Provision Newsletter

Key points:

• After phasing down its quantitative easing (QE) program all year the US Fed has finally ended it. Monetary tightening still looks unlikely until mid-next year at the earliest and is contingent on further improvement in the economy and higher inflation.

• QE has worked – the US economy is now well into expansion mode and looking a lot stronger than Europe and Japan that have taken longer to adopt it.

• While the ending of QE could contribute more volatility to shares it has largely been anticipated. With the US likely to continue growing & monetary conditions expected to remain easy for some time to come the cyclical bull market in shares likely has further to go.

• The ending of US QE is also positive for Australia as it is a sign that the world’s biggest economy is better and removes a source of upwards pressure on the $A.

http://www.youtube.com/watch?v=0pVibUgAJ3U

Key Points:

• After phasing down its quantitative easing (QE) program all year the US Fed has finally ended it. Monetary tightening still looks unlikely until mid-next year at the earliest and is contingent on further improvement in the economy and higher inflation.

• QE has worked – the US economy is now well into expansion mode and looking a lot stronger than Europe and Japan that have taken longer to adopt it.

• While the ending of QE could contribute more volatility to shares it has largely been anticipated. With the US likely to continue growing & monetary conditions expected to remain easy for some time to come the cyclical bull market in shares likely has further to go.

• The ending of US QE is also positive for Australia as it is a sign that the world’s biggest economy is better and removes a source of upwards pressure on the $A.

Download The end of US quantitative easing pdf 

I have long thought of the US Federal Reserve’s quantitative easing program (QE) as a bit like a drip keeping a patient in a coma alive until it can be brought out of the coma and survive on its own. The patient was the US economy post the GFC and the Fed was administering the drip. Quantitative easing involved the Fed using printed money to pump cash into the struggling US economy by buying up government bonds and mortgage backed securities. The first two rounds of QE ended prematurely in 2010 and 2011 before the US economy was ready to be taken off life support. However, having learned its lesson the phasing down of the latest round – commonly called QE3 – was made contingent on the economy strengthening. The Fed has concluded that this has happened so has been “tapering” its bond purchases all year and is now bringing them to an end.

But has QE worked? Was it worth the costs? What next? What does it mean for investment markets?

Has QE worked?

Quantitative easing sounds extraordinary – and in the context of the inflation prone world we all became used to it would have been. But given the deflationary shock delivered to the global economy from the GFC it is not. QE was needed to boost the supply of money in the US economy given the difficulties in pushing interest rates negative.

Quantitative easing helps the economy via: lower borrowing costs; more cash in the economy; forcing investors to take on more risks; and by boosting wealth, to the extent it drives shares higher, which boosts spending.

But has it worked? While there is much debate, at the end of the day the proof is in the pudding. And the evidence clearly suggests it has worked. While the US economy is still far from booming: growth has picked up pace; bank lending is strengthening; housing construction is recovering; consumer spending growth is reasonable; business investment is strengthening; business conditions are strong; employment is above its early 2008 high and unemployment has fallen to 5.9% (see the next chart); and deflation has been avoided.

Source: Bloomberg, AMP Capital

By contrast, the European Central Bank has dragged the chain on QE and so the Eurozone has unemployment stuck at 11.5% and inflation at just 0.3% is flirting with deflation.

Could the Fed be too early again?

In 2010 and 2011 the Fed was too quick to end QE. There is a risk now too. The global economic expansion is still uneven and US inflation is below the Fed’s 2% target. However, most US growth indicators are now in far better shape, so the risk is reduced. For example, compared to 2010 & 2011 unemployment is lower, employment is higher (previous chart) and consumer confidence and durable goods orders (a guide to investment) are higher (see next chart).

Source: Bloomberg, AMP Capital

But what about the costs – was it worth it?

Most of the arguments against doing QE don’t hold water:

• There has been no hyperinflation. US inflation is less than 2%. The mistake the hyperinflationists made was to confuse a surge in narrow money such as cash and bank reserves which rose with QE with a surge in broader money supply measures such as M2 and credit which hasn’t happened. And they ignored the spare capacity in US factories and in the labour market.

• Financial market distortions are relatively modest. Yes bond yields are low but this mainly reflects the reality of a long period of sub-par growth, low inflation and excess savings rather than distortions caused by the Fed’s holding of US bonds. And the forward price to earnings multiple on US shares at around 15 times is actually below its long term average and less than suggested by current bond yields. That said, maintaining easy money longer than need be does risk creating bubbles, but I doubt we are there yet.

• Currency wars. There was much concern in the emerging world that the $US would crash pushing emerging market currencies up or leading to uncontrollable capital inflows. In the event this was really much ado about nothing and more recently the argument has been run in reverse with some emerging market countries complaining the phasing down of US QE would cause capital outflows and a collapse in their currencies!

