Olivers Insights

– shares are vulnerable to a bout of volatility but here’s five reasons why the trend will likely remain up

Introduction

From their lows last October, it has been relatively smooth sailing for shares – with US shares up 28%, global shares up 25% & Australian shares up 17% to recent highs. But the last few weeks have seen a rough patch with renewed concerns about interest rates and fears of an escalation in the war around Israel to include Iran (after Iran fired missiles & launched drones at Israel in retaliation for an attack on its consulate in Syria). The obvious issue is how vulnerable are shares? Could the bull market that got under way from the inflation and interest rate lows of 2022 (that has seen global shares rise 42% and Australian shares rise 23%) be over?

The worry list for shares

The bull market since the 2022 lows has been driven by optimism that inflation is falling enabling central banks to lower interest rates at the same time that economic growth has held up better than feared resulting in a sort of Goldilocks – not too hot and not too cold – scenario. But after such strong gains there is now a significant worry list for shares.

• First, share market valuations are stretched. The next chart shows that the risk premium offered by shares over bonds – proxied by the gap between forward earnings yields and 10-year bond yields – has fallen to its lowest since the early 2000s in the US. Australia is a bit more attractive, but the premium is still near the lowest since 2010.

Equity risk premium over bonds

Source: Bloomberg, AMP

• Second, US investor sentiment is at levels that can warn of corrections (red arrows). It’s not a super reliable timing indicator but it is back to levels seen last July prior to the 10% fall in shares into October.

Composite Investor Sentiment vs US shares

Sentiment index based on a composite of surveys of investors and investment advisers and options positioning. Source: Bloomberg, AMP

• Thirdly, after strong gains shares have become technically overbought, but it’s normal to have 5% plus pullbacks every so often.

Periodic share market pull backs are normal

Source: Bloomberg, AMP

• Fourth, uncertainty over when the Fed will start to cut rates has been increased by three worse than expected monthly CPI inflation results in a row as a result of sticky services inflation. This has seen money market expectations for 0.25% rate cuts this year scaled back from 7 starting in March this year to now less than two starting in September. And in Australia they have been scaled back from nearly three starting in June to no rate cut until late this year/early next.

• Fifth, Iran’s retaliatory attack on Israel risks an escalation depending on how Israel responds. This would threaten Iran’s 3% of world oil production and the flow of oil through the Strait of Hormuz (through which roughly 20 million barrels a day or 20% of world oil production flows mainly enroute to Asia). Another sharp spike in oil prices would be a threat to the economic outlook as it could boost inflation again and risk adding to inflation expectations potentially resulting in higher than otherwise interest rates and act as a tax hike on consumers leaving less to spend on other things. Australian petrol prices are already around record levels despite oil prices still being well below their 2022 highs because of the rise in oil prices this year and wider refinery margins. A spike in world oil prices from around $US85/barrel for West Texas to around $US100/barrel would add around $15cents/litre to average Australian petrol prices and push the weekly household petrol bill in Australia to a record $76 up $10 a week from where it was a year ago. This would mean more than $500 less a year for the average family available to spend on other things.

Australian petrol prices versus Tapis oil price

Source: Bloomberg, AMP

• Sixth, the US presidential election threatens to cause volatility particularly if it looks like former President Trump will be returned. His policies to lower taxes would be taken positively by the US share market as they were in 2017, but his talk of raising tariffs (10% on all imports and 60% or more on Chinese imports) threatening higher inflation and an all out trade war would be negative. In his first term he went with tax cuts first (shares surged in 2017) then tariffs (shares slumped in 2018), but he may go with tariffs first if he wins this time.

• Finally, while the global economy has held up well, the risk of recession remains high as the full impact of the monetary tightening since 2022 continues to feed through as things like savings buffers built up through the pandemic are run down. Chinese growth also remains at risk given the ongoing weakness in its property sector.

In short, the combination of stretched valuations, high levels of investor optimism and technically overbought conditions leave shares potentially vulnerable to a further pull back. Geopolitical risks including events in the Middle East, delays to rate cuts and recession risks could provide a trigger.

Five reasons for optimism

However, while shares may be vulnerable a pull back and a period of increased volatility, several considerations suggest that the bull market will remain intact and the trend in shares will remain up.

First, US, global shares and Australian shares are still tracing out a pattern of rising lows and highs from 2022, which is still consistent with a bull market. Similarly, we have yet to see the sort of churning and a declining trend in the proportion of stocks making new highs that normally comes at major share market tops. And while many worry about a new tech bubble (and have done for years) the tech and AI centric stocks of today make real profits so Nasdaq’s PE is around 35 times, not the 100 times plus it was at the tech bubble high in 2000.

Second, while there are areas of weakness, global and Australian economic conditions generally continue to hold up far better than feared. In fact, business conditions according to purchasing manager surveys (PMIs) have improved recently. Consistent with this, profits have generally held up better than expected – while down slightly in Australia they have increased more than expected in the US and March quarter earnings results are likely to show a continuation of this.

Global Composite PMI vs World GDP

Source: Bloomberg, AMP

Third, despite the relative resilience of economic activity inflation has fallen sharply globally (from highs around 8% to 11% to around 3%) and will likely keep falling allowing rate cuts. Although the US has proven a bit stickier in the last three months reflecting its stronger economy, inflation has continued to fall in other countries. And even in the US, cooling measures of labour market tightness are continuing to point to lower services inflation ahead. It’s a similar picture in Australia. So, while rate cuts have been delayed, they are still likely.

Fourth, while Chinese economic growth is not as strong as it used to be it seems to be hanging in there around 5% despite its property slump. While the iron ore price has recently fallen it remains in the same range it’s been in for the last two and a half years and well above many assumptions. Furthermore, the copper price appears to be breaking higher which is normally a sign of strength.

