Olivers Insights

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

Key points

• A surge in financial information and opinion along with our natural inclination to focus on bad news is arguably making us worse investors: more fearful & short term.

• Five ways to help manage the noise and stay focussed as investors are: put the latest worry list in context; recognise that shares return more than cash in the long term because they can lose money in the short term; find a process to help filter noise; make a conscious effort not to check your investments so much; and look for opportunities that investor worries throw up.

Introduction

It sometimes seems that the worry list for investors has become more threatening and more confusing than ever. This was an issue prior to coronavirus – with trade wars, President Trump, social polarisation, tensions with China, concerns the Eurozone would break apart, slow growth in Australia, and ever-present predictions of a new global financial collapse. Coronavirus has only added to the worries with hourly updates about new cases, lockdowns, vaccines, etc. It sometimes seems that if coronavirus won’t get us, inflation and the mountain of debt will. To be sure these risks are real and can’t be ignored, but the risks around investing seem to receive ever higher prominence these days as the digital age enables the rapid dissemination of news and opinion. The danger is that all this noise is making us worse investors as we lurch from one worry to the next. The key to investor success is to manage the noise and stay focussed. This is an update of a note I wrote a few years ago but the need to turn down the noise is more important than ever.

Ever more worrying worries

While there’s no denying there are things to worry about, there is a psychological aspect to this that is combining with the increasing availability of information, and intensifying competition amongst different forms of media for clicks, which is magnifying perceptions around various worries.

Firstly, our brains are wired in a way that makes us natural receptors of bad news. People suffer from a behavioural trait that has become known as “loss aversion” in that a loss in financial wealth is felt much more distastefully than the beneficial impact of the same sized gain. This probably reflects the evolution of the human brain in the Pleistocene age when the key was to avoid being eaten by a sabre-toothed tiger or squashed by a wholly mammoth. This leaves us biased to be more risk averse and it also leaves us more predisposed to bad news stories as opposed to good. Consequently, bad news and doom and gloom find a more ready market than good news or balanced commentary as it appeals to our instinct to look for risks. So “bad news and pessimism sells”. Flowing from this, prognosticators of gloom are more likely to be revered as deep thinkers than optimists. As Joseph Schumpeter observed “pessimistic visions about anything usually strike the public as more erudite than optimistic ones.”

Secondly, we are now exposed to more information than ever on how our investments are going and everything else. We can now check facts, analyse things, sound informed easier than ever. But for the most part we have no way of weighing such information and no time to do so. So, it becomes noise. As Frank Zappa (and maybe some others) noted “Information is not knowledge, knowledge is not wisdom.” This comes with a cost for investors. If we don’t have a process to filter it and focus on what matters, we can suffer from information overload. This can be bad for investors as when faced with more (and often bad) news we can freeze up and make the wrong decisions with our investment. In particular our natural “loss aversion” can combine with what is called the “recency bias” – that sees people give more weight to recent events in assessing the future – to see investors project recent bad news into the future and so sell after a fall. A 1997 study by US behavioural economist Richard Thaler and others showed that providing investors in an experiment “with frequent feedback about their [investment] outcome is likely to encourage their worst tendencies…More is not always better. The subjects with the most data did the worst in terms of money earned.” As famed investor Peter Lynch observed “Stock market news has gone from hard to find (in the 1970s and early 1980s), then easy to find (in the late 1980s), then hard to get away from.”

Thirdly, there is an explosion in media outlets all competing for our eyes and ears. We are now bombarded with economic and financial news and opinions with 24/7 coverage by multiple web sites, subscription services, finance updates, dedicated TV and online channels, chat rooms, individuals’ comments via social media, etc. And, following from loss aversion, in competing for your attention, bad news and gloom naturally trumps good news and balanced commentary. So naturally it seems that the bad news is “badder” and the worries more worrying than ever.

I Googled the words “the coming financial crisis” recently and found 352 million search results with titles such as:

• “brace for the next crisis”;

• “stimulus spending could cause the next economic crash”;

• “cryptocurrencies will lead the next financial crisis”;

• “a new crisis is ahead – can you survive it?”.

In the pre-social media/pre-internet days it was much harder for ordinary investors to be exposed to such disaster stories on a regular basis. The danger is that the combination of a massive ramp up in information and opinion, combined with our natural inclination to zoom in on negative news, is making us worse investors: more distracted, fearful, jittery and short-term focussed, and less reflective and long-term focussed.

Five ways to manage information & opinion overload

To be a successful investor you need to make the most of the power of compound interest and to do that you need to invest for the long-term in assets that grow with the economy and not get blown around by each new worry and fad. The only way to do this is to turn down the noise on the worry list and the explosion in investment information and opinion. This is getting harder given the distractions on social media. At an obvious level, it makes sense to turn off all notifications on your phone or iPad, but more fundamentally, here are five suggestions as to how to turn down the noise and stay focussed as an investor:

Firstly, put the latest worry in context. There’s always been an endless stream of worries. Here’s a partial list since 1900: 1906 San Francisco earthquake; 1907 US financial panic; WWI; 1918 Spanish flu pandemic (up to 50 million killed); The Great Depression; WW2; Korean War; 1957 flu pandemic; 1960 credit crunch; Cuban missile crisis; Vietnam War; 1968 flu pandemic; 1973 OPEC oil embargo; Watergate; the cancellation of The Brady Bunch; stagflation in the 1970s; the 1979 oil crisis; Latin American debt crisis; Chernobyl disaster; 1987 crash; First Gulf War; Japanese bubble economy collapse; US Savings & Loan crisis; Asian crisis; Tech wreck; 9/11 terrorist attacks; Second Gulf War; the GFC; the Eurozone public debt crisis; US trade wars; President Trump; & the coronavirus pandemic. But despite this investment returns have actually been good as shares climb a long-term wall of worry with the result being that since 1900 Australian shares have returned 11.8% pa and US shares 10% pa (including capital growth and dividends).

