Sub Heading

Author: Provision Wealth

Inflation – why it matters for investment markets

Date: Jun 11th, 2021

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

Key points

  • The shift from high inflation to low inflation has been a key tailwind for investment returns over the last 40 years – in particular it has allowed capital growth in excess of growth in earnings and rents.

  • A long-term stabilisation in inflation around central bank targets which is our base case would remove this tailwind but still allow reasonable returns, whereas a sustained break higher in inflation (beyond the current likely transient inflation spike) could start to reverse it.

Introduction

There has been much concern about inflation this year – but why should it matter for growth assets like shares and property? Surely earnings and rents will just go up with higher inflation offsetting any negative impact from higher interest rates due to higher inflation? In reality, it’s more complicated. Our note two weeks ago had a look at the outlook for inflation – why the current spike should prove transitory, but more broadly why the long-term decline in inflation over the last 40 years or so may be over. This note takes a closer look at the impact of inflation on growth assets like shares and property.

What drives investment returns?

In considering the impact of inflation on investment returns the best place to start is a consideration of what makes up returns. The percentage return on an asset is driven by its income flow (or yield) and capital growth – which can be broken down into growth in earnings or rents and changes in valuations. So:

Return = Income Yield Earnings Grth Change in Valuation

The first two components are fairly obvious and less interesting:

  • The income yield is simply the flow of income the asset produces – whether its dividends in the case of shares or rent from property. It tends to be relatively stable over time.

  • The second is the rate of growth in the investment’s earnings (or rents in the case of property). 

  • The third component is the portion of return due to changes in valuation which is basically where the asset’s price rises by more or less than earnings growth, resulting in rising or falling price to earnings multiples in the case of shares.

Cash & government bonds and inflation

For cash and bank deposits the income yield (or interest rate) is what matters and to the extent that higher inflation leads to higher interest rates investors in these assets can be protected. However, just note that interest rates tend to lag big moves in inflation so in the mid-1970s interest rates rose but not as quickly as inflation (as central banks and investors took time to realise that inflation would stay high) meaning investors went backwards in real terms. They only got ahead when rates overshot in the early 1980s and then inflation fell.

Australian bank interest rates, bond yields and inflation

Source: RBA, Bloomberg, AMP Capital

For investors in government bonds there is no earnings growth and they suffer a capital loss when yields rise with inflation (ie, the change in valuation component goes negative). Ultimately, bond investors benefit from higher yields once they roll over their investments into the higher yields but in the interim, they are not protected. Inflation linked bonds paying a yield linked to inflation are the best protection for bond investors.

Changes in PEs have a big impact on share returns

For shares and other growth assets a big driver of the impact of changes in inflation comes through changes in the price to earnings ratio (or price to rent ratios for property). Price to earnings multiples can be volatile in the short term as the share market anticipates swings in earnings and due to changes in sentiment. But they can also be subject to longer-term or secular swings. The next chart shows the contribution to rolling 10-year share market returns in the US from dividends, earnings and changes to valuations (or PEs).

US shares – contribution to total sharemarket return

Source: Bloomberg, AMP Capital

And here it is for Australia, albeit for a shorter period as the PE series for Australia does not go back as far as in the US.

Australian shares – contribution to total sharemarket return

Source: Bloomberg, AMP Capital

The change in valuations or PEs (the green portion) was a big boost for US share market returns in the 1960s (as PEs rose), then it became a big drag in the 1970s (with virtually all of the return contribution from earnings offset by falling PEs), but became a big positive (often running at 5% pa or more) from the early 1980s into the 2000s and even recently (with PEs rising). Several factors impacted this including the optimism of the go-go years of the late 1960s, the supply side revolution of the 1980s and the 1990s tech boom which were positive for PEs. But a big driver was the swing in inflation from low in the 1960s to high in the 1970s (which pushed PEs down), to then low again from the 1980s (which pushed PEs up).