• Inequality in the US had been worsening long before QE. While it may be claimed that QE by boosting share prices accentuated inequality because more rich people hold shares, the alternative of allowing the economy to spiral on down and unemployment to surge would hardly have been good for equality. Moreover, other factors including technological innovation are arguably more important in explaining rising inequality in the US.

• The exit problem. This is the biggest risk. Given the lack of experience with quantitative easing there is a degree of unknown regarding the impact of exiting from it.

Much of the critique of the Fed has come from gold bugs and disciples of the Austrian school of economic thought that holds that periods of financial excess should be allowed to fully unwind to allow a proper cleansing of the system. As such they saw the Fed as interfering with the natural order of things and so foresaw dire consequences. The problem with this is that it ignores the role of free market forces in causing the problem in the first place and the likelihood that if free market forces are able to run their course numerous innocent bystanders would be adversely affected. This was what happened in the 1930s when US authorities stood by and allowed a 50% collapse in industrial production, the demise of hundreds of banks and 20% plus unemployment. Hardly a great outcome and hardly great for equality. So there is a case for monetary policy to smooth any adjustment in the economy, which of course is what QE has done. Knowing what the Fed knew about the risks around the GFC and the lessons of the 1930s they have done the right thing. To let the patient die (well not quite – but you know what I mean!) would have been morally indefensible.

What next?

If things go according to plan the next step is that the Fed will actually start to tighten. This will come in the form of raising interest rates and starting to reverse its QE program. It looks like it will primarily unwind its bond holdings by not replacing them as they mature, as opposed to actually selling them.

However, the Fed has made it clear that tightening is contingent on the economy continuing to improve and signs inflation is moving up to target. It has also continued to point out that it anticipates a “considerable time” to elapse before it starts to tighten. This reflects the fact that growth is still far from booming, labour force underutilisation remains, inflation on the Fed’s preferred measures is just 1.5% and inflation expectations have been falling. Our base case is the Fed will start raising rates and allowing maturing bonds to run down its bond holdings from around mid-2015. But if economic conditions are weaker than expected it could come later and a renewed round of quantitative easing cannot be ruled out.

What does the end of QE mean for shares?

Memories of the last two times when QE ended are fresh. After QE1 ended in March 2010 US, global and Australian shares fell around 15% and soon after QE2 ended in June 2011 shares fell around 20%. Fears of a re-run when QE3 ends have been one factor behind the recent roughly 10% correction in shares, so investors have partly pre-empted it.

Source: Bloomberg, AMP Capital

However, while the ending of QE3 may add to volatility it’s very different to the premature ending of QE1 and QE2, which occurred when the US was a lot weaker. Now the US economy is on a sounder footing. And while US QE has ended, it’s being replaced by QE in Japan and Europe.

It’s also worth noting that the rally in shares over the last five years is not just due to easy money. It has helped, but the rally has been underpinned by record profit levels in the US.

Source: Bloomberg, AMP Capital

Finally, it should be noted that US QE is ending because the economy is stronger, which is a positive for shares.

What about the impact on Australia?

The ending of US quantitative easing is a positive for Australia for two reasons. First, it’s another sign the US economy is on its feet again and a stronger US is good news for Australia as it means a stronger global economy. Second, it removes a source of upwards pressure on the $A, allowing it to continue its downtrend, once current oversold conditions are relieved, which will likely see it fall to around $US0.80 over the next year or so. This will help the Australian economy rebalance as the mining boom fades.

Concluding comments

With the US economy now on a sounder footing, the Fed is right to end its quantitative easing program. While this could contribute to short term volatility in shares, providing the US continues to grow as we think it will and given that we are a long way from tight monetary conditions the cyclical rally in shares that got underway back in 2011 is likely to continue.

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

 This video must be taken in its entirety and any given chapter viewed in isolation does not represent the entire message.

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.

Key Points:

• After phasing down its quantitative easing (QE) program all year the US Fed has finally ended it. Monetary tightening still looks unlikely until mid-next year at the earliest and is contingent on further improvement in the economy and higher inflation.

• QE has worked – the US economy is now well into expansion mode and looking a lot stronger than Europe and Japan that have taken longer to adopt it.

• While the ending of QE could contribute more volatility to shares it has largely been anticipated. With the US likely to continue growing & monetary conditions expected to remain easy for some time to come the cyclical bull market in shares likely has further to go.

• The ending of US QE is also positive for Australia as it is a sign that the world’s biggest economy is better and removes a source of upwards pressure on the $A.

