Provision Newsletter

By Emily Woodland

Co-Head of Sustainable InvestmentHong Kong, China

Impact investing has become much more sophisticated, as funds in this asset class start to develop more meaningful ways of measuring their outcomes. Global investors’ growing commitment to frameworks such as the UN’s Sustainable Development Goals (SDGs) are also helping increase exposure to and discussion around this still relatively niche investment area.

This style of investing was the focus of a recent AMP Capital roundtable, involving leading fund managers in this area, as well as a host of other experts in this field.

Investment opportunities

Impact investors aim to deploy capital in a way that creates positive social and/or environmental effects, in addition to a financial return.

Although impact investing is asset-class agnostic, according to a survey published by the Global Impact Investing Network (GIIN)¹, on average 41 per cent of impact investors’ capital is currently invested in private debt and 18 per cent in private equity. While the tides are slowly turning, this is largely due to the fact it’s still more difficult to find pure-play companies in impact investing in public markets.

Additionally, there tends to be more opportunities for impact investments in developing and emerging markets, rather than developed markets. This is because far more capital is required in developing markets to achieve a real social impact, compared to developing markets.

One example discussed at the roundtable was the Newpin Social Benefit Bond, which is funding the expansion of the Newpin program, run by Uniting Care Burnside. The A$7 million bond aims to reduce the number of children needing to enter foster care, and support those currently in foster care to return to their families. Designed to achieve specific outcomes, it also includes capital guarantees, while returns depend on children being able to stay with their families on a permanent basis.

The bond aims to achieve a 60 to 65 per cent success rate in terms of children going back to their families, and a return of between 8 per cent and 12 per cent a year. So far, it has achieved a return of 12.2 per cent and 130 children have been reunited with their families.

Challenges of impact investing

One of the challenges of impact investing discussed was how to measure success. Environmental impacts tend to be easier to measure than social impacts because there is more common quantifiable data, such as the amount of CO2 emissions avoided, or the number of gigawatts of renewable energy produced. Social impacts, on the other hand, may include the number of affordable homes provided or dollar savings achieved by the government.

However, it’s difficult to attain consistency of measurement across different investments because of the vast array of impacts, a lack of commonality and difficulty in quantifying and comparing impact. Currently, the 17 SDGs are the most commonly used impact performance measurement tool, where investors assign impact to one or more of the goals, such as climate action or gender equality. The Impact Management Project is also being commended as another potential solution for impact reporting frameworks.

Similarly, getting the balance right between delivering a strong return to investors and ensuring the community or issue the investors are attempting to resolve receives adequate funding, is another obstacle impact investing is currently navigating.

In short, it is absolutely possible to achieve competitive returns. The Responsible Investment Association of Australia²  recently found that investor experience in Australia has largely been in line with their expectation for market returns. Globally, The GIIN1 2018 Annual Investor Survey found that the majority of respondents reported performance in line with both impact (82%) and financial (76%) expectations (where financial targets were mostly risk-adjusted, market-rate returns). 15% even experienced outperformance versus expectations in terms of both impact and financial returns.

Despite these encouraging findings, it is still proving difficult to draw meaningful conclusions about impact investment performance, due to a lack of available data over the short history of the industry, and lack of clarity over the appropriate definition of market return or benchmark in these instances.

Overall, we believe there are plenty of opportunities for impact investors to improve and refine the way capital is allocated and returns are measured. It appears that the sector is moving in the right direction to achieve these aims, for the benefit of groups that require funds to tackle social and other global issues, and the communities in which they are focused.

Please contact us on |PHONE| if you seek further assistance on this topic .

¹Global Impact Investing Network. See https://thegiin.org/assets/2018_GIIN_Annual_Impact_Investor_Survey_webfile.pdf

²RIAA is the Responsible Investment Association of Australia, the peak body for impact investing advocacy in Australia, see https://responsibleinvestment.org/about-us/ for further information. Impact Investing is a relatively immature but rapidly growing industry, so there is limited information available on actual investments and their financial and impact performance outside of RIAA’s work. In this article, unless otherwise stated, we have sourced all data from the RIAA Benchmarking Impact – Australian Impact Investment Activity and Performance Report 2018

Source : AMP Capital June 2019 

 Important notes: 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

The vision for ethical investing is simple: invest for the long term while making the world a better place. It’s noble and hard to argue with.

