Olivers Insights

For some time now, the investment world has been characterised by a search for decent yield paying investments. This “search for yield” actually started last decade but was interrupted by the Global Financial Crisis (GFC) and the Eurozone debt crisis before resuming again in earnest. 

When investment assets are in strong demand from investors, their price goes up relative to the cash flow (eg dividends, interest or rent) they provide pushing their yield down. This is evident in recent times in response to the “search for yield” with yields falling across the board as the next chart shows. 

Source: Bloomberg, REIA, RBA, AMP Capital

But everything goes in cycles. So has the “search for yield” gone too far? Will the US Federal Reserve’s shift to start reducing its bond holdings cause a reversal? 

Drivers of the search for yield

Interest in yield based investing is not new and is in fact a normal part of investing. Particularly when investors are a bit wary about going for growth. In fact, in Japan it’s become pretty much the norm as interest rates have been stuck at zero for years. In the 1950s, yield focussed investing was the norm in the US and Australia. The search for yield also became apparent last decade and played a role in the GFC itself (as investors piled into yield based investments underpinned by “sub-prime” mortgages, oblivious of the risks). There are three main drivers of the “search for yield” in recent years:

• First, low interest rates and bond yields and the flow on to bank deposit rates due to low inflation and sub-par growth have encouraged investors to search for higher yielding investments. Central banks buying up bonds and displacing investors into other assets have accentuated this.

• Second, reduced fear of economic meltdown (as the GFC and subsequently the Eurozone public debt crisis subsided) has helped investors feel comfortable in taking on the greater risk that this entails. 

• Finally, aging populations in developed countries is seeing baby boomers move into pre-retirement and retirement, driving a demand for less volatile investments paying income. Normally, this demand would go to bonds and bank deposits but as their yields are so low some of this demand has gone into other yield paying investments.

Demand for yield from aging populations has further to go as populations age. For example, in Australia the share of the population aged 65 and over is projected to rise from 15% now to 22% by 2061. However, the second driver is cyclical and will reverse next time there is a sustained bout of risk aversion – just as it did in the GFC. 

The first driver is a mix of structural and cyclical influences, though, and it’s probably been the main driver of the search for yield. Bond yields and interest rates have been trending down for 30 years or so and this is structural reflecting a downtrend in inflation, which resulted in a long-term super cycle bull market in bonds. But falls this decade also contain a big cyclical element reflecting the sub-par global growth and deflation seen after the GFC. This accentuated the super cycle bull market in bonds and put the search for yield on steroids. This is where the greatest risk of a reversal in the search for yield trade lies.

The logic of falling yields 

The search for yield is understandable and can be seen in relation to Australian commercial property ie office, retail and industrial property. The next chart shows average commercial property yields and 10-year bond yields. While average commercial property yields have fallen since the early 1980s from an average of 8.3% to around 5.5%, the yield on bonds has crashed. The longer the decline in bond yields has persisted, the more investors have expected it to continue, driving rising demand for higher yielding assets like property.

Source: Bloomberg, AMP Capital

With Australian 10-year bonds yielding 2.8%, it’s little wonder investors might find commercial property on an average yield of around 5.5% more attractive particularly once capital growth of, say, 2.5% pa (ie inflation) for a total return of 8%, is allowed for. The property risk premium – the return potential property provides over bonds – at 5.2% remains high & well above early 1990s and pre-GFC levels that caused problems for property.

Source: Bloomberg, AMP Capital

The same logic applies to investment in assets such as unlisted infrastructure, listed variants of both commercial property and infrastructure, shares and corporate debt.

But are we getting close to a reversal?

Has it gone too far? The greatest risks are around corporate debt where the gap between US investment grade and junk bond yields and US government bond yields has narrowed sharply to around levels that prevailed prior to the tech wreck and again prior to the GFC. But as we saw in the mid-1990s and mid-2000s, spreads can remain low for a while before trouble arises, which is usually when the economy turns down and there is no sign of that just yet. 

For equities the gap between the forward earnings yield on shares and bond yields has narrowed in recent years. But this gap – which is a guide to the risk premium shares offer over bonds – still remains relatively wide by pre GFC standards.

Source: Thomson Reuters, Bloomberg, AMP Capital

And finally for real assets, using commercial property as a guide, as indicated earlier the risk premium offered by commercial property relative to bonds remains wide, albeit it has narrowed as property yields have fallen and bond yields have risen (a bit). Overall, it’s hard to argue the search for yield has gone too far given how low bond yields still are. That said, corrections like what we saw in shares and corporate debt during 2015-16 are healthy in ensuring this remains the case.

• First, global growth is looking stronger as evident in strong business conditions indicators across most countries. Global growth is improving and becoming more synchronised globally. Nearly 75% of the 45 countries tracked by the OECD are seeing accelerating growth, the highest it’s been since the initial bounce out of the GFC in 2010.

