Olivers Insights

Introduction

After a third round of talks made little progress last week, the US/China trade war has escalated badly with tit for tat moves on an almost daily basis by each side. This has seen share markets fall sharply with US, global and Australian shares down about 5-6% from recent highs and safe haven assets like bonds and gold benefiting on the back of worries about the global growth outlook. This note looks at the key issues.

What is a trade war?

A trade war is where countries raise barriers to trade with each other usually motivated by a desire to “protect” jobs often overlaid with “national security” motivations. To be a “trade war”, the barriers need to be significant in terms of their size and the proportion of imports covered. The best-known global trade war was that in 1930 which saw average 20% tariff hikes on US imports.

What is so good about free trade?

A basic concept in economics is comparative advantage: that if Country A and B are both equally good at making Product X but Country B is best at making Product Y then they will be best off if A makes X and B makes Y. Put simply, free trade leads to higher living standards and lower prices whereas restrictions on trade lead to lower living standards and higher prices.

So why is President Trump raising tariffs then?

It’s basically about fulfilling a presidential campaign commitment to “protect” American workers from what he regards as unfair trading practices in countries that the US has a trade deficit with – notably China. And he knows this is popular with his supporters but there is also some degree of bi-partisan support for taking on China.

What does President Trump want?

Basically, he wants China to lower its tariffs, allow better access for US companies, end US companies being forced to hand over their technologies and protect intellectual property of US companies. At a high level he wants a reduction in America’s trade deficit with China. Along the way he has renegotiated the NAFTA free trade agreement with Mexico and Canada and the free trade deal with South Korea and is in talks with Europe and Japan. In recent times he has also used the threat of tariffs to get what he wants from countries (eg Mexico in relation to border protection).

Where are we now?

Fears of a global trade war kicked off in March last year with Trump’s announcement of a 10% tariff on aluminium imports and a 25% tariff on steel imports. US allies were subsequently exempted but China was not. On March 22 Trump announced 25% tariffs on $US50bn of US imports from China. These were implemented in July and August. After Chinese retaliation Trump announced a 10% tariff on another $US200bn of imports from China (implemented in September) which would increase to 25% on January 1 this year. The latter was delayed as the talks made progress.

However, following May 5 tweets by Trump, on May 10 the delayed tariff hike from 10% to 25% on $US200bn of imports from China was put in place and the US kicked off a process to tariff the remaining roughly $US300bn of imports from China at 25%. If fully implemented this would take the average US tariff rate on imports to around 7.5%, which is significant (albeit minor compared to the 20% 1930 tariff hikes). See next chart.

Average weighted tariff rate across all products

View larger image

Source: World Bank, Deutsche Bank Research

Along the way, China’s retaliation has been less than proportional, partly reflecting lower imports from the US. The US has also put in place restrictions on dealing with Chinese tech companies like Huawei.

Following a meeting in late June between Presidents Trump and Xi the trade war was put on hold pending a third round of talks. These look to have made little progress and Trump announced last week that from September 1 the remaining $US300bn of imports from China will be taxed at 10% and this may go beyond 25%.

China has responded by allowing the Renminbi to fall below 7 to the $US and reportedly ordering state-owned enterprises to halt imports of agricultural products from the US. The US then named China a currency manipulator (even though basic economics pointed to a fall in the Renminbi in response to the tariffs on its good) which opens the door to possibly further action by the US (eg intervention to lower the $US versus the Renminbi) and potentially a further escalation in the trade war.

At the same time, the US is still considering auto tariffs after a report lodged in February.

What happened to the US/China trade talks?

This has been the third round of trade talks that look to have failed. The timing of the announcement of the latest round of tariffs may also reflect a desire by Trump to force the Fed to ease more as he wasn’t happy with its 0.25% cut last week and to show that he is tougher on trade than far-left Democrat presidential candidates Sanders and Warren. Whatever it is, there is likely to have been a further breakdown in trust between China and the US and China may have decided to wait till after the election.

Ongoing tensions around North Korea, Iran, Hong Kong, Taiwan and the South China sea are probably not helping the issue either.

What will be the economic impact?

The latest round of tariff increases from September 1 would be a big deal compared to last year’s tariffs and see the impact shift to largely consumer goods as opposed to intermediate goods in the first tariff rounds. The 10% tariff could knock around 0.3% from US and Chinese GDP particularly as investment gets hit in response to uncertainty about supply chains. The full 25% tariff could take that to around 0.75% with roughly a 0.2% boost to US core inflation (albeit this would be temporary and looked through by the Fed). This would flow on to slower global growth and lead to less demand for Australia’s exports even though we are not directly affected.

