Olivers Insights

Introduction

After sharp share market falls when headlines scream about the billions wiped off the market the usual questions are: what caused the fall? what’s the outlook? and what does it mean for superannuation? The correct answer to the latter should be something like “nothing really, as super is a long-term investment and share market volatility is normal.” But that often sounds like marketing spin. However, the reality is that – except for those who are into trading or are at, or close to, retirement – shares and super really are long-term investments. Here’s why.

Super funds and shares

Superannuation is aimed (within reason) at providing maximum (risk-adjusted) funds for use in retirement. So typical Australian super funds have a bias towards shares and other growth assets, particularly for younger members, and some exposure to defensive assets like bonds and cash in order to avoid excessive short-term volatility in returns.

The power of compound interest

These approaches seek to take maximum advantage of the power of compound interest. The next chart shows the value of a $100 investment in each of Australian cash, bonds, shares, and residential property from 1926 assuming any interest, dividends and rents are reinvested along the way. As return series for commercial property and infrastructure only go back a few decades I have used residential property as a proxy.

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Source: ABS, REIA, Global Financial Data, AMP Capital

Because shares and property provide higher returns over long periods the value of an investment in them compounds to a much higher amount over long periods. So, it makes sense to have a decent exposure to them when saving for retirement. The higher return from shares and growth assets reflects compensation for the greater risk in investing in them – in terms of capital loss, volatility and illiquidity – relative to cash & bonds.

But investors don’t have 90 years?

Of course, we don’t have ninety odd years to save for retirement. In fact, our natural tendency is to think very short term. And this is where the problem starts. On a day to day basis shares are down almost as much as they are up. See the next chart. So, day to day, it’s pretty much a coin toss as to whether you will get good news or bad. So, it’s understandable that many are skeptical of them. But if you just look monthly and allow for dividends, the historical experience tells us you will only get bad news around a third of the time. If you go out to once a decade, positive returns have been seen 100% of the time for Australian shares and 82% for US shares.

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Daily & mthly data from 1995,yrs & decades from 1900. GFD, AMP Capital

This can also be demonstrated in the following charts. On a rolling 12 month ended basis the returns from shares bounce around all over the place relative to cash and bonds.

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Source: Global Financial Data, AMP Capital

However, over rolling ten-year periods, shares have invariably done better, although there have been some periods where returns from bonds and cash have done better, albeit briefly.

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Source: Global Financial Data, AMP Capital

Pushing the horizon out to rolling 20-year returns has almost always seen shares do even better, although a surge in cash and bond returns from the 1970s/1980s (after high inflation pushed interest rates up) has seen the gap narrow.

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Source: Global Financial Data, AMP Capital

Over rolling 40-year periods – the working years of a typical person – shares have always done better.

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Source: Global Financial Data, AMP Capital

This is all consistent with the basic proposition that higher short-term volatility from shares (often reflecting exposure to periods of falling profits and a risk that companies go bust) is rewarded over the long term with higher returns.

But why not try and time short-term market moves?

The temptation to do this is immense. With the benefit of hindsight many swings in markets like the tech boom and bust and the GFC look inevitable and hence forecastable and so it’s natural to think “why not give it a go?” by switching between say cash and shares within your super to anticipate market moves. Fair enough if you have a process and put the effort in. But without a tried and tested market timing process, trying to time the market is difficult. A good way to demonstrate this is with a comparison of returns if an investor is fully invested in shares versus missing out on the best (or worst) days. The next chart shows that if you were fully invested in Australian shares from January 1995, you would have returned 9.7% pa (with dividends but not allowing for franking credits, tax and fees).

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Source: Bloomberg, AMP Capital

If by trying to time the market you avoided the 10 worst days (yellow bars), you would have boosted your return to 12.4% pa. And if you avoided the 40 worst days, it would have been boosted to 17.3% pa! But this is very hard, and many investors only get out after the bad returns have occurred, just in time to miss some of the best days. For example, if by trying to time the market you miss the 10 best days (blue bars), the return falls to 7.6% pa. If you miss the 40 best days, it drops to just 3.6% pa.

The following chart shows the difficulties of short-term timing in another way. It shows the cumulative return of two portfolios.