Inflation and PEs

The next chart shows the long-term relationship between US inflation and the US price to earnings ratio. The PE tends to fall as inflation moves up (as occurred in the 1970s) and it rises when inflation falls (as has occurred over the period since the early 1980s), although it’s less clear once inflation falls into deflation. Oddly enough it seems the market’s preferred inflation rate is the same as the Fed’s, ie, about 2%!

US shares – Low inflation = higher PEs

Source: Bloomberg, AMP Capital

The next chart shows the same relationship for Australia although it only goes back to 1962 as our PE data does not go back as far.

Australian shares – Low inflation = higher PEs

Source: ASX, Bloomberg, AMP Capital

There are three drivers of the inverse relationship between PEs and inflation:

  • First, low inflation means lower interest rates which boosts the value of future profits and dividends making shares more attractive. Or put simply lower inflation and interest rates boosts the attractiveness of higher yielding assets so investors switch into those assets which pushes up their price relative to their earnings, dividends or rents and so their yield goes down.

  • Second, low inflation means reduced economic volatility and uncertainty, hence investors are prepared to price shares on higher price to earnings multiples.

  • Finally, low inflation means improved quality of earnings as firms tend to understate depreciation when inflation is high and so overstate actual earnings. So again, investors are prepared to pay more for shares when inflation is low.

Of course, if inflation becomes deflation it can be bad to the extent its associated with economic contraction. But assuming deflation is avoided the bottom line is that a shift from high inflation to low inflation drives PEs higher (and yields lower), and vice versa for a shift from low inflation back to high inflation.

The bottom line

The bottom line is that share market returns have been boosted since the early 1980s as PE multiples rose (or earnings yields fell) on the back of the downtrend in inflation over the last 40 years. This phenomenon has also boosted returns from other growth assets like property, which have also seen a significant rise in prices relative to rents as evident in a sharp fall in rental yields as can be seen below – notably for residential property.

Australian investment yields have all fallen with low inflation

Source: REIA, JLL, Bloomberg, AMP Capital

So, if inflation rises sharply in the years ahead this could start to reverse the boost to returns from growth assets seen since the early 1980s as investors demand lower price to earnings and lower price to rents ratios (or higher yields).

Inflation is likely to rise further in the next few months, which could push bond yields higher and threaten share valuations (particularly high PE stocks, like tech), but with the rise in inflation being driven by base effects and bottlenecks associated with the pandemic and reopening this should be transitory. However, in a longer-term context we are likely now seeing the bottoming in inflation & long-term bond yields after a 40-year downtrend. This will mean that the tailwind which has helped propel growth assets higher – as lower inflation drove ever lower yields and higher PEs which in turn meant higher returns than would be implied by increases in earnings and rents alone – will start to fade, resulting in returns more constrained to underlying yields and earnings/rental growth. Inflation around central bank targets is the best scenario as it would still mean low inflation – but less risk of deflation & likely higher wages growth and investment returns would still be ok. The risk would be if inflation gets out of control again on a sustained basis, then the valuation boost from low inflation will be reversed, resulting in poor returns from growth assets. This is not our base case given central banks are still focussed on inflation targets and technological innovation will impose some brake on inflation, but it’s a risk.

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

The Australian economic recovery remained strong in the March quarter with GDP up 1.8%

Date: Jun 03rd, 2021

– here are seven reasons for optimism

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

Key points

  • With growth of 1.8% in the March quarter, Australian GDP is now back above its pre pandemic level.

  • While uncertainties remain – including around the latest coronavirus outbreak in Victoria – there are seven reasons for optimism that the recovery will continue at a decent rate: vaccines; global growth is ramping up; consumer spending is well supported; dwelling investment is likely to remain strong; business investment is strengthening; fiscal stimulus is continuing; and monetary policy remains ultra-easy.

Introduction

After a far stronger than expected rebound from the national pandemic lockdown through the second half of last year, Australian growth slowed a bit in the March quarter but is now above its pre pandemic level. This note looks at the outlook.