Download The end of US quantitative easing pdf 

I have long thought of the US Federal Reserve’s quantitative easing program (QE) as a bit like a drip keeping a patient in a coma alive until it can be brought out of the coma and survive on its own. The patient was the US economy post the GFC and the Fed was administering the drip. Quantitative easing involved the Fed using printed money to pump cash into the struggling US economy by buying up government bonds and mortgage backed securities. The first two rounds of QE ended prematurely in 2010 and 2011 before the US economy was ready to be taken off life support. However, having learned its lesson the phasing down of the latest round – commonly called QE3 – was made contingent on the economy strengthening. The Fed has concluded that this has happened so has been “tapering” its bond purchases all year and is now bringing them to an end.

But has QE worked? Was it worth the costs? What next? What does it mean for investment markets?

Has QE worked?

Quantitative easing sounds extraordinary – and in the context of the inflation prone world we all became used to it would have been. But given the deflationary shock delivered to the global economy from the GFC it is not. QE was needed to boost the supply of money in the US economy given the difficulties in pushing interest rates negative.

Quantitative easing helps the economy via: lower borrowing costs; more cash in the economy; forcing investors to take on more risks; and by boosting wealth, to the extent it drives shares higher, which boosts spending.

But has it worked? While there is much debate, at the end of the day the proof is in the pudding. And the evidence clearly suggests it has worked. While the US economy is still far from booming: growth has picked up pace; bank lending is strengthening; housing construction is recovering; consumer spending growth is reasonable; business investment is strengthening; business conditions are strong; employment is above its early 2008 high and unemployment has fallen to 5.9% (see the next chart); and deflation has been avoided.

Source: Bloomberg, AMP Capital

By contrast, the European Central Bank has dragged the chain on QE and so the Eurozone has unemployment stuck at 11.5% and inflation at just 0.3% is flirting with deflation.

Could the Fed be too early again?

In 2010 and 2011 the Fed was too quick to end QE. There is a risk now too. The global economic expansion is still uneven and US inflation is below the Fed’s 2% target. However, most US growth indicators are now in far better shape, so the risk is reduced. For example, compared to 2010 & 2011 unemployment is lower, employment is higher (previous chart) and consumer confidence and durable goods orders (a guide to investment) are higher (see next chart).

Source: Bloomberg, AMP Capital

But what about the costs – was it worth it?

Most of the arguments against doing QE don’t hold water:

• There has been no hyperinflation. US inflation is less than 2%. The mistake the hyperinflationists made was to confuse a surge in narrow money such as cash and bank reserves which rose with QE with a surge in broader money supply measures such as M2 and credit which hasn’t happened. And they ignored the spare capacity in US factories and in the labour market.

• Financial market distortions are relatively modest. Yes bond yields are low but this mainly reflects the reality of a long period of sub-par growth, low inflation and excess savings rather than distortions caused by the Fed’s holding of US bonds. And the forward price to earnings multiple on US shares at around 15 times is actually below its long term average and less than suggested by current bond yields. That said, maintaining easy money longer than need be does risk creating bubbles, but I doubt we are there yet.

• Currency wars. There was much concern in the emerging world that the $US would crash pushing emerging market currencies up or leading to uncontrollable capital inflows. In the event this was really much ado about nothing and more recently the argument has been run in reverse with some emerging market countries complaining the phasing down of US QE would cause capital outflows and a collapse in their currencies!

• Inequality in the US had been worsening long before QE. While it may be claimed that QE by boosting share prices accentuated inequality because more rich people hold shares, the alternative of allowing the economy to spiral on down and unemployment to surge would hardly have been good for equality. Moreover, other factors including technological innovation are arguably more important in explaining rising inequality in the US.

• The exit problem. This is the biggest risk. Given the lack of experience with quantitative easing there is a degree of unknown regarding the impact of exiting from it.

Much of the critique of the Fed has come from gold bugs and disciples of the Austrian school of economic thought that holds that periods of financial excess should be allowed to fully unwind to allow a proper cleansing of the system. As such they saw the Fed as interfering with the natural order of things and so foresaw dire consequences. The problem with this is that it ignores the role of free market forces in causing the problem in the first place and the likelihood that if free market forces are able to run their course numerous innocent bystanders would be adversely affected. This was what happened in the 1930s when US authorities stood by and allowed a 50% collapse in industrial production, the demise of hundreds of banks and 20% plus unemployment. Hardly a great outcome and hardly great for equality. So there is a case for monetary policy to smooth any adjustment in the economy, which of course is what QE has done. Knowing what the Fed knew about the risks around the GFC and the lessons of the 1930s they have done the right thing. To let the patient die (well not quite – but you know what I mean!) would have been morally indefensible.

What next?

If things go according to plan the next step is that the Fed will actually start to tighten. This will come in the form of raising interest rates and starting to reverse its QE program. It looks like it will primarily unwind its bond holdings by not replacing them as they mature, as opposed to actually selling them.