Australian shares have climbed a wall of worry

Source: ASX, AMP Capital

Secondly, recognise how markets work. A diverse portfolio of shares returns more than bonds and cash long term because it can lose money short term. As seen in the chart below, while the share market can be highly volatile in the short-term it has strong returns over all rolling 20-year periods.

Australian share returns over over rolling 12 mth & 20 yr periods

Source: ASX, AMP Capital

And invariably the short-term volatility is driven by investors projecting recent events around profits, dividends, rents and interest rates into the future, and so, causing shares to periodically diverge from long-term fundamental value. So, share market volatility driven by worries, bad news, and bouts of recovery and investor euphoria is normal. It’s the price investors pay for higher longer-term returns.

Thirdly, find a way to filter news so that it doesn’t distort your investment decisions. There are lots of ways to do this depending on how much you want to be involved in managing your investments. If you want to be heavily involved it could mean building your own investment process or choosing 1-3 good investment subscription services and relying on them. Or simpler still, agreeing to a long-term strategy with a financial planner and sticking to it.

Fourthly, don’t check your investments so much. If you track the daily movements in the Australian All Ords price index, measured over the last twenty-five years or so it has been down almost as much as it has been up (see the next chart). It’s little different for the US S&P 500. So, each day is pretty much a coin toss as to whether you will get good news or bad as markets are thrown around by the daily noise. By contrast, if you only look at how the share market has gone each month and allow for dividends, historical experience tells us you will get bad news less than 35% of the time. Looking only on a calendar year basis, data back to 1900 indicates that the probability of bad news in the form of a loss slides further to just 20% of the time for Australian shares and less than 30% for US shares. And if you can stretch it out to once a decade, again since 1900, positive returns have been seen 100% of the time for Australian shares and 82% of the time for US shares.

Percentage of positive share market returns

Daily and monthly data from 1995. Data for years and decades from 1900.
Source: ASX, AMP Capital

The less frequently you look the less you will be disappointed, and so, the lower the chance that a bout of “loss aversion” will be triggered which leads you to sell at the wrong time. So, try to avoid looking at market updates so regularly and even consider removing related apps from your smartphones & tablets.

Finally, look for opportunities that bad news and investor worries throw up. Always remember that periods of share market turbulence after bad news throw up opportunities for investors as such periods push shares into cheap territory from which strong gains have historically been seen. This is exactly what we saw last year at the height of coronavirus uncertainty.

Concluding comment

There is no denying that things occasionally go wrong weighing on investment returns. But predictions of imminent disaster are a dime a dozen. My long-term experience around investing tells me that it’s far more productive to lean into prognostications of financial gloom because most of the time they are wrong and end up just distracting investors from their goals.

Source: AMP Capital July 2021

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

– expect more modest but still good returns this financial year

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

Key points

• 2020-21 saw investment returns rebound after the coronavirus hit depressed 2019-20 returns.

• Key lessons for investors from 2020-21 were to: allow that share markets look ahead; timing markets is hard; don’t fight central banks; and turn down the noise.

• Over the next 12 months returns from a well-diversified portfolio are likely to be slower but still solid.

Introduction

The past financial year saw a spectacular rebound in returns for investors as the focus shifted from the recession to recovery against a backdrop of policy stimulus and vaccines. This note reviews the last financial year and takes a look at the outlook.

The big developments of the last financial year

A year ago, many were wondering whether share markets had gone bonkers as they pushed higher despite lots of bad news. To be sure there were big negatives over the last 12 months:

• The global and Australian economies were confirmed to have seen deep recessions in first half 2020.

• There have been several waves of coronavirus globally, propelled over the last six months by new and more virulent strains. This in turn drove numerous returns to lockdowns.

• Budget deficits and public debt relative to GDP blew out in many countries to levels not seen since the end of WW2.

• The US saw a divisive election that turned violent with an invasion of the Capitol by Trump supporters.

• Tensions between Australia and other Western democracies with China have increased with more talk of a cold war.

• Bond yields rose sharply early this year on inflation fears & talk of an early exit from easy money, notably by the Fed.

However, for investors in well diversified portfolios the bad news was dominated by the good, in particular:

• Despite various coronavirus-related setbacks, global growth has seen an almost Deep V rebound and is on track for 6% growth this year and 4% next, after last year’s 3% slump.

• Australian GDP has rebounded faster than expected to be one of the few developed countries to see GDP back above pre-coronavirus levels, despite numerous snap lockdowns – this in turn has driven a sharp rebound in company profits.

• Good news on vaccines and their deployment in developed countries has provided confidence in continued recovery.

• This has been reinforced by key central banks – notably the Fed and RBA – shifting to focus on actual inflation being sustained at target before tightening.

• The election of Joe Biden in the US has reduced global policy uncertainty and led to much more US fiscal stimulus.

• Australian fiscal stimulus continued, dulling any “fiscal cliff”.

Strong returns more than making up for a poor 2019-20

With the recession and profit slump associated with coronavirus already factored in and giving way to recovery, and vaccines and stimulus providing confidence it would continue, the past financial year has been very strong for growth assets.

Global shares returned 37% in local currency terms. A rebound in the growth sensitive Australian dollar saw this reduced to a still very strong 28% in Australian dollar terms.

Australian shares returned 28% helped by a sharper rebound in the Australian economy, a surge in profits and numerous companies reinstating or increasing their dividends. Of course, this followed a 7.7% loss the previous financial year.

Reflecting the growth rebound, listed property rebounded and unlisted property and infrastructure also saw a good recovery.

