Olivers Insights

I first ran through a set of five charts to keep an eye on regarding the global economy last September. Since then share markets plunged into December and have since rebounded. The rebound has been great, but we have seen such rebounds before only to see weakness resume so on its own it does not prove we are out of the woods. It’s rare for US shares to have a deep V recovery after a 20% or so fall as seen last year. And with share markets having run hard from their December lows and technically overbought some sort of short-term pull back is a high risk. But will it be the resumption of the downturn in shares that began last year or just a pullback setting the scene for the next leg higher? Our view is that it will more likely be the latter. We don’t see an imminent US, global or Australian recession. And the swing now underway towards more dovish/stimulatory global economic policy along with declining trade war risks will likely drive stronger global economic growth in the second half of the year. As a result this year is expected to ultimately provide decent returns for shares.

Of course, no one really knows for sure so this note revisits the five charts we see as critical to which way it will ultimately go and adds a table on US recession risks to monitor.

Chart 1 – Global business conditions PMIs

Global Purchasing Managers Indexes (PMIs) – surveys of purchasing managers at businesses in most major countries – are an excellent and timely guide to the state of the global economy. These remain high but they have been falling over the last year indicating slowing growth (as occurred into 2012 and 2016). There are some signs of stabilisation in the US, but they will need to improve more broadly to be consistent with our view that growth will pick up in the second half of the year. At least they are a long way from recessionary readings.

Source: Bloomberg, AMP Capital

Chart 2 – Global inflation

Major economic downturns are invariably preceded by a rise in inflation to above central bank targets causing central banks to slam the brakes on. At present, core inflation in major global economies is benign. In the US core inflation is just below the Fed’s 2% inflation target, which along with headwinds to growth has enabled the Fed to pause its interest rate hikes. Inflation in China has been falling and is well below the Government’s 3% target/forecast. And inflation in the Eurozone and Japan, is well below target and provides no constraint to ongoing policy stimulus with the ECB likely to soon announce another round of cheap funding for banks. A clear upswing in core inflation would be a warning sign of aggressive monetary tightening being on the way, but this keeps getting delayed by events like last year’s global growth slowdown and oil price collapse.

Source: Bloomberg, AMP Capital

Chart 3 – The US yield curve

The yield curve is a guide to the stance of monetary policy. When short-term interest rates are low relative to long-term rates businesses can borrow short and lend (or invest) long and this grows the economy. But it’s not so good when short rates are above long rates. An inverted US yield curve has preceded US recessions. So, when it’s heading in this direction some worry. And it has been lately, with both the gap between the 10-year bond yield and the Fed Funds rate and the gap between the 2- year bond yield and the Fed Funds rate flattening lately.

Source: NBER, Bloomberg, AMP Capital

But there are several things to allow for. First, the yield curve can give false signals (circled on the chart) and the lags from an inverted curve to a recession can be around 15 months. So even if it inverted now recession may not arrive till mid next year and historically the share market has peaked 3-6 months before recessions, so it would be too far away for markets to anticipate.

Second, various factors may be flattening the yield curve which are unrelated to economic growth including near zero German and Japanese bond yields holding down US yields and high investor demand for bonds post the GFC as they have proven to be a good diversifier – rallying every time shares have a major fall.

Third, other indicators suggest that US monetary policy is far from tight – the real Fed Fund rate is barely positive, and the nominal Fed Funds rate is well below nominal GDP growth and both are far from levels that in the past have preceded US recessions.

So the yield curve is worth keeping an eye on – particularly now it’s flashing amber – but its short comings need to be allowed for.

Chart 4 – The US dollar

Unlike moves in most individual currencies, which are only of relevance to the country they belong to, moves in the $US are of broad global significance. This is because of its reserve currency status and that a lot of global debt is denominated in US dollars particularly in emerging countries. So when the $US goes up like in 2015 and last year it makes it tough for emerging countries. It also depresses US company profits with a lag.

Source: Bloomberg, AMP Capital

A continuing upswing would cause further damage for emerging markets and so pose a threat to global growth (as the emerging world is around 60% of global GDP). Since late last year the $US has come of its recent highs though – if it remains more benign as we expect it will help emerging market shares and US profits.

Chart 5 – World trade growth

Growth in world trade may be expected to slow over time as services become an ever-greater share of economic activity and manufacturing becomes less labour dependent. But last year it was under threat from slowing global growth and the protectionist threat from President Trump in the US. This saw trade volume growth stall and trade war talk dent business confidence. So far US average import tariffs have been increased by less than 2% so it’s early days. But more has been threatened. Fortunately, the trade war is in a truce at present with positive signs regarding US/ China talks and slowing growth (and Trump’s desire to get re-elected next year) providing an incentive to reach a deal which we expect. But if the truce and trade talks with China, the EU and Japan fail and it’s back to escalating tariffs threatening a decline in world trade then it would be a bad sign.

Source: CPB World Trade Volume Index, Thomson Reuters, AMP Capital

US recession still a way away

The historical experience tells us that what happens in the US is critical to how deep share market falls get. Deep (“grizzly”) bear markets like the 50% plus fall seen in the GFC are invariably associated with US recession. So, whether a recession is imminent in the US, and more broadly globally, is critically important in terms of whether a major bear market commenced last year or is on the way. The next table summarises the key indicators we are watching in this regard.