• Part of the reason for this is that the “muscle memory” from the GFC, which commenced a decade ago, is fading and this is contributing to stronger confidence.

• The risk of deflation is receding and giving way to the risk of a rise in inflation as capital and labour utilisation is on the rise globally & productivity growth is poor, reflecting: low levels of investment; increasing levels of populist regulation in some countries; and as older workers retire. While the impact of technological innovation (the Amazon effect, artificial intelligence) will keep this gradual there will still be a cycle in inflation and the risks are gradually pointing up.  

• Reflecting this, central banks are gradually retreating from ultra easy policy. The Fed is the most advanced here as the US economic recovery is further advanced. As a result, the Fed is moving towards allowing its holding of government bonds and mortgage-backed securities to start declining. This will be achieved by the Fed not rolling over (ie not reinvesting) the bonds on its books as they mature so it won’t be as dramatic as actually selling bonds. But its holding of bonds will nevertheless decline and it will be sucking cash out of the US economy. In other words, it will be undertaking “quantitative tightening” to reverse the “quantitative easing” of a few years ago. This is good news and reflects the strength of the US economy much as its commencement of rate hikes did in 2015. Nevertheless, combined with continuing gradual Fed rate hikes, it will likely see a resumption of the upwards pressure on bond yields acting as a gradual dampener on the search for yield.

The upswing in bond yields is likely to be gradual – with periodic spurts higher then fall backs like over the last year – as the Fed will likely be gradual, other central banks including the Reserve Bank of Australia are well behind the Fed in being able to tighten and yield focussed demand from aging populations will act as a constraint. But the trend in bond yields is likely to be up unless there is an unexpected relapse in global growth.

What does it all mean for investors?

There are several implications for investors: expect lower returns from government bonds as yields gradually rise; the search for yield likely has further to go in relation to commercial property and infrastructure but it is likely to wane as bond yields rise; share markets are now more dependent on earnings growth for future gains (and the signs are positive) but cyclical sectors geared to higher earnings will likely be the outperformers and yield plays may be underperformers. That the Fed is moving to start reversing its post-GFC quantitative easing (money printing) is another sign the global economy is getting back to normal. This is good for investors.

Source: AMP Capital 21 September 2017

Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

New ways to access various investments, tax changes and new regulations, all with social media adding to the noise. But it’s really quite simple and this can be demonstrated in charts. This note continues our series that began with “Five great charts on investing”, which can be found here and looks at another five great charts – well, one is actually a table – on investing.

Chart #1 Time in versus timing

Without a tried and tested asset allocation process, trying to time the market, ie selling in anticipation of falls and buying in anticipation of gains, is very difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 11.3% per annum (including dividends but not allowing for franking credits, tax and fees). 

Source: Bloomberg, AMP Capital  

If by trying to time the market you avoided the 10 worst days (yellow bars), you would have boosted your return to 12.5% pa. If you avoided the 40 worst days, it would have been boosted to 17% pa. But this is very hard to do and many investors only get out after the bad returns have occurred, just in time to miss some of the best days and so end up damaging their returns. For example, if by trying to time the market you miss the 10 best days (blue bars), the return falls to 8% pa. If you miss the 40 best days, it drops to just 3.7% pa. Hence the old cliché that “it’s time in that matters, not timing”.

Key message: market timing is great if you can get it right, but without a process the risk of getting it wrong is very high and if so it can destroy your returns.

Chart #2 Look less

If you look at the daily movements in the share market, they are down almost as much as they are up, with only just over 50% of days seeing positive gains. See the next chart for Australian and US shares. So day by day, it’s pretty much a coin toss as to whether you will get good news or bad news. But if you only look monthly and allow for dividends, the historical experience tells us you will only get bad news around a third of the time. Looking out further on a calendar year basis, data back to 1900 indicates the probability of bad news in the form of a loss slides to just 20% in Australian shares and 26% for US shares. And if you go all the way out to once a decade, since 1900 positive returns have been seen 100% of the time for Australian shares and 82% for US shares. 

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

Key message: the less you look at your investments, the less you will be disappointed. This matters because the more you are disappointed, the greater the chance of selling at the wrong time.

Chart #3 Risk and return

This chart is basic to investing. Each asset class has its own risk (in terms of volatility and risk of loss) and return characteristics. Put simply: the higher the risk of an asset, the higher the return you will likely achieve over the long term and vice versa. The next chart shows a stylised version of this. Starting with cash (and bank deposits), it’s well known that they are very low risk but so is their return potential. Government bonds usually offer higher returns but their value can move around a bit in the short term (although major developed countries have not defaulted on their bonds). Corporate debt has a higher return potential again but a higher risk of default – particularly for junk bonds. Corporate debt is basically a hybrid between equities & government bonds. Unlisted or directly held commercial property and infrastructure offer a higher return again but they come with higher risk and are less liquid and can be less able to be diversified (although this can be remedied by investing via a managed fund). Equities can offer another step up in return but this is because they come with higher risk as they are subject to share market volatility and individual companies can go bankrupt wiping out share holder capital. Beyond this, private equity entails more risk again and so tends to command an even higher return premium. Each step up involves more risk and this is compensated for with more return.