Of course, bonds performed poorly as bond yields rose and cash had a near zero return reflecting the near zero cash rate.

This drove very strong returns from balanced growth super funds of around 19% after fees and taxes. Over the last five years super fund returns averaged around 8.5% pa which is not bad given sub 2% bank deposit rates and inflation.

2020-21 – major asset class returns

Source: Thomson Reuters, AMP Capital

Australian residential property prices also surged on the back of ultra-low rates, various incentives and economic recovery resulting in their strongest 12-month gain since 2004.

Key lessons for investors from the last financial year

• Share markets look ahead – and they climbed a wall of worry of the last year, but this is what they always do.

• Timing markets is hard – staying fully invested as markets rebounded despite the recession and ongoing coronavirus scares would have been very hard at times.

• Don’t fight the Fed or the RBA – despite zero interest rates they still impact investment markets in a big way.

• Investment valuations need to be assessed relative to interest rates – low rates mean higher PEs.

• Turn down the noise – the noise around investing is now at fever pitch making it very hard to stay focused on long term investing, so the best thing is to turn it down.

The worry list weighing on the outlook

Share markets have had strong gains from last year’s lows (US shares are up 94%, global shares are up 83% and Australian shares are up 60%) and are no longer unambiguously cheap so the easy gains are likely behind us. And as always there remains a worry list to contend with.

• First, coronavirus is continuing to cause havoc with the global trend in new daily cases starting to head up again, particularly driven by the newer more transmissible Delta and Beta variants. This is particularly evident in lowly vaccinated countries – like parts of Asia, Africa and South America. And in Australia, albeit the numbers are very low. But it’s also evident in advanced more vaccinated countries like the UK, parts of Europe and the US.

• Second, inflationary pressures have increased globally with reopening and this is most evident in the US.

• Third, at the same time central banks are starting to back away from ultra-easy monetary policy, eg, the Fed dots flagging an earlier start to rate hikes than previously and the RBA starting to taper its bond buying from September.

• Fourth, peak fiscal stimulus has likely already been seen.

• And geopolitical tensions between Western democracies and China are arguably continuing.

The positives are likely to ultimately dominate

These negatives have the potential to cause a correction in share markets. However, there are a bunch of positives that are ultimately likely to dominate in terms of investment markets.

• First, while coronavirus cases may be on the rise again the vaccines are keeping a light shining at the end of the tunnel. They don’t appear to be completely effective against getting infected by the new variants, but the evidence suggests they are 90% effective in preventing serious illness requiring hospitalisation and causing death. In the countries that are further advanced in vaccination (eg, Israel, the UK, most of the US, Europe, etc.) this should allow reopening to continue without rising new cases overwhelming the hospital system, ie, learning to live with coronavirus. For those countries further behind in reaching herd immunity – like Australia – it likely means a continuing reliance on snap lockdowns to keep case numbers down and head off bigger outbreaks that overwhelm the hospital system and send economies backwards. But the evidence so far is that snap lockdowns don’t derail the recovery. And global production schedules point to plenty of vaccines being available later this year enabling Australia and other vaccine laggards to proceed down the same path as other advanced countries later this year or early next in terms of avoiding lockdowns.

• Second, while inflation pressures have picked up this is mainly evident in the US and largely reflects pandemic related distortions. Other countries including Europe, Japan and Australia are seeing far less of an inflation spike.

• Third, this in turn will likely keep central banks gradual in removing ultra-easy monetary policy with rates likely to remain low for a long while yet. We don’t expect the first rate hikes in the US and Australia till 2023 (and Europe and Japan are a long way behind that) and even then it will take several years to reach tight monetary policy that threatens economic activity and company profits.

• Fourth, against this backdrop while we have probably seen the peak in terms of growth momentum globally, the recovery is likely to continue as the rollout of vaccines progressively allows more countries to safely reopen, pent up demand is spent (evident in about $US2.5trn of excess savings in the US and about $200bn in Australia) and monetary policy remains very easy.

Global Composite PMI vs World GDP

Source: Bloomberg, AMP Capital

• Finally, while traditional valuation measures for shares show them to be expensive, they continue to look okay relative to still low bond yields. This is particularly evident in Australia with a grossed-up dividend yield of 5% or so for the year ahead well above bank term deposit rates of around 0.5%.

Aust shares offer a very attractive yield versus bank deposits

Source: RBA; AMP Capital

What about the return outlook?

While there is a risk of a short-term correction in shares and returns are likely to slow from the pace of the last year, overall returns from well diversified portfolios are still likely to be reasonable over the next 12 months.

• Shares are expected to see okay returns helped by strong economic and earnings growth and still low interest rates.

• Cash and bank deposit returns are likely to remain poor as the RBA is expected to keep the cash rate at 0.1%.

• Low starting point yields and a capital loss from gradually rising yields are likely to result in low returns from bonds.

• Unlisted commercial property may still see some weakness in retail and office returns but industrial is likely to be strong. Unlisted infrastructure is expected to be solid.

• Home prices are expected to rise 20% this year but slow to 5% next year as poor affordability, rising fixed rates, tighter lending standards and reduced population growth impact.

• The $A is likely to trend up in line with global recovery and strong commodity prices.

Things to keep an eye on

The key things to keep an eye on are: covid hospitalisations and deaths in more vaccinated countries; inflation; central banks; growth momentum; and tensions with China.

Source: AMP Capital July 2021

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

– why snap lockdowns in Australia make sense until herd immunity is reached

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

Key points

• Snap lockdowns in Sydney, Perth and Queensland are likely to cost the economy $2.5bn, but like previous snap lockdowns are unlikely to derail the recovery.

