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Five big picture implications of the war in Ukraine of relevance for investors

Posted On:Mar 03rd, 2022     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
– and why are Australian shares holding up better?

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

Key points

The situation regarding Ukraine is at high risk of getting worse before it gets better for investment markets.

The key is how much Russian energy exports are disrupted & whether NATO forces avoid the conflict.

Five big picture implications are

Read More

– and why are Australian shares holding up better?

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

Key points

  • The situation regarding Ukraine is at high risk of getting worse before it gets better for investment markets.

  • The key is how much Russian energy exports are disrupted & whether NATO forces avoid the conflict.

  • Five big picture implications are likely to be: increased geopolitical tensions; reduced globalisation; higher commodity prices; higher inflation; and higher interest rates over the medium term.

  • Australian shares have so far been more resilient thanks to higher commodity prices & strong dividends.

Introduction

Humans do horrible things to each other, and war is the worst example of that. What was first announced by Russia earlier last week as a “peacekeeping” force moving into part of eastern Ukraine controlled by Russian separatists quickly morphed into a full-blown attack. This in turn has seen a progressive ramping up in western sanctions on Russia. All of which has contributed to high levels of financial market volatility. This note looks at the current situation, five big picture implications of relevance to investors and the performance of Australian shares.

The current situation

The falls and volatility in global share markets in response to the war reflects a fear of the unknown about how far the conflict will extend and how severe the economic impact will be. The main economic threat is through higher energy prices as Russia supplies around 30% of Europe’s gas and oil imports and accounts for around 11% of world oil production. In short, investors are worried about a stagflationary shock.

If the conflict is limited to Ukraine with Russian gas still flowing to Europe and NATO not getting directly involved (Scenario 1), then the economic fallout will be limited, and further share market falls may be minor or we may have seen the low. But if Russian energy is cut off and NATO military forces get directly involved (Scenario 2) then share markets could have a lot more downside (like another 15% or so). And given the uncertainty investors may fear the latter scenario even if its ultimately avoided. There are several points to make regarding all of this.

  • First, Russia is aiming to prevent Ukraine joining NATO but it has no interest in war with NATO as Russian military capability is weaker. President Biden has continued to stress that the US will not engage in military conflict with Russia – just as it managed to avoid it through the Cold War. The presence of nuclear weapons on both sides remains a huge deterrent – as President Putin reminded us. This along with western sanctions excluding Russian energy exports should help limit the war to Ukraine and minimise the global economic impact. This would favour Scenario 1.

  • But trying to get geopolitical moves right is never easy. And there is a high risk the situation gets worse before it gets better. Things may not be going as well as Putin first assumed. Ukrainians seem to be fighting back hard. The West seems to be a lot more united and strident in its response to Russia including via severe sanctions (which will drive deep recession in Russia) & the supply of military equipment to Ukraine. Even China failed to support Russia at the UN & has expressed concern about harm to civilians.

  • While a backdown by Putin is possible, to avoid a humiliating outcome he may go in harder. But with images being beamed around the world a more forceful Russian attempt to gain control with huge loss of life could further harden global resolve against Russia.

  • European exports to Russia are just 0.7% of its GDP and US exports to Russia and Ukraine are less than 0.2% of its GDP so the direct impact on them from a collapse in the Russian economy would be small. The main threat comes via a hit to energy supply and so far the US and Europe have sought to minimise this threat by excluding the Russian energy sector from the sanctions.

  • The US economy is far less vulnerable on the energy front than Europe as it produces and exports more energy than it consumes and imports. Russia needs the revenue from its energy exports to Europe and it’s not possible for it to quickly replace exports to Europe with exports to China (as the gas pipeline is already at capacity). But the more the sanctions on Russia escalate and the conflict goes on the greater the risk that Russia will curtail energy supplies. This is why the oil price has surged to around $US115/barrel.

  • Even if there is no direct disruption, energy prices are likely to be higher than otherwise reflecting a risk premium as long as uncertainty remains high around supply. The same will apply to other commodity prices including foodstuffs where Russia and Ukraine are significant producers – eg, they account for about 25% of global wheat production.

No one knows for sure how this will unfold. There is a long history of various crisis impacting share markets and the pattern is the same – an initial sharp fall followed by a rebound. Dark as it may seem at present the same is likely to apply this time as well, but trying to time it will be hard, so the best approach is for investors to stick to an appropriate long-term investment strategy. There are some things that will help drive a rebound once some dust settles:

  • Just as in the Cold War (when the ideological divide was wide) Russia & the West will likely find a way to co-exist.

  • The crisis is more inflationary than deflationary, but for the next few months its likely to be a constraint on more rapid central bank rate hikes.

  • Additional defence spending will provide a boost to growth.

  • While European growth will take a bit of a dent, global growth this year is still likely to be strong at around 4%.

  • As a result, company profit growth is likely to remain solid this year, albeit down from last year.

Five big picture implications of the Ukraine crisis

On a medium-term basis though, the war in Ukraine will have some lasting implications of relevance to investors.

#1 A new “cold war” & reversal of the peace dividend

Geopolitical tensions were on the rise prior to the pandemic with the relative decline of the US & faith in liberal democracies waning from the time of the GFC. This has seen various regional powers flex their muscles – China, Russia, Iran and Saudi Arabia. The pandemic inflamed US/China tensions. And now Russia, under President Putin, is seeking to stop the eastward drift of NATO using force and to restore Russia to some of its former status, against the background of a Russia-China partnership. All of which is leading to fears (or maybe the reality) of a new cold war which the Ukraine war has given a push along. This in turn means a return to ramping up defence spending (with even Germany now planning to increase military spending to 2% of GDP) – reversing the peace dividend that saw countries reduce defence spending and allocate public spending to more productive uses in the post-Cold War era.

Implications: it may be good news for defence stocks but heightened geopolitical risks adds to investment market volatility and may require higher risk premiums (ie, lower price to earnings multiples) on growth assets. But its not all negative as the competition between nations can boost technological innovation as it did in the post WW2 Cold War.

#2 Reduced globalisation

A backlash against globalisation became evident last decade in the rise of Trump, Brexit & populist leaders. Coronavirus added to this with pressure to onshore supply chains. A reversal in globalisation has been evident in recent years in a peak in global exports and imports as a share of global GDP. Short of a quick negotiated solution or Putin being replaced there is a high-risk Russia will be excluded from much trade with the West for years, driving a further reversal of globalisation. Higher war risks also add to pressure for onshoring.

Implications: reduced globalisation risks leading to reduced growth potential for the emerging world generally, reduced global competition and reduced productivity if supply chains are managed on other than economic grounds. It threatens to add to inflationary pressure in the global economy. It will also reduce the breadth of global share and bond indices with Russia likely to be removed from global equity and bond indices – albeit its only 0.3% of the global share index.

#3 Higher commodity prices

The Ukraine conflict, thanks to the disruption and threats to the supply of energy, industrial and agricultural commodities and increased demand for metal intensive defence goods is providing a further boost to commodity prices and adds to the case that we have entered a new commodity super cycle. This is also underpinned by low levels of resource investment in recent years and decarbonisation.