US recession signposts

Source: AMP Capital

These indicators are not foreshadowing an imminent recession in the US. The yield curve is most at risk (hence the question mark) but even it is not there yet. Meanwhile, other measures of monetary policy in the US are not tight and we have not seen the sort of excesses that normally precede recessions – there has been no overinvestment in capital goods or housing, private debt growth has not been excessive, the US leading indicator is far from recessionary levels and inflation is benign. Maybe it could happen from mid-next year or it could be driven by an external shock like an intensified trade war but at this stage its not imminent, so our view remains that last year’s share market falls are unlikely to be the start of a deep bear market.

Concluding comments

On balance these indicators still suggest the outlook remains okay. But to be consistent with our view that this year will see decent returns from shares we need (and expect) to see global growth indicators such as PMIs stabilise and head higher in the months ahead, inflation to remain benign, the $US to be relatively constrained and the trade threat continue to recede.

Source: AMP Capital 21 Feb 2019

Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) 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.

Investing seems to be getting more and more complex. Ever increasing complexity in terms of investment products and choices, regulations and rules around investing, the role of social media in amplifying the noise around investment markets and the increasing ways available to access various investments are all adding to this complexity. However, at its core, the basic principles of successful investing are simple. And one way to demonstrate that is in charts or pictures. This note revisits five charts I find useful in understanding investing. They are particularly pertinent in volatile and seemingly uncertain times like the present, so they are worth a revisit.

Chart #1 The power of compound interest

My love of this chart came out of my good friend and well-known economist, Dr Don Stammer, regularly espousing the importance of the magic of compound interest. And it is like magic – but many miss out because they are too busy looking for disasters around the corner or assuming that once disaster hits it will be with us indefinitely! What it shows is the value of $1 invested in various Australian assets in 1900 allowing for the reinvestment of dividends and interest along the way.

Source: Global Financial Data, AMP Capital

That $1 would have grown to $238 if invested in cash, to $906 if invested in bonds and to $532,739 if invested in shares. While the average return since 1900 is only double that in shares relative to bonds, the huge difference between the two at the end owes to the impact of compounding or earning returns on top of returns. So any interest or return earned in one period is added to the original investment so that it all earns a return in the next period. And so on. I only have Australian residential property data back to 1926 but out of interest it shows (on average!) similar long term compounded returns to shares.

Blowed if I know where it came from, but the “Law of 72” is useful way to understand how long it takes an investment to double in value using compounding. Just divide 72 by the rate of return and that’s the answer (roughly). For example, if the rate of return is 2% per annum (eg, the interest rate on a bank term deposit), it will take 36 years to double in value (= 72 divided by 2). But if it’s, say, 8% pa (eg, what shares may be expected to return over the medium-term including dividends), then it will take just 9 years (= 72 divided by 8).

Key message: to grow our wealth, we must have broad exposure to growth assets like shares and property. This is far more important than second order issues like which particular stocks to have in your share portfolio. While shares have been volatile lately and the short-term outlook for Australian housing is messy, both will likely do well over the long term.

Chart #2 The investment cycle lives on

The trouble is that shares can have lots of setbacks along the way as is particularly evident during the periods highlighted by the arrows on the share market line. The higher returns shares produce over time relative to cash and bonds is compensation for the periodic setbacks that they have. But understanding those periodic setbacks – that there will always be a cycle – is important in being able to not miss out on the higher returns that shares and other growth assets provide over time. The next chart shows a stylised version of the investment cycle.

The investment cycle

Source: AMP Capital

The grey line shows the economic cycle from “boom” to “bust” to “boom” again. Just before the low point in the economic cycle, shares invariably find a bottom and start to move higher thanks to attractive valuations and easy monetary policy and as smart investors anticipate an eventual economic recovery. This phase usually sees scepticism and disbelief as economic conditions are still weak. Shares are eventually supported by stronger earnings as economic conditions improve, which eventually gives way to a blow off phase or euphoria as investors pile in. This ultimately comes to an end as rising inflation flowing from strong economic growth results in ever tighter monetary policy, which combines with smart investors anticipating an economic downturn and results in shares falling. Often around the top of the cycle real assets – like property and infrastructure – are a better bet than shares as they benefit from strong real economic conditions. But that’s not always the case. Once the downturn starts, bonds are the place to be as slowing growth gives way to falling inflation which sees bond yields fall producing capital gains for investors. At some point, of course, easing monetary conditions and attractive valuations see shares bottom out and the whole cycle repeats.

Key message: cycles are a fact of life and it’s usually the case that the share market leads the economic cycle (bottoming before economic recovery is clear and topping before economic downturn hits) and that different assets do best at different phases in the cycle. Of course, each cycle is a bit different. Some are short but some, like the big bull market in US shares since 2009, are long because the recovery is slow and so it takes longer to build up excesses that end the cycle.

