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The trade war is back – what went wrong, what it means for share markets and Australia

Posted On:May 14th, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

After taking a back seat over the last six months as negotiations appeared to make progress the US/China trade war is back on with the President Trump – “tariff man” – ramping up tariffs on Chinese imports again and threatening more and China moving to retaliate. This note takes a simple Q & A approach to the key issues.

 

What is

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After taking a back seat over the last six months as negotiations appeared to make progress the US/China trade war is back on with the President Trump – “tariff man” – ramping up tariffs on Chinese imports again and threatening more and China moving to retaliate. This note takes a simple Q & A approach to the key issues.

 

What is a trade war?

A trade war is where countries raise barriers to trade with each other (such as tariffs or quotas on imports or subsidies to domestic industries) usually motivated by a desire to “protect” domestic jobs often overlaid with (or dressed up by) “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 of 1930 where average 20% tariff hikes on US imports led to retaliation by other countries and contributed to a plunge in world trade.

What is so good about free trade and wrong with protectionism?

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.

It often strikes me as perverse that some want to protect local industry, but they don’t buy local themselves. The experience of heavily protecting Australian industry in the post WW2 period was that it was just leading to higher prices and lower quality products and Australians were voting with their wallets to buy better value foreign made goods anyway. We and many other countries started to realise this in the 1980s and so cut protection. We might have protected lots of manufacturing jobs if we stayed at the levels of protection of 45 years ago, but we would have become a museum piece as would the US.

Fortunately, despite the loss of jobs in manufacturing (from 25% of the workforce in 1960 to around 8% now) other jobs have come along in the services sector where Australia’s and America’s relatively highly-skilled but highly-paid workforce have a comparative advantage compared to workers in less developed countries.

In short, if you want to support your country’s products buy them, but trade barriers don’t work.

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?

While it’s been feared at times that Trump was willing to get into trade wars with any country that the US has a trade deficit with his main focus is China. 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.

Where are we now?

Fears of a global trade war were 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 to March 1 in response to trade talks and then was delayed further as the talks made progress.

Last year’s tariff increases took the weighted average tariff across all imports to the US from around 1.8% to around 3% which took the US above the developed country average of around 2% but not dramatically so.

However, 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% tariff hikes of 1930.) See the next chart.

Average weighted tariff rate across all products


click to enlarge

Source: World Bank, Deutsche Bank Research

Along the way China has retaliated with a 10% tariff on $US60bn of imports from the US and in response to the latest move has announced this will be raised to as high as 25%. Its retaliation has been less than proportional partly reflecting lower imports from the US but it has also so far refrained from retaliating via other means such as selling US bonds (possibly because it could just depress the $US) and making life tougher for US companies.

At the same time the US is considering auto tariffs after a report lodged in February. A decision is due by May 18 but could be delayed given talks with the US and Japan.

What happened to the US/China trade talks?

Up until a week or so ago the trade talks were reportedly going well – with key elements reportedly agreed and only disagreement remaining about when tariffs would be removed and enforcement. But President Trump’s May 5 tweets announcing a resumption of tariff hikes with more to come was supposedly in response to China back tracking on what had been agreed. There has been much speculation about what happened: maybe negotiators agreed more than was politically acceptable to China’s leadership, maybe China saw it as two big a step down given Trump’s often perceived insulting approach, maybe they misjudged what he would agree to, maybe Trump’s resort to threats is just more “Art of the Deal” stuff to get what he wants and to prove that he is standing up for his base. Who knows for sure! But it’s likely that both sides may have become emboldened by better economic data and share markets this year, and so have decided to take risks again. Ongoing or rising tensions around Huawei, North Korea, Iran (with the US ending sanction waivers on China importing Iranian oil) and Taiwan are probably not helping the issue either.

What will be the economic impact?

Contrary to President Trump’s assertions China is not paying the tariffs being collected on imports from China. China will ultimately suffer if there is less demand for its exports but most of the cost is borne by US businesses or passed on to consumers. Taxing all US imports from China at 25% would be a big deal compared to last year’s tariffs and see the impact shift to largely consumer goods as opposed to industrial and intermediate goods in the first tariff rounds. Which in turn could add around 0.2% to core inflation and detract up to 0.75% from US GDP particularly as investment gets hit in response to uncertainty about supply chains. Given the flow on to slower global growth (which is where Australia could be impacted), hopefully the latest tariff hikes will be short-lived and the extra tariffs will be avoided.

What is the most likely outcome?

Our base case remains that the US and China will ultimately reach a deal to resolve the issue before too much damage is caused – once both sides refocus on the economic costs of slower growth, higher consumer prices and potentially rising unemployment. This is particularly relevant for President Trump given his desire to get re-elected next year as rising prices at Walmart and rising unemployment will drive a backlash. However, things could still get worse before they get better.

Why have share markets reacted relatively calmly? Can it last?

Since President Trump’s tweets announcing a resumption of the trade war, US and global shares have fallen about 4.5% and Australian shares have lost 1.7%. Chinese shares have been hit harder reflecting their greater vulnerability. But overall the falls have been benign compared to last year’s sharp falls (and they followed a sharp rebound so far this year). This likely reflects a combination of: investor optimism of a deal to resolve the issue; last years’ experience where the worst case fears of tariff hikes did not come to pass; hopes for more Chinese economic stimulus to offset the negative impact; and perceptions that the Fed is more supportive of growth now compared to last year when it was more worried about inflation. Australian shares have also been helped by their high exposure to defensive high yield stocks and ongoing strength in the iron ore price.