Long term bull and bear markets in commodity prices

Source: CRB, Bloomberg, AMP

Implications: this is good news for commodity producers like Australia, but bad news for commodity importers like most industrial countries. It may see Australian shares and the $A outperform like during the commodity boom of the 2000s.

#4 Higher inflation

The boost to commodity prices – notably for energy and food – from the Ukraine war and longer-term from increased defence spending and a reversal in globalisation will further add to global inflation pressures. While the boost to energy and food prices may be temporary, the danger is that coming on the top of already high inflation rates it will add to inflation expectations and become more entrenched.

#5 Higher interest rates

The near-term uncertainty caused by the Ukraine crisis may take the edge of central bank monetary tightening in the short-term. But ultimately the hit to economic activity globally and in Australia is likely to be limited and the upwards pressure it adds to commodity prices and the risk of higher inflation for longer will reinforce the case for monetary tightening, and see higher interest rates and bond yields over the medium-term.

Implications: higher inflation, interest rates and bond yields will constrain longer-term returns from shares and property compared to what we have seen over the last 30 years.

Why are Australian shares holding up a bit better?

From their bull market highs global shares are down 8%, but Australian shares are only down 6% and have so far held above their January low. Australia will suffer from any hit to global growth from the crisis and Australian consumers will be hit with record petrol prices which could easily spike another 15-20 cents a litre in the next few weeks reflecting the rise in global oil prices to around $US115 a barrel. Against this though, Australia is relatively well protected: our trade links with Russia are trivial – with exports to Russia accounting for less than 0.1% of GDP; many of our energy and agricultural products can help fill the global gap left by disruption of Russian and Ukraine exports; and national income will receive a boost from higher energy and commodity prices. And finally, the just ended profit reporting season was positive and (based on calculations by The Coppo Report) will see $36bn in dividends paid to investors over the next two months, which is nearly 40% up on a year ago & only just down on the record payments six months ago. All of which should help the relative performance of Australian shares.

Source: AMP Capital March 2022

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

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The escalation in Ukraine tensions – implications for investors

Posted On:Feb 23rd, 2022     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Key points

Ukraine tensions have escalated with Russia ordering troops into Ukraine regions already occupied by Russian separatists.

Share markets are at high risk of more downside on fear of further escalation and uncertainty about sanctions/gas supply to Europe.

The history of crisis events shows a short term hit to

Read More

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

Key points

  • Ukraine tensions have escalated with Russia ordering troops into Ukraine regions already occupied by Russian separatists.

  • Share markets are at high risk of more downside on fear of further escalation and uncertainty about sanctions/gas supply to Europe.

  • The history of crisis events shows a short term hit to markets followed by a rebound over 3 to 12 months.

  • Given the difficulty in timing market reactions to geopolitical developments the best approach for most investors is to stick to an appropriate long term investment strategy.

Introduction

The last few days have seen a sharp escalation in the situation between Russia and Ukraine, with Russia recognising the independence of two regions in the Donbas area of eastern Ukraine that have been controlled by Russian separatists since 2014 and ordering Russian “peacekeeping” troops into the regions. At this stage its unclear how big the force will be, whether it will push beyond the areas controlled by the separatists and, if so, how far. Although President Putin continues to deny plans to invade Ukraine, his comments suggest a move into the areas of Donetsk and Luhansk in the Donbas that the rebels do not yet control.

As a result share markets have fallen further, with US and global shares falling just below their January lows and Australian shares under pressure too, albeit so far they have held up a bit better. Bond yields have also fallen due to safe haven demand and oil prices have pushed to new post 2014 highs. The market reaction reflects a combination of uncertainty around how far the conflict will go – with Ukraine being Europe’s second biggest country (after Russia), the threat of further sanctions (so far they have been limited) and uncertainty about how severe their economic impact will be. Although it has said it won’t, there is also the risk Russia cuts off its supply of gas to Europe where prices are already very high, with a potential flow on to oil demand at a time when conflict may threaten supply. In short, investors are worried about a stagflationary shock to Europe and, to a lesser degree, the global economy generally.

Possible scenarios

Trying to work out which way this goes is not easy and I am not a geopolitical expert. But it still seems there are four scenarios, some of which may overlap:

  1. Russia stands down – this would provide a brief boost for share markets, including Australian shares, (eg 2 to 4%) as markets reverse recent falls that were driven by escalating tensions.

  2. Russia moves in to occupy the Donbas areas that are already controlled by Russian separatists with sanctions from the west but not so onerous that Russia cuts off gas to Europe – this could see a further hit to markets (say -2%), although it looks like it may be getting close to priced in. This may be similar to what happened in the 2014 Ukraine crisis (with Crimea) and if that’s all that happens then markets would soon forget about it and move on to other things. Much as occurred in 2014.

  3. Russian invasion of all of Ukraine with significant sanctions and Russia stopping gas to Europe but no NATO military involvement – this would cause a stagflationary shock to Europe & to a less degree globally as oil prices rise further and could see a bigger hit to markets (say -10%) but then recovery over six months.

  4. Invasion of all of Ukraine with significant sanctions, gas supplies cut & NATO military involvement – this could be a large negative for markets (say -15-20%) as war in Europe, albeit on its edge, fully reverses the “peace dividend” that flowed from the end of the cold war in the 1990s. Markets may then take longer to recover, say 6-12 months.

Given the path Russia has gone down and the stridency of President Putin’s recent comments, Scenario 1 is looking less and less likely, but is still possible if there is a breakthrough in talks. And Scenario 2 looks to be already on the way, with Putin’s ordering of “peacekeeping” troops into the Donbas region. This may be the “military-technical” action that Russia referred to last week. At the other extreme, it’s still hard to see Russia undertaking a full invasion of Ukraine given the huge cost it would incur. And it’s hard to see NATO troops being involved particularly given limited public support for it in Europe and the US. The US has said US forces would not go into Ukraine. However, some combination of scenarios 2 and 3 are possible whereby the crisis escalates further if, say, the Donbas separatists and the Russian “peacekeepers” push into Donbas territory that the separatists do not yet control and beyond.

And, of course, with Russian troops moving into the Donbas region of Ukraine investment markets will worry that we will move on to a wider invasion of Ukraine, until signs appear to the contrary. So, we could still see share markets fall further and oil prices rise further in the short term.

Crisis and share markets

Of course, there is a long history of various crisis events impacting share markets. This includes major events in wars, terrorist attacks, financial crisis, etc. The following table shows major crisis events since World War Two in the first column, the period over which the US share market initially reacts in the second column, the percentage share market fall in the third column and the percentage change from the low over 3, 6 and 12 months in the final three columns.

