Sub Heading

Category: Rss-feed-oliver

US China trade war fears – Q & A

Date: Apr 12th, 2018

Introduction

Much has been written about the trade dispute between the US and China and the risk of a global trade war. Much of it has been hyperbole but financial markets have had to price in the risks of a full-blown trade war zapping global growth. This has been difficult given almost daily developments on the issue since early March. This note takes a simple Q & A approach to the key issues.

What is a trade war?

A trade war is a situation where countries raise barriers to trade with each other (such as tariffs or quotas on imports or subsidies to domestic industries) usually motivated by a desire to “protect’ domestic jobs and workers sometimes overlaid with “national security” motivations. To be a “trade war” the barriers needs to be significant in terms of their size and the proportion of imports covered. Tariffs on a few goods don’t really count as a trade war because it’s not significant.

The best known global trade war was that of 1930 where average 20% tariff hikes on most US imports under Smoot-Hawley legislation led to retaliation by other countries and contributed to a collapse in world trade.

What is wrong with protectionism?

A basic concept in economics is comparative advantage: that if Country A and B are both equally good at making Product X but Country B is best at making Product Y then they will be best off if A makes X and B makes Y. Put simply free trade leads to higher living standards and lower prices whereas restrictions on trade lead to lower living standards and higher prices. This is why economics should be compulsory in final years at high school!

The trade war of the early 1930s is one factor – along with wrong-footed monetary and fiscal policy – that contributed to the severity of The Great Depression.

A few years ago, at a presentation in Adelaide I tried to explain all this to a woman in the audience who was incensed by the recent closure of auto production in South Australia by Mitsubishi. After a while someone else in the audience asked for a show of hands as to who drives an Australian-made car – only about five hands went up including mine (the Holden!) but most people’s hands stayed down, including the lady’s and she said she liked the safety of a Volvo. Fair enough. But it seems that while some want to protect local industry they don’t buy it themselves. The experience of heavily protecting Australian industry in the post WW2 period was that it was just leading to higher costs and prices and lower quality products and Australians’ were voting with their wallets to buy better value foreign made goods. We might have protected lots of manufacturing jobs if we stayed at the levels of protection of 45 years ago, but we would have become a museum piece as would the US.

Fortunately, despite the loss of jobs in manufacturing (from 25% of the workforce in 1960 to around 8% now) other jobs have come along in the services sector where Australia’s and America’s relatively highly-skilled but highly-paid workforce have a comparative advantage compared to workers in less developed countries.

In short, if you want to support your country’s products buy them, but trade barriers don’t work.

Why is President Trump raising tariffs then?

It’s simple. He is fulfilling a 2016 presidential campaign commitment to “protect” American workers from what he regards as unfair trading practices. He has long held this view – see his 1986 interview with Oprah where his focus was Japan. Last year his focus was on deregulation and tax reform, which helped share markets. This year the November mid-term elections are approaching & polling not helped by his poor popularity has been pointing to the Republicans losing control of the House, so he is back in campaign mode returning to his campaign commitments on trade, knowing tariffs are popular with his supporters.

What does President Trump want?

President Trump wants better access for US exports to China. While it’s been feared at times that Trump was willing to get into trade wars with any country that the US has a trade deficit with, including long time US allies – with criticism of Europe and Germany on the trade front and regular threats to tear up the South Korea/US free trade deal (KORUS) and NAFTA, and US aluminium and steel tariffs originally thought to apply to all countries, it’s clear the main focus is China:

  • Europe has been exempted for now from US tariffs on aluminium and steel (along with most US allies).

  • KORUS has been renegotiated with only minor concessions to the US (on steel and cars with a focus on reducing non-tariff trade barriers); and

  • The NAFTA free trade deal with Mexico and Canada looks on track to be renegotiated.

So maybe Trump is not so blindly protectionist as feared. Basically, the US under Trump feels that China is not giving its exports fair access and alleges – after a review under section 301 of the US Trade Act – that it’s not respecting the US’s intellectual property.

Where are we now?