What is the most likely outcome?

At this point, it’s hard to see a way out of the escalating trade war and it risks flowing into other issues as well including around HK, Taiwan, and the South China sea as the US and China slip further towards some sort of “cold war”. However, as the economic impact in the US mounts – so far it’s just been impacting business confidence and investment plans but risks impacting consumer spending too – President Trump is likely to become more concerned. Recessions and rising unemployment have historically killed the re-election of sitting presidents (Hoover, Ford, Carter and Bush senior) and for this reason, we remain of the view that a deal will be reached before the election. President Trump showed late last year that he was sensitive to the impact of the trade conflict on the US share market (as after sharp falls he called President Xi to set up a new meeting). So sharp share market falls may be needed again to get the US and China negotiating. But this means it could still get worse before it gets better – the US share market had a top to bottom fall last year of 20%!

It’s also worth noting that policy stimulus by the Fed and the Chinese government will offset some of negative impact which along with the absence of the sort of excesses (like in cyclical spending, inflation and private debt) that normally precede recessions in the US is why we are not predicting a recession.

What does it mean for investment markets?

Basically, the uncertainty around the escalating trade war is bad for listed growth assets like shares as it threatens the outlook for growth and profits, but positive for safe-haven assets which is why bond yields in many countries including Australia have pushed further into record low territory and gold has increased in value.

Following last week’s highs, global and Australian shares have fallen roughly 5-6%, mainly reflecting concern about the impact on growth from the escalating trade war. Further downside is likely in the short term as the trade war continues to escalate and we are also in a seasonally weak part of the year for shares. This is likely to be associated with further falls in bond yields.

However, providing we are right and recession is avoided, a major bear market in shares (ie where shares fall 20% and a year later are down another 20% or so) is unlikely.

What does it all mean for Australia?

Fortunately, Australians aren’t having to pay higher taxes on imports like Americans, but the main risk is that we are indirectly affected as the US/China trade war drags down global growth, weighing on demand for our exports and leading to unemployment pushing higher than our 5.5% forecast for year end. This all adds to the case for further easing by the RBA (we expect the cash rate to fall to 0.5% by February) and for further fiscal stimulus.

What should investors do?

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 as can be seen in the next chart. The setbacks are the price we pay for the higher long-term return from shares. After 25% or so gains from their lows, last December shares were at risk of a correction.

View larger image

Source: Bloomberg, AMP Capital

• 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 be falling in value, the dividends from the market aren’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.

• Finally, 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.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 7th August 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

As widely anticipated, the US Federal Reserve has cut its key Fed Funds cash rate by 0.25% to a range of 2-2.25%. This is the Fed’s first rate cut since December 2008 and follows nine 0.25% rate hikes between December 2015 and December last year. The Fed also announced that quantitative tightening (ie the process of reversing its quantitative easing program by letting bonds on its balance sheet mature) will end immediately, which is about two months earlier than previously flagged. The Fed’s post-meeting statement left the door open to more cuts although Fed Chair Powell’s press conference confused things a bit (again!) by saying it’s a “mid-cycle adjustment” and “not the beginning of a long series of cuts” but it may not be “just one”.

Taking out some insurance

With underlying US growth still solid and the jobs market tight this should be seen as the Fed taking out some insurance given various threats to the growth outlook including from the US/China trade war, tensions with Iran and slower global growth generally and a greater willingness by the Fed to take risks with higher inflation as opposed to deflation.

So it’s a bit like the easings of 1987 after the share market crash and in 1998 during the LTCM hedge fund crisis when Russia defaulted leading LTCM to go bust, threatening the US financial system.

The pattern of the past 50 years or so is for the Fed to cut rates after some form of crisis threatens the economic outlook. See the next chart. In 2001 it was the tech wreck and in 2007 it was the sub-prime mortgage crisis. This time around there is nothing on that scale although it may be argued that the trade wars are providing the biggest single threat.

Source: Thomson Financial, AMP Capital Investors

This year’s fall in core private final consumption inflation back below the Fed’s 2% target provided the Fed with the scope to move.

Further easing is likely, but it’s likely to be limited

It’s rare for the Fed to just cut once. In the insurance cuts of 1998 through the LTCM crisis it eased 3 times by 0.25%. Given that the risks to the growth outlook – particularly on trade – won’t go away quickly and that the Fed appears to have taken the decision that it’s easier to control a rise in inflation than a further slide or deflation, it’s likely to cut rates further and we are allowing for another cut in September.

