Provision Newsletter

Most concerns regarding the share market outlook relate to US shares. It invariably sets the direction for global share markets including Australia’s but many contend that at record highs it is overvalued and at risk of a crash.

Common concerns about US shares

There seem to be three commonly expressed concerns regarding US shares: record highs, valuations and complacency. Looking at each of these in turn: US shares are at record highs. Does this mean they are due for a bust? The following chart shows the US S&P 500 since 1990. It broke out to record highs last year and is now up 190% from its Global Financial Crisis (GFC) low in 2009.

Source: Bloomberg, AMP Capital

However, just because US shares are at a record high does not mean a crash is on the way. The breakout seen last year came after a 13 year secular bear market, which saw US shares stuck in a huge range. Our assessment is that US shares have entered a new secular bull market helped by a range of factors including an energy boom, a manufacturing renaissance and a return to better health for US debt measures. And as can be seen in the chart the surge in the share market has been supported by a surge in profits to record levels.

Are US shares way overvalued? Proponents of this view typically cite the following:

• the ratio of share prices to the 10-year moving average of earnings (Shiller PE) is well above its long-term average;

• the overvaluation is even worse if allowance is made for higher than average profit margins; and

• the ratio of the market value of US listed company capital to its replacement cost (called Tobin’s Q) is well above its long-term average implying share prices have been pushed beyond levels justified by their asset base.

To be sure, these are valid concerns but while such valuation measures are useful they need to be treated with caution.

• While the Shiller PE (next chart) at 23 times is well above its long-term average since 1881 of 16, the equilibrium PE has likely risen since the 1800s. During the last 100 years, shares have become easier and cheaper to trade and it’s become easier to assemble a well diversified portfolio, all of which has likely seen the equilibrium PE rise. On this basis, it’s noteworthy that the Shiller PE is only marginally above its long-term rising trend suggesting US shares are not particularly overvalued.

Source: AMP Capital

• In a world of very low inflation, interest rates and bond yields, earnings yields on shares should be lower & price to earnings multiples higher than longer-term averages.

• Although US profit margins are high, they have been high for a long time and attempts to forecast their return to some long-run average have failed. It’s debatable what the normal level should be and with falling capital prices and with a global supply of cheap labour it’s hard to know what will cause profit margins to fall.

• Finally, there is reason to be sceptical of Tobin’s Q as it does not allow for a world where corporate capital is increasingly dominated by intellectual capital as opposed to physical capital.

Is the decline in volatility a major concern? The next chart shows the VIX index, which is a guide to expected volatility in the US share market implied by options.

Source: Bloomberg, AMP Capital

It is clearly very low and is consistent with the US share market having traded in a relatively narrow rising trend since mid-2012. There hasn’t been a 10% or more correction in US shares since mid-2012. In many ways this is a good thing. It is far better than the extreme volatility seen through the GFC and its aftermath and worrying about it is perhaps a bit like worrying that there is nothing to worry about! The concern, though, is that periods of low volatility can lead to a false sense of investor security and excessive risk taking, eg using high levels of gearing to buy overvalued assets.

However, the low level of volatility is arguably a rational reaction to the more stable macro-economic environment seen in more recent times. It is doubtful that risk taking has reached the extremes seen at previous major market tops and, as the 2004-07 period showed, volatility can remain at very low levels for a long time before it runs its course.

Broad cycle view

More generally, our view remains it’s too early in the investment cycle to expect a new bear market or crash. The normal play out for a cyclical bull market is as follows.

• Phase 1 is driven by an unwinding of very cheap valuations helped by easy monetary conditions as smart investors start to snap up undervalued shares as investor sentiment moves from pessimism to scepticism.

• Phase 2 is driven by strengthening profits. This is the part of the cycle where optimism starts to creep in.

• Phase 3 sees euphoria with investors pushing cash flows into shares to extremes. The combination of tight monetary conditions, overvaluation and investor euphoria then sets the scene for a new bear market.

Our assessment remains that we are still in Phase 2. We still don’t see the signs of euphoria that become evident in Phase 3 as precursors to a new bear market. 

• Price to earnings ratios based on forward earnings are around or below their averages seen during the low inflation era seen since the early 1990s.

Source: Thomson Reuters; AMP Capital

The gap between earnings yields and bond yields, a proxy for the excess return shares offer, remains above pre-GFC norms. This is reflected in our preferred valuation indicators, which show markets slightly cheap. 