Fears of a global trade war were kicked off in early March with Trump’s announcement of a 10% tariff on aluminium imports and a 25% tariff on steel imports. US allies were subsequently exempted but China was not, and it announced similar tariffs on roughly $US4bn of imports from the US matching the US tariffs. So tit for tat. But tariffs on $US4bn of imports are trivial – less than 0.1% of US imports for example.Fears of a global trade war were kicked off in early March with Trump’s announcement of a 10% tariff on aluminium imports and a 25% tariff on steel imports. US allies were subsequently exempted but China was not, and it announced similar tariffs on roughly $US4bn of imports from the US matching the US tariffs. So tit for tat. But tariffs on $US4bn of imports are trivial – less than 0.1% of US imports for example.

The focus then shifted to China. On March 22 in response to the Section 301 intellectual property review, Trump announced 25% tariffs on $US50bn of US imports from China with the details announced two weeks later but to be subject to a period of comment before “proposed” implementation in late May/early June. At the same time the US lodged a case against China with the World Trade Organisation, providing confidence Trump is not trying to undermine the global trading system.

China then announced “plans” for 25% tariffs on $US50bn of imports from the US with a focus on agricultural products. So more tit for tat – but in this case only in relation to proposals or plans. And still only small at around 1.5% of US imports, implying an average tariff increase across all US imports of just 0.4%.

To appear to stand up for American farmers, President Trump announced that the US would consider tariffs on another $US100bn of imports from China. China indicated it would again announce a proportional response should the US do so. So fears started to rise of an escalation. But again, it’s all proposals.

On March 22 Trump asked the US Treasury to consider restrictions on Chinese investment in the US by May 21.

What is the most likely outcome?

So far what we have really seen is not a trade war but a phoney trade war between the US and China. The tit for tat tariffs triggered in relation to US steel and aluminium imports are trivial in size. All the other tariffs are just proposals, contingent on the US and China being unsuccessful in reaching a negotiated solution. Our view is that a negotiated solution will head off their implementation, indefinitely delay them contingent on trade success or result in very watered-down tariffs:
 

  • President Xi Jinping’s speech at the Boao Forum committing to lower import tariffs for various products, increased market access for foreign investors and strengthened protection of intellectual property rights echoes comments by Premier Li and indicates that China is aware of the issues and willing to negotiate. PBOC Governor Yi has added more detail in relation to making it easier for foreign participation in the Chinese financial system and indicated the China will not manipulate a Renminbi depreciation in the trade conflict. So it’s a good first step.

  • Similarly, while President Trump wants to be seen to “stand tough for American workers” a full blown escalation into a real trade war with China come the November mid-term elections is not in his interest as it would mean higher prices at Walmart and hits to US agricultural exports both of which will hurt his base and a much lower US share market which he has regarded as a barometer of his success.


Reaching a deal with China will be harder than “fixing” KORUS and NAFTA and there is a long way to go with setbacks inevitable, but ultimately a deal is likely.

Will all this really fix the US trade deficit?

No. The real issue is that America as a nation spends more than it earns which results in it importing more than it exports. The only way to solve this is for it to save more but the now rising US budget deficit due to tax cuts and spending hikes will mean it will save less. So while a deal with China may reduce the US trade deficit with China the trade deficit will simply shift to other countries.

What to watch?

Key to watch for is negotiation between the US and China on trade. Meanwhile, the US Trade Representative will hold hearings on its proposed US tariffs on $US50bn of imports from China on April 23, these tariffs “if any” are due to be finalised by May 21 and the US Treasury is due to propose restrictions on Chinese investment in the US by May 21 – but both could be delayed if negotiations are ongoing. May 1 will also see exemptions to the US’s steel and aluminium tariffs expire if they are not renewed.

What would be the impact of a full-on trade war?

