Olivers Insights

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

Key points

• There are increasing signs that science and medicine are getting the upper hand against coronavirus: new global cases are in decline; vaccines are working; half the global population and 73% of Australians have had at least one vaccine dose; and there are more treatments for coronavirus.

• Key to watch will be whether hospitalisations in response to any resurgence in cases remains subdued.

• Coronavirus coming under better control means a continuation of the economic recovery and supply constraints starting to come under control both of which are positive for shares, although the latter will take time

Introduction

Coronavirus continues to wreak havoc globally and in Australia, but there are increasing signs that its grip is loosening as humanity gets the upper hand thanks to science and modern medicine. This note looks at the current state of play regarding coronavirus, the risks and the implications for investors.

Coronavirus losing its grip? Five reasons for optimism

There are five key reasons for optimism regarding coronavirus.

• First, new coronavirus cases globally are continuing to fall with most regions in a downtrend or flat.

Global Coronavirus New Cases & Deaths

Source: ourworldindata.org, AMP Capital

• Second, the Delta variant arguably turned out to be less transmissible globally than was feared in mid-year as even some poorer less vaccinated countries & regions have not seen a feared surge in cases (eg, Africa & South America).

• Third, vaccines appear to be working. Of course, coronavirus has surged and subsided before so it could rebound again which is why vaccines are so important. While they may be only 60-80% effective in preventing infection – and this fades a bit after five months or so requiring booster shots – they are highly effective at around 85-95% in preventing serious illness. This is evident in new deaths remaining subdued relative to past waves – eg in the first chart new deaths globally have been in a downtrend this year relative to new cases. It’s particularly apparent in the more highly vaccinated developed countries where hospitalisations and deaths are far more subdued relative to new cases in comparison to the previous wave. For example, deaths in the UK (the red line in the next chart) are running less than 20% below the level suggested by the December/January wave (the dashed line). While Israel saw a Delta spike in new cases in August and September – likely not helped by waning efficacy for Pfizer vaccinations from earlier this year – the level of hospitalisations and deaths remained subdued compared to the previous wave and all are trending down, again helped by booster shots.

United Kingdom COVID-19: New cases & deaths

Source: ourworldindata.org, AMP Capital

• Fourth, 50% of people globally have now had one dose and 37% have had two doses.

Percent of the population who are fully vaccinated

Source: ourworldindata.org, AMP Capital

• Finally, there are now several effective coronavirus treatments either approved or seeking approval. These include Ronapreve from Roche, a Merck COVID-19 treatment pill and AstraZeneca’s antibody cocktail – where clinical trials of all three showed the risk of severe illness to be at least halved – and a Pfizer anti-viral cocktail. So, there’s now more ways to treat patients. These are useful for high-risk groups for whom vaccines are less effective and the unvaccinated.

The good news also applies to Australia

In Australia, new cases in Victoria are down from their recent high and if NSW, which led by a month, is any guide, Victoria should peak soon if it hasn’t already.

Australian: New Daily Coronavirus Cases by State

Source: covid19data.com.au, AMP Capital

After a slow start Australia is vaccinating around 1.1% of the population a day. 58% of Australia’s whole population are fully vaccinated which is in line with the US and 73% have had one dose which is well above the US. For first doses for adults, the ACT is at 98%, NSW is at 92%, Victoria will reach 90% in a few days and Australia will reach 90% in early November. Allowing for current trends and the average gap between doses the next chart shows roughly when key vaccine targets will be met.

Percentage of population with two doses

Source: covid19data.com.au, AMP Capital

NSW and the ACT have already reached the 80% of adults double vax target. Australia (on average), Victoria and Tasmania are either at 70% of adults or will be there in a day or so and will hit 80% late this month or early next month. Other states and territories will hit the 70% target in mid-November.

Meanwhile, vaccination is continuing to help keep serious illness down in Australia too and is the key factor supporting the reopening now underway. Coronavirus case data for NSW shows that the fully vaccinated make up a low proportion of cases (at around 5%), hospitalisations (5%) and deaths (11%) despite making up 67% of the NSW population as a whole and around 80% of the older most at risk of dying from coronavirus population. The level of deaths in Australia (the red line in the next chart) is running at around 20% of the level predicted on the basis of the previous wave (dashed line). On this basis the vaccines are helping save roughly 54 lives a day at present.

Australia COVID-19: New cases & deaths

Source: ourworldindata.org, covid19data.com.au, AMP Capital

What are the risks?

Key risks to watch for globally are:

• a possible resurgence in cases in the northern winter particularly as vaccine efficacy starts to wear off in some countries in the absence of rapid booster programs. This may already be happening in the UK (where new cases are on the rise again) and parts of Europe. The key though is what happens to hospitalisations – if they remain subdued as has been the case since June and the hospital system is coping then it should be manageable;

• the possibility of more transmissible/deadly mutations; and

• the low level of vaccination in poor countries which is currently around 18% with a first dose – which contributes to an ongoing risk of mutations.

Some increase in new cases in NSW, the ACT and Victoria after reopening is highly likely. But the main risk in Australia is that too rapid a reopening in south eastern Australia leads to a resurgence in cases – like Singapore which after reopening saw new cases surge to around 3000 a day – which threatens to overwhelm the hospital system, necessitating new restrictions to slow new cases down. Which is what Singapore has done. Note that NSW is still only at 67% and Victoria at 55% of the whole population fully vaccinated compared to 83% in Singapore. This could particularly be a risk in the months ahead if vaccine efficacy for those vaccinated earlier this year starts to wear off. A less risky approach would have been to wait three weeks or so between each reopening stage in order to ensure that new cases and most importantly hospitalisations are not surging and overwhelming the hospital system. At this stage it’s all just a risk though, booster shots are now on the way from next month and even if it does happen it would probably not be enough to derail the economic recovery as a return to long hard lockdowns is most unlikely unless vaccines completely fail in preventing serious illness.