The recovery has slowed but continues

The March quarter saw GDP growth slow but to a still very strong 1.8% quarter on quarter. The gain was driven by a 1.2% rise in consumer spending with a rotation back to services spending (up 2.4%) offsetting a fall back to more normal goods spending (down 0.5%), a 6.4% rise in dwelling investment, a 3.6% gain in business investment and a 0.8 percentage point contribution from inventories offsetting a detraction from trade.

Australian real GDP growth

Source: ABS, AMP Capital

This saw growth up 1.1% on a year ago and GDP has now made it 0.8% above its pre pandemic high in December quarter 2019. As can be seen in the next chart, the economy has effectively traced out a Deep V style rebound. With growth averaging over 3% over the September and December quarters some slowing in the pace of recovery was inevitable as the easy gains from economic reopening are behind us. What’s more, various snap lockdowns across most states impacted over the last quarter. With the reopening gains behind us, the Victorian snap lockdown and potentially others impacting this quarter and some sectors remaining slower to recover – notably travel and higher education given closed international borders – the pace of growth is likely to slow further over the year ahead.

Australian real GDP level

Source: ABS, AMP Capital

The ongoing hit to immigration means it will take longer for Australia to regain its pre-virus trend compared to other countries that normally have relatively lower immigration levels.

Australia has performed relatively well

That said, Australia has performed comparatively well through the pandemic. While China is ahead, Australia is one of the few developed countries with GDP back above pre pandemic levels.

March qtr real GDP, % from pre-CPVID levels

Source: OECD, ABS, AMP Capital

This reflects a combination of better control of coronavirus – which meant lower hospitalisations and deaths, less severe lockdowns and less self-regulation limiting mobility – and a good well-targeted policy response that protected incomes, jobs and businesses. Countries with less coronavirus related deaths like Australia have had better GDP outcomes.

Real GDP growth, % from pre-COVID levels v COVID-19 deaths per million people

Source: ourworldindata, OECD, ABS, AMP Capital

Seven reasons for optimism on Australian growth

Our Australian Economic Activity Tracker – based on weekly data – has continued to trend higher into this quarter and remains strong relative to our US and European Trackers.

Economic Activity Trackers: Australia, Europe & US

Source: AMP Capital

Uncertainties remain: Australia is vulnerable to new coronavirus outbreaks given the low level of vaccination (just 17% versus 51% in the US and 59% in the UK) as highlighted by the problems in Victoria; some parts of the economy are a long way from normal; and tensions with China could escalate further. However, there are seven reasons for optimism that recovery will continue at a decent rate.

  • First, the vaccines will help in underpinning reopening and recovery – they work in protecting against coronavirus infection and severe illness (as evident in Israel, the UK and US), global vaccine production is ramping up with plentiful global supply likely in the next 6-9 months and Australia appears to be speeding up its vaccine rollout with the events in Victoria helping to spur it on. We are assuming the Victorian lockdown will be successful in heading off a bigger problem and so will be relatively brief. But the uncertainty around outbreaks will diminish as vaccination ramps up.

  • Second, global growth is recovering rapidly – driven by vaccines enabling reopening, monetary and fiscal stimulus, and pent-up demand. This is driving strong growth in demand for Australian exports and high commodity prices.

Global Composite PMI vs World GDP

Source: Bloomberg, AMP Capital

  • Third, growth in consumer spending is well supported – by high levels of consumer confidence, a still high saving rate of 11.6%, excess bank deposits of over $200bn (spread across the household and corporate sectors) relative to what would have occurred in the absence of the pandemic, positive wealth effects from the rise in the share market and house prices, ultra-low interest rates and further to go for services spending to recover.

  • Fourth, dwelling investment will provide a strong contribution to growth – the surge in building approvals points to more upside in housing construction this year.

Building approvals v new dwelling investment

Source: ABS, AMP Capital

  • Fifth, business investment is strengthening – investment plans for the next financial year are up nearly 15% on plans for a year ago which is consistent with high levels of business confidence, excess corporate cash and the instant asset write-off tax break. Adjusting business intentions for the past average gap between intentions and actual outcomes points to investment growth of around 20% in the next financial year with mining investment the strongest but manufacturing and other industries also strong.