Crisis events and the US share market

Event

Share market reaction period

% fall

% chg from mkt low over:

 

 

 

3 mths

6 mths

1 yr

Germany Invades Fr

9/5/40-22/6/40

-17.1

8.4

7.0

-5.2

Pearl Harbour

6/12/41-10/12/41

-6.5

-2.9

-9.6

5.4

Truman Upset Win

2/11/48-10/11/48

-4.9

3.5

1.9

6.1

Korean War

23/6/50-13/7/50

-12.0

15.3

19.2

26.3

Eisenhower H Attack

23/9/55-26/9/55

-6.5

6.6

11.7

5.7

Suez Canal Crisis

30/10/56-31/10/56

-1.4

-0.6

3.4

-9.5

Sputnik

3/10/57-22/10/57

-9.9

6.7

7.2

29.2

Cuban Missile Crisis

19/10/62-27/10/62

1.1

17.1

24.2

30.4

JFK Assassination

21/11/63-22/11/66

-2.9

12.4

15.1

24.0

MLK Assassination

3/4/68-5/4/68

-0.4

6.4

9.3

10.8

US bombs Cambodia

29/4/70-14/5/70

-7.1

3.8

13.5

36.7

Kent State Shootings

1/5/70-26/5/70

-14.0

20.3

20.7

43.7

Penn C Bankruptcy

19/6/70-7/7/70

-7.1

16.0

24.9

33.8

Arab Oil Embargo

16/10/73-5/12/73

-18.5

10.2

7.2

-25.5

Nixon Resigns

7/8/74-29/8/74

-17.6

-5.7

12.5

27.2

Iran Hostage Crisis

2/11/79-7/11/79

-2.7

11.1

2.3

17.0

USSR Afghanistan

24/12/79-3/1/80

-2.2

-4.0

6.8

21.0

Hunt Silver Crash

13/2/80-27/3/80

-15.9

16.2

25.8

30.6

Falkland Islands War

1/4/82-7/5/82

4.3

-9.8

20.8

41.8

Beirut Bombing

21/10/83-23/10/83

0.0

-0.5

-6.9

-2.9

US Invades Grenada

24/10/83-7/11/83

-2.7

-2.8

-3.2

2.4

Continental Ill Bailout

8/4/84-27/5/84

-6.4

11.5

10.1

18.3

US Bombs Libya

14/4/86-21/4/86

2.8

-4.1

-1.0

25.9

1987 Share Crash

2/10/87-19/10/87

-34.2

11.4

15.0

24.2

Panama Invasion

15/12/89-20/12/89

-1.9

0.3

8.0

-2.2

Iraq Invades Kuwait

2/8/90-23/8/90

-13.3

2.3

16.3

22.4

First Gulf War

16/1/91-17/1/91

4.6

14.3

15.0

24.5

Gorbachev Coup

16/8/91-19/8/91

-2.4

1.6

11.3

14.9

UK Pound Crisis

15/9/92-16/10/92

-4.6

3.2

9.2

14.7

WTC Bombing

25/2/93=27/2/93

-0.3

5.1

8.5

14.2

Oklahoma Bombing

18/4/95-20/4/95

1.2

9.7

12.9

30.8

Asian Crisis

7/10/97-27/10/97

-12.4

10.5

25.0

16.9

US Embassy Bomb

6/8/98-14/8/98

-1.8

4.8

10.4

32.0

USS Cole Bombing

11/10/00-18/10/00

-4.2

6.1

6.1

-5.1

9/11

10/9/01-21/9/01

-14.3

21.2

24.8

-6.7

Afghanistan War

5/10/01-9/10/01

-0.7

11.5

12.4

-16.8

Bali Bombing

11/10/02-13/10/02

0.3

12.3

6.7

24.4

Iraq War

19/3/03-1/5/03

2.3

9.2

15.6

22.0

Madrid Terror Attacks

10/3/04-24/3/04

-2.4

3.9

-0.1

4.4

London Train Bombs

6/7/05-7/7/05

0.3

0.1

5.6

7.8

India, etc Bombs

11/7/06-18/7/06

-3.0

10.9

16.4

28.3

Bear Stearn Collapse

13/3/08-14/3/08

-1.6

3.0

-4.4

-38.1

Russia/Georgia

8/8/08-16/8/08

-2.2

-26.0

-34.2

-19.2

Lehman Collapse

15/9/08-16/9/08

1.3

-22.6

-32.3

-11.5

Israel Invades Gaza

27/12/08-21/1/09

-3.0

-4.2

7.9

23.6

Boston Bombing

12/4/13-15/4/13

-1.8

6.1

4.4

11.4

Chinese Shares Fall

21/8/15-25/8/15

-4.8

13.6

6.6

17.8

Brexit Vote

23/6/16-27/6/16

-4.8

5.6

16.3

25.2

Covid 19 Fall

4/3/20-23/3/20

-31.4

40.0

46.0

74.4

Average

 

-6

6

9

15

Median

 

-3

6

9

18

Based on the Dow Jones Index. Intended as a guide only as other developments also impact shares around the dates shown. Source: Ned Davis Research

The pattern is pretty much the same for most events, with an initial sharp fall in the share market followed by a rebound. Since World War Two the average decline has been 6%, but six months later the share market is up 9% on average and 1 year later its up around 15%.

What does it all mean for investors?

I don’t have a perfect crystal ball and its even hazier when it comes to events around wars. But from the point of sensible long-term investing, the following points are always worth bearing in mind in times of investment markets uncertainty like the present:

  • Periodic sharp falls in share markets are healthy and normal, but with the long-term rising trend ultimately resuming and shares providing higher long term returns than other more stable assets.

  • Selling shares or switching to a more conservative investment strategy after a major fall just locks in a loss and trying to time the rebound is very hard such that many only get back in after the market has recovered.

  • When shares fall, they are cheaper and offer higher long-term return prospects. So, the key is to look for opportunities the pullback provides. It’s impossible to time the bottom but one way to do it is to average in over time.

  • While shares have fallen, dividends from the market haven’t. Companies like to smooth their dividends over time – they never go up as much as earnings in the good times and so rarely fall as much in the bad times. And in the meantime, the income the dividends provide is still being received.

  • Shares and other related assets bottom at the point of maximum bearishness, ie, just when you feel most negative towards them.

  • The best way to stick to an appropriate long-term investment strategy, let alone see the opportunities that are thrown up in rough times, is to turn down the noise around the news and opinion flow that is now bombarding us.

 

Source: AMP Capital February 2022

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

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Investment outlook Q&A

Posted On:Feb 15th, 2022     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
– inflation, interest rates, Russia & Ukraine, the risk of a share crash, house prices and other issues

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

Key points

Inflation will likely slow later this year but remain well above pre-pandemic levels over the medium term.

Wages growth is likely to pick up to 3% this year.

A Russian invasion

Read More

– inflation, interest rates, Russia & Ukraine, the risk of a share crash, house prices and other issues

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

Key points

  • Inflation will likely slow later this year but remain well above pre-pandemic levels over the medium term.

  • Wages growth is likely to pick up to 3% this year.

  • A Russian invasion of Ukraine risks a short term hit to shares followed by recovery over the next 3 to 12 mths.

  • Australian home prices are likely to peak later this year followed by falls into 2024.

Introduction

This note covers the main questions investors commonly have regarding the investment outlook in a simple Q&A format.

Is the rise in inflation temporary or permanent?

I suspect it’s a bit of both. Much of the rise in inflation (to a 40 year high in the US and to 3.5%yoy in Australia) can be traced to distortions caused by the pandemic which boosted goods demand and restricted supply (both of goods & workers). Global energy prices are also being boosted by geopolitical tensions (notably in Europe). As consumer demand rebalances back to services, workers return and production catches up to demand, inflation should subside over the next 12 months or so.

