Olivers Insights

Introduction

The Government’s decision to revamp the Stage 3 tax cuts has stirred up a hornet’s nest. The move to reduce the size of the benefits for higher income earners (with those on $200,000 or more getting $4546 a year less) and redistribute them to lower and middle-income earners (with those earning between $50,000 and $130,000 now getting $804 a year more) in order to provide cost of living relief is something that’s easy to understand.

The arguments against it though are a bit more esoteric.

• First, is the politics around committing in the last election and until recently to proceed with the tax cuts as legislated (despite cost of living issues long being well known) only to then break the commitment.

• Second, is the concern that the move treats the symptoms and not the causes of high inflation and risks backfiring. This is because by skewing them to low- and middle-income earners who consume a higher proportion of their income runs the risk that it will add to demand and hence inflation. This risks delaying interest rate cuts.

• Finally, is the argument that it’s yet another backward step in terms of tax reform. This is critical as in recent years Australia’s productivity performance has deteriorated. This has driven a slump in growth in per capita GDP which means lower than otherwise living standards.

Australian Labour Productivity Growth

Source: ABS, AMP

To boost productivity growth we need to do a bunch of things (there is a short list here) but a key thing is to reform our tax system. The Stage 3 tax cuts were a step in that direction because they reduced the issue of bracket creep (where taxpayers jump into higher tax brackets never intended for them just by seeing average wages growth). It did this by having one flat 30% tax rate for earnings between $45,000 & $200,000. They were also part of a three-stage process with the first two focussed on low and middle income earners. The Stage 3 tax changes unravel this modest reform.

Why the need for tax reform?

The good news is Australia is a relatively low tax country. Total tax revenue as a share of GDP at 29% in 2022 was at the low end of OECD countries.

Total Tax Revenues, % of GDP

Source: OECD, AMP

The complication is that this does not tell the whole picture because it doesn’t include superannuation contributions. If adjustment is made for this then we are likely more in the middle of the pack. More fundamentally there are five key issues with our tax system:

#1 – It’s very reliant on income tax, either personal or corporate, as opposed to indirect tax like the GST

Income tax is 62% of tax collections versus the OECD average of 34%.

Income as % of total tax revenues

Source: OECD, AMP

The problem with this is that income tax is highly distortionary – as it impacts decisions to work and invest – whereas a GST levied at the same rate on all items is far less distortionary. So a GST is a far more efficient tax than income tax and a greater reliance on it versus income tax will likely lead to more productivity. The high reliance on income tax will also create equity issues as the aging population will see an increasing burden placed on younger workers to foot rising health and aged care bills. Of course, the GST is also more regressive hitting lower income earners harder, but this can be addressed by the setting of the tax scales and compensation.

#2 – It’s complicated with various “tax concessions”

Several “tax concessions” are often in the headlines: negative gearing, the capital gains tax discount, franking credits, superannuation and trust structures. The arguments put up for curtailing them are that they cost the government revenue, create distortions in the tax system and that the benefits fall mainly to high earners. It’s actually more complicated than this:

• Negative gearing arises due to the way the tax system works in allowing deductions for expenses incurred in earning income. Removing or curtailing it for property investment as some want will create a distortion as it will still be available for investment in other assets. What’s more negative gearing is not the reason housing affordability is poor and removing or curtailing it could make the situation worse by reducing the supply of rental property. Finally, while the dollar value of negative gearing rises with income the majority of taxpayers that negatively gear property are middle-income earners. That said there may be a case for curtailing excessive use of this tax concession.

• The capital gains tax discount allows investors to halve their taxable capital gain on an asset if they hold it for more than a year. The discount does appear excessive though and it provides an inducement to earn income as a capital gain as it’s taxed at half the rate. So there is a case to consider removing the capital gains tax discount and return to the pre-1999 approach of adjusting capital gains for price inflation.

• Dividend imputation is a sensible concession that removes a bias against equities by removing the double taxation of earnings – once in the hands of companies and in the hands of investors as dividends. Therefore, it puts shares onto a level footing with corporate debt. So, it reduces the incentive of firms to excessively rely on debt and encourages firms to pay decent dividends as opposed to hoarding earnings. Curtailing dividend imputation would be a big mistake.

• The case for super tax concessions to remain is strong in terms of boosting savings, supporting a large pool of patient capital, providing for self-funding in retirement and reducing reliance on the pension.

Finally, calls to end or curtail the various tax concessions need to be assessed in the context of the whole tax system in Australia.

#3 – The Australian tax system is highly progressive

In this regard, not only does the Australian tax system have a high reliance on income tax but it is highly progressive. The current top marginal tax rate at 47% (including Medicare) is above the median of comparable countries and kicks in at a relatively low multiple of average weekly earnings.

Global individual tax rates comparison

Source: OECD, AMP

As a result, the Australian individual tax system is highly progressive and this is reflected in the fact that the top 3.6% of tax payers earning more than $180,000 pay around 32% of income tax and the top 10% pay nearly 50% of income tax. ABS data also indicates that only the top 20% of income earners pay more tax than they receive in government transfers. This is likely working against Australia’s long-term interest to the extent that it discourages work effort and hence productivity.