Source: AMP Capital Key message: Investors need to allow for the risk (and liquidity) and return characteristics of each asset. Those who don’t mind short-term risk (and illiquidity in the case of unlisted assets) can take advantage of the higher returns growth assets offer over long periods. The key is that there is no free lunch.

Chart #4 Diversification

But this not the end of the story. The next table shows the best and worst performing asset class in each year over the last 15. 

Best and worst performing major asset class 
 

Note: refers to the major asset classes. Source: Thomson Reuters, AMP Capital 

It can be seen that the best performing asset each year can vary dramatically and that last year’s top performer is no guide to the year ahead. For example, those who loaded up on listed property after their strong pre-Global Financial Crisis (GFC) performances were badly hurt as they were amongst the worst performing assets through the GFC. So it makes sense to have a combination of asset classes in your portfolio. This particularly applies to assets that are lowly correlated ie that don’t just move in lock step with each other. For example, global and Australian shares tend to move together during extreme events. But bonds and shares tend to diverge when crises hit – as we saw in the GFC when shares fell sharply but bonds rallied. And so there is a case to have bonds in a portfolio to help stabilise returns.

Key message: diversification is also a bit like the magic of compound interest. Having a well-diversified exposure means your portfolio won’t be as volatile. And this can help you stick to your strategy when the going gets rough.

Chart #5 Residential property has a role 

Chart #1 in the first edition in this Five Charts series highlighted the power of compound interest, with a comparison showing the value of $1 invested in various Australian asset classes back in 1900 and what it would be worth today. Unfortunately, I do not have monthly data for Australian residential property returns back that far but I do have them on an annual basis back to 1926 and this is shown in the next chart starting with a $100 investment. (Commercial property return series only really go back a few decades.)

Source: ABS, REIA, Global Financial Data, AMP Capital  

Again it can be seen that over very long periods the power of compounding works wonders for shares compared to bonds and cash. But it can also be seen to work well for Australian residential property with an average total return (capital growth plus net rental income) of 11% pa, which is similar to that for shares. All of which highlights, along with the diversification benefits of a real asset like property, the case to have it in a well-diversified portfolio along with listed assets like shares, bonds and cash. The key is to allow for the different “risks” experienced by property versus shares. Property prices are less volatile than share prices as they are not traded on share markets and so are not as subject to the whims of investors and movements in their values tend to relate more to movements in the real economy. But residential property takes longer to buy and sell and it’s harder to diversify as you can’t easily have exposure to hundreds or thousands of properties exposed to different sectors and countries like you can with shares. So there are trade-offs between residential property and shares.

Key message: given their long-term returns and diversification benefits, there is a key role for residential property in your investment portfolio (putting aside issues of current valuations).

Source: AMP Capital 11 September 2017 

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

Growth bounces back (again)

Threats, risks and worries

• Housing construction is starting to slow with falling approvals pointing to a further slowing (see next chart).

• Related to this, there is the risk of a house price crash “as seen” on Four Corners. However, there have been endless property crash calls since around 2004. In the absence of a stronger supply surge, the Reserve Bank of Australia (RBA) making a mistake and raising rates too high and/or unemployment surging, our view is that a slowdown in Sydney and Melbourne is likely, but not a crash.

• Consumer spending is constrained by record low wages growth and high levels of underemployment. While consumer spending has been running faster than income growth, as rising wealth has allowed consumers to run down household savings (to now just 4.6%) this is unlikely to continue as the wealth effects flowing from property price gains in Sydney and Melbourne slow. Rapid power cost increases and high debt are also not helping. All of which is driving low consumer confidence.

• Mining investment is still falling with business investment intentions pointing to another 22% fall this financial year.

• The Australian dollar is up 16% from last year’s low and at around $US0.80 (and threatening to go higher) it is at risk of slowing growth (and investment) in trade-exposed sectors like tourism, agriculture and manufacturing.  

• Underlying inflation is too low and risks staying below target for longer due to record low wages growth, a rising $A, competitive pressures & weak rents as new supply hits.

• Our political leaders seem collectively unable to undertake productivity-enhancing economic reforms and take decisive action (eg, on energy policy). With the citizenship crisis threatening an early election, it’s unlikely we will see an improvement any time soon.

Five reasons to expect growth to improve

These worries are well known and despite them we remain of the view that recession will be avoided and growth will pick up over the year ahead: First, the growth drag from falling mining investment is nearly over. Mining investment peaked at nearly 7% of GDP four years ago and has since been falling at around 25% per annum (pa), knocking around 1.5% pa from GDP growth. At around 2% of GDP now, its weight in the economy has collapsed reducing its growth drag to around 0.4% this year and it’s near the bottom (see next chart). 