Finally, while geopolitical risks are high, they may not turn out the be as bad as feared – much as was the case last year:

• While the risk of an escalation between Israel and Iran is high – Iran’s retaliation to the attack on its Syrian consulate was similar to its response when General Soleimani was killed by the US in in 2020. It was well flagged, measured and there was minimal damage and designed not to provoke a bigger Israeli counter-retaliation. The US is also pressuring Israel to hold back and of course is motivated by trying to keep oil prices down in an election year. So far so good so markets have not gone into free fall and the oil price has not surged. Hopefully that remains the case, but there is a way to go yet.

• There is still a long way to go in the US election.

• It’s worth bearing in mind the response of shares to past geopolitical events. An analysis by Ned Davis Research on a range of crisis events back to WW2 shows an initial average 6% fall in US shares, but with shares up an average 6%, 9% and 15% over the subsequent 3, 6 and 12 months. Of course, there is a huge range around that!

Implications for investors

We remain of the view that shares will do okay this year as central banks ease. But given the long worry list, global and Australian shares are vulnerable to a correction or at least a more volatile and constrained ride than seen so far this year. For most investors though the key is to recognise that share market pullbacks are healthy and normal, it is very hard to time market moves and the best way to grow wealth is to adopt an appropriate long term investment strategy and stick to it.

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

Source: AMP Capital April 2024

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.

Introduction

It’s four years since the COVID lockdowns started. The pandemic ended when it morphed into the less deadly Omicron variant in late 2021, but just as a sound can reverberate around a room the effects of the pandemic continue to reverberate in economies. Putting aside the long-term health impacts this note looks at 7 key lasting economic impacts.

#1 Bigger government and more public debt

The malaise of the 1970s ushered in “smaller” government in the 1980s in the Thatcher, Reagan, Hawke and Keating era. But the political pendulum started to swing back to “bigger” government after the GFC & COVID has given it another push. Memories of the problems of high government intervention in the 1970s have faded and there is rising support for the view that government is the solution to most problems – via regulation, taxes, spending or education campaigns. The pandemic added to support for “bigger” government: by showcasing the power of government to protect households and businesses from shocks; enhancing perceptions of inequality; and adding support to the view that governments should ensure supply chains by bringing production back home. It’s combining with a desire for governments to pick & subsidise clean energy “winners”.

Public spending as a share of GDP

Source: IMF, Australian Government, AMP

IMF projections for government spending in advanced countries show it settling nearly 2% of GDP higher than pre-COVID levels. The success of governments in protecting households from the worst of the pandemic has also reinforced expectations they would do the same in the next crisis. The pandemic ushered in even bigger public debt just as the GFC did. While high inflation helped lower debt to GDP ratios in 2022 it’s settling at higher levels than pre-pandemic.

Net public debt as a share of GDP

Source: IMF, AMP

Implications – While there may initially be a feel good factor, the long-term outcome of “bigger” government is likely to be less productive economies, lower than otherwise living standards and less personal freedom. It will take time before this becomes apparent though. Meanwhile, higher public debt means: less flexibility to respond with fiscal stimulus to a crisis; a greater incentive for politicians to inflate their way out; and interest payments being a high share of tax revenue.

#2 Tighter labour markets and faster wages growth

In the pre-pandemic years, wages growth was relatively low, & a key driver was high levels of underemployment, particularly evident in Australia. After the pandemic, labour markets have tightened reflecting the rebound in demand post pandemic, lower participation rates in some countries and a degree of labour hoarding as labour shortages made companies reluctant to let workers go. As a result, wages growth increased, possibly breaking the pre-pandemic malaise of weak wages growth.

Australia – unemployment & underutilisation

Source: ABS, AMP

Implications – Tighter labour markets run the risk that wages growth exceeds levels consistent with 2 to 3% inflation.

#3 Reduced globalisation/more geopolitical tensions

A backlash against globalisation became evident last decade in the rise of Trump, Brexit and populist leaders pushing a nationalist gender when the benefits of free trade were being questioned. Also, geopolitical tensions were on the rise with the relative decline of the US and faith in liberal democracies waning resulting in a shift from a unipolar world dominated by the US, to a multipolar world as regional powers (Russia, Iran, Saudi Arabia and notably China) flexed their muscles. The pandemic inflamed both: with supply side disruptions adding to pressure for the onshoring of production; conflict over the source of and management of coronavirus; it heightened tensions between the west and China; and it appears to have added to nationalism and populism. So, the days of global free trade agreements and falling defence spending seem long gone for now. Rather we are seeing more protectionism (eg with subsidies and regulation favouring local production) and increased defence spending.

Implications – Reduced globalisation risks leading to reduced potential economic growth for the emerging world and reduced productivity if supply chains are managed on other than economic grounds. And combined with increased geopolitical tensions resulting in more defence spending it could result in a more inflation prone world than was the case.

#4 Higher prices, inflation and interest rates

A big downside of the pandemic support programs was the surge in inflation. The combination of massive money printing along with a big increase in government payments to households (eg, Job Keeper) resulted in a massive boost to spending once lockdowns were lifted which combined with supply chain disruptions, also flowing from the pandemic, to cause a surge in inflation. Inflation is now starting to come under control as the monetary easing and spending boost has been reversed and supply has improved again but the pandemic has likely ushered in a more inflation prone world by: boosting “bigger” government; adding to a reversal in globalisation; and adding to geopolitical tensions. All of which combine with aging populations to potentially result in more inflation.