• Australia has little choice but to continue with snap lockdowns until increased vaccination sets up herd immunity from around early 2022.

• The latest lockdowns and ongoing coronavirus threat will keep the RBA relatively dovish at its July meeting.

Introduction

News that I and many others were effectively in lockdown from Friday was depressing. It got even more depressing when the whole of Sydney and surrounds was put into a two-week lockdown on Saturday. And I am not in Victoria which has had it even worse over the last year, and I can only imagine how bad this must be for those looking forward to school holidays. Or far worse still for those with businesses dependent on people coming together. And now Perth & Darwin are in lockdowns too.

With Sydney and surrounds having around 6.6 million people and about 25% of Australian GDP we estimate a hit to national economic activity from the two-week Sydney lockdown of around $2 billion (or 0.1% of GDP). Perth’s four-day lockdown will cost another $200m and Queensland’s three-day lockdown another $300m. And this follows around a $1.5bn hit from Victoria’s two-week lockdown from late May.

With ongoing lockdowns, it seems like ground hog day. Some even think the lockdowns themselves are the problem – that Australia has become paranoid, going into lockdown & shutting borders at the whiff a new case, locking out the rest of the world and becoming a “lost kingdom of the South Pacific” – imposing a great cost on the economy all to control what some think poses no or little risk for most, or is just a bad dose of the flu.

Australia has made some mistakes. High on the list is: the slow rollout of vaccines; the management of the returned traveller quarantine system; the poor treatment of Australians overseas (particularly those recently in India); and we arguably have been too slow in relation to starting some lockdowns (in Victoria mid-last year and recently in NSW) risking longer lockdowns.

But gloomy as it all seems, Australia’s approach has led to relatively less deaths and a stronger economy. And being early in the vaccination process – both globally and in Australia – it’s still too early to simply relax controls. This note puts it into perspective and what it means for investors.

1. Healthy people = healthy economy

The first thing to note is that Australia has performed relatively well through the coronavirus pandemic. Early last year I also thought it may be a bad case of flu, but quickly changed my mind in March last year when it was clear that it was far worse and if not controlled, the hospital system would be overwhelmed leading to more deaths. The occurrence of “long covid”, potential long-term health effects even in the young and now more transmissible variants reinforce this. So, thanks to a sensible health response, rigorous application of restrictions and periodic snap lockdowns after the initial lockdown we have been able to keep cases and deaths per capita relatively low.

Coronavirus Cases Per Million People

Source: ourworldindata, OECD, ABS, AMP Capital

As evident in the next chart, better health outcomes in terms of deaths per capita (vertical axis) have been associated with better economic performance as measured by GDP (horizontal axis). Along with well targeted government support that protected incomes, jobs and businesses Australia is one of the few developed countries with GDP above pre pandemic levels.

Real GDP Growth, % from pre-COVID levels v COVID-19 deaths per million people

Source: ourworldindata, OECD, ABS, AMP Capital

Better control of the virus has enabled much of Australia to go about life with relatively modest restrictions over much of the last year in contrast to many countries that have seen almost continuous lockdowns, with some only just coming out of them. Even countries that adopted a laxer approach such as the US or a “let it rip” approach like Sweden saw a bigger hit to their economies than Australia did. If Australia had a laxer approach and as a result had the same per capita deaths as the US, it would have lost an extra 47,000 Australians on top of the 910 deaths so far. More deaths and a worse economy do not strike me as a compelling case to avoid lockdowns.

2. Snap lockdowns work

Australia has already had eight snap lockdowns since November last year and the evidence strongly suggests that if applied early when the flow of new cases is relatively low, they head off a bigger problem with coronavirus and hence a longer and more economically damaging lockdown (in the absence of course of most being vaccinated). “A stitch in time saves nine” as the old saying goes! Providing they are short, the economic impact is relatively “minor” (although still horrible) as spending and economic activity is delayed, which then bounces back once the lockdown ends. This is evident in our weekly Australian Economic Activity Tracker (see the next chart), which combines weekly data and shows a rising trend in economic activity through the snap lockdowns since last November, including after Victoria’s recent snap lockdown ended.

Australia Economic Activity Tracker^*

Source: AMP Capital

Ideally, the Sydney lockdown should have started a few days earlier when the flow of new cases was lower, but starting at around 20-30 a day was still relatively low compared to last July when the Melbourne hotspot lockdown started when new cases were already spiralling over 60 a day or the over 600 a day when the full Victorian lockdown started in August. This should provide some confidence this lockdown will work in controlling the spread of new cases and can be limited to two weeks or so. See the next chart which puts it into perspective.

Australia: New Daily Coronavirus Cases by State

Source: covid19data.com.au

If so, while we estimate a hit to economic activity from the Sydney lockdown of about $2 billion if it’s contained to two weeks, much of that will likely be recouped upon reopening. Of course, the risk is greater now that we are dealing with the more virulent Delta variant, but so too was Victoria in late May.

3. Border confusion

Everyone wants freedom to travel out of Australia and back in, and an open international border is key to having a dynamic economy long-term, but its short-term importance to the recovery is exaggerated. First, the economy has already rebounded beyond pre-coronavirus levels. Second, Australia normally loses more from Australians travelling overseas than we gain from foreigners coming here, so trapping that spending here benefits the economy. Third, we normally run a trade surplus in education of 2% of GDP but with the pandemic we only lost maybe half that as many foreign students went online. Finally, while the loss of immigration means lower long term potential growth it won’t necessarily impact per capita GDP (& hence living standards) or short-term recovery prospects (except for some sectors). So long-term the international border closure is a big deal, but it’s not so big short-term.