Source: ABS, AMP Capital

• Second, non-mining investment is likely to rise this year. Comparing corporate investment plans for this financial year with those made a year ago points to a decline in business investment this year of around 3.5% (see next chart). But this is the best it’s been since 2013 and once mining investment is excluded this turns into an 8% gain for non-mining investment.

Source: ABS, AMP Capital

• Third, public investment is rising strongly, up 14.7% over the last year, reflecting state infrastructure spending.

• Fourthly, net exports are likely to continue adding to growth as the completion of resources projects boosts mining and energy export volumes and services sectors like tourism and higher education remain strong.

• Finally, profits for listed companies are rising again after two years of falls. This is a positive for investment and the flow of dividends helps household incomes.

Implications for investors

Source: Thomson Reuters, AMP Capital

If you would like to discuss anything in this article, please call us on |PHONE|.

Source: AMP Capital 06 September 2017

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.

Introduction

It seems momentous things happen in years ending in seven. Well, at least in the last 50 years starting with the “summer of love” in 1967 and the introduction of the Chevrolet Camaro. But after that, it was downhill with Elvis leaving the building in 1977, the 1987 share market crash, the Asian crisis of 1997 and the GFC that started in 2007. While Lehman Brothers didn’t go bankrupt until September 2008, the GFC’s initial tremors occurred in 2007. Financial markets really started to take notice in August of that year, with shares taking a big hit before rebounding to new highs for US and Australian shares in October/November 2007 ahead of a roughly 55% decline into March 2009. This note looks at the main lessons for investors from the GFC and whether it can happen again.

What drove the GFC

But first some history. The GFC was the worst global financial crisis since the Great Depression. It saw the freezing up of lending between banks, multiple financial institutions needing to be rescued, 50% plus share market falls and the worst post-war global economic contraction. At the core of the GFC was something very basic. In an environment of low interest rates (with often initially low “teaser” rates) too many loans were made to US homebuyers that set off a housing boom that went bust when interest rates rose and supply surged. So no big deal – it happens all the time! But it was what went on around it that ultimately saw it turn into a global crisis.

• A massive proportion of the loans (40% or so) went to people who had no ability to service them – sub-prime and low doc borrowers. Remember NINJA loans – loans to people who had no income, no job and no assets! And many were non-recourse loans – so borrowers could just hand over the house if its value fell below the debt owed on it and that was the end of their liability. Recall – jingle mail!

• This was encouraged by public policy aimed at boosting home ownership and ending discrimination in lending. 

• It was made possible by a massive easing in lending standards facilitated by financial innovation that packaged up the sub-prime loans into securities, which were then given AAA ratings on the basis that while a small proportion of loans may default the risk will be offset by the broad exposure. These securities were then leveraged up and sold all over the world with fancy names like Collateralised Debt Obligations (CDOs) that found willing buyers looking for decent low risk (remember AAA rated!) yield at a time of low interest rates. Hedge funds investing in such products even got awards like “yield manager of the year”. But the trouble was that with the sub-prime loans moved out of the banks, there was no “bank manager” looking after them.

• This all came as banks globally were sourcing an increasing amount of the money they were lending from global money markets – which had freed them up from relying on expensive bank deposits via bricks and mortar branches.

The music stopped in 2006 when poor affordability, an oversupply of homes and 17 interest rates hikes from the Fed over two years saw US house prices peak and then start to slide. This made it harder for sub-prime borrowers to refinance their loans at their initial “teaser” rates. As a result, more and more borrowers defaulted causing investors in the fancy products that invested in sub-prime loans (like CDOs) to start suffering losses. The problem really caught the attention of global investors in August 2007 after BNP froze redemptions from three of its funds because it couldn’t value the CDOs within them, which in turn set in train a credit crunch with sharp rises in the cost of funding for banks and a reduction in its availability triggering sharp falls in share markets. Shares rebounded but only to peak in late October/November 2007 before commencing roughly 55% falls as the credit crunch worsened, the global economy fell into recession, mortgage defaults escalated and multiple banks failed.

The crisis went global as: losses mounted; these were magnified by gearing, which forced investment banks and hedge funds to liquidate sound positions to meet redemptions thereby spreading the crisis to other assets; the distribution of securities investing in US sub-prime debt globally led to a wide range of exposed investors and hence greater worries about who was at risk; this all led to a freezing up of lending between banks. All of which affected confidence and economic activity.

Fault lay with home borrowers, the US Government, lenders, ratings agencies, regulators, and investors and financial organisations for taking on too much risk.

It came to an end in 2009 after significant monetary easing and fiscal stimulus helped restore the normal operation of money markets, confidence and growth. That said, aftershocks continued with sub-par global growth and very low inflation.

