BJP victory means that the reform process will likely get underway again. Narendra Modi’s pro-development track record in Gujarat state where he has been Chief Minister for the last decade has been impressive, resulting in 10% pa growth over the last five years. The BJP and Modi ran their campaign with a pro-business and pro-reform policy agenda, which they now have a mandate to deliver upon. Based in large part on the BJP’s economic agenda, key reforms are likely to include:

• cutting subsidies and price controls;

• implementing the GST;

• increasing infrastructure spending over current spending;

• reducing the budget deficit;

• faster privatisation;

• commencing a high speed rail network;

• boosting urbanisation and low cost housing;

• cutting read tape;

• simplifying labour laws; and

• support for inflation targeting by the central bank.

The BJP led alliance found support from all social classes and regions (with the exception of Muslims) indicating that the electorate is supportive of the reform agenda. These reforms should help to boost India’s average growth rate back up to around 8% pa in the years ahead. That there are some signs of slowing inflation and a stabilisation/revival in growth indicators may mean that the task may be a bit easier in that at least some of the hard work in getting inflation down has already been undertaken by the Reserve Bank of India.

Short term challenges

Of course, Modi and the BJP alliance will face a number of short term challenges worth keeping an eye on:

• First, the BJP alliance does not have a majority in the upper house and support from the states will be required. There are potentially ways around the upper house though using joint sessions, although this will take time. And un-cooperative states will be under pressure as they will lose out to states that go down the reform path.

• Second, there’s a lot to fix.

• Third, past experience with economic reforms indicates that economic conditions can get worse before they get better.

• Finally, there are some concerns that the BJP’s victory will fuel tensions with Muslims. A counter though is that at the end of the day Modi and the BJP are pro-development and pragmatic.

Implications for the world & Australia

A reformed India combined with its large and strongly growing population will put it back on the path to (again) becoming the world’s biggest economy – probably by the end of the current century (but after China gets there first).

Like China, India will become an increasingly important driver of global economic growth, it will add to commodity demand and its abundant cheap labour and cost advantages will see India play an ever increasing role in world trade adding to downwards pressure on global inflation. In terms of commodity demand, the following table highlights the potential. India’s per capita consumption of commodities is a long way behind that of China, let alone developed countries.

India has a long way to go though. Its per capita real GDP is about where China’s was in 2000 and its commodity demand is only around 15% of that of China. So, it’s a long way from being able to fill any gap in commodity demand should China have a short term setback. However, its long term demand for commodities will be large and over time this will provide a strong source of growth for Australian exports. India is now Australia’s 4th largest export market, having risen rapidly from 7th largest in 2007 and 15th in 2001.

What about the Indian share market?

On most metrics the Indian share market is expensive. Its price to earnings ratio and its price to book value ratio is above that in other emerging countries and the world average and its dividend yield is far lower.

A higher return on equity does provide some support for richer valuations, but having risen so rapidly this year to record highs and relative to other markets Indian shares are at risk of a short term set back. This could be triggered by short term uncertainties or setbacks regarding the reform process.

However, with the election ushering in a business friendly reform Government, which should be very positive for long term Indian growth, any short term set back should be seen as a buying opportunity. Over the long term Indian shares are likely to be relative outperformers globally.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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

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Key budget measures

Many of the measures announced in the budget come as no surprise. The key savings measures are as follows:

• a tightening in eligibility for family tax benefits (FTB), eg the income threshold for FTB-B reduced to $100,000 from $150,000 and to end when the youngest child is six;

• pensions to be indexed to inflation not wages, a pause in eligibility thresholds;

• a further increase in the pension age to 70 by 2035;

• a $7 co-payment for GP visits;

• a further 16,500 public sector jobs to go and the merging or elimination of numerous government agencies;

• the resumption of fuel excise indexation from August;

• a 2 percentage point increase in the top marginal tax rate which kicks in at $180,000 for three years;

• reintroduction of the work for the dole scheme;

• moves to increase the cost of higher education;

• the increase in the Superannuation Guarantee beyond 9.5% delayed till 2018; and

• reduced foreign aid spending.

There are several sweeteners though, eg using asset sales to fund infrastructure spending, the start of a new paid parental leave (PPL) scheme, funding for medical research, the planned abolition of the mining and carbon taxes, and a 1.5% cut to corporate tax next year to offset the PPL levy.