The negative economic impact from a full-blown trade war would come from reduced trade and the disruption to supply chains that this would cause. This is always a bit hard to model reliably. Modelling by Citigroup of a 10% tariff hike by the US, China and Europe showed a 2% hit to global GDP after one year with Australia seeing a 0.5% hit to GDP reflecting its lower trade exposure compared to many other countries, particularly in Asia which will face supply chain disruption. But of course we are currently nowhere near a 10% average tariff hike. And the current situation really just involves the US and China so arguably Chinese and US goods flowing to each other could – to the extent that there are substitutes – just be swapped for goods coming from countries not subject to tariffs thereby reducing the impact.

Why have share markets fallen?

A full-blown trade war would depress global growth so share markets have moved to make some allowance for the probability of this. If a trade war is averted, even though we may not have trade peace, share markets will be able to unwind this, albeit volatility will still remain high given other issues such as Fed tightening and ongoing risks around President Trump.

Source: AMP Capital 12 April 2018

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.

Falling Sydney & Melbourne home prices – is this the crash? What about other cities & the impact on the economy?

Date: Apr 09th, 2018

Australian capital city home prices fell 0.2% in March, their fifth monthly fall in a row. This has brought annual growth down to 0.8% from 11.4% in May last year. Most of the recent weakness relates to Sydney and to a less extent Melbourne.


Source: CoreLogic, AMP Capital

This is unusual in that property price downturns are usually preceded by significant interest rate increases. Consistent with the fall in Sydney and Melbourne property prices, auction clearance rates and home sales have also fallen.


Source: Domain, AMP Capital

How far will prices will drop? Will the weakness spread to other cities? And what will it mean for the broader economy?

Australia’s Achilles heel – the risk of a crash

With prices falling in Sydney and Melbourne some see this as the start of a crash. There is good reason to be concerned:
 

  • Real capital city house prices are 27% above their long-term trend (see the next chart) and are at the high end of OECD countries in terms of the ratio of prices to income and rents.


Source: ABS, AMP Capital

  • The surge in prices relative to income since the mid-1990s has gone hand in hand with a surge in the ratio of household debt to income that has taken it to the top end of OECD countries.

  • With a long period of strong prices and low mortgage rates has come some deterioration in lending standards with the share of new interest only loans reaching around 45% in 2015 and concerns about the reliability of borrowers’ income and living expense assessments when they take out loans.

  • Finally, there has been a surge in the supply of apartments, notably in Sydney evident in the high number of residential cranes in use, raising concerns about oversupply.


Source: Rider, Levett, Bucknall Crane Index, AMP Capital

However, a crash remains unlikely

While crash calls and stories of mortgage stress are common, they have been repeated endlessly over the last 15 years. But, a crash (say a 20% national average price fall) remains unlikely:

First, the real driver of high home prices and their persistence has been that, thanks to tight development controls and lagging infrastructure, the supply of dwellings has not kept pace with population driven demand.  Over the last decade annual population growth has averaged about 150,000 above what it was over the decade to the mid-2000s, which would require roughly an extra 50,000 new homes per year. But it’s only recently that supply has caught up with the pick-up in population growth. And population growth remains very strong.


Source: ABS, AMP Capital

Consistent with this average capital city vacancy rates are at or below their long-term averages, notably in Sydney.

Secondly, while mortgage stress is a risk: there has been a sharp reduction in interest only loans since APRA strengthened lending standards; debt servicing payments as a share of income have actually fallen slightly over the last decade and Census data shows that the share of owner occupier households with a mortgage for which debt servicing is above 30% of income has fallen from 28% in 2011 to around 20%; a significant number of households with a mortgage are ahead on their repayments; and banks non-performing loans remain low. While there has been some deterioration in lending standards it does not appear to be anything like that seen with NINJA (no income, no job, no assets) loans in the US prior to the GFC.

Finally, it is dangerous to generalise. Property prices have surged in Sydney and Melbourne but have fallen in Perth and Darwin and have seen only moderate growth in other capitals.

To see a property crash we probably need much higher interest rates or unemployment (neither of which are expected) or a continuation of recent high construction for several years (which is unlikely as approvals have cooled from their 2016 highs).