Chart #3 The roller coaster of investor emotion

Its well known that the swings in investment markets are more than can be justified by moves in investment fundamentals alone – like profits, dividends, rents and interest rates. This is because investor emotion plays a huge part. The next chart shows the roller coaster that investor emotion traces through the course of an investment cycle. A bull market runs through optimism, excitement, thrill and ultimately euphoria by which point the asset class is over loved and overvalued and everyone who is going to buy has – and it becomes vulnerable to bad news. This is the point of maximum risk. Once the cycle turns down in a bear market, euphoria gives way to anxiety, denial, capitulation and ultimately depression at which point the asset class is under loved and undervalued and everyone who is going to sell has – and it becomes vulnerable to good (or less bad) news. This is the point of maximum opportunity. Once the cycle turns up again, depression gives way to hope and optimism before eventually seeing euphoria again.

The roller coaster of investor emotion

Source: Russell Investments, AMP Capital

Key message: investor emotion plays a huge role in exaggerating the investment cycle. The key for investors is not to get sucked into this emotional roller coaster: avoid assets where the crowd is euphoric and convinced it’s a sure thing and favour assets where the crowd is depressed and the asset is under loved. Of course, doing this is easier said than done which is why many, if not most, investors end up getting wrong footed by the investment cycle. Getting sucked in during the good times only to panic out during the bad times.

Chart #4 The wall of worry

There is always something for investors to worry about. The worries ramped up last year with concern around inflation, the Fed, rising bond yields, trade wars, US politics and President Trump generally, Italy, the ongoing Brexit soap opera, Chinese debt and slowing growth, the surging and then plunging oil price and in Australia with the Royal Commission and falling home prices. And in a world where social media is competing intensely with old media and itself for attention on the nearest screen right in front of you it all seems more magnified and worrying than ever. But of course most of this stuff is just noise. The global economy has had plenty of worries over the last century, but it got over them with Australian shares returning 11.7% per annum since 1900, with a broad rising trend in the All Ords price index as can be seen in the next chart, and US shares returning 9.8% pa. (Note that this chart shows the All Ords share price index whereas the first chart shows the value of $1 invested in the All Ords accumulation index, which allows for changes in share prices and dividends.)

Source: ASX, AMP Capital

Key message: worries are normal around the economy and investment markets but most of them are just noise. It all seems louder and more worrying now because it’s getting magnified by social media screaming for attention. Try to turn it down.

Chart #5 Time is on your side

In the short term, investment markets bounce all over the place. Even annual returns in the share market are highly volatile, but longer-term returns tend to be solid and relatively smooth as can be seen in the next chart. Since 1900, for Australian shares roughly two years out of ten have had negative returns but there are no negative returns over rolling 20-year periods. (It’s roughly three years out of ten for US shares since 1900.)

Source: Global Financial Data, AMP Capital

Key message: the longer the time horizon, the greater the chance your investments will meet their goals. So in investing, time is on your side and its best to invest for the long term.

Source: AMP Capital 13 Feb 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) 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.

Scepticism about China’s economic success amongst (mostly western) investment commentators has been an issue for as long as I can remember. The current China worries mainly relate to slowing growth, high debt and the trade dispute with the US. China is now the world’s second largest economy and its biggest contributor to growth so what happens in China has big ramifications globally. This is particularly so in Australia as China is its biggest export destination. This note looks at the main issues and what it means for investors and Australia.

Is growth slowing a little or a lot?

China slowed through 2018. GDP growth for the whole of 2018 came in at 6.6% which was a bit above our expectation of 6.5%, but it was down from 6.8% growth in 2017 and momentum slowed to 6.4% year on year in the December quarter. Some commentators argue that China’s actual GDP growth is much weaker – maybe just half the reported rate. The argument often runs along the lines that the GDP data comes out too early after the end of each quarter, it’s too smooth to be believed and that it’s made up to suit the annual growth target. This speculation has long been around and I’ve always thought it’s a bit of a distraction: it stands to reason that emerging countries like China have less to spend on stats so they may be less accurate than in rich countries, and if China’s economy is really a lot smaller than it claims then why is the rest of the world so concerned about a slowdown in its economy? And why is the US concerned about its rising economic clout? The bottom line is that it’s all too academic to get too hung up on and so I tend to see the GDP data as a rough, but admittedly imperfect, guide.

So what does other data say? As can be seen in the next chart, growth in industrial production, retail sales and fixed asset investment all slowed through 2018 to multi-year lows, albeit it’s all still pretty solid compared to most other countries. 

Source: Thomson Reuters, AMP Capital

Annual growth in exports and imports also went negative in December and the weakness in exports could have further to go given that they were arguably artificially boosted as Chinese exporters/US importers sought to “front run” US tariffs.

Source: Bloomberg, AMP Capital

Chinese manufacturing conditions PMIs have also fallen sharply. See the next chart.

Source: Bloomberg, AMP Capital

For those sceptical of official Chinese data, I have shown the private sector Caixin survey but it’s a similar message from the official PMI survey, ie manufacturing has slowed.

While concerns about the trade war may have contributed to the slowdown, the main driver so far appears to be tighter credit conditions aimed at slowing debt growth via the less regulated “shadow banking” system. This would explain why smaller businesses are doing it tough relative to larger businesses.

However, it’s not all doom and gloom. First, the housing sector has been doing well with house prices rising.

Source: Bloomberg, AMP Capital

Second, while manufacturing has slowed, services has continued to hold up well. This is evident in relatively solid readings for the services conditions PMIs (in both the official and Caixin PMIs) of around 54 in contrast to weaker manufacturing PMIs – see the second chart above. Services are less affected by trade wars and the services sector is expanding relative to the manufacturing sector. Out of interest this may partly explain why GDP growth in China is now smoother and does better than expected with most commentators focusing on the old manufacturing sector.