While our view remains that a deal will ultimately be reached and that this will see shares end the year higher than they are now, the risks have ramped up again after the setback in the talks and the associated loss of trust on both sides so investors need to allow that the trade war could again get worse before it gets better risking further short-term weakness in share markets. In fact, sharper share market falls may be needed to remind the US and China of the need for a deal.

What does it all mean for Australia?

Fortunately, Australian’s aren’t having to pay higher taxes on imports like Americans, but the main risk is that we are indirectly affected if the trade war is not quickly resolved and this drags down global growth weighing on demand for our exports leading to unemployment pushing higher than our 5.5% forecast for year end. The risk of this adds in turn to pressure on the RBA to cut interest rates, although we think they will do that anyway.

What to watch?

Key to watch for will be a continuation of trade talks. So far, the indications are mixed. The June 28 G20 meeting in Tokyo may be critical in terms of providing an opportunity for Trump and Xi to get negotiations back on track, with Trump saying that they will meet.

Please call us on |PHONE if you would like to discuss.

 

Source: AMP Capital 13 May 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.

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Seasonal patterns in shares – should we “sell in May and go away” and what about renewed trade war fears?

Posted On:May 06th, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

Since late last year share markets have rebounded with US shares up 25% to their recent high, global shares up 22% and Australian shares up 17% as last year’s worries about tightening monetary policy led by the Fed, global growth and trade wars have faded to varying degrees. Following such a strong rebound some have said that maybe it’s now

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Since late last year share markets have rebounded with US shares up 25% to their recent high, global shares up 22% and Australian shares up 17% as last year’s worries about tightening monetary policy led by the Fed, global growth and trade wars have faded to varying degrees. Following such a strong rebound some have said that maybe it’s now time to “sell in May and go away” given the old share market saying. Of course, this is a reference to seasonal pattern in shares.

It’s all seasonal

Seasonal patterns have long been observed in equity markets. Yet, despite the potential they provide for astute investors to profit from them – and in so doing arbitrage them away – they seem to persist. The “January effect” has perhaps been the most famous, where January typically provides the best gains for US stocks, but anticipation of it in recent years has seen it morph into December such that it has become the strongest month of the year for US shares. However, it is part of a broader seasonal pattern, which is positive for shares from around October/November to around May and then weaker from May. This can be seen in the seasonal pattern of average monthly changes in US share prices (using the S&P 500 index) shown in the next chart.

Source: Thomson Reuters, AMP Capital

The key factor behind the seasonal pattern is the regular ebb and flow of investor demand for shares relative to their supply through the course of the year. In the case of US shares the principal drivers of the seasonal pattern are:

  • investors and mutual funds selling losing stocks to realise tax losses (to offset against capital gains) towards the end of the US tax year in September. This is also normally at a time when capital raisings are solid; 

  • investors buying back in November and December at a time when capital raisings wind down into year-end; 

  • which then combines with the tendency for investors to invest bonuses early in the new year, new year optimism as investors refocus on the future, put any disappointments of the past year behind them and down play bad news all at a time when capital raisings are relatively low. The illiquid nature of investment markets around late December and January (due to holidays) makes these effects all the more marked.

The net effect has been that the US share market is relatively weak around the September quarter, strengthens into the new year with January often being the strongest month and then remains solid out to around May by which point new year optimism starts to fade a bit. As noted earlier, in recent years anticipation of the “January effect” has caused buying to pull it forward into December. Calendar year end window dressing by fund managers may have also added to this tendency. Since 1985 US share prices for December have had an average monthly gain of 1.5% monthly gain. This compares to an average monthly gain across all months of 0.76%. By contrast August and September are the weakest months with falls on average.

Consistent with the influence of the US share market on global markets generally, along with specific local influences, this seasonal pattern is also discernible in other countries, including Europe, Asia and Australia. In Australia the January or now December effect is not as dominant as in the US, possibly because tax effects are not relevant in Australia around that time of year. The seasonal pattern for the Australian stock market is shown in the next chart. While the strongest months of the year in the Australian market are April and July, December also tends to provide above average gains. Since 1985, Australian share price gains in December have averaged 2.1%, with April averaging 2.3% and July 2.2%. This compares to an average monthly gain for all months of 0.61%. (Note that the lower average monthly gain for all months in Australia compared to the US partly reflects the fact that a greater proportion of the return from Australian shares comes from a higher dividend yield compared to the US.)

Source: Thomson Reuters, AMP Capital

In Australia, tax loss selling may explain the weakness often observed in May and June and the strength often seen in July, given that the Australian tax year ends in June.

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

As a result of this monthly behaviour a typical pattern through the year is for stocks to strengthen from around October/November until around May (or July in Australia’s case) of the next year and then weaken into September/October (and November for Australian shares). This seasonal pattern can clearly be seen in the following chart which shows an index for US and Australian shares and the month to month pattern of share prices after the longer term fundamentally driven trend is removed.

Source: Thomson Reuters, AMP Capital

Breaking the year into two six-month periods also reflects this pattern. Since 1970, the average total return (ie, from price gains and dividends) from US shares from end November to end May is more than double that from end May to end November. A similar pattern exists in Australia, Asia and for global shares as shown in the next chart.