Implementing the vision, however, is not so easy.

The investing world is seldom black and white. Investors often face a decision choosing the lesser of two evils, or the better of two goods, rather than between good and evil. Every investment decision has consequences. Responsible investors think about the direct and indirect ramifications of every buy and sell recommendation.

For example, withdrawing money from a resources project on the back of political concerns has the potential to decimate a rural village in an under-privileged part of the world, condemning hundreds or thousands of people to poverty. Quitting investing in coal fired power generation and putting everything into renewables would, in the short term, literally result in the lights going out.

These are the sorts of conundrums ethical investors face every day. They have to balance the goal of making the world a better place with achieving acceptable returns. (Investing, by definition, includes achieving a return and when people put money into an investment, they expect the return to be financial.)

The best ethical investors have clear guidelines on how to work towards making the world a better place while also achieving a financial return. The AMP Capital Responsible Investment Leaders (RIL) funds are guided by three principles.

1. We invest in companies and managers at the better end of the spectrum on environmental, social and governance issues.

2. We believe part of our job is to lobby for change and expect all of our managers in Australia and overseas to share our philosophy.

3. We exclude companies and assets that have a significant negative social impact.

Environment, social and governance (ESG)

The environment, and specifically climate change, is arguably the biggest challenge facing the world today and we are committed to invest to help find solutions. But there is no quick fix or easy answer.

The AMP Capital RIL funds think about climate change using some key parameters.

Our first parameter is that we exclude all companies that make a material amount of money – more than ten per cent of sales – from the most carbon intensive fossil fuels. These are thermal coal, oil sands, brown-coal coal-fired power and the conversion of coal to liquid fuels or feedstock.

The second is that we do not invest in infrastructure companies that facilitate the most emissions intensive fossil fuels. For example, it means we do not invest in companies that own oil sands pipelines.

This approach to exclusion and divestment means that the Socially Responsible Investment Balanced option at AMP Capital has a significantly smaller carbon footprint than the markets we invest in. For example, in Australia, its carbon footprint is 50 per cent less than the ASX200¹.

Our approach is to support the transition needed to address climate change. So, we still invest in some oil and gas companies which are best of breed in terms of environmental, social and governance impacts. This is the third parameter. It is not practical to stop investing in all energy and resource companies, even as we ramp up investments in companies that are helping economies transition to a renewable basis.

Gas in particular, is also expected to play a much more important role in providing energy to the world under a two degree temperature rise scenario (a two degree temperature rise by 2040 is the current goal contained in the Paris Agreement).

For example, the International Energy Agency² expects that demand for natural gas will increase by 11 per cent under its most ambitious scenario, known as the Sustainable Development Scenario. Coal is likely to need to be replaced by renewables but natural gas will remain an important part of the global energy mix.

There are some fossil fuels that do not yet have a natural alternative. An example is the type of coal used to make steel (metallurgical coal) and oil used for transportation. Developing economies like China and India, who have not benefited from the full spectrum of fossil fuels like we have, will need some fossil fuels as they develop, bringing millions of people out of poverty.

Away from the environment (though often these issues are inextricably linked) are other important social and governance issues which ethical investors consider.

Rates of pay for labour in factories in parts of Asia remains an issue as does deforestation. Access to medicines – something Australians almost take for granted – is a major barrier for millions of people in both the developed and underdeveloped world. The use of plastics, the prevalence of antibiotics in the food supply and the rights and wrongs of investing in social media are all issues ethical investors, including AMP Capital, grapple with.

Lobbying for change

The biggest difference a fund manager can make in helping make the world a better place is to lobby for change and influence countries and companies to do things differently.

Large fund managers such as AMP Capital are in the privileged position of being able to encourage change. We do this by meeting with the executives and boards of the companies that we own and asking them to do things differently.