Implications for investors

While the risk of setbacks remains, our broad perspective is that coronavirus is gradually coming under control and this will permit a sustained reopening globally and in Australia in the months ahead. Although coronavirus will leave some lasting impacts, at a very high level sustained reopening will be positive for the investment outlook as reopening means:

• more demand – and in Australia a resumption of the economic recovery this quarter; and

• a return to work and a rotation in spending back towards services as opposed to goods.

The former is positive for corporate revenue (albeit profit growth will be slower than it has been) and the latter should ultimately relieve supply constraints and inflation pressures – although it may take 6-12 months. It will mean a continued winding down of ultra-easy monetary stimulus though.

Source: AMP Capital October 2021

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

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

Key points

• It’s still too early to say that the pull back in share markets is over. Some of the worries around US fiscal policy and politics, China, global supply constraints and central banks likely have further to run and could see the correction go further.

• Historically the main driver of whether we see a correction or a mild bear market, as opposed to a major bear market, is whether we see a recession. While it may take time, ultimately, we see the current worries being resolved in a way that does not severely threaten global or Australian growth.

• So, we continue to see the broader trend in global and Australian shares remaining up once the correction runs its course.

Introduction

September was a poor month for shares with global shares losing 3.7% in local currency terms and Australian shares losing 2.7%. It’s possible that following top to bottom falls of 5-6% in global and Australian shares we have now seen the low. But it’s impossible to be definitive, and with the worry list around US fiscal policy, China, energy, supply bottlenecks and inflation, central bank hawkishness and ongoing risks around coronavirus there could still be another leg down. The extent of the rally since March last year – US shares more than doubled and Australian shares rose 68% – has left them vulnerable to a deeper pullback. However, our view remains that recent turbulence in share markets is a correction rather than the start of a deep bear market. This note reviews the current worries.

The US debt ceiling

The US Government would have hit its debt limit sometime around 18th October after which if it wasn’t increased, it would have had to slash spending to be in line with revenue which would have meant a spending cut of around 12% of US GDP (ie, defaulting on some commitments). But following an offer by Senate Minority leader McConnell, the US debt ceiling has been pushed back into early December (with maybe a little bit of leeway – some say out to January). The move showed McConnell does not want a default and wants to make sure the Democrats increase the debt limit on their own. But this just means the issue will come up again in a few months (along with the need to avoid a Government shutdown where funding was also extended into December). Republican’s still don’t plan to vote for it as that will be seen as signing up to Democrat spending. This means the Democrats will most likely have to do it on their own via the budget reconciliation process for which they now have plenty of time, or with regular legislation if they suspend the ability for Republican’s to filibuster – both of which only require the votes of the 50 Democrat Senators plus VP Harris to pass. The Democrats don’t want to do either as they would prefer Republican cover and so there may still be brinkmanship involved to finally resolve the issue – to get enough Republican senators to support it such that 60 Senate votes are reached or as is more likely to get the support of moderate Democrat senators (like Manchin and Sinema) to pass with 50 votes plus VP Harris. Debt ceiling argy bargy contributed to a 19% pullback in US shares in 2011 and a 4.5% fall in 2013. But ultimately the Democrats (& Republicans) won’t allow the US to default (just as they didn’t in 2011 or 2013).

US fiscal policy and taxes

Progress in passing the Administration’s $550 billion infrastructure spending and $3.5 trillion Build Back Better social spending packages has been delayed. Tensions between moderate and progressive Democrats are high with the latter becoming the left-wing equivalent of the Tea Party. While the $4 trillion boost to spending is spread over eight years, it’s a big boost to government spending which partly explains moderate Democrats’ reluctance to agree to the full amount and raising the debt ceiling at the same time. So, to get moderate support for the package and the debt ceiling increase, the Build Back Better package will likely be cut from $3.5 trillion to $1.5-$2 trillion. Likewise, tax hikes to partly pay for Build Back Better (on profits, capital gains and dividends) are likely to be scaled back. The share market is not focussed on these, but failure to agree to anything on infrastructure and Build Back Better would be seen as policy gridlock and tax hikes could knock 5% of US earnings if they are not cut back – both of which could be a short-term negative for shares (albeit not much beyond that).

Fed Chair Powell’s renomination

The Fed’s trading controversies have damaged Powell and progressive Democrats are against him, but markets tend to prefer continuity. It’s either going to be Powell or someone more dovish (like Lael Brainard) who runs the Fed so I suspect this is not ultimately going to be a big issue for markets.

Evergrande and the Chinese slowdown

China Evergrande is yet to be resolved and other developers are having problems. But Evergrande is not “too big to fail” – it may account for 5% of China’s $US bonds (where investors may not be protected) but it’s only 0.1% of Chinese bank debt so a Lehman moment is looking unlikely. Evergrande shareholders and top management are unlikely to be protected, but the Chinese Government appears to be stepping up efforts to limit the fall out and protect healthy developers, home buyers and the property market (but maybe not global bondholders).

The broader slowdown in Chinese growth reflects the earlier removal of stimulus and coronavirus restrictions in August which have since been relaxed. It’s hard to see the Government allowing much of a slowdown given the risk of social unrest. So, some policy easing is likely to boost growth next year.