Implications – Higher inflation than seen pre-pandemic means higher than otherwise interest rates over the medium term which reduces the upside potential for growth assets like shares and property.

#5 Worse housing affordability

At the start of the pandemic, it was thought the economic downturn and higher unemployment and a freeze in immigration would cause a collapse in home prices and they did initially fall. But not by much as it was quickly turned around by policy measures to support household income, allow a pause in mortgage payments and slash interest rates and mortgage rates to record lows. What’s more the lockdowns and working from home drove increased demand for houses over units and interest in smaller cities and regional locations. As a result, Australian home prices surged to record levels. Meanwhile the impact of higher interest rates in the last two years on home prices was swamped by housing shortages as immigration surged in a catch up. The end result is now record low levels of housing affordability for buyers (who are hit by a double whammy of higher prices relative to incomes – see the next chart – and higher mortgages rates) and renters (who have seen surging rents).

Ratio of home prices to wags and incomes

Source: ABS, CoreLogic, AMP

Implications – Ever worse housing affordability means ongoing intergenerational inequality and even higher household debt.

#6 Working from home likely here to stay

While there has been a return to the office, for many its only two or three days a week. Basically, the lockdowns resulted in a step jump towards working from home (WFH). A UK study of over 2000 firms is indicative. It showed that while around 90.8% of employees were fully onsite in 2018, last year this had fallen to 62.3%, with 30.2% with hybrid (working in the office and at home) arrangements. Similarly, the ABS found 37% of employed people in Australia regularly worked from home. Of course, this masks a huge range with industries with a high proportion of computer-based workers having more hours working at home. And firms expect this to remain the case. There are huge benefits to physically working together around culture, collaboration, idea generation and learning but there are also benefits to working from home with no commute time, greater focus, less damage to the environment, better life balance and for companies – lower costs, more diverse workforces and happier staff. So the ideal is probably a hybrid model. The proportion of workers in a hybrid model may even rise as new firms are quicker to embrace WFH.

Working arrangements for UK employees

Source: K Shah, and others, Managers say working from home here to stay, CEPR

Implications – Less office space demand as leases expire resulting in higher vacancy rates/lower rents, more people living in cities as vacated office space is converted and reinvigorated life in suburbs and regions.

#7 Faster embrace of technology

Lockdowns dramatically accelerated the move to a digital world. Everyone was forced to embrace new online ways of doing things. Many have now embraced online retail, working from home and virtual meetings. It may be argued that this fuller embrace of technology will enable the full productivity enhancing potential of technology to be unleased. The rapid adoption of AI will likely help.

Implications – This has meant a faster embrace of online retailing (up from 7% of retailing pre-pandemic to around 11%) at the expense of traditional retailing, virtual meeting attendance becoming the norm for many (even in the office) and business travel settling at a lower level.

Concluding comments

Perhaps the biggest impact is that the pandemic related stimulus broke the back of the ultra-low inflation seen pre-pandemic. Together with bigger government and reduced globalisation, this means a more inflation-prone world. So, a return to pre-pandemic ultra-low inflation and interest rates looks unlikely. It’s not all negative though – apart from the faster technology uptake, the global and Australian economies have come through the last four years in far better shape than might have been imagined at the start of the lockdowns!

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

Source: AMP Capital March 2024

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.

Introduction

After another 80% or so plunge from its high in 2021 to its low in 2022, Bitcoin has rebounded again to a new record high. The next chart shows Bitcoin’s price relative to the $US since 2010, both on a regular scale and on a log scale to show perspective. From its 2022 low it’s up more than fourfold. This is naturally sparking a new round of questions as to “what’s driving it”? and “should we invest in it”? The answer not simple. Bitcoin attracts extreme views – evangelists on the one hand and agnostics and atheists on the other in contrast to other things where the debate is between bulls and bears. This note looks at what it means for investors.

Bitcoin price in US dollars

Source: Bloomberg, AMP

Bitcoin basics

Bitcoin was invented in 2008 by a person or group named Satoshi Nakamoto and the first “genesis block” was created in 2009. Trying to explain it and cryptocurrencies generally (and the blockchain technology that underpins them) is very complicated! The blockchain basically means that transactions in Bitcoin are verified and recorded in a public ledger (the blockchain) by a network of nodes (or databases) on the internet. New Bitcoins are created as a reward for an intensive computational record keeping process called mining, that groups new transactions into a block which is added to the chain. This requires significant computing power to show what is called “proof of work”. The supply of Bitcoins is limited to 21 million, but because of a process called “halving” which occurs roughly every four years and sees miners compensated by less Bitcoins over time the limit will only be reached around 2140 after which transactions fees will be the only reward for record keeping. Because each node stores its own copy, there is no need for a trusted central authority like a central bank. Bitcoin is also anonymous with funds tied to Bitcoin addresses which require a private key (a long password) to access.

Because of Bitcoin’s limited supply and independence from government it’s seen as a hedge against the debasement of paper currencies (through inflation), the failure of central banks or outright seizure. This has made it attractive to supporters of the Austrian school of economics (which advocates a free market in money), libertarians and anarchists.

As with most technologies, the more that use it the greater its appeal. So news that various groups will accept transactions in it, El Salvador’s 2021 move to allow it as legal tender and various financial organisations allowing customer access via their platforms have aided its growth. The recent approval of Bitcoin ETFs and regulation of it, along with a coming halving (around April) have helped propel the recent surge in its price.

The number of cryptocurrencies blew out to more than 10,000 at the end 2023. Some started as jokes (eg, Dogecoin); some prioritise underpinning smart contracts (like Ethereum); some prioritise transactions (stablecoins that link to the value of a paper currency, eg, Tether); whereas others prioritise being a store of value independent of government (eg, Bitcoin). Of course, there is a lot of overlap. The focus for most remains on Bitcoin which is the oldest and biggest with a near 50% crypto market share.