However, the Fed has made it clear that tightening is contingent on the economy continuing to improve and signs inflation is moving up to target. It has also continued to point out that it anticipates a “considerable time” to elapse before it starts to tighten. This reflects the fact that growth is still far from booming, labour force underutilisation remains, inflation on the Fed’s preferred measures is just 1.5% and inflation expectations have been falling. Our base case is the Fed will start raising rates and allowing maturing bonds to run down its bond holdings from around mid-2015. But if economic conditions are weaker than expected it could come later and a renewed round of quantitative easing cannot be ruled out.

What does the end of QE mean for shares?

Memories of the last two times when QE ended are fresh. After QE1 ended in March 2010 US, global and Australian shares fell around 15% and soon after QE2 ended in June 2011 shares fell around 20%. Fears of a re-run when QE3 ends have been one factor behind the recent roughly 10% correction in shares, so investors have partly pre-empted it.

Source: Bloomberg, AMP Capital

However, while the ending of QE3 may add to volatility it’s very different to the premature ending of QE1 and QE2, which occurred when the US was a lot weaker. Now the US economy is on a sounder footing. And while US QE has ended, it’s being replaced by QE in Japan and Europe.

It’s also worth noting that the rally in shares over the last five years is not just due to easy money. It has helped, but the rally has been underpinned by record profit levels in the US.

Source: Bloomberg, AMP Capital

Finally, it should be noted that US QE is ending because the economy is stronger, which is a positive for shares.

What about the impact on Australia?

The ending of US quantitative easing is a positive for Australia for two reasons. First, it’s another sign the US economy is on its feet again and a stronger US is good news for Australia as it means a stronger global economy. Second, it removes a source of upwards pressure on the $A, allowing it to continue its downtrend, once current oversold conditions are relieved, which will likely see it fall to around $US0.80 over the next year or so. This will help the Australian economy rebalance as the mining boom fades.

Concluding comments

With the US economy now on a sounder footing, the Fed is right to end its quantitative easing program. While this could contribute to short term volatility in shares, providing the US continues to grow as we think it will and given that we are a long way from tight monetary conditions the cyclical rally in shares that got underway back in 2011 is likely to continue.

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

 This video must be taken in its entirety and any given chapter viewed in isolation does not represent the entire message.

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.

Key Points:

• The search for assets providing decent investment yield is continuing. The aging population is playing a role but the main drivers are low interest rates and bond yields.

• With global growth remaining uneven and inflation falling again, global and Australian monetary tightening remains distant so a sharp back up in bond yields threatening investments such as shares, commercial property and infrastructure still looks a way off.

• A range of assets continue to provide attractive yields relative to low cash and term deposit rates.

Download Sub-par global growth, aging populations and the search for yield pdf 

There has been much talk about the “search for yield” in investment markets. Investor interest in decent yield bearing investments has seen the price of such assets rise and their yields (or the cash flow they provide relative to their price) fall. This is clearly evident during the last three years. The chart below shows the yield available on various Australian assets today versus what they offered three years ago. All have seen a fall in their yields to varying degrees.

Source: Bloomberg, REIA, RBA, AMP Capital

But what's driving this? Is it a bubble? What warning signs should we watch? What does it mean for investors?

Why all the interest in yield?

 The first thing to note is that interest in the yield or cash flow an investment provides is a normal part of investing. But it seems to become a greater focus at various points in time. This is particularly so when interest rates are relatively low and investors are a bit wary about going for growth. In Japan it’s become the norm as interest rates have stayed at/near zero for 15 years. In the US and Australia, yield focussed investing was in favour in the 1950s when interest rates were low and investors still cautious after the Great Depression and WW2. It became particularly apparent last decade as investors started putting more into yield plays like property, infrastructure and credit as bond yields remained relatively low only to be interrupted by the GFC. It has since returned with a vengeance.

There are three main drivers:

• Low interest rates have pushed bank deposit rates and bond yields down, all of which is encouraging investors into higher-yielding alternatives.

• Reduced fear of economic meltdown has helped investors feel comfortable taking on more risk but with memories of the GFC and its aftermath still fresh, this is only in a cautious fashion. So there is a desire for the comfort provided by investments that get a high proportion of their return from income.

• Finally, aging populations are driving a longer term interest in yield. This started last decade as the first baby boomers moved into their pre-retirement phase and is intensifying now as they are starting to retire. This is driving demand for investments paying decent income in the form of dividends, rent, interest payments, etc. That said, trying to get a handle on the precise impact of this is nigh on impossible given increasing retirement ages and longevity driving a need for a decent growth exposure.

Is it structural of cyclical?