The European and Chinese energy crises

A surge in energy prices/cutbacks in power supply in China (owing to carbon emission controls and a shortage of coal) and Europe (where gas prices rose six-fold since early this year reflecting increased global gas demand with reopening, issues with the supply of alternative energy and Russia limiting gas exports) is now dragging oil prices up too. This is all adding to supply bottlenecks, depressing growth, and adding to prices which likely has further to go. But there is some light at the end of the tunnel on this issue: Russia has offered to increase gas supply to Europe (although it may come with some strings attached); the crisis will likely hasten the opening of the Nord Stream 2 gas pipeline thereby boosting gas supply to Europe; Australian, Qatari, US and possibly Iranian (if the nuclear deal is agreed to) gas production is increasing; and there are some signs China is easing restrictions on coal and electricity supply.

Supply constraints and inflation

This is the biggest issue because a permanent increase to significantly higher inflation will mean lower price to earnings multiples/higher required yields for assets.

US shares – Low inflation = higher PEs

Source: Bloomberg, AMP Capital

However, while the surge in global money and fiscal stimulus pose the longer-term risk of higher inflation, what we are seeing now looks mostly due to distortions to global supply and demand caused by the pandemic. In the pre-covid world, the global supply system was a very finely tuned and highly efficient machine. Coronavirus threw it off with outbreaks (people can’t go to work) and their response (eg, enhanced unemployment benefits encouraging people not to work) causing disruptions to production, and demand swinging to goods from services all of which is showing up in today’s problems and spikes in, particularly, goods price inflation. As can be seen in the next chart consumer goods spending in the US is 18% above its pre-coronavirus trend whereas spending on services is below trend.

But as the world goes back to work and consumer spending rotates away from goods back to services, the bottlenecks should start to resolve. This may take up to 12 mths to resolve risking more uncertainty and higher bond yields. But ultimately it should settle down. Key to watch for will be: increased goods production; reduced goods demand in favour of services (as per the arrows); and wages growth as this will determine whether one off price increases become entrenched as higher inflation.

US Personal Consumer Expenditure

Source: Bloomberg, AMP Capital

Central banks becoming more hawkish

While central banks are heading towards the exits from ultra-easy money, with some moving faster than others, we are a long way from the sort of tight monetary policy that brings economic cycles and bull markets to an end. Some central banks have already started to raise rates, but those that have seen inflation below target in the post-GFC period are lagging as they are wary of jumping at shadows and ending up with inflation back below target again. This includes the Fed, RBA, ECB and the Bank of Japan. While the RBA has already slowed its bond buying and the Fed will likely do the same next month, “tapering” is not tightening as cash is still being pumped into the economy, it’s just at a slower rate.

Covid still poses risks, science looks to be winning

The exit from the coronavirus pandemic is proving longer and messier than expected. But there is reason for optimism: new global cases are on the decline again; vaccines while not perfect and requiring booster shots are helping keep serious illness down; new Merck & AstraZeneca drugs looks likely to significantly improve treatment; and after a slow start vaccination rates have surged in Australia (with the help of “vaccination mandates”). Of course, humanity is not yet out of the woods and key risks to watch include: whether cases surge in the northern winter; low vaccination rates in poor countries; the possibility of more transmissible/more deadly mutations; and whether new cases overwhelm the hospital system following reopening in NSW, the ACT and Victoria.

Concluding comment

Some good news on some of these issues in the last week (the debt ceiling and the energy crisis) have helped shares stabilise a bit, but the risk is that the correction has further to run. Historically the main driver of whether we see a correction or even a mild bear market, as opposed to a major bear market (like that seen in the GFC or in March last year), is whether we see a recession. Right now, it remains doubtful that the worry list will be enough to drive a US, global or Australian recession. Ultimately, we see the issues being largely resolved in a way that does not severely threaten global growth and so with global monetary policy likely to remain relatively easy for some time, we continue to see the broader trend in global and Australian shares remaining up, once the correction runs its course.

Source: AMP Capital October 2021

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

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

Key points

• The key drivers of poor housing affordability and high household debt levels in Australia have been low rates and poor housing supply.

• Macro prudential controls to slow home lending now look imminent. But this is just a cyclical measure.

• More fundamental measures to improve housing affordability need to focus on boosting housing supply and decentralising away from major cities.

Introduction

For as long as I can recall housing affordability has been an issue in Australia but since the 1990s it’s gone from being a periodic cyclical concern to a chronic problem. The 20% rise in prices over the last year has put the spotlight on the issue again. With the surge in house prices since the 1990s has come a surge in debt which brings with it the risk of financial instability should something go wrong in the ability of borrowers to service that debt. This note looks at the main issues. Where is the property market now? What’s driving poor affordability? How big is the risk of financial instability? What can be done about both issues? And what’s the outlook for home prices?

Home prices up 20% in a year

After a dip around mid-last year in response to the initial national coronavirus lockdown, average residential property prices have since risen around 20% according to CoreLogic.

Average Australian property prices at a record high

Source: CoreLogic, AMP Capital

The gains have been led by houses and regional Australia, with units and Melbourne lagging. And while the monthly pace of growth has slowed from 2.8% in March, despite east coast lockdowns daily CoreLogic data indicates that its remained strong at around 1.3% in September. The gains have been driven by record low mortgage rates, buyer incentives, a tight jobs market, a desire for more home space as a result of the pandemic and working from home, numerous government home buyer incentives, the “fear of missing out” and lower than normal listings. This has pushed average prices to record highs & real house prices to around 23% above their long-term trend.

Home prices and household debt have gone up together

Source: ABS, RBA, AMP Capital

Poor affordability

As can be seen in the last chart house prices have been well above trend for nearly the last two decades. Which brings us to the issue of chronically poor housing affordability.

• Over the last 20 years average capital city dwelling prices rose 200% compared to an 82% rise in wages. Over the last 10 years dwelling prices went up 58% & wages by only 26%.