Government benefits less taxes paid by household income groups, 2021-22

Source: ABS, AMP

Curtailing access to any or all of the “tax concessions” will only add to the burden on this relatively small group and act as a disincentive for work effort at a time when we should be doing the opposite. Ideally, we should be looking to reduce the reliance on income tax. If we did this the interest in strategies like negative gearing would likely decline.

#4 – Bracket creep is an ongoing issue

Just keeping up with inflation can see a worker pushed into a tax bracket that was never intended for them. Bracket creep has been a major contributor to the rise in income tax payments as a share of household income to a record level. Over the last two years increasing tax payments have been more of a drag on income than higher mortgage payments.

Household Payments, % of Gross Income

Source: ABS, AMP

The ideal solution is to index the tax brackets to inflation. This would keep the Government accountable by denying them the ability to give back bracket creep and claim it’s a tax cut and force them to pass higher tax rates through Parliament if they want more tax revenue.

#5 – The tax system has numerous anachronisms

Key issues are that: the GST applies to a diminishing share of consumer spending; states’ stamp duties grossly distort property decisions and worsen housing affordability and should be replaced with land tax; state payroll taxes discourage employment; car tariffs are still levied when there is no car industry to protect; and road user charges need to replace fuel excise to avoid a diminishing share of road users paying for roads.

So what to do?

What is needed by way of tax reform is simple: lower personal tax rates with higher thresholds; a lower corporate tax rate; a higher and more comprehensive GST; compensation of low income earners and welfare recipients for increasing the GST; the indexation of tax brackets to inflation; and the removal of stamp duty & its replacement with land tax.

This would take political courage as seen a generation ago. But failure to do so will only hamper productivity and living standards for all Australians.

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

The surge in inflation coming out of the pandemic and its subsequent fall has been the dominant driver of investment markets over the last two years – first depressing shares and bonds in 2022 and then enabling them to rebound. But what’s driving the fall, what are the risks and what does it mean for interest rates and investors. This note looks at the key issues.

Inflation is in retreat

Inflation appears to be falling almost as quickly as it went up. In major developed countries it peaked around 8 to 11% in 2022 and has since fallen to around 3 to 4%. It’s also fallen in emerging countries.

Global Inflation

Source: Bloomberg, AMP

What’s driving the fall in inflation?

The rise in inflation got underway in 2021 and reflected a combination of massive monetary and fiscal stimulus that was pumped into economies to protect them through the pandemic lockdowns that was unleashed as spending (first on goods then services) at a time when supply chains were still disrupted. So it was a classic case of too much money (or demand) chasing too few goods and services. Its reversal since 2022 reflects the reversal of policy stimulus as pandemic support measures ended, pent up or excess savings has been run down by key spending groups, monetary policy has gone from easy to tight and supply chain pressures have eased. In particular, global money supply growth which surged in the pandemic has now collapsed.

Why is Australian inflation higher than other countries?

While there has been some angst about Australian inflation (at 4.3%yoy in November) being higher than that in the US (3.4%), Canada (3.1%), UK (3.9%) and Europe (2.9%) this mainly reflects the fact that it lagged on the way up and lagged by around 3 to 6 months at the top. The lag partly reflects the slower reopening from the pandemic in Australia and the slower pass through of higher electricity prices. So we saw inflation peak in December 2022, whereas the US, for instance, peaked in June 2022. But just as it lagged on the way up it’s still following other countries down with roughly the same lag. In fact, with a very high 1.5% mom implied rise in the Monthly CPI Indicator to drop out from December last year, monthly CPI inflation is likely to have dropped to around 3.3 to 3.7%yoy in December last year, which is more in line with other countries.

Monthly CPI Indicator verus Quarterly CPI

Source: Bloomberg, AMP

What about profit gouging?

There has been some concern that the surge in prices is due to “price gouging” with “billion-dollar profits” cited as evidence. In fact, the Australian Government has set up an inquiry into supermarket pricing. There are several points to note in relation to this. First, it’s perfectly normal for any business to respond to an increase in demand relative to supply by raising prices. Even workers do this (eg, asking for a pay rise and leaving if they don’t get one when they are getting lots of calls from head-hunters). It’s the way the price mechanism works in allocating scarce resources. Second, national accounts data don’t show any underlying surge in the profit share of national income, outside of the mining sector. Finally, blaming either business or labour (with wages growth picking up) risks focussing on the symptoms of high inflation not the fundamental cause which was the pandemic driven policy stimulus & supply disruption. This is not to say that corporate competition can’t be improved.

Source: ABS, RBA, AMP

What is the outlook for inflation?

Our US and Australian Pipeline Inflation Indicators continue to point to a further fall in inflation ahead.

AMP Pipeline Inflation Indicator 

Australia Pipeline Inflation Indicator

Source: Bloomberg, AMP

This is consistent with easing supply pressures, lower commodity prices and slowing demand. We are not assuming recession, but it is a high risk and if that occurred it would likely result in inflation falling below central bank targets. Out of interest, the six-month annualised rate of core private final consumption inflation in the US, which is what the Fed targets, has fallen below its 2% inflation target. In Australia, we expect quarterly CPI inflation to have fallen to and around 3%yoy by year end. The return to the top of the 2-3% target is expected to come around one year ahead of the RBA’s latest forecasts.