Finally, policy stimulus is ramping up…

Policy easing

In response to the growth slowdown, China has moved to start providing significant policy stimulus with the People’s Bank of China cutting the required reserves that banks have to keep (allowing them to lend out more) and the government recently announcing fiscal stimulus focused on tax cuts for households and small businesses but also infrastructure spending amounting in total to 2-3% of GDP for this year. With public debt and inflation relatively low there is little constraint on policy stimulus except to avoid another big ramp up in debt, which is why stimulus is now more focused on tax cuts than debt-related investment. Which in turn means more of a boost to services demand in China than to global commodity demand and a less certain impact than was seen from the 2008 and 2015-16 stimulus programs.

Growth and inflation outlook

We expect Chinese growth this year to slow further in the short term particularly as exports weaken after front running, but policy stimulus should help head off a deeper downturn and see growth improve in the second half. But it’s more aimed at preventing a sharp downturn in growth rather than pushing growth a lot higher. So overall growth is expected to be around 6.2% this year which is still a bit slower than last year’s 6.6% growth rate. Inflation is likely to remain low.

What about China’s “debt time bomb”?

This is the most commonly expressed concern about China, with the ratio of non-financial debt to GDP having increased very rapidly from around 150% a decade ago to nearly 300% now. This has caused some to fear a financial catastrophe for China. However, China’s debt problems are different to most countries. First, China has borrowed from itself – so there’s no foreigners to cause a foreign exchange crisis. Second, much of the rise in debt owes to corporate debt that’s partly connected to fiscal policy and so the odds of a government bailout if things go wrong are high. Finally, the key driver of the rise in debt in China is that it saves around 45% of GDP (roughly double that in developed countries) and most of this is recycled through the banks where it’s called debt. So unlike other countries with debt problems, China needs to save less and consume more, and it needs to transform more of its saving into equity rather than debt. Chinese authorities are aware of the issue and overall growth in debt has slowed but slamming on the debt brakes without seeing stronger consumption makes no sense. But boosting consumption will take time and will involve moving to a more progressive tax system and enhanced social welfare.

What about the trade war?

While the tariff increases that have actually been implemented so far in the US/China trade war are relatively small the threat of more to come has clearly adversely affected confidence (and thus investment) in both countries. Trade negotiations between the US and China are reportedly progressing well but big differences apparently still remain. The pressure from slowing growth on both sides means that both China and the US are under pressure to reach a deal though – notably President Trump who doesn’t want to see recession or an extended bear market derail his 2020 re-election prospects. As such we see roughly an 80% chance that a deal is reached – either before the March 1 deadline for negotiations or after an extension.

The Chinese share market

Chinese shares have bounced 9% from their December low. But they had a 32% top to bottom fall last year and are still cheap trading on a price to forward earnings ratio of just 10 times (compared to 14.7 times for Australian shares) which is about as cheap as they ever get. See the next chart.

Source: Thomson Reuters, AMP Capital

They may have a short-term pullback as growth slows further in the first half, but with valuations cheap they should perform well on a 12-month horizon as growth and hence profits improve through the second half.

Implications for Australia

A sharp slowdown in China would be a double whammy for the Australian economy coming at the same time as the housing downturn. But while it’s a risk it’s not our base case. Rather our outlook for China’s economy to stabilise and growth to pick up a bit in the second half implies a reasonable – but not spectacular – outlook for commodity prices. Combined with the spike in iron ore prices on the back of Vale’s problems (albeit temporary) it points to reasonable growth in export earnings, which will be one source of support helping to counter the housing downturn. Reasonable commodity prices will help prevent a sharp drop in the $A, but we still see it falling into the $US0.60s as the RBA cuts the cash rate to 1% this year.

Source: AMP Capital 7 Feb 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) 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.

The housing cycle and house prices always incite high interest in Australia. Until recently it was all about surging prices and poor affordability – particularly in Sydney and Melbourne. Over the last year it’s turned into how far prices will fall and what’s the impact on the economy. Global issues and the election aside, the housing downturn is likely to be the main issue for Australia in 2019. This note provides a Q&A on the main issues.

How far have home prices fallen?

According to CoreLogic data, up until December capital city dwelling prices are down 7% from their September 2017 high. This masks a wide range though with Sydney down 11% from its July 2017 high, Melbourne down 7% from its November 2017 high, Perth down 16% and Darwin down 25% from their mid 2014 mining investment boom highs but other cities continuing to trend up to varying degrees. Recently the declines have been led by Sydney and Melbourne. House prices are on average down more than unit prices and prices in regional centres have generally held up better than capital cities.  

Source: CoreLogic, AMP Capital

What is driving the falls?

The fall in property prices comes after a boom – most recently over the five years to 2017 that in particular saw Sydney prices rise 72% and Melbourne prices gain 56%. This, on top of gains since the mid-1990s, saw a sharp deterioration in affordability, prices become overvalued relative to income, rents and their long-term trend and reach expensive levels by global standards. The surge in home prices went hand in hand with a surge in debt that has seen the ratio of household debt to income go from the low end of OECD countries to the top end. High prices and high debt left Australian housing very vulnerable. What has changed in the last two years is that:

• It’s become harder to get a loan as regulators forced banks to tighten lending standards and the Royal Commission seems to have made banks even more cautious. 