However, underlying inflation is unlikely to fall back to pre-pandemic lows and risks running above central banks targets over the next 5-10 years: we are now seeing much easier monetary and fiscal policy & many of the structural forces that drove low inflation look to be going in reverse: globalisation is in retreat; the ratio of workers to consumers is in decline; and we are now seeing bigger more interventionist government.

Will wages growth rise too?

Wages growth has already lifted to 4-5% yoy in the US, depending on the measure. But it has higher inflation and has seen less workers return through the reopening than in Australia. Nevertheless, numerous signs point to faster wages growth in Australia: the jobs market is tight, pushing towards full employment; various business surveys point to rising labour costs; ABS data shows payroll wages accelerating relative to jobs; and there are numerous anecdotes of wage pressure. We expect wages growth to rise to a 3% annual pace by mid-year.

How high will Australian interest rates rise?

We expect the RBA to start raising the cash rate in August (possibly June) after news of more strong inflation data, unemployment below 4% and wages growth pushing up to 3% and see the cash rate rising to around 1.5 to 2% over the next two years or so. This would add a similar amount to variable mortgage rates. It will take household debt interest payments relative to income back to around 2018 levels. Higher household debt to income levels relative to the past and compared to say, the US, along with falling house prices will allow the RBA to proceed cautiously in raising rates through next year and see rates peak at lower levels compared to the past. Australia also has half the US’s inflation rate.

Will the end of QE & rate hikes be a double whammy?

Not really. Bond buying by central banks (or Quantitative Easing) was an alternative to cutting rates when rates had hit zero. With economic activity recovering and inflation up, it makes sense to end it and begin the withdrawal of the liquidity that was pumped in via QE (ie start quantitative tightening). But central banks can manage this with rate hikes to make sure the overall tightening in monetary conditions is not excessive.

Is coronavirus no longer an economic concern?

Not quite, but nearly. Starting last year each successive covid wave seems to have had progressively less economic impact. This reflects a combination of vaccines, new treatments and recent covid variants being less harmful which has combined to enable reopening to continue. While the risk remains of a new variant which is more harmful, causing a setback, coronavirus could finally be moving from a pandemic to being endemic.

Is the economic recovery on track?

While supply side constraints, monetary tightening, geopolitical threats and covid will constrain global and Australian economic growth, it will still be reasonable at around 4.5% this year. Key drivers are likely to be: ongoing reopening; pent up demand and excess savings; still easy monetary policy; strong business investment; and low inventory levels.

How would a Russian invasion of Ukraine impact investment markets?

Russia has been building up its military presence on the Ukraine border and is demanding that Ukraine never join NATO and NATO not station strategic weapons there. Negotiations have made little progress as the US fears consequences in other parts of the world if NATO does not stand tough. If anything, tensions have worsened as NATO has been shoring up Ukrainian defences and Russia has built up more military assets around it, with the US warning of possible imminent invasion. However, Russia has signalled it will continue with talks. Of course, there is a long history of various crisis events impacting share markets (major events in wars, terrorist attacks, financial crisis, etc) and the pattern is the same – an initial sharp fall followed by a rebound. Based on multiple crisis since 1907 Ned Davis Research found an average decline of 7% in the US share market from such events, but 6 months later the market is up 10% on average and 1 year later its up around 15%. Put very simply, there are four scenarios:

  1. Russia stands down – this would provide a very brief boost for share markets, including Australian shares (eg 1%).

  2. Russia moves in to occupy the Donbas (which is already controlled by Russian separatists) with sanctions from the west but not so onerous that Russia cuts of gas to Europe – this could see a brief hit to markets (say -2-4%) like in the 2014 Ukraine crisis but it would soon be forgotten about.

  3. Russian invasion of all of Ukraine with significant sanctions and Russia stopping gas to Europe (causing a stagflationary shock to Europe & possibly globally as oil prices rise further) but no NATO military involvement – this could see a bigger hit to markets (say -10%) but then recovery over six months.

  4. Invasion of all of Ukraine with significant sanctions, gas supplies cut & NATO military involvement – this could be a large negative for markets (say -15-20%) as war in Europe, albeit on its edge, fully reverses the “peace dividend” of the 1990s. Markets may then take 6-12 months to recover.

Scenario 1 is still possible & it’s hard to see Russia undertaking a full invasion of Ukraine given the huge cost it would incur, let alone NATO troops being involved, but some combination of scenarios 2 and 3 are possible. But the history of such events points to an initial hit to shares, followed by a rebound.

What is the threat posed by global geopolitical tensions – including those with China?

Geopolitical issues have been building since the GFC and seemed to get a push along by the pandemic. The key drivers have been: a populist backlash against economically rationalist policies; the declining relative power of the US; and the polarising impact of social media. The most pressing are those with Russia (see above), China (in relation to Taiwan and trade with Australia) and Iran (in relation to its nuclear ambitions and oil supply). Although hard to time, they all make for a potentially more volatile ride in markets and possibly contribute to a less favourable return environment as they threaten higher inflation and less globalisation. It should be noted though that the economic impact of Australia’s tensions with China has been minor to date as most of the exports impacted were fungible commodities and able to find other markets. The same may apply in relation to iron ore if the adjustment occurs slowly.

Will the Australian Federal election have much impact?

There is a tendency for Australian shares to be somewhat flat in the run up to Federal elections followed by a bounce once it’s over and this is likely to apply this year with the election likely in May. In contrast to the 2019 election where Labor offered a higher tax and higher regulation agenda the policy differences so far appear less significant and if this remains the case the impact on investment markets is likely to be minor.

What is the outlook for Australian home prices?

From their pandemic lows in 2020 Australian dwelling prices are up 25%, but the gains have been slowing since March last year. We expect a further slowing in the months ahead as a result of worsening affordability, already rising fixed mortgage rates and rising variable rates from around August with average prices peaking in the September quarter and then falling into 2024. While prices are likely to rise 3% this year, they are likely to fall -5-10% next year. Top to bottom the fall could be around -10-15%, which would take prices back to the levels of mid last year. Sydney and Melbourne are the most vulnerable to higher rates as they have worse affordability and higher debt to income levels. They are both likely to see house prices peak by mid-year and risk top to bottom price falls of around 15%, whereas other cities and regions may not peak till later this year and have more modest top to bottom price falls.

Will the return of immigrants support home prices?

The return of immigrants this year will provide some support but will unlikely be enough to stop falls given the dominant impact of higher mortgage rates in constraining demand and given the likelihood that the initial return of immigrants will be gradual and won’t offset the net negative immigration of the last two years.

How can we improve housing affordability?

This requires a multifaceted solution across all levels of government with targets to be achieved over say a five-year period. My list of policies to improve affordability includes:

  • Measures to boost new supply – relaxing land use rules, releasing land faster and speeding up approval processes.

  • Matching the level of immigration in a post pandemic world to the ability of the property market to supply housing.

  • Encouraging greater decentralisation – the “work from home” phenomenon shows this is possible, but it should be helped along with appropriate infrastructure and of course measures to boost regional housing supply. Excess CBD office space should be speedily converted to residential.