We have asked retailers to map and publish their supply chains and pay factory workers a living wage. We have asked banks to lift their game on responsible lending, address sales-based cultures and compensate customers who have been treated poorly. We have asked the world’s largest resource and utilities companies to map and disclose their path to a lower carbon economy.

Just as importantly, we appoint investment managers who ascribe to our philosophy and we take part in investor coalitions that call for change. This includes Climate Action 100+, a five-year global initiative designed to bring together the world’s largest investors and the world’s largest greenhouse gas emitters. To date, 320 investors responsible for more than US$33 trillion of assets under management have committed to the initiative.

Negative and positive social impact

While the environment garners much of the attention, there are other companies and sectors which many ethical investors avoid because they are inherently destructive and cause harm to people.

For example, the AMP Capital Responsible Investment Leaders Balanced fund does not invest in any companies that manufacture or produce:

• tobacco;

• nuclear weapons;

• cluster munitions;

• land mines; or

• other biological or chemical weapons manufacturers.

Nor does it invest in companies that make more than 10 per cent of their sales from alcohol, gambling and/or pornography. This is because of the social harm that the use of these products can cause.

Our position on nuclear power is clear: we exclude companies that make 10% or more of their sales from the production of nuclear power. The main reasons are; the potential for significant accidents, such as the Fukushima Daiichi nuclear reactors in Japan; and the unsolved problem of safe long-term nuclear waste disposal. (As we’ve seen in much of the western world there are also serious questions about the financial viability of nuclear power).

The flip side is the many opportunities to invest in assets that improve society and are constructive to people. Investing in schools and higher educational facilities, hospitals, water treatment and desalinisation plants, and even prisons focused on rehabilitation all fall into that category of ethical investing which will make the world a better place.

Green bonds

One of the most important ways we support companies and assets that are developing solutions to ESG challenges is by investing in green bonds. These are essentially loans, made by investors such as the World Bank or governments, for green projects all over the world. Projects that the Socially Responsible Investment Balanced option are funding right now include solar energy farms, energy efficient technology, energy storage solutions, sustainable transport, cycleways, recycling research and development and forestry plantations.

In Australia, one of the green bonds we bought in 2018 is funding a water recycling plant in New South Wales that is expected to save 18 billion litres of drinking water each year.

Another way we finance renewables is by investing in cleantech private equity. This way we provide early stage capital for companies developing the next generation of clean energy.

Conclusion

There are no easy solutions to the myriad of questions raised by investing ethically. A set of clear principles to guide investment decisions is the most practical and effective way of facilitating change. It is an evolutionary process, not a revolution, that will make the world a better place.

By Kristen Le Mesurier

Portfolio Manager, Multi Asset GroupSydney, Australia

1 Calculated at 30 June 2018 by AMP Capital. 
2 The IEA is an intergovernmental agency started by the OECD

Source : AMP Capital May 2019 

 Important notes: 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

Introduction

After a third round of talks made little progress last week, the US/China trade war has escalated badly with tit for tat moves on an almost daily basis by each side. This has seen share markets fall sharply with US, global and Australian shares down about 5-6% from recent highs and safe haven assets like bonds and gold benefiting on the back of worries about the global growth outlook. This note looks at the key issues.

What is a trade war?

A trade war is where countries raise barriers to trade with each other usually motivated by a desire to “protect” jobs often overlaid with “national security” motivations. To be a “trade war”, the barriers need to be significant in terms of their size and the proportion of imports covered. The best-known global trade war was that in 1930 which saw average 20% tariff hikes on US imports.

What is so good about free trade?

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

So why is President Trump raising tariffs then?

It’s basically about fulfilling a presidential campaign commitment to “protect” American workers from what he regards as unfair trading practices in countries that the US has a trade deficit with – notably China. And he knows this is popular with his supporters but there is also some degree of bi-partisan support for taking on China.

What does President Trump want?