Source: Bloomberg, AMP Capital

• Global economic indicators have been gradually heading higher, which should be supportive of earnings growth. US growth is rebounding from its March quarter soft patch, Japan seems to be weathering its April sales tax hike pretty well, European growth remains slow but atleast it is continuing and Chinese growth appears to have bottomed after slowing earlier this year with various ministimulus measures helping.

  In Australia, a likely softening of some of the measures in the Federal Budget to allow it to pass through the Senate combined with continuing low interest rates, strong housing construction activity and strong resource export volumes should see the economy back on track by year end.

• Global and Australian monetary policy remains easy and is likely to remain so for some time yet.

• Finally, there is no sign of the investor exuberance usually seen at major market tops. Various surveys show that investor scepticism towards shares remains high. The mountain of money that built up in bond funds in the US has yet to fully reverse. In Australia, investors still prefer bank deposits over shares and the share of cash in the superannuation system remains double pre-GFC levels.

Concluding comments

None of this rules out a short term correction in shares and a return to more volatility. Numerous possible triggers for a correction exist including: a continued run of stronger US economic data raising concerns about an earlier Fed rate hike; risks around Ukraine and Iraq; maybe a return of worries about Europe on the back of European Central Bank bank stress tests and independence referendums later this year in Scotland and (possibly) Catalonia. And in Australia, we need to see confidence levels pick up. However, we still seem a fair way from a major market top in shares. As such, the cyclical bull market in shares likely has further to go. Our year-end target for the ASX 200 remains 5800.

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.

Our bias is more the latter. As often with major market moves it’s the US that sets the direction and on this front it seems a Fed rate hike is gradually starting to appear on the horizon and debate will increasingly start to hot up as to whether it’s closer than we think.

What’s driven the bond rally?

Numerous lists have been put together on drivers of the bond rally this year. The reasons fall into four groups:

• The global growth soft patch at the start of the year and various growth threatening geopolitical risks – the US economy contracted in the March quarter, growth disappointed in Europe, Japan was consumed by worries about the impact of the April 1 sales tax hike, Chinese growth slowed and emerging country growth generally disappointed. On top of this, geopolitical risk has remained with first the crisis in Ukraine and now Iraq. So one might be forgiven for thinking: here we go again with another year of global growth disappointment.

• Dovish central banks – deflation fears and further easing in Europe, an easing bias in Japan and dovish comments from Fed Chair Yellen to the effect rate hikes are a still a considerable period away have reduced fears the world was closer to serious monetary tightening.

• Short covering– last year bond rates rose leading to poor returns from bond funds such that by the start of this year traders were short bonds and some pension funds may have been under pressure to rebalance towards bonds as share weights had increased. News of growth disappointment and dovish central banks may have simply been the trigger to unleash this.

• A growing pricing in of lower long term central bank rates – in response to talk of a period of “secular stagnation” that has been gaining increased airplay lately. It basically says that as a result of a combination of factors including slowing labour force growth, slowing productivity growth (as a result of less investment and a lower payoff from recent innovation), slower credit growth (in response to tougher regulation and high private sector debt ratios) and rising inequality (reducing the spending power of low and middle income earners) will result in a slower trend of economic growth. This in turn will mean lower real interest rates over the long term, a bit like Japan’s experience over the last two decades.

The reality is that each of these factors has probably played a role. And not just globally, but also in Australia where the decline in global yields has flowed though to a fall in Australian bond yields particularly as a combination of lower March quarter inflation, the Federal Budget’s impact on confidence and a bounce back in the Australian dollar have pushed out expectations for the first rate RBA rate hike.

But is it sustainable?

My concern is that the bond rally has gone too far:Firstly, while the global economy started the year on a soft noter, abstracting from normal volatility, leading indicators point to a pick-up in global growth.

Stronger growth after the first quarter soft patch is particularly noticeable in the US:

• business conditions indicators (often called PMI’s) are at levels consistent with solid growth;

• business investment looks to be strengthening;

• consumer spending has picked up;

• housing related indicators are continuing to trend higher;

• bank lending growth is trending higher; and

• the level of employment has finally regained its pre 2008-09 recession high.

Secondly, while central banks in Japan, Europe, Australia and China will likely maintain a dovish or on hold tone for some time to come, the Fed is likely to start shifting its rhetoric in the direction of an eventual rate hike:

• if current trends continue, unemployment will have fallen to 5.5% by mid next year, which is often seen as full employment; and

• while inflation and wages growth remain low, both appear to have bottomed and with the core CPI (ie inflation ex food and energy) already at 2%, it’s likely that the Fed’s preferred measure of inflation, the core private consumption deflator, will reach 2% by year end. In other words inflation will soon be back at the Fed’s target.