However, we remain of the view that a US recession is not imminent (see The longest US economic expansion ever). While the yield curve is flashing warning signs, the excesses that normally precede US recessions are not present. In particular: the US has not seen a spending boom with cyclical spending on consumer goods, investment and housing running around average as a share of GDP; private debt growth has been moderate; and inflation has been low. Consequently, there is no boom to go bust. Moreover, monetary policy had not become tight with the Fed Funds rate never having reached the high levels that normally precede recessions. See the next chart.

Source: NBER, Bloomberg, AMP Capital

As a result, we see this easing cycle by the Fed as being limited to around 2 or 3 rate cuts with the next likely coming in September as opposed to the 4 or so that the money market has factored in.

Of course, the main threats to this relate to US trade wars and tensions with Iran.

The Fed and shares

Falling interest rates are generally positive for shares. They help boost economic and profit growth and make shares relatively more attractive than cash and hence are usually associated with a higher price to earnings multiples. The table below shows the US share market’s response after the first-rate cut following major tightening cycles.  

US recession highlighted in red. Source: Thomson Reuters, AMP Capital

The US share market rose over the subsequent 3, 6 and 12 months after the commencement of 5 of the last 8 Fed easing cycles. The exceptions were after the rate cuts in 1981, 2001 and 2007 which were associated with recessions.

The reaction by the Australian share market is similar, except the Australian share market wasn’t greatly affected by the post-2000 bursting of the tech bubble.

US recessions highlighted in red. Source: Thomson Reuters, AMP Capital

So if we are right and the US avoids a recession in the next year or so then US interest rate cuts should be positive for shares beyond any near term uncertainty (and the initial reaction which has seen US shares fall as the Fed wasn’t as dovish as hoped) and are likely to be higher on a 6-12 month horizon. It is worth repeating the old saying “don’t fight the Fed”. While scepticism is high that central banks with low-interest rates and QE will spur growth, an investor would have made a huge mistake over the past decade betting against them. The key though is that global economic indicators need to start improving in the months ahead.

Implications for Australian interest rates

The directional relationship between the US and Australian interest rates weakened long ago. The RBA started raising rates in 2009 when the Fed held at zero, it was easing in 2016 when the Fed was hiking and this year it started cutting ahead of the Fed. So just because the Fed moves doesn’t mean the RBA will as well! On the one hand the Fed’s easing along with stimulus elsewhere globally should help support global growth which is good for Australia. But it’s probably not enough to change the outlook for the RBA. Our view remains that it’s on track to cut the cash rate to 0.5% by early next year and to some degree the Fed cutting too reinforces that to the extent that the RBA would like to keep the Australian dollar down.

What about the role of President Trump?

President Trump has been highly critical of Fed rate hikes over the past year and has been saying they should be cutting in recent times. Of course, presidents and prime ministers usually prefer lower than higher rates but the issue, in this case, has been more around whether his comments represent a threat to the Fed’s independence, which is necessary to ensure sensible monetary policy as opposed to politically driven moves. In a world of increasing populism, this could become more of an issue. In terms of the role he may have played in the Fed’s latest decision it’s likely that the Fed has made up its own mind but it’s also interesting to note that President Trump’s huge fiscal easing last year likely played a role in Fed hikes last year and now his escalating trade war has played a role in its easing! So, one way or another he had an impact.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 01 August 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

As widely anticipated, the US Federal Reserve has cut its key Fed Funds cash rate by 0.25% to a range of 2-2.25%. This is the Fed’s first rate cut since December 2008 and follows nine 0.25% rate hikes between December 2015 and December last year. The Fed also announced that quantitative tightening (ie the process of reversing its quantitative easing program by letting bonds on its balance sheet mature) will end immediately, which is about two months earlier than previously flagged. The Fed’s post-meeting statement left the door open to more cuts although Fed Chair Powell’s press conference confused things a bit (again!) by saying it’s a “mid-cycle adjustment” and “not the beginning of a long series of cuts” but it may not be “just one”.

Taking out some insurance

With underlying US growth still solid and the jobs market tight this should be seen as the Fed taking out some insurance given various threats to the growth outlook including from the US/China trade war, tensions with Iran and slower global growth generally and a greater willingness by the Fed to take risks with higher inflation as opposed to deflation.

So it’s a bit like the easings of 1987 after the share market crash and in 1998 during the LTCM hedge fund crisis when Russia defaulted leading LTCM to go bust, threatening the US financial system.

The pattern of the past 50 years or so is for the Fed to cut rates after some form of crisis threatens the economic outlook. See the next chart. In 2001 it was the tech wreck and in 2007 it was the sub-prime mortgage crisis. This time around there is nothing on that scale although it may be argued that the trade wars are providing the biggest single threat.