Basically, he wants China to lower its tariffs, allow better access for US companies, end US companies being forced to hand over their technologies and protect intellectual property of US companies. At a high level he wants a reduction in America’s trade deficit with China. Along the way he has renegotiated the NAFTA free trade agreement with Mexico and Canada and the free trade deal with South Korea and is in talks with Europe and Japan. In recent times he has also used the threat of tariffs to get what he wants from countries (eg Mexico in relation to border protection).

Where are we now?

Fears of a global trade war kicked off in March last year with Trump’s announcement of a 10% tariff on aluminium imports and a 25% tariff on steel imports. US allies were subsequently exempted but China was not. On March 22 Trump announced 25% tariffs on $US50bn of US imports from China. These were implemented in July and August. After Chinese retaliation Trump announced a 10% tariff on another $US200bn of imports from China (implemented in September) which would increase to 25% on January 1 this year. The latter was delayed as the talks made progress.

However, following May 5 tweets by Trump, on May 10 the delayed tariff hike from 10% to 25% on $US200bn of imports from China was put in place and the US kicked off a process to tariff the remaining roughly $US300bn of imports from China at 25%. If fully implemented this would take the average US tariff rate on imports to around 7.5%, which is significant (albeit minor compared to the 20% 1930 tariff hikes). See next chart.

Average weighted tariff rate across all products

View larger image

Source: World Bank, Deutsche Bank Research

Along the way, China’s retaliation has been less than proportional, partly reflecting lower imports from the US. The US has also put in place restrictions on dealing with Chinese tech companies like Huawei.

Following a meeting in late June between Presidents Trump and Xi the trade war was put on hold pending a third round of talks. These look to have made little progress and Trump announced last week that from September 1 the remaining $US300bn of imports from China will be taxed at 10% and this may go beyond 25%.

China has responded by allowing the Renminbi to fall below 7 to the $US and reportedly ordering state-owned enterprises to halt imports of agricultural products from the US. The US then named China a currency manipulator (even though basic economics pointed to a fall in the Renminbi in response to the tariffs on its good) which opens the door to possibly further action by the US (eg intervention to lower the $US versus the Renminbi) and potentially a further escalation in the trade war.

At the same time, the US is still considering auto tariffs after a report lodged in February.

What happened to the US/China trade talks?

This has been the third round of trade talks that look to have failed. The timing of the announcement of the latest round of tariffs may also reflect a desire by Trump to force the Fed to ease more as he wasn’t happy with its 0.25% cut last week and to show that he is tougher on trade than far-left Democrat presidential candidates Sanders and Warren. Whatever it is, there is likely to have been a further breakdown in trust between China and the US and China may have decided to wait till after the election.

Ongoing tensions around North Korea, Iran, Hong Kong, Taiwan and the South China sea are probably not helping the issue either.

What will be the economic impact?

The latest round of tariff increases from September 1 would be a big deal compared to last year’s tariffs and see the impact shift to largely consumer goods as opposed to intermediate goods in the first tariff rounds. The 10% tariff could knock around 0.3% from US and Chinese GDP particularly as investment gets hit in response to uncertainty about supply chains. The full 25% tariff could take that to around 0.75% with roughly a 0.2% boost to US core inflation (albeit this would be temporary and looked through by the Fed). This would flow on to slower global growth and lead to less demand for Australia’s exports even though we are not directly affected.

What is the most likely outcome?

At this point, it’s hard to see a way out of the escalating trade war and it risks flowing into other issues as well including around HK, Taiwan, and the South China sea as the US and China slip further towards some sort of “cold war”. However, as the economic impact in the US mounts – so far it’s just been impacting business confidence and investment plans but risks impacting consumer spending too – President Trump is likely to become more concerned. Recessions and rising unemployment have historically killed the re-election of sitting presidents (Hoover, Ford, Carter and Bush senior) and for this reason, we remain of the view that a deal will be reached before the election. President Trump showed late last year that he was sensitive to the impact of the trade conflict on the US share market (as after sharp falls he called President Xi to set up a new meeting). So sharp share market falls may be needed again to get the US and China negotiating. But this means it could still get worse before it gets better – the US share market had a top to bottom fall last year of 20%!