Outlook

A further tightening in lending standards as banks get tougher on borrowers’ income and living expense levels along with rising supply and more realistic capital growth expectations by home buyers will see Sydney and Melbourne property prices fall another 5% or so this year with further falls likely next year.


Source: CoreLogic, AMP Capital

By contrast home prices in Perth and Darwin are either at or close to the bottom, price growth is likely to be moderate in Adelaide and Canberra, but it may pick up a bit in Brisbane thanks to stronger population growth and the boom in Hobart has a way to go yet.

Regional centres are likely to provide relatively faster capital growth reflecting weaker supply and offering more attractive rental yields (around 1.5 percentage points higher than in cities). Units are at greater risk given surging supply, but so far house prices have slowed more in Sydney and Melbourne.

The property cycle and the economy

A slowdown in the housing cycle can affect the broader economy via slowing dwelling construction, negative wealth effects on consumer spending and via the banks if mortgage defaults rise. However, as things currently stand the drag from housing construction is likely to be minimal – building approvals don’t point to a collapse in new construction (see the next chart) and it looks like alterations and additions will rise, negative wealth effects will weigh on consumers but not dramatically if we are right, and in the absence of a property price crash the impact on the banks will be manageable. Finally, other sectors of the economy are taking over from housing, eg business investment and state capital works, as being growth drivers.


Source: ABS, AMP Capital

Implications for investors

There are several implications for investors:

  • Firstly, over the very long term residential property adjusted for costs has had a similar return to Australian shares (see next chart). Its low correlation with shares, lower volatility but lower liquidity makes it a good portfolio diversifier. So, there is clearly a role for property in investors’ portfolios.


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

  • Secondly, there remains a case to be cautious regarding housing as an investment destination for now. It is expensive on all metrics and offers very low income (rental) yields compared to other growth assets. This means a housing investor is more dependent on capital growth.

  • Thirdly, these comments refer to Australian housing overall but it’s dangerous to generalise. Other cities and regional property are far more attractive than Sydney & Melbourne.

Source: AMP Capital 9 April 2018

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.

Share market volatility – Trump and trade war risks

Date: Mar 27th, 2018

After the calm of 2017, 2018 is proving to be anything but with shares falling in February on worries about US inflation, only to rebound and then fall again with markets back to or below their February low, notwithstanding a nice US bounce overnight. From their highs in January to their lows in the last few days, US and Eurozone shares have fallen 10%, Japanese shares are down 15% (not helped by a rise in the Yen), Chinese shares have fallen 12% and Australian shares have fallen 6%. So what’s driving the weakness and what should investors do?

What’s driving the weakness in shares?

The weakness in shares reflects ongoing worries about the Fed raising interest rates and higher bond yields, worries that President Trump’s tariff hikes will kick off a global trade war of retaliation and counter retaliation which will depress economic growth and profits, worries around President Trump’s team and the Mueller inquiry, rising short-term bank funding costs in the US and a hit to Facebook in relation to privacy issues weighing on tech stocks. The hit to Facebook is arguably stock specific so I will focus on the other bigger picture issues.

Should we be worried about the Fed?

Yes, but not yet. The risks to US inflation have moved to the upside as spare capacity continues to be used up and the lower $US adds to import prices. We continue to see the Fed raising rates four times this year and this will cause periodic scares in financial markets. However, the Fed looks to be tolerant of a small overshoot of the 2% inflation target on the upside and the process is likely to remain gradual and US monetary policy is a long way from being tight and posing a risk to US growth.

What’s the risk of a global trade war hitting growth?

In a nutshell, risk has gone up but is still low. This issue was kicked off by Trump’s tariffs on steel imports and aluminium and then went hyper when he proposed tariffs on imports from China and restrictions on Chinese investment into the US and China threatened to hit back. It looks scary and is generating a lot of noise, but an all-out trade war will likely be avoided.