Source: Thomson Financial, AMP Capital Investors

This year’s fall in core private final consumption inflation back below the Fed’s 2% target provided the Fed with the scope to move.

Further easing is likely, but it’s likely to be limited

It’s rare for the Fed to just cut once. In the insurance cuts of 1998 through the LTCM crisis it eased 3 times by 0.25%. Given that the risks to the growth outlook – particularly on trade – won’t go away quickly and that the Fed appears to have taken the decision that it’s easier to control a rise in inflation than a further slide or deflation, it’s likely to cut rates further and we are allowing for another cut in September.

However, we remain of the view that a US recession is not imminent (see The longest US economic expansion ever). While the yield curve is flashing warning signs, the excesses that normally precede US recessions are not present. In particular: the US has not seen a spending boom with cyclical spending on consumer goods, investment and housing running around average as a share of GDP; private debt growth has been moderate; and inflation has been low. Consequently, there is no boom to go bust. Moreover, monetary policy had not become tight with the Fed Funds rate never having reached the high levels that normally precede recessions. See the next chart.

Source: NBER, Bloomberg, AMP Capital

As a result, we see this easing cycle by the Fed as being limited to around 2 or 3 rate cuts with the next likely coming in September as opposed to the 4 or so that the money market has factored in.

Of course, the main threats to this relate to US trade wars and tensions with Iran.

The Fed and shares

Falling interest rates are generally positive for shares. They help boost economic and profit growth and make shares relatively more attractive than cash and hence are usually associated with a higher price to earnings multiples. The table below shows the US share market’s response after the first-rate cut following major tightening cycles.  

US recession highlighted in red. Source: Thomson Reuters, AMP Capital

The US share market rose over the subsequent 3, 6 and 12 months after the commencement of 5 of the last 8 Fed easing cycles. The exceptions were after the rate cuts in 1981, 2001 and 2007 which were associated with recessions.

The reaction by the Australian share market is similar, except the Australian share market wasn’t greatly affected by the post-2000 bursting of the tech bubble.

US recessions highlighted in red. Source: Thomson Reuters, AMP Capital

So if we are right and the US avoids a recession in the next year or so then US interest rate cuts should be positive for shares beyond any near term uncertainty (and the initial reaction which has seen US shares fall as the Fed wasn’t as dovish as hoped) and are likely to be higher on a 6-12 month horizon. It is worth repeating the old saying “don’t fight the Fed”. While scepticism is high that central banks with low-interest rates and QE will spur growth, an investor would have made a huge mistake over the past decade betting against them. The key though is that global economic indicators need to start improving in the months ahead.

Implications for Australian interest rates

The directional relationship between the US and Australian interest rates weakened long ago. The RBA started raising rates in 2009 when the Fed held at zero, it was easing in 2016 when the Fed was hiking and this year it started cutting ahead of the Fed. So just because the Fed moves doesn’t mean the RBA will as well! On the one hand the Fed’s easing along with stimulus elsewhere globally should help support global growth which is good for Australia. But it’s probably not enough to change the outlook for the RBA. Our view remains that it’s on track to cut the cash rate to 0.5% by early next year and to some degree the Fed cutting too reinforces that to the extent that the RBA would like to keep the Australian dollar down.

What about the role of President Trump?

President Trump has been highly critical of Fed rate hikes over the past year and has been saying they should be cutting in recent times. Of course, presidents and prime ministers usually prefer lower than higher rates but the issue, in this case, has been more around whether his comments represent a threat to the Fed’s independence, which is necessary to ensure sensible monetary policy as opposed to politically driven moves. In a world of increasing populism, this could become more of an issue. In terms of the role he may have played in the Fed’s latest decision it’s likely that the Fed has made up its own mind but it’s also interesting to note that President Trump’s huge fiscal easing last year likely played a role in Fed hikes last year and now his escalating trade war has played a role in its easing! So, one way or another he had an impact.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|. 

Author: Dr Shane Oliver, Head of Investment Strategy and Chief Economist

Source: AMP Capital 01 August 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)  (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

A common concern ever since the Global Financial Crisis (GFC) ended a decade ago is that the next recession is imminent. This concern has become more pronounced recently as yield curves – ie the gap between long-term bond yields and short-term borrowing rates – have inverted (or gone negative) as in the US. This concern has taken on added currency now that the US economic expansion is the longest on record. Surely it must be living on borrowed time?