The safest option in investment markets is to assume something is cyclical (ie short term) rather than structural (ie long term) until proven otherwise. Demographic influences are clearly structural and long term. However, there is a structural aspect to low interest rates that cannot be ignored.

• First, to state the obvious, interest rates have been trending down with lower peaks & troughs since the 1980s.

• Second, the period of near zero/low global interest rates that has followed the GFC doesn’t look like it is about to end anytime soon. While the low global rates and easy money of the last few years have been constantly met with scepticism and concern about inflation and higher rates around the corner, the reality is that it hasn’t happened. We are now into the fourth year in a row where the hoped for lift off to above trend global growth has not happened. Global growth remains okay at around 3 to 3.5%, but it’s below trend and uneven with periodic flare ups of concern about recession and deflation as we have seen during the last month or so in relation to Europe. While it’s dangerous to say “this time it’s different”, quite clearly the world is different to the pre-GFC environment with excess levels of saving, spare capacity and more cautious attitudes to debt resulting in sub-par, uneven growth & low inflation/deflationary risks.

The impact of low bond yields

The logic of the chase for yield can be seen in relation to Australian commercial property (ie office, retail and industrial property). The next chart shows average commercial property yields relative to ten year bond yields. While commercial property yields have fallen over the last 34 years from an average of 8.3% to an average of 6.6%, the yield on bonds has literally collapsed. While the step down in bond yields was initially treated with scepticism on the grounds that “it’s just a bubble” or “inflation will soon take off forcing yields back up”, the longer it has persisted, thanks to sub-par growth and low inflation, the more investors have come to expect bond yields to stay down. So they increasingly invest in yield bearing alternatives such as property.

Source: Bloomberg, AMP Capital

Faced with the choice of investing in a ten year government bond yielding 3.2% as they are in Australia now, or allocating to commercial property with a 6.6% average yield and capital growth of, say, 2.5% pa (ie inflation) giving a total return of 9.1%, an investor might well conclude the latter makes more sense. In fact, looked at this way the property risk premium – ie the return potential property provides over current bond yields – at about 5.9% is about as high as it ever gets.

Source: Bloomberg, AMP Capital

And of course, the same logic can be applied to investment in assets such as infrastructure, shares and corporate debt.

But is the chase for yield on borrowed time?

Is it wise for investors to behave this way? Probably yes… until it goes too far, bond yields surge or growth disappoints.

Has it gone too far? Inevitably the search for yield will be pushed too far as it was last decade. Perhaps the greatest risks are seen to be around corporate debt where the gap between US investment grade and junk bond yields and US government bond yields has fallen to the range that prevailed prior to the GFC. However, credit spreads remained around these narrow levels for many years in the mid-1990s and mid-2000s before trouble arose. Nor have credit lending standards deteriorated like they did prior to the GFC.

Source: Bloomberg, AMP Capital

In terms of equities, there has certainly been a narrowing in the gap between the forward earnings yield on shares and bond yields. But, as can be seen in the next chart, this gap – or a guide to the risk premium shares offer relative to bonds – still remains relatively wide compared to pre-GFC levels.

Source: Bloomberg, AMP Capital

And finally for real assets (if commercial property is a guide), as indicated earlier, the risk premium offered by commercial property relative to bonds remains about as wide as it’s ever been. So overall, it’s hard to argue the search for yield has gone too far. That said, corrections like the one we have seen in shares and corporate debt markets during the last month are healthy in ensuring this remains the case.

What about the risk of an upswing in bond yields? The events of the last month, with renewed worries global growth and deflation, tell us that the immediate threat from higher interest rates is low. The US is closest to raising rates but global risks and a strong $US importing low inflation to the US could see that pushed out to the second half of next year. Australia is under no pressure to raise rates, with sub-trend growth and low inflation, and probably won’t start raising rates till after the US and for both it will be gradual. Rate hikes aren’t even on the horizon in Europe, Japan and China.

What about the risk of slower growth? Slower growth is perhaps a bigger risk globally, with the global economic recovery remaining fragile. In the absence of a major external shock or a major monetary tightening, however, it’s hard to see a sharp slowing in global/Australian growth.

What to watch?

Our basic assessment is that the search for yield hasn’t yet gone too far. Key indicators to watch for signs that it has include the following:

• Valuation indicators – such as price to earnings multiples and the gap between earnings yields and bond yields for shares, corporate bond yield spreads and the return premium property offers over bonds;

• Signs global growth is becoming more synchronised and picking up and that global inflation is rising as a guide to global monetary tightening.

• Global business conditions PMIs as a guide to whether growth is slowing again.

So far so good, but they are all worth keeping an eye on.

What does it all mean for investors?

While the yields and return potential across most assets has continued to fall, shares, non-residential property and infrastructure continue to offer better prospects than low-yielding cash, government bonds and term deposits. Some value has also been returned to corporate debt following the recent back up in corporate bond yields.