Reasons for scepticism

Bitcoin enthusiasts see it as the future currency and as a way to riches with rapid price gains since inception seen as confirmation. The counter view is that it’s just another bubble. Reasons for caution are as follows:

• First, it’s not suitable for everyday transactions: Bitcoin transactions are not cheap costing $US9 at present; they can take 8 minutes or so to complete; its price is very volatile (being roughly 13 times greater than US shares, 12 times greater than gold, 26 times greater than the $US and 17 times greater than the $A/$US exchange rate) suffering 80% plunges in price every few years (in 2011, 2013-15, 2017-18 and 2021-22) rendering it unreliable as a short term store of value. Its limited value for use as a means of payment explains why most Bitcoin transactions are by speculators, not merchants. This is not to say Bitcoin may not have a role in some countries – eg, El Salvador – where the government is not trusted and much of the population lives in the US and faces high transaction costs sending money home. But even in El Salvador merchants have not rushed into using Bitcoin and the US, Europe & Australia are not banana republics!

• Second, there may be a role for cryptocurrency in payments systems (either stablecoins or Ethereum that have moved to speed up their processing), but who knows which one it will be and governments are likely to want to provide it themselves. But even here work on Central Bank Digital Currencies has slowed as its not clear people want to use them as we can already do digital transactions instantly & cheaply. There is almost certainly a role for blockchain technology in smart contracts but it’s hard to work out which cryptocurrencies it will be.

• Third, given the uncertainty around the use case for cryptocurrencies and particularly Bitcoin (which is less amenable for smart contracts and payments), it’s very hard if not impossible to value. Unlike property or shares, it is not a capital asset and so does not generate rents or earnings. Unlike most commodities, it is not used to make things. Most of the major positive news about its value (eg the introduction of Bitcoin ETFs) have nothing to do with its fundamental use or value. Some claim it can generate a “yield” if you lend (or stake) your Bitcoin to traders…but this is relying on them actually making money trading crypto currencies. This makes it impossible to put a price on what it’s worth – it could go to $1,000,000 or $100.

• Fourth, cryptocurrencies have had various issues with illegal activity and a lack of integrity. While there have been no cases of the Bitcoin or Ethereum blockchains being hacked, there have been high profile cases of people having their private keys hacked, people losing their holding via crypto exchanges and people simply losing their keys. Cryptocurrencies, notably Bitcoin, are also used for criminal activity. One benefit of using a bank to hold your cash is that it provides protection in the event your account is compromised, or you lose your password. Of course, wild west behaviour can be common at the start of new asset classes which may settle with regulation.

• Fifth, the computing power involved in mining for Bitcoin requires significant electricity, just below that of Denmark. This makes it bad for the environment. A single Bitcoin transaction consumes as much energy as 500,000 Visa transactions. Of course, not all cryptos are the same with those using a “proof of stake” (or proof of ownership of a currency) being less energy intensive (but arguably also less secure).

• Finally, Bitcoin and other crypto currencies face numerous threats from governments. Many governments have been looking at doing CBDCs although progress has been slow. Government’s may also crack down on illicit use of crypto currencies, its energy use and regulation is on the rise – although some see this as strengthening it.

Is Bitcoin “digital gold’?

Bitcoins longevity, its ability to rebound to new highs after each setback (so far), the potential use value from blockchain technology in smart contracts and decentralised finance and progress to greater respectability (with regulation on the rise) suggests Bitcoin and cryptocurrencies can’t simply be dismissed as just another bubble.

However, the question remains that if Bitcoin is not really digital cash and it’s not a capital asset suitable for normal valuation, what is it? The short answer is that it’s something to speculate on. The strongest argument for its existence is that it’s a digital version of gold and is displacing some of the demand that would have gone into gold. For millennia there has been demand for precious metals, like gold. While gold has a fall-back use as jewellery, its use for this does not explain movements in its price. Rather it has value because enough people have faith in it as a store of wealth which is independent of government – and people buy it not because they see jewellery demand going up but if they believe someone will pay a higher price for it. Some call this the “greater fool” theory.

Apart from not having the fall back of jewellery demand and not being able to see and touch, Bitcoin has many of the characteristics of gold – notably limited supply and independence of government. Bitcoin’s resistance to relaxing its proof of work approach has by limiting its ability to be used as cash effectively strengthened its decentralisation and immutability characteristics – making it more gold like (unlike many other cryptos). Like gold bugs it has a similar demand base of people who don’t trust central banks and governments. Which partly explains why Bitcoin resembles “more of a cult than a currency” – with a god (the mysterious Satoshi Nakamoto), a belief set and defined behaviours. Critical amongst the latter is to hodl (buy and “hold on for dear life”) and have faith that new buyers will come along to keep it going to the moon, Of course many might describe this as a giant Ponzi scheme (without the illegality).

Of course, Bitcoin has arguably failed its first big test as a hedge against inflation because as inflation surged in 2022 Bitcoin saw a near 80% fall in value. Gold has also failed as an inflation hedge at various points though, but this has not stopped faith in it. Bitcoin’s rising sensitivity to movements in interest rates suggest its becoming more gold like as rising rates increase the opportunity cost of holding gold or Bitcoin and vice versa for falling rates – like now which has pushed both to record highs.

If Bitcoin is digital gold it could have lots more upside as younger digital savvy buyers favour it over gold. Rough estimates suggest that if Bitcoin were to approach say 25% of the market value of gold its price could rise to $US160,000. Increasing ease of exposure via vehicles like ETF’s could see it pushed beyond that as buyers extrapolate past gains. But just be aware that owes to an assumption that enough have faith. If investors decide to move on to a new next best thing then watch out below!