• A fixed balanced mix of 70 per cent Australian equities, 25 per cent bonds and five per cent cash;

• A “switching portfolio” which starts off with the above but moves 100 per cent into cash after any negative calendar year in the balanced portfolio and doesn’t move back until after the balanced portfolio has a calendar year of positive returns. We have assumed a two-month lag.

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Source: Global Financial Data, AMP Capital

Over the long run the switching portfolio produces an average return of 8.8% pa versus 10.2% pa for the balanced mix. From a $100 investment in 1928 the switching portfolio would have grown to $218,040 compared to $705,497 for the constant mix.

Key messages

First, while shares and other growth assets go through periods of short-term underperformance relative to bonds and cash they provide superior returns over the long term. As such it makes sense that superannuation has a high exposure to them.

Second, switching to cash after a bad patch is not the best strategy for maximising wealth over time.

Third, the less you look at your investments the less you will be disappointed. This reduces the chance of selling at the wrong time or adopting an overly cautious stance.

The best approach is to simply recognise that super and investing in shares is a long-term investment. The exceptions to this are if you are really into putting in the effort to getting short-term trading right and/or you are close to, or in, retirement.

Source: AMP Capital 14th November 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.

Bad meme

There is always someone telling us that there is some sort of economic/financial disaster coming our way. However, there does seem to be a higher level of hand wringing now about the global economic outlook than normal. These concerns basically go something like this:

• Global debt – both public and private – is at record levels relative to GDP and with public debt ratios so high there is no scope for fiscal stimulus should things go really bad.

Source: IMF, RBA, AMP Capital

• Years of quantitative easing and other unconventional monetary policies like negative interest rates by central banks in major advanced countries haven’t worked and seem to have no end.

• More and more debt globally is trading on negative interest rates – it’s now around $US14 trillion including around 25% of all government bonds – which is unnatural and causing distortions in valuing assets with risks of asset bubbles.

• Inequality (as measured by Gini coefficients) is rising – particularly in the US – which is driving a populist backlash against rationalist market-friendly economic policies of globalisation/free trade (as evident in Trump’s trade wars), deregulation and privatisation.

Source: OECD, Standardised World Income Inequality Database, AMP Capital

• This along with the relative decline of US economic and military power is contributing to geopolitical tensions as we move from a “unipolar world” (dominated by the US after the end of the Cold War) to a “multipolar world” as other countries (China, Russia, Iran/Saudi Arabia, etc) move in to fill the gap left by the US or even “challenge” the US.

This is all seen as being bad for global growth and hence growth assets, all of which is being heightened by the downturn in global growth seen over the last year or so.

Five reasons not to be too fussed.

There is no denying these concerns. Debt is at record levels globally. QE has been running in various iterations for more than a decade now in some countries. Inequality is up – albeit its mainly a US and emerging country issue. Support for market-friendly economic rationalist policies such as globalisation, deregulation and privatisation seems to have waned (except in France). And geopolitical risks are up. All these developments point to the risk of slower global growth and investment returns ahead and may figure in the next major bear market. But there is always something to worry about (otherwise shares would offer no return advantage over cash) and trying to time the next downturn is hard. Moreover, there are five reasons not to get too fussed about the global outlook.

1. Debt is more complicated than being at a record

History tells us that the next major crisis will involve debt problems of some sort. But what’s new – they all do! Just because global debt is at record levels does not mean that a crisis is imminent. There are several points to note here:

• debt has been trending up ever since it was invented;

• comparing debt to income (or GDP) is like comparing apples to oranges as debt is a stock and income is a flow – the key is to compare debt against assets and here the numbers are not so scary because debt and assets tend to rise together

• debt interest burdens are low thanks to low interest rates

• all of the rise in debt in developed countries since the GFC has come from public debt and the risk of default here is very low because governments can tax and print money.

While Modern Monetary Theory has its issues, it does remind us that as long as a government borrows in its own currency and inflation is not a problem, it has more flexibility to provide stimulus than high public debt to GDP ratios suggest.

2. QE’s end point is not necessarily negative

Quantitative easing and other unconventional monetary policies actually do appear to have helped. Since its high in 2013 unemployment in the Eurozone has fallen from 12% to 7.5% and in the US it fell from 9% in 2011 to 4% in 2017 enabling the Fed to start unwinding unconventional monetary policy. Inflation has not been returned to 2% targets, but wages growth has lifted and at the start of last year it looked like the global economy was getting back to normal. What kicked the global economy off the rails again was a combination of Trump’s trade wars, a debt squeeze in China and tougher auto emission controls. But this it wasn’t due to a failure of quantitative easing.