First, the tariff hikes are small. The steel and aluminium tariffs relate to less than 1% of US imports once exemptions are allowed for and the tariffs on Chinese imports appear to relate to just 1.5% of total US imports. And a 25% tariff on $US50bn of imports from China implies an average tariff increase of 2.5% across all imports from China and just 0.375% across all US imports. This is nothing compared to the 20% Smoot Hawley tariff hike of 1930 and Nixon’s 10% tariff of 1971 that hit most imports. The US tariff hike on China would have a very minor economic impact – eg, maybe a 0.04% boost to US inflation and a less than 0.1% detraction from US and Chinese growth.

Second, President Trump is aiming for negotiation with China. So far the US tariffs on China are just a proposal. The goods affected are yet to be worked out and there will a period of public comment, so it could be 45 days before implementation. So, there is plenty of scope for US industry to challenge them and for a deal with China. Trump’s aim is negotiation with China and things are heading in this direction. Consistent with The Art of the Deal he is going hard up front with the aim of extracting something acceptable. Like we saw with his steel and aluminium tariffs, the initial announcement has since been softened to exempt numerous countries with the top four steel exporters to the US now excluded!

Third, just as the US tariffs on China are small so too is China’s retaliation of tariffs on just $US3bn of imports from the US, and it looks open to negotiation with Chinese Premier Li agreeing that China’s trade surplus is unsustainable, talking of tariff cuts and pledging to respect US intellectual property. While the Chinese Ambassador to the US has said “We are looking at all options”, raising fears China will reduce its purchases of US bonds, Premier Li actually played this down and doing so would only push the $US down/Renminbi up. It’s in China’s interest to do little on the retaliation front and to play the good guy.

Finally, a full-blown trade war is not in Trump’s interest as it will mean higher prices in Walmart and hits to US goods like Harleys, cotton, pork and fruit that will not go down well with his base and he likes to see a higher, not lower, share market.

As a result, a negotiated solution with China looks is the more likely outcome. That said, trade is likely to be an ongoing issue causing share market volatility in the run up to the US mid-term elections with Trump again referring to more tariffs and markets at times fearing the worst. So, while a growth threatening trade war is unlikely, we won’t see trade peace either.

Australia is vulnerable to a trade war between the US & China because 33% of our exports go to China with some turned into goods that go to US. The proposed US tariffs are unlikely to cause much impact on Australia as they only cover 2% of total Chinese exports. The impact would only be significant if there was an escalation into a trade war.

Should we worry about Trump generally?

Three things are worrying here. First, it’s a US election year and Trump is back in campaign mode and so back to populism. Second, Gary Cohn, Rex Tillerson and HR McMaster leaving his team and being replaced by Larry Kudlow, Mike Pompeo and John Bolton risk resulting in less market friendly economic and foreign policies (eg the resumption of Iran sanctions). Finally, the Mueller inquiry is closing in and the departure of John Dowd as Trump’s lead lawyer in relation to it suggests increasing tension. The flipside of course is that Trump won’t want to do anything that sees the economy weakening at the time of the mid-term elections. But it’s worth watching.

What about rising US short term money market rates?

During the global financial crisis, stress in money and credit markets showed up in a blowout in the spread between interbank lending rates (as measured by 3-month Libor rates) and the expected Fed Funds rate (as measured by the Overnight Indexed Swap) as banks grew reluctant to lend to each other with this ultimately driving a credit crunch. Since late last year the same spread has widened again from 10 basis points to around 58 points now. So far the rise in the US Libor/OIS spread is trivial compared to what happened in the GFC and it does not reflect credit stresses. Rather the drivers have been increased US Treasury borrowing following the lifting of the debt ceiling early this year, US companies repatriating funds to the US in response to tax reform and money market participants trying to protect against a faster Fed. So, it’s not a GFC re-run and funding costs should settle back down.

Source; Bloomberg, AMP Capital  

Is the US economy headed for recession?