So what does all this mean for investors?

There are five key things to be aware of when considering an investment in Bitcoin or crypto currencies. First, Bitcoin may have a lot more upside: its very momentum driven so its recent gains will attract new buyers; new demand via ETFs and the next “halving” are giving it a push; it tends to run to a four-year cycle which would run into next year; and displacement of gold may have further to go. So far we are yet to see all the crypto ads like in late 2021/early 2022 which suggests its yet to hit a manic phase. It is worth cautioning though that as more own crypos their returns appear to be slowing (as highlighted by the arrows in first chart).

Second, none of this has anything to do with a fundamental assessment as to Bitcoin’s worth which is impossible. Like gold it depends on faith that more buyers will arrive to push its price ever higher.

Third, it’s hard to work out where to put Bitcoin in a portfolio. It’s too volatile to be a defensive asset like cash. It’s impossible to get any reasonable idea as to what it may be worth or return (unlike shares, property, bonds or regular cash). And since its inception its seen a rising positive correlation with shares (averaging 40% over the last five years) with a beta of 2.3 times shares – so if US shares move 1% it moves by more than twice as much in the same direction – so its a poor diversifier.

Bitcoin vs US Shares

Source: Bloomberg, AMP

Fourth, its extreme volatility means investors should expect a wild ride.

Finally, don’t forget the basic principles of investing – there is no free lunch (high returns mean high risk); past returns are a poor guide to future returns; and if you don’t understand something, don’t invest in it.

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

Source: AMP Capital March 2024

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.

Introduction

Investing can be scary and confusing at times. But the basic principles of successful investing are timeless and quotes from experts help illuminate these. This note revisits a series on insightful quotes on investing I first started a decade ago.

The aim of investing

“How many millionaires do you know who have become wealthy by investing in savings accounts?” Robert G Allen, investment author

Cash and bank deposits are low risk and fine for near term spending requirements and emergency funds, but they won’t build wealth over long periods of time. The chart below shows the value of $1 invested in various assets since 1900. Despite periodic setbacks (see the arrows) shares and other growth assets like property (not shown) provide much higher returns over the long term than cash and bank deposits.

Shares versus bonds & cash over the very long term – Australia

Source: ASX, RBA, AMP

“The aim is to make money, not to be right.” Ned Davis, investment analyst

There is a big difference between the two. But many let their blind faith in a strongly held view (e.g. “there is too much debt”, “aging populations will destroy share returns”, “global oil production will soon peak”, “the IT revolution means this time it’s different”) drive their decisions. They could be right at some point but end up losing a lot of money in the interim.

The investment process

“Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.” Warren Buffet, investor, chair & CEO of Berkshire Hathaway

Unless you really want to put a lot of time into trading, it’s advisable to only invest in assets you would be comfortable holding for the long term. This is less risky than constantly tinkering in response to predictions of short-term changes in value and all the noise around investment markets.

“Investing should be like watching paint dry or watching grass grow. If you want excitement…go to Las Vegas.” Paul Samuelson, economist

Investing is not the same as gambling and requires a much longer time frame to payoff.

“Successful investing professionals are disciplined and consistent and they think a great deal about what they do and how they do it.” Benjamin Graham, investment author, “father of value investing”

Having a disciplined investment process and consistently applying it is critical for investors if they wish to actively manage their investments successfully in the short term.

“Don’t look for the needle in the haystack, just buy the haystack!” John C Bogle, founder of Vanguard

The key insight here is that trying to beat the market by stock picking can be hard and so if you want to grow wealth over time the key is to get a broad exposure to the market and letting compound interest do its job.

The investment market

“Remember that the stock market is a manic depressive.” Warren Buffett

Rules of logic often don’t apply in investment markets. The well-known advocate of value investing, Benjamin Graham, coined the term “Mr Market” (in 1949) as a metaphor to explain the share market. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from euphoria to pessimism. But not only is Mr Market highly unstable, he is also highly seductive – sucking investors in during the good times with dreams of riches and spitting them out during the bad times when all hope seems lost. Investors need to recognise this.

“Markets can remain irrational longer than you can remain solvent.” John Maynard Keynes, economist

A key is to respect the market and recognise that it can be fickle rather than try and take big bets that can send you bust if you get the timing wrong. For example, by heavily selling shares short if you think a crash is about to happen or gearing in too heavily via margin debt when the market is strong. Such approaches can often undo investors and send them bust as they are too dependent on accurately timing the market.

Investment cycles and contrarian investing

“Bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria.” John Templeton, investor

This is one of the best characterisations of how the investment cycle unfolds. It follows that the point of maximum opportunity in terms of prospective return is around the time most investors are pessimistic and bearish and the point of maximum risk is when most investors are euphoric and bullish, but unfortunately many don’t realise this because it involves going against the crowd.

“The four most dangerous words in investing are: ‘this time it’s different’.” John Templeton

History tells us that that there are good times and bad and assuming that either will persist indefinitely is a big mistake. Whenever you hear talk of “new paradigms”, “new eras”, “new normals” or “new whatevers” it’s usually getting time for the cycle to go in the other direction.

“History doesn’t repeat but it rhymes.” Often attributed to Mark Twain (although it’s not sure he actually said it), author

No two cycles are the same, but they do have common elements which make them rhyme. In upswings investment markets are pushed to the point where the relevant asset has become overvalued, over loved (in that everyone is on board) and over bought and vice versa in downturns.

Recognising these common elements is necessary if you are to get a handle on cyclical swings in investment markets.