• A big pool of interest only borrowers are switching to principal and interest driving higher debt servicing costs.

• Banks have cut lending to SMSF funds to invest in property.

• The supply of units has surged to record levels.

• Foreign demand has fallen sharply.

• As rising prices fed on themselves by driving expectations for more price gains (FOMO – fear of missing out), falling prices are driving reduced price expectations and leading to reduced demand and FONGO (fear of not getting out).

• Investors are starting to factor in less favourable negative gearing and capital gains tax arrangements if there is a change of government.

• Problems regarding the Lacrosse and Opal buildings have dented confidence around building standards. 

• Its unlikely interest rate cuts will quickly end this property cycle downturn as occurred in the 2008 and 2010-12 downswings. Rates are already low & debt is much higher.

What will be the impact of tax changes?

The Australian Labor Party’s policy since the last election has been to limit negative gearing to new property and double capital gains tax on investments held for more than 12 months. This is aimed at improving housing affordability which means lower prices. Put simply, such changes would make it less attractive for investors to invest in residential property which would be negative for prices. A study by Riskwise Property Research and Wargent Advisory found that this would lower property prices ranging from 2 to 3% in Tasmania to around 9% in Sydney. While the tax changes are proposed to be grandfathered, it’s likely it’s already reducing investor demand as investors worry that when it comes time to sell their property if the tax changes occur then there will be less demand.

How far will home prices fall?

For Sydney and Melbourne our base case has been that prices would have a top to bottom fall of around 20% out to 2020. However, the further plunge in auction clearance rates and acceleration in price falls late last year suggest a deeper fall possibly of around 25% (although it’s impossible to be precise). This suggests around another 15% fall in Sydney and more in Melbourne. A 25% top to bottom drop would take prices back to where they were in late 2014/early 2015.  

Source: Domain, AMP Capital

While prices in other cities are being affected by credit tightening they were less speculative and so are less vulnerable. Perth and Darwin have already seen prices fall back to decade ago levels. Other capital cities and regional centres generally didn’t have a boom and so are unlikely to have a bust. So for the rest of Australia flat prices to modest gains are likely. Taken together this suggests a top to bottom fall in national average prices of 10 to 15%, with another 5 to 10% this year.

Will home prices crash?

This is a bit of an unhelpful question like the “are we in a property bubble” questions of a few years ago as it’s hard to define and implies a degree of inevitability in terms of the implications. A 25% plunge in Sydney and Melbourne may seem like a crash but given the extent of the prior gains it’s arguably not. But a 25% national average fall would probably be interpreted as a crash. Our assessment is that this is unlikely unless we see much higher interest rates or unemployment (neither of which are expected) driving a sharp rise in defaults and forced property sales or a collapse in immigration (which would collapse demand). Strong population growth is still driving strong underlying demand for housing. While mortgage stress is a risk, it tends to be overstated, and is unlikely to be a generalised issue unless interest rates or unemployment shoot higher. And, while Sydney and Melbourne are at risk, other cities have not seen the same boom & so are unlikely to crash.

Although many like to make comparisons to the US at the time of the GFC, there are two big differences. Australia has not seen the surge in sub-prime loans where money was lent to home owners who often had “no income, no job, no asset” (NINJA loans). Secondly, our mortgages are full recourse meaning we won’t see “jingle mail”, where home owners can send back the keys just because the house value falls below their debt, which then saw the bank put the property back on the market pushing home prices even lower.

However, the risk of a crash cannot be ignored given the danger that banks may become too tight and that investors decide to exit in the face of falling returns.

Have home prices fallen before?

A common property myth is that prices only ever go up and never fall. But a simple look at history tells us this is not so. Real house prices (ie prices after the impact of inflation) in Sydney fell 36% in 1934-35, 32% in 1937-41, 41% in 1942-43, 12% in 1947-48, 14% in 1951-53, 12% in 1961-62 and 22% in 1974-77. In nominal terms based on CoreLogic data Sydney dwelling prices fell 25% in 1980-83, 10% in 1989-91, 8% in 2004-06 and 7% in 2008-09. So a 25% fall this time around would be similar to that seen in the early 1980s.

What will be the impact on the economy?

The housing downturn will affect the broader economy via slowing dwelling construction, negative wealth effects on consumer spending (ie, our wealth goes down, we feel poorer, we spend less than otherwise) and if rising defaults drive a further slowing in bank lending. The first two will detract 1 to 1.5 percentage points from economic growth. Growth in infrastructure spending and business investment should help keep the economy growing but its likely to be constrained to around 2.7% which in turn will keep wages and inflation low.  

Source: ABS, AMP Capital

What is the impact on banks?

The main risk for banks is that the property downturn drives a rise in defaults. However, full recourse loans mean that just because home prices fall resulting in negative equity, defaults won’t necessarily rise. In the absence of much higher interest rates or unemployment making it harder for people to service their loans, a big rise in defaults is unlikely. However, it’s still a risk and the housing downturn will likely mean slower bank lending which will constrain bank profits.