Source: Thomson Reuters, AMP Capital

While the US influence may be playing a big role in the continuation of this seasonal pattern in shares, the old saying in its full form of “sell in May and go away, buy again on St Leger’s Day” has its origins in the UK as St Leger’s Day is a UK horse race on the second Saturday in September suggesting that the seasonal pattern in shares dates back to the UK. In fact it may have its origins in crop cycles with grain merchants having to sell their shares at the end of the northern summer to buy the summer crop (which depresses shares around August/September) and they then bought back in after they sold the crop on to mills. Of course, that’s not so relevant to today. So, the explanation discussed earlier explains why it likely persists.

Qualifications

There is no guarantee that seasonal patterns will always prevail. They can be overwhelmed when contrary fundamental influences are strong, so they don’t apply in all years. For example, while Decembers are on average strong months in the US and Australia that wasn’t the case last December and not all years see weakness in the May to October/November period. However, they nevertheless provide a reasonable guide to the monthly rhythm of markets that investors should ideally be aware of. In simplistic terms, around May (and July in Australia) is perhaps not the best time to be piling into shares and around September to November is not the best time to be selling them.

What about now?

For the year as a whole we see shares doing okay. Valuations are okay helped in part by very low bond yields, global growth is expected to improve into the second half of the year and monetary and fiscal policy has become more supportive of markets all of which should support decent gains for share markets through 2019 as a whole.

However, from their December lows, shares – globally and in Australia – have run hard and fast and so are vulnerable to a short-term correction. Still soft global growth indicators and the latest flare up regarding US and China trade could provide triggers.

President Trump’s latest threat to increase the tariff on $US200bn of imports from China from 10% to 25% (delayed from January) and his threat to look at taxing remaining imports from China too suggest that the latest round of US/China trade talks in China did not go as well as planned and looks aimed at putting pressure on China to resolve the talks. Ultimately, we remain of the view that there will be a resolution given the economic damage not doing so would cause, particularly ahead of Trump’s re-election bid next year (US presidents don’t get re-elected when unemployment is rising). But the latest threat adds to the risk of market weakness in the short term, particularly if China delays a trip to the US to continue the negotiations in response to Trump’s threat.

In Australia, uncertainty around the impact of various tax increases if there is a change of Government in the upcoming Federal election could cause short-term nervousness for the Australian share market.

Of course, long term investors should look through all this.

Please call us on |PHONE| if you would like to discuss.

 

Source: AMP Capital 06 April 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.

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Inflation undershoots in Australia – why it’s a concern, is the RBA running out of ammo & what it means for investors?

Posted On:Apr 29th, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

Surprisingly weak Australian inflation has led to expectations the Reserve Bank will soon cut rates. But what’s driving low inflation? Is it really that bad? Why not just lower the inflation target? Will rate cuts help?And what does it mean for investors?

Inflation surprises on the downside again

Australian inflation as measured by the CPI was flat in the March quarter and

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Surprisingly weak Australian inflation has led to expectations the Reserve Bank will soon cut rates. But what’s driving low inflation? Is it really that bad? Why not just lower the inflation target? Will rate cuts help?And what does it mean for investors?

Inflation surprises on the downside again

Australian inflation as measured by the CPI was flat in the March quarter and up just 1.3% over the last year. Sure, the zero outcome in the quarter was partly due to a nearly 9% decline in petrol prices and they have since rebounded to some degree. And high-profile items like food, health and education are up 2.3%, 3.1% and 2.9% respectively from a year ago. But against this price weakness is widespread in areas like clothing, rents, household equipment & services and communications.


Source: ABS, AMP Capital

But why the focus on “underlying inflation”?

The increase in the CPI is the best measure of changes in the cost of living. But it can be distorted in the short term by often volatile moves in some items that are due to things like world oil prices, the weather and government administered prices that are unrelated to supply and demand pressures in the economy. So, economists and policy makers like the RBA focus on what is called underlying inflation to get a handle on underlying price pressures in the economy so as not to jump at shadows. There are various ways of measuring this ranging from excluding items like food and energy as in the US version of core inflation, to excluding items whose prices are largely government administered to statistical measures that exclude items that have volatile moves in each quarter (as with the trimmed mean and weighed median measures of inflation). Right now they all show the same thing ie that underlying inflation is low ranging between 1.2% to 1.6% year on year. The average of the trimmed mean and weighted median measures is shown in the previous chart and is averaging 1.4%. The common criticism of underlying inflation that “if you exclude everything there is no inflation” is funny but irrelevant. The point is that both headline and underlying inflation are below the RBA’s 2-3% target and this has been the case for almost four years now.

What is driving low inflation?

The weakness in inflation is evident globally. Using the US definition, core (ex food & energy) inflation is just 1.8% in the US, 0.8% in the Eurozone, 0.4% in Japan and 1.8% in China.


Sources: Bloomberg, AMP Capital

Several factors have driven the ongoing softness in inflation including: the sub-par recovery in global demand since the GFC which has left high levels of spare capacity in product markets and underutilisation of labour; intense competition exacerbated by technological innovation (online sales, Uber, Airbnb, etc); and softish commodity prices. All of which has meant that companies lack pricing power & workers lack bargaining power.

Why not just lower the inflation target?

Some suggest that the RBA should just lower its inflation target. This reminds me of a similar argument back in 2007-08, when inflation had pushed above 4%, that the RBA should just raise its inflation target. Such arguments are nonsense. First, the whole point of having an inflation target is to anchor inflation expectations. If the target is just raised or lowered each time it’s breached for a while then those expectations – which workers use to form wage demands and companies use in setting wages and prices – will simply move up or down depending on which way inflation and the target moves. And so inflationary or deflationary shocks will turn into permanent shifts up or down in inflation. Inflation targeting would just lose all credibility.