“If it’s obvious, it’s obviously wrong.” Joe Granville, investment author

This doesn’t apply to everything (e.g. if it is obviously sunny outside according to the usual definition, then it is!), but investing can be perverse. When everyone is saying “it’s obvious that the recession will continue” or “it’s impossible to see a recession as things are obviously good” then maybe the crowd is already on board and the cycle will soon turn.

,b>“I will tell you how to become rich…Be fearful when others are greedy. Be greedy when others are fearful.” Warren Buffett

This is another great quote on contrarian investing that follows on from those above.

“Sell in May and go away, buy again on St Leger’s Day.” Anon

Shares have long been observed to have a seasonal pattern that sees strength from November through to May and then relative weakness through to around October. This can be seen in seasonal indexes for US and Australian shares in the next chart. (St Leger’s Day in terms of the UK horse race on the second Saturday in September may be a bit early, but not to worry!)

The seasonal pattern in US and Australian shares

Source: Bloomberg, AMP

The reasons vary and relate to tax loss selling associated with a September tax year end for US mutual funds, a wind down in new equity raisings around December/January, New Year cheer and the investment of bonuses, but may have its origins in crop cycles. The point is that buying in May, might not be the best time, nor selling in September or October.

Investor pessimism

“To be an investor you must be a believer in a better tomorrow.” Benjamin Graham

This is a pre-requisite. If you don’t believe the bank will look after your term deposits, that most borrowers will pay back their debts, that most companies will see rising profits over time, that properties will earn rents etc then there is no point investing. This is flippant but true – to be a successful investor you need a favourable view of the future.

“More money has been lost trying to anticipate and protect from corrections than actually in them.” Peter Lynch, investor, fund manager

Preserving capital is important, but this can be taken too far and often is in the aftermath of bad times with the result that investors end up so focused on trying to avoid capital losses in share markets that they miss the returns they offer.

“I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.” J.S. Mill, economist

It invariably seems that higher regard is had for pessimists predicting disaster than for optimists seeing better times. As the US economist JK Galbraith once observed “we all agree that pessimism is a mark of a superior intellect.” And we all know that bad news sells. There may be a neurological reason for this as the human brain evolved in the Pleistocene era when the key was to dodge woolly mammoths and sabre tooth tigers, so it has been hard wired to be always on guard and so naturally attracted to doom sayers. But for investors, giving too much attention to pessimists doesn’t pay over the long term.

Risk

“There is nothing riskier than the widespread perception that there is no risk.” Howard Marks (I think), investor, co-founder of Oaktree Capital

Many like to measure risk by looking at measures of volatility, but the riskiest time in markets is invariably when the common view is that there is no risk for it’s often around this point that everyone who wants to invest has already done so leaving the market vulnerable to bad news.

Debt

“It’s not what you own that will send you bust but what you owe.” Anon

Always make sure that you don’t take on so much debt that it may force you to sell all your investments and potentially send you bust, just at the time you should be buying.

The right mindset for an investor

“The investor’s chief problem and even his worst enemy is likely to be himself.” Benjamin Graham

This may sound perverse as surely it is events which drive investment markets down and destroy value. But the trouble is that events and bear markets are normal. Rather what causes the greatest damage is our reaction to events – selling after markets have already plunged and only buying back in after euphoria has returned. Smart investors have an awareness of their psychological weaknesses and their tolerance for risk and seem to manage them.

“You get recessions, you have stock market declines. If you don’t understand that’s going to happen then you’re not ready, you won’t do well in the markets.” Peter Lynch

If you can’t handle volatility associated with investment markets, then either they are not for you or you should just take a long term approach and leave it to someone else to manage and advise on the investment of your funds.

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

Source: AMP Capital March 2024

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.

Introduction

Share markets have pushed up to record highs this year, but can it continue? For some time now we have been monitoring seven key charts that are critical for the investment outlook. This note provides an update.

Chart 1 – global business conditions PMIs

A big driver of how shares perform this year will be whether major economies including Australia slide into recession and, if so, how deep that is. While it’s not our base case we would concede that the risk of a mild recession is still high given the big monetary tightening since 2022 and it’s noteworthy that the UK and Japan have already fallen into a technical recession with Europe stagnating. But even if the US and Australia slide into recession too at least a deep recession should be avoided as we have not seen the sort of spending excesses that often precede deep recessions. Global business conditions indexes (PMIs) – which are surveys of purchasing managers at businesses – will be a key warning indicator.

Global Composite PMI vs World GDP

Source: Bloomberg, AMP

Right now they are soft but at levels consistent with okay growth.

Chart 2 (and 2b) – inflation

A lot depends on what central banks do with interest rates and inflation is still the key here. While the ride has been bumpy lately and will likely remain so, the good news is that inflation in major countries is well down from its highs of 8 to 11% and now around 3 to 4%. So central banks are likely at the top on interest rates with many (the Fed and ECB) starting to debate when to cut rates.

Our US Pipeline Inflation Indicator has picked up slightly this year partly reflecting higher global shipping costs but these appear to be stabilising and the Indicator appears to reflect normal volatility around the 2% Fed target level and so it’s still consistent with lower US inflation. Services inflation remains sticky but is likely to slow reflecting cooling wages growth and rising productivity growth. We expect the Fed to start cutting rates in June.

AMP Pipeline Inflation Indicator

Source: Bloomberg, AMP

Australian inflation is lagging the US by 6 months, but our Australian Pipeline Inflation Indicator is continuing to trend down pointing to a further fall in inflation. While the RBA retains a mild tightening bias awaiting “sufficient confidence that inflation [will] return to target in a reasonable time frame” our assessment is that the cash rate has peaked and that the RBA will start cutting from around mid-year.