• The ratio of average house prices to average household disposable income has more than doubled over the last thirty years from around 3 times to around 6.5 times.

• Affordability has deteriorated more in Australia than in other comparable countries. According to the 2021 Demographia Housing Affordability Survey, the median multiple of house prices to income for major cities is 7.7 times in Australia compared to 4.8 times in the UK and 4.2 times in the US. In Sydney, it’s 11.8 times and in Melbourne its 9.7 times.

• The ratios of house prices to incomes and rents versus long-term averages are at the high end of OECD countries.

• While interest rates may be at record lows, the surge in prices relative to incomes has seen the ratio of household debt to income rise nearly 3-fold over the last 30 years, going from the low end of OECD countries to the high end.

• This is making it far harder for first home buyers to get into the market – it now takes 8 years to save for a deposit in Sydney and nearly 7 years in Melbourne. While government grants and deposit schemes can help speed this up the higher debt burden will take today’s borrowers far longer to pay down than was the case a generation ago.

What’s the problem with high home prices?

While a gradually rising level of home prices in line with growth in the economy is healthy and positive for the wealth of existing property owners very high house prices and debt levels relative to wages pose two key problems.

• First high debt levels pose the risk of financial instability should something make it harder to service loans.

• Secondly, the deterioration in affordability is resulting in rising wealth inequality, a deterioration in intergenerational equity (as boomers and Gen Xers benefit and millennials and Gen Z miss out), confining more to renting will exacerbate wealth inequality and it is likely contributing to rising homelessness. All of which risk increasing US style social tensions and polarisation.

What’s the risk of a financial crisis?

Predictions that high debt levels would lead to a crash in property prices threatening the financial system and the economy have been a dime a dozen over the last two decades. None have come to pass. Most borrowers are able to service their mortgages. Non-performing loans are low & the collapse in mortgage rates has seen household interest payments as a share of income fall to levels last seen in the mid-1980s.

Household interest payments have collapsed

Source: ABS, RBA, AMP Capital

However, there is a danger in getting too complacent here. Household debt to income ratios are very high and allowing them to get ever higher runs the risk that there could be a major problem at some point so it makes sense to act pre-emptively to cool things down. But whether there is the risk of a financial crisis or not the really big problem is poor affordability.

So why is housing so expensive?

There are two main drivers of the surge in Australian home prices relative to incomes over the last two decades. First, the shift from high to low interest rates has boosted borrowing ability and hence buying power. Second, there has been an inadequate supply response to demand. Starting in the mid-2000’s annual population growth surged by around 150,000 people per annum and this was not matched by a commensurate increase in the supply of dwellings resulting in a chronic shortage (see the green line in the next chart). The supply short fall relative to population driven underlying demand is likely the major factor in explaining why Australian housing is expensive compared to many other countries that have low or even lower interest rates. And the concentration of Australians in just a handful of coastal cities has not helped either.

Home construction and underlying demand

Source: ABS, AMP Capital

A range of other factors have played a role including negative gearing and the capital gains tax discount for investors, foreign buying and SMSF buying, but they have been relatively minor compared to the chronic undersupply. And investor and foreign demand have not been drivers of the latest surge.

So what can be done?

The good news is that we may be getting closer to the end of the 25-year bull market in property prices: interest rates are likely at or close to the bottom so the tailwind from falling interest rates is fading; strong home building in recent years and the collapse in immigration may lead to an oversupply of property; and the work from home phenomenon may take pressure of capital city prices. However, there are no guarantees. And things could just bounce back on the demand side once the pandemic recedes and immigrants return. So a long-term multifaceted solution is called for.

The first thing to do is to tighten macro prudential controls to slow record levels of housing finance. Raising interest rates is not possible given the weakness and uncertainty hanging over the rest of the economy and crashing the economy to get more affordable housing will help no one. So, a tightening in macroprudential controls to slow lending is warranted. With housing credit now growing faster than incomes and at a faster monthly pace than when APRA last started macro prudential controls in 2014 and more than 20% of new loans going to borrowers with debt-to-income ratios above 6 times up from 14% two years ago they are arguably overdue. This time around investors are playing a lessor role in the property boom so macro prudential controls should be broader than was the case in 2014-17. The main options are restrictions on how much banks can lend to borrowers with high debt to income ratios & high loan to valuation ratios and increased interest rate servicing buffers. Ideally first home buyers will need some sort of exemption. With the Treasurer supporting action and the Council of Financial Regulators (RBA, APRA & ASIC) expressing concern about household leverage they look to be on the way, although their implementation still looks several months away. And last decade’s experience showed that they work.

Of course, this is just a cyclical response and more fundamental policies are needed to address poor housing affordability. Ideally these should involve a multi-year plan involving state and federal governments. My shopping list on this front include:

• Measures to boost new supply – relaxing land use rules, releasing land faster and speeding up approval processes.

• Matching the level of immigration in a post pandemic world to the ability of the property market to supply housing.

• Encouraging greater decentralisation to regional Australia – the work from home phenomenon shows this is possible but it should be helped along with appropriate infrastructure and of course measures to boost regional housing supply.

• Tax reform including replacing stamp duty with land tax (to make it easier for empty nesters to downsize) and reducing the capital gains tax discount (to remove a distortion in favour of speculation).

Policies that are less likely to be successful include grants and concessions for first home buyers (as they just add to higher prices) and abolishing negative gearing would just inject another distortion in the tax system and could adversely affect supply (although I can see a case to cap excessive benefits).

What is the outlook for home prices?