The budget bottom line

Beyond the projections for the current financial year (which look a bit too pessimistic), the budget deficit projections now look much healthier than those seen in MYEFO, with the budget deficit for 2014-15 now projected to be $30bn, down from $34bn in MYEFO.

Interestingly, despite all the talk of a tough budget, the actual additional policy tightening for 2014-15 is just 0.1% of GDP, but as the spending cuts build the impact rises to 0.6% of GDP by 2016-17 rising dramatically beyond that. See the red rows. Reflecting this, the turnaround in the 2017-18 deficit from 1.5% of GDP to now just 0.2% is substantial. The end result is that the budget is now projected to be in surplus by 2019-20 (versus deficits indefinitely in MYEFO).

Source: Australian Treasury, AMP Capital

Relative to MYEFO, the improvement initially reflects increased revenue and lower spending, but from 2018-19 owes mainly to spending (as savings build, the income tax hikes end and fiscal drag is assumed to be handed back).

Source: Australian Treasury, AMP Capital

Economic assumptions

The major economic assumptions underpinning the Budget are shown in the next table.

There is only fine tuning since the MYEFO forecasts and nominal GDP growth is projected to remain soft as the terms of trade weakens. We continue to think that the 2014-15 growth assumptions are a bit too pessimistic and they remain below the RBA’s 2.75% mid-point forecast. This partly explains why we are a bit more optimistic on unemployment.

Assessment and risks

Australia does not really have a ’budget emergency‘: the budget deficit has not come anywhere near the 10% of GDP plus levels that sparked concern in the US, parts of Europe and Japan. Net public debt at 16% of GDP is a fraction of what it is in the US (82%), the Eurozone (73%) and Japan (137%); ratings agencies are not downgrading our AAA rating and bond yields remain low.

Source: IMF, AMP Capital

That said, the budget is always about balance and Australia does have a budget problem. After the biggest boom in our history, the budget should be in far better shape. Comparing ourselves to a bad bunch is not necessarily wise. In 2006 Ireland’s net public debt was close to where Australia’s is now and yet it skyrocketed when its boom turned to bust. Given our (albeit shorter) resources boom but 20 plus years with no recession we should be much closer to Norway which is running huge surpluses and negative net public debt (-205% of GDP). This was a major and valid criticism of the last few years’ budgets.

Against this backdrop, the 2014-15 Budget is a step in the right direction with the measures put in place to control spending growth over the medium to long term likely to put it on to a sustainable path. The Budget also gets a tick in terms of its focus on boosting infrastructure, reducing public sector duplication and renewed privatisation – all of which should help boost productivity over the long term.

There are three main risks though. First, the tax hikes and welfare cutbacks could drag on consumer spending. Fortunately, the Government has not front-loaded its savings and partly offset them initially by infrastructure spending.

Second, taking the top marginal tax rate to 49% (which will put it as the world’s 15^th highest and way above our neighbours, eg NZ 33%, Singapore 20%, HK 15%) is a backward step in terms of incentive and trying to discourage tax minimisation efforts. However, I have sympathy with the fairness rationale (although there would have been better alternatives such as reducing the capital gains tax discount).

Finally, there is a big risk that many of the budget measures will not pass through the Senate.

Implications for interest rates

While the fiscal tightening in the year ahead is less than feared at about 0.1% of GDP, it comes on top of 0.3% of tightening already in train from the previous Government (mainly the 0.5% NDIS levy). In addition, the scaling back of welfare access and the public sector could negatively impact confidence. So while we still see the RBA raising interest rates around September/October, there is some risk that rate hikes may be delayed into next year.

Implications for Australian assets

Cash and term deposits – the ongoing fiscal tightening means that interest rates will remain pretty low (even when they do eventually start to rise). Expect term deposit rates to remain at 4% or below in the months ahead.

Bonds – the measures to bring spending under control and provide confidence the budget will be returned to surplus will help ensure Australia’s AAA rating remains secure. This, plus additional fiscal tightening, albeit spread over time, and the risk rate hikes will be delayed till next year should help ensure bond yields remain low. But with five year bond yields at 3.2% it’s hard to see great returns from Australian sovereign bonds over the next few years.

Shares – the fiscal austerity in the Budget is only a minor headwind for profits. And against this, the increase in infrastructure spending, the reform inherent in public sector downsizing and privatisation and putting the budget on a sounder footing are long term positives and the Budget will help keep interest rates down. Overall, its impact is unlikely to be huge. Construction and building material stocks are likely to benefit, whereas it’s a slight drag for retailers.