This is still consistent with the first Fed rate hike being 9-12 months away, but as we get closer the Fed is likely to start warning of it and markets will start trying to anticipate.

Third, investor positioning regularly sets markets up for corrections that reverse the primary trend for a while. But short trader positions in bonds have been cut and more broadly the strong inflow into bond funds seen through the GFC and its aftermath have yet to be fully reversed. In other words the great rotation from bonds to shares may still be ahead of us.

Finally, while the secular stagnation story has some merit, it is worth noting that the US economic recovery to date has more in common with the sort of cyclical recovery seen after a debt crisis rather than the stagnation scenario experienced by Japan over the last twenty years. What’s more, America’s quick fiscal and monetary stimulus and bank recapitalisation stands in contrast to Japan’s failure to move quickly on these fronts, so there is less risk of the US following Japan.

More broadly, the secular stagnation concept reminds me of the talk of new eras or permanently strong growth that were popular after the run of strong conditions around the end of last century. In other words, it looks a bit like a reflection of the classic behavioural finance tendency to extrapolate recent and current conditions into the future, in this case rationalise a more severe than normal cycle and turn into something more permanent. In other words just an ex-post rationalisation of the bond rally.

All of these considerations suggest that the bond rally might have gone a bit too far.

What about Iraq?

Just when we were getting used to the crisis in Ukraine and starting to see the risks as acceptable, Iraq has popped back into the headlines. In the low inflation era since the 1980s globally, oil supply shocks have been more of a concern to growth than inflation. There are two main concerns regarding Iraq: the loss of Iraqi oil exports which amounts to around 2.3 million barrels a day (compared to global production of about 91.7 mbd) and the threat of wider (Sunni v Shia) Middle East conflict dragging in the US and its allies (again).

However, it is worth bearing in mind that we have seen it all before: OPEC looks to have enough spare capacity of around 3 mbd to meet any short fall from Iraq; the Iraqi conflict is in the north of the country, but most of its oil exports (2.1 mbd) come from the south; US shale oil has reduced the threat to the US, which is likely to mean only a limited US intervention (eg air strikes as opposed to full on ground forces); and many Middle East conflicts seem to flare up regularly only to settle down again without turning into a broader conflict. So for these reasons, whilst Iraq could get worse before it gets better causing share market volatility along the way, it’s hard to see it disrupting the broader global economic recovery and uptrend in share markets. Since the early 1970s it’s clear that it’s not the level of the oil price that poses a risk to global growth but its rate of change. Severe hits to growth have required a doubling in the oil price in the space of 12 months. And right now we are a long way from that. See the next chart that shows the relationship between the oil price and US growth.

Concluding comments

Bonds have had a surprise rally this year. However this is likely overdone and with US growth picking up it’s only a matter of time before debate about the start of Fed tightening hots up causing a resumption of the rising trend in bond yields. However, while this could contribute to a correction in shares, it’s unlikely to be the end of the bull market in shares as even when US interest rates do start to rise we are still going to be a long way from tight monetary conditions.

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.

With the end of the financial year fast approaching, it’s a good opportunity to have your super savings reviewed by a superannuation expert. A simple conversation today could help you build for a better lifestyle tomorrow – as well as keep a few more tax dollars in your pocket this financial year.

Over 55? More End of Financial Year strategies which could help you pay less tax, or save on fees

Whether you’re starting to make the transition to retirement or you’re already retired, there are plenty of ways you could maximise your benefits and minimise your tax before the end of the financial year.

But it could be a case of use it or lose it. Once 1 July dawns, you’ll lose the chance this financial year to take advantage of the annual limits on different kinds of super contributions.

Below we’ve outlined some opportunities that could help members over age 55 make the most of their super. However, because everyone’s situation is different, you should consider whether they are right for you. An AMP financial planner can help you decide whether the opportunities mentioned are suitable for your circumstances.

…and it doesn’t stop there. It’s important to start planning for the next financial year.

Like to know more?

If you have questions about how to take full advantage of the Government’s super concessions before the end of financial year, call us today on 07 5447 7740.

1 You have until 30 June of each year to split contributions for the previous financial year. This means you have until 30 June 2014 to choose to split a contribution made in the 2012/13 financial year. You can also split contributions for the present financial year even if your entire benefit is to be rolled over, transferred or withdrawn.

2 Deeming is used to calculate income for pension, benefit and allowance payments. The deeming rules assume your financial assets are earning a certain amount of income, regardless of the income they actually earn. Deeming encourages you to earn more income from your investments and reduces the extent that your payments may vary.