Lessons from the GFC and its aftermath

The GFC highlighted several lessons for investors:  
 

• The economic and investment cycle is alive and well. Talk of a “great moderation” was all the rage prior to the GFC but the GFC reminded us yet again that periods of great returns are invariably followed by a fall back. If returns are too good to be true they probably are.

• High returns come with higher risk. While risk is often dormant for years, it usually returns with a vengeance as was apparent in the GFC. Backward-looking measures of volatility are no better than attempting to drive focussed only on the rear view mirror. 

• While each boom bust cycle is different, markets are pushed to extremes of valuation and sentiment. The low in 2009 was characterised by ultra cheap shares and credit investments with investors highly pessimistic.

• Be sceptical of financial engineering or hard-to-understand products. The biggest losses for investors in the GFC were generally in products that relied heavily on financial engineering purporting to turn junk into AAA investments that were impossible to understand. 

• Avoid too much gearing or gearing of the wrong sort. Gearing is fine when all is going well. But it will magnify losses when things reverse and can force the closure of positions at a big loss when the lenders lose their confidence and refuse to roll over maturing debt or when a margin call occurs forcing an investor to sell their position just at the time they should be adding to it.

• The importance of true diversification. While listed property trusts and hedge funds were popular alternatives to low-yielding government bonds prior to the GFC, through the crisis they ran into big trouble (in fact Australian Real Estate Investment Trusts (REITs) fell 79%), whereas government bonds were the star performers. REITs have cut their gearing and returned to their knitting. But “in a crisis correlations go to one – except for true safe havens”.

• Fiscal and monetary policy work. There is a role for government in putting free market economies back on track when they get into a downward spiral. While some have argued that easy money just benefitted the rich (who invest in shares), doing nothing would have likely ended with 20% plus unemployment and worse inequality. 

• The return to normal from major financial crises can take time, as the blow to confidence depresses lending and borrowing and hence consumer spending and investment for years afterwards. This muscle memory eventually fades but the impact can be seen for a decade or so. 

• The importance of asset allocation. The GFC provided an extreme reminder that what really matters for your investment performance is your asset mix – ie your allocation to shares, bonds, cash, property, etc. Exposure to individual shares or fund managers is second order. 

• Finally, “stuff happens”. While after each economic crisis there is a desire to “make sure it never happens again”, history tells us that manias, panics and crashes are part and parcel of the process of “creative destruction” that has led to an exponential increase in material prosperity in capitalist countries. The trick is to ensure that the regulation of financial markets minimises the economic fallout that can occur when free markets go astray but doesn’t stop the dynamism necessary for economic prosperity. 

Will it happen again?

Of course there will be another boom and bust…but as Mark Twain is thought to have said “history doesn’t repeat, but it rhymes” so the specifics will be different next time. History is replete with bubbles and crashes and tells us it’s inevitable that they will happen again as each generation forgets and must relearn the lessons of the past. Often the seeds for each new bubble are sown in the ashes of the former. Fortunately, in the post-GFC environment seen so far there has been an absence of broad-based bubbles on the scale of the tech boom or US housing/credit boom. E-commerce stocks like Facebook and Amazon are a candidate but they have seen nowhere near the gains or infinite PEs seen in the late 1990s tech boom. 

Source: Thomson Reuters, Bloomberg, AMP Capital

On the global debt front, a concern is that after a post-GFC pull back, it has grown to an all-time high relative to global GDP. 

Source: IMF, Haver Analytics, BIS, Ned Davis Research, AMP Capital

However, just because global debt has grown to a new high doesn’t mean a crisis is upon us. It has been trending up for decades, much of the growth in debt in developed countries post the GFC has been in public debt and debt interest burdens are low thanks to low interest rates in contrast to the pre-GFC period. Furthermore, the other signs of signs of excess that normally set the scene for recessions and associated deep bear markets in shares like that seen in the GFC are not present on a widespread basis just now. Inflation is low, monetary policy globally has barely tightened, there has been no widespread overinvestment in technology (as preceded the tech wreck) or housing (as preceded the GFC in the US) and bank lending standards have not been relaxed to the same degree as seen prior to the GFC. Moreover, financial regulations have tightened significantly with banks required to have higher capital ratios and source a greater proportion of funds from their depositors.

So another boom bust cycle is inevitable at some point, but it will likely be very different to the GFC. And many of the signs of excess that normally precede deep bear markets are still absent.

If you would like to discuss anything in this report, please call us on |PHONE|.

Source: AMP Capital 24 August 2017

Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

Introduction

Tensions with North Korea have been waxing and waning for decades now but in recent times the risks seem to have ramped up dramatically as its missile and nuclear weapon capabilities have increased. The current leader since 2011, Kim Jong Un, has launched more missiles than Kim Il Sung (leader 1948-1994) and Kim Jong Il (1994-2011) combined.