Australia Pipeline Inflation Indicator

Source: Bloomberg, AMP

Chart 3 – unemployment and underemployment

Labour market tightness remains critical as it determines wages growth which is the biggest component in most business costs. Tight labour market conditions post the pandemic have seen wages growth pick up and this is now the main driver of sticky service sector inflation. The risk is that high wages growth locks in high inflation making it harder to get inflation back down without a deep recession. However, while labour markets remain tight – evident in still low unemployment – they appear to be cooling with falling job openings and hiring plans and a gradual rising trend in unemployment and underemployment now evident in both the US and Australia. As a result, wages growth looks to have passed the peak in the US, Europe and UK and is likely at the peak in Australia. However, central banks including the RBA would like to see more evidence that this is the case and so labour market underutilisation will be watched closely.

Labour market underutilisation rates

Source: Bloomberg, AMP

Chart 4 – longer term inflation expectations

The 1970s tells us the longer inflation stays high, the more businesses, workers and consumers expect it to stay high and then they behave in ways which perpetuate it – in terms of wage claims, price setting and tolerance for price rises. The good news is that short term inflation expectations have fallen sharply, and longer-term inflation expectations remain low. This is very different from 1980 when US inflation expectations were around 10% and deep recession was required to get inflation back down.

US University of Michigan Consumer Inflation Expectations

Source: Macrobond, AMP

Chart 5 – earnings revisions

Consensus US and global earnings growth expectations for this year are running around 8%, whereas Australia is expected to see a 5% or so fall in earnings this financial year.

Earnings Revision Ratio

Source: Reuters, AMP

The main risk is a recession resulting in an earnings slump like those seen in the early 1990s, 2001-03 in the US and 2008 but recently revisions to earnings expectations have been around average.

Chart 6 – the gap between earnings and bond yields

Since 2020, rising bond yields weighed on share market valuations. As a result, the gap between earnings yields and bond yields (which is a proxy for shares’ risk premium) has narrowed to narrowed to its lowest since the GFC in the US and Australia. Compared to the pre-GFC period shares still look cheap relative to bonds, but this is not the case compared to the post GFC period suggesting valuations may be a bit of a constraint to share market gains given uncertainties around interest rates, economic and earnings growth and various geopolitical issues. Australian share valuations look a bit more attractive than those in the US though helped by a higher earnings yield (or lower PEs). Ideally bond yields need to decline.

Equity risk premium over bonds

Source: Reuters, AMP

Chart 7 – the US dollar

Due to the relatively low exposure of the US economy to cyclical sectors (like manufacturing) and the high use of US dollar denominated debt, the $US is a “risk-off” currency. It tends to go up when there are worries about global growth and down when the outlook brightens. An increasing $US is also bad news for those with $US denominated debt in the emerging world. So, moves in it bear close watching as a key bellwether of the investment cycle. 2022 saw a surge in the $US with safe haven demand in the face of worries about recession, war and aggressive Fed tightening. Since its high it has fallen back which is a positive sign – but the decline has stalled over the last year suggesting a degree of caution. A further downtrend in the $US would be a positive sign for investment markets this year, whereas a sustained new upswing would suggest they may be vulnerable. So far though it looks stuck, which also partly explains the softness in the $A which is a cyclical currency.

The $A and the $US v major currencies

Source: Bloomberg, AMP

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

Source: AMP Capital February 2024

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.

Introduction

Last year shares climbed a “wall of worry” as inflation fell leading to prospects for lower interest rates ahead. But can it continue? After participating in a webinar on the investment outlook this note takes a look at the main questions investors have in a simple Q&A format.

Are high interest rates working to cut inflation?

The evidence of this is overwhelming. Inflation has fallen from highs around 8 to 11% in major developed countries, including Australia, to now around 3-4%. This reflects a combination of the improved supply of goods and services as well as cooler demand (evident in cooling economic growth and slower labour markets) and higher interest rates have been a key driver. There has further to go and it will be bumpy as we saw with the January US CPI, but central banks are likely to start cutting interest rates in the June quarter with the Fed and ECB expected to cut 5 times this year (by 0.25% each time) and the RBA 3 times.

Global Inflation

Source: Bloomberg, AMP

But aren’t high rates unfair? Isn’t there a better way?

Relying on higher interest rates is not the only or fairest way to slow inflation because it particularly hits 25 to 45 year olds with big mortgages. Ideally the medicine should also involve a mix of tighter fiscal policy (tax hikes and public spending cuts) and structural policies to boost productivity and hence the supply of goods and services. But it’s clear governments don’t want to tighten fiscal policy because it’s not politically popular (if anything they want to provide “cost of living relief”) and supply side policies take time to work and aren’t popular these days either. So after the experience of high inflation in the 1970s, it was concluded that central banks are best placed to control inflation and they really only have one main tool – i.e. higher interest rates.

What is the risk of recession?

Global and Australian growth has held up far better than expected a year ago helped by a combination of savings buffers built up through the pandemic, reopening boosts, resilient labour markets and in Australia far stronger than expected population growth (which has masked a per capita recession). Consequently, while global and Australian growth has slowed it has remained positive. Our base case is for a further softening in growth but for it to remain positive ahead of lower interest rates providing a boost from later this year.

However, the risk of recession remains high after what has been the biggest rate hiking cycle since the 1980s and this being reflected in inverted yield curves (short term rates above long term bond yields), falling leading economic indicators and tighter bank lending standards all of which warn of the high risk of recession particularly as some of last year’s supports like saving buffers, reopening demand and very strong population growth in Australia start to fade. So we put the risk of recession at 40% in Australia and the US. Europe is already close to recession having been stagnant GDP over the last year. China is also a risk – see below. Fortunately, if a recession does occur it’s likely to be mild as most countries have not seen a boom in consumer spending, business investment or housing investment that needs to be unwound.