What are the risks?

Of course, the decline in inflation is likely to be bumpy and some say that the “last mile” of returning it to target might be the hardest. There are five key risks to keep an eye in terms of inflation:

• First, the escalating conflict in the Middle East has the potential to result in inflationary pressures. Disruption to Red Sea/Suez Canal shipping is already adding to container shipping rates due to extra time in travelling around Africa. So far this has seen only a partial reversal of the improvement in shipping costs seen since 2022 and commodity prices and the oil price remain down. The US and its allies are likely to secure the route relatively quickly such that any inflation boost is short lived. The real risk though is if Iran is drawn directly into the conflict threatening global oil supplies.

• Economic activity could surprise on the upside again keeping labour markets tight fuelling prices & wages & hence sticky services inflation.

• Central banks could ease before inflation has well and truly come under control in a re-run of the stop/go monetary policy of the 1970s.

• In Australia, recent flooding could boost food prices and delays associated with industrial disputes at ports could add to goods prices. At present though the floods are not on the scale of those seen in 2022 and we expect any impact from both to be modest (at say 0.2%).

• Finally, and also in Australia if productivity remains depressed, 4% wages growth won’t be consistent with the 2-3% inflation target.

What lower inflation means for investors?

High inflation tends to be bad for investment markets because it means: higher interest rates; higher economic uncertainty; and for shares, a reduced quality of earnings. All of which means that shares tend to trade on lower price to earnings multiples when inflation is high, and growth assets trade on higher income yields. We saw this in 2022 with bond yields surging, share markets falling and other growth assets pressured.

Australian shares – High Inflation = lower PEs & vice versa

Source: Bloomberg, AMP

So, with inflation falling much of this goes in reverse as we started to see in the last few months. In particular:

• Interest rates will start to come down. We expect the Fed to start cutting in May & the ECB to start cutting around April both with 5 cuts this year. There is some chance that both could start cutting in March. We expect the RBA to start cutting around June with 4 cuts this year.

• Shares can potentially trade on higher PEs than otherwise.

• Lower interest rates with a lag are likely to provide some support for real assets like property.

Of course, the main risk is if economies slide into recession, which will mean another leg down in share markets before they start to benefit from lower interest rates. This is not our base case but it’s a high risk.

Concluding comment

Finally, while inflation is on the mend cyclically, it’s worth remembering that from a longer-term perspective we have likely now entered a more inflation-prone world than the one prior to the pandemic reflecting: bigger government; the reversal of globalisation; increasing defence spending; decarbonisation; less workers and more consumers as populations age. So short of a very deep recession, don’t expect interest rates to go back to anywhere near zero anytime soon.

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

Source: AMP January 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 poor returns in 2022 on the back of high and rising inflation, a surge in interest rates, the invasion of Ukraine and recession worries, 2023 was a far better year for investors as inflation fell and investment markets anticipated lower interest rates ahead. This saw average balanced growth superannuation funds return around 9.5% more than making up for the 4.8% loss in 2022, as both shares and bonds rallied. Over the last five years, they returned around 7.5% pa, which exceeded inflation.

Balanced growth superannuation fund returns

Source: Mercer Investment Consulting, Morningstar, AMP

Can the rebound continue or will markets have a rough year. Here is a simple point form summary of key insights and views on the outlook.

Five key themes from 2023

• Stronger than feared growth. Despite fears recession was inevitable, on the back of rate hikes, it’s been avoided so far, helped by saving buffers, reopening boosts and some labour hoarding.

• Disinflation. Inflation across major countries fell from peaks of 8 to 11% in 2022 to around 3 to 5% as supply pressure and demand eased.

• Peak interest rates. Most major central bank policy rates look to have peaked and this probably includes the RBA’s cash rate.

• Geopolitical threats proved not to be as worrying as feared.

• Artificial intelligence hit the big time after the launch of Chat GPT. This helped tech stocks (mostly US) tech stocks reverse their 2022 slump.

Five lessons for investors from 2023

• Monetary policy still works in controlling inflation – the lags may be long and variable but this time was not really different. Of course, an easing in supply chain disruptions helped and there is still a way to go.

• Don’t ignore population growth – a surge in immigration played a big role in pushing home prices back up and avoiding recession in Australia.

• Timing markets is hard – it was easy to be gloomy a year ago with a long worry list and shares plunging into October but timing markets on the back of this was a loser as shares surged, putting in strong returns.

• Geopolitics matters – but it’s hard to predict (eg, Hamas’ attacks on Israel) and the impact can often be less than feared, with the world learning to live with the war in Ukraine and the Israel/Hamas war not (yet) causing a surge in oil prices.

• Turn down the noise – investors are being hit with often irrelevant, low quality & conflicting information which boosts uncertainty. The key is to turn down the noise and stick to a long-term strategy.

The three big worries for 2024

• Inflation is still too high and its decline is likely to remain bumpy – so central banks could still have another hawkish turn and even if not there is a high risk that rate cuts may come later than markets expect.