Second, there are problems with allowing too-low inflation. Most central bank inflation targets are set at 2% or so because statistical measures of inflation tend to overstate actual inflation by 1-2% because statisticians have trouble actually adjusting for quality improvements and so some measured price rises often reflect quality improvements. In other words, 1.3% inflation as currently measured could mean we are actually in deflation. And there are problems with deflation.

What’s wrong with falling prices (deflation) anyway?

Deflation refers to persistent and generalised price falls. It occurred in the 1800s, 1930s and the last 20 years in Japan. Most people would see falling prices as good because they can buy more with their income. However, deflation can be good or bad. In the period 1870-1895 in the US, deflation occurred against a background of strong growth, reflecting rapid technological innovation. This can be called “good deflation”. However, falling prices are not good if they are associated with falling wages, rising unemployment, falling asset prices and rising real debt burdens. For example, in the 1930s and more recently in Japan. This is “bad deflation”. Given high debt levels, sustained deflation could cause big problems. Falling wages and prices would make it harder to service debts. Lower nominal growth will make high public debt levels harder to pay off. And when prices fall people put off decisions to spend and invest, which could threaten economic growth. This could risk a debt deflation spiral of falling asset prices and falling incomes leading to rising debt burdens, increasing defaults, spurring more falls in asset prices, etc.

The problem for RBA credibility?

The problem for the RBA is that inflation has been undershooting its forecasts and the target for several years now. The longer this persists the more the RBA will lose credibility, seeing low inflation expectations become entrenched making it harder to get inflation back to target and leaving Australia vulnerable to deflation in the next economic downturn.


Source: RBA, Bloomberg, AMP Capital

Due to the slowdown in economic growth flowing partly from the housing downturn we have been looking for two rate cuts this year since last December. We had thought that the RBA would prefer to wait till after the election is out of the way before starting to move and coming fiscal stimulus from July also supports the case to wait as does the still strong labour market. However, with underlying inflation coming in much weaker than expected the RBA its arguably too risky to wait until unemployment starts to trend up. And the RBA has moved in both the 2007 and 2013 election campaigns. So, while it’s a close call our base case is now for the first rate cut to occur at the RBA’s May meeting. Failing that, then in June.

Will the banks pass on RBA rate cuts?

This has been an issue with all rate cuts since the GFC due to a rise in bank funding costs. But most cuts have been passed on largely or in full (the average pass through since the Nov 2011 cut has been 89%), notwithstanding out of cycle hikes. Short term funding costs have fallen lately pointing to a reversal of last year’s 0.1 to 0.15% mortgage rate hikes or at least the banks having little excuse not to pass on any RBA cuts in full.

But will more rate cuts help anyway?

Some worry that rate cuts won’t help as they cut the spending power of retirees and many of those with a mortgage just maintain their payments when rates fall. However, there are several points to note regarding this. First, the level of household deposits in Australia at $1.1 trillion is swamped by the level of household debt at $2.4 trillion. So the household sector is a net beneficiary of lower interest rates. Second, the responsiveness to changes in spending power for a family with a mortgage is far greater than for retirees. Third, even if many with a mortgage just let their debt get paid off faster in response to falling rates this still provides an offset to the negative wealth effect of falling house prices, reducing pressure to cut spending. Fourth, the fall in rates since 2011 has helped the economy keep growing as mining investment collapsed. And of course, RBA rate cuts help push the $A lower. So, while rate cuts may not be as potent with higher household debt levels today and tighter bank lending standards, they should provide some help.

Is the RBA out of ammo?

This is a common concern around major central banks. However, they are a long way from being unable to do anything: the Fed can reverse the 9 rate hikes seen since December 2015 and start quantitative easing again if needed; and both the ECB and Bank of Japan could expand their QE programs. The ultimate option is for central banks to provide direct financing of government spending or tax cuts using printed money. This is often referred to as “helicopter money”. Fortunately, non-traditional monetary policy has worked in the US and so at least these concerns are unlikely to need to be tested. Of course, the RBA still has plenty of scope to cut interest rates if needed (there is 150 basis points to zero) and it could still do quantitative easing if needed so it’s a long way from being out of ammo (not that we think it needs to do a lot more anyway).

Implications for investors?

There are a number of implications for investors. First, low interest rates will remain in place for some time keeping bank deposit rates unattractive. Second, given the absence of inflationary pressure, a 1994-style bond crash remains distant.

Third, the low interest rate environment means the chase for yield is likely to continue supporting commercial property, infrastructure and shares offering sustainable high dividends.

Fourth, an earlier RBA rate cut may bring forward the timing of the bottom in Australian house prices.

Finally, as can be seen in the next chart, low inflation is generally good for shares as it allows shares to trade on higher price to earnings multiples. But deflation tends to be bad for shares as it tends to go with poor growth and profits and as a result shares trade on lower PEs. The same would apply to assets like commercial property and infrastructure.


Source: Global Financial Data, Bloomberg, AMP Capita
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Source: AMP Capital 29 April 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.

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The 2019 Australian Federal election and investors

Posted On:Apr 11th, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
The Federal Election

Some might be forgiven for thinking the wheels have fallen off Australian politics over the past decade with the same number of PM changes as Italy, a fractured Senate and “minority government” at times making sensible visionary long-term policy making hard. With the May 18 Federal Election offering a starker than normal choice political uncertainty may see another

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The Federal Election

Some might be forgiven for thinking the wheels have fallen off Australian politics over the past decade with the same number of PM changes as Italy, a fractured Senate and “minority government” at times making sensible visionary long-term policy making hard. With the May 18 Federal Election offering a starker than normal choice political uncertainty may see another leg up. Polls give Labor a clear lead, albeit it’s narrowed a bit.