As to how quantitative easing is eventually unwound there is no easy answer, but there is no reason to believe that it will end with a calamity. First, in the absence of a surge in inflation necessitating a withdrawal of the money that has been pumped into the global economy there is no reason to withdraw it. And when inflation does start to rise it can be reversed gradually by central banks not replacing their bond holdings as they mature.

Second, the assets central banks purchased as part of QE have boosted the size of their balance sheets but the varied size of central bank balance sheets from one country to another as a share of their economy shows that there is no natural optimal level for them. In fact, the Fed is now resuming natural growth in its balance sheet as occurred prior to the GFC so its balance sheet may just stay high (as along as inflation is not a problem).

Finally, if push came to shove just consider what would happen if say the Bank of Japan told the Japanese government that it no longer expects payment at maturity for the 50% of Government bonds it holds? The BoJ would write down its bond holding and the Japanese Government would suffer a loss on its investment in the BoJ but that would be matched by a write down in its liabilities. Basically, nothing would happen except that Japanese government debt would fall dramatically!

3. Inflation and interest rates are low

The key thing that has caused many sceptics to miss out on good returns this decade is that they focussed on low inflation as reflecting low demand growth but missed out on the positive valuation boost to assets like shares and property that low inflation and low interest rates provides.

4. Rapid technological innovation and growth in middle income Asia is continuing

This is well known and has been done to death, so I won’t go over it suffice to say that there are still a lot of positives helping underpin the global outlook and these two remain big ones.

5. Global growth looks like it may pick up

While the slowdown in global growth over the last 18 months has been scary and associated with share market volatility, the conditions are not in place for a deeper slide into global recession like we saw at the time of the GFC – excesses like overspending, surging inflation, excessive monetary tightening are not present. In fact, various signs are pointing to a cyclical global pick up ahead:

• Bond yields are up from their lows & look to be trending up

• The US yield curve is now mostly positive – suggesting the inversion seen this year may have been another false recession signal like seen in 1996 and 1998

Source: NBER, Bloomberg, AMP Capital

• European, Japanese & emerging shares are looking better

• Cyclical sectors like consumer discretionary, industrials and banks are looking better

• The US dollar looks like it might have peaked; and

• Business conditions PMIs for the US, Europe & China were flattish in October & may be stabilising. This saw the global manufacturing PMI go sideways and a rise in the services PMI and both still look like the 2012 and 2016 slowdowns.

Source: Markit, Bloomberg, AMP Capital

These could be pointers to global monetary easing getting traction. Of course, much depends on what happens to geopolitical risks. The US election next year will be a big one to keep an eye on and beyond that US/China tensions look likely to be with us for years. But there is reason to expect some respite in the short term on the geopolitical front:

First, the economic slowdown in both China and the US is pressuring both to defuse the trade dispute in the short term. This pressure is greater now as Trump wants to get re-elected next year and knows that he won’t if he lets the US slide into recession or unemployment rise. China may prefer to wait till after the election but is more likely to opt for the devil it knows.

Second, Trump’s avoidance of retaliation after the attack on Saudi’s oil production facilities in September shows a desire to avoid getting into military conflict in the Middle East.
Third, Brexit risks are on the back burner for now (although they could still come up again next year).

Concluding comment

There is good reason to expect the global economic cycle to turn up in the year ahead just as it did after the growth in 2012 and 2016. This should be positive for growth assets like shares. Finally, for those worried that more and more debt will trade at negative interest rates our view is that this is unlikely: many countries have already sworn off using rates including the US and RBA Governor Lowe says it’s extremely unlikely in Australia. And if growth picks up as we expect the proportion of global debt on negative rates will decline as it did after 2016.

Source: AMP Capital 7th November 2019

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

The world of investing can be confusing and scary at times. But fortunately, the basics of investing are timeless and some investors (often the best) have a knack of encapsulating these in a sentence or two that is insightful and easy to understand. In recent years I’ve written several insights highlighting investment quotes I find particularly useful. Here are some more.

