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Australian’s love affair with debt – how big is the risk?

Posted On:Feb 15th, 2018     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
Introduction

If Australia has an Achille’s heal it’s the high and still rising level of household debt that has gone hand in hand with the surge in house prices relative to incomes. Whereas several comparable countries have seen their household debt to income ratios pull back a bit since the Global Financial Crisis (GFC), this has not been the case in

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Introduction

If Australia has an Achille’s heal it’s the high and still rising level of household debt that has gone hand in hand with the surge in house prices relative to incomes. Whereas several comparable countries have seen their household debt to income ratios pull back a bit since the Global Financial Crisis (GFC), this has not been the case in Australia. Some worry Australians are unsustainably stretched, and it is only a matter of time before it blows up, bringing the economy down at the same time. Particularly now that global interest rates are starting to rise. This note looks at the main issues.

Australia – from the bottom to the top in debt stakes

The chart below shows the level of household debt (mortgage, credit card and personal debt) relative to annual household disposable income for major countries.
 

Source: OECD, ABS, RBA, AMP Capital

While rising household debt has been a global phenomenon, debt levels in Australia have gone from the bottom of the pack to near the top. In 1990, there was on average $70 of household debt for every $100 of average household income after tax. Today, it is nearly $200 of debt (not allowing for offset accounts) for every $100 of after tax income.

Why has debt gone up so much in Australia?

The increase in debt reflects both economic and attitudinal changes. Memories of wars and economic depression have faded and with the last recession ending nearly 27 years ago, debt seems less risky. Furthermore, modern society encourages instant gratification as opposed to saving for what you want. Lower interest rates have made debt seem more affordable and increased competition amongst financial providers has made it more available. So, each successive generation since the Baby Boomers through to Millennials have been progressively more relaxed about taking on debt than earlier generations. 

It’s not quite as bad as it looks

There are several reasons why the rise in household debt may not be quite as bad as it looks:  

  • Firstly, higher debt partly reflects a rational adjustment to lower rates and greater credit availability via competition.

  • Secondly, household debt has been rising since credit was first invented. It is unclear what a “safe” level is. This is complicated because income is a flow and debt is a stock which is arguably best measured against the stock of assets or wealth.

  • And on this front, the rise in the stock of debt levels has been matched by a rise in total household wealth in Australia. Thanks to a surge in the value of houses and a rise in financial wealth, we are far richer. Wealth rose 9.5% last year to a new record. The value of average household wealth has gone from five times average annual after tax household income in 1990 to 9.5 times today. 

Source: ABS, RBA, AMP Capital  

So, while the average level of household debt for each man, woman and child in Australia has increased from $11,837 in 1990 to $93,943 now, this has been swamped by an increase in average wealth per person from $86,376 to $475,569.   

Source: ABS, RBA, AMP Capital  

As a result, Australians’ household balance sheets, as measured by net wealth (assets less debt), are healthy. Despite a fall in net wealth relative to income through and after the GFC as shares and home prices fell, net wealth has increased substantially over the last 30 years and is in the middle of the pack relative to comparable countries.

Source: OECD, ABS, RBA, AMP Capital  

  • Fourthly, Australians are not having major problems servicing their loans. According to the Reserve Bank’s Financial Stability Review non-performing loans are low and Census and Household Expenditure Survey data shows that mortgage stress has been falling. Of course, this may reflect low mortgage rates with interest costs as a share of income running a third below its 2008 high. 

  

Source: RBA, AMP Capital  

  • Fifthly, debt is concentrated in higher income households who have a higher capacity to service it. This is particularly the case for investment property loans.

  • Sixthly, a disproportionate share of the rise in housing debt over the last 20 years owes to investment property loans. As servicing investment loans is helped by tax breaks the debt burden is not even as onerous.

  • Finally, lending standards have not deteriorated to the same degree in Australia as they did in the US prior to the GFC where loans were given to NINJAs – borrowers with no income, no job and no assets.

So what are the risks?

None of this is to say the rise in household debt is without risk. Not only has household debt relative to income in Australia risen to the top end of comparable countries but so too has the level gearing (ie the ratio of debt to wealth or assets).   

Source: OECD, RBA, AMP Capital

It certainly increases households’ vulnerability to changing economic conditions. There are several threats:  

  1. Higher interest rates – the rise in debt means moves in interest rates are three times as potent compared to say 25 years ago. Just a 2% rise in interest rates will take interest payments as a share of household income back to where they were just prior to the GFC (and which led to a fall in consumer spending). However, the RBA is well aware of the rise in sensitivities flowing from higher debt and so knows that when the time comes to eventually start raising rates (maybe later this year) it simply won’t have to raise rates anywhere near as much as in the past to have a given impact in say controlling spending and inflation. And so, it’s likely to be very cautious in raising rates (and is very unlikely to need to raise rates by anything like 2%.)

  2. Rising unemployment – high debt levels add to the risk that if the economy falls into recession, rising unemployment will create debt-servicing problems. However, it is hard to see unemployment rising sharply anytime soon.

  3. Deflation – high debt levels could become a problem if the global and local economies slip into deflation. Falling prices increase the real value of debt, which could cause debtors to cut back spending and sell assets, risking a vicious spiral.  However, the risk of deflation has been receding. 