 (Source: http://www.humanservices.gov.au/customer/enablers/deeming)

How important is a structured training plan?

It’s critical to have structure if I am to peak at key times each year. But I’ve been doing this long enough to allow a little flexibility because you never know when injury or even the flu can strike. Also, there are sponsors to fit in and you can receive invitations that are too good to pass up. So flexibility is as important as structure but not at the expense of performance. It’s a juggling act that my coach, my manager and I have to continually monitor.

Talk us through a typical day’s training for the 2014 Commonwealth Games in Glasgow

Variation and innovation in training are the keys to longevity in sport. I am lucky in that while I train six days a week, it’s not every day at the track. I have pool sessions, gym sessions, yoga and Pilates to give me variety. There is no typical day except that every day I do two sessions of something!

What role does your coach play?

I have changed coaches this year and it has given me fresh ideas and a renewed motivation. My coach is young and he’s an athlete who trains beside me, so he knows when to ramp it up and back it off. My competitors are doing everything they can to beat me so I can’t sit still and wait for them to catch up. I’ve got to train as if I’m second or third best in the world. My coach is critical to this process. He is continually challenging me to be better. I thrive on the challenge.

What’s the secret to staying motivated when it’s a cold and wet winter morning?

Ha ha…I take much of the grief out of training by living on the Gold Coast. Every day is paradise. However when I head overseas and the weather is tough it is still easy to motivate myself by realising that my competitors are out there. I am not prepared to give them any advantage.

Do you have any set routines before a big race?

No, by the time I get to race day I keep it simple. I try to rest as much as possible during the day and when I get to the track I concentrate on the things that I can influence. I make sure my warm up is efficient and effective and I focus on the job in front of me. I pay no attention to my competitors…there is plenty of time to chat after the race!

How are you planning for life after hurdling?

I think I have some years yet before I contemplate retiring from athletics but for the past few years I have been grabbing every opportunity to experience other avenues and other occupations. I have spent time at radio stations reading the news. I have spent time at Currumbin Wildlife Sanctuary working with animals, which I am passionate about. My husband and I have been dabbling in real estate on the Gold Coast and we have been building an online business through my company Kwikchik Enterprises. Time will tell.

Planning for success is just as important when it comes to your finances. We can help you set up your financial goals, and help keep you on track to achieve them. Call us today on 07 5447 7740and we’ll help you with your financial plan.

How should investors adjust their strategies in the lead-up to retirement as we work longer, retire later and potentially receive less age pension?

The traditional approach was that you’d shift your investments into less risky defensive assets as you got older.

This is still valid to a degree, but you need to think more about your impending retirement – both when you’ll retire and how long you’re likely to live beyond that.

With the pension age increasing, you might end up retiring later. And then when you do retire, the odds are you will live for longer. With life expectancy now over 80, even someone who retires at 70 could potentially have 15 years or more to go. So you need to make your retirement savings last longer.

If you’re 55 and you’ve potentially got another 15 years to go until you retire, you might consider starting to think about how to make a transition towards retirement and delaying the ‘derisking’ of your portfolio because you’re less vulnerable to market falls in the short term.

What’s the best way to guard against the risk of retiring in a bad year for investment markets?

This is called ‘sequencing risk’ and it’s one of the biggest concerns for investors approaching retirement. A big share market fall just before retirement or in the first years of retirement can adversely affect you right through retirement. If share prices fall towards the end of your retirement, it’s not as big a problem.

History suggests that the sharemarket experiences a significant fall about once every 10 years. But if you focus too much on avoiding a crash, you end up losing out on the higher returns that shares offer.

There’s a balance between having some sort of protection and trying to maintain exposure to growth assets. It’s a difficult trade-off and there isn’t an easy answer. One solution is a protected portfolio with some sort of guarantee. But then that could also mean lower returns.

The best approach is to talk with your financial planner about how much risk you’re prepared to take on. One way to look at it is how much potential return and therefore protection against a longer retirement do you want to give up in return for protecting your investments in the short term?

There’s no such thing as a free lunch. You can’t have access to shares at the same time as having no risk. Shares deliver higher returns over time but they come with significant risks. On the other hand, more defensive assets like cash and government bonds give you more security but don’t have anywhere near the same return potential.

So if you’re 55 and you’ve got a portfolio that you probably need to rely on for the next 25 to 30 years, you’ve got to try and balance out those two competing alternatives.

And how should investors adjust their strategy once they’ve retired?