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.

Key Points:

• The search for assets providing decent investment yield is continuing. The aging population is playing a role but the main drivers are low interest rates and bond yields.

• With global growth remaining uneven and inflation falling again, global and Australian monetary tightening remains distant so a sharp back up in bond yields threatening investments such as shares, commercial property and infrastructure still looks a way off.

• A range of assets continue to provide attractive yields relative to low cash and term deposit rates.

Download Sub-par global growth, aging populations and the search for yield pdf 

There has been much talk about the “search for yield” in investment markets. Investor interest in decent yield bearing investments has seen the price of such assets rise and their yields (or the cash flow they provide relative to their price) fall. This is clearly evident during the last three years. The chart below shows the yield available on various Australian assets today versus what they offered three years ago. All have seen a fall in their yields to varying degrees.

Source: Bloomberg, REIA, RBA, AMP Capital

But what's driving this? Is it a bubble? What warning signs should we watch? What does it mean for investors?

Why all the interest in yield?

 The first thing to note is that interest in the yield or cash flow an investment provides is a normal part of investing. But it seems to become a greater focus at various points in time. This is particularly so when interest rates are relatively low and investors are a bit wary about going for growth. In Japan it’s become the norm as interest rates have stayed at/near zero for 15 years. In the US and Australia, yield focussed investing was in favour in the 1950s when interest rates were low and investors still cautious after the Great Depression and WW2. It became particularly apparent last decade as investors started putting more into yield plays like property, infrastructure and credit as bond yields remained relatively low only to be interrupted by the GFC. It has since returned with a vengeance.

There are three main drivers:

• Low interest rates have pushed bank deposit rates and bond yields down, all of which is encouraging investors into higher-yielding alternatives.

• Reduced fear of economic meltdown has helped investors feel comfortable taking on more risk but with memories of the GFC and its aftermath still fresh, this is only in a cautious fashion. So there is a desire for the comfort provided by investments that get a high proportion of their return from income.

• Finally, aging populations are driving a longer term interest in yield. This started last decade as the first baby boomers moved into their pre-retirement phase and is intensifying now as they are starting to retire. This is driving demand for investments paying decent income in the form of dividends, rent, interest payments, etc. That said, trying to get a handle on the precise impact of this is nigh on impossible given increasing retirement ages and longevity driving a need for a decent growth exposure.

Is it structural of cyclical?

The safest option in investment markets is to assume something is cyclical (ie short term) rather than structural (ie long term) until proven otherwise. Demographic influences are clearly structural and long term. However, there is a structural aspect to low interest rates that cannot be ignored.

• First, to state the obvious, interest rates have been trending down with lower peaks & troughs since the 1980s.

• Second, the period of near zero/low global interest rates that has followed the GFC doesn’t look like it is about to end anytime soon. While the low global rates and easy money of the last few years have been constantly met with scepticism and concern about inflation and higher rates around the corner, the reality is that it hasn’t happened. We are now into the fourth year in a row where the hoped for lift off to above trend global growth has not happened. Global growth remains okay at around 3 to 3.5%, but it’s below trend and uneven with periodic flare ups of concern about recession and deflation as we have seen during the last month or so in relation to Europe. While it’s dangerous to say “this time it’s different”, quite clearly the world is different to the pre-GFC environment with excess levels of saving, spare capacity and more cautious attitudes to debt resulting in sub-par, uneven growth & low inflation/deflationary risks.

The impact of low bond yields

The logic of the chase for yield can be seen in relation to Australian commercial property (ie office, retail and industrial property). The next chart shows average commercial property yields relative to ten year bond yields. While commercial property yields have fallen over the last 34 years from an average of 8.3% to an average of 6.6%, the yield on bonds has literally collapsed. While the step down in bond yields was initially treated with scepticism on the grounds that “it’s just a bubble” or “inflation will soon take off forcing yields back up”, the longer it has persisted, thanks to sub-par growth and low inflation, the more investors have come to expect bond yields to stay down. So they increasingly invest in yield bearing alternatives such as property.

Source: Bloomberg, AMP Capital

Faced with the choice of investing in a ten year government bond yielding 3.2% as they are in Australia now, or allocating to commercial property with a 6.6% average yield and capital growth of, say, 2.5% pa (ie inflation) giving a total return of 9.1%, an investor might well conclude the latter makes more sense. In fact, looked at this way the property risk premium – ie the return potential property provides over current bond yields – at about 5.9% is about as high as it ever gets.

Source: Bloomberg, AMP Capital

And of course, the same logic can be applied to investment in assets such as infrastructure, shares and corporate debt.

But is the chase for yield on borrowed time?