This is the critical question. The historical experience tells us that slumps in shares tend to be shallower and/or shorter when there is no US recession and deeper and longer when there is. The next table shows US share market falls of 10% or greater. The first column shows the period of the fall, the second shows the decline in months, the third shows the percentage decline from top to bottom, the fourth shows whether the decline was associated with a recession or not, the fifth shows the gains in the share market one year after the low and the final column shows the decline in the calendar year associated with the share market fall. Falls associated with recessions are highlighted in red. Averages are shown for the whole period and for falls associated with recession at the bottom of the table. Share market falls associated with recession tend to last longer with an average fall lasting 16 months as opposed to 9 months for all 10% plus falls and be deeper with an average decline of 36% compared to an average of 17% for all 10% plus falls.

Our assessment remains that a US recession is not imminent:
 

  • The post-GFC hangover has only just faded with high levels of confidence driving investment and consumer spending.

  • US monetary conditions are still easy. The Fed Funds rates of 1.5 – 1.75% is still well below nominal growth of just over 4%. The yield curve is still positive, whereas recessions are normally preceded by negative yield curves.

  • Tax cuts and increased public spending are likely to boost US growth at least for the next 12 months.

  • We have not seen the excesses – debt, overinvestment, capacity constraints or inflation – that precede recessions.


We have not seen the excesses – debt, overinvestment, capacity constraints or inflation – that precede recessions.

Falls associated with recessions are in red. Source: Bloomberg, AMP Capital.

What should investors do?

Sharp market falls are stressful for investors as no one likes to see the value of their wealth decline. But I don’t have a perfect crystal ball so from the point of sensible long-term investing:

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

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

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

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

Fifth, shares often bottom at the point of maximum bearishness. And investor confidence does appear to be getting very negative which is a good sign from a contrarian perspective.

Finally, turn down the noise. In periods of market turmoil, the flow of negative news reaches fever pitch. Which makes it very hard to stick to your well-considered long-term strategy let alone see the opportunities. So best to turn down the noise.

Source : AMP Capital 27 March 2018 

Author: 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.

 

Where are we in the unlisted commercial property cycle

Date: Mar 21st, 2018

Unlisted commercial property (office, retail and industrial) and infrastructure have had strong returns this decade. For commercial property, since 2010 returns have averaged nearly 11% pa. This initially reflected a recovery from the slump associated with the global financial crisis (GFC) and then a search for decent income bearing investments from investors in response to falling interest rates and bond yields that has pushed up property values and hence pushed property yields (basically rents divided by property values) down to record lows. But have yields been pushed too low? And will it reverse with global interest rates starting to bottom/move up? 

Commercial property and the investment cycle 

Just as shares lead in the investment cycle, unlisted assets like commercial property, being more connected to the real economy, tend to lag. The next chart is a stylised version of the investment cycle – the thick grey line is the economic cycle. 


click to enlarge

Source: AMP Capital

Bonds do well in the economic downturn phase as interest rates fall and when inflation is still falling. Shares tend to lead the economic recovery as they respond first to easy money and as far sighted investors sniff out recovery and continue doing well as profits rise before coming under pressure from tight money and fears of a new downturn. Real assets do relatively well later in the cycle as: it takes longer for easy money to flow into them; the valuation process results in a lag; and they tend to move more with current economic conditions which drives rent.

Our assessment is that the current investment cycle is starting to mature, and that central banks gradually exiting easy money will drive a rising trend in bond yields, albeit this will be slow. So, the tailwind from falling yields for unlisted assets will fade.

The collapse in commercial property yields 

The next chart shows average yields for office, retail and industrial property and for a weighted composite across all three. With each 0.25% fall in commercial property yields roughly translating to a 4.25% capital gain and with average commercial property yields having fallen from 7.3% to 5.25% since 2009 this has provided a huge boost to return, averaging roughly 4.2% pa. Values today are nearly 40% above where they were in December 2009 thanks to the plunge in yields.


click to enlarge

Source: JLL, AMP Capital 

A-REITs show the way..albeit with a lot of noise! 