  4. A sharp collapse in home prices – by undermining the collateral for much household debt – could cause severe damage. Fortunately, it is hard to see the trigger for a major collapse in house prices, ie, much higher interest rates or unemployment. And full recourse loans provide a disincentive to just walk away from the home and mortgage unlike in parts of the US during the GFC.

  5. A change in attitudes against debt – households could take fright at their high debt levels (maybe after a bout of weakness in home prices or when rates start to rise) and seek to cut them by cutting their spending. Of course, if lots of people do this at same time it will just result in slower economic growth. At present the risk is low but its worth keeping an eye on with Sydney and Melbourne property prices now falling. But high household debt levels are likely to be a constraint on consumer spending.

Conclusion

While the surge in household debt has left Australian households vulnerable to anything which threatens their ability to service their debts or significantly undermines the value of houses, the trigger for major problems remains hard to see. However, household discomfort at their high debt levels poses a degree of uncertainty over the outlook for consumer spending should households decide to reduce their debt levels.  

Source: AMP Capital 15 February 2018

Important note:

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

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The pullback in shares – seven reasons not to be too concerned

Posted On:Feb 09th, 2018     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

The pullback in shares seen over the last week or two has seen much coverage and generated much concern. This is understandable given the rapid falls in share markets seen on some days. From their highs to their recent lows, US and Japanese shares have fallen 10%, Eurozone shares have fallen 8%, Chinese shares have fallen 9% and Australian shares

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The pullback in shares seen over the last week or two has seen much coverage and generated much concern. This is understandable given the rapid falls in share markets seen on some days. From their highs to their recent lows, US and Japanese shares have fallen 10%, Eurozone shares have fallen 8%, Chinese shares have fallen 9% and Australian shares have lost 6%. This note looks at the issues for investors and puts the falls into context.

Drivers behind the plunge

There are basically three drivers behind the plunge in share prices. First, the trigger was worries that US inflation would rise faster than expected resulting in more aggressive rate hikes by the US Federal Reserve and higher bond yields. Flowing from this are worries that the Fed might get it wrong and tighten too much causing an economic downturn and that higher bond yields will reduce the relative attractiveness of shares and investments that have benefitted from the long period of low interest rates.

Second, after not having had a decent correction since before Donald Trump was elected president and with high and rising levels of investor confidence, the US share market was long overdue a correction, which had left the market vulnerable.

Finally, and related to this, the speed of the pull back is being exaggerated by the unwinding of a large build up of so-called short volatility bets (ie bets that volatility would continue to fall) via exchange traded investment products that made such bets possible. The unwinding of such positions after volatility rose further pushed up volatility indexes like the so-called VIX index and that accelerated the fall in US share prices. Quite why some investors thought volatility would continue to fall when it was already at record lows beats me, but this looks to be another case of financial engineering gone wrong!

With shares having had a roughly 5-10% decline (in fact US share futures had had a 12% fall) from their recent highs to their lows and oversold technically and with the VIX volatility index having spiked to levels usually associated with market bottoms, we may have seen the worst but as always with market pull backs it’s impossible to know for sure particularly with bond yields likely to move still higher over time and if there is further unwinding of short volatility positions to go.

Considerations for investors

Sharp market falls with talk of billions of dollars being wiped off shares are stressful for investors as no one likes to see the value of their investments decline. However, several things are worth bearing in mind:

First, periodic corrections in share markets of the order of 5-15% are healthy and normal. For example, during the tech com boom from 1995 to early 2000, the US share market had seven pull backs greater than 5% ranging from 6% up to 19% with an average decline of 10%. During the same period, the Australian share market had eight pullbacks ranging from 5% to 16% with an average of 8%. 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. More recently, the Australian share market had a 10% pullback in 2012, an 11% fall in 2013 (remember the taper tantrum?), an 8% fall in 2014 and a 20% fall between April 2015 and February 2016 all in the context of a gradual rising trend. And it has been similar for global shares, but against a strongly rising trend. See the next chart. In fact, share market corrections are healthy because they help limit a build up in complacency and excessive risk taking.

 


Source: Bloomberg, AMP Capital

Related to this, shares literally climb a wall of worry over many years with numerous events dragging them down periodically, but with the long-term trend ultimately rising and providing higher returns than other more stable assets. In fact, bouts of volatility are the price we pay for the higher longer-term returns from shares.



Source: ASX, AMP Capital

Second, the main driver of whether we see a correction (a fall 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) as opposed to a major bear market (like that seen in the global financial crisis (GFC)) is whether we see a recession or not. Our assessment remains that recession is not imminent:

  • The post-GFC hangover has only just faded with high levels of business and consumer confidence globally only just starting to help drive stronger consumer spending and business investment.

  • While US monetary conditions are tightening they are still easy, and they are still very easy globally and in Australia (with monetary tightening still a fair way off in Europe, Japan and Australia). We are a long way from the sort of monetary tightening that leads into recession.

  • Tax cuts and their associated fiscal stimulus will boost US growth in part offsetting Fed rate hikes.

  • We have not seen the excesses – in terms of debt growth, overinvestment, capacity constraints and inflation – that normally precede recessions in the US, globally or Australia.

Reflecting this, global earnings growth is likely to remain strong providing strong underlying support for shares.