Actual and expected capital expenditure

Source: ABS, AMP Capital

  • Sixth, fiscal stimulus continues – Australia has successfully negotiated the so-called fiscal cliff with the wind down of JobKeeper and other supports, and fiscal stimulus looks set to continue for now including extra stimulus in the May Budget.

  • Finally, monetary policy remains ultra-easy – while the RBA is likely to cut its quantitative easing in the next 6 months, rates are likely to remain around zero for the next few years.

Concluding comment

We expect GDP growth through this year of 5% and 3.5% next year. This in turn should underpin an ongoing rebound in corporate profits which, along with continuing low interest rates, will underpin a still rising trend in the Australian share market – notwithstanding the risk of a correction in the next few months. Key risks to keep an eye on are: coronavirus outbreaks; a likely further near term inflation scare; and tensions with China.

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

The 2021-22 Australian Budget – spending the growth windfall to further grow the economy towards full employment

Date: May 12th, 2021

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

Key points

  • The Government now expects the Federal budget deficit to peak at $161bn this financial year (down from $214bn in October’s Budget) and fall to $107bn in 2021-22.

  • The windfall to the budget from stronger growth is being spent on extra stimulus. Return to budget surplus looks more than a decade away.

  • Key measures include more spending on aged care, childcare, infrastructure, investment tax breaks and more help for home buyers.

  • Avoiding fiscal austerity and focussing on growing the economy is the right thing to do at present.

Introduction

The 2021-22 Budget sees the Government ditch its plan to start budget repair (or austerity) once unemployment is “comfortably below 6%” in favour of continuing to focus on growing the economy to drive full employment and, in doing so, repair the budget that way. As a result, the Budget provides more stimulus and, thanks to the stronger economic recovery and high iron ore prices, is still able to report a declining deficit. This may seem like having your cake and eating it too – but it was also a feature of the budgets in the pre-GFC years and makes sense as reverting to austerity would delay the return to full employment and decent wages growth.

Policy stimulus

The key Budget measures are:

  • $17.7bn in aged care spending over 5 years;

  • an extra $1.7bn over four years on child-care subsidies;

  • more spending on disability, mental health & preschools;

  • $15bn added to the $110bn 10-year infrastructure program;

  • $1.2bn to support the digital economy;

  • measures to help boost women’s economic security including removing the $450 per month super threshold;

  • more assistance for home buyers via deposit schemes with a Family Home Guarantee to help 10,000 single parents buy their own home with just a 2% deposit, another 10,000 places under the New Home Guarantee in addition to the next 10,000 in the First Home Loan Deposit Scheme which allow first home buyers to get it in with a 5% deposit;

  • the maximum amount of voluntary contributions under the First Home Super Saver Scheme that can be released is increased from $30,000 to $50,000;

  • the age at which people can downsize their family home and contribute $300,000 to their super will be reduced to 60 from 65 and the work test for super contributions is abolished;

  • an extension of the Low and Middle Income Tax Offset (LMITO) to cover the next financial year; and

  • instant expensing for business investment & ability to offset losses against prior profits extended to 30 June 2023.

Total direct stimulus to the economy since pre-covid (both spent and projected to be spent) is now around $350bn.

Economic assumptions

Reflecting the faster recovery, the Government has revised up its growth forecasts with 2021-22 GDP growth forecast to be 4.25% (up from 3.5% in MYEFO) and unemployment falling to 4.75% by June 2023 (down from 6%). Inflation and wages forecasts have also been revised up a bit. We (and the RBA) are a bit more optimistic on growth. The hit to immigration (estimated to be -97,000 persons in 2020-21 and -77,000 in 2021-22 before 75,000 in 2022-23 and a gradual recovery to normal at 235,000 by 2024-25) remains a big constraint on medium term growth. Population growth this financial year will be just 0.1%, the lowest since 1917. The Government pushed out its $US55/tonne iron ore price assumption again to now March quarter 2022. With the iron ore now over $US200/tonne this remains a source of upside for budget revenue.