This matters a lot. The US is the world’s biggest economy in US dollar terms (at 24% of world GDP), its share market is around 56% of global share market capitalisation and being central to the world’s financial system it sets the direction for global share markets, including Australia’s. What’s more, while share corrections (say falls of 5-15%) and even mild bear markets (with say a 20% decline that turns around quickly) are common, the key driver of whether they turn into a major bear market (where shares fall 20% and a year later are down another 20% or so like in the GFC) is whether we see a recession or not – notably in the US (see the table in Correction time for shares?). So, whether a US recession is imminent or not is critically important in terms of whether a major bear market is imminent.

Longest but not the strongest

The cyclical bull market in US shares is now over ten years old. This makes it the longest since WW2 and the second strongest in terms of percentage gain. And according to the US National Bureau of Economic Research the current US economic expansion that started in June 2009 is now 121 months old and compares to an average expansion of 58 months since 1945. This makes it the longest on record (since 1854). See the next two tables. But it’s noteworthy that it’s not the strongest. In fact, GDP and employment growth through this expansion have averaged around half that seen in the average post war expansion. Both have been the second weakest. 

Data is for the S&P 500. A cyclical bull market is defined as a rising trend in shares that ends when shares have a 20% or more fall. It could be argued that the 20% fall in July to October 1990 was not really a bear market as it was too short & shares surpassed their prior highs within a year. If it was not really a bear then the latest bull market becomes the second longest. Source: Bloomberg, AMP Capital.

Source: National Bureau of Economic Research, AMP Capital

Absence of excess

Numerous growth slowdowns and recession scares – notably around 2011-12, 2015-16 and since last year – and post GFC caution have kept this expansion slow. A key lesson of past economic expansions is that “they do not die of old age, but of exhaustion”. The length of economic expansions depends on how quickly recovery proceeds, excess builds up, inflation rises and the central bank tightens. The current US economic expansion may be long, but it has been slow. As a result, it’s been taking longer than normal for excesses that precede recessions – around cyclical spending, debt and inflation – to build up. First, cyclical spending in the US as a share of GDP remains low. In particular, there has been no “boom” in spending on consumer durables, business or housing investment resulting in a glut that needs to be worked off as occurred prior to all of the recessions in the last 50 years. All are around or below long-term averages as a share of GDP, in contrast to highs seen prior to past recessions. Basically, no boom = no bust!  

Source: NBER, Bloomberg, AMP Capital

Second, growth in private sector debt has been modest and well below the surge seen prior to the recessions of the early 1990s, early 2000s and 2008-09 as household debt growth has been weak. While corporate debt is up, the ratio of profits to interest payments is well above average and the ratio of corporate debt to assets is low. (Yes, public debt to GDP in the US is a concern but high public debt has not been a precursor to recession and the public sector’s taxing and money printing abilities mean it’s a totally different risk to excessive private debt.)

Finally, there is no sign of the surge in inflation that traditionally precedes recessions. Sure, the labour market has been flashing warning signs with unemployment and underemployment having fallen sharply, warning of a wages breakout and inflation pressure.

Source: NBER, Bloomberg, AMP Capital

However, there is arguably still spare capacity in the US labour market (the participation rate has yet to see a normal cyclical rise) and wages growth around 3% remains very low. The last three recessions were preceded by wages growth above 4%. And industrial capacity utilisation at 78% is well below levels that in the past have shown excess and preceded recessions. Reflecting this, along with intense competition which has been accentuated by technological innovation, core inflation has fallen below target.

Source: NBER, Bloomberg, AMP Capital

So, while the Fed has raised interest rates since late 2015 it has not slammed the brakes on with tight monetary policy. Past US recessions have been preceded by the Fed Funds rates being well above inflation and nominal growth, whereas that’s not the case now. See the last chart. And given perceived risks to growth and the concern that it will be easier to deal with a rise in inflation than deflation, the Fed is now moving to cut rates again anyway.

The bottom line is that the excesses that normally precede US recessions – a spending boom, surging private debt and/or rising inflation/tight monetary policy – are absent. So while US economic expansion may be long in the tooth it’s far from exhausted.

But what about the inverted yield curve?

The inverted US yield curve that started in the last few months is certainly a concern as they have preceded past US recessions.

Source: NBER, Bloomberg, AMP Capital

However, there are several reasons not to be too concerned. First, the lag from yield curve inversion to recession averages around 15 months (which takes us to second half next year), there have been numerous false signals and following yield curve inversions in 1989, 1998 and 2006 shares actually rallied. Second, various factors may be inverting the yield curve unrelated to growth expectations including still falling long-term inflation expectations, low German and Japanese bond yields and higher levels of investor demand for bonds post the GFC as they have proven to be a good diversifier to shares in times of crisis. Third, the retreat from monetary tightening has been a factor behind the rally in bonds but this is positive for growth. Finally, other indicators are not pointing to imminent recession – as noted above we have not seen the sort of excess that normally precedes recession.