Third, selling shares or switching to a more conservative investment strategy or superannuation option after a major fall just locks in a loss. With all the talk of billions being wiped off the share market, it may be tempting to sell. But this just turns a paper loss into a real loss with no hope of recovering. The best way to guard against making a decision to sell on the basis of emotion after a sharp fall in markets is to adopt a well thought out, long-term investment strategy and stick to it.

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

Fifth, while shares may have fallen in value the dividends from the market haven’t. So the income flow you are receiving from a well-diversified portfolio of shares continues to remain attractive, particularly against bank deposits.



Source: RBA, Bloomberg, AMP Capital

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

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, record point declines for the Dow Jones index 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. And as share indices rise in level over time of course given size percentage pullbacks will result in bigger declines in terms of index points. And 4% or so market falls are hardly a “crash”. Moreover, they provide no perspective and only add to the sense of panic. 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 09 February 2018

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

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Correction time for shares?

Posted On:Feb 05th, 2018     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

2017 was unusual for US shares. While Japanese, European and Australian shares had decent corrections throughout the year of around 5 to 7%, the US share market as measured by the S&P 500 saw only very mild pullbacks of less than 3%. This was against the backdrop of a strongly rising trend thanks to very positive economic conditions and President

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2017 was unusual for US shares. While Japanese, European and Australian shares had decent corrections throughout the year of around 5 to 7%, the US share market as measured by the S&P 500 saw only very mild pullbacks of less than 3%. This was against the backdrop of a strongly rising trend thanks to very positive economic conditions and President Trump’s business friendly policies. In fact, up to its high a week ago it went a record 310 days without a 3% or greater pullback and every month last year saw a positive total return (ie capital growth plus dividends) which is also unusual. This, combined with a very strong start to this year of 7.5%, very high levels of short-term investor optimism and lots of talk of a “melt up” left the US share market overbought and highly vulnerable to a correction, which we may now be starting to see.

The past week has seen shares come under pressure as Fed rate hike expectations increased, partly reflecting an acceleration in US wages growth, and the bond yield rose sharply. From their recent high, US shares have fallen 3.9% making it the deepest pullback since a 4.8% fall prior to the November 2016 US election. It’s likely the pullback has further to go as investors adjusts to more Fed tightening than currently assumed – we see four (or possibly five) Fed rate hikes this year against market expectations for three – and higher bond yields.

This will impact most major share markets, including the Australian share market which is vulnerable given its high exposure to yield plays like real estate investment trusts and utilities. However, the pullback is likely to be just an overdue correction (with say a 10% or so fall) rather than a severe bear market – providing the rise in bond yields is not too abrupt and recession is not imminent in the US with profits continuing to rise. So the two key questions are how severe the back up in bond yields will be and whether a recession is approaching?

How severe will the back up in bond yields be?

We had a look at this issue last week in Higher global inflation and higher global bond yields. With global inflation risks rising, bond yields running well below long-term sustainable levels, bonds subject to the reversal of huge fund inflows in recent years and central bank bond buying starting to slow, the trend in bond yields is likely to be up. But notwithstanding periodic spikes, the rising trend in bond yields is likely to be gradual as historically it will take a while for inflation expectations to turn up significantly after a long downswing, the Fed is still likely to be “gradual” in raising rates and central banks outside the US remain a fair way off monetary tightening. Also, global inflation is unlikely to take off too quickly given spare capacity outside the US, technological innovation will continue to act as a drag on inflation and inflation expectations are well anchored compared to say the 1970s, 80s and 90s.

Today is very different from 1994, when US shares corrected 9% and Australian shares fell 22% as bond yields rose over 200 basis points in the US in less than a year and 400 basis points in Australia as the Fed doubled the Fed Funds rate from 3% to 6% in 12 months and the Reserve Bank of Australia (RBA) hiked the cash rate from 4.75% to 7.5% over 6 months. Thanks to higher debt levels and more constrained underlying growth, the Fed and RBA won’t be able to raise rates anywhere near like that and RBA hikes are unlikely until late this year at the earliest.

Is the US economy headed for recession?

This is a critical question as the US share market invariably sets the direction for global shares including the Australian share market and historical experience tells us that slumps in shares tend to be shallower and/or shorter when there is no US recession and deeper and longer when there is (eg, the tech wreck and the Global Financial Crisis). The next table shows US share market falls greater than 10% since the 1970s. I know the latest fall is far less than that, but I haven’t shown falls less than 10% because there are so many of them – in other words 5% or so pullbacks are a dime a dozen, ie, normal! 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 a recession or not, the fifth shows the gains in the share market one year after the low and the final column shows the decline in the calendar year associated with the share market fall. Falls associated with recessions are highlighted in red. Averages are shown for the whole period and for falls associated with recession at the bottom of the table.

Several points stand out.

First, share market falls associated with recession tend to last longer with an average fall lasting 16 months as opposed to 9 months for all 10% plus falls.

Second, falls associated with recession also tend to be deeper with an average decline of 36% compared to an average of 17% for all 10% plus falls.

Third, falls associated with recessions are more likely to be associated with negative total returns (ie capital growth plus dividends) in the associated calendar year as a whole with an average total loss of 8% compared to an average total return of 6% across all calendar years associated with 10% plus falls.