Will Taylor Swift shake off Aussie consumer gloom?

For the next two and half weeks it will certainly help for the roughly 630,000 concert goers and the retailers, hotels, and food outlets that will get some extra spending. If each attendee spends a total of $900 on average (which sounds generous) it will mean spending of $570m which is a lot of money. But it won’t take us out of the woods because Taylor is an import and so maybe only $400m of that will stay in the country. And $400m is just 0.02% of our economy. And as Governor Bullock implied it will likely come at the expense of other things. So maybe a two-week blip and then back to where we were. In other words, if you are all excited about Swiftonomics you need to calm down. That said I am excited about finally getting a ticket…even if it is one of the partially obscured seats.

What happened to US bank problems?

Quick action by US and Swiss authorities settled the banking problems seen last year and the tightening in lending standards associated with it has eased. In the US, the Fed’s December quarter bank lending survey showed less tightening in lending standards and loan demand becoming less negative, which suggests an easing in regional banking problems. But with monetary policy still tight and ongoing falls in commercial property values the problems could return – as seen with New York Community Bank and Japan’s Aozora Bank recently. So, it’s worth watching.

Loan Officer Surveys – Net % of Domestic
Respondents Tightening Standards

Source: Bloomberg, AMP

What about China and Evergrande’s liquidation?

China faces three big challenges: a falling population; trying to get consumer spending to take over as a key growth driver from capital investment and the property sector; and political tensions with the West. Taken together they imply a slowdown in China’s long term growth rate.

In the near term the property slump continues. But a Hong Kong court ordering the liquidation of property developer Evergrande is not going to trigger a Lehman moment that will turn China’s property downturn into a global crisis. First, it’s not a big surprise. Second, it’s doubtful that PRC courts will allow liquidators to sell Evergrande assets in China in a fire sale given the Chinese Government’s focus on protecting home buyers and completing more homes. Finally, the Chinese Government will continue offset any impact from the property downturn and Evergrande’s woes on the economy with property and economy wide stimulus measures.

Overall, we see Chinese growth as being constrained with downside risks – but it’s likely to be around 4.7% this year with the Government providing just enough stimulus. It’s hard to have a strong view on Chinese shares but their bear market may be nearing an end. After having nearly halved since October 2021 they are now undervalued (with a forward PE below 10x), oversold & underloved and due at least a further bounce.

How big a threat are geopolitical risks?

Geopolitical risk is high this year: with half the world’s population seeing elections; the US looking like another divisive Biden v Trump election on the way; tensions with China remaining high; the war in Ukraine continuing; and an ongoing escalation in the Israel/Hamas war to include other countries in the region including Houthi rebels disrupting Red Sea shipping with a risk that further escalation could threaten global oil supplies. Trying to quantify what these mean for the global economy and investment markets is impossible – as we saw last year geopolitical risks turned out to be less threatening. But odds are that they will contribute to a more constrained and volatile ride in investment market this year.

What about the US election?

A Trump victory could lead to considerable global uncertainty given his style of governing and trade policies but this may not be immediately apparent because the US election has a long way to go yet and both Biden and Trump could drop out, US presidential election years historically see average share market returns and after the 2016 Trump victory shares rallied with 2017 being a strong year because of Trump’s pro-business policies (the trade war didn’t start till 2018).

What about share valuations?

Shares are not cheap with above average forward PE’s and a lower risk premium on offer over bonds than seen over the last decade – which leaves shares a bit vulnerable given the high level of economic and geopolitical risks which will likely contribute to volatility. However, the risk premium is a bit higher than it was last October thanks to lower bond yields and shares should be okay providing central banks cut interest rates this year and the profit outlook improves.

Equity risk premium over bonds

Source: Bloomberg, AMP

What will happen to bond yields if interest rates fall?

If as we expect economic growth slows, inflation falls further and central banks cut interest rates then bond yields are likely to fall a bit this year. Of course if there is a recession, central banks are likely to cut interest rates more than we are allowing and bond yields will likely fall a lot pushing up bond values and see bonds be a good portfolio diversifier.

Will high levels of global debt de-rail things?

Global debt is now estimated to be around $US310trn or 340% of global GDP. This clearly poses a threat if bond yields resume rising which will be a big problem in emerging countries with $US debt but will also ramp up pressure for fiscal austerity in rich countries as debt interest payments rise. However, much of the rise in debt since the pandemic has been in the public sector where the risk of major problems is less (as governments can raise taxes), and most advanced country governments borrow in their own currency heading off foreign exchange crises.

How close is America to breaking?

It’s easy to look at the political polarisation, inequality and rising public debt in the US and get depressed. Then again people have long been looking at the US and getting depressed, but it seems to keep on keeping on. It has a very dynamic economy, its productivity growth is impressive, it continues to have world beating tech companies, its growth rate has been surprising on the upside, and it still has very low unemployment.

Why are rich countries running high immigration?

Part of this is a catch up after low immigration in the pandemic but it has been a bit out of control and does run the risk of a political backlash as it accentuates already expensive housing.

When will the $A get back to $US0.80-$US1?

We see upside in the $A to $US0.72 as the Fed cuts rates more than the RBA, commodity prices remain in a long-term upswing and the $US falls on hopefully reducing global uncertainty. However, a move much beyond that looks unlikely given slowing growth in China and geopolitical risks.

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

Source: AMP Capital February 2024

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.