The bottom line

Issues around the trade war and tensions with Iran certainly pose a risk to US growth and could drive short term volatility in share markets. But the combination of easing monetary conditions globally, the removal of caps on US Government spending for next year (which threatened a mini “fiscal cliff”) as part of a deal to suspend the debt ceiling and the absence of the excesses that contribute to recessions would suggest that US – and hence global and Australian – shares are likely to be higher in 6-12 months’ time.

Shares up and bond yields down – which is right?

This brings us back a puzzle that has worried some this year: share markets are up but bond yields are down…surely one market must be wrong? But this occasionally happens in the investment cycle. Basically, shares having fallen last year on growth fears are looking through short-term growth uncertainties and focusing on lower for longer interest rates and bond yields making shares relatively cheaper and the likelihood that monetary and fiscal stimulus will ultimately boost economic growth. By contrast bonds have been focussing on falling inflation and lower for longer short-term interest rates. So, there is logic behind both shares and bonds rallying at the same time. Ultimately though if global growth picks up over the next 12 months, bond yields will start to rise again – but it’s likely to remain gradual and constrained.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|.

Source: AMP Capital 23 July 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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

The past financial year saw a roller coaster ride for investors. Share markets plunged into Christmas only to rebound over the last six months. This note reviews the last financial year and takes a look at the investment outlook for 2019-20.

A volatile but good year for diversified investors

The past financial year saw pretty good returns for investors. But it didn’t feel so good around Christmas as a combination of worries – President Trump’s trade war with China, a slowdown in China, Fed rate hikes, an end to quantitative easing in the Eurozone, falling property prices and election fears in Australia saw share markets fall sharply. In fact, from its September high to Christmas Eve US shares plunged 20%. But in the last six months share markets have rebounded as while the trade threat has run hot and cold and tensions in the Middle East have escalated central banks have turned dovish with many either easing (like the RBA and PBOC) or signalling that monetary easing is likely (such as the Fed and ECB). This has seen global share markets rebound sharply with Australian shares having their best June half since the early 1990s – helped along by the return of the Coalition Government.

So for the financial year as a whole global shares returned 6.6% in local currency terms and thanks to a fall in the Australian dollar they returned 12% in Australian dollar terms. Australian shares returned 11.6% touching an 11-year high.

Cash and bank deposits had poor returns not helped by the RBA cutting the cash rate to a new record low in June. But bonds had a spectacular turnaround as rising bond yields on the back of Fed tightening a year ago gave way to plunging yields – to record lows in many countries – as inflation subsided and central banks turned dovish resulting in Australian bonds returning 9.6%. The plunge in bond yields reinvigorated the search for yield and so helped yield-sensitive listed property and infrastructure have strong returns. Unlisted property and infrastructure continued to do well, despite a rougher ride for retail property. Balanced growth superannuation funds are estimated to have returned around 7% after taxes and fees. For the last five years their returns have averaged around 7.4% pa, which is not bad given sub 2% inflation.

Source: Thomson Reuters, AMP Capital

Australian residential property fared poorly though with average capital city prices down 8%, but signs of stabilisation have emerged recently helped by the election result and rate cuts.

Key lessons for investors from the last financial year

These include:

• Turn down the noise – despite the endless predictions of financial disaster it turned out okay again.

• Maintain a well-diversified portfolio – while shares had a rough ride, bonds, unlisted assets and exposure to foreign currency for Australian investors provided some stability. 

• Cash is still not king – while cash and bank deposits provided safe steady returns, they remain very low.

The negatives which will likely constrain returns…

There are a bunch of threats which are likely to lead to bouts of volatility and constrain returns.

• First, President Trump’s trade war with China and threats against other countries is adversely affecting business confidence and investment. Trade talks with China have resumed and both sides have a strong incentive to resolve the issue but there is a risk that they may not.

• Second, global growth indicators are well down from their highs at the start of last year. And the yield curve in the US is flashing a recession warning.

Source: Bloomberg, AMP Capital

• Third, the risk of conflict with Iran has escalated after the US ditched its commitment to the 2015 Iran nuclear agreement. As roughly 20% of global oil demand flows through the Strait of Hormuz its disruption would threaten sharply higher oil prices.