Finally, as would be expected the share market rebound in the year after the low is much greater following share market falls associated with recession.


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

So whether a recession is imminent or not in the US is critically important in terms of whether we will see a major bear market or not. In fact, the same applies to Australian shares.

Our assessment is that recession is not imminent in the US. We will look at this in more detail in a subsequent note, but the key reasons are that:

  • The post-GFC hangover has only just faded with high levels of confidence helping drive stronger investment and consumer spending. 

  • While US monetary conditions are tightening they are still easy. The Fed Funds rates of 1.25 – 1.5% is still well below nominal growth of just over 4%. The yield curve is still positive and in fact has been steepening lately as long-term bond yields have been rising relative to short-term interest rates, whereas recessions are normally preceded by negative yield curves.

  • Tax cuts and their associated fiscal stimulus are likely to boost US growth at least for the next 12 months.

  • We have not seen the excesses – massive debt growth, overinvestment, capacity constraints or excessive inflation – that normally precede recessions.

As a result, earnings growth is likely to remain strong in the year ahead. The December quarter US earnings reporting season is coming in much stronger than expected with profits up around 14.5% year on year and revenue up 8%. And earnings growth expectations for this year have recently pushed up to 16% as tax cuts get factored in.

But what about the long-awaited pickup in US wages growth (up from around 2.5% year on year to around 2.9% so far)? Surely that must be bad for profits? Actually, the historical experience points to rising wages growth as being positive for profits as it drives stronger spending – until of course it turns into an inflation problem prompting tight monetary policy – but we are still a long way from that.

Conclusion

So for these reasons the pullback in the direction-setting US share market should be limited in depth and duration to a correction and we remain of the view that returns from shares will be positive this year. However, it’s increasingly clear that it’s going to be a more volatile year than last year and that share market sectors that are sensitive to rising interest rates and bond yields are likely to remain relative underperformers.

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

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Higher global inflation and higher bond yields – what’s the risk and implications for other assets?

Posted On:Feb 01st, 2018     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

Since the Global Financial Crisis (GFC) there have been a few occasions when many feared inflation was about to rebound and push bond yields sharply higher only to see growth relapse and deflationary concerns dominate. As a result, expectations for higher inflation globally has been progressively squeezed out to the point that few seem to be expecting it. However, the

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Since the Global Financial Crisis (GFC) there have been a few occasions when many feared inflation was about to rebound and push bond yields sharply higher only to see growth relapse and deflationary concerns dominate. As a result, expectations for higher inflation globally has been progressively squeezed out to the point that few seem to be expecting it. However, the global risks to inflation and bond yields are finally shifting to the upside, with investment markets starting to take note as evident in the pullback in global share markets seen over the last few days. But how big is the risk? Are we on the brink of another bond crash that will engulf other assets?

Inflation and bond yields – some context

But first some context. In a big picture sense, inflation has been falling since the mid 1970s-early 1980sThe global economy is finally emerging from its post-Global Financial Crisis (GFC) hangover. Talk of secular stagnation was overdone. Slow global growth since the GFC largely reflected a typical constrained aftermath from a major financial crisis.


Source: Global Financial Data, AMP Capital

The fall in inflation over the last 30-40 years reflects: the inflation-fighting policies of central banks; supply side reforms that boosted productivity; globalisation that brought a billion or so workers into the capitalist system; and the benefits of the information technology revolution harnessed by the likes of Amazon and Uber. The fall in inflation in turn has been the main driver of a super cycle bull market in bonds, with yields trending down since the early 1980s. (Don’t forget, when bond yields fall, bond prices rise. Suppose the government issues a $100 bond paying $4 pa in interest for an initial yield of 4%. If investors push yields down to 3%, the bond’s price will be pushed up until the 3% yield is achieved with the $4 interest payment.)


Source: Global Financial Data, AMP Capital

The collapse in bond yields into 2016 was accentuated by: worries about deflation; investors extrapolating very low official interest rates; worries economic growth will remain slow; safe-haven investor demand for bonds in response to geopolitical concerns and the experience that bonds always rally when shares fall; an increasing demand for income-yielding assets as populations age; and a shortage in the supply of bonds as budget deficits fell when central banks have been buying bonds. But the main driver since the early 1980s has been the fall in inflation.

Inflation and other assets

The 35-40-year fall in inflation and bond yields has also underpinned strong gains in most other assets. Put simply:

  • the shift to lower in inflation allowed interest rates to fall;

  • ​this allowed bond yields to fall (resulting in capital gains); 

  • which in turn allowed shares to be rerated higher (price to earnings multiples rose from around seven or eight times in the early 1980s to around 15-17 times), which boosted share returns over and above what would have been expected from dividend yields and earnings growth alone;

  • lower interest rates allowed other assets to trade on lower yields boosting both commercial property returns, house prices and infrastructure returns. In particular, residential property gained as lower mortgage rates allowed people to borrow more relative to their incomes.

Inflation starting to stir globally, bond yields on the up

Since late 2016, our assessment has been that the super cycle bull market in bonds is over. This remains the case for several reasons. First, deflation risks are receding and gradually giving rise to inflation risks, led by the US:

  • Global growth is now starting to run above potential again and this is leading to a decline in spare capacity and with global growth now accelerating this is likely to have been used up by late next year. Diminishing spare capacity makes it easier for companies to raise prices.