Property – property prices are likely to continue gaining on the back of low interest rates, although momentum may slow a bit from last year’s surge in Sydney and Melbourne.

The $A – the announcements in the Budget alone are not radical enough to have much of an impact on the Australian dollar. Affirmation of the AAA rating is a positive while the dampening impact on long term growth from fiscal austerity is a drag. Not much in it really though. With the commodity price boom fading, the interest rate differential in favour of Australia having fallen and the Australian dollar overvalued on a purchasing power parity basis, the trend in the Australian dollar is likely to remain down. 

Concluding comments

The 2014-15 Budget goes a fair way to getting the budget heading back towards surplus without going overboard with fiscal austerity for the next financial year. Better to start down the path though before any crisis hits, so when it does we will have greater fiscal flexibility.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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

Why were interest rates cut to zero?

By way of background, it’s first worth thinking about how we got here. Put simply it was just part of the cycle: growth weakened and so monetary conditions were eased. But of course the GFC related slump in the US and most developed countries was deeper than normal downturns with companies and households more focused on reducing debt. So once interest rates hit zero and it was apparent the recovery was still sub-par, the focus shifted to measures to boost the supply of money. This became known as quantitative easing (QE) and involved the Fed printing money and using this to buy government bonds and mortgage backed debt. It helps growth by reducing borrowing costs, injecting cash into the economy, forcing investors to take on more risks, and to the extent it drives shares higher, it helps build wealth that helps spending.

Is the US economy on the mend?

The short answer is yes. A range of indicators suggest that the headwinds to growth in the US have abated and the economy is now on a sounder footing:

• companies and businesses look to have stopped trying to reduce their debt;

• bank lending growth is trending higher;

• house prices have been recovering and housing construction has picked up;

• consumer spending has picked up;

• business investment looks stronger;

• business conditions indicators (often called PMIs) are running around levels consistent with solid growth; and

• the level of employment is nearly back to its early 2008 high and unemployment has fallen to 6.3%.

Source: Bloomberg, AMP Capital

In particular, a range of indicators for confidence, jobs, durable goods orders, etc, suggest that growth is picking up after a winter soft patch. Finally, while inflation remains very low at 1.5%, it appears to be bottoming.

When will QE end & what happens after that?

The continuing improvement in the US economy suggests that the Fed will keep tapering its QE program by $US10bn a month at its six weekly meeting. QE3 started at $US85bn a month in bond purchases in late 2012 and following the start of tapering in December last year has now been cut to $US45bn a month. At the current rate it will have fallen to just $US5bn in October and to zero at the December meeting. In other words it’s on track to end late this year.

After QE has ended the next step would be for the Fed to actually start tightening monetary policy. This could come in the form of reversing its QE program (ie unwinding the bonds it holds) or raising interest rates or a combination of the two. Raising interest rates is simple, but unwinding its bond holding is a bit more complicated. It could do this by: not replacing the bonds as they mature – ie the Fed gets paid back just like any bond investor; or actively selling them back into the market. I suspect more of a reliance on the former as it’s less disruptive but of course it may take 5 to 10 years.

How long before the Fed raises interest rates?

While US economic growth looks to be picking up, US interest rate hikes are still probably 12 months or so away:

• Growth is still far from booming.

• Spare capacity remains significant with a wide output gap, ie the difference between actual and potential GDP. See the next chart.

Source: Bloomberg, AMP Capital

• While the unemployment rate has fallen to 6.3%, the labour market is a long way from being back to normal. A slump in labour force participation has exaggerated the fall in the unemployment rate. While much of this is structural, some is cyclical and at some point will bounce back slowing the fall in unemployment. Labour force underutilisation, which includes unemployment and those who want to work longer, at 12.3% is well above its average of 8.8% when the Fed was last raising rates

• Wages growth is up from its 2009 low, but it remains very weak currently running at just 1.8% year on year.

Source: Thomson Reuters, AMP Capital

What about the impact on the share market?

Just like talk of tapering upset shares around the middle of last year, so too a move towards the first monetary tightening could cause a similar upset. However, beyond a short term upset, when the initial monetary tightening comes it is unlikely to be a huge problem for shares.

