Provision Newsletter

1. Superannuation

1.1 Superannuation Guarantee (SG) rate – Change to increase schedule

Proposed effective date 1 July 2014

The Government will change the schedule for increasing the SG rate. SG contributions are the compulsory super contributions made by employers into the super accounts of eligible employees. The current SG rate is 9.25%.

The SG rate will increase from 9.25% to 9.5% from 1 July 2014 as currently legislated. The rate will remain at 9.5% until 30 June 2018 and then increase by 0.5% each year until it reaches 12% in 2022-23 as per the following table:

1.2 Superannuation preservation age

Unless you meet an earlier condition of release, your preservation age is the minimum age you can draw on your super. The preservation age is currently 55, rising to 60 depending on when you were born.

While no change to the preservation age for super benefits was announced in the Budget, the Government has indicated that this will be considered by future Government enquiries.

1.3 Excess non-concessional contributions (NCCs)

Proposed effective date 1 July 2013

NCCs are generally the after-tax contributions you make to your super. There is a limit (or cap) on the amount of NCCs you can make to your super each year.

Currently, superannuation contributions that exceed the NCC cap are taxed at 46.5%.

The Government proposes to change this treatment for any excess NCCs made from 1 July 2013. You will be allowed to withdraw those excess contributions and associated earnings.

If you choose this option, no excess contributions tax will be payable and the associated earnings will be taxed at your marginal tax rate.

Final details of the proposal, including the calculation of associated earnings, will be determined following consultation with the superannuation industry.

2. Taxation

2.1 Personal marginal tax rates in 2014-15

Proposed effective date 1 July 2014

2.2 Temporary budget repair levy (‘deficit levy’)

Proposed effective date 1 July 2014

Previously announced in the media as the ‘deficit levy’, an additional 2% levy is proposed to apply to high income earners. The levy will be applied to taxable income in excess of $180,000 pa from 1 July 2014 for a period of three years expiring at 30 June 2017. This will effectively raise the top marginal tax rate from 45% to 47%.

What does it mean for you?

• With the legislated rise in the Medicare levy (see below) and this proposed deficit levy, you might consider deferring tax deductible expenses to next tax year or bringing forward income to the current tax year where possible.

  With liability to both the Medicare levy and this proposed new deficit levy based on your taxable income, any tax deductions (eg investment loan interest) will reduce your potential liability to these levies. So, for example, while contribution caps apply, salary sacrifice to super (or making personal tax deductible contributions where eligible) will reduce your liability to these levies.

As everyone’s circumstances are different, you should speak to your financial adviser to help you decide whether these strategies are suitable for you.

2.3 Temporary increase in fringe benefits tax (FBT) rate

Proposed effective date 1 April 2015

The FBT rate has already risen to 47% as a consequence of the increase in the Medicare levy and an additional rise to a total of 49% is now proposed. This proposal aims to broadly prevent anyone liable for the proposed deficit levy from swapping taxable income (taxed at 49%) for fringe benefits taxed at the lower rate of 47%.  The increase in the FBT rate to 49% will occur from 1 April 2015 to 31 March 2017 (aligning with the FBT years).

2.4 Medicare levy rises

Effective date 1 July 2014

Medicare levy will rise to 2% on 1 July 2014 (currently 1.5%). This was announced and legislated by the previous government, to assist with funding the Disability Care Australia Fund (previously known as the National Disability Insurance Scheme).

2.5 Abolition of certain tax offsets

Proposed effective date 1 July 2014

The Government proposes to abolish the following tax offsets from 1 July 2014:

• Dependent Spouse Tax Offset. Currently this tax offset applies to dependent spouses born before 1 July 1952.

• Mature Age Worker Tax Offset. Currently this tax offset is limited to taxpayers born before 1 July 1957. This tax offset is $500 and is assessed on ‘net income from working’.

2.6 First Home Saver Accounts (FHSAs) scheme is ending

Proposed effective date 1 July 2014

The Government proposes to abolish the FHSA scheme.