Source: IMF, AMP Capital

  • While Europe, Japan and Australia are lagging (as evident in still low inflation readings recently), the US economy is likely around full capacity evident in unemployment around 4%, increasing anecdotes of labour shortages and rising wages and business surveys pointing to rising selling prices. This will likely drive 4 (or possibly 5) Fed hikes this year whereas the market is only allowing for 2 or 3, with the Fed’s January meeting indicating a bit more hawkishness.

  • Commodity prices are rising most notably oil, which will at least boost headline inflation.

Second, this is occurring when bond yields remain well below levels consistent with likely long-term nominal growth (see the next table). Over the long-term, nominal bond yields tend to average around long-term nominal GDP growth.


Source: Bloomberg, AMP Capital

Thirdly, bonds remain over loved with a huge post-GFC inflow into bond funds in the US. (The same picture applies if ETFs are added in.) This leaves them vulnerable to a reversal if investor sentiment towards them turns really negative.


Source: ICI, AMP Capital

Finally, central bank buying of bonds is starting to slow.

For these reasons, it’s likely that the upswing in bond yields that began in the second half 2016, then paused last year and has since resumed, will continue. 

Reasons bond crash/perfect storm fears are overdone

Naturally as falling inflation gives way to rising inflation and bond yields head higher many assume the worst – such as a rerun of the 1994 mini bond crash or some sort of “perfect storm” where inflation takes off but central banks are powerless to stop it because high debt levels mean they can’t raise rates much. While we see bond yields rising, it’s likely to be gradual (like over the last 18 months) and a perfect storm is unlikely:

  • Historically, bond yields have remained low after a long-term downswing for around several years as it takes a while for growth and inflation expectations to really turn back up. See the circled areas for US and Australian bond yields in the second chart in this note.

  • While the Fed is likely to raise interest rates more than currently expected by the US money market (we expect four hikes and the market is factoring in two or three), the process of rate hikes is still likely to remain gradual. 

  • Central banks in Europe, Japan and Australia remain a fair way off starting to tighten so global monetary policy will remain easy for a while yet.

  • Global inflation is unlikely to take off too quickly given spare capacity in labour markets (in Europe and Australia) and technological innovation continuing to constrain inflation.

  • Inflation expectations are anchored at low levels far better than was the case in, say, 1994.

  • Finally, the idea that high debt levels mean that central banks will either have to live with a debt crisis or much higher inflation is nonsense. High debt levels just mean that interest rate increases are more potent than they used to be – so when inflation does start to become an issue, they won’t have to raise interest rates as much to bring spending and inflation back under control than was the case in the past. In fact, high debt levels mean central banks have more power than in the past to control inflation.

Implications for investors?

There are several implications from rising bond yields. Firstly, expect mediocre returns from sovereign bonds. Over the medium term, the return an investor will get from a bond will basically be driven by what the yield was when they invested. 10-year bond yields of 2.8% in Australia imply bond returns over the next decade of just 2.8% or so! And in the short term, rising bond yields will mean capital loses.

Secondly, higher bond yields will impact share market returns as they make shares more expensive. Shares will be okay if the rise in bond yields is gradual and so can be offset by rising earnings – as we expect this year – but a large abrupt back up in bond yields will be more of a concern. In any case expect a more volatile ride in shares.

Thirdly, defensive high-yield sectors of the share market are likely to remain under pressure. This includes real estate investment trusts and utilities that benefitted from falling bond yields. With bond yields trending up, REITs and utilities are likely to remain relative underperformers.

Fourthly, when it comes to real assets like unlisted commercial property and unlisted infrastructure, the search for yield is likely to remain a return driver unless bond yields rise aggressively. Commercial property has lagged listed property in responding to the decline in bond yields and so the gap between commercial property yields and bond yields leaves commercial property still looking attractive. Heading into the GFC, it was only when bond yields rose above commercial property yields that commercial property prices started to struggle. We are a long way from that but as bond yields trend higher the valuation boost to commercial property and infrastructure returns will gradually fade.

 

Source: AMP Capital 01 February 2018

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

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2018 a list of lists regarding the macro investment outlook

Posted On:Jan 24th, 2018     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
Although 2017 saw the usual worry list – around President Trump, elections in Europe, China, North Korea and Australian property – it was good for investors. Balanced super funds had returns around 10%, which is pretty good given inflation was around 2%. This year has started favourably but volatility may pick up as geopolitical threats loom a little larger and

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Although 2017 saw the usual worry list – around President Trump, elections in Europe, China, North Korea and Australian property – it was good for investors. Balanced super funds had returns around 10%, which is pretty good given inflation was around 2%. This year has started favourably but volatility may pick up as geopolitical threats loom a little larger and US inflation rises.  This note provides a summary of key insights on the global investment outlook in simple dot point form.

Five lessons from 2017

  • The global economy is finally emerging from its post-Global Financial Crisis (GFC) hangover. Talk of secular stagnation was overdone. Slow global growth since the GFC largely reflected a typical constrained aftermath from a major financial crisis.