Elections, the economy & markets in the short term

There is anecdotal evidence that uncertainty around elections causes households and businesses to put some spending decisions on hold – the longer the campaign the greater the risk. Fortunately, this time around it’s a relatively short campaign at five weeks. However, hard evidence regarding the impact of elections on economic indicators is mixed and there is no clear evidence that election uncertainty effects economic growth in election years as a whole. In fact, since 1980 economic growth through election years averaged 3.6% which is greater than average growth of 3.1% over the period as a whole.

In terms of the share market, there is some evidence of it tracking sideways in the run up to elections, which may be because investors don’t like the uncertainty associated with the prospect of a change in policies. The next chart shows Australian share prices from one year prior to six months after federal elections since 1983. This is shown as an average for all elections (but excludes the 1987 and 2007 elections given the global share crash in late 1987 and the start of the global financial crisis (GFC) in 2007), and the periods around the 1983 and 2007 elections, which saw a change of government to Labor, and the 1996 and 2013 elections, which saw a change of government to the Coalition. The chart suggests some evidence of a period of flat lining in the run up to elections, possibly reflecting investor uncertainty, followed by a relief rally.


Source: Thomson Reuters, AMP Capital

However, the elections resulting in a change of government have seen a mixed picture. Shares rose sharply after the 1983 Labor victory but fell sharply after the 2007 Labor win, with global developments playing a role in both. After the 1996 and 2013 Coalition victories shares were flat to down. So based on historical experience it’s not obvious that a victory by any one party is best for shares in the immediate aftermath, and historically the impact of swings in global shares arguably played a bigger role than the outcomes of federal elections.

The next table shows that 9 out of the 13 elections since 1983 saw shares up 3 months later with an average gain of 4.8%.


(Based on All Ords index.) Source: Bloomberg, AMP Capital

The next chart shows the same analysis for the Australian dollar. In the six months prior to Federal elections there is some evidence the $A experiences a period of softness and choppiness, which is consistent with policy uncertainty, but the magnitude of change is small. On average, the $A has drifted sideways to down slightly after elections.


Source: Thomson Reuters, AMP Capital

Political parties and shares

Over the post-war period shares have returned 12.7% pa under Coalition governments and 10.7% pa under Labor governments. It may be argued that the Labor governments led by Whitlam in the 1970s and Rudd and Gillard more recently had the misfortune of severe global bear markets and, if these periods are excluded, the Labor average obviously rises to 15.8% pa, although that may be taking things a bit too far. But certainly, the Hawke/Keating government defied conventional perceptions that conservative governments are always better for shares. Over the Hawke/Keating period from 1983 to 1996 Australian shares returned 17.3% pa, the strongest pace for any post-war Australian government.

Once in government, political parties are usually forced to adopt sensible macro-economic policies if they wish to ensure rising living standards and arguably there has been broad consensus on both sides of politics in recent decades regarding key macro-economic fundamentals – eg, low inflation and free markets.

Policy differences starker than since the 1970s

However, after narrowing in the 80s and 90s with the rationalist reform oriented agenda kicked off by Hawke and Keating, in recent years the policy differences between the Coalition and Labor have been intensifying again to the point that they are now arguably starker than they have been since the 1970s (when there used to be more of a focus around “class warfare”). In part this is consistent with rising interest in populist policies globally which in turn reflects angst over low wages growth, widening inequality, globalisation and automation. Each side of politics is now offering very different visions on the role and size of government. And so the policy uncertainty around this election is greater than usual.

The Coalition is focussed on containing government spending and encouraging economic growth via infrastructure spending, significant personal tax cuts (to return bracket creep and cap taxation revenue at its long term high of around 24% of GDP) and mild economic reforms.

By contrast Labor is focussed on spending more on health and education and in the process allowing the size of the public sector to increase. This is proposed to be funded by “tax increases” including:

  • cancelling the Coalition’s middle and upper income personal tax cuts scheduled for next decade and reimposing the 2% Deficit Repair Levy on incomes above $180,000;

  • restricting negative gearing to new residential property (and no other assets) and halving the capital gains tax discount from January 1 2020;

  • stopping cash refunds for excess franking credits;

  • and a 30% tax rate on distributions from discretionary trusts;

It’s not proposing to spend all the extra revenue this will raise with some earmarked for higher budget surpluses (ie paying down public debt). It’s also promising a sharp lift in the minimum wage towards being a “living wage”, some labour market re-regulation, far more aggressive climate policy (with a 45% reduction in emissions on 2005 levels by 2030, which is almost double the Coalition’s policy) and in relation to superannuation key changes are likely to include a resumption of the increase in the Super Guarantee, lower non-concessional contributions and a lower income threshold for the application of the 30% tax rate on super contributions. Intervention in the economy is likely to be higher under a Labor government.

Perceptions that a more left leaning Labor government will mean bigger government, more regulation and higher taxes and hence act as a drag on productivity and be less business friendly may contribute to more nervousness in shares and the $A than usual around this election. More specifically there are a number of risks:

  • There is a danger that relying on tax hikes on the “top end of town” will dampen incentive in that Australia’s top marginal tax rate of 47% is already high – particularly compared to our neighbours: 33% in NZ; 20% in Singapore; and 15% in HK. Australia’s income tax system is already highly progressive: 1% of taxpayers pay 17% of the total personal income tax take (with an average tax rate of 42%) & the top 10% pay 45% of tax compared to the bottom 50% who pay around 12% (with an average tax rate around 11%).