• New accounts opened from Budget night will not be eligible for concessions.

• For existing accounts, the Government co-contribution will cease from 1 July 2014.

• Tax concessions and the income and asset test exemptions for government benefits associated with these accounts will cease from 1 July 2015.

• From 1 July 2015, account holders will be able to withdraw their account balances without restriction.

3. Social Security

3.1 Age Pension – Increasing eligibility age

Proposed effective date 1 July 2025

From 1 July 2025, the Age Pension qualifying age will continue to rise by six months every two years, from the qualifying age of 67 years that will apply by that time, to gradually reach a qualifying age of 70 years by 1 July 2035.

People born before 1 July 1958 will not be affected by this measure.

3.2 Resetting the deeming rate thresholds on financial investments

Proposed effective date 20 September 2017

Currently, the deeming thresholds are $46,600 for singles, $77,400 for pensioner couples and $38,700 for members of allowee couples.

From 20 September 2017, the deeming thresholds for means tested payments will be reset to $30,000 for singles and $50,000 for couples (for both pensioners and allowees).

What does it mean for you?

The lower deeming thresholds will result in a higher level of deemed income (assuming current deeming rates) being counted under the social security income test. This may have negative impacts for strategies affected by deemed income, such as the assessment of account based pensions started from 1 January 2015 and eligibility for the Commonwealth Seniors Health Care Card (CSHC) from that date.

3.3 Other changes that could affect older Australians and families

Proposed effective date – various

• The family home will continue to be exempt as an asset regardless of its value.

• Concessions for pensioners and Seniors Card holders may reduce due to Government withdrawing state and territory funding in provision of state and territory concessions for eligible pensioners and seniors.

• The minimum age to qualify for Newstart Allowance and Sickness Allowance will increase to 25 years for new applicants from 1 January 2015.

• Currently, many social security related payments are indexed in line with the higher of the increases in the Consumer Price Index (CPI), Male Total Average Weekly Earnings or the Pensioner and Beneficiary Living Cost Index.

From 1 September 2017, certain social security payments will be indexed by the CPI. These payments include:

• Bereavement Allowance

• Age Pension

• Disability Support Pension

• Carer Payment

• Certain Department of Veterans’ Affairs pensions.

What does it mean for you?

The proposed new indexation arrangements will lead to a comparative reduction in the growth of the above entitlements. So to maintain your standard of living, you may need to rely more on your own capital and closely monitor your cash flow needs.

4. Older Australians – Self-funded

4.1 Commonwealth Seniors Health Card (CSHC) eligibility test changes

Proposed effective date 1 January 2015

Untaxed superannuation income will be included in the assessment of income to determine eligibility for the CSHC from 1 January 2015.

The assessment of superannuation income will be the same for CSHC holders as for Age Pension recipients and will align with the 2013-14 Budget measure – that is, it will deem the balances of account-based superannuation of pensioners from 1 January 2015.

All superannuation account-based income streams held by CSHC holders as of 1 January 2015 will be grandfathered and any income/lump sums from these income streams will not be assessed.

What does it mean for you?

Currently, tax free income payments or lump sums received by those over age 60 are exempt from assessment for the CSHC.  This proposal appears to change the eligibility test for CSHC from a ‘taxable income’ test to a Centrelink income test. But if you start receiving a super account-based income stream before 1 January 2015 you won’t come under the new deeming rules.

4.2 Wage subsidy for employers hiring job seekers age 50 and over

Proposed effective date 1 July 2014

Under a new program named Restart, a payment of up to $10,000 over two years will be available to employers who hire an eligible mature age job seeker aged 50 years or over on a full-time basis.

Employers that hire mature-aged job seekers on a part‑time basis (12-29 hours per week) will be eligible for a pro‑rated subsidy based on hours worked.

To be eligible for a payment, employers must employ job-seekers over age 50 that were previously unemployed for a minimum of six months, plus they must employ that person for at least six months.