  • The withdrawal of extreme monetary stimulus won’t cause economic chaos if central banks don’t move too quickly and recovery is entrenched – this is clear in the US where the Fed has now been able to move away from zero interest rates and start reversing quantitative easing. 

  • The Eurozone is far more resilient than many give it credit for – with voters across numerous countries opting for centrist pro-Euro parties as opposed to the populist parties that many said were going to sweep to power.

  • Turn down the noise – retreating to cash on talk of war with North Korea, worries about Trump, ahead of elections in Europe and perennial talk of a property crash in Australia – would have been costly in terms of missed returns.

  • Stick to an investment strategy – 2017 had its share of distractions for investors but they would have done okay provided they stuck to an investment strategy that prevented them from getting blown around by various scares.

Key themes for 2018

  • Still in the sweet spot for investors – a further rise in global growth to around 3.9%, driving solid earnings growth with continuing low inflation and easy global monetary conditions should keep investment returns favourable. 

  • But expect more volatility as US inflation stirs, the Fed hikes more than the market expects, other central banks edge towards less stimulus and political risk increases.

  • Apart from the likelihood of more volatility through the year, global shares are likely to trend higher through 2018 on the back of rising earnings and still easy monetary conditions.

  • Australian shares are likely to do okay but underperform global shares with returns around 8% with moderate earnings growth. Expect the ASX 200 to reach 6300.

  • Commodity prices are likely to push up with global growth. 

  • Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds.

  • Unlisted commercial property & infrastructure are still likely to benefit from the search for yield, but it is waning and listed variants are vulnerable to rising bond yields.

  • National capital city residential property price gains are expected to slow to around zero as the air comes out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms. 

  • Cash & bank deposit returns to remain poor at around 2%.

  • After a short-term further bounce higher, the $A is likely to fall against the $US as the gap between the Fed Funds rate and the RBA’s cash rate goes negative. Solid commodity prices will provide a floor for the $A, though.

Seven things to watch

  • President Trump – the risks around the Mueller inquiry and renewed political pressure from the mid-term elections risks more populist policies (with trade conflict with China and Mexico and a possible escalation with North Korea and Iran high on the list) after the business-friendly policies of 2017.

  • How quickly US inflation turns up – a rapid upswing would see a far more aggressive Fed, a strong rise in the $US and bond yields, and pressure on emerging market shares.

  • Bond yields – a rapid rise in bond yields would be bad for shares and assets that benefitted from the search for yield.

  • The March Italian election – the Five Star Movement is likely to do well, which may create investor angst, but they are unlikely to be able to form government and are less anti-Euro. Moreover, support for the Euro remains high in the rest of Europe so Italy is unlikely to trigger a domino effect. 

  • Whether China, post the Party Congress, embarks on a more reform focussed agenda, slowing short-term growth.

  • The Sydney and Melbourne property markets in Australia – too fast a slowdown could threaten broader growth. 

  • Global business conditions indicators (PMIs).

Four reasons why global growth is likely be strong

  • The post-GFC hangover has faded with high levels of confidence helping drive stronger investment and consumer spending. Self-sustaining growth has returned.

  • Global monetary conditions are still easy. While some fret about a flattening US yield curve, this is unlikely to signal a growth downturn because it’s been driven by rising short rates rather than falling long rates, high demand for long bonds as a portfolio diversifier and continuing QE in Europe and Japan holding down global and hence US bond yields.

  • Fiscal austerity has faded, with the US seeing stimulus.

  • We have not seen the excesses – massive debt growth, overinvestment, capacity constraints or excessive inflation – that normally precede recessions.

Three reasons why a grizzly bear market is unlikely

Shares are overdue a decent correction and even a brief (or gummy) bear market (where shares fall 20% but are back up a year after) is possible. But a deep (or grizzly) bear (where shares fall 20% and a year after are even lower) is unlikely:

  • A recession is unlikely with growth more likely to accelerate. Most grizzly bear markets are associated with recession.

  • Short-term sentiment measures are bullish but longer-term sentiment and positioning suggests investors are far from euphoric. (Some of the euphoria may have even been siphoned off to schemes like Bitcoin!)

  • The liquidity backdrop for shares is still positive, with low rates still providing an inducement to allocate to shares.

Three reasons why risks around Trump may rise a bit

For 2017, we expected Trump the business-friendly pragmatist to dominate, but there are several reasons why we may see a bit more of Trump the populist in 2018: 

  • Much of his business-friendly policy agenda has been implemented notably tax reform and deregulation. So the good news from these sources is largely behind us.

  • The Mueller inquiry is getting closer to Trump. We don’t see the Republicans impeaching Trump unless there is clear evidence of wrongdoing. Even if he is replaced by Vice-President Pence, policy wouldn’t change much – but markets may worry about it and this may be intensified if Trump lashes out and creates populist distractions.

  • The mid-term Congressional elections in November (with polling pointing to the GOP possibly losing control of the House) will see a renewed focus on issues around trade (as evident in just imposed US tariffs on solar panels & washing machines) and inequality as Trump tries to boost his base.

But the 2016 fears around Trump are still unlikely to be realised – he has a focus on growth and jobs and won’t want to threaten this. A full on trade war with Mexico or China is unlikely as a surge in consumer prices won’t go down well with his base.