  • Tax reform to replace stamp duty with land tax (to make it easier for empty nesters to downsize & cutting the upfront burden for first home buyers) & cutting the capital gains tax discount (to end a distortion favouring speculation).

What is the outlook for commercial property?

Commercial property may see weakness in retail and office returns as the influence of the pandemic on online buying and working from home impacts as retail and office leases come up for renewal, but industrial property is likely to be strong.

Should investors invest in Bitcoin and other cryptos?

It’s hard to see Bitcoin becoming digital cash – its transactions are slow and high cost, its highly volatile and it’s a massive user of electricity. It’s not an asset generating cash flows like rent or dividends which makes it very hard to value. And it appears to move in magnified fashion relative to shares, particularly during share market falls making it a poor portfolio diversifier. All of which makes it hard to justify other than as something to speculate on! Of course, this is not to say it can’t go up further as more jump on the bandwagon. Blockchain and distributed ledger technology offer significant potential but it’s hard to separate this from the speculation around crypto currencies.

Will high inflation cause a share market crash?

Shares have had a very strong rebound from their pandemic lows and are vulnerable to higher inflation as it puts upwards pressure on interest rates and downwards pressure on share market valuations (or price to earnings multiples). However, while a crash is always a risk it’s not our base case. First, earnings expectations are still being revised up albeit not as strongly as a year ago. Second, while monetary policy will be tightened its unlikely to become so tight as to cause a recession and slump in earnings. Finally, share markets still offer a strong earnings yield premium relative to bond yields in contrast to in the year 2000 when bond yields rose above earnings yields. Of course, if inflation just continues to surge then the risks to shares will increase.

What are good hedges against higher inflation?

Sustained higher inflation will ultimately mean upwards pressure on the yield structure in the economy which is negative for investments that have benefitted from years of low and falling interest rates, like high PE tech stocks. The best protection against sustained higher inflation would be inflation linked bonds, real assets like commodities and parts of the share market that will see stronger earnings growth.

With bond yields still low why invest in bonds?

Bonds are likely to see another year of negative returns this year reflecting still low starting point yields and capital losses as yields rise. However, they are still a good portfolio diversifier as they are likely to rally if significant concerns arise about a recession.

Source: AMP Capital February 2022

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

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Corrections, gummy bears and grizzly bears in shares

Posted On:Feb 10th, 2022     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Key points

Shares have had a good rebound but could still fall further in the short term as risks remain high around monetary tightening and geopolitical tensions.

However, a deep bear market is unlikely as US, global and Australian recessions are unlikely to be imminent.

Introduction

While shares have had a

Read More

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

Key points

  • Shares have had a good rebound but could still fall further in the short term as risks remain high around monetary tightening and geopolitical tensions.

  • However, a deep bear market is unlikely as US, global and Australian recessions are unlikely to be imminent.

Introduction

While shares have had a nice rebound from their January lows helped in part by some good earnings news – reversing around half of their 10% or so fall, concerns remain high around inflation, monetary tightening and the high risk of a Russian invasion of Ukraine. Our assessment remains that it’s too early to say we have seen the lows, but we remain of the view that January’s falls are not the start of major bear market.

The three bears – correction, gummy & grizzly

Very simply there are 3 types of significant share market falls:

  • corrections with falls around 10% – of course these aren’t really bear markets, but some might feel they are!;

  • “gummy” bear markets with falls around 20% meeting the technical definition many apply for a bear market but where a year after falling 20% the market is up (like 2018 & 2020 in the US and 2011, 2015-16 & 2020 for Australian shares); &

  • “grizzly” bear markets where falls are a lot deeper and usually longer lived and where a year after the initial first 20% fall the market is still down (like in 1973-74, US and global shares through the tech wreck or the GFC).

I first saw the terms “gummy bear” and “grizzly bear” applied by stockbroker Credit Suisse several years ago and find them to be a good way to conceptualise bear markets. Grizzly bears maul investors but gummy bears eventually leave a nicer taste (like the lollies). As we pointed out a couple of weeks ago in “Share market falls – seven things for investors to keep in mind”, corrections are quite normal and healthy as they enable the sharemarket to let off steam and not get too overheated. Excluding the present episode, since 2011 there have been roughly seven corrections and three gummy bear markets (2011, 2015-16 and 2020) in Australian shares.

The next table shows bear markets in Australian shares since 1900. The first column shows bear markets, the second shows the duration of their falls and the third shows the size of the falls. The fourth shows the percentage change in share prices 12 months after the initial 20% decline. The fifth shows whether they are associated with a recession in the US and/or Australia. The final column shows the 1-year rebound from the low.

Bear markets in Australian shares since 1900

Bear markets in Aust shares

Mths

% fall

% chge 12 mths after -20%

Recession Aust, US or both

1 yr gain from low, %

Jun 14-Dec 16

30

-22

11

Yes

10

Jul 29-Aug 31

25

-46

-30

Yes

33

Mar 37-Apr 42

61

-32

7

Yes

30

May 51-Dec 52

19

-34

-13

No

8

Sep 60-Nov 60

2

-23

5

Yes

12

Feb 64-Jun 65

16

-20

8

No

9

Jan 70-Nov 71

22

-39

-3

Yes

52

Jan 73-Sep 74

20

-59

-38

Yes

51

Aug 76-Nov 76

3

-23

8

No

5

Nov 80-Jul 82

20

-41

-13

Yes

39

Sep 87-Nov 87

2

-50

3

No

35

Aug 89-Jan 91

17

-32

10

Yes

39

Aug 91-Nov 92

15

-20

54

No

54

Feb 94-Feb 95

12

-22

16

No

25

Mar 02-Mar 03

12

-22

24

Yes

27

Nov 07-Mar 09

16

-55

-38

Yes

55

Apr 11-Sep 11

5

-22

10

No

12

Apr 15-Feb 16

10

-20

19

No

19

Feb 20-Mar 20

2

-37

20

Yes

53

Avg from 1900

16

-33

3

NA

30

Avg gummy bear

14

-27

15

NA

25

Avg grizzly bear

20

-46

-23

NA

40

Based on the All Ords, excepting the ASX 200 for 2015-16. I have defined a bear market as a 20% or greater fall in shares that is not fully reversed within 12 months. Source: ASX, Bloomberg, AMP

If a gummy bear market is defined by a 20% decline after which the market is higher 12 months later, whereas a grizzly bear market sees a continuing decline over the subsequent 12 months after the first 20% decline, then since 1900 there have been 13 gummy bears (highlighted in black). That leaves six grizzly bear markets (in red). Several points stand out:

  • First, the gummy bear markets tend to be a bit shorter and usually see much smaller declines averaging 27% compared to 46% for the grizzly bear markets.

  • Second, the average change over 12 months after the initial 20% fall is 15% for the gummy bear markets, but it’s a 23% decline for the grizzly bear markets.

  • Third, the grizzly bear markets invariably go with recessions, whereas the gummy bear markets tend not to be. Five of the six grizzly bear markets saw a US and/or Australian recession whereas less than half of the gummy bears did.

  • Fourth, after the low the share market rebounds sharply. This makes it hard to time, as by the time investors get back in the market is often above where they sold.