Payments will be paid in the following instalments:

To be eligible for Restart, employers will need to demonstrate that the job they are offering is sustainable and ongoing, and that they are not displacing existing workers with subsidised job seekers.

4.3 Removal of Seniors Supplement

Proposed effective date 20 September 2014

The Government will remove the Seniors Supplement for holders of the CSHC. This measure will also apply to veterans who hold a CSHC or Gold Card. The Seniors Supplement is currently paid at the rate of $876.20 pa for a single person and $660.40 pa for each member of a couple.

Eligible seniors who do not receive a pension will continue to be eligible for the CSHC.

5. Families

5.1 Paid Parental Leave

Proposed effective date 1 July 2015

The Government has restated its plan to revamp the paid parental leave scheme.

The scheme will provide paid parental leave for 26 weeks based on pre-birth earnings up to an annual cap of $100,000 including superannuation payments, a payment of up to $50,000 including super over the 26 week period. 

5.2 Changes to Family Tax Benefit (FTB) Part A and B

• Indexation of FTB payment rates will be frozen for two years until 1 July 2016. This will affect the maximum and base rates of FTB Part A and FTB Part B.

• The end of year supplement for both FTB Part A and Part B will decrease. The Part A supplement will fall from $726.35 to $600.00 per child pa whilst the Part B supplement will fall from $354.05 to $300.00 per family pa. Indexation of these supplements will also cease from 1 July 2015  

• Currently, families do not receive a reduction below the base rate of FTB Part A until annual family income reaches $94,316 plus $3,796 per child. From 1 July 2015 the $3,796 per child add-on to the allowed income will cease.

• Currently, FTB Part A families receive a large family supplement which is payable for their third and each subsequent child. This is currently $313.90 per child pa. From 1 July 2015, this payment will apply for the fourth and subsequent children in a family.

• The current primary income earner limit of $150,000 pa will reduce to $100,000 pa. FTB Part B will also cease to be paid to families from 1 July 2015 once their youngest child reaches six years of age. Transitional arrangements will apply which allow families receiving FTB Part B on 1 July 2015 for a child six years of age or over to remain eligible for a further two years.

• Single parent families on the maximum rate of FTB Part A will receive $750 pa for each child aged between six and 12. The payment will start when the family becomes ineligible for FTB Part B due to their youngest child turning six.

What does it mean for you?

1. The changes to the FTB Part A income thresholds will mean that you may need to look at the income estimates you provide to Human Services to receive this payment. If this estimate is miscalculated and you receive fortnightly payments throughout the year, you may incur a debt at the end of the financial year. A potentially safer option if you’re close to the upper threshold is to wait until the end of the financial year and receive an annual payment when you lodge your tax return.

2. For parents with young families, the FTB Part B changes could mean you need to plan for the extra cashflow required if one of you wants to stay at home or only work part time after your youngest child turns six.

6. Other

6.1 Medical appointment co-payment

Proposed effective date 1 July 2015

A patient contribution of $7 is proposed for each visit to a doctor (GP), out-of-hospital pathology and diagnostic imagery services (even from those who currently bulk-bill). This co-payment would also be able to be applied to those attending a hospital emergency department for services usually supplied by a GP.  The co-payment is proposed to apply from 1 July 2015.  Patients who hold concession cards and children under age 16 will generally only pay the contribution for the first ten visits in a year.

6.2 Fuel excise

Proposed effective date 1 August 2014

The Government is reintroducing indexation of fuel excise from 1 August 2014 with the goal of securing more stable funding for additional road infrastructure projects.

Twice-yearly indexation by the CPI of excise and excise-equivalent customs duty will be reintroduced for all fuels except aviation fuels.

If you would like to discuss any changes proposed in the budget, please phone on or email peter.talty@clientcomm.com.au.