National home price growth this year is likely to be around 20% with prices already up by around 17%. 2022 is likely to see property price growth slow to around 7% as a result of worsening affordability, reduced incentives, possibly higher fixed mortgage rates, continuing lower than normal immigration & macro prudential tightening. If the latter does not happen then we are likely to have to revise up our house price forecasts.

Source: AMP Capital September 2021

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

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

Key points

• Share markets have hit the wobbles lately on the back of a long worry list ranging from growth concerns, central bank tapering, the US debt ceiling and fears of about China Evergrande’s problems.

• Shares may still have more downside as it will take a while to resolve some of these issues.

• Key things for investors to bear in mind are that: corrections are healthy and normal; a renewed recession is unlikely and this will limit share market falls; selling shares after a fall locks in a loss; share pullbacks provide opportunities for investors to buy them more cheaply; shares offer an attractive income flow; and finally, to avoid getting thrown off a long-term investment strategy it’s best to turn down the noise during times like this.

Introduction

The past week has seen share markets wobble – with US shares and global shares down 4% from their recent high and Australian shares falling about 5% – amidst concern about global growth, central banks starting to reduce monetary stimulus and problems at a major Chinese property developer. Some are even talking about a “Lehman moment” in relation to the latter – a reference to the collapse of Lehman Brothers in September 2008 that contributed to the worst of the GFC. Markets have stabilised a bit in the last day or so but its too early to say that we have seen the bottom. This note looks at the key issues for investors and puts the falls into context.

A long worry list is behind the weakness

The wobbles in shares reflects a long worry list that has been building for a few months now.

• Recent economic data globally has been softer than expected, leading to concerns peak growth is behind us.

• Uncertainty remains over the impact of the Delta variant.

• Supply side constraints globally appear to be constraining growth and threatening to continue boosting inflation.

• Central banks are starting to slow monetary stimulus with a focus this week on when the Fed will announce a “tapering”, or slowing, of its bond buying.

• The US Congress needs to pass a continuing resolution to fund Federal spending by the end of the month (to avoid another Government shutdown) and will need to increase or suspend the debt ceiling sometime between mid-October and mid-November (to avoid the US Government defaulting on its debt servicing and social security commitments).

• Congress is looking at tax hikes (on corporates which could knock 5% off US earnings, capital gains and dividends) to help fund Biden’s $US3.5trillion remaining stimulus plans.

• The Chinese economy has been slowing in response to earlier policy tightening and recent coronavirus restrictions, adding to concerns about global growth.

• Debt servicing problems at China Evergrande Group – China’s second largest property developer has gotten into trouble as a result of high debt levels and property tightening measures. If Evergrande ends in a full-scale default and liquidation of its assets, some worry that this may lead to another “Lehman moment” in terms of a flow on the Chinese financial system and property market, posing a big threat to the Chinese economy, global growth and commodity prices (like iron ore).

• And share markets having had huge gains since their March lows last year – with US shares doubling having risen 14 of the last 17 months and Australian shares up 68% having risen 16 of the last 17 months – are arguably vulnerable to a bit of a pull back.

Considerations for investors

Sharp market falls with talk of “Lehman moments” are stressful for investors as no one likes to see their investments fall in value. However, several things are worth bearing in mind:

First, while they all have different triggers and unfold differently, periodic corrections in share markets of the order of 5%, 15% and even 20% are healthy and normal. For example, during the tech/dot-com boom from 1995 to early 2000, the US share market had seven pull backs ranging from 6% to 19% with an average decline of 10%. During the same period, Australian shares had eight pullbacks ranging from 5% to 16% with an average fall of 8%. All against a backdrop of strong returns every year. During the 2003 to 2007 bull market, the Australian share market had five 5% plus corrections ranging from 7% to 12%, again with strong positive returns every year. And the last decade regularly saw major pullbacks. See the next chart.

Share markets pullbacks is normal

Source: Bloomberg, AMP Capital

And right now, we are in the time of year often associated with share market pullbacks. Over the last 35 years, September has been the weakest month of the year for both US and Australian shares. See the next chart. US shares have fallen in five of the last 10 Septembers and the Australian share market has fallen in seven of the last 10, with both falling in September last year.

September is often a rough month

Source: Bloomberg, AMP Capital

But while share market pullbacks can be painful, they are healthy as they help limit complacency and excessive risk taking. Related to this, shares climb a wall of worry over many years with numerous events dragging them down periodically, but with the long-term trend ultimately up & providing higher returns than other more stable assets. Bouts of volatility are the price we pay for the higher longer-term returns from shares.

Australian shares have climbed a wall of worry

Source: ASX, AMP Capital

Second, historically the main driver of whether we see a correction (a fall of say 5% to 15%) or even a mild bear market (with say a 20% decline that turns around relatively quickly like we saw in 2015-2016) as opposed to a major bear market (like that seen in the global financial crisis (GFC) or the 35% or so falls seen in February/March last year going into the coronavirus pandemic) is whether we see a recession or not – notably in the US as the US share market tends to lead most major global markets. Right now it’s doubtful that the worry list referred to above, while extensive, will be enough to drive a US, global or Australian recession:

• While global growth is likely to slow in 2022 business surveys remain strong and global growth is still likely to be strong at around 4%.

• The exit from the coronavirus pandemic is proving longer and messier than expected – but vaccines are helping protect against serious illness with little support for a return to lockdowns in developed countries. In Australia, the delayed but now rapid vaccination program looks on track to allow a gradual reopening as we learn to live with higher levels of coronavirus though next quarter, avoiding recession ahead of much stronger growth next year.

• Supply side constraints and hence the near-term inflation threat is likely to recede as recovery continues and spending rotates back towards services from goods.