US share market falls are also much deeper and longer when there is a recession and, of course, moves in US shares have a significant influence on the Australian share market. The next table shows US share market falls greater than 10% since the 1970s. The first column shows the period of the fall, the second shows the decline in months, the third shows the percentage decline from top to bottom, the fourth shows whether the decline was associated with US recession or not and the fifth shows the gains in the share market one year after the low. Falls associated with recessions are highlighted in red.

Falls in US shares greater than 10% since the 1970s

Share mkt fall

Mths

% fall top to bottom

Recession
Yes/No

1 yr gain from low, %

Nov 68-May 70

18

-36

Yes

44

Apr 71-Nov 71

7

-14

No

30

Jan 73-Oct 74

21

-48

Yes

38

Sep 76-Mar 78

18

-19

No

13

Sep 78-Nov 78

2

-14

No

12

Oct 79-Nov 79

1

-10

No

29

Feb 80-Mar 80

2

-17

Yes

37

Nov 80-Aug 82

20

-27

Yes

58

Oct 83-Jul 84

9

-14

No

30

Aug 87-Dec 87

3

-34

No

21

Sep 89-Jan 90

4

-10

No

5

Jul 90-Oct 90

3

-20

Yes

29

Oct 97-Oct 97

1

-11

No

21

Jul 98-Aug 98

2

-19

No

38

Jul 99-Oct 99

3

-12

No

10

Mar 00-Oct 02

31

-49

Yes

34

Oct 07-Mar 09

17

-57

Yes

69

Apr 10-Jul 10

3

-16

No

31

Apr 11-Oct 11

6

-19

No

32

Apr 12-Jun 12

2

-10

No

26

May 15-Feb 16

9

-14

No

27

Jan 18-Feb 18

1

-10

No

15

Sep 18-Dec 18

3

-20

No

37

Feb 20-Mar 20

2

-34

Yes

75

Average

8

-22

NA

32

Avg with recessions

14

-36

NA

48

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

Again, several points stand out:

  • First, US share market falls associated with recessions tend to be longer and deeper than those without a recession.

  • Second, after the low the US share market rebounds sharply, particularly after falls associated with recession.

So, whether a recession is imminent, particularly in the US, is critical in terms of whether we will see a major bear market.

Is recession likely?

Our assessment is that, short of an external shock – a Russian invasion of Ukraine driving much higher European gas prices or a more deadly covid wave are the main risks here – a US, global and/or Australian recession is not imminent. Short term forecasting is fraught with difficulty, but right now, while inflation and worries about monetary tightening are concerning, it seems premature to expect a recession:

  • While new coronavirus cases exploded with Omicron, serious illness did not as vaccines and new treatments provided protection and the Omicron variants have been less harmful than prior variants. And the latest wave has had far less damaging economic impact. While the risk remains high, coronavirus could finally be moving from a pandemic to being endemic.

  • Excess savings of around $US2.3trn in the US and $250bn in Australia will provide an ongoing boost to spending.

  • While central banks will tighten monetary policy by more than previously expected, interest rates will still be very low.

  • It’s usually only when monetary policy is tight that it ends the economic cycle & the bull market and that’s a fair way off.

  • Rate hikes in Australia will cut into household spending power and home buyer demand but a hike to around 2% over the next 2-3 years will only push household housing debt interest payments as a share of household income back to around 2018 levels – but that’s 2-3 years away and is unlikely to push a significant number of households into debt problems as many are ahead on payments & given the 2.5% interest serviceability buffers banks apply.

Household housing interest payments v disposable income

Source: RBA, Macrobond, AMP

  • While the surge in inflation is a major threat, we are likely to see some moderation in inflation this year as production increases and spending rotates from goods back to services, which may take some pressure off central banks.

  • Business surveys point to strong investment – but we are a long way from boomtime levels that precede US recessions.

No US investment boom -yet

Source: NBER, Bloomberg, AMP

  • Inventories are low and will need to be rebuilt, which will provide a boost to production.

  •  Positive wealth effects from the stronger than expected rise in share markets and home prices since early 2020 are still feeding through and will help boost consumer spending.

  • China is starting to ease policy, which will boost Chinese growth over the next 6 to 12 months.

Global growth is likely to slow this year but to a still strong 4.5%, with Australian growth also around 4.5%, despite the Omicron wave resulting in a brief set back in the March quarter. So, it’s unlikely the falls in shares in January are the start of a grizzly bear market. That said, shares could still fall further in the short term, before resuming the bull market.

Source: AMP Capital February 2022

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

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The RBA ends bond buying

Posted On:Feb 02nd, 2022     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
– but remains “patient” on rates. We expect the first rate hike in August

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

Key points

The RBA will end quantitative easing this month.

While it now sees unemployment falling below 4% and higher inflation it is prepared to be “patient” for now.

We expect rate hikes to commence in August.

Ultimately,

Read More

– but remains “patient” on rates. We expect the first rate hike in August

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

Key points

  • The RBA will end quantitative easing this month.

  • While it now sees unemployment falling below 4% and higher inflation it is prepared to be “patient” for now.

  • We expect rate hikes to commence in August.

  • Ultimately, we see the cash rate rising to around 1.5 to 2% in the years ahead but it’s a bit of guess and the RBA will only raise rates as far as necessary to cool inflation.

  • Rate hikes from later this year are unlikely to be enough to threaten the economic recovery but they will add to the slowdown in the property market where we see dwelling prices peaking later this year.

Introduction

Over the last six months several central banks have raised interest rates. This started in emerging markets but developed country central banks have also hiked rates – notably those in the UK, NZ, Norway and South Korea. Both the Fed and Bank of Canada are likely to hike in March.

And now the RBA is (slowly) getting closer to rate hikes too. Last year it ended cheap funding for banks in June, slowed its bond buying and in November ended its 0.1% yield target for the April 2024 Government bond. It has now decided to end bond buying this month and while the RBA’s commentary was less hawkish than expected – being prepared to be “patient” in waiting for more confidence that the pick up in inflation will be sustained and still wanting to see faster wages growth – its forecasts have now shifted in a more hawkish direction: it now expects unemployment to fall below 4% this year; it expects a further pick up in wages growth; and now sees underlying inflation rising to around 3.25% in coming quarters before falling back to 2.75% next year (where it was forecast to be 2.25%).

So, while the RBA was not as hawkish as expected in its post meeting statement, its revised more upbeat forecasts have moved it in a more hawkish direction to at least allow the possibility of a start to rate hikes later this year, whereas previously its forward guidance was that a rate hike was unlikely until 2024, possible in 2023 but not in 2022.

For some time we have been more hawkish than the RBA and coming into this year were expecting the first hike would occur in November, but brought that forward to August two weeks ago. And that remains our view.

What’s driving expectations of earlier rate hikes?

Pretty much as has been seen in other countries, key data for jobs and inflation in Australia have been far stronger than expected with unemployment falling to 4.2% in December (against the RBA’s own forecast for 4.75%) and underlying inflation has now surprised on the upside for two quarters in a row reaching 2.6% in the December quarter. Moreover, the Melbourne Institute’s monthly Inflation Gauge, which is based on price surveys, has done a good job of pre-empting the official inflation data over time (albeit with a bit more volatility) points to a further rise in underlying inflation (the Trimmed Mean) into this quarter.