• The risk of recession is high. It’s hard to see the biggest rate hiking cycle since the 1980s not having a major impact and the risks are already evident in tighter US lending standards, falling lending in Europe and stalling consumer spending in Australia. Risks around the Chinese economy and property sector also remain high.

• Geopolitical risk is high: with half the world’s population seeing elections including the US, EU & India; the US Government could have a shutdown starting 19 January & could have another divisive Biden v Trump presidential election; the result of Taiwan’s 13 January election could see an easing or an escalation of tensions with China depending who wins; the war in Ukraine is continuing; and there is a high risk the Israel/Hamas war could spread, threatening oil supplies, particularly with Iran’s proxy Houthi rebels disrupting Red Sea shipping.

Four reasons for optimism

• Inflation has eased sharply to around 3% in major industrial countries and around 5% in Australia and is likely to continue to fall as: supply chain pressures have eased; demand is cooling; and labour markets are easing. This includes in Australia which lagged US inflation on the way up and is just doing so again on the way down.

• We expect the ECB to start cutting rates in March, followed by the Fed and BoC in the June quarter. While there is still a high risk of one more hike in Australia in February, falling inflation should head this off so our base case is that the RBA has peaked ahead of rate cuts from June, taking the cash rate down to 3.6% by year end. Just as rate hikes were bad for shares in 2022, rate cuts should ultimately be positive.

• While recession is a high risk and markets are no longer priced for it, if it does occur it should be mild: most countries have not seen a spending boom that needs to be unwound; in Australia consumer spending, housing investment and business investment are not running at excessive levels relative to GDP; and Chinese growth is soft and property sector risks are high, but it’s likely to target roughly 5% GDP growth again and back this up with fiscal stimulus if need be.

• Finally, while there’s lots of geopolitical risks they may not turn out so badly: the US has a strong incentive to avoid an escalation in the Israel/Hamas war; the Ukraine war could turn into a frozen conflict; & elections won’t necessarily go in an adverse direction for markets. In relation to the US, the presidential election year normally sees average share returns and Trump could falter before the election.

Key views on markets for 2024

Easing inflation pressures, central banks moving to cut rates and prospects for stronger growth in 2025 should make for okay returns in 2024. However, with growth still slowing, shares historically tending to fall during the initial phase of rate cuts, a very high risk of recession and investors and share market valuations no longer positioned for recession, it’s likely to be a rougher and more constrained ride than in 2023. We expect balanced growth super funds to return around 5.3% this year.

• Global shares are expected to return a far more constrained 7%. The first half could be rough as growth weakens, but shares should ultimately benefit from rate cuts and lower bond yields and the anticipation of stronger growth later in the year and in 2025.

• Australian shares are likely to outperform global shares, after underperforming in 2023 helped by somewhat more attractive valuations. A recession could threaten this though so it’s hard to have a strong view. Expect the ASX 200 to end 2024 at around 7,900 points (revised up from our initial target of 7500).

• Bonds are likely to provide returns around running yield or a bit more, as inflation slows, and central banks cut rates.

• Unlisted commercial property returns are likely to be negative again due to the lagged impact of high bond yields & working from home.

• Australian home prices are likely to fall 3-5% as high rates hit demand & unemployment rises. The supply shortfall should prevent a sharper fall & expect a wide dispersion. Rate cuts will help later in the year.

• Cash and bank deposits are expected to provide returns of over 4%.

• A rising trend in the $A is likely taking it to $US0.72, due to a fall in the overvalued $US and the Fed cutting rates more than the RBA.

Five points on Bitcoin

• Bitcoin rose 157% through 2023.

• However, this followed a 64% fall in 2022, so it remains very volatile.

• It and other crypto currencies remain highly geared to US shares and expectations for interest rates – explaining its sharp fall in 2022 when shares fell and rates rose and rebound with shares in 2023.

• Bitcoin is yet to find a clear use (beyond as something to speculate in) making it very hard to value fundamentally – unlike, say, property which provides rents and shares which provide earnings. Recent gains owe partly to excitement around this year’s “halving” (in the amount of Bitcoin that miners receive) and anticipation of an exchange traded fund that can invest in Bitcoin – rather than developments in its use.

• There is value in blockchain technology (for decentralised finance, contracts, etc) which is positive for cryptocurrencies like Ethereum, but this is hard to value.

Five things to watch

• Inflation – if it fails to continue falling as we expect, central banks will be more hawkish than we are allowing for, risking deep recession.

• Recession – a mild recession should be manageable but a deep recession will mean significant downside in shares. So far global business conditions PMIs are soft but consistent with okay growth.

Global Composite PMI vs World GDP

Source: Bloomberg, IMF, AMP

• The Chinese economy – China’s property sector is continuing to struggle and without measures to support consumers this could hurt its economy with a flow on to demand for Australian exports.

• Geopolitics – the key risks relate to Taiwan, a possible expansion of the Israel/Hamas war and the US Presidential election.

• The Australian consumer – consumer spending has slowed sharply and risks stalling as a result of cost-of-living pressures, high interest rates and higher unemployment.