First, the historical experience tells us the start of a monetary tightening cycle is not necessarily bad for shares. The next table shows US shares around the first rate hikes in the past 8 Fed tightening cycles. The initial reaction after 3 months is mixed with shares up half the time and down half the time. But after 12 and 24 months a positive response dominates.

Source: Thomson Reuters, AMP Capital

The reason for this lies in the improvement in growth and profits that normally accompanies an initial monetary tightening. It’s only later in the cycle when rates interest rise to onerous levels to quell inflation that it’s a worry. At this point short term interest rates have invariably pushed above long term bond yields. Right now we are a long way from that.

Secondly, the rally in shares over the last five years is not just due to easy money. Easy money has helped, but the rally has been underpinned by record profit levels in the US.

Source: Bloomberg, AMP Capital

Finally, shares are likely to benefit from long term cash flows as the mountain of money that has gone into bond funds since 2008 continues to gradually reverse.

So while talk of Fed rate hikes and their eventual reality could cause a correction as bond yields rise, they are unlikely to be enough to cause a major share market slump.

What about other economies?

The global economy is far from a synchronised cycle regarding interest rates. While the US is gradually heading towards monetary tightening, the rest of the world is different:

• The Eurozone may still require further monetary easing as bank lending and inflation remains extremely low;

• Japan is in a similar situation with the April sales tax hike having disrupted growth and a stalling in the decline of the Yen threatening progress towards the Bank of Japan’s inflation objective;

• Many parts of the emerging world have already been through a tightening cycle which has seen a cooling in growth and so could see an eventual monetary easing over the next 12-18 months.

In other words, global monetary conditions are likely to remain relatively easy for some time.

What about Australia?

For Australia, an eventual move towards monetary tightening in the US may come as a relief as it will help remove upwards pressure on the $A, allowing it to fall towards $US0.80 which we judge to be necessary to deal with Australia’s relatively high cost base.

Concluding comments

With the US economy recovering from its winter slumber the next big issue for investors may well be when the Fed will start to raise interest rates. While this could contribute to a significant correction, even when US interest rates do start to rise we are a long way away from tight monetary conditions that will seriously threaten the cyclical rally in shares.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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

Aim

“How many millionaires do you know who have become wealthy by investing in savings accounts?” Robert G Allen

Cash and bank deposits are low risk and fine for near term spending requirements and emergency funds but they won’t build wealth over long periods of time. The chart below shows the value of $1 invested in various assets since 1900. Despite periodic setbacks (see the arrows) shares and other growth assets provide much higher returns over the long term than cash and bank deposits.

Source: Global Financial Data, AMP Capital

“The aim is to make money, not to be right.” Ned Davis

There is a big difference between the two. But many let their blind faith in a strongly held view (eg “the US borrows too much”, “aging populations will destroy share returns”, “global oil production will soon peak”, “the IT revolution means this time it’s different”) drive their decisions. They could be right at some point, but end up losing a lot of money in the interim.

Process

“I buy on the assumption they could close the market the next day and not reopen it for five years” and “Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.” Warren Buffet

Unless you really want to put a lot of time into trading, it’s advisable to only invest in assets you would be comfortable holding for the long term. This is less risky than constantly tinkering in response to predictions of short term changes in value and all the noise around investment markets.

“Investing should be like watching paint dry or watching grass grow. If you want excitement…go to Las Vegas.” Paul Samuelson

Investing is not the same as gambling, and requires a much longer time frame to payoff.

“Successful investing professionals are disciplined and consistent and they think a great deal about what they do and how they do it.” Benjamin Graham

Having a disciplined investment process and consistently applying is critical for investors if they wish to actively manage their investments successfully in the short term.

“Never invest in a business you can’t understand” and “Beware geeks bearing formulas.” Warren Buffett

Many lost a fortune through the GFC in investments that were not understandable and involved excessive complexity.

The market

“Remember that the stock market is a manic depressive.” Warren Buffett

Rules of logic often don’t apply in investment markets. The well-known advocate of value investing, Benjamin Graham, coined the term “Mr Market” (in 1949) as a metaphor to explain the share market. 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. But not only is Mr Market highly unstable, he is also 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. Investors need to recognise this.

“Markets can remain irrational longer than you can remain solvent.” John Maynard Keynes

A key is to respect the market and recognise that it can be fickle rather than try and take big bets that can send you bust if you get the timing wrong. Eg, by heavily selling shares short if you think a crash is about to happen or gearing in too heavily via margin debt. Such approaches can often undo investors and send them bust as they are too dependent on accurately timing the market.