Economic assumptions

 

 

2020-21

2021-22

2022-23

2023-24

Real GDP

Govt

1.25

4.25

2.5

2.25

% year

AMP

1.1

5.0

3.0

2.5

Inflation

Govt

3.5

1.75

2.25

2.5

% to June

AMP

3.7

1.7

2.0

2.25

Wages, %yr

Govt

1.25

1.5

2.25

2.5

 

AMP

1.5

2.0

2.5

3.0

Unemp Rate

Govt

5.5

5.0

4.75

4.5

% June

AMP

5.25

4.75

4.5

4.25

Source: Australian Treasury, AMP Capital

Budget deficit projections

The Government’s revised budget projections are shown in the next table. The boost to revenue and savings in spending from the faster than expected economic rebound, alongside higher iron ore prices, is estimated to have reduced the budget deficit since the Mid-Year Economic and Fiscal Outlook last December by $40bn for this financial year with smaller improvements in future years (see the line called “parameter changes”). The 2020-21 budget deficit will still be the biggest as a share of GDP since 1946, but at 7.8% of GDP at least it’s well down from the 11% projected in last October’s budget. New stimulus measures since MYEFO are shown in the line labelled “New stimulus”. It amounts to $18bn in 2021-22 rising to $29bn by 2023-24. As a result of the extra stimulus more than outweighing the windfall from the stronger economy the budget deficit profile for the next four years is on balance a bit worse than previously projected although the trend is still down.

Underlying cash budget balance projections

 

2020-21

2021-22

2022-23

2023-24

2024-25

2020-21 Budget, $bn

-213.7

-112.0

-87.9

-66.9

-57.5

2020-21 MYEFO, $bn

-197.7

-108.5

-84.4

-66.0

-55.2

Parameter chgs, $bn

40.1

20.1

9.9

15.8

18.4

New stimulus, $bn

-3.3

-18.2

-24.8

-29.3

-20.2

Projected budget, bn

-161.0

-106.6

-99.3

-79.5

-57.0

% GDP

-7.8

-5.0

-4.6

-3.5

-2.4

Source: Australian Treasury, AMP Capital

Over the forward estimates to 2025 the deficit is still projected to fall rapidly as support programs phase down & the economy expands. This will see spending as a share of GDP fall from 32% this financial year to 28% next financial year. This has mostly already happened with the end of JobKeeper in March.

Federal Government spending and revenue

Source: Australian Treasury, AMP Capital

The Government is not expecting a return to surplus in the next decade – and given the commitment to cap tax revenue at 23.9% this is likely to require spending cuts at some point.

Australian Federal budget deficit

Source: RBA, Australian Treasury, AMP Capital

Gross public debt as a share of GDP – which is at its highest since the early 1950s – is expected to stabilise later this decade at a slightly lower level than previously expected. Gross public debt is expected to reach $1tn by 2023 and $1.5trn by 2030.

Australian Federal gross debt

Source: RBA, Australian Treasury, AMP Capital

Economic growth will help ease the debt burden but – in the absence of a post-WW2 style population and immigration boom – it’s unlikely to be anywhere near enough to achieve anything like the rapid post-WW2 decline seen in the debt to GDP ratio.

Assessment

At a micro level the Budget may be criticised on the grounds that: more money is likely still needed for aged care and childcare; the extra infrastructure spending is still not enough; there is not a lot of productivity enhancing reforms; and the housing measures continue to focus more on boosting demand rather than supply which will result in higher prices & more debt. In terms of housing, a preferable approach would be to focus far more on boosting supply and to take advantage of the opportunities provided by the work from home phenomenon to encourage more to move to more affordable regions while at the same time making sure increased regional demand is matched by more supply. Reducing some of the buying power of investors by reducing the capital gains tax discount (not likely!) could also help free up space for first home buyer and single parent incentives.