Nine things investors should remember

• Make the most of compound interest to grow wealth. Saving regularly in growth assets can grow wealth significantly over long periods. Using the “rule of 72”, it will take 16 years to double an asset’s value if it returns 4.5% pa (ie, 72/4.5) but only 9 yrs if the asset returns 8% pa.

• Don’t get thrown off by the cycle. Falls in asset markets can throw investors of a well-considered strategy, destroying potential wealth.

• Invest for the long-term. Given the difficulty in timing market moves, for most it’s best to get a long-term plan that suits your wealth, age and risk tolerance and stick to it.

• Diversify. Don’t put all your eggs in one basket.

• Turn down the noise. This is critical with the information overload coming from social and mainstream media, with plenty of clickbait.

• Buy low, sell high. The cheaper you buy an asset, the higher its prospective return will likely be and vice versa.

• Avoid the crowd at extremes. Don’t get sucked into euphoria or doom and gloom around an asset.

• Focus on investments you understand offering sustainable cash flow. If it looks dodgy, hard to understand or has to be justified by odd valuations or lots of debt, then stay away. There is no free lunch!

• Seek advice. Investing can get complicated and its often hard to stick to a long-term investment strategy on your own.

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

Source: AMP Capital January 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.

Five key themes from 2023

Despite lots of angst at the start of the year, 2023 turned out far better than feared. Key big picture themes of relevance for investors were:

1. Stronger than feared growth. Despite fears that recession was inevitable, on the back of multiple rate hikes and a rough reopening in China, it’s been avoided so far, including in Australia, helped by saving buffers, reopening boosts particularly to eating out & travel and some labour hoarding. Economic growth in 2023 looks to have been around 3% globally and around 1.9% in Australia which was helped by a population surge partly offsetting severe mortgage pain for some.

2. Disinflation. Inflation across major countries has fallen sharply from peaks of 8 to 11% last year to around 2 to 5%. Australia lagged on the way up and is doing the same on the way down, but it’s falling too.

   Inflation – falling as fast as it went up

   

   Source: Bloomberg, AMP

3. Peak interest rates. It took longer to get there and there was a “high for longer” scare on rates but most major central bank policy rates look to have peaked and this probably includes the RBA’s cash rate.

4. Geopolitical threats proved not to be as worrying as feared – the war in Ukraine remained contained, conflict in Israel flared again but so far has not spread to key oil producers (oil prices actually fell a bit) & the Cold War with China thawed a bit. A lack of major elections helped.

5. Artificial intelligence hit the big time after the launch of Chat GPT with hopes it will boost productivity. The immediate beneficiaries were key (mostly US) tech stocks – which helped them reverse the 2022 slump.

The return of Goldilocks

There were lots of bumps along the way – notably in the seasonally weak August to October period on the back of the sticky inflation/high for longer rates scare. But for diversified investors 2023 turned out okay with okay growth & falling inflation. The next table shows investment returns.

Investment returns for major asset classes

* Year to date to Nov. Source: Bloomberg, Morningstar, REIA, CoreLogic, AMP

• Global shares had a strong year as investors looked through more rate hikes and focussed on still strong profits and prospects for rate cuts.

• Chinese shares underperformed again on economic and property worries and this weighed on emerging market shares. Japanese shares outperformed followed by US shares with its high-tech weight.

• After outperforming in 2022, Australian shares underperformed on the back of worries about China & interest rate sensitive consumers.

• Government bonds slumped into October as yields rose to new highs but then rallied in anticipation of rate cuts giving modest returns.

• Real estate investment trusts remained constrained by higher bond yields and worries about reduced space demand.

• Unlisted assets were constrained by the valuation effect of high bond yields with property seeing losses from reduced space demand.

• Australian home prices rebounded as a supply shortfall with booming immigration swamped the negative effect of higher mortgage rates.

• Cash and bank term deposit returns improved substantially.

• The $A fell with higher US interest rates versus Australian rates and China growth worries before a partial recovery from October.

• Reflecting all this, balanced super funds had solid returns, continuing a zig zag pattern of strong, weak, strong, etc, years since 2017.

Four big worries for 2024

The worry list remains long:

• Inflation is still too high in most major countries – so central banks could still have another hawkish turn if it proves sticky above targets.

• The risk of recession is high reflecting the lagged impact of rate hikes. It’s hard to see how the biggest rate hiking cycle won’t have a major impact and the risks are already evident in tighter lending standards in the US, falling lending in Europe and stalling consumer spending in Australia. And unlike a year ago many are no longer worried about a recession which is negative from a contrarian perspective.

• Risks around the Chinese economy and property sector remain high.

• Geopolitical risk is high: with half the world’s population seeing 2024 elections including the US, the EU, India, Russia & South Africa; the US Government could have a shutdown starting 19 January & could have another divisive Biden v Trump presidential election with a Trump victory running the risk of weakening US democracy & US alliances & another trade war; the result of Taiwan’s 13 January election could see an easing or an escalation of tensions with China depending who wins; the war in Ukraine is continuing; and there is a high risk that the Israel/Hamas war could spread, eg to Iran, threatening oil supplies.

The recession risk suggests a high risk of a sharp pull back in shares.