What will it mean for interest rates?

Constrained growth due to the housing downturn resulting in lower for longer inflation will likely drive the RBA to cut interest rates this year, with two cuts taking the cash rate to 1% by year end. Our base case is that this will occur in August and November (giving the RBA chance to assess the election and tax cuts), but soft data could see it come earlier. Tax cuts from July are unlikely to be big enough (the Government is allowing for just $3bn pa in tax cuts which is just 0.1% of GDP) to head off the need for rate cuts.

Is the house price downturn good or bad?

This depends on who you are. For baby boomers who got in years ago, have paid off their debt and saw the value of their home rise to levels they never believed sustainable, a fall back to 2014/15 levels may be no big deal. For those who got in more recently and have a big mortgage price falls are more of a downer and its this group for whom negative wealth effects will be greatest. For millennials trying to get in its great news – assuming the housing downturn is not so great that it knocks the economy for six and they lose their jobs. For investors…

What does it mean for investors?

Over the very long-term, residential property adjusted for costs has similar returns to Australian shares. So, there is a role for it in investors’ portfolios. However, right now the slump in property prices in some cities is bad news for investors given that rental yields are often just 1-2% after costs. Falling rents in Sydney are a double whammy. Add to this uncertainty about tax and it’s not a great time for a property investor. That said, other cities and regional centres offer more attractive rental yields than Sydney and Melbourne and falling prices in Sydney and Melbourne will throw up opportunities at some point.

Source: AMP Capital 23 January 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) 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.

2017 was a great year for well diversified investors – returns were solid (balanced super funds returned around 10%) and volatility was low. So optimism was high going into 2018 but it turned out to be anything but great for investors who saw poor returns (average balanced super funds look to have lost around 1-2%) and volatile markets. As a result, and in contrast to a year ago, there is much trepidation about the year ahead. Having just written lists for Christmas presents and New Year resolutions, I was again motivated to provide a summary of key insights and views on the investment outlook in simple point form. In other words, a list of lists. So here goes.

Five key things that went wrong in 2018

In 2018 global growth was good, profits were up, inflation was benign and monetary conditions were relatively easy. It should have been good for markets. There were five reasons it wasn’t:

• Fear of the Fed – the Fed didn’t really surprise but investors became increasingly concerned that it would overtighten. This reached a crescendo in late December.

• US dollar strength – a rising US dollar is a defacto global monetary tightening and this weighed particularly on emerging countries and US earnings expectations.

• Geopolitics – President Trump’s trade war hit confidence from March and morphed into fears of a broader Cold War with China. Other worries around Trump (with ongoing turmoil in his team, fears of impeachment as the Mueller inquiry progresses and a return to divided government) along with the populist government in Italy also weighed.

• Global desynchronisation – US growth was strong, but it slowed everywhere else.

• In Australia, tightening credit conditions (with fears of a credit crunch due to the Royal Commission) and falling house prices weighed on banks & growth expectations.

Five lessons from 2018

• Global growth remains fragile with post GFC caution lingering. This and technological change are helping to keep inflation down. Trade war fears didn’t help. Amongst other things this means central banks need to tread carefully in normalising monetary policy.

• Investors continue to find it easy to fear the worst – this has been evident in three major circa 20% sharemarket declines since the GFC – in 2011, 2015-16 and now 2018.

• Geopolitics remains a significant driver of markets and economic conditions.

• Government bonds remain a great diversifier – they rallied when shares plunged.

• Stuff happens – history tells us markets have periodic setbacks. 2018 was just another example.

Five big picture themes for 2019

• Policy pause and stimulus – the turmoil in markets and threat to global growth is likely to drive a policy response early this year with the Fed pausing, China providing more stimulus and the ECB providing cheap bank financing. There may also be some fiscal easing in Europe.

• While global growth is likely to weaken a bit further in the coming months, it’s likely to stabilise and resynchronise as the year progresses helped by policy stimulus, an easing in the $US and by the late 2018 plunge in energy costs.

• Global inflation is likely to remain benign helped by the 2018 growth slowdown and fall in energy costs. In this sense the malaise of 2018 by forestalling inflation and hence monetary tightening has arguably helped extend the economic cycle. The US remains most at risk on the inflation front though given its still tight labour market. 

• But expect volatility to remain high given the lower level of spare capacity in the US and ongoing political risk.

• Australian growth is expected to be sub-par as the housing downturn detracts 1-1.5 percentage points or so off growth.

Key views on markets for 2019

• Global shares could still make new lows early in 2019 (much as occurred in 2016) and volatility is likely to remain high but valuations are now improved and reasonable growth and profits should see a recovery through 2019 helped by more policy stimulus.

• Emerging markets are likely to outperform if the $US is more constrained as we expect.

• After a low early in the year, Australian shares are likely to do okay, recovering to around 6000 or so by year end.

• Low yields are likely to see low returns from bonds, but they continue to provide an excellent portfolio diversifier.

• Unlisted commercial property and infrastructure are likely to see slower returns over the year ahead. This is likely to be particularly the case for Australian retail property.

• National capital city house prices are likely to fall roughly 5% led again by 10% or so price falls in Sydney and Melbourne off the back of tight credit, rising supply, reduced foreign demand & possible tax changes under a Labor Government.