MI Inflation Gauge points to a further rise in underlying inflation

Source: Melbourne Institute, AMP

And, at its February meeting while the RBA was not as hawkish as expected it indicated that its forecasts for unemployment have been revised down and its inflation revised up. Wages growth is not yet at the “3 point something” that the RBA would like to see, but with unemployment on track to fall below 4% wages growth is now likely to pick up to the desired pace in the second half, while underlying inflation is now comfortably in the target range and likely to run above it through the second half of this year.

So while I can understand the RBA’s near term “patience” – although it does remind a bit of the Fed six months or so ago – the conditions for rate hikes look like being met in the second half of the year. With inflation pushing into the top half of the target range, the danger in waiting too long to start monetary tightening is that it will allow inflation to become entrenched and it will then be harder to get back under control again. This is the risk that central banks like the Fed may now be facing.

When will the RBA start raising rates?

Our base case remains for the first hike to come in August followed by another in September taking the cash rate to 0.5%. But if December quarter wages data due in three weeks shows an acceleration in wages growth, then the first rate hike could come in June.

Does this mean that the RBA got it wrong?

Some may complain that its forecasts were too cautious and so its forward guidance that a rate hike was unlikely until 2024, possible in 2023, but not in 2022 has been too dovish. But that guidance was based on data and forecasts and both change. Forecasting is always hard. Particularly in a pandemic which has blown forecasts all over the place and caused massive dislocation to supply and demand. And don’t forget that the RBA’s shift to focussing on actual inflation, as opposed to forecast inflation and adoption of very dovish guidance were designed to break Australia out of the very low inflation and low wages growth trap it has been in for the last six or seven years and for which many criticised it for being too hawkish. In this sense it may be argued that the RBA is now finally getting what it wanted, and it’s been right to be dovish! And it’s not as if inflation is now out of control in Australia. Underlying inflation is in the middle of the target range and headline inflation is half what it is in the US. And at 3.5%yoy, inflation in Australia is well below that in many comparable countries, viz 7% in the US, 5% in Europe, 5.4% in the UK, 4.8% in Canada and 5.9% in NZ.

How far will interest rates rise in Australia?

This is a guessing game as there are lots of cross currents.

  • On the one hand, very high household debt to income ratios compared to when rates last went up (in 2009-10) and particularly when inflation was last a big problem mean much smaller rate hikes will be necessary than in the past as they will now be more potent in slowing spending. For example, the threefold increase in the household debt to income ratio since the late 1980s means a 0.25% rate hike today is equivalent to a 0.75% rate hike back then. What’s more a big part of the rise in inflation has been caused by a pandemic driven surge in demand for goods and disruptions to supply, both of which should correct in time, which the RBA is rightfully mindful off so as not to overtighten.

  • On the other hand, many households have used the pandemic and lockdown period to pay down their debt faster (or build up saving buffers) and there has been increased use of fixed rate mortgages (which accounted for 50% of new lending). Both of which will help protect borrowers against initial rate hikes to some degree.

As best we can tell though fixed rate mortgages are still only around 30% of total mortgage debt outstanding and fixed rates have already started to rise cooling the property market which is one of the avenues through which monetary policy acts to cool things. And, of course, monetary policy operates with a lag of around 12 months and many who took out fixed rate deals in 2020 will see them start to mature later this year and next resulting in borrowers rolling over to much higher rates anyway. On balance while buffers and fixed rates may complicate things, the high level of household debt is likely to ultimately dominate in constraining how much the RBA will need to raise rates.

We are assuming a rise in the cash rate over the next few years to around 1.5 to 2%, which all things being equal will translate to an increase in variable mortgage rates of up to 2%. While this will cut into household spending power it should still be manageable for borrowers as banks were imposing a serviceability buffer of 2.5% up until October (ie, borrowers had to still be able to service the loan with up to a 2.5% higher interest rate) which has since been raised to 3%. This would take the cash rate back to or just above where it was in the years just before the pandemic but assumes much lower unemployment and faster wages growth and inflation.

Of course, this is all a bit of a guess at present and the RBA will not be on autopilot mindlessly raising rates to some level based on where rates were in the past and crashing the economy and property market in the process. The RBA will move in small increments – probably two steps at a time and pause to see what happens before doing more, but rates will not rise to nosebleed levels.

Official interest rates

Source: Bloomberg, AMP

What about the impact on the economy and shares?

At a high level, that the RBA is removing stimulus and getting closer to rate hikes is good news because it means economic conditions are improving. While rate hikes will cause bouts of uncertainty, we don’t see RBA rate hikes this year as being enough to end the economic recovery & bull market in shares:

  • Monetary policy will still be relatively easy for much of this year at least. It’s usually only tight monetary conditions that result in economic downturns & we are a long way from that.

  • This means that profits will continue to rise.

  • Despite the recent falls in share markets on rate hike fears, credit spreads have remained low, metal prices have held up and value stocks have been outperforming growth stocks all of which are positive signs for economic growth.

  • Even with two RBA rate hikes this year term, deposit rates would only rise to around 0.7% so they will still be very low relative to the grossed-up dividend yield on the Australian shares of around 5%.

However, the move towards RBA interest rate hikes does mean that we are now in a more constrained and volatile period for shares compared to the environment of the last year.

What about residential property prices?

The Australian property market is highly sensitive to the monetary cycle as a result of very high price and debt to income ratios. Rate hikes in 2009-10 were quickly followed by a period of weaker prices and macro prudential tightening achieved the same in 2015-16 and then more so in 2017-19. Dwelling price growth has already started to slow and we expect the combination of worsening affordability along with rising fixed rates and then rising variable rates later this year to see home prices peak in the September quarter and fall 5 to 10% in 2023.

Average capital city home prices

Source: CoreLogic; AMP

Source: AMP Capital February 2022

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

Read Less

Share market falls – seven things for investors to keep in mind

Posted On:Jan 25th, 2022     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Share markets have fallen in recent weeks on the back of worries about inflation, monetary tightening, the Omicron disruption and the rising risk of a Russian invasion of Ukraine.

Its too early to say markets have bottomed.

Key things for investors to bear in mind are that: corrections are

Read More

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

  • Share markets have fallen in recent weeks on the back of worries about inflation, monetary tightening, the Omicron disruption and the rising risk of a Russian invasion of Ukraine.

  • Its too early to say markets have bottomed.

  • Key things for investors to bear in mind are that: corrections are healthy and normal; in the absence of a renewed recession share market falls may be limited; selling shares after a fall locks in a loss; share pullbacks provide opportunities for investors to buy them more cheaply; shares offer an attractive income flow; and finally, to avoid getting thrown off a long-term investment strategy it’s best to turn down the noise.

Introduction

Most of the time share markets are relatively calm and don’t make the headlines. But every so often they have a tumble and make the “front page” with headlines (or these days click bait) like “billions wiped off share market” and “biggest share plunge since…” Each one is met with lots of analysis and prognostication from experts. Sometimes the plunge ends quickly and the market heads back up again and is forgotten about (like last September when I last wrote a note like this). But once every so often share markets keep falling for a while. Sometimes the falls are foreseeable, but rarely are they forecastable (which requires a call as to timing and magnitude)…despite many (who got lucky) claiming otherwise. In my career, I have seen many share market falls, and I even saw the market fall 25% one day.