Three reasons for optimism

However, there is reason for optimism. First, inflation has eased sharply to around 3% in major industrial countries and around 5% in Australia and is likely to continue to fall as: supply chain pressures have reversed; demand is cooling; and labour markets are easing with sharp falls in job vacancies. This includes in Australia which lagged US inflation on the way up and is just doing so again on the way down with our Inflation Indicator pointing to a further sharp fall.

Australia Pipeline Inflation Indicator

Source: Bloomberg, AMP

Second, we expect central banks in the US, Canada and Europe to start cutting rates in March or the June quarter. While there is still a high risk of one more hike in Australia in February, falling inflation should head this off so our base case is that the RBA has peaked ahead of rate cuts in the September quarter, taking the cash rate down to 3.6% by year end.

Third, while recession is a high risk and markets are no longer priced for it unlike at the start of 2023 if it does occur it should be mild:

• Most countries have not seen a spending boom that needs to be unwound and traditionally makes recessions deep. For example, in the US there has been no overinvestment in housing and capex, leverage is low and inventory levels are low.

• Similarly, in Australia consumer spending, housing investment and business investment are not running at excessive levels relative to GDP. And there is still a large pipeline of home building work yet to be done providing some offset to the slump in building approvals, and business investment plans still point to growth (albeit slower than it has been).

• Chinese growth has well and truly lost its lustre and property sector risks are high, but it’s likely to target roughly 5% GDP growth again and back this up with more fiscal stimulus if need be.

Finally, while there are a lot of geopolitical risks to keep an eye on it may not turn out badly: the US has a strong incentive to avoid an escalation in the Israel/Hamas war; the stalemate in Ukraine could turn into a frozen conflict – not good for Ukraine but no problem for investment markets; and elections won’t necessarily go in an adverse direction for markets. In relation to the US, the presidential election year normally sees average share returns (it’s the next two years that are normally sub-par), and since 1927 US shares have only had negative returns in four election years and for those worried about Trump it could turn out to be Nikki Haley.

Overall, global growth in 2024 is likely to be around 2.5%, down from around 3% in 2023, but not disastrous – with weakness in the first half and stronger conditions in the second half going into 2025. In Australia, growth is expected to slow to 1.5% in the year ahead with very weak, possibly mild recession conditions in the first half but stronger conditions later. Inflation is expected to fall to 3% in Australia.

Implications for investors

Easing inflation pressures, central banks moving to cut rates and prospects for stronger growth in 2025 should make for okay returns in 2024. However, with growth still slowing, shares historically tending to fall during the initial phase of rate cuts, a very high risk of recession and investors and share market valuations no longer positioned for recession, it’s likely to be a rougher and more constrained ride than in 2023.

• Global shares are expected to return a far more constrained 7%. The first half could be rough as growth weakens and possibly goes negative and valuations are less attractive than a year ago, but shares should ultimately benefit from rate cuts and lower bond yields and the anticipation of stronger growth later in the year and in 2025. Expect a slight outperformance by Asian and emerging market shares.

• Australian shares are likely to outperform global shares, after underperforming in 2023 helped by somewhat more attractive valuations. A recession could threaten this though so it’s hard to have a strong view. Expect the ASX 200 to end 2024 at around 7,500 points.

• Bonds are likely to provide returns around running yield or a bit more, as inflation slows and central banks cut rates.

• Unlisted commercial property returns are likely to be negative again due to the lagged impact of high bond yields & working from home.

• Australian home prices are likely to fall as high interest rates hit demand again and unemployment rises. The supply shortfall should prevent a sharper fall & expect a wide dispersion with prices still rising in Adelaide, Brisbane & Perth. Rate cuts later in the year will help.

• Cash and bank deposits are expected to provide returns of over 4%, reflecting the back up in interest rates.

• A rising trend in the $A is likely taking it to $US0.70, due to a fall in the overvalued $US and the Fed moving to cut rates before the RBA.

What to watch?

The main things to keep an eye on in 2024 are as follows: sticky inflation and central banks; the risk of recession & whether it’s mild or deep; the Chinese economy & property sector; US shutdown risks & the presidential election; and in Australia how the consumer and home prices respond to the lagged impact of high rates, including via rising unemployment.

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

Source: AMP Capital December 2023

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

At its December meeting the RBA left the cash rate on hold at 4.35%. This was in line with our own view & that of most economists along with money market expectations. It followed a 13th hike at its November meeting which meant a total of 425 basis points over 19 months since May last year, which has been the biggest interest rate hiking cycle since the late 1980s.

RBA rate hiking cycles since the late 1980s

Source: RBA, AMP

This took the cash rate to levels last seen in 2011 and mortgage rates to levels last seen in 2008.

Australian interest rates

Source: RBA, AMP

The RBA retains a tightening bias

The RBA no doubt considered again whether to hike or hold before opting to hold. In this regard it noted that since the last meeting new information has been broadly in line with their expectations, the October CPI suggests inflation continues to moderate and it doesn’t expect much further rise in wages growth. However, it continues to stress the importance of returning inflation to target and keeping inflation expectations down and remains concerned about sticky services inflation with the jobs market easing but still tight. While the RBA retained the softened wording from the November meeting that “whether further tightening of monetary policy is required…will depend upon the data and the evolving assessment of risks” it’s clear that it retains a bias to raise rates again.