• While central banks are heading towards the exits from ultra-easy money, it’s likely to be gradual with low interest rates for some time and the sort of tight monetary policy that brings an end to cyclical bull markets looks a long way off.

• The path to pass a funding resolution and resolve the debt ceiling in the US looks likely to be a white-knuckle ride with lots of brinkmanship, but neither side wants to be blamed for shutting the government or causing a default so a last minute deal remains likely.

• Confirmation of rising taxes in the US will be a negative for shares – but tax hikes are likely to be watered down from already watered-down plans such that it’s only a partial reversal of the Trump tax cuts and the direct drag on US profits will only be about 5%.

• While there is much uncertainty about how Evergrande will be resolved – which could cause more short-term weakness in share markets and the iron ore price – it’s not as systemically important to the Chinese/global financial system as Lehman Brothers was. While the Chinese authorities want to teach property developers and investors a lesson about the dangers of too much debt, it’s unlikely to allow Evergrande’s failure to mushroom into a full-on credit squeeze or a “Lehman moment” that collapses the property sector (via forced property sales) and the economy. So ultimately, some sort of debt restructuring rather than full bankruptcy is likely, with reports of a deal with bond holders regarding a payment due on 23rd September and the relative calm in China’s own debt markets possibly being a sign of that. And more broadly China is likely to provide policy stimulus to support growth into year end.

Third, selling shares or switching to a more conservative investment strategy whenever shares suffer a setback just turns a paper loss into a real loss with no hope of recovering. And trying to time a market recovery is very hard. The best way to guard against deciding to sell on the basis of emotion after weakness in markets is to adopt a well thought out, long-term strategy and stick to it.

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

Fifth, Australian shares are offering a very attractive dividend yield compared to banks deposits. While resource stocks dividend payments may have peaked for a while following the plunge in iron ore prices, they’re unlikely to fall back much as they didn’t go up as much as earnings and high prices for gas, coal and metals are providing some offset. So, the income flow you are receiving from a well-diversified portfolio of shares is likely to remain attractive, particularly against bank deposits.

Australian shares offer a very attractive yield versus bank deposits

Source: RBA, Bloomberg, AMP Capital

Sixth, shares and other related assets often bottom at the point of maximum bearishness, ie, just when you and everyone else feel most negative towards them. So, the trick is to buck the crowd. “Be fearful when others are greedy. Be greedy when others are fearful,” as Warren Buffett has said.

Finally, turn down the noise. In times of uncertainty, negative news can reach fever pitch. But it often provides no perspective and only adds to the sense of panic. All of this makes it harder to stick to an appropriate long-term strategy let alone see the opportunities that are thrown up. So as always, it’s best to turn down the noise.

Source: AMP Capital September 2021

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

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

Key points

• Since its February high of around $US0.80 the $A the $A has fallen on the back of global growth concerns, a slowdown in China and the Delta outbreak in Australia.

• However, there is good reason to expect the $A to resume its rising trend: sentiment towards the $A is negative; global growth is likely to remain strong; commodities look to have entered a new super cycle; Australia has a large current account surplus; and Australia is likely to see strong growth next year.

• There is a case for Australian based investors to tilt a bit to hedged global investments but while maintaining a still decent exposure to foreign currency given the diversification benefits it provides.

Introduction

Movements in the value of the Australian dollar are important for Australian-based investors in that they directly impact the value of (and hence returns from) international investments and indirectly effect the performance of domestic assets like shares via the impact on Australia’s competitiveness. But currency movements are also one of the hardest things to get right. This year has been no exception with the $A initially surging to $US0.80 in February only to then fall to a recent low of $US0.71. This note takes a look at the outlook for the $A.

The $A is around long-term fair value

From a long-term perspective the $A is around fair value. The best guide to this is what is called purchasing power parity (PPP) according to which exchange rates should equilibrate the price of a basket of goods and services across countries – see the next chart that shows annual data for the $A back to 1900.

The $A is “around” fair value based on relative prices

Source: RBA, ABS, AMP Capital

If over time Australian inflation and costs rise relative to the US, then the value of the $A should fall to maintain its real purchasing power. And vice versa if Australian inflation falls relative to the US. Consistent with this the $A tends to move in line with relative price differentials – or its purchasing power parity implied level – over the long-term. And right now, it’s around fair value. So, nothing to get excited about, right?

But as can be seen in the chart, it rarely spends much time at the purchasing power parity level. Cyclical swings in the $A are largely driven by swings in the prices of Australia’s key commodity exports and relative interest rates, such that a fall in Australian rates relative to US rates makes it more attractive to park money in the US and hence pushes the $A down. “Investor” sentiment and positioning also impacts – such that if the $A is over-loved with investors overweight in it then it becomes vulnerable to a fall and vice versa if it’s under-loved.

Why has the $A fallen since February?

• First, there has been concern that global growth may have peaked not helped by the latest global coronavirus wave driven by the more contagious Delta variant, supply chain constraints and central banks moving to reduce stimulus. This weighs on the Australian dollar because it’s a “growth asset” which, because of Australia’s high commodity exposure, is harmed by fears of weaker global growth.

• Second, there is likely no quick exit from the coronavirus pandemic, and this is also adding to uncertainty to the global growth outlook. The vaccines provide very good protection against serious illness, but only 60% to 80% protection against infection and their efficacy appears to decline over time requiring boost shots. All of which combined with the higher transmissibility of the Delta variant is making coronavirus hard to eradicate. To this must be added the low level of vaccination in less developed countries which risks the mutation of new more problematic variants. All of which risks ongoing waves of coronavirus outbreaks until global immunity is built up by exposure to it and vaccination – and this will take time.