And so it is again – with share markets starting the year on a sour note. From their highs, US shares have fallen 8%, with the tech heavy Nasdaq down 14%, global shares are down 7% and Australian shares are also down 7%. Always the drivers are slightly different. But as Mark Twain is said to have said “history doesn’t repeat but it rhymes”, and so it is with share market falls. This means that from the point of basic investment principles, it’s hard to say anything new. So apologies if you have seen my “seven things for investors to keep in mind” before, but at times like this they are worth reiterating.

What’s driving the fall in share markets

The decline in share markets reflects a range of factors.

  • Inflation readings have continued to surprise on the upside most recently for the US where inflation is now 7% and is at its highest in nearly 40 years. But Europe, the UK and Canada have also reported sharp increases in inflation.

  • Along with hawkish comments from central banks, this has seen increased expectations for central bank interest rate hikes this year. Markets now expect four or more rate hikes from the Fed, Bank of England, Bank of Canada, Reserve Bank of New Zealand and the RBA this year.

  • This has come at a time when the surge in Omicron cases globally has disrupted economic activity, recent economic releases have been mixed and investors fret the rate hikes will depress economic activity and hence profits.

  • There is a high risk Russia will invade Ukraine or part of it as talks around its demand for Ukraine not to join NATO and NATO countries not to station strategic weapons there failed to resolve the issue. While it’s hard to see NATO countries going to war with Russia in Ukraine, an invasion will likely trigger sanctions on Russia, further worsening Europe’s gas shortage and threatening European growth and inflation.

  • And share markets have had huge gains since their March 2020 lows. US shares rose 114% and Australian shares rose 68% to their recent highs. Shares are no longer dirt cheap. There has been froth with meme stocks, SPACs and the crypto craze. And relatively calm years – with the biggest drawdowns last year being 5% in US shares and 6% in Australian shares – are often followed by a rough year. So, some are talking of crashes (as they often do).

Seven things for investors to bear in mind

Sharp market falls are stressful for investors as no one likes to see their investments fall in value. But at times like these there are seven things investors should keep in mind:

First, while they all have different triggers and unfold differently, periodic share market corrections of the order of 5%, 15% and even 20% are healthy and normal. For example, during the tech/dot-com boom from 1995 to early 2000, the US share market had seven pullbacks ranging from 6% to 19% with an average decline of 10%. During the same period, Australian shares had eight pullbacks ranging from 5% to 16%. All against a backdrop of strong returns every year. During the 2003 to 2007 bull market, the Australian share market had five 5% plus corrections ranging from 7% to 12%, again with strong positive returns every year. And the last decade regularly saw major pullbacks. See the next chart.

Share markets pullbacks are normal

Source: Bloomberg, AMP

But while share market pullbacks can be painful, they are healthy as they help limit complacency and excessive risk taking. Related to this, shares climb a wall of worry over many years with numerous events dragging them down periodically (see the next chart), but with the long-term trend ultimately up & providing higher returns than other more stable assets. Bouts of volatility are the price we pay for the higher longer-term returns from shares.

Australian shares have climbed a wall of worry

Source: ASX, AMP

Second, historically, the main driver of whether we see a correction (a fall of say 5% to 15%) or even a mild bear market (with say a 20% decline that turns around relatively quickly like we saw in 2015-2016 in Australia or in 2018 in the US) as opposed to a major bear market (like that seen in the global financial crisis (GFC), or the 35% or so falls seen in early 2020 going into the coronavirus pandemic) is whether we see a recession or not – notably in the US, as the US share market tends to lead most major global markets. Of course, short term forecasting is fraught with difficulty and should not be the basis for a long-term investment strategy, but right now, while inflation and worries about monetary tightening are concerning, it seems premature to expect a US, global or Australian recession:

  • New coronavirus cases in the US, Europe and Australia are slowing with vaccines providing protection against serious illness and the Omicron variant proving less harmful than prior variants. This should see business conditions indicators rebound. While the risk remains high, coronavirus could finally be moving from a pandemic to being endemic.

  • Excess savings of around $US2.3trn in the US and $250bn in Australia will provide an ongoing boost to spending.

  • While central banks will tighten monetary policy this year it will still be easy as rates will still be very low.

  • It’s usually only when monetary policy becomes tight that it ends the economic cycle & the bull market and that’s a fair way off.

  • Inventories are low and will need to be rebuilt which will provide a boost to production.

  • Positive wealth effects from the stronger than expected rise in share markets and home prices since early 2020 are still feeding through and will help boost consumer spending.

  • China is starting to ease policy which will boost Chinese growth over the next 6 to 12 months.

Global growth is likely to slow this year but to a still strong 5%, with Australian growth of around 4%, despite the Omicron wave resulting in a brief set back in the March quarter.

Third, selling shares or switching to a more conservative investment strategy whenever shares suffer a setback just turns a paper loss into a real loss with no hope of recovering. Even if you get out and miss a further fall, trying to time a market recovery is very hard. And the risk is you don’t feel confident to get back in until long after the market has fully recovered. The best way to guard against deciding to sell on the basis of emotion after weakness in markets is to adopt a well thought out, long-term strategy and stick to it.

Fourth, when shares and growth assets fall, they’re cheaper and offer higher long-term return prospects. So, the key is to look for opportunities’ pullbacks provide. It’s impossible to time the bottom but one way to do it is to “average in” over time.

Fifth, Australian shares are offering a very attractive dividend yield compared to banks deposits. Companies don’t like to cut their dividends, so the income flow you are receiving from a well-diversified portfolio of shares is likely to remain attractive, particularly against bank deposits.

Australian shares offer a very attractive yield versus bank deposits

Source: RBA, Bloomberg, AMP

More broadly, while bond yields are well up from their lows the risk premium shares offer over bonds – as proxied by their earnings yield less the bond yield – remains relatively attractive. And in the last few days bond yields have started to fall again, reflecting safe haven demand which along with the fall in share markets has helped improve share market valuations.

Shares still offer a reasonable risk premium over bonds

Source: Reuters, AMP

Sixth, shares and other related assets often bottom at the point of maximum bearishness, ie, just when you and everyone else feel most negative towards them. So, the trick is to buck the crowd. “Be fearful when others are greedy. Be greedy when others are fearful,” as Warren Buffett has said. The last month has seen investor sentiment swing negative again which is positive from a contrarian perspective. Of course, investor sentiment could still get more negative in the short term before it bottoms.

Finally, turn down the noise. At times like the present, the flow of negative news reaches fever pitch – and this is being accentuated by the growth of social media. Talk of billions wiped off share markets and talk of “crashes” help sell copy and generate clicks and views. But such headlines are often just a distortion. We are never told of the billions that market rebounds and the rising long-term trend in share prices adds to the share market. All of this makes it harder to stick to an appropriate long-term strategy let alone see the opportunities that are thrown up. So best to turn down the noise and watch Brady Bunch, 90210 or Gilmore Girls re-runs!

Source: AMP Capital January 2022

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

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