4. Covid is not over globally – but vaccines work

Which brings us to the basic problem that coronavirus is still not over globally. The good news is that new daily cases have fallen sharply in the last few months as vaccination ramps up. The bad news is that only 24% of the global population has had one dose. Even in developed countries where 49% have had a first dose, we are yet to hit herd immunity which may be around 80% fully vaccinated, and new more virulent strains (notably Beta, Delta and maybe Delta Plus) are causing problems with rising cases in the UK, Israel and Seychelles (where around 70% are fully vaccinated). In the UK, new cases are running around 18,000 a day which has caused a postponement to the final stage of reopening. But here is the really good news – while the vaccines are not completely effective in stopping people getting the new variants, the evidence suggests they are highly effective in preventing serious illness (which should minimise pressure on hospital systems) and death. So, reopening should be manageable once herd immunity is reached, even with coronavirus circulating in the community. But we are not at that point yet – so coronavirus still poses a risk to reopening in the US and Europe.

Which in turn highlights why Australia – which is further behind on the vaccine front with only 24% of the population having had one dose of vaccine – still has to be cautious in preventing coronavirus taking hold, and so has little choice but to continue down the snap lockdown/global border closure path to keep people healthy and to protect the economy from more debilitating coronavirus-driven lockdowns. Better to wait until herd immunity is reached and we can learn to live with a level of coronavirus circulating in the community rather than dropping our guard too early and having to learn to die from it.

With global vaccine production ramping up and more Pfizer and Moderna vaccines scheduled to arrive in Australia through the second half we should be able to reach herd immunity by early 2022. This is the only way to end the endless snap lockdowns in a way that does not risk Australians’ health and the economy.

Implications for investors

There are several implications for investors:

First, the ongoing threat posed by coronavirus and lockdowns will likely keep the RBA relatively dovish at its July meeting. While we expect it to stick to the April 2024 bond for its yield target and announce some tapering of its bond buying, it’s likely to reiterate that rate hikes remain a long way off.

Second, the threat from coronavirus setbacks is likely to limit the upside in bond yields in the short term. Third, coronavirus setbacks are another potential trigger for a near term correction in shares and in cyclical stocks specifically. But if snap lockdowns remain relatively short as we expect, they are unlikely to de-rail the Australian economic recovery or the rising trend in Australian shares.

Source: AMP Capital June 2021

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

– five reasons not to be too concerned

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

Key points

• The gradual shift of central banks including the Fed and RBA towards an exit from monetary easing has caused some volatility in investment markets.

• We continue to expect the first RBA rate hike to be in 2023, albeit there is a risk it could come in late 2022.

• However, there are five reasons not to be too concerned: central banks are simply reflecting economic recovery; monetary policy remains easy; shares rose through the last Fed taper; share bull markets usually only end when monetary policy is tight; and it’s normal in this phase of the investment cycle for returns to slow.

Introduction

The drumbeat of central banks heading towards the exits from ultra-easy monetary policy is getting louder. It started with the Bank of Canada, then the Bank of England followed by the RBNZ and the Bank of Korea. Russia and Brazil have raised rates. The US Federal Reserve is starting to “talk about talking about tapering” (or slowing) its bond buying, and Fed officials are signalling the start of rate hikes in 2023 via the so-called “dot plot” of the median Fed official’s interest rate expectations. While Fed Chair Powell played down the importance of the dots, it was still too big a move to ignore. Our view is that formal taper talk is likely to start at next month’s Fed meeting with actual tapering likely to start late this year or early next and that 2023 for the first Fed hike is a reasonable expectation.

In Australia, the RBA is also slowly heading towards the exit of easy money with: 0.1% funding for banks ending this month; the bond targeted for its 0.1% bond yield target up for review in July and likely to see the target slip below 3 years; its bond buying program also up for review in July and also likely to be reduced or reviewed more frequently; and a speech by Governor Lowe dropping a reference to the conditions for a rate hike as being “unlikely to be met until 2024 at the earliest.” For several months now we have been anticipating that the first RBA rate hike would come in 2023, and after the strong jobs data for May this seems to be becoming consensus. In fact, it’s possible (covid permitting) that the conditions for higher rates (wages growth of 3% or more and inflation sustainably in the 2-3% target) may fall into place by late next year enabling a rate hike at the same time, although our base case remains 2023.

The hawkish shift by central banks – notably since the Fed last week – has caused some wobbles in investment markets. Some are fearing the Fed and other central banks may not be as committed to sustainably achieving their 2% or so inflation targets as previously thought and that the hawkish Fed tilt will threaten the recovery. So, should investors be concerned?

Five reasons not to be too fussed

Shares are vulnerable to a correction – they have run very hard and we are now in a seasonally weak period of the year – so the rough patch could have further to go. However, we would see this as just normal gyrations for this stage in the cycle. Here are five reasons not to be too concerned by central banks.

First, central banks are reflecting the reality of global economic recovery – this is being reinforced by the deployment of vaccines but with monetary stimulus having done its job, the need for emergency monetary settings is starting to recede. The recent shift in tone from central banks is most unlikely to signal that they are backing away from their commitments to getting inflation sustainably back to target – rather it reflects the reality that as recovery has been stronger than expected they will likely meet their objectives earlier than previously expected. Consistent with this Fed Chair Powell’s comments this week have been calming.

Second, monetary policy remains ultra-easy and is a long way from being tightened – tapering of bond purchases is not monetary tightening, it’s just slower easing. While some emerging country central banks have raised rates, rate hikes in the US and Australia are still 18 months to 2 years away and the ECB and Bank of Japan are further behind. While much concern has been expressed about the spike US inflation and in producer prices globally, the evidence suggests its transitory: the spike in US inflation is narrowly based on components impacted by the pandemic which won’t be sustained as things return to “normal”; reflecting this median inflation remains soft (see the next chart); various commodity prices have rolled over – with, eg, US timber prices down nearly 50%; and US wages pressure will subside as enhanced unemployment benefits end and schools return sending workers back into the jobs market and it will be similar in Australia when backpackers return.