There is no meeting in January but by the February meeting the RBA will have December quarter inflation data, two more rounds of retail sales and jobs data and revised RBA forecasts – so all of these will be critical. Given its hawkish bias our view is that the risk of another rate hike remains high at around 40% – and if it occurs it will be at the February meeting.

The case for rates being at the top

We have been way too optimistic as to how far the RBA would raise the cash rate, but our view remains that the RBA has done more than enough to bring inflation back to target and that we are likely at the peak in rates.

First, while the economy has been far more resilient than we expected when rate hikes started 19 months ago its well known in the words of Milton Friedman that “monetary actions affect economic conditions only after a lag that is both long and variable”. This can be up to 18 months or more. This is because it takes a while for the hikes to be passed through to borrowers and for them to adjust their spending and for this to impact companies and jobs. The experience of the late 1980s in Australia where the cash rate was raised from 10.5% to 18% though 1988 and 1989 but unemployment kept falling, only for the economy to fall into recession in 1990 is a classic example of these lags at work. (Rates were higher then, but the level of household debt to income was one third current levels.)

RBA rate hikes & unemployment in the late 1980s/early 1990s

Source: ABS, AMP

This time around the lag has likely been lengthened by savings buffers built up in the pandemic, the reopening boost, more than normal home borrowers locking in at 2% or so fixed rates and “labour hoarding” boosting employment. However, these protections are likely now wearing off.

The 13 rate hikes since May last year mean that a variable rate borrower with a $600,000 mortgage will have seen around an extra $17,000 a year added to their mortgage payments. Most may have sought a better deal but even if they got a 0.5% discount on their mortgage rate it would now amount to an extra $14,900 in extra mortgage payments. This has already seen housing debt interest payments as a share of household income double from their lows with scheduled total payments rise to a record share of income. It’s hard to see this not having a big impact on household spending. Particularly given the RBA’s analysis based on variable and fixed borrowers that around one in seven households with a mortgage were already cash flow negative in July, which will likely be higher by now.

Secondly, while the data is noisy, we are seeing ongoing evidence that rate hikes are biting with real per person retail sales down 4% on a year ago and the ABS’s Monthly Household Spending Indicator pointing to now falling real consumer spending, a sharp fall in building approvals from their highs, slowing business investment plans, job vacancies well down from their highs, unemployment starting a modest rising trend and now signs that home price gains are slowing again. Combined this is likely to continue to bear down on underlying inflationary pressures. And while a surge in petrol prices was a concern a month ago global oil prices have since turned down again and this is flowing through to lower petrol prices.

Retail sales growth

Source: ABS, AMP

Thirdly, the news on Australia inflation has improved after a setback in August and September and points to an ongoing fall. The Monthly CPI indicator for October came in far less than expected at 4.9%yoy, down from 5.6%, with an implied monthly fall of 0.3% mom. Of course, the monthly CPI can be very volatile, various subsidies impacted in October, key services (like hairdressing, dental and pet services weren’t measured) and underlying measures of inflation fell by less so there is a case to be cautious, but the good news is that the downtrend looks to be resuming.

Monthly CPI Indicator versus Quarterly CPI

Source: ABS, AMP

Consistent with this, our Australian Pipeline Inflation Indicator points to a further fall in inflation ahead.

Australia Pipeline Inflation Indicator

Source: AMP

In fact, monthly inflation could have a three in front of it by December. While some fret that Australian inflation is now well above the circa 3% yoy rates that apply in the US, Canada and Europe it should be recalled that Australian inflation lagged on the way up and peaked three to six months later and it’s doing the same on the way down so there is no reason to be alarmed that its currently higher. In fact, with monthly rises in November and December 2022 of 0.9% mom and 1.5% mom to drop out respectively in the next two months’ CPI releases we are likely to see monthly inflation with a three in front of it by year end. This will bring Australian inflation more into line with US, Canadian and European inflation.

Fourthly, the decline in global inflation points to a broader easing in global inflation pressure which will benefit Australia and it highlights that monetary policy still works in slowing inflation and so there is no reason why it shouldn’t work here too.

Finally, it should be noted that while the RBA has not raised its key policy rate as much as in other comparable countries (5% in Canada, 5.25% in the UK, 5.37% in the US & 5.5% in NZ), the rise in actual outstanding mortgage rates exceeds that in most other countries (reflecting the higher reliance on short dated borrowing here) implying a much bigger hit to households.

Changes in outstanding mortgage rates since 2021

Note this data is mostly only available up to Sept/Oct. Source: Macrobond, RBA, AMP

Concluding comment

The short-term risk for interest rates still remains on the upside given the RBA’s own tightening bias – so we are allowing for a 40% risk of another hike which would most likely come in February if it occurs. Yet continuing to raise interest rates will only add to the already very high risk of recession, particularly given the uncertainty around the long and variable lags with which rate hikes impact the economy meaning that there is a big impact yet to fully show up. As a result, the economy is likely to slow further into next year which along with supply chain improvements is likely to push headline inflation down to three point something earlier than the RBA is allowing. As a result, our base case is that the cash rate has peaked with rate cuts starting in the second half of next year. Key to watch will be the global economy, household spending, inflation and the labour market.