Source: CNN, AMP Capital

The tension has ramped up particularly over the last two weeks with the UN Security Council agreeing more sanctions on North Korea and reports suggesting North Korea may already have the ability to put a nuclear warhead in an intercontinental ballistic missile that is reportedly capable of reaching the US (and Darwin).

US President Trump also threatened North Korea with “fire, fury and, frankly, power” only to add a few days later that that “wasn’t tough enough” and “things will happen to them like they never thought possible” and then that “military solutions…are locked and loaded should North Korea act unwisely”. Meanwhile, North Korea talked up plans to fire missiles at Guam before backing off with Kim Jong Un warning he could change his mind “if the Yankees persist in their extremely dangerous reckless actions”. 

This is all reminiscent of something out of James Bond (or rather Austin Powers) except that it’s serious and naturally has led to heightened fears of military conflict. As a result, share markets dipped last week and bonds and gold benefitted from safe haven demand, although the moves have been relatively modest and markets have since bounced back.

At present there are no signs (in terms of military deployments, evacuation of non-essential personnel, etc) that the US is preparing for military conflict and it could all de-escalate again, but given North Korea’s growing missile and nuclear capability it does seem that the North Korean issue, after years of escalation and de-escalation, may come to a head soon. It’s also arguable that the volatile personalities of Kim Jong Un and Donald Trump and the escalating war of words have added to the risk of a miscalculation – eg where North Korea fires a missile into international waters, the US seeks to shoot it down, which leads to a cycle of escalating actions. This note looks at the implications for investors.

Shares and wars (or threatened wars)

Of course there have been numerous conflicts that don’t even register for global investors beyond a day or so at most if at all. Many have little financial market impact because they are not seen as having much economic impact (eg the war in Afghanistan in contrast to 1991 and 2003 wars with Iraq, which posed risks to the supply of oil). As such, I have only focussed on the major wars/potential wars since World War 2 and only on the US share market (S&P 500) as it sets the direction for others (including European, Asian and Australian shares).

• World War 2 (September 1939-September 1945) – US shares fell 34% from the outbreak of WW2 in September 1939, with 20% of this after the attack on Pearl Harbour, and bottomed in April 1942. This was well before the end of WW2 in 1945. Six months after the low, shares were up 25% and by the time WW2 had risen by 108%.

• Korean War (June 1950-July 1953) – US shares initially fell 8% when the war started but this was part of a bigger fall associated with recession at the time. Shares bottomed well before the war ended and trended up through most of it.

• Vietnam War (1955-1975) – For most of this war US shares were in a secular bull market but with periodic bear markets on mostly other developments. Rising inflation and a loss of confidence associated with losing the Vietnam war may have contributed to the end of the secular bull market in the 1970s – but the war arguably played a small role in this.

• Cuban Missile Crisis (October 1962) – Shares initially fell 7% over eight days as the crisis erupted but this was part of a much bigger bear market at the time. They bottomed five days before it was resolved and then rose sharply. This is said to be the closest the world ever came to nuclear war 

• Iraq War I (August 1990-January 1991) – Shares fell 11% from when Iraq invaded Kuwait to their low in January 1991 but again this was part of a bigger fall associated with a recession. Shares bottomed 8 days before Operation Desert Storm began and 19 days before it ended and rose sharply.

• Iraq War II (March-May 2003) – Shares fell 14% as war loomed in early 2003 but bottomed nine days before the first missiles landed and then rose substantially although again this was largely due to the end of a bear market at the time.

 Source: AMP Capital

 The basic messages here are that:

• Shares tend to fall on the initial uncertainty but bottom out before the crisis is resolved (militarily or diplomatically) when some sort of positive outcome looks likely; 

• Six months after the low they are up strongly; and

• The severity of the impact of the war/threatened war on shares can also depend on whether they had already declined for other reasons. For example, prior to World War 2, the Cuban Missile Crisis and the two wars with Iraq, shares had already had bear markets. This may have limited the size of the falls around the crisis.

Possible scenarios 

In thinking about the risks around North Korea, it’s useful to think in terms of scenarios as to how it could unfold:

1. Another round of de-escalation – With both sides just backing down and North Korea seemingly stopping its provocations. This is possible, it’s happened lots of times before, but may be less likely this time given the enhanced nature of North Korea’s capabilities.

2. Diplomacy/no war – Sabre rattling intensifies further before a resolution is reached. This could still take some time and meanwhile share markets could correct maybe 5-10% ahead of a diplomatic solution being reached before rebounding once it becomes clear a peaceful solution is in sight. An historic parallel is the Cuban Missile Crisis of 1962 that saw US shares fall 7% and bottom just before the crisis was resolved, and then stage a complete recovery. 

3. A brief and contained military conflict – Perhaps like the 1991 and 2003 Iraq wars proved to be, but without a full ground war or regime change. In both Iraq wars while share markets were adversely affected by nervousness ahead of the conflicts, they started to rebound just before the actual conflicts began. However, a contained Iraq-style military conflict is unlikely given North Korea’s ability to launch attacks against South Korea (notably Seoul) and Japan.