US Core Inflation v Median Inflation

Source: Bloomberg, AMP Capital

And of course, risks remain around the more contagious Delta variant of coronavirus even in countries where a big portion of the population has had a first vaccine dose but where it’s still not enough for herd immunity as the current UK experience highlights. This will keep central banks a bit cautious in terms of removing stimulus, at least until herd immunity is reached via vaccination programs. The RBA in particular is likely to be more cautious than the Fed given the threat posed by Delta variant outbreaks in Australia, with the lower level of vaccination here and given that the inflation spike is likely to be less in Australia.

Third, through the actual period of the last US taper from December 2013 to September/October 2014 US shares rose – this is likely because tapering is a slowing in easing not actual tightening and rates were still low. There is no reason to expect a different outcome through the next taper, particularly given that the start of tapering is being well flagged.

Fourth, even if the first rate hikes from the Fed and RBA are sooner than we anticipate the experience of the last 30 years suggests an initial dip in share markets around the first rake hike but then the bull market resumes – and continues until rates become onerously tight which weighs on economic activity and hence profits. This can be seen in the next chart for US rates and shares. Shares had wobbles when interest rates first started to move up in February 1994 (US shares had a 9% correction), in June 2004 (US shares had a 8% correction) and in December 2015 (US shares had a 13% correction) but thereafter they resumed their rising trend and a bear market did not set in till 2000, 2007 and 2020 after multiple hikes. Recession did not come for seven years after the February 1994 first hike, for three and a half years after the June 2004 first hike and for four years after the December 2015 first hike (and that was due to the pandemic). This is because the first rate hike only takes monetary policy from very easy to a bit less easy, and it’s only when monetary policy becomes tight after numerous rate hikes that the economy gets hit. This is all a long way off as even the first hike is a while away.

US shares and interest rates

Source: Bloomberg, AMP Capital

Finally, this is all consistent with where we are in the investment cycle – a stylised version of which is shown in the next chart. A typical cyclical bull market in shares – the green area in the chart – has three phases:

• Phase 1 normally starts when economic conditions are still weak and confidence is poor, but smart investors start to see value in shares helped by ultra-easy monetary conditions, low interest rates and low bond yields.

• Phase 2 is driven by strengthening profits as economic growth turns up and investor scepticism gives way to optimism. While monetary policy may start to tighten, it is from very easy conditions & remains easy as underlying inflation remains low and so bond yields may be moving higher but not enough to derail the cyclical bull market.

• Phase 3 sees investors move from optimism to euphoria helped by strong economic and profit conditions, which pushes shares into clearly overvalued territory. Meanwhile, strong economic conditions drive inflation problems and force central banks to move into tight monetary policy, which pushes bond yields significantly higher. The combination of overvaluation, investors being fully loaded up on shares and tight monetary policy sets the scene for a new bear market.

The investment cycle

Source: AMP Capital

Right now, we are likely in Phase 2 of the investment cycle. Monetary support is likely starting to diminish (albeit only slowly), and we are now more dependent on earnings growth. This shifting of the gears from the Phase 1 valuation driven gains typically sees some slowing in average share market gains. But the trend remains up and we are likely still a fair way away from the unambiguous overheating and exhaustion evident at the end pf a cyclical bull market.

Implications for other asset classes

There are several implications for other asset classes from central banks gradually moving to exiting monetary stimulus:

• It may weaken one source of demand for Bitcoin and so-called “meme stocks” – as the opportunity cost of holding Bitcoin rises with higher bond yields and demand for it as a hedge against inflation may diminish. 

• Interest rates are gradually shifting from a tailwind to a potential headwind for Australian residential property demand. But as with shares, rates are still low and so this may not become a significant issue for a while but is likely to drive a slowing in property price gains and RBA rate hikes in 2023 will likely trigger price falls. The key for homeowners is to make the most of the currently still low fixed mortgage rates to get their debt down ahead of rate hikes. 

• While some may see a more bearish Fed as being positive for the US dollar, in reality it’s messy. For example, rate hikes in the 1994 and 2004 Fed tightening cycles saw the $US fall, which is consistent with the view that in times of economic recovery and rising rates, demand for safe haven currencies like the US dollar declines. So, while the $A could have some short-term wobbles, if the global recovery remains solid, the $A is likely to resume its rising trend.

The $US and US interest rates

Source: Bloomberg. AMP Capital

Source: AMP Capital June 23rd, 2021

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

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

Key points

• The shift from high inflation to low inflation has been a key tailwind for investment returns over the last 40 years – in particular it has allowed capital growth in excess of growth in earnings and rents.

• A long-term stabilisation in inflation around central bank targets which is our base case would remove this tailwind but still allow reasonable returns, whereas a sustained break higher in inflation (beyond the current likely transient inflation spike) could start to reverse it.

Introduction

There has been much concern about inflation this year – but why should it matter for growth assets like shares and property? Surely earnings and rents will just go up with higher inflation offsetting any negative impact from higher interest rates due to higher inflation? In reality, it’s more complicated. Our note two weeks ago had a look at the outlook for inflation – why the current spike should prove transitory, but more broadly why the long-term decline in inflation over the last 40 years or so may be over. This note takes a closer look at the impact of inflation on growth assets like shares and property.

What drives investment returns?

In considering the impact of inflation on investment returns the best place to start is a consideration of what makes up returns. The percentage return on an asset is driven by its income flow (or yield) and capital growth – which can be broken down into growth in earnings or rents and changes in valuations. So:

Return = Income Yield Earnings Grth Change in Valuation

The first two components are fairly obvious and less interesting:

• The income yield is simply the flow of income the asset produces – whether its dividends in the case of shares or rent from property. It tends to be relatively stable over time.