The market

“Stock price movements actually begin to reflect new developments before its generally recognised they have taken place.” Arthur Zeikel

This goes to the nub of how share markets work – they are forward looking. Regularly I have seen share markets bottom and start moving higher even when the fundamental news is still terrible, only to see the news improve and vice versa. This is why many often get wrong footed – selling at bear market depths because the fundamental news is so bad and buying at the height of a bull market because the news is so good.

“It’s a basic fact of life that many things everybody knows turn out to be wrong.” Jim Rogers

This can’t apply to everything – eg if it’s raining outside then it is. But when it comes to investing this quote highlights how perverse it can be because when everyone is saying the same thing – like economic conditions are so bad shares can’t recover – then maybe the share market has already factored it in, the crowd has sold and the cycle will soon turn up.

“That men and women do not learn very much from the lessons of history is the most important of all the lessons of history.” Aldous Huxley

Which is partly why investment cycles perpetuate no matter how much regulators try and guard against a return to the behaviour which gave us the last boom and bust. The key for investors is to have an historical perspective, partly so they can filter the noise from what matters but also to help guard against being sucked up in periods of euphoria or pessimism.

“Cash is a fact, profit is an opinion.” Alfred Rappaport

This is one reason why dividends are great – providing they are not being paid for out of debt, they reflect that companies are actually generating cash and so can afford to pay the dividend.

Contrarian investing

“Even the intelligent investor is going to need considerable willpower to keep from following the crowd.” Ben Graham

When times are good the crowd is happy and fully invested. But it gets to a point where everyone who wants to buy has. This leaves the market vulnerable to bad news because there is no one left to buy. Similarly, after a sharp fall the crowd gets negative, sells their investments to the point that everyone who wants to sell has and so the market sets up for a rally when some good, or less bad, news comes along. So the point of maximum risk is when most are euphoric, and the point of maximum opportunity is when most are pessimistic. But for many investors trying to sell when the market is booming and all around you are euphoric is tough. As is trying to buy after the market has crashed and everyone is pessimistic.

Having a goal and a plan

“Compound interest is the eighth wonder of the world. He who understands it, earns it…he who doesn’t, pays it.” Albert Einstein

Some may argue it was Patsy Kensit! But when it comes to investing, your best friend is time and the earlier you start, the better. This is the best way to take advantage of the magic of compound interest. (And the worst way to experience its downside is letting credit card debt build up!) The next chart shows the value of $1 invested in various Australian asset classes since 1900 allowing for reinvesting any income along the way. That $1 would have grown to $241 if invested in cash, $979 in bonds but a whopping $630,819 in shares.

 

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 Source: Global Financial Data, AMP Capital

 

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Source: Global Financial Data, AMP Capital

Since I first looked at “Five great charts on investing for income” two years ago, the Australian cash rate has halved, 10-year bond yields have fallen by two thirds and interest rates have resumed falling globally. Ever lower interest rates and periodic turmoil in investment markets provides an ongoing reminder of the importance of the income (cash) flow or yield an investment provides. The environment of low interest rates is challenging for those relying on investment income to fund their living costs and investing for income can seem daunting. So this note looks at five charts I find useful in understanding investing for income.

Chart #1 Alternatives to bank deposits

The income yield an investment provides is basically its annual cash flow divided by the value of the investment.

• For bank deposits, the yield is simply the interest rate, eg bank 1-year term deposit rates in Australia are about 1.3% and so this is the cash flow they will yield in the year ahead.

• For ten-year Australian Government bonds, annual cash payments on the bonds (coupons) relative to the current price of the bonds provides a yield of 1% right now.

• For corporate debt, it’s a margin above government bond yields and depends on the riskiness of the company but is currently averaging around 2% in Australia.

• For residential property, the yield is the annual value of rents as a percentage of the value of the property. On average in Australian capital cities it is about 4.2% for apartments and around 2.8% for houses. After allowing for costs, net rental yields are about 2 percentage points lower. 

• For unlisted commercial property, yields are around 4.9%.

• For infrastructure investment it averages around 4%, but franking credits could add 0.45% to this.

• For a basket of Australian shares represented by the ASX 200 index, annual dividend payments are running around 4.3% of the value of the shares. Once franking credits are allowed for, this pushes up to around 5.6%.

The next chart shows the yield available on a range of investments both now and in December 2009 for comparison.