• Fourth, US political risk is likely to ramp up with the debt ceiling needed to be increased around September (remember the debt ceiling/US ratings downgrade of 2011!) and Democratic presidential debates highlighting a sharp leftward lurch at a time when the top Democrat nominees are polling ahead of Trump.

• Fifth, Eurozone risks remains with an increased risk of a no deal Brexit which would be a big drag on the UK economy as 46% of its exports go to the EU and a small drag on European growth as 6% of its exports go to the UK. More important for the Eurozone is the ongoing tensions around the still worsening Italian budget deficit.

• Finally, in Australia while house prices are showing signs of being at or near the bottom, rising unemployment risks resulting in a negative feedback loop and another leg down, which in turn would further weigh on economic growth.

…but a bunch of things should keep returns positive

• However, there are a bunch of positives providing an offset.

• First, while global growth indicators are soft, there has been a loss of downwards momentum in the Eurozone and globally it still looks like the growth slowdowns of 2011-12 and 2015-16.

• Second, the fall in global inflation has seen central banks move from tightening to easing to various degrees, providing a renewed stimulus to growth. This is a big difference to a year ago when it was thought that the hurdle for central bank easing was high.

• Third, while the US yield curve is flashing red it’s not always reliable, it may be distorted by central bank quantitative easing and it has long lead times. What’s more there is still little sign of the sort of excess that normally precedes recessions – there is still spare capacity globally, growth in private debt remains moderate, investment as a share of GDP is around average or below, wages growth and inflation remain low and we are yet to see a generalised euphoria in asset prices. The current growth slowdown globally maybe seen as extending the investment cycle by delaying the build up of recession driving excesses.

• Fourth, while Trump’s trade wars and maximum pressure on Iran may reflect the pursuit of international relevance at a time when his ability to do anything in the US is constrained (having lost Congress) it is in his interest to resolve both in a non-disruptive way as American’s don’t re-elect presidents when unemployment is rising and oil prices are surging.

• Fifth, share valuations are not excessive. While price to earnings ratios are moderately above long-term averages in developed countries, this is to be expected in a world of low inflation. Valuation measures that allow for low interest rates and bond yields show shares to be fair value or cheap.

• Finally, while unemployment is expected rise to 5.5% this year in Australia it should be limited as infrastructure spending remains strong, mining investment bottoms out, export demand holds up with overall growth helped by monetary and fiscal stimulus and the low Australian dollar.

What about the return outlook?

The threats around trade and geopolitical risks along with the tendency for seasonal weakness out to September/October could see a pull back in share markets and returns are likely to be constrained. But easy money and the absence of large-scale economic excess should help extend the cycle and keep returns positive at around 6% over the next 12 months from a well diversified portfolio. Looking at the major asset classes:

• Cash and bank deposit returns are likely to be poor at around 1% as the RBA is expected to cut the cash rate to 0.5% by early next year. Investors still need to think about what they really want: if it’s capital stability then stick with cash but if it’s a decent stable income flow then consider the alternatives with Australian shares and unlisted commercial property and infrastructure still offering attractive yields. 

Source: RBA; AMP Capital

• Sovereign bond investors benefit from falling yields but once they stop falling expect returns to slow again as yields are now very low. Bonds are good portfolio diversifiers though. 

• Listed and unlisted commercial property and infrastructure are likely to benefit from the ongoing “search for yield” and okay economic growth.

• Residential property still has a bit more short-term downside risk but expect flattish prices through calendar 2020 as an upwards drift in unemployment constrains returns.

• Shares are at risk of a correction into the seasonally weak September/October period, but okay valuations, reasonable economic growth and profits and even easier monetary conditions should see the broad trend in shares remain up. 

• Finally, the $A is likely to fall to around $US0.65 by year end as the RBA eases, but with significant short positions, the Fed easing too and the sharp 39% $A fall already seen since 2011 it has become a closer call.

Things to keep an eye on

The key things to keep an eye are: global business conditions PMIs for any deeper slowing; the trade war – this needs to be resolved soon; Middle East tensions around Iran; US political risks; risks around Chinese growth; and Australian unemployment and house prices.

Concluding comments

Returns are likely to be okay over 2019-20 as conditions are not in place for recession. But expect constrained returns – say around 6% for a diversified fund – and bouts of volatility.

Source: AMP Capital 2 July 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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.

This decade has now seen three global growth scares – around 2011-12, 2015-16 and now since last year. Each have been associated with softening business conditions indicators (or PMIs) as indicated in the next chart – see the circled areas.

Source: Bloomberg, AMP Capital

And each have been associated with roughly 20% falls in share markets.