• The second is the rate of growth in the investment’s earnings (or rents in the case of property). 

• The third component is the portion of return due to changes in valuation which is basically where the asset’s price rises by more or less than earnings growth, resulting in rising or falling price to earnings multiples in the case of shares.

Cash & government bonds and inflation

For cash and bank deposits the income yield (or interest rate) is what matters and to the extent that higher inflation leads to higher interest rates investors in these assets can be protected. However, just note that interest rates tend to lag big moves in inflation so in the mid-1970s interest rates rose but not as quickly as inflation (as central banks and investors took time to realise that inflation would stay high) meaning investors went backwards in real terms. They only got ahead when rates overshot in the early 1980s and then inflation fell.

Australian bank interest rates, bond yields and inflation

Source: RBA, Bloomberg, AMP Capital

For investors in government bonds there is no earnings growth and they suffer a capital loss when yields rise with inflation (ie, the change in valuation component goes negative). Ultimately, bond investors benefit from higher yields once they roll over their investments into the higher yields but in the interim, they are not protected. Inflation linked bonds paying a yield linked to inflation are the best protection for bond investors.

Changes in PEs have a big impact on share returns

For shares and other growth assets a big driver of the impact of changes in inflation comes through changes in the price to earnings ratio (or price to rent ratios for property). Price to earnings multiples can be volatile in the short term as the share market anticipates swings in earnings and due to changes in sentiment. But they can also be subject to longer-term or secular swings. The next chart shows the contribution to rolling 10-year share market returns in the US from dividends, earnings and changes to valuations (or PEs).

US shares – contribution to total sharemarket return

Source: Bloomberg, AMP Capital

And here it is for Australia, albeit for a shorter period as the PE series for Australia does not go back as far as in the US.

Australian shares – contribution to total sharemarket return

Source: Bloomberg, AMP Capital

The change in valuations or PEs (the green portion) was a big boost for US share market returns in the 1960s (as PEs rose), then it became a big drag in the 1970s (with virtually all of the return contribution from earnings offset by falling PEs), but became a big positive (often running at 5% pa or more) from the early 1980s into the 2000s and even recently (with PEs rising). Several factors impacted this including the optimism of the go-go years of the late 1960s, the supply side revolution of the 1980s and the 1990s tech boom which were positive for PEs. But a big driver was the swing in inflation from low in the 1960s to high in the 1970s (which pushed PEs down), to then low again from the 1980s (which pushed PEs up).

Inflation and PEs

The next chart shows the long-term relationship between US inflation and the US price to earnings ratio. The PE tends to fall as inflation moves up (as occurred in the 1970s) and it rises when inflation falls (as has occurred over the period since the early 1980s), although it’s less clear once inflation falls into deflation. Oddly enough it seems the market’s preferred inflation rate is the same as the Fed’s, ie, about 2%!

US shares – Low inflation = higher PEs

Source: Bloomberg, AMP Capital

The next chart shows the same relationship for Australia although it only goes back to 1962 as our PE data does not go back as far.

Australian shares – Low inflation = higher PEs

Source: ASX, Bloomberg, AMP Capital

There are three drivers of the inverse relationship between PEs and inflation:

• First, low inflation means lower interest rates which boosts the value of future profits and dividends making shares more attractive. Or put simply lower inflation and interest rates boosts the attractiveness of higher yielding assets so investors switch into those assets which pushes up their price relative to their earnings, dividends or rents and so their yield goes down.

• Second, low inflation means reduced economic volatility and uncertainty, hence investors are prepared to price shares on higher price to earnings multiples.

• Finally, low inflation means improved quality of earnings as firms tend to understate depreciation when inflation is high and so overstate actual earnings. So again, investors are prepared to pay more for shares when inflation is low.

Of course, if inflation becomes deflation it can be bad to the extent its associated with economic contraction. But assuming deflation is avoided the bottom line is that a shift from high inflation to low inflation drives PEs higher (and yields lower), and vice versa for a shift from low inflation back to high inflation.

The bottom line

The bottom line is that share market returns have been boosted since the early 1980s as PE multiples rose (or earnings yields fell) on the back of the downtrend in inflation over the last 40 years. This phenomenon has also boosted returns from other growth assets like property, which have also seen a significant rise in prices relative to rents as evident in a sharp fall in rental yields as can be seen below – notably for residential property.

Australian investment yields have all fallen with low inflation

Source: REIA, JLL, Bloomberg, AMP Capital

So, if inflation rises sharply in the years ahead this could start to reverse the boost to returns from growth assets seen since the early 1980s as investors demand lower price to earnings and lower price to rents ratios (or higher yields).

Inflation is likely to rise further in the next few months, which could push bond yields higher and threaten share valuations (particularly high PE stocks, like tech), but with the rise in inflation being driven by base effects and bottlenecks associated with the pandemic and reopening this should be transitory. However, in a longer-term context we are likely now seeing the bottoming in inflation & long-term bond yields after a 40-year downtrend. This will mean that the tailwind which has helped propel growth assets higher – as lower inflation drove ever lower yields and higher PEs which in turn meant higher returns than would be implied by increases in earnings and rents alone – will start to fade, resulting in returns more constrained to underlying yields and earnings/rental growth. Inflation around central bank targets is the best scenario as it would still mean low inflation – but less risk of deflation & likely higher wages growth and investment returns would still be ok. The risk would be if inflation gets out of control again on a sustained basis, then the valuation boost from low inflation will be reversed, resulting in poor returns from growth assets. This is not our base case given central banks are still focussed on inflation targets and technological innovation will impose some brake on inflation, but it’s a risk.