Three reasons why the trend in bond yields is likely up 

  • Deflation risks have retreated and are being replaced by inflation risks as global spare capacity is being gradually used up (led by the US) and commodity prices trend higher.

  • Long bond yields remain well below levels consistent with nominal growth of around 3-3.5% in developed countries.

  • Bonds are over-loved with a huge post-GFC inflow.

Three reasons why Chinese growth won’t slow much

  • The Chinese Government’s tolerance for a sharp slowing in growth is low given the risk of social instability it may bring. 

  • Monetary & fiscal policy has not been tightened significantly.

  • In the absence of much lower savings (the main driver of debt growth), rapid deleveraging would be dangerous.

Five reasons Australia won’t have a recession (again)

A downturn in the housing cycle and uncertainty around the consumer are the main risks facing Australia but against this:

  • The drag from falling mining investment has faded.

  • Non-mining investment and infrastructure spending are turning up. 

  • National income is no longer falling as commodity prices have stabilised or are trending higher.

  • Stronger export volumes from resource projects like LNG and stronger global growth will provide an additional boost.

  • Interest rates can still fall further if needed.

The next move in Australian interest rates will likely be up, but the RBA will wait for more confidence on growth & that inflation has bottomed before starting to gradually hike later this year.

Five reasons to expect more share market volatility

  • As US inflation rises it will likely result in a more aggressive Fed than the market is allowing for.

  • Geopolitics may be a bit more negative than it was in 2017 if Trump becomes more populist. 

  • Volatility indexes like VIX are around record lows and net speculative short positions on VIX (bets volatility will fall further) are near record highs, warning of some reversal.

  • Low volatility years like 2017 often lead more volatile years.

  • The US share market is expensive on some measures.

Three reasons Bitcoin is a bad “investment”

  • It’s impossible to value, generating no income flow – making it highly speculative (as evidenced in extreme volatility) and subject to a crowd-driven mania (as we saw in 2017).

  • New supply potential is huge – eg, from other crypto currencies and futures trading which is allowing easy shorting and syphoning away demand.

  • Governments are likely to ramp up regulation of it, are unlikely to give up their monopoly of legal tender (and the “seigniorage” they earn from it) and will likely develop their own crypto currencies using block chain.

Nine things investors should remember

  • The power of compound returns – saving regularly in growth assets can grow wealth substantially over long periods. Using the “rule of 72”, it will take 29 years to double an asset’s value if it returns 2.5% pa (ie 72/2.5) but only 9 years if the asset returns 8% pa.

  • The cycle lives on – markets cycle up and down and we need to allow for it and not get thrown off by rough patches.

  • Diversify – don’t put all your eggs in one basket.

  • Turn down the noise – increasing social media and the competition for your eyes and ears is creating much noise around investing that is really just a distraction.

  • Starting point valuations matter – for example still low bond yields will mean low medium term bond returns.

  • Remember that while shares can be volatile, the income stream from a diversified portfolio of shares is more stable over time and higher than the income from bank deposits. 

  • Avoid the crowd – at extremes it’s invariably wrong.

  • Focus on investments with sustainable, decent cash flows – not financial engineering and schemes like Bitcoin.

  • Accept that it’s a low nominal return world – when inflation is 2%, a 10% superannuation return is pretty good (and probably not sustainable at that rate).

Source: AMP Capital 24 Jan 2018

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

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The Fed hikes again, still gradual but likely to be a bit faster next year – implications

Posted On:Dec 14th, 2017     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

Two years after it first started raising interest rates in this cycle in December 2015, the Fed has increased rates for the fifth time, raising the Fed Funds rate another 0.25% to a target range of 1.25-1.5%. For the last two years, it has been right not to fear the Fed as tightening was conditional on better economic conditions, it

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Two years after it first started raising interest rates in this cycle in December 2015, the Fed has increased rates for the fifth time, raising the Fed Funds rate another 0.25% to a target range of 1.25-1.5%. For the last two years, it has been right not to fear the Fed as tightening was conditional on better economic conditions, it would be gradual and we were only moving from very easy monetary policy to less easy. Despite a few ructions after the first move into early last year, this has been correct as the US and global recovery has accelerated and share markets and other growth assets have performed well. The question now is where to from here? Will the Fed get more aggressive? Should investors be more concerned?

Fed hike number 5

In raising the target range for the Fed Funds rate by another 0.25%, the Fed noted the continuing strengthening in the US labour market and solid growth and continues to expect inflation to pick up towards its 2% target. The Fed continues to refer to only “gradual” increases in interest rates going forward and the Fed’s so-called “dot plot” median of Fed meeting participants’ interest rate expectations is continuing to allow for three hikes in 2018 (the same as flagged in the September meeting). Quite clearly the Fed is confident that growth will remain strong with tax cuts providing an additional stimulus – it revised up its 2018 growth forecast from 2.1% to 2.5% – and that this will start pushing inflation back towards the 2% target. 

The transition to new leadership at the Fed in March from Janet Yellen to Jerome Powell (assuming he is confirmed by the Senate, which is most likely) isn’t expected to signal a big change at the Fed on monetary policy. Powell is likely to follow the broad path the Fed is already on in terms of rates hikes and quantitative tightening. There may be a more relaxed approach to regulation, though, but for now that’s a separate issue.