4. A significant military conflict – If attacked, North Korea would most likely launch attacks against South Korea and Japan causing significant loss of life. This would entail a more significant impact on share markets with, say, 20% or so falls (more in Asia) before it likely becomes clear that the US would prevail. This assumes conventional missiles – a nuclear war would have a more significant impact.

Of these, diplomacy remains by far the most likely path. The US is aware of the huge risks in terms of the likely loss of life in South Korea and Japan that would follow if it acted pre-emptively against North Korea and it retaliates, and it has stated that it’s not interested in regime change there. And North Korea appears to only want nuclear power as a deterrent. In this context, Trump’s threats along with the US show of force earlier this year in Syria and Afghanistan are designed to warn North Korea of the consequences of an attack on the US or its allies, not to indicate that an armed conflict is imminent. Rather, comments from US officials it’s still working on a diplomatic solution. As such, our base case is that there is a diplomatic solution, but there could still be an increase in uncertainty and share market volatility in the interim. Key dates to watch are North Korean public holidays on August 25 and September 9, which are often excuses to test missiles, and US-South Korean military exercises starting August 21.

Correction risks

The intensification of the risks around North Korea comes at a time when there is already a risk of a global share market correction: the recent gains in the US share market have been increasingly concentrated in a few stocks; volatility has been low and short-term investor sentiment has been high indicating a degree of investor complacency; political risks in the US may intensify as we come up to the need to avoid a government shutdown and raise the debt ceiling next month, which will likely see the usual brinkmanship ahead of a solution (remember 2013); market expectations for Fed tightening look to be too low; tensions may be returning to the US-China trade relationship; and we are in the weakest months of the year seasonally for shares. While Australian shares have already had a 5% correction from their May high, they are nevertheless vulnerable to any US/global share market pull back. 

However, absent a significant and lengthy military conflict with North Korea (which is unlikely), we would see any pullback in the next month or so as just a correction rather than the start of a bear market. Share market valuations are okay – particularly outside of the US, global monetary conditions remain easy, there is no sign of the excesses that normally presage a recession, and profits are improving on the back of stronger global growth. As such, we would expect the broad rising trend in share markets to resume through the December quarter.

Implications for investors

Military conflicts are nothing new and share markets have lived through them with an initial sell-off if the conflict is viewed as material followed by a rebound as a resolution is reached or is seen as probable. The same is likely around conflict with North Korea. The involvement of nuclear weapons – back to weapons of mass destruction! – adds an element of risk but trying to protect a portfolio against nuclear war with North Korea would be the same as trying to protect it against a nuclear war during the Cold War, which ultimately would have cost an investor dearly in terms of lost returns. While there is a case for short-term caution, the best approach for most investors is to look through the noise and look for opportunities that North Korean risks throw up – particularly if there is a correction.

If you would like to discuss anything in this report, please call us on |PHONE|.

Source: AMP Capital 15 August 2017

Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

Introduction

The issue of rising inequality has seen increasing interest over the last year or so, particularly following the Brexit and Trump votes for which rising inequality was seen as a key driver. This is an issue we have looked at before in terms of driving a swing to the left amongst median voters in Anglo countries and contributing to a backlash against economic rationalist policies (see “The political pendulum swings to the left”, Oliver’s Insights, June 2016 (http://bit.ly/1UWCUX1) but this note takes a more detailed look at the economic and investment implications.

Is inequality rising?

Because inequality is a politically-charged issue, all sorts of numbers are thrown around with a favourite seeming to be the share of gross income going to a particular income group, say the top 1% or 10%. But this may not be the best guide because of the impact of progressive income taxes and welfare transfers. In fact, the best measure of income inequality is the Gini coefficient calculated on incomes after taxes and transfers. Basically it shows the variation between the actual distribution of income in a country and what would apply if it’s distributed perfectly equally. As such, it ranges from zero indicating perfect equality to one indicating perfect inequality with one household, or individual, receiving all income. Naturally, there is much debate about the data but the best available for global comparisons appears to be from the OECD and the Standardised World Income Inequality Database. The Gini coefficient from these sources is shown for various countries and for developed and emerging country averages in the next chart.  

Source: OECD, Standardised World Income Inequality Database, AMP Capital

As might be expected, emerging countries are less equal than advanced countries but the key point is that there has been a general trend higher in inequality during the last 30 years. This is particularly evident in the emerging world and the US, but less so in the Eurozone where it’s actually been stable since the mid-1990s. There has also been a rising trend in Australia, although its stabilised since 2008 (and the data pre 1994 is less reliable). In terms of advanced countries, the US and UK are the least equal, and Eurozone and Scandinavian countries tend to be more equal. Inequality in Australia is above the OECD average but below that in the US and UK – see the next chart. 