Source: Bloomberg, REIA, RBA, JLL, AMP Capital

Key messages: First, the yield on bank deposits and government bonds is woeful. Second, there are alternatives to cash when it comes to yield or income, notably shares, property and infrastructure but even here yields have generally trended down (albeit less so for shares). Of course, investors need to allow for risk. Bank deposits have close to zero risk but any move to higher-yielding investments does entail taking on risk.

Chart #2 The gap between yields on different assets provides a guide to value

The next chart shows average yields on Australian shares and unlisted commercial property relative to the one-year term deposit rate since 2000. With share and property yields not plunging to the degree bank deposit rates have, the gap between the former and latter is extremely wide. In fact, the share yield is in its historic range. All things equal, this suggests commercial property and Australian shares continue to provide better value. The same applies to unlisted infrastructure.

Source: JLL, Bloomberg, AMP Capital

Key message: comparing yields provides a guide to relative value, and shares and unlisted commercial property remain very attractive relative to bank deposits.

Chart #3 Shares can provide stronger growth in income with less volatility than bank deposits

Investing in shares entails the risk of capital loss, but can offer a higher and less volatile income flow over time. The next chart compares initial $100,000 investments in Australian shares (ASX 200) and one-year term deposits in December 1979 and the income they have provided over time (before franking credits are allowed for in the case of shares).

2019 data is year to date/annualised. Source: RBA, Bloomberg, AMP Capital

The term deposit would still be worth $100,000 (red line) and last year would have paid roughly $2200 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1.31 million (blue line) now and last year would have paid $47,792 in dividends before franking credits (blue bars). The point is that dividends tend to grow over time (because profits and hence an investment in shares tends to rise in value) and are relatively stable compared to income from bank deposits, which vary with interest rate settings. Over the period the worst decline in dividend income from shares was a 32% decline between 2009 and 2011, whereas the income from bank deposits plunged 68% between 1990 and 1994 and by 65% between 2011 and this year. And it’s set to plunge even more given the falls in term deposit rates since June. Once franking credits are allowed for, the comparison would become even more favourable towards shares.

Key message: shares come with the risk of capital loss, but a well-diversified portfolio of Australian shares can provide stronger growth in income with less volatility in that income than bank term deposits. The key question investors focused on income (or cash flow) need to ask is what is most important: stability in the value of their investment or a higher, more sustainable income flow than bank deposits offer? But if investors do go down the share path, it’s critical to have a well-diversified portfolio of shares paying high and sustainable dividend yields. Look for stocks that have a reliable track record of growing those dividends and that have dividends that are not threatened by things like excessive gearing.

Chart #4 A bird in the hand is worth two in the bush

A high and sustainable starting point yield provides some security during volatile times. Since 1900, dividends (prior to allowing for franking credits) have provided just over half of the 11.8% average annual return from Australian shares and as can be seen in the next chart their contribution has been stable in contrast to the capital value of shares.

Source: Global Financial Data, Bloomberg, AMP Capital

Dividends are relatively smooth over time because most companies hate having to cut them as they know it annoys shareholders, so they prefer to keep them sustainable.

Key message: a high and sustainable income yield for an investment provides some security during volatile times. It’s a bit like a down payment on future returns.

Chart 5 Yield provides a guide to future returns

The income yield an investment provides is a key building block in its total return, which is determined by the following.

Total return = yield + capital growth

Generally speaking, the higher the yield an investor invests at, the higher the return their investment will likely provide. This is self-evident in the case of bank deposits because the yield is the return (assuming the bank does not default on its deposits – which is very unlikely in Australia given government protections). It can be seen in relation to bonds in the next chart, which shows a scatter plot of Australian ten-year bond yields since 1950 (along the horizontal axis) against subsequent ten-year bond returns based on the Composite All Maturities Bond Index (vertical axis). Over short-term periods, bond prices can move up and down and so influence short-term returns, but over the medium term the main driver of the return a bond investor will get is what bond yields were when they invested. If the yield on a ten-year bond is 5%, then if you hold the bond to maturity your return will be 5%. Of course, a portfolio of bonds will reflect a range of maturities and so the relationship is not perfect, but it can be seen in the next chart that the higher the starting point bond yield, the higher the subsequent return.