What you need to know

Any advice in this document is general in nature and is provided by AMP Life Limited ABN 84 079 300 379 (AMP Life). The advice does not take into account your personal objectives, financial situation or needs. Therefore, before acting on this advice, you should consider the appropriateness of this advice having regard to those matters and consider the Product Disclosure Statement before making a decision about the product. AMP Life is part of the AMP group and can be contacted on 131 267. If you decide to purchase or vary a financial product, AMP Life and/or other companies within the AMP group will receive fees and other benefits, which will be a dollar amount or a percentage of either the premium you pay or the value of your investments. You can ask us for more details.

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Key budget measures

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

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

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

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

• a $7 co-payment for GP visits;

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

• the resumption of fuel excise indexation from August;

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

• reintroduction of the work for the dole scheme;

• moves to increase the cost of higher education;

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

• reduced foreign aid spending.

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

The budget bottom line

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

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

Source: Australian Treasury, AMP Capital

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

Source: Australian Treasury, AMP Capital

Economic assumptions

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

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

Assessment and risks

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

Source: IMF, AMP Capital

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

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

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

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

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

Implications for interest rates

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

Implications for Australian assets

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

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

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

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

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

Concluding comments

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

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

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

Why were interest rates cut to zero?

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

Is the US economy on the mend?

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

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

• bank lending growth is trending higher;

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

• consumer spending has picked up;

• business investment looks stronger;

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

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

Source: Bloomberg, AMP Capital

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

When will QE end & what happens after that?

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

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

How long before the Fed raises interest rates?

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

• Growth is still far from booming.

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

Source: Bloomberg, AMP Capital

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

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

Source: Thomson Reuters, AMP Capital

What about the impact on the share market?

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

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

Source: Thomson Reuters, AMP Capital

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

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

Source: Bloomberg, AMP Capital

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

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

What about other economies?

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

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

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

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

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

What about Australia?

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

Concluding comments

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

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

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

Aim

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

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

Source: Global Financial Data, AMP Capital

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

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

Process

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

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

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

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

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

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

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

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

The market

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

Rules of logic often don’t apply in investment markets. The well-known advocate of value investing, Benjamin Graham, coined the term “Mr Market” (in 1949) as a metaphor to explain the share market. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from euphoria to pessimism. But not only is Mr Market highly unstable, he is also highly seductive – sucking investors in during the good times with dreams of riches and spitting them out during the bad times when all hope seems lost. Investors need to recognise this.

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

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

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

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

Cycles and contrarian investing

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

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

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

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

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

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

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

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

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

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

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

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

Source: Thomson Reuters, AMP Capital

Pessimism

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

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

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

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

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

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

Risk

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

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

Debt

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

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

Self-perception

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

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

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

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

Download Market Watch – April edition and read the full report. (319 KB file)

In this edition:

• The public jury is out on Japan’s bold plan to awaken its economy – on the ground sentiment is optimistic.

• A success and some set-backs surrounding the US stimulus unwind.

• Domino’s Pizza continues its global expansion into Japan.

• While shares are well-placed to rise, the road will likely be bumpy.

A tougher, more volatile year for shares..

Our view is that this year will see more constrained returns from shares with increased volatility – including the likelihood of a 10-15% correction along the way – than we saw in 2012 and 2013. Shares are no longer dirt cheap, they are more dependent on earnings for gains, the prospect of Fed rate hikes are starting to loom and as usual there are numerous other “worries” that could give us that volatility: China, Ukraine, etc. And of course, the seasonal pattern in shares often sees corrections occur around mid-year.

..but the trend is likely to remain up

However, it’s too early in the economic and investment cycle to expect a new bear market or crash. A typical cyclical bull market goes through three phases.

• 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 backing their bullishness by pushing cash flows into shares to extremes. The combination of tightening monetary conditions, overvaluation and investor euphoria then sets the scene for a new bear market.

At present we are likely in Phase 2. Some optimism regarding the economic outlook and share markets has returned but we don’t see the signs of euphoria that become evident in Phase 3 as precursors to a new bear market:

• Valuations aren’t dirt cheap, but they’re far from expensive. Price to earnings ratios are only at long term average levels of 14.4 times in Australia (average of 14.1 since 1992) and 15.1 in the US (average of 15.9). Some tech stocks have rich valuations, but the tech heavy Nasdaq trades on a price to earnings ratio that is one third of the tech boom peak and the broader US share market on 15x forward earnings is way below its tech boom peak of 24. So it’s hard to see a tech driven crash.