• Third, these concerns for Australia have been accentuated by the slowdown in Chinese economic growth, in particular Chinese moves to slow steel production (to limit carbon emissions) and the property sector which has seen the iron ore price fall more than 40% since July.

• Fourth, and related to this, tensions between China and Australia that have resulted in restrictions on various Australian imports into China have arguably been keeping the Australian dollar lower than it otherwise would be.

• Finally, the Delta coronavirus outbreak has interrupted the Australian economic recovery, seen the RBA extend bond buying albeit at the reduced rate of $4bn a week and has pushed back expectations for the first rate hike. This is at a time when Fed tapering is getting closer and there is debate about whether the first Fed rate hike might come next year.

But there are five positives likely to push the $A up

Against this there are a bunch of forces suggesting that what we have seen since February is most likely part of a correction.

• Firstly, global sentiment towards the $A is now negative again and this is reflected in short or underweight positions being back near extreme levels. In other words, many of those who want to sell the $A have already done so and this leaves it vulnerable to a rally if there is any good news.

$A positioning is back to being very short

Source: Bloomberg, AMP Capital

• Second, the global recovery is likely to remain strong even if we have seen the peak in growth. While it’s not a smooth ride, vaccines are helping keep hospitalisations and deaths down relative to past waves allowing heavily vaccinated countries in Europe, the UK and parts of the US to continue reopening and avoid a return to lockdowns. And policy easing in China is likely to see Chinese growth pick up next year. This is ultimately positive for the growth sensitive $A.

• Third, commodity prices look to be embarking on a new super cycle. After bottoming in last year’s global lockdown metal prices and wider commodity indexes that include energy have surged to around the last mining boom highs of around 2011. The key drivers are a surge in goods demand, onshoring requiring new capex to avert a rerun of pandemic supply chain disruptions, the demand for clean energy and vehicles all compounded by global underinvestment in new commodity supply. For example, a battery electric vehicle contains 4 to 10 times as much copper as a conventional car. This has all seen Australia’s terms of trade rise to levels that last saw the $A above parity in 2011. Of course, the 40% and still falling collapse in the iron ore price will put a dent in this, but it’s partly offset by a surge in coal prices.

Long term bull and bear markets in commodity prices

Source: Bloomberg, AMP Capital

• Fourth, Australia is seeing its biggest current account surpluses since the 1950s. A big part of this has been the surge into a trade surplus in the last four years – this will likely fall back somewhat due to the declining iron ore price but strength in other commodity prices will partly offset this. However, in recent years there has been a significant decline in Australia’s net income deficit as a result of super funds investing in international assets providing higher income yields than Australia pays on its foreign debt. The swing into a current account surplus means Australia is a capital exporter and that there is more natural transactional demand for the $A than supply.

Biggest Aust current account surpluses since 1950s

Source: ABS, AMP Capital

• Finally, rapid vaccination is likely providing a path out lockdowns with Australia likely to see a return to growth next quarter and strong growth in 2022, which could neutralise the interest rate outlook between Australia and the US.

So where to from here?

Ultimately, we expect the positives notably in the form of strong global growth and high commodity prices to triumph over the negatives and push the Australian dollar higher, and over the next 12 months see it rising to around $US0.80-0.85.

What does it mean for investors?

A rise in the value of the Australian dollar will reduce the value of an international asset (and hence its return) by one for one, and vice versa for a fall in the $A. So last year global shares returned 13.8% in local currency terms but only 5.7% in Australian dollar terms as the $A rose in value. So, when investing in international assets an Australian investor has the choice of being hedged (which removes this currency impact) or unhedged (which leaves the investor exposed to $A changes). Given our expectation for the $A to rise over the next 12 months there is a case for investors to tilt towards a hedged exposure of their international investments.

However, this should not be taken to an extreme for two key reasons. First, currency forecasting is hard to get right. Second, having foreign currency in an investor’s portfolio via unhedged foreign investments is a good diversifier if the economic and commodity outlook turns sour. As can be seen in the next chart there is a rough positive correlation between changes in global shares in their local currency terms and the $A. Major falls in global shares which are circled in the next chart saw sharp falls in the $A which offset the fall in global shares for Australian investors. So being short the $A and long foreign exchange provides good protection against threats to the global outlook.

Global share prices versus $A

Source: Bloomberg, AMP Capital

Finally, the last commodity super cycle in the 2000s saw Australian shares outperform global shares, so one way to play a new commodity super cycle would be via a higher exposure to Australian shares.

Source: AMP Capital September 2021

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

– but here’s 7 reasons to look beyond the gloom

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

Key points

• Australian GDP growth slowed in the June quarter but to a stronger than expected 0.7%qoq. This avoids a technical recession, but the current quarter is likely to see a 4% slump due to the lockdowns.

• While there is lots of gloom around there remains strong reason for optimism regarding economic growth in 2022: the vaccines are effective in helping prevent serious illness; Australia’s vaccination rate has increased dramatically; pent up demand will help drive recovery; and global growth is likely to be strong.

Introduction

Three months ago there was much optimism about the Australian economic outlook. GDP regained its pre pandemic level, confidence was strong, the jobs market was roaring, there was minimal community coronavirus & vaccines were providing optimism of a more sustained reopening. Since then renewed coronavirus outbreaks of the Delta variant have seen the near-term outlook turn pear shaped – notably in NSW & Victoria. However, much as the near term is depressing in lockdown states there are good reasons for optimism about 2022.