Source: Bloomberg, AMP Capital

All have seen central banks shift towards easing to varying degrees. And in the first two this saw growth indicators pick up again and share markets rebound and clearly move on to new highs. We now seem to be seeing a re-run – at least with respect to central banks.

Central banks go from tightening to neutral to easing

It had looked like a shift from a tightening bias to a neutral/slight easing bias – the US Federal Reserve’s “patient” “pause” and end to quantitative tightening and the European Central Bank’s new round of cheap bank financing (what they call TLTRO) and pushing out its guidance on how long it won’t be raising interest rates for – would do it for the Fed and the ECB this time.

But then the trade war resumed in May adding to a new round of fears about global growth and inflation. And so the ECB and Fed look to be going beyond neutral and back to “whatever it takes”, joining central banks in China, India, Australia, New Zealand and other countries in easing:

• ECB President Mario Draghi has indicated this week that “in the absence of improvement…additional stimulus will be required” and that it “will use all the flexibility within our mandate to fulfil our mandate”. Further ECB easing could include more rate cuts (taking them further into negative territory) and a return to quantitative easing. ECB easing in July or September is looking very likely.

• The US Federal Reserve at its June meeting has clearly shifted in a very dovish direction strongly hinting at interest rate cuts ahead. It downgraded its economic activity assessment from “solid” to “moderate”, it noted falling inflation expectations, it dropped the reference to being “patient” in raising rates, it noted that uncertainties have risen, it lowered its inflation forecasts to below the 2% target and it said it will “closely monitor” the economy, which is often code for moving to easing. While its dot plot of Fed officials’ interest rate expectations still sees rates on hold this year, it’s now line ball with 8 out of 17 officials now seeing a cut of which 7 see two cuts and many of those who have rates on hold see an increased case for a cut and it only requires one of those to shift for the dot plot to move to a cut this year. What’s more, the dot plot now sees a cut next year and it has lowered the long run rate to 2.5%. The dot plot is well down from a year ago when three rate hikes were indicated for this year and one for next year. Overall, absent a clear move towards resolution of trade issues and much better data the Fed looks on track for a cut in July and we continue to see two Fed rate cuts this year.

Source: US Federal Reserve, Bloomberg, AMP Capital

The shift towards monetary easing by the Fed and ECB risks ramping up currency wars again – at least in the minds of commentators – but as we have seen in the past this is just a means of spreading easing globally. And many central banks are already easing anyway.

This is of relevance to the Reserve Bank of Australia, which would prefer to see a lower Australian dollar. The Fed now moving towards easing does make the RBA’s job a little bit harder on this front. However, we still see the RBA easing more than the Fed as the Australian economy is weaker than the US economy and has much higher labour market underutilisation than the US (13.7% of the workforce in Australia versus 7.1% in the US). So, we still see the Australian dollar heading down to around $US0.65 by year end. But Fed easing which will weigh on the $US generally is one reason why the $A is unlikely to crash to past lows.

Presidents Trump and Xi to meet

In the meantime, Presidents Trump and Xi will meet at the G20 meeting in Japan next week. This could lead to a delay in the next round of tariff hikes on China – on the roughly $US300bn of remaining Chinese imports. Ultimately, I expect a deal to resolve the trade dispute because of the threat to growth in both countries (and the risks this poses to Trump’s 2020 re-election prospects). But given the false starts so far it’s not clear this round of meetings will do it just yet.

But it looks like we will get some combination of a trade deal/easier monetary policy or no trade deal and even easier monetary policy.

Implications for investors

The risks are higher this time around given the trade war mess and with the US yield curve inverting – although it does give false signals, has long lags and may be distorted by the threat of more quantitative easing, recently it may more reflect a plunge in inflation expectations as opposed to growth expectations and the normal excesses that precede US recessions aren’t present to the same degree now.

And there will be bumps along the way, i.e.) shares could still go down in response to weak economic data and trade upsets before they go up and we are in a seasonally weak part of the year.

However, for investors it’s always worth remembering the old line “don’t fight the Fed”…or the ECB or RBA, etc. This is because low rates make shares cheaper and can help boost earnings.

While there is scepticism that central banks with the ultra low/negative rates and QE will do the trick, an investor would have made a huge mistake over the last decade betting against them!

So while the risks are higher this time around, my inclination is still to see the current period as just another global growth scare like those in 2011-12 and 2015-16 which will give way to somewhat stronger growth globally and higher share markets on a six to 12 month view.

If you would like to discuss any of the issues raised by Dr Oliver, please call on |PHONE| or email |STAFFEMAIL|.

Source: AMP Capital 20 June 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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.