Source: Thomson Reuters; AMP Capital

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

Source: Bloomberg, AMP Capital

• Global economic indicators have been gradually heading higher which should be supportive of earnings growth. This is indicated in business conditions PMIs (next chart).

Source: Bloomberg, AMP Capital

There are now more indicators pointing upwards in Australia and profits are now helping share market gains, as evident in the following chart that breaks down annual changes in the All Ords into that driven by profits and that due to changes in the ratio of share prices to earnings.

Source: Bloomberg, AMP Capital

• Inflation remains benign and monetary policy easy. Ample spare capacity has meant that global inflation remains low. As a result even though the Fed is slowing its quantitative easing program, interest rates will likely remain low for some time.

• Finally, there is no sign of the investor exuberance seen at major market tops. Short term measures of investor confidence in the US are around neutral levels. See next chart. 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 super system is double pre GFC levels.

Source: Bloomberg, Sentimentrader, Investors Intelligence, AMP Capital

Of course there could be a left field shock – an escalation in Ukraine, a policy mistake in China or the Fed. But if you worry too much about such things you would never invest.

Is the Fed to blame?

One thing I find many of the perennial bears seem to have in common is a hatred of the Fed. They argue the Fed should have stood by and done nothing through the Global Financial Crisis – as advocated by whacky disciples of Austrian economics – to allow a full “cleansing” of the economy and that it is in some way causing the slow recovery seen over the last few years. There are several points worth noting on this.

First, just standing by and doing nothing through the GFC could have led to a re-run of the Great Depression which left an unmeasurable human toll and scared a generation, many of whom were innocent bystanders during the excesses of the 1920s. Allowing the same so called “cleansing” to happen needlessly again after the GFC would have been immoral and pointless.

Second, while the Fed’s actions have not led to a boom in the US it has at least bought time to allow the economy to heal – much like keeping a coma patient on life support. The slow recovery is not the Fed’s fault but rather the desire to reduce debt and caution seen post the GFC.

Third, while the Fed’s quantitative easing program has helped support the US share market the main driver has been a surge in US company profits to record levels. In other words the rise in US shares has not detached from reality but reflects fundamental improvement. See the next chart.

Source: Bloomberg, AMP Capital

Fourth, the Fed’s move to wind down or taper its quantitative easing program and talk of eventual rate hikes is a sign of success. In other words, extreme monetary easing has done its job and so can now start to be withdrawn. This is a good thing, not bad. And of course even when US interest rates do start going up next year it will be a long time before they reach levels that seriously threaten economic growth.

Finally, misinterpretations of Fed communications are inevitable and are not a sign that it does not know what it is doing. The Fed under Bernanke and Yellen have made it pretty clear what they are looking at and in this context their policy moves have made sense.

What about the demographic cliff?

Some have long tried to link demographic trends with share markets, but it is very messy. The basic thesis is that as the baby boomer wave moves through the population it will stop being a big positive for shares (as they either run-down savings or consume less depending on which demographic thesis you follow) and that this should start around 2009-10. This approach predicted a big rally through the 1990s and 2000s and got it completely right in the former but disastrously wrong last decade in relation to US shares. Given shares never got anywhere near the levels they were supposed to reach last decade (the biggest advocate of the demographic model had the Dow Jones going to 40,000 through the 2000s) it’s hard to see why they will now crash.

Concluding comments

While shares might see a brief 10-15% correction at some point this year, a new bear market is unlikely and as such returns should remain favourable through the year as a whole. The time to get really worried is when the topic of conversation with cabbies and at parties is about what a great investment shares are, but I have yet to find a cabbie talking about shares in recent years and at a party I attended last weekend the only person who mentioned shares told me he had just switched all his exposure to cash!

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.