Is it wise for investors to behave this way? Probably yes… until it goes too far, bond yields surge or growth disappoints.

Has it gone too far? Inevitably the search for yield will be pushed too far as it was last decade. Perhaps the greatest risks are seen to be around corporate debt where the gap between US investment grade and junk bond yields and US government bond yields has fallen to the range that prevailed prior to the GFC. However, credit spreads remained around these narrow levels for many years in the mid-1990s and mid-2000s before trouble arose. Nor have credit lending standards deteriorated like they did prior to the GFC.

Source: Bloomberg, AMP Capital

In terms of equities, there has certainly been a narrowing in the gap between the forward earnings yield on shares and bond yields. But, as can be seen in the next chart, this gap – or a guide to the risk premium shares offer relative to bonds – still remains relatively wide compared to pre-GFC levels.

Source: Bloomberg, AMP Capital

And finally for real assets (if commercial property is a guide), as indicated earlier, the risk premium offered by commercial property relative to bonds remains about as wide as it’s ever been. So overall, it’s hard to argue the search for yield has gone too far. That said, corrections like the one we have seen in shares and corporate debt markets during the last month are healthy in ensuring this remains the case.

What about the risk of an upswing in bond yields? The events of the last month, with renewed worries global growth and deflation, tell us that the immediate threat from higher interest rates is low. The US is closest to raising rates but global risks and a strong $US importing low inflation to the US could see that pushed out to the second half of next year. Australia is under no pressure to raise rates, with sub-trend growth and low inflation, and probably won’t start raising rates till after the US and for both it will be gradual. Rate hikes aren’t even on the horizon in Europe, Japan and China.

What about the risk of slower growth? Slower growth is perhaps a bigger risk globally, with the global economic recovery remaining fragile. In the absence of a major external shock or a major monetary tightening, however, it’s hard to see a sharp slowing in global/Australian growth.

What to watch?

Our basic assessment is that the search for yield hasn’t yet gone too far. Key indicators to watch for signs that it has include the following:

• Valuation indicators – such as price to earnings multiples and the gap between earnings yields and bond yields for shares, corporate bond yield spreads and the return premium property offers over bonds;

• Signs global growth is becoming more synchronised and picking up and that global inflation is rising as a guide to global monetary tightening.

• Global business conditions PMIs as a guide to whether growth is slowing again.

So far so good, but they are all worth keeping an eye on.

What does it all mean for investors?

While the yields and return potential across most assets has continued to fall, shares, non-residential property and infrastructure continue to offer better prospects than low-yielding cash, government bonds and term deposits. Some value has also been returned to corporate debt following the recent back up in corporate bond yields.

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 points:

• After recent sharp falls the $A may see a short-term bounce, but the broad trend is likely to remain down against the $US reflecting a rising $US generally, a secular downswing in commodity prices, overvaluation in terms of relative prices and monetary tightening in the US relative to Australia.

• So while the $A may consolidate into year end, it’s expected to see another leg down next year taking it to around $US0.80.

• The downtrend in the $A is good news for the local economy and share market (via a boost to earnings), but along with the downtrend in commodity prices highlights the case for global investments in foreign currencies.

A secular upswing in the $US

Not only has the Australian dollar fallen sharply against the $US recently but so too have currencies such as the Euro and Yen. The chart below shows the value of the $US against a trade weighted basket of major currencies.

Source: Thomson Reuters, AMP Capital

The $US has been tracing out a broad bottom since 2008. This is likely part of a broader long term or secular pattern:

• During the second half of the 1990s the $US surged in value as the US was seen as a global growth and innovation leader.

• During last decade from 2002 the $US traced out a broad decline as emerging market countries were much stronger.

• But since the GFC the $US seems to be bottoming. Our assessment is that the secular downtrend in the $US since 2002 is now over and that it will now trend higher.

Because the US was proactive in dealing with the GFC its economy is now on a sounder footing globally and, like in the 1990s, it’s becoming something of a growth locomotive again:

• The Fed will soon end its quantitative easing program and may start to raise interest rates next year.

• But there is no end in sight for the Bank of Japan’s bigger money printing program and the European Central Bank is about to embark on its own QE program this month. Neither is even contemplating raising interest rates.

• While China is still strong its pace of growth has slowed with its own structural issues and pressure on the People’s Bank of China to ease monetary policy. What’s more the bulk of the rise in the Renminbi is likely behind us.

• The emerging world is now beset by various structural problems which will possibly constrain their growth.

All of this points to a longer term upswing in the $US. This has a number of implications including less pressure on the Fed to raise rates as a rising $US is a de-facto monetary tightening (so lower US interest rates for even longer) and downwards pressure on commodity prices. In many ways it looks like we could be seeing a re-run of the second half of the 1990s which saw the US as the world’s locomotive, a strong $US, weak commodity prices, benign inflation, relatively low interest rates and strong gains in US shares.