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

Source: AMP Capital December 2023

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

Changes in the value of the Australian dollar are important for Australian investors as they directly impact the value of international investments and indirectly effect the performance of domestic assets like shares via the impact on Australia’s global competitiveness. They also impact the cost of travelling overseas and import prices. But currency movements are also very hard to get right. Over the last few years, the $A has been soft. This note takes a look at the outlook for the $A.

Why has the $A been so soft?

Since reaching $US0.80 in February 2021 the $A has fallen leaving it below its average levels of the last few decades.

The $A and the $US v major currencies

Source: Bloomberg, AMP

The downtrend since February 2021 reflects a combination of:

• The initial slow reopening of the Australian economy from the pandemic relative to the US and Europe.

• Worries about a hit to global growth from the inflation surge and higher interest as the $A tends to be sensitive to global growth given Australia’s high proportion of commodity exports.

• This has been accentuated by worries about China with lockdowns last year, a patchy recovery this year and property sector worries.

• A downtrend in commodity prices after an initial boost mainly to energy prices from the Ukraine war.

• Less rate hikes from the RBA, compared to the US Federal Reserve which has reduced the incentive for investors to park their cash in Australia. As evident in the next chart the $A tends to fall when the gap between the RBA’s cash rate and the Fed Funds rate narrows (highlighted with arrows) as over the last two years and vice versa.

The interest rate gap between Aust and the US versus the $A

The dashed part of the rate gap line reflects money mkt expectations. Source: Bloomberg, AMP

• Relative strength in the $US generally (see the first chart above) as it tends to benefit in times of global uncertainty.

But there are five reasons to expect the $A to rise

After hitting a low of around $US0.63 in October the $A has risen to nearly $US0.66 and there’s good reason to expect a further rise.

• Firstly, from a long-term perspective the $A is somewhat cheap. The best guide to this is what is called purchasing power parity (PPP) according to which exchange rates should equilibrate the price of a basket of goods and services across countries – see the next chart.

The $A is below fair value based on relative prices

Source: RBA, ABS, AMP

If over time Australian prices and costs rise relative to the US, then the value of the $A should fall to maintain its real purchasing power. And vice versa if Australian inflation falls relative to the US. Consistent with this the $A tends to move in line with relative price differentials – or its purchasing power parity implied level – over the long-term. Over the last 25 years it has swung from being very cheap (with Australia being seen as an old economy in the tech boom) to being very expensive into the early 2010s with the commodity boom. Right now, it’s back to being modestly cheap again.

• Second, relative interest rates are starting to swing in Australia’s favour with increasing signs that the Fed is at the top whereas there is still a high risk that the RBA will hike rates further. Money market expectations show a narrowing gap between the RBA’s cash rate and the Fed Funds rate – see the relative interest rate chart above. More broadly the $US is expected to fall further as US interest rates top out.

• Third, global sentiment towards the $A is somewhat negative and this is reflected in short or underweight positions. In other words, many of those who want to sell the $A may have already done so and this leaves it vulnerable to a further rally if there is any good news.

$A positioning remains short

Source: Bloomberg, AMP

• Fourth, commodity prices look to be embarking on a new super cycle. The key drivers are the trend to onshoring reflecting a desire to avoid a rerun of pandemic supply disruptions and increased nationalism, the demand for clean energy and vehicles and increasing global defence spending all of which require new metal intensive investment compounded by global underinvestment in new commodity supply. This is positive for Australia’s industrial commodity exports.

Long term bull and bear markets in commodity prices

Source: Bloomberg, AMP

• Finally, reflecting continuing relatively high energy and iron ore prices Australia is continuing to run a current account surplus, albeit its down from recent highs (as gas & coal prices have fallen back and Australians have resumed travelling internationally). The swing into a current account surplus means Australia is a capital exporter and that there is more natural transactional demand for the $A than supply.

Aust current account surplus till very high

Source: ABS, AMP

Where to from here and what is the main risk?

We expect the combination of a slightly more hawkish RBA, a falling $US at a time when the $A is undervalued and positioning towards it still short to push the $A higher into next year, likely taking it back above $US0.70.

The main risk is if the global and/or Australian economies slide into recession next year – this is not our base case but it’s a very high risk and if it occurs it could result in a new leg down in the $A as it is a growth sensitive currency and a rebound in the relatively defensive $US.

What would a further rise in the $A mean for investors?

For Australian based investors, a rise in the $A will reduce the value of an international asset (and hence its return), and vice versa for a fall in the $A. The decline in the $A over the last few years has enhanced the returns from global shares in Australian dollar terms. So, when investing in international assets, an Australian investor has the choice of being hedged (which removes this currency impact) or unhedged (which leaves the investor exposed to $A changes). Given our expectation for the $A to rise further into next year there is a case for investors to tilt towards a more hedged exposure of their international investments.

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

Global share prices versus $A

Source: Bloomberg, AMP

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

Source: AMP Capital November 2023

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.