• Cash and bank deposits are likely to provide poor returns as the RBA cuts the official cash rate to 1% by end 2019.

• Beyond any near-term bounce as the Fed moves towards a pause on rate hikes next year, the $A is likely to fall into the $US0.60s as the gap between the RBA’s cash rate and the US Fed Funds rate will still likely push further into negative territory as the RBA moves to cut rates.

Six things to watch

• The US trade war – while it may now be on hold thanks to negotiations with China, Europe and Japan these could go wrong and see it flare up again. US/China tensions generally pose a significant risk for markets.

• US inflation and the Fed – our base case is that US inflation remains around 2% enabling the Fed to pause/go slower, but if it accelerates then it will mean more aggressive tightening, a sharp rebound in bond yields and a much stronger $US which would be bad for emerging markets.

• Global growth indicators – if we are to be right, growth indicators need to stabilise in the next six months.

• Chinese growth – a continued slowing in China would be a major concern for global growth and commodity prices.

• Politics – political risks abound in the US with the Mueller inquiry getting ever closer to President Trump and a return to divided government leading to risks around raising the debt ceiling and Trump adopting more populist policies. In Europe the main risks are around Brexit, Italy and the EU parliamentary elections in May. Australia’s election risks are more interventionist government policy and tax changes.

• The property price downturn in Australia – how deep it gets and whether non-mining investment, infrastructure spending and export earnings are able to offset the drag from housing construction and consumer spending.

Three reasons why global growth is likely to be okay

Global growth indicators are likely to weaken further in the next few months but then stabilise, resulting in okay global growth of around 3.5% this year:

• Global monetary conditions are still easy. While the flattening US yield curve is a concern all other measures of monetary policy show it to be easy – particularly globally.

• Market volatility and associated uncertainty are likely to drive a policy response with the Fed pausing, other central banks easing and possible fiscal stimulus in Europe.

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

Three reasons why Chinese growth won’t slow much

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

• Monetary and fiscal policy is being eased.

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

Four reasons Australia still won’t have a recession

A downturn in the housing cycle and its flow on to consumer spending will detract around 1 to 1.5 percentage points from growth, and growth is likely to be constrained to around 2.5-3%, but recession is still unlikely:

• The growth drag from falling mining investment (which was up to 2 percentage points) has faded.

• Non-mining investment & infrastructure spending are rising.

• Interest rates can still fall further, and the RBA is expected to cut the cash rate to 1%.

• The $A will likely fall further providing a support to growth.

Three reasons why the RBA will cut rates this year

• The housing downturn will constrain growth to at or below potential.

• This will keep underemployment high, wages growth weak and inflation lower for longer.

• The RBA may ultimately want to prevent the decline in house prices getting so deep it threatens financial instability.

Three reasons why a grizzly bear market is unlikely

Shares could still fall further in the short term given various uncertainties resulting in a brief (“gummy”) bear market before recovering. But a deep (or “grizzly”) bear (where shares fall 20% and a year after are a lot lower again) is unlikely:

• A recession is unlikely. Most deep grizzly bear markets are associated with recession.

• Measures of investor sentiment suggest investors are cautious, which is positive from a contrarian perspective.

• The liquidity backdrop for shares is still positive. For example, bank term deposit rates in Australia are around 2% (and likely to fall) compared to a grossed-up dividend yield of around 6% making shares relatively attractive.

Seven things investors should allow for in rough times

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

• First, periodic sharp setbacks in share markets are healthy and normal. Shares literally climb a wall of worry over many years with periodic setbacks, but with the long-term trend providing higher returns than more stable assets. The setbacks are the price we pay for the higher long-term return from shares.

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

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

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

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

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

• Finally, accept that it’s a low nominal return world – low nominal growth and low bond yields and earnings yields mean lower long-term returns. This means that periods of relative high returns like in 2017 are often followed by weaker years.

Source: AMP Capital 15 Jan 2019

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) 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.

Three years after it first started raising interest rates in this cycle the Fed has increased rates for the ninth time, raising the Fed Funds rate another 0.25% to a target range of 2.25-2.5%. While this was largely anticipated by markets, the Fed was less dovish than expected and so shares sold off in response. That said it does appear that the Fed has got to a point where it can now pause or at least raise rates more slowly.

Fed hikes and market turmoil

After some initial ructions after the first Fed hike in December 2015 into early 2016, markets generally were not too fussed about Fed hikes in 2016 and 2017 as tightening was “gradual” and we were only going from very easy monetary policy to less easy. However, this year markets have become fearful that the Fed will go too far and push the US into recession. In fact, fears about the Fed were the main initial trigger for falls in shares back in February and more recently since October. Of course, lately they have combined with worries around trade, US technology stocks, slowing growth indicators globally, worries around President Trump and the Mueller inquiry and US politics to accentuate share market falls. This has all combined to push global shares down 14% from their September high and Australian shares down 13% from their August high.

The Fed blinks, but not enough yet

In raising the target range for the Fed Funds rate by another 0.25%, the Fed remains upbeat on the outlook for the US economy and noted the continuing strength in the US labour market and solid growth. However, it has added the word “some” in reference to “further gradual” increases in interest rates going forward. It has also indicated it’s monitoring global economic and financial developments. And it has lowered the “dot plot” median of Fed meeting participants interest rate expectations from three hikes next year to two – albeit it’s still above market expectations – and edged down the long run estimate for the Fed Funds rate to 2.75%. While it’s not enough to satisfy share markets just yet, the Fed is moving dovish.