A secular downswing in commodity prices

Just as the $US appears to be embarking on a long term upswing, commodity prices look to be in a long term down swing. In fact they are related as there are two drivers of the trend in commodity prices:

• Supply and demand. Last decade demand for industrial commodities was surging led by industrialisation in China as supply (after years of commodity weakness) struggled to catch up. Now it’s the other way around as demand growth in China while still strong has slowed(accentuated by a cyclical downturn in property related demand) and supply is surging after record investment in sources for everything from coal and iron ore to gas.

• The value of the $US. Since commodities are priced in US dollars they move with it. They rose last decade when the $US was in decline and are now heading down as the $US is on the way up.

As can be seen in the next chart raw material prices trace out roughly 10 year long term upswings followed by 10 to 20 year long term bear markets. After an upswing last decade, they now look to be embarking on a secular downtrend.

Source: Global Financial Data, Bloomberg, AMP Capital

..and a secular downswing in the $A

Against this backdrop the big picture outlook for the $A is not flash. First, it’s best to start with what economists call purchasing power parity, according to which exchange rates should equilibrate the price of a basket of goods and services across countries. A guide to this is shown below which shows the $A/$US rate (against where it would be if the rate had moved to equilibrate relative consumer price levels between the US and Australia since 1900.

Source: RBA, ABS, AMP Capital

Purchasing power parity doesn’t work for extended periods. But, it does provide a guide to where exchange rates are headed over long periods of time. Right now on this measure the $A is still 15-20% overvalued, with fair value around $US0.75. This also lines up with anecdotes of high prices and labour costs in Australia compared to other countries.

Second, as already noted, commodity prices are in a secular downswing. This is highlighted by the iron ore price which a decade ago was around $US20/tonne rose to $US180/tonne in 2011 and has since fallen back to around $US80/tonne.

Source: Bloomberg, AMP Capital

Third, while Australian interest rates are still above those in the US and elsewhere the gap has narrowed. Moreover the Fed in the US is soon to end its monetary stimulus program and is likely to start raising interest rates well ahead of the RBA.

Fourthly, perceptions of global investors about the $A appear to be changing. Over much of the last decade it was positive reflecting Australia’s favourable fundamentals tied to growth in the emerging world and more latterly as an AAA rated safe haven. Now there is a bit more wariness as emerging markets have gone out of favour and if Australia fails to get its budget deficit under control (with Senate blockages and the fall in the iron ore price likely to result in another deterioration in the next MYEFO budget outlook due later this year) foreign perceptions could deteriorate further.

Finally, as already discussed the trend in the $US is likely to be up.

In the short term, the Australian dollar has fallen a bit too far too fast (just as the $US has risen too far to fast), so a short covering bounce could well emerge over the next month or so. Indeed the $A seems to be finding support around $US0.8640.

However, for the reasons noted above the broad trend in the $A is likely to remain down. I remain of the view that it will fall to around $US0.80 in the next year or so as the Fed eventually starts to raise interest rates, with the risk of an overshoot on the downside.

Of course it’s worth noting that the fall in the $A on a trade weighted basis won’t be as pronounced as against the $US as major currencies like the Yen and Euro are also likely to fall against the $US.

Implications for investors

There are several implications for investors.

First, the fall in the $A back towards more fundamentally justified levels is good for the Australian economy and ultimately the local share market. When the $A is in free-fall it is often bad news for the Australian share market as foreign investors retreat to the sidelines for fear of losing more of their money. But after a while the lower $A will become a source of support for the market as it flows through to upwards revisions to earnings expectations. A rough rule of thumb is that each 10% fall in the value of the $A boosts company earnings by 3%. Providing the downtrend in the $A remains gradual the negative impact from the boost to inflation flowing from higher import prices should remain modest.

Second, and perhaps more significantly, the outlook for a continuing downtrend in the value of the Australian dollar highlights the case for Australian based investors to have a relatively greater exposure to offshore assets that are not hedged back to Australian dollars (ie remain exposed to foreign currencies) than was the case say a decade ago when the $A was in a strong rising trend. Put simply, a declining $A boosts the value of an investment in offshore asset denominated in foreign currency 1 for 1. Eg a 10% fall in the value of the $A will boost a foreign share portfolio by 10% in value in Australian dollar terms.

Finally, the longer term downtrend in commodity prices also works in favour of having a relatively greater exposure to traditional global shares as the US, Europe and Japan are commodity users and tend to benefit from softer commodity prices whereas it’s a headwind for the Australian economy.

This video must be taken in its entirety and any given chapter viewed in isolation does not represent the entire message.

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.