But at a macro level it’s hard to fault the Government’s overall strategy since the pandemic began. Our assessment remains that the blow out in the budget deficit to support the economy through the pandemic was necessary and we are now seeing the benefit of the Government’s strategy in that its enabling the economy and jobs to rebound far faster than is normally the case after recessions. This, in turn along with windfall corporate tax revenue flowing from much higher than expected iron ore prices, is helping to improve the budget deficit (and we suspect will do so at a faster rate than the Government is projecting). It’s also worth noting that Australia’s level of net debt remains low compared to other developed countries. While bond yields have increased, debt interest costs remain very low making high debt more sustainable and most of the support programs were temporary and targeted and so, are rightly ending as the need for them declines. In terms of the latter, it made sense for JobKeeper to end as the jobs market has recovered, and its ending does not appear to have caused a major problem.

Likewise, it makes sense for the Government to remain focussed on growing the economy. We are still a long way from full employment, which could be at a 4% unemployment rate or below, particularly when high underemployment is allowed for. Reverting quickly to fiscal austerity would just put all the pressure back on the RBA at a time when it has few levers to pull – and delay the return to full employment and decent wages growth. Which would risk heightened social tensions.

There are few direct losers in this Budget and many winners – including aged care recipients, parents, business, low and middle income earners, women, downsizers, first home buyers, single parents, older super members, builders, etc.

Implications for Australian assets

Cash and term deposits – with the cash rate likely remain at 0.1%, cash & bank deposit returns will stay low for a long time.

Bonds – still low bond yields combined with a rising trend in yields as the economy recovers resulting in capital loss mean that medium-term bond returns are likely to be low.

Shares – ongoing fiscal stimulus, strong growth and low rates all remain supportive of Australian shares, notwithstanding the high risk of a short-term correction.

Property – more home buyer incentives along with low rates & economic recovery will likely see house prices rise further this year and next although the pace of increase is likely to slow.

The $A – ongoing fiscal stimulus, rising commodity prices and a declining $US point to more upside for the $A.

 

Source: AMP May 2021

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

The return of geopolitical risk? – what to watch over the remainder of 2021

Date: May 05th, 2021

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

Key points

  • Geopolitical issues generate much interest but don’t necessarily have a significant impact on markets

  • But geopolitical risks are higher than prior to the GFC reflecting three big themes: a populist backlash against economic rationalist policies; the falling relative power of the US; and the polarising impact of social media

  • After a lull following the transition to President Biden, key geopolitical issues to watch this year are: US and Australian tensions with China; Iran/Israel tensions; Russia and Ukraine; the German election; US tax hikes and a possible early Australian election.

Introduction

Over the last decade or so it seems geopolitical risk has become of greater significance for investors – particularly with the 2016 Brexit vote and Donald Trump’s election, and tensions with China from 2018. However, beyond lots of noise around President Trump and the US election, geopolitical risk took a back seat for most of the last year in terms of relevance for global investment markets as coronavirus dominated. But, after a period of relative calm following the handover to President Biden, there is a growing risk that it may make a bit of a comeback with tensions building in a number of areas.

Big picture geopolitical trends

Although significant geopolitical events impacted investment markets in the 1980s, 1990s and 2000s (with notably two Gulf Wars and 9/11), the broad trend in terms of geopolitical influence was reasonably positive for investment markets with the embrace of free market/economic rationalism (after the perceived failure of widespread government intervention in the 1970s), the collapse of communism and associated surge in global trade, the peace dividend and the dominance of the US as the global cop. However, over the last decade geopolitical developments have arguably started to move in a direction which is less favourable for investment markets. There are three big geopolitical developments contributing to this:

The political pendulum is swinging back to the left – the slow post-global financial crisis recovery, rising inequality, a dimming in memories of the malaise associated with interventionist economic policies and high inflation in the 1970s, and stress around immigration in various developed countries has contributed to a backlash against establishment politics and economic rationalist policies. This has been showing up in support for re-regulation, nationalisation, increased taxes and protectionism and other populist responses. While aspirational politics ruled in the 1980s & 1990s it’s since been replaced with scepticism about trickle-down economics. The trend towards bigger government has been pushed along by the pandemic, which has seen last decade’s fiscal austerity ditched in favour of big government spending and big budget deficits made possible by very low interest rates.