  • The proposed changes to franking credits even though they only impact around 8% of taxpayers are potentially a negative for stocks with high-franked dividends.

  • The proposed changes to capital gains tax and negative gearing have been estimated to cause a 5 to 12% decline in home prices & a boost to rents of 7 to 12%. This is risky as the property market is already weak. This could further impact construction/property stocks, banks & retail shares.

  • Higher minimum wages and some labour market re-regulation risk higher unemployment, a less flexible labour market and are a negative for hospitality and retail stocks.

  • The focus on economic reform needed to boost productivity looks to have fallen by the wayside in the face of populism – eg, why aren’t we considering injecting more competition into the health sector along with spending more on it?

That said there are some offsets in relation to ALP policies that investors need to allow for:

  • Some ALP policies may not pass the Senate, including those around negative gearing and repealing the middle & upper income tax cuts that have already passed into law.

  • Labor is planning bigger budget surpluses which is positive.

  • Labor policies encouraging “build to rent/affordable housing” are positive, but it’s unclear how much impact they will have.

  • Labor policies focussed on greater spending and tax cuts more targeted to lower saving low income earners may provide more of a short-term boost to economic growth.

  • Labor has a track record of taking sensible advice & responding quickly to help the economy in a crisis (think 1983 and in the GFC). In the short term, this could include a First Home Buyer grant to mute the property downturn.

Concluding comment

The now wider left right divide in Australian politics suggests greater uncertainty going into this election potentially affecting all asset Australian classes. But the bigger concern is the dwindling prospects for productivity enhancing reform, which could be an ongoing dampener on growth in living standards.

 

Source: AMP Capital 11 April 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.

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The 2019-20 Australian Budget – the long-awaited surplus and the promise of more tax cuts ahead of the election

Posted On:Apr 03rd, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

The 2019-20 Budget had three aims: to cement the Government’s fiscal credentials by delivering the long-awaited return to budget surplus; to provide fiscal stimulus to an ailing economy; and to help get the Government re-elected. It looks on track for the first thanks to a revenue windfall, this has provided room for fiscal stimulus and of course time will tell

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The 2019-20 Budget had three aims: to cement the Government’s fiscal credentials by delivering the long-awaited return to budget surplus; to provide fiscal stimulus to an ailing economy; and to help get the Government re-elected. It looks on track for the first thanks to a revenue windfall, this has provided room for fiscal stimulus and of course time will tell whether it makes a difference in the May election. Of course, while whoever wins the election will provide stimulus next financial year its timing and precise makeup won’t really be known for some time which makes the Budget a bit academic.

Key budget measures

The goodies include:

  • Income tax cuts from July focussed on low to middle income earners of an additional $10 a week (following last year’s announced tax cut of around $10/week) which is mainly achieved by doubling the Low & Middle Income Tax Offset.

  • More generous tax stimulus in later years especially for higher income earners (which builds on the tax changes announced in last year’s budget), starting in 2022 with an expansion in the 19% rate tax bracket and a reduction in the 32.5% rate to 30% in 2024.

  • Expansion of the small business instant asset write off by $5,000 to $30,000 until 2020 (which is also now extended to medium-sized businesses) and a drop in small business company tax to 25% earlier than expected.

  • A $75 to $125 cash payment to 3.9 million pensioners and other welfare recipients.

  • Greater flexibility for 65 & 66 year olds to top up their super.

  • Spending on energy efficiency measures including an equity injection of $1.4bn on the Snowy Hydro project.

  • An extra $25bn in infrastructure spending over the next decade including $2bn for a rail from Geelong to Melbourne, and a large allocation to NSW transport projects.

Stronger revenue, but tax cuts

Thanks to stronger corporate revenue, better personal tax revenue thanks to higher employment and reduced spending the 2018-19 budget deficit is projected to come in at $4.2bn compared to $5.2bn in the Mid-Year review. The Government has assumed that this revenue boost is only temporary (see the “parameter changes” line in the table below) and has only used some of it to fund tax cuts and other measures. The net result is that the budget is projected to continue to reach a surplus in the next financial year, albeit its still only small at $7.1bn or 0.4% of GDP. The move to higher surpluses is slowed slightly by the fiscal easing from policy changes (predominately tax cuts).

However, note that the fiscal stimulus proposed for 2019-20 is actually bigger than that shown in the table below under “policy changes” as $3bn in tax cuts were already allowed for in the Mid-Year Review and if the already legislated tax cuts are allowed for in total its around $9bn or 0.5% of GDP. That said this is still relatively small and not enough to offset low wages growth and the negative wealth effect from falling house prices.

Source: Australian Treasury, AMP Capital

The already legislated tax cuts for higher income earners next decade are designed to satisfy the Government’s commitment from the 2014 Budget to cap tax revenue at 23.9% of GDP (or total revenue with dividends at 25.4% of GDP) on the grounds that this is around the historic highs. This cap is now projected to be reached in 2021-22.

Source: Australian Treasury, AMP Capital

Economic assumptions

The Government’s growth forecasts look a little bit on the optimistic side, particularly the assumptions for wages growth. It remains hard to see wages growth rising significantly over the next few years given unemployment is not expected to fall and on our forecasts is expected to rise to 5.5%.