It’s also worth noting that policy stimulus by the Fed and the Chinese government will offset some of negative impact which along with the absence of the sort of excesses (like in cyclical spending, inflation and private debt) that normally precede recessions in the US is why we are not predicting a recession.

What does it mean for investment markets?

Basically, the uncertainty around the escalating trade war is bad for listed growth assets like shares as it threatens the outlook for growth and profits, but positive for safe-haven assets which is why bond yields in many countries including Australia have pushed further into record low territory and gold has increased in value.

Following last week’s highs, global and Australian shares have fallen roughly 5-6%, mainly reflecting concern about the impact on growth from the escalating trade war. Further downside is likely in the short term as the trade war continues to escalate and we are also in a seasonally weak part of the year for shares. This is likely to be associated with further falls in bond yields.

However, providing we are right and recession is avoided, a major bear market in shares (ie where shares fall 20% and a year later are down another 20% or so) is unlikely.

What does it all mean for Australia?

Fortunately, Australians aren’t having to pay higher taxes on imports like Americans, but the main risk is that we are indirectly affected as the US/China trade war drags down global growth, weighing on demand for our exports and leading to unemployment pushing higher than our 5.5% forecast for year end. This all adds to the case for further easing by the RBA (we expect the cash rate to fall to 0.5% by February) and for further fiscal stimulus.

What should investors do?

Times like the present are stressful for investors. No one likes to see their wealth fall and uncertainty seems very high. I don’t have a perfect crystal ball, so from the point of sensible long-term investing the following points are worth bearing in mind.

• First, periodic sharp setbacks in share markets are healthy and normal as can be seen in the next chart. The setbacks are the price we pay for the higher long-term return from shares. After 25% or so gains from their lows, last December shares were at risk of a correction.

View larger image

Source: Bloomberg, AMP Capital

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

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

• Fourth, while shares may be falling in value, the dividends from the market aren’t. The income flow you are receiving from a diversified portfolio of shares remains attractive.

• Fifth, shares often bottom at the point of maximum bearishness. So, when everyone is negative and cautious it’s often time to buy.

• Finally, turn down the noise on financial news. In periods of market turmoil, the flow of negative news reaches fever pitch, which makes it very hard to stick to a well-considered, long-term strategy, let alone see the opportunities.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 7th August 2019

Important notes: 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

At its meeting today, the Board decided to leave the cash rate unchanged at 1.00 per cent.

The outlook for the global economy remains reasonable. However, the increased uncertainty generated by the trade and technology disputes is affecting investment and means that the risks to the global economy remain tilted to the downside. In most advanced economies, unemployment rates are low and wages growth has picked up, although inflation remains low. The slowdown in global trade has contributed to slower growth in Asia. In China, the authorities have taken steps to support the economy, while continuing to address risks in the financial system.

Global financial conditions remain accommodative. The persistent downside risks to the global economy combined with subdued inflation have led a number of central banks to reduce interest rates this year and further monetary easing is widely expected. Long-term government bond yields have declined further and are at record lows in many countries, including Australia. Borrowing rates for both businesses and households are also at historically low levels. The Australian dollar is at its lowest level of recent times.

Economic growth in Australia over the first half of this year has been lower than earlier expected, with household consumption weighed down by a protracted period of low income growth and declining housing prices. Looking forward, growth in Australia is expected to strengthen gradually from here. The central scenario is for the Australian economy to grow by around 2½ per cent over 2019 and 2¾ per cent over 2020. The outlook is being supported by the low level of interest rates, recent tax cuts, ongoing spending on infrastructure, signs of stabilisation in some housing markets and a brighter outlook for the resources sector. The main domestic uncertainty continues to be the outlook for consumption, although a pick-up in growth in household disposable income and a stabilisation of the housing market are expected to support spending.