The swing of the political pendulum to the left is most acute in Anglo Saxon countries as it was here that the pendulum swung most towards free markets in the 1980s and 1990s. This swing is clearly evident under President Biden who is ushering in a greater focus on public spending to fix economic and social problems, partly financed by increased taxes and with bigger budget deficits. It’s also evident in Australia with the budget repair focus of last decade now on the backburner and the Government focussed on pushing unemployment below 5%. But the swing to the left is also evident in German politics. And scepticism about western capitalist democracy has also become more evident in some countries, notably China which has backed away from becoming more like the West.

In the short term, big government spending could boost growth and productivity and may be seen as necessary to “save capitalism from itself” (as FDR’s New Deal did). Longer term, big government could act as a dampener on productivity growth and boost inflation – but if the post-WW2 experience is anything go by that could take a while to be a major issue.

The relative decline of US power – this is shifting us away from the unipolar world that dominated after the Cold War when the US was the global cop, and most countries were moving to become free market democracies. Now we are seeing the rise of China at the same time that it’s strengthening the role of the Communist Party, Russia revisiting its Soviet past and efforts by other countries to fill the gap left by the US in parts of the world, resulting in a multi-polar world and increased tensions – all of which has the potential to upset investment markets at times.

Third, social media is allowing us to make our own reality resulting in entrenched division and less scope for cooperation amongst socio-political groups to achieve common goals. As politicians pander to this, the danger is that economic policy making will be less rational and more populist.

Global geopolitical issues to keep an eye on in 2021

The main geopolitical risks to key an eye on this year are:

US/China tensions, particularly regarding Taiwan – this is probably the biggest risk. Trump’s tariffs have not been reduced and Biden has maintained a hard line on China reflecting US public opinion. Tensions are heating up again as the US is preparing to sell weapons to Taiwan with military exercises in the Taiwan Strait and South China Sea, and some in China threatening to reunify Taiwan by force. The issue is arguably being accentuated by US restrictions on semiconductor sales to China and, of course, Taiwan has a state-of-the-art semiconductor industry. It’s hard to see China reunifying Taiwan by force given the economic costs that would flow from trade sanctions and it all sounds like a lot of posturing, but the risks have gone up and markets may start to focus on it more, particularly if there are accidental military clashes in the area. And there are reportedly signs Europe may be moving towards the US’s side on the broader US-China issue. Key to watch will be the Biden Admin’s review of US policy on China in coming months and Biden’s first bilateral meeting with President Xi.

Australia/China tensions – these have been building since Australia banned Huawei from participating in its 5G rollout and intensified last year after Australia called for an independent inquiry into the source of coronavirus, and China put bans and tariffs on various imports from Australia. The tensions may be escalating again with the Federal Government cancelling Victoria’s Belt and Road Initiative with China which could result in a further escalation in bans and tariffs on Australian exports to China. So far these have not had a major macroeconomic impact because the value of the products affected is small (less than 1% of GDP) and the impact has been swamped by the strength in iron ore exports and prices. And with Australia accounting for 50% of iron ore exports globally, there is insufficient iron ore supply from other countries for China to move to other sources. It could become more of an issue over the longer term if the tensions continue to worsen and ultimately impact iron ore, and this may already be showing up as a risk premium in Australian assets with the $A trading lower against the $US than might be suggested by the level of commodity prices and the trade surplus, and this may also be constraining the relative performance of the Australian share market. So any easing of tensions could boost the $A and Australian shares, but it could also go the other way if tensions escalate.