Source: Australian Treasury, AMP Capital

Assessment and risks

Like last year’s this is an upbeat Budget. First the near-term tax cuts for low to middle income earners will help households at a time of soft wages growth, falling home prices and tightening lending standards. But while roughly two times bigger than planned a year ago, this will still be relatively small though at around $20 a week (enough for 3 rounds of coffee and a muffin!). Second, the Budget continues to recognise that we cannot rely on bracket creep to cut public debt. The Australian tax system is already highly progressive and is becoming more so with the top 10% of earners accounting for roughly 45% of income tax revenue, up from 36% two decades ago. Compared to other comparable countries the top marginal tax rate is both relatively high and kicks in at a relatively low multiple of average earnings. In fact only the top 20% of income earners pay more tax than they receive in government benefits. If this is not limited it risks dampening incentive and productivity. Third, the continuing focus on infrastructure is good for short term growth, productivity and “crowding in” private investment. It will help to keep the economy growing.

Source: ATO, AMP Capital

Finally, thanks to constrained spending growth and the surge in revenue in recent years the outlook for surpluses is positive.

Source: Australian Treasury, AMP Capital

However, we have still seen a record run of 11 years of budget deficits. While our net public debt to GDP ratio is low at 19% compared to 78% in the US, 70% in the Eurozone and 156% in Japan, comparing ourselves to a bad bunch is dangerous. The run of deficits swamps those of the 1980s and 1990s and this was without a deep recession! Rather we have achieved this thanks to a combination of ramping up spending at the time of the GFC and then not reining it in again. Unlike prior to the GFC we have nothing put aside for a rainy day and there is a risk that the revenue surprise will prove temporary if global growth slows or more likely Australian growth and employment disappoints.

While the Government’s revenue growth assumptions for the years ahead are modest partly due to tax cuts and they are relatively conservative in assuming that the iron ore price falls back to $US55 a tonne, a big risk remains that wages don’t accelerate as assumed leading to a resumption of poor personal tax collections.

Finally, the budget strategy and fiscal stimulus comes with greater than normal uncertainty given the coming election in May and whether the tax measures pass parliament. A Labor Government would likely also undertake a similar sized stimulus but there may be a greater focus on government spending and the timing may be delayed as a new government would likely have a mini-budget in the second half of the year.

Implications for the RBA

While this Budget should provide some boost to household finances and confidence – the fiscal boost to the economy and household income is still relatively modest and uncertainty around its timing and details may dampen any positive announcement effect. So while it will help the economy it’s not enough to change our view that the RBA will cut interest rates twice by year end taking the cash rate to 1%.

Implications for Australian assets

Cash and term deposits – with interest rates set to fall, returns from cash and bank term deposits will remain low.

Bonds – a major impact on the bond market from the Budget is unlikely. With Australian five-year bond yields at 1.4%, it’s hard to see great returns from bonds over the next few years albeit Australian bonds will likely outperform US/global bonds.

Shares – the boost to household spending power could be a small positive for the Australian share market (via consumer stocks) and there is an ongoing boost for construction companies. But it’s hard to see much impact on shares.

Property – the Budget is unlikely to have much impact on the property market. We expect Sydney and Melbourne home prices to fall further.

Infrastructure – continuing strong infrastructure spending should in time provide more opportunities for private investors as many of the resultant assets are ultimately privatised.

The $A – the Budget alone won’t have much impact on the $A. With the interest rate differential in favour of Australia continuing to narrow the downtrend in the $A has further to go.

Concluding comments

The 2019-20 Budget has a sensible focus on providing support to households at the same time as returning the budget to surplus. However, the actual fiscal stimulus is pretty modest – particularly for a pre-election budget – and comes with greater than normal uncertainty given the upcoming election.

Source: AMP Capital

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.

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Global growth slowing, plunging bond yields & inverted yield curves – not terminal but shares are due a pull back

Posted On:Mar 27th, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

The past week has seen a renewed intensification of concerns about global growth. Bond yields have plunged and associated growth worries have weighed on share markets. This note looks at the global growth outlook, why shares are vulnerable to a pullback and why it’s unlikely to be a resumption of last year’s downtrend.

Background

But first some perspective. At their lows back

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The past week has seen a renewed intensification of concerns about global growth. Bond yields have plunged and associated growth worries have weighed on share markets. This note looks at the global growth outlook, why shares are vulnerable to a pullback and why it’s unlikely to be a resumption of last year’s downtrend.

Background

But first some perspective. At their lows back in December global shares had fallen 18% from their highs with US shares down 20% and Australian shares down 14% and many were convinced that recession was around the corner. Since then share markets have staged an impressive rebound with global shares rising 18%, US shares up 21% and Australian shares up 14%. So the 2% or so fall in shares seen in the past few days is a bit of a non-event.


Source: Bloomberg, AMP Capital

Late last year investor sentiment had become very negative and since then many of the fears that had depressed shares have faded: the Fed has become more dovish and less threatening to the US growth outlook; other central banks have actually eased notably in China and Europe; the Chinese authorities have shifted from cutting debt to stimulating growth; the US partial government shutdown has ended; the US and China look to be heading towards a trade deal; and fears around recession faded. And so shares rebounded.

However, after a 20% plunge as seen in US shares last year it’s unusual to have a deep V rebound like that since December, shares had become technically overbought & some measures of investor sentiment have become complacent. More fundamentally, there are several “worries” that could impact share markets – notably around growth. And this is being reflected in plunging bond yields & an inverted US yield curve. This has all left shares vulnerable to a short term pull back.

Growth worries and plunging bond yields

The problem now is that while some of the worries from last year have faded, global growth looks to be continuing to slow. Particularly disappointing in this regard were March business conditions PMIs which showed falls in the US and Europe and continuing weakness in Japan (and Australia).