Source: US Federal Reserve, AMP Capital

Basically, with the Fed Funds rate getting close to neutral, US core inflation stabilising around the 2% target, interest sensitive sectors like housing and autos slowing and various headwinds to the US economy next year the Fed can afford to pause or at least go more slowly in raising interest rates. Our base case is that the Fed will hold the Fed Funds rate flat during the first half of next year and only raise rates once in the second half. So, to the extent that fear of the Fed has been a big factor driving share markets lower and volatility up this year, a more cautious Fed next year should help start to allay the fears around it.

It could be a gummy, but is still unlikely to be a grizzly

As I have pointed out in recent notes, there are three types of significant share market falls:

• Corrections with falls around 10%;

• “gummy” bear markets with falls around 20% meeting the technical definition many apply for a bear market but where a year after falling 20% the market is up (like in 1998 in the US, 2011 and 2015-16 for Australian & global shares); and

• “grizzly” bear markets where shares fall 20% and then a year later are down another 20% or so (like in 1973-74, US and global shares through the tech wreck or the GFC).

Grizzly bears maul investors but gummy bears leave a nicer taste. Corrections are quite normal and healthy as they enable the sharemarket to let off steam. Excluding the present episode since 2012 there have been four corrections and one gummy bear market (2015-16) in global and Australian shares. Bear markets generally are a lot less common, but what we saw in 2015-16 was a gummy bear market.

Source: Bloomberg, AMP Capital

Gummy bear markets are shorter and see smaller declines than grizzly bear markets. And the deeper grizzly bear markets are invariably associated with recession, whereas the milder gummy bear markets including the 1987 share market crash tend not to be. (The Australian experience is discussed here.)

With uncertainty around trade, global growth and President Trump remaining high shares could still have more downside into early next year, particularly after having broken below their October/November lows. In other words the further break down in share markets seen in December may be signalling a shift from a simple correction to a gummy bear market. However, our view remains that a grizzly bear market is unlikely because a US, global or Australian recession is not imminent. Put simply:

• Monetary conditions are still not tight in the US and they are still very easy globally. While there has been much fretting about the US yield curve flattening and in some cases inverting (with long term bond yields falling below short-term interest rates) the two yield curves we have found most reliable are still positive albeit less so. The gap between the 10-year bond yield and the Fed Funds rate has flattened dramatically but is still positive at 39 basis points. And the gap between 2-year bond yields and the Fed Funds rate has also flattened a lot but is still positive. As can be seen in the next chart, prior to the last three US recessions both of these yield curves inverted – but there were several false signals and the gap between the initial inversion and recession can be around 15 months. So even if they both invert now recession may not occur until 2020 and yet historically share markets only precede recessions by around 3-6 months so it would be too far away for markets to anticipate. And past recessions in the US have also been preceded by the Fed Funds rate being well above inflation and nominal growth and it’s a long way from that.  

Source: Bloomberg, AMP Capital

• Fiscal stimulus will continue to boost US growth in 2019.

• We have not seen the sort of excesses – in terms of debt growth, overinvestment, capacity constraints and inflation – that normal precede recessions in the US or globally. While the housing downturn is an issue in Australia its negative impact on the economy is likely to be offset by business investment albeit growth will still be constrained.

A more dovish Fed, the US and China starting to work through their differences on trade and the positive impact of the 40% fall in oil prices since their October high (which is bad for energy producers but takes pressure off inflation and helps boost consumer spending) add to confidence that we are not heading towards a US/global recession. Which in turn would mean we are not heading into a grizzly bear market.

However, our expected road map for share looks like this: shares possibly have more downside into early next year into a gummy bear market (hopefully at least after a Santa rally!) as global growth indicators remain softish in the near term. This in turn is likely to prompt more stimulus in China, the ECB to provide more cheap bank funding and a bit of fiscal stimulus out of Europe (was Macron’s concession to the “yellow shirts” a sign of things to come for fiscal stimulus in Europe?) at a time when the Fed pauses. This combines with signs that US/China trade negotiations are making make progress. Shares then bottom around March. Economic data starts to improve, and it looks like 2015-16 all over again (albeit a bit more compressed in time). In this context a further leg down in shares turning the correction we have seen so far into a “gummy bear” market (down 20% or so from top to bottom but up a year later) is a high risk. But a grizzly bear market is unlikely.

What should investors do?

Of course, sharp market falls are stressful for investors as no one likes to see their wealth decline. I don’t have a perfect crystal ball so from the point of sensible long-term investing the following points are worth bearing in mind.

First, periodic sharp setbacks in share markets are healthy and normal. Shares literally climb a wall of worry over many years with numerous periodic setbacks, but with the long-term trend providing higher returns than other more stable assets.

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

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

Fourth, while shares may have fallen in value the dividends from the market haven’t. So, the income flow you are receiving from a well-diversified portfolio of shares remains attractive.

Fifth, shares often bottom at the point of maximum bearishness. So, when everyone is warning of disaster it’s often time to buy.

Source: AMP Capital 20 December 2018

Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) 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.