Iran/Israel tensions – the US is looking to return to the 2015 nuclear deal with Iran in order to continue its “pivot to Asia” and given its energy independence making it less reliant on Middle East oil. Iran wants a return to the deal to take pressure of its economy. But Israel is not keen, is strongly opposed to Iran’s nuclear ambitions and has allegedly sabotaged some Iranian facilities with Iran vowing retaliation. Ideally Biden needs to get a deal done before August when a more hawkish Iranian president may take over. Reports indicate US/Iran talks are making progress, but there is a long way go and tensions between Iran & Israel and Saudi Arabia & Iran could flare up in the interim with potential to impact oil prices – although beyond short term spikes the impact here is not what it used to be.

Russia tensions – Biden has taken a hard line against Russia. It could insist that Germany cancel the Nord Stream 2 (Russian/German gas) pipeline which would risk Russian retaliation possibly with another incursion into Ukraine. A full-scale Russian invasion of Ukraine is unlikely as it would unite Europe & the US against Russia and be costly economically, but another incursion is a risk. Tensions have faded in the last few weeks but could flare up again ahead of Russian elections in September with Putin looking for something to rally political support. Note though that the Russian invasion of Crimea and the shooting down of MH17 only saw brief 2% and 1% dips respectively in US shares in 2014 in what was a solid year.

German election – with Angela Merkel stepping down after nearly 16 years as Chancellor in Germany, polls indicate there is a good chance that the Greens will win control of government in the 26th September elections or if not then be a part of it. However, while this will likely need to be in coalition with the Christian Democrats which would limit the Greens more extreme left-wing policies, it’s likely to see German policy tilt to the left with more fiscal stimulus (a direction the Christian Democrats are leaning in anyway) which will boost recovery in Europe and be a further force for European integration. So, a Green win could actually be a positive risk for European shares.

Terrorism – The risks here have subsided, but new attacks can’t be ruled out. However, economies and markets seem to have become desensitised to them to a degree.

North Korea – Biden appears to be set on taking a more incremental approach to resolving issues with North Korea than Trump did, but more North Korean provocations could occur before progress is made. Note though that North Korean provocations had little lasting impact on markets in 2017.

US tax hikes – so far, the US share market has not been too concerned much about the Biden Administration’s proposed tax hikes on the assumption the negative impact will be offset by extra spending and congress will scale them back – which they probably will. This could change if they are not scaled back.

Australia – the main risk is an early election but differences between the Government and Labor are minor compared to the 2019 election. The Coalition is now eschewing fiscal austerity in favour of boosting growth to deliver a tight jobs market and higher wages. And Labor Leader Anthony Albanese has dropped most of the “big end of town” taxes it proposed in 2019. A Labor Government would take a tougher stance on climate and a more interventionist approach, however, a significant impact on the economy from a change of government is low compared to the 2019 election. To avoid separate House and Senate elections, the latest the next election can be is 21 May 2022. Recent controversies have reduced the chance of an early election.

Implications for investors

Our view is that share markets will head higher this year as recovery continues and this boosts earnings. However, investor sentiment is very bullish which is negative from a contrarian perspective and we are coming into a seasonally softer period of the year for shares, as the old saying “sell in May and go away..” reminds us and the next chart illustrates (although Australian shares can push higher into July). Geopolitical risks as noted above – along with a resumption of the bond market tantrum as inflation rises further and maybe a new coronavirus scare – could provide a trigger for a short-term correction.

The seasonal pattern in US and Australian shares

Source: Bloomberg, AMP Capital

That said, there are several points for investors to bear in mind. First, geopolitical issues create much interest, but as we seen with, eg, Brexit, North Korea and trade wars, they rarely have lasting negative impacts on markets. Second, it’s hard to quantify geopolitical risks as you have to understand each issue separately. Finally, trying to time negative geopolitical shocks & pick their impact is not easy and it often makes more sense for investors to respond once they are factored into markets as the worst usually doesn’t happen, rather than permanently sheltering from them in low returning cash.

Source: AMP May 2021

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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