Data is after taxes and Welfare Transfers. Source:  OECD, SWID, AMP Capital 

With rising levels of income inequality also appears to have come an increase in wealth inequality. After falling into the 1970s, the share of wealth in the US held by the top 0.1% has increased from around 7% to over 20%.  To some degree, rising wealth inequality is not that surprising as higher income earners save a higher proportion of their income and allocate a higher proportion of their savings to growth assets (like shares and property) that have higher long-term returns than bank deposits provide. So naturally their wealth will grow faster than that of lower income earners. Easy money from central banks post the Global Financial Crisis (GFC) may have contributed to this but returns from growth assets haven’t been in excess of pre-GFC norms, and the higher unemployment that would have followed if central banks had not run easy money would have arguably resulted in a far more significant increase in inequality.

What has driven the increase in income inequality?

The rise in the level of inequality likely reflects a range of drivers:

• The rise in the profit share of GDP from its lows around the early 1980s in developed countries (which it should be recalled was depressing economic growth at the time) likely benefitted higher income earners who derive a greater share of income from profits (via higher levels of company ownership either directly or via shares).  

• Technological innovation has likely boosted inequality as it: boosted demand for skilled workers at the expense of unskilled workers; supplanted middle income jobs in more recent years; and has contributed to a “superstar economy” in which a few “winner-take-all” firms (and their owners) and app designers can earn super normal returns (and hence income) globally without generating the jobs and incomes that the technologies of the past might have (think Google or Facebook versus Ford or GM in their heyday).

• Globalisation, by supplanting low income jobs in advanced countries, may have contributed to increased inequality.

• Rapid economic development in emerging countries at a time when their progressive taxation systems are not fully developed likely benefitted higher income earners more than lower income earners in these countries, even though living standards rose across the board.

But why is it only causing angst now?

As the first chart shows, inequality has been trending up globally for many years so why has it become more of an issue lately? Prior to the GFC, rising levels of inequality were likely masked as either wages were rising solidly and/or people were able and willing to take on more debt. When your own income or at least your living standard is on the rise, you are less likely to take note of those better off than you are. But when your income growth slows and you are less able to take on more debt to make up for it, how the “better off” Jones’s are doing becomes a bigger issue.

This has been an issue for much longer in the US (with median real incomes reportedly stagnating since the early 1980s) but may be becoming an issue in Australia, too. The recent HILDA (or Household Income and Labour Dynamics in Australia report), which tracks roughly 7000 Australian households since early last decade, shows a flat Gini coefficient for its sample of households since 2001 (in contrast to the much broader measure shown in the first chart) but stagnant real median incomes since 2009 (see the next chart), suggesting it’s the weakness in incomes (made worse by record low wages growth) that’s the real issue. 

Worker insecurity post the GFC, with higher levels of underemployment and rapid workplace change partly as a result of technological disruption, is likely adding to anxiety and tension around the issue of rising inequality.

Source:  Melbourne Institute, AMP Capital
 

Angst around the issue may also be accentuated in Australia by the issue of poor housing affordability, with many millennials feeling that they are locked out of home ownership although this is perhaps more an intergenerational issue.

Why is rising inequality an issue economically and for investors?

A degree of inequality is essential in a free market economy to ensure there are incentives to be productive, invest and innovate. For example, it makes sense that wages and incomes grow faster in some usually higher skilled areas than others to encourage people to train and work in areas where there is stronger demand. However, (putting aside the debate about “fairness”) inequality that rises too high can reduce economic growth. It can do this because households with high disposable incomes save more and spend less than low income households who survive from pay day to pay day, and this will result in slower short-term economic growth. High levels of inequality can also create social tensions, which can disrupt production and investment and hence economic growth. 

Inequality may become an even bigger issue going forward as technological innovation risks concentrating income and wealth in the hands of a few global winners, which could further drive up inequality over time. So for all these reasons, inequality is an issue that governments should be interested in. 

The danger is that such a focus may lead to a return to economic policies, such as ever-higher top marginal tax rates, that discourage work effort, lead to a smaller national cake than would otherwise be the case, and a return to the worker versus boss confrontational environment that resulted in lower growth in productivity and living standards in the 1970s. This is particularly a risk in Australia where the tax system is already very progressive (with the top 10% of income earners contributing around 45% of total income tax revenue raised) and the top marginal tax rate is high by global standards. 

The risk is that rising inequality and a populist response to it help drive a shift away from rational economic policies, which ultimately leads to slower productivity growth and eventually rising inflation as the supply side of economies is damaged. Which, in turn, will contribute to constrained medium-term investment returns. So the key for governments and policy makers in seeking to address the issue of rising inequality is to get the balance right between achieving an outcome which is fair and contributes to balanced sustainable growth but not going so far as to depress incentive and productivity. 

If you would like to discuss anything in this report, please call us on |PHONE|.

Source: AMP Capital 10 August 2017

Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.