Employment has grown strongly over recent years and labour force participation is at a record high. There has, however, been little inroad into the spare capacity in the labour market recently, with the unemployment rate having risen slightly to 5.2 per cent. The unemployment rate is expected to decline over the next couple of years to around 5 per cent. Wages growth remains subdued and there is little upward pressure at present, with strong labour demand being met by more supply. Caps on wages growth are also affecting public-sector pay outcomes across the country. A further gradual lift in wages growth would be a welcome development. Taken together, recent labour market outcomes suggest that the Australian economy can sustain lower rates of unemployment and underemployment.

The recent inflation data were broadly as expected and confirmed that inflation pressures remain subdued across much of the economy. Over the year to the June quarter, inflation was 1.6 per cent in both headline and underlying terms. The central scenario remains for inflation to increase gradually, but it is likely to take longer than earlier expected for inflation to return to 2 per cent. In both headline and underlying terms, inflation is expected to be a little under 2 per cent over 2020 and a little above 2 per cent over 2021.

Conditions in most housing markets remain soft, although there are some signs of a turnaround, especially in Sydney and Melbourne. Growth in housing credit remains low. Demand for credit by investors continues to be subdued and credit conditions, especially for small and medium-sized businesses, remain tight. Mortgage rates are at record lows and there is strong competition for borrowers of high credit quality.

It is reasonable to expect that an extended period of low interest rates will be required in Australia to make progress in reducing unemployment and achieve more assured progress towards the inflation target. The Board will continue to monitor developments in the labour market closely and ease monetary policy further if needed to support sustainable growth in the economy and the achievement of the inflation target over time.

Source: Reserve Bank of Australia, August 6th, 2019

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As widely anticipated, the US Federal Reserve has cut its key Fed Funds cash rate by 0.25% to a range of 2-2.25%. This is the Fed’s first rate cut since December 2008 and follows nine 0.25% rate hikes between December 2015 and December last year. The Fed also announced that quantitative tightening (ie the process of reversing its quantitative easing program by letting bonds on its balance sheet mature) will end immediately, which is about two months earlier than previously flagged. The Fed’s post-meeting statement left the door open to more cuts although Fed Chair Powell’s press conference confused things a bit (again!) by saying it’s a “mid-cycle adjustment” and “not the beginning of a long series of cuts” but it may not be “just one”.

Taking out some insurance

With underlying US growth still solid and the jobs market tight this should be seen as the Fed taking out some insurance given various threats to the growth outlook including from the US/China trade war, tensions with Iran and slower global growth generally and a greater willingness by the Fed to take risks with higher inflation as opposed to deflation.

So it’s a bit like the easings of 1987 after the share market crash and in 1998 during the LTCM hedge fund crisis when Russia defaulted leading LTCM to go bust, threatening the US financial system.

The pattern of the past 50 years or so is for the Fed to cut rates after some form of crisis threatens the economic outlook. See the next chart. In 2001 it was the tech wreck and in 2007 it was the sub-prime mortgage crisis. This time around there is nothing on that scale although it may be argued that the trade wars are providing the biggest single threat.

Source: Thomson Financial, AMP Capital Investors

This year’s fall in core private final consumption inflation back below the Fed’s 2% target provided the Fed with the scope to move.

Further easing is likely, but it’s likely to be limited

It’s rare for the Fed to just cut once. In the insurance cuts of 1998 through the LTCM crisis it eased 3 times by 0.25%. Given that the risks to the growth outlook – particularly on trade – won’t go away quickly and that the Fed appears to have taken the decision that it’s easier to control a rise in inflation than a further slide or deflation, it’s likely to cut rates further and we are allowing for another cut in September.

However, we remain of the view that a US recession is not imminent (see The longest US economic expansion ever). While the yield curve is flashing warning signs, the excesses that normally precede US recessions are not present. In particular: the US has not seen a spending boom with cyclical spending on consumer goods, investment and housing running around average as a share of GDP; private debt growth has been moderate; and inflation has been low. Consequently, there is no boom to go bust. Moreover, monetary policy had not become tight with the Fed Funds rate never having reached the high levels that normally precede recessions. See the next chart.

Source: NBER, Bloomberg, AMP Capital

As a result, we see this easing cycle by the Fed as being limited to around 2 or 3 rate cuts with the next likely coming in September as opposed to the 4 or so that the money market has factored in.