While Australian Real Estate Investment Trusts (A-REITs) are more volatile, they provide a good lead for unlisted commercial property and their weakness since 2016 signals some caution.


click to enlarge

Source: Bloomberg, Mercer/IPD, AMP Capital

This leading relationship can be seen more clearly in relation to yields, with A-REIT yields tending to lead the trend in unlisted property yields. The search for yield by investors pushed the yield on A-REITs down as low as 4% but since 2015 they have been drifting higher, whereas unlisted commercial property yields have been catching down to the earlier decline in A-REIT yields. The lead from A-REIT yields suggests that unlisted property yields are getting close to their lows for this cycle.


click to enlarge

Source: JLL, Bloomberg, AMP Capital

Unlisted property versus housing and bonds 

Against a range of other assets, unlisted commercial property yields remains attractive. This is particularly so compared to residential property. In the 1980s the rental yield on residential and commercial property was similar, but today commercial property has a far higher average rental yield. See the next chart. With Australian residential property over-valued on most measures, commercial property is far more attractive on a medium-term horizon as it is less dependent on capital growth.


click to enlarge

Source: JLL, REIA, Bloomberg, AMP Capital 

While the Australian 10-year bond yield is up from its lows, the gap between the average commercial property yield and the bond yield remains very wide, unlike in 2007 when it closed.

Commercial property risk premium still high 

The biggest risk regarding commercial property is if bond yields back up sharply as global growth and inflation rises. Of course, comparing the bond yield with the average property yield is not strictly correct as the former is a nominal yield while the latter is real yield. So, a better comparison is to look at the risk premium offered by commercial property over bonds. The next chart shows a proxy for this. It assumes that rental and capital growth will average 2.5% pa over time (ie, in line with average inflation) and adds this to the average non-residential property yield to give a guide to potential total returns. The 10-year bond yield has been subtracted to show a property risk premium. While it’s been falling it remains high and above its historical average, suggesting a still decent buffer against rising bond yields.

Commercial property has in fact been a beneficiary of investor flows during periods of rising bond yields in the past. This happened in the bond crash of 1994 and in the gradual backup in bond yields that occurred prior to 2007 as investors simply switched out of bonds into commercial property that offered higher yields at a time when leasing conditions were strong.


click to enlarge

Source: JLL, Bloomberg, AMP Capital 

Property was vulnerable in 1990 and 2008 as the property risk premium was far less attractive than now & leasing deteriorated in the face of rising supply and a fall in space demand.

The demand and supply for space 

Which brings us to leasing conditions, which typically perk up later in the cycle. While leasing conditions remain more difficult in the Perth and Brisbane office property markets due to oversupply and weaker economic conditions (albeit vacancy rates there look to have peaked) and in retail property as a result of tougher consumer conditions, a switch in consumer demand to “services” relative to goods and online competition, it’s been improving elsewhere, noticeably in the Sydney and Melbourne office markets where vacancy rates have fallen to around 6% with more downside ahead and rents are rising strongly. There is a risk around early next decade when new office supply will hit but that’s a while a way and it still looks Ike a non-event compared to the early 1990s. See the next chart. 


click to enlarge

Source: AMP Capital 

Return outlook and what to watch 

Our expectation is for a gradual rise in bond yields (to around 3.5% by end 2019 for Australian 10-year yields) and that a US recession won’t be a risk until around 2020. Against this backdrop, overall returns from unlisted commercial property are likely to remain strong for a while yet as stronger leasing conditions take over from yield compression as a key return driver. However, returns are likely slow to around 9.5% as the “search for yield” tailwind fades. Office is most attractive with retail least, as the great re-rating of retail relative to office that occurred over the last 30 years and saw retail yields fall below office yields looks at risk of some reversal as various cyclical & structural factors contain retail rental growth relative to office.

The choice between unlisted commercial property and A-REITS is now line ball with the latter having reversed their recent outperformance and now offering similar yields to unlisted. 

The key threats to watch for are a sharp rise in bond yields and a deterioration in the global/Australian economic outlook.

Source: AMP Capital 21 March 2018

Author: 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.

Provision Insights

Subscribe to our Quarterly e-newsletter and receive information, news and tips to help you secure your harvest.

Newsletter Powered By : XYZScripts.com