June quarter GDP slowed less than expected

The June quarter saw GDP up 9.6% from the lockdown depressed June quarter last year, but quarterly growth slowed to 0.7%qoq. Thanks to smaller detractions from stocks & trade and very strong growth in public demand (which contributed 0.5 percentage points to growth) this was above our final estimate for a 0.3% gain and well above our initial estimate of a -0.1% decline and avoids the label of a double dip technical recession as September quarter GDP is almost certain to be negative – providing of course we see some recovery into year end.

Australian real GDP growth

Source: ABS, AMP Capital

While domestic final demand rose a strong 1.7% – with consumer spending 1.1%, business investment 2.3%, dwelling investment 1.7% & public demand 1.9% – stocks detracted -0.2% points from growth and net exports -1% points.

Consistent with the growth rebound since first half last year, the June half earnings reporting season saw listed company profits rise nearly 50% last financial year driven mainly by resources & banks, with 75% of companies seeing profits up. But the big positive was a huge return of capital to shareholders – with 89% of companies raising or maintaining dividends driving a record dividend payout of nearly $40bn and over $20bn in buybacks.

Proportion of Australian companies seeing profits up and raising or maintaining dividends

Source: AMP Capital

First the bad news

The news flow since late June has been bleak:

• Locally acquired coronavirus cases have surged – driven mainly by NSW but with problems in Victoria & the ACT too.

Australia: New Daily Coronavirus Cases by State

Source: covid19data.com.au

• This has led to various hard lockdowns notably in Sydney and Melbourne with both likely to be extended into October.

• Our rough estimate is that the lockdowns since late May are costing the economy around $25bn in lost output and will result in a 4% fall in September quarter GDP. And of course, there is the psychological costs of lockdowns too.

• This is occurring when other developed countries are reopening thanks to being more advanced in vaccinations – leading to a sense that Australia is being left behind.

• Even when reopening comes as vaccination targets are met it will be very different to last year’s reopening. That occurred when coronavirus cases had fallen to around zero, but this time coronavirus cases are likely to be running much higher. While people in Europe, the UK & the US may be used to this (eg, the same number of per capita cases as the UK is now seeing would mean 13,000 cases a day in Australia), it may take a bit of getting used to in Australia which may act as a constraint on confidence, and hence the pace of economic recovery, initially, compared to last year.

• The degree of reopening that can safely occur without problems in hospital systems when the national 70% & 80% of adults’ vaccination targets are met (which mean that 44% and 36% of the whole population will still be unvaccinated) may initially be limited if daily case numbers remain high in some states, and the zero case states (like WA & Queensland) may delay the opening of their borders until higher vaccination rates are achieved.

…but there is good news too

While it would be wrong to get too confident – as coronavirus has had a few occasions over the last 18 months where it looked under control only to flare up again – there is reason for optimism and this, along with the strong return of capital to shareholders, partly explains why the Australian share market remains relatively resilient.

• First, while the lockdowns are very painful, Australia’s policy of suppression has saved lives. If we had taken a laxer approach and had the same per capita number of deaths as the UK and US, we would have lost an extra 48,000 people.

• Second, while the vaccines are less effective in preventing infection from the Delta variant (at 60-80% effective), look to require top ups and may have to be tweaked against new variants, they remain highly effective in preventing serious illness (at 85-95%). This is evident in the UK (where deaths are running around one fifth the level predicted on the basis of the last wave), Europe, Canada and in highly vaccinated US states. It can also be seen in Australia where deaths in this wave are running around one quarter the level predicted on the basis of Victoria’s second wave last year likely thanks to high levels of vaccination amongst older/at risk people.

Australia COVID-19 New cases & deaths

Source: ourworldindata.org, covid19data.com.au, AMP Capital

• Third, the pace of vaccination in Australia has doubled from 1 million vaccines a week to nearly 2 million a week over the last six weeks. At the current rate we will reach the first national reopening target of 70% of the adult population in October, 80% of the adult population in November and 80% of the whole population (which may be needed for a safe reopening) in December and 90% of the whole population (which would be ideal) in January. Of course, incentives may be needed to reach the higher vaccination rates – vaccine passports (no jab, no entry) are being implemented and will help in this. NSW is about 3 weeks ahead of the national average.

Coronavirus Vaccinations: Daily vaccinations per 100 people

Source: ourworldindata.org, AMP Capital

• Fourth, while the process of “learning to live” with covid may mean that the initial part of the recovery will be slower than seen last year, pent up demand (thanks to government support payments and constraints on spending in the lockdowns) and a reasonable degree of job security (with state business support payments contingent on businesses maintaining their workforce) along with bank payment holidays will still see significant spending unleashed once reopening occurs which will spur recovery through 2022.

• Fifth, despite the lockdowns the ABS’s business investment survey of July/August still points to significant growth in investment this financial year.

• Sixth, monetary policy will likely be easier as the hit from the lockdowns and a slower initial recovery results in a higher unemployment profile through next year than the RBA has been assuming. We expect the RBA to delay the tapering of its bond buying and to continue buying bonds at the rate of $5bn a week into early next year and the first RBA rate hike is now likely pushed back into 2024. 

• Finally, Australia will benefit from the cyclical recovery globally. While peak global growth will probably be seen this year with global GDP growth of 6% it’s still likely to be strong next year at 5%, increasing vaccination globally allows a continuing reopening. This assumes that China moves to boost its growth rate which has slowed lately.

The Australian economy – rough now, better in 2022

The Australian recovery will see a big setback this quarter (of around -4% for GDP), but the start of a gradual reopening from October gathering pace later this year and through next year as higher vaccination rates are reached should see the recovery start to get back on track in 2022. While growth though this year is likely to be just 1% (compared to our expectation for 4.8% 3 months ago), it’s likely to be around 6.5% through next year.

Australian real GDP level

Source: ABS, AMP Capital

Source: AMP Capital September 2021

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