Of course, the main threats to this relate to US trade wars and tensions with Iran.

The Fed and shares

Falling interest rates are generally positive for shares. They help boost economic and profit growth and make shares relatively more attractive than cash and hence are usually associated with a higher price to earnings multiples. The table below shows the US share market’s response after the first-rate cut following major tightening cycles.  

US recession highlighted in red. Source: Thomson Reuters, AMP Capital

The US share market rose over the subsequent 3, 6 and 12 months after the commencement of 5 of the last 8 Fed easing cycles. The exceptions were after the rate cuts in 1981, 2001 and 2007 which were associated with recessions.

The reaction by the Australian share market is similar, except the Australian share market wasn’t greatly affected by the post-2000 bursting of the tech bubble.

US recessions highlighted in red. Source: Thomson Reuters, AMP Capital

So if we are right and the US avoids a recession in the next year or so then US interest rate cuts should be positive for shares beyond any near term uncertainty (and the initial reaction which has seen US shares fall as the Fed wasn’t as dovish as hoped) and are likely to be higher on a 6-12 month horizon. It is worth repeating the old saying “don’t fight the Fed”. While scepticism is high that central banks with low-interest rates and QE will spur growth, an investor would have made a huge mistake over the past decade betting against them. The key though is that global economic indicators need to start improving in the months ahead.

Implications for Australian interest rates

The directional relationship between the US and Australian interest rates weakened long ago. The RBA started raising rates in 2009 when the Fed held at zero, it was easing in 2016 when the Fed was hiking and this year it started cutting ahead of the Fed. So just because the Fed moves doesn’t mean the RBA will as well! On the one hand the Fed’s easing along with stimulus elsewhere globally should help support global growth which is good for Australia. But it’s probably not enough to change the outlook for the RBA. Our view remains that it’s on track to cut the cash rate to 0.5% by early next year and to some degree the Fed cutting too reinforces that to the extent that the RBA would like to keep the Australian dollar down.

What about the role of President Trump?

President Trump has been highly critical of Fed rate hikes over the past year and has been saying they should be cutting in recent times. Of course, presidents and prime ministers usually prefer lower than higher rates but the issue, in this case, has been more around whether his comments represent a threat to the Fed’s independence, which is necessary to ensure sensible monetary policy as opposed to politically driven moves. In a world of increasing populism, this could become more of an issue. In terms of the role he may have played in the Fed’s latest decision it’s likely that the Fed has made up its own mind but it’s also interesting to note that President Trump’s huge fiscal easing last year likely played a role in Fed hikes last year and now his escalating trade war has played a role in its easing! So, one way or another he had an impact.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 01 August 2019

Important notes: 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

As widely anticipated, the US Federal Reserve has cut its key Fed Funds cash rate by 0.25% to a range of 2-2.25%. This is the Fed’s first rate cut since December 2008 and follows nine 0.25% rate hikes between December 2015 and December last year. The Fed also announced that quantitative tightening (ie the process of reversing its quantitative easing program by letting bonds on its balance sheet mature) will end immediately, which is about two months earlier than previously flagged. The Fed’s post-meeting statement left the door open to more cuts although Fed Chair Powell’s press conference confused things a bit (again!) by saying it’s a “mid-cycle adjustment” and “not the beginning of a long series of cuts” but it may not be “just one”.

Taking out some insurance

With underlying US growth still solid and the jobs market tight this should be seen as the Fed taking out some insurance given various threats to the growth outlook including from the US/China trade war, tensions with Iran and slower global growth generally and a greater willingness by the Fed to take risks with higher inflation as opposed to deflation.

So it’s a bit like the easings of 1987 after the share market crash and in 1998 during the LTCM hedge fund crisis when Russia defaulted leading LTCM to go bust, threatening the US financial system.

The pattern of the past 50 years or so is for the Fed to cut rates after some form of crisis threatens the economic outlook. See the next chart. In 2001 it was the tech wreck and in 2007 it was the sub-prime mortgage crisis. This time around there is nothing on that scale although it may be argued that the trade wars are providing the biggest single threat.