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

– here are seven reasons for optimism

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

Key points

• With growth of 1.8% in the March quarter, Australian GDP is now back above its pre pandemic level.

• While uncertainties remain – including around the latest coronavirus outbreak in Victoria – there are seven reasons for optimism that the recovery will continue at a decent rate: vaccines; global growth is ramping up; consumer spending is well supported; dwelling investment is likely to remain strong; business investment is strengthening; fiscal stimulus is continuing; and monetary policy remains ultra-easy.

Introduction

After a far stronger than expected rebound from the national pandemic lockdown through the second half of last year, Australian growth slowed a bit in the March quarter but is now above its pre pandemic level. This note looks at the outlook.

The recovery has slowed but continues

The March quarter saw GDP growth slow but to a still very strong 1.8% quarter on quarter. The gain was driven by a 1.2% rise in consumer spending with a rotation back to services spending (up 2.4%) offsetting a fall back to more normal goods spending (down 0.5%), a 6.4% rise in dwelling investment, a 3.6% gain in business investment and a 0.8 percentage point contribution from inventories offsetting a detraction from trade.

Australian real GDP growth

Source: ABS, AMP Capital

This saw growth up 1.1% on a year ago and GDP has now made it 0.8% above its pre pandemic high in December quarter 2019. As can be seen in the next chart, the economy has effectively traced out a Deep V style rebound. With growth averaging over 3% over the September and December quarters some slowing in the pace of recovery was inevitable as the easy gains from economic reopening are behind us. What’s more, various snap lockdowns across most states impacted over the last quarter. With the reopening gains behind us, the Victorian snap lockdown and potentially others impacting this quarter and some sectors remaining slower to recover – notably travel and higher education given closed international borders – the pace of growth is likely to slow further over the year ahead.

Australian real GDP level

Source: ABS, AMP Capital

The ongoing hit to immigration means it will take longer for Australia to regain its pre-virus trend compared to other countries that normally have relatively lower immigration levels.

Australia has performed relatively well

That said, Australia has performed comparatively well through the pandemic. While China is ahead, Australia is one of the few developed countries with GDP back above pre pandemic levels.

March qtr real GDP, % from pre-CPVID levels

Source: OECD, ABS, AMP Capital

This reflects a combination of better control of coronavirus – which meant lower hospitalisations and deaths, less severe lockdowns and less self-regulation limiting mobility – and a good well-targeted policy response that protected incomes, jobs and businesses. Countries with less coronavirus related deaths like Australia have had better GDP outcomes.

Real GDP growth, % from pre-COVID levels v COVID-19 deaths per million people

Source: ourworldindata, OECD, ABS, AMP Capital

Seven reasons for optimism on Australian growth

Our Australian Economic Activity Tracker – based on weekly data – has continued to trend higher into this quarter and remains strong relative to our US and European Trackers.

Economic Activity Trackers: Australia, Europe & US

Source: AMP Capital

Uncertainties remain: Australia is vulnerable to new coronavirus outbreaks given the low level of vaccination (just 17% versus 51% in the US and 59% in the UK) as highlighted by the problems in Victoria; some parts of the economy are a long way from normal; and tensions with China could escalate further. However, there are seven reasons for optimism that recovery will continue at a decent rate.

• First, the vaccines will help in underpinning reopening and recovery – they work in protecting against coronavirus infection and severe illness (as evident in Israel, the UK and US), global vaccine production is ramping up with plentiful global supply likely in the next 6-9 months and Australia appears to be speeding up its vaccine rollout with the events in Victoria helping to spur it on. We are assuming the Victorian lockdown will be successful in heading off a bigger problem and so will be relatively brief. But the uncertainty around outbreaks will diminish as vaccination ramps up.

• Second, global growth is recovering rapidly – driven by vaccines enabling reopening, monetary and fiscal stimulus, and pent-up demand. This is driving strong growth in demand for Australian exports and high commodity prices.

Global Composite PMI vs World GDP

Source: Bloomberg, AMP Capital

• Third, growth in consumer spending is well supported – by high levels of consumer confidence, a still high saving rate of 11.6%, excess bank deposits of over $200bn (spread across the household and corporate sectors) relative to what would have occurred in the absence of the pandemic, positive wealth effects from the rise in the share market and house prices, ultra-low interest rates and further to go for services spending to recover.

• Fourth, dwelling investment will provide a strong contribution to growth – the surge in building approvals points to more upside in housing construction this year.

Building approvals v new dwelling investment

Source: ABS, AMP Capital

• Fifth, business investment is strengthening – investment plans for the next financial year are up nearly 15% on plans for a year ago which is consistent with high levels of business confidence, excess corporate cash and the instant asset write-off tax break. Adjusting business intentions for the past average gap between intentions and actual outcomes points to investment growth of around 20% in the next financial year with mining investment the strongest but manufacturing and other industries also strong.

Actual and expected capital expenditure

Source: ABS, AMP Capital

• Sixth, fiscal stimulus continues – Australia has successfully negotiated the so-called fiscal cliff with the wind down of JobKeeper and other supports, and fiscal stimulus looks set to continue for now including extra stimulus in the May Budget.

• Finally, monetary policy remains ultra-easy – while the RBA is likely to cut its quantitative easing in the next 6 months, rates are likely to remain around zero for the next few years.

Concluding comment

We expect GDP growth through this year of 5% and 3.5% next year. This in turn should underpin an ongoing rebound in corporate profits which, along with continuing low interest rates, will underpin a still rising trend in the Australian share market – notwithstanding the risk of a correction in the next few months. Key risks to keep an eye on are: coronavirus outbreaks; a likely further near term inflation scare; and tensions with China.

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