“Unless you can watch your stock holding decline by 50% without becoming panic stricken, you should not be in the stock market.” Warren Buffett

Recessions and bear markets are a normal aspect of investing. But history tells us markets eventually recover. The worst thing an investor can do is get in during good times only to get out after a bear market & miss the recovery.

Cycles and contrarian investing

“Bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria.” John Templeton

This is one of the best characterisations of how the investment cycle unfolds. It follows that the point of maximum opportunity is around the time most are pessimistic and bearish and the point of maximum risk is when all are euphoric, but unfortunately many don’t realise this because it involves going against the crowd. 

“The four most dangerous words in investing are: ‘this time it’s different’.” John Templeton

History tells us that that there are good times and bad and assuming that either will persist indefinitely is a big mistake. Whenever you hear talk of “new paradigms”, “new eras”, “new normals” or “new whatevers” it’s usually getting time for the cycle to go in the other direction.

“History doesn’t repeat but it rhymes.” Often attributed to Mark Twain (although I am not sure he actually said it)

No two cycles are the same but they do have common elements which make them rhyme. In upswings investment markets are pushed to the point where the relevant asset has become overvalued, over loved (in that everyone is on board) and over bought and vice versa in downturns. Recognising these common elements is necessary if you are to get a handle on cyclical swings in investment markets.

“If it’s obvious, it’s obviously wrong.” Joe Granville

This doesn’t apply to everything (eg if it is obviously sunny outside according to the usual definition, then it is!), but investing can be perverse. When everyone is saying “it’s obvious that the recession will continue” or “it’s impossible to see a recession as things are obviously good” then maybe the crowd is already on board and the cycle will soon turn.

“I will tell you how to become rich…Be fearful when others are greedy. Be greedy when others are fearful.” Warren Buffett

This is another quote on contrarian investing that follows on from those above.

“Sell in May and go away, buy again on St Leger’s Day.” Anon

Shares have long been observed to have a seasonal pattern that sees strength from November through to May and then relative weakness through to around October. This is evident in the next chart for US and Australian shares. (St Leger’s Day in terms of the UK horse race on the second Saturday in September may be a bit early, but not to worry!)

Source: Thomson Reuters, AMP Capital

Pessimism

“To be an investor you must be a believer in a better tomorrow.” Benjamin Graham

This is a pre-requisite. If you don’t believe the bank will look after your term deposits, that most borrowers will pay back their debts, that most companies will see rising profits over time, that properties will earn rents etc then there is no point investing. This is flippant but true – to be a successful investor you need a favourable view of the future.

“More money has been lost trying to anticipate and protect from corrections than actually in them.” Peter Lynch

Preserving capital is important, but this can be taken too far and often is in the aftermath of bad times with the result that investors end up so focused on trying to avoid capital losses in share markets that they miss the returns they offer.

“I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.” J.S. Mill

It invariably seems that higher regard is had for pessimists predicting disaster than optimists seeing better times. As JK Galbraith once observed “we all agree that pessimism is a mark of a superior intellect.” And we all know that bad news sells. There may be a neurological reason for this as the human brain evolved in the Pleistocene era when the key was to dodge woolly mammoths and sabre tooth tigers, so it has been hard wired to always be on guard and so naturally attracted to doom sayers. But for investors, giving too much attention to pessimists doesn’t pay long term.

Risk

“There is nothing riskier than the widespread perception that there is no risk.” Howard Marks (I think)

Many like to measure risk by looking at measures of volatility, but the riskiest time in markets is invariably when the common view is that there is no risk for it’s often around this point that everyone who wants to invest has already done so leaving the market vulnerable to bad news.

Debt

“It’s not what you own that will send you bust but what you owe.” Anon

Always make sure that you don’t take on so much debt that it may force you to sell all your investments and potentially send you bust, just at the time you should be buying.

Self-perception

“The investor’s chief problem and even his worst enemy is likely to be himself.” Benjamin Graham

This may sound perverse as surely it is events which drive investment markets down and destroy value. But the trouble is that events and bear markets are normal. Rather what causes the greatest damage is our reaction to events – selling after markets have already plunged and only buying back in after euphoria has returned. Smart investors have an awareness of their psychological weaknesses and their tolerance for risk and seem to manage them.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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