Source: Thomson Financial, AMP Capital Investors

This year’s fall in core private final consumption inflation back below the Fed’s 2% target provided the Fed with the scope to move.

Further easing is likely, but it’s likely to be limited

It’s rare for the Fed to just cut once. In the insurance cuts of 1998 through the LTCM crisis it eased 3 times by 0.25%. Given that the risks to the growth outlook – particularly on trade – won’t go away quickly and that the Fed appears to have taken the decision that it’s easier to control a rise in inflation than a further slide or deflation, it’s likely to cut rates further and we are allowing for another cut in September.

However, we remain of the view that a US recession is not imminent (see The longest US economic expansion ever). While the yield curve is flashing warning signs, the excesses that normally precede US recessions are not present. In particular: the US has not seen a spending boom with cyclical spending on consumer goods, investment and housing running around average as a share of GDP; private debt growth has been moderate; and inflation has been low. Consequently, there is no boom to go bust. Moreover, monetary policy had not become tight with the Fed Funds rate never having reached the high levels that normally precede recessions. See the next chart.

Source: NBER, Bloomberg, AMP Capital

As a result, we see this easing cycle by the Fed as being limited to around 2 or 3 rate cuts with the next likely coming in September as opposed to the 4 or so that the money market has factored in.

Of course, the main threats to this relate to US trade wars and tensions with Iran.

The Fed and shares

Falling interest rates are generally positive for shares. They help boost economic and profit growth and make shares relatively more attractive than cash and hence are usually associated with a higher price to earnings multiples. The table below shows the US share market’s response after the first-rate cut following major tightening cycles.  

US recession highlighted in red. Source: Thomson Reuters, AMP Capital

The US share market rose over the subsequent 3, 6 and 12 months after the commencement of 5 of the last 8 Fed easing cycles. The exceptions were after the rate cuts in 1981, 2001 and 2007 which were associated with recessions.

The reaction by the Australian share market is similar, except the Australian share market wasn’t greatly affected by the post-2000 bursting of the tech bubble.

US recessions highlighted in red. Source: Thomson Reuters, AMP Capital

So if we are right and the US avoids a recession in the next year or so then US interest rate cuts should be positive for shares beyond any near term uncertainty (and the initial reaction which has seen US shares fall as the Fed wasn’t as dovish as hoped) and are likely to be higher on a 6-12 month horizon. It is worth repeating the old saying “don’t fight the Fed”. While scepticism is high that central banks with low-interest rates and QE will spur growth, an investor would have made a huge mistake over the past decade betting against them. The key though is that global economic indicators need to start improving in the months ahead.

Implications for Australian interest rates

The directional relationship between the US and Australian interest rates weakened long ago. The RBA started raising rates in 2009 when the Fed held at zero, it was easing in 2016 when the Fed was hiking and this year it started cutting ahead of the Fed. So just because the Fed moves doesn’t mean the RBA will as well! On the one hand the Fed’s easing along with stimulus elsewhere globally should help support global growth which is good for Australia. But it’s probably not enough to change the outlook for the RBA. Our view remains that it’s on track to cut the cash rate to 0.5% by early next year and to some degree the Fed cutting too reinforces that to the extent that the RBA would like to keep the Australian dollar down.

What about the role of President Trump?

President Trump has been highly critical of Fed rate hikes over the past year and has been saying they should be cutting in recent times. Of course, presidents and prime ministers usually prefer lower than higher rates but the issue, in this case, has been more around whether his comments represent a threat to the Fed’s independence, which is necessary to ensure sensible monetary policy as opposed to politically driven moves. In a world of increasing populism, this could become more of an issue. In terms of the role he may have played in the Fed’s latest decision it’s likely that the Fed has made up its own mind but it’s also interesting to note that President Trump’s huge fiscal easing last year likely played a role in Fed hikes last year and now his escalating trade war has played a role in its easing! So, one way or another he had an impact.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 01 August 2019

Important notes: 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.