Source: Bloomberg, AMP Capital

The weakness in growth indicators along with the “great retreat” back to dovishness and monetary easing by central banks aided by falling inflation has seen a renewed plunge in bond yields.


Source: Global Financial Data, AMP Capital

This has seen US yields fall to levels not seen since 2017, German and Japanese bond yields go negative again and Australian bond yields fall to a record low.

The decline in US bond yields has added to growth fears by pushing various measures of the yield curve to flat or negative. A negative, or inverted, US yield curve – ie when long-term bond yields fall below short-term rates – has preceded US recessions so it’s natural for investors to be concerned. The gap between the US 10-year bond yield and the 2-year bond yield has now fallen to just 0.22%, the gap between the 10-year bond yield and the Fed Funds rate has fallen to just 0.02% and the gap between the 2-year bond yield and the Fed Funds rate has fallen to -0.02%.


Source: NBER, Bloomberg, AMP Capital

But there are several things to allow for before getting sucked into the current frenzy around an inverted yield curve. First, the yield curve can give false signals (circled on the chart).

Second, the lag from an inverted curve to a recession has been around 15 months. So even if it becomes decisively inverted now recession may not come till mid next year. Historically the share market has peaked 3-6 months before recessions, so it’s too far away for markets to anticipate. After US yield curve inversions in 1989, 1998 and 2006 US shares first rallied more than 20%.

Third, various factors may be flattening the US yield curve which may not be indicative of an approaching US recession including the Fed’s new-found dovishness, negative German and Japanese bond yields holding down US yields, the realisation that central banks won’t be dumping their bond holdings and high investor demand for bonds post the GFC as they have proven to be a good diversifier – rallying every time shares have a major fall.
Fourth, other indicators suggest that US monetary policy is far from tight – the real Fed Fund rate is barely positive, and the nominal Fed Funds rate is well below nominal GDP growth and both are far from levels that have preceded US recessions.

Finally, we are yet to see the sort of excesses that precede US recessions: wages growth is still moderate, inflation is benign, there has been no boom in consumer spending, investment or housing construction, and private debt growth overall has been modest. It may also be argued that President Trump will do whatever he can to avoid recession next year as US presidents don’t get re-elected when unemployment is rising.

So while the US yield curve may be flashing a warning sign and should be watched its short comings need to be allowed for and other indicators are not foreshadowing a US recession. This is important because the historical experience tells us that what happens in the US is critical to how deep share market falls get. Deep (“grizzly”) bear markets are invariably associated with US recession. Our view remains that US recession is not imminent and last year’s share market falls are unlikely to be the start of a deep bear market.

More broadly, global growth is likely to pick up into the second half reflecting policy stimulus & reduced trade war fears. Signs of green shoots in terms of global growth include Chinese credit and investment, US data for retail sales, capital goods orders and consumer confidence and Eurozone industrial production.

But what about the risks around global trade, Brexit and the Mueller inquiry?

These could cause a share market pullback but none look significant enough to cause a resumption of last year’s falls:

  • US and China trade negotiations continue to see argy bargy but look to be on track to a significant deal in terms of reducing trade barriers and protecting intellectual property as it’s in both sides’ interests (particularly Trump’s who doesn’t want a trade war depressing the economy and shares and ruining his 2020 re-election prospects). But a deal with China would beg the question of whether Trump will then turn his attention to trade with Europe starting with auto tariffs. However, our assessment is that he probably won’t: America’s trade deficit with Europe is small compared to that with China; public and Congressional support for a trade war with Europe is low; most of Trump’s advisers are against it; the EU would retaliate and this would badly affect states that support Trump that export to Europe; it would be a new blow to confidence and share markets ahead of Trump’s 2020 re-election campaign.

  • The Brexit soap opera continues to create huge risks for the UK but it’s a second order issue globally. 46% of UK exports go to the EU but only 6% of EU exports go to the UK, so Brexit means far more for the UK economy that it does to the EU! Given the threat to the UK economy, the issue around the Irish border and that the 2016 Brexit vote was around immigration and sovereignty but not free trade with the EU, a soft Brexit or no Brexit (after another referendum) is more likely than a hard or no deal Brexit. What happens in the Eurozone though is far more significant than Brexit.

  • Finally, despite the hopes of Democrats it looks like the Mueller inquiry has failed to come up a smoking gun significant enough to see Trump removed from office. 

What about Australian bond yields at a record low?

The plunge in Australian bond yields to a record low of 1.78% (below 2016’s low of 1.81%) reflects a combination of weak economic data locally causing the fixed interest market to price in RBA rate cuts and falling bond yields globally. We remain of the view that Australian bonds will outperform global bonds (reflecting RBA easing at a time of the Fed holding) and that the Australian share market will continue to underperform global shares (as earnings growth locally lags that globally in response to weaker economic conditions in Australia). We continue to see the RBA cutting rates twice this year.

Concluding comments

Share markets are due a correction or pullback after rallying strongly since their December lows and worries about inverted yields curves and the growth outlook could provide the trigger. But US and global recession still looks to be a fair way off and we continue to see this being a reasonably good year for shares. The continuing fall in bond yields is not necessarily inconsistent with rising share markets (in 2016 shares bottomed in February and bond yields didn’t bottom till July/August!) but it does highlight that the post GFC environment of constrained growth and inflation and low rates remains alive and well.

 

Author: Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist, AMP Capital Sydney, Australia

Source: AMP Capital 26 March 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.

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