An approach that makes sense is to divide your savings into two broad investment streams – income-based assets like cash, term deposits and yield-bearing investments to fund day-day-day living expenses and growth assets that focus more on longer term savings.

What about younger investors who have more time to save for retirement but are more likely to be affected by changes to the age pension?

The message flowing from policymakers is that we need to be less dependent on the age pension going forward. It’s going to become harder to get the pension, you’ll have to wait longer and means testing will be a lot tougher.

So you need to do everything possible to make sure your savings can last throughout a retirement that is likely to be longer than that of your parents. You need to make the most of your years in the workforce to build up a savings nest egg that will cover your retirement period without having to rely on the pension.

There’s often a tendency for investors to get hung up on what shares they should buy or which country to invest in or what fund manager to use. But the really important question to ask yourself is what mix of growth and defensive assets is right for you.

The returns we get from defensive assets are likely to be quite low in the years ahead because yields have fallen dramatically with very low interest rates.

So you should think about whether your superannuation fund is appropriate for your longer term saving needs. If you haven’t actively chosen where your super is invested, your savings may be in what’s called a ‘default’ fund. Traditionally many default funds have been balanced and one could argue that they don’t take on enough risk for young workers. Some of the newer lifecycle default funds introduced as part of the My Super reforms have more of a growth bias for younger members and that’s probably appropriate.

Growth assets are particularly important when you’re starting out in the workforce. You don’t want to spend your whole career with your fund in a low-risk option that will leave you with inadequate retirement savings.

What you need to know
This document was prepared by AMP Capital Investors Limited (ABN 59 001 777 591, AFSL No 232497). This document, unless otherwise specified, is current at 13 June 2014 and will not be updated or otherwise revised to reflect information that subsequently becomes available, or circumstances existing or changes occurring after that date. While every care has been taken in the preparation of this document, AMP Capital Investors Limited makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

Australians love property but the idea of property investment—and where to start—can be daunting. One way to get started sooner is by unlocking the value in your home to invest. But it pays to understand the risks as well as the benefits.

Using your home to invest

Many Australians are releasing some of the value in their own homes to buy an investment property. And when you consider the potential tax advantages, it could make financial sense to buy a second property while paying off your home loan. When you own an investment property, you can often claim a tax deduction for the interest you’ve paid on your loan and many other expenses related to the property.

It’s a matter of weighing up what’s most important. For some people, clearing the home loan is the number one goal. Others prefer to take on extra financial responsibility with a view to buying an investment property that may:

1. Increase in value over time (providing capital growth) and

2. Provide an extra source of income down the track.

If you have to save-up first, it could be years before you can buy an investment property. And during that time, property prices may increase, making it harder for you to get a foothold. On the other hand, if your home loan is out of control already, your first priority might be to get on top of your existing debt.

Before you consider this type of strategy, it’s important to understand the risks. Say interest rates rise more quickly than you’d expected―if you’re unable to cover the increase in loan repayments, you may not only lose your investment property but put at risk the home you released the equity from. So it pays to explore the possibilities before putting all you’ve worked for at risk.

How much will an investment property cost?

Make sure you consider the upfront costs before deciding whether or not an investment property is a good choice for you. Here are some of the main costs to consider:

1. The purchase price—what you’ll pay for the property.

2. Stamp duty—based on which state you live in.

3. Legal and conveyancing fees—conveyancing is the process of transferring the property from a seller to a buyer. You would generally engage a solicitor or specialist conveyancer and fees can vary; expect to pay between approximately $700 and $2,500 or more in some cases.

4. Home loan application fees—these vary by lender.

5. Any fees charged by your lender to recover its cost of taking out lender’s mortgage insurance in respect of your loan—there may be none at all depending on the lender and/or the amount you borrow relative to the property’s value.

6. Building, pest and strata inspection reports—these can really add up but may help you understand what you’d be buying.

7. Any upfront costs you’ll need to incur to make the property ready for the rental market. For example, the costs of renovating a kitchen or bathroom.  

And make sure you look into the ongoing costs like interest charges on the money you borrow, strata fees, council rates, utilities charges payable by the owner and rental insurance to protect you from rental default or property damage from your tenants. There’s a lot to consider.

Should I buy an investment property?

So should you buy an investment property? It really depends on you, your situation, your financial goals and attitude to risk―which is why getting the right advice is always a good place to start. Like any property, you should also be careful about what and where you buy. Spend as much time as you can researching, and make sure there are no structural issues with your property.

Speak with us today on 07 5447 7740 before deciding whether or not to consider unlocking the value in your home.