Market expectations for just two Fed rates in 2018 hikes remain below the Fed’s dot plot signal of three hikes. While the market has been right in expecting lower interest rates than the Fed has been signalling in recent years, it wrongly underestimated the Fed in 2017 and is likely to do so again 2018. I suspect that the risks for US inflation are now swinging to the upside with spare capacity in the US economy gradually diminishing. So just as the market proved too cautious in allowing for just two Fed hikes this year when it has actually done three, we suspect it will be surprised again next year. In fact, given our views of a pick-up in inflation risks, we are allowing for four rate hikes next year in 2018 (conditional on tax reform being passed).


Source: US Federal Reserve, AMP Capital

Will the Fed start to become a problem for markets?

It’s still too early to get too concerned about the Fed.

  • First, the Fed is only tightening because the US economy is strong. Confidence is high, business investment is improving, the labour market is tight and profits are strong. And future rate increases will remain conditional on the economy continuing to improve.


Source: Bloomberg, AMP Capital

  • Second, for now at least, Fed rate hikes can remain “gradual” as there is still some slack remaining and inflation is currently still low.

  • Third, US economic downturns have historically only come three years after the first Fed rate hike in a tightening cycle. And it’s likely to be even longer this time as it’s only when monetary policy becomes tight after numerous hikes that the economy gets hit and we are still a long way from that – so the gradual nature of the rate hikes so far could stretch it out further. In the last tightening cycle in 2004-2006, rates rose 17 times in just over two years – now they have only gone up five times over two years and from a much easier base. Shares often have wobbles around the first rate hike – as we saw in second half 2015 and early 2016 – but again, sustained problems usually only set in when monetary policy has become tight. This can be seen in the next chart. Shares had wobbles when interest rates first started to move up in February 1994 and in June 2004. Thereafter they resumed their rising trends and bear markets did not set in till 2000 and 2007 after multiple hikes and with recessions looming. Again, we are a long way from that.


Source: Bloomberg, AMP Capital

  • Finally, other major countries – Europe, Japan and Australia – are a long way from monetary tightening. So global monetary conditions remain very easy. 

However, we are now two years into tightening and the Fed might cause a few gyrations in the year ahead.

  • The risks around inflation in the US are rising. The US labour market is even tighter than it was a year ago with most indicators pointing to very tight conditions – unemployment near 4%, ultra-low jobless claims, very high hiring and quits rates, business surveys indicating high employment plans, etc – and anecdotal evidence continuing to point to rising wages. Sooner or later this will show in higher official wage data with some flow on to inflation. Upstream price pressures are also building, which is evident in a rise in core producer price inflation from just 0.3% year on year two years ago to 2.4% now.

  • The US money market remains relatively complacent factoring less rate hikes than the Fed is signalling even though the Fed was right in 2017. This suggests the risk of a snap up in market Fed expectations at some point, particularly if inflation does start to rise as we expect.

  • The US is now further into monetary tightening so policy is no longer ultra easy. This is evident in a flattening in the US yield curve (although this may be heavily due to quantitative easing in Europe holding down Eurozone bond yields and this weighing in US bond yields). 

  • Finally, after a pause this year market positioning is no longer long the US and a more aggressive Fed could see the US dollar head higher in 2018 constraining US profits, commodity prices and reigniting concerns about a dollar funding crisis in the emerging world.

So while we are not particularly concerned about the Fed, there is a case to be a bit more cautious regarding it than was the case over the last two years.  

What does it mean for investors?

There are several implications for investors:

  • It’s too early for US monetary tightening to be a cyclical negative for shares, which will also likely benefit from US fiscal stimulus next year. However, the Fed is likely to become a source of volatility as next year progresses if US inflation starts to pick up as we expect. Other markets remain more attractive than US shares – notably Eurozone and Japanese shares that will benefit from cheaper valuations, easier monetary policy and lower currencies.

  • Continuing Fed rate hikes and US fiscal stimulus in 2017 will likely be a source of upwards pressure on global bond yields in 2018. So bonds are likely to continue to provide constrained returns. With the Reserve Bank of Australia (RBA) unlikely to follow the Fed though until maybe 2018, we continue to favour Australian over US bonds.

Impact on Australia

To the extent that the Fed’s further interest rate hike signals ongoing strength in the US, it’s good for Australia. It doesn’t signal that the RBA will soon follow and hike soon, though. Recent experience with the RBA hiking in 2009-10 (despite the Fed on hold at zero) and the RBA cutting in 2016 (when the Fed was hiking) highlights there is no automatic link. With the Australian economy remaining weaker relative to its potential than the US, risks around the Australian consumer, inflation running below target and Sydney and Melbourne house prices cooling, we remain of the view that the RBA will be on hold through much of next year and won’t raise rates till year end. 

The main relevance of ongoing US monetary tightening is that it will serve to keep the $A down, notwithstanding the risks of a short term bounce higher in the $A. With the RBA on hold and the Fed set to continue raising rates, by March next year the Fed Funds rate will likely exceed the RBA’s cash rate with the interest rate differential set to further deteriorate against Australia through next year. If history is any guide, this is likely to see downwards pressure on the $A. We see the $A falling to around $US0.70 by end 2018 after its surprise strength in 2017.


Source: Bloomberg, AMP Capital

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

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