Source: Global Financial Data, Bloomberg, AMP Capital

When bond yields are high, they drive high bond returns over the medium term and vice versa. For example, when Australian ten-year bond yields in January 1982 were 15.2% it’s not surprising that returns from bonds over the subsequent ten years were 15.4% per annum. Similarly, when bond yields were just 3.1% in January 1950, it’s no surprise that returns from bonds over the next ten years were 3.1%. At 1% now, we are off (the bottom of) the chart meaning record low bond returns for the next decade.

Similar, albeit less perfect, relationships exist for other asset classes – the higher the yield, the higher the subsequent return.

As always, there are some risks investors must watch out for. At the individual share level, a very high dividend yield may be a sign of a “value trap” – where current profits and dividends may be fine but there is an impending threat to the company and so the share price is low. Second, high distributions may also be unsustainable if they are being paid for out of debt and reflect excessive gearing or high-risk investments. There is no free lunch.

Key message: while returns have been solid lately, low investment yields do warn of lower returns ahead – most notably from government bonds.

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

Source: AMP Capital 15 Oct 2019

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

The claim that Australia has gone 28 years without a recession since the early 1990s recession ended in 1991 has been subject to some criticism in recent times with the economy sliding into a “per capita recession” where economic growth has been below population growth. Some have latched on to a recent Federal Reserve Bank of St Louis analysis that noted the 28 year claim should be “taken with a grain of salt” because “Australia has had three recessions since 1991 when looking at GDP per capita, the most recent one being from the second quarter of 2018 to the first quarter of 2019.”

GDP per capita

It’s true that Australia’s relatively strong population growth helps grow the economy. And in terms of living standards it’s GDP per person or per capita that really matters and the recent slowdown in GDP growth to 1.4% year on year which is below 1.6% population growth is a big concern. I even wrote a note after the release of the December quarter GDP data entitled “Australia enters a per capita recession” (which can be found here). But it does not measure up as a conventional recession.

Recession definitions

The conventional definition of recession is two or more consecutive quarters of falling real GDP. 

Source: ABS, AMP Capital

On this basis Australia’s last recession ended back in 1991, ie 28 years ago.

However, if GDP per capita is looked at then Australia has had three per capita recessions since 1991 using the two or more consecutive quarters of decline approach – in the September and December quarters of 2000, the March and June quarters of 2006 and the September and December quarters of 2018. There was also a per capita recession in 1985-86.

Source: ABS, AMP Capital

However, while it may be reasonable to call them “per capita recessions” they don’t compare at all to the scale of the conventional recessions in 1981-83 and 1990-91 that saw far deeper and longer falls in GDP and per capita GDP.

* Because there were two periods of consecutive quarterly declines in per capita GDP in each of the 1981-83 and 1990-1991 periods broken by one quarterly rise the Fed Reserve Bank of St Louis note ascribes two per capita recessions in each period although for all intents and purposes they were really each just one big recession. Source: ABS

Wider definitions of recession

Nor would the per capita recessions of 1985-86, 2000, 2006 and 2018 comply with wider definitions of recession such as that of the US National Bureau of Economic Research that defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.

For example, the next chart shows employment growth and unemployment since 1980 with per capita recessions shaded.  

Source: ABS, AMP Capital

Only the per capita recessions of 1981-83 and 1990-91 which were also conventional recessions saw a significant slump in employment (both of around 4%) and sharp rises in unemployment (with both seeing around a 5 percentage point rise). The other per capita recessions saw very little or no fall in employment and only small or no rises in unemployment. In fact, through the last per capita recession of 2006 jobs growth remained solid and unemployment fell, which makes a non-sense of calling it a recession particularly given it was in the midst of the mining boom! The recessions of the early 1980s and 1990s were horrendous events in terms of mass job losses, corporate collapses and financial failures. The per capita recessions of 2000, 2006 and more recently do not compare.

Which brings us to the smell test. For Australians like myself who lived through the early 1980s and early 1990s recessions it’s doubtful that they would recall the per capita recessions of 1985-86, 2000 or 2006 as real recessions. Which is why they are often just referred to as slowdowns. The 2000 slowdown occurred because of the pull forward of spending due to the start up of the GST and also the end of the Olympics and the 2006 per capita recession can hardly be seen as a recession given it was in one of the biggest booms in Australian history, ie the mining boom. And a common question in relation to the recent episode is “things aren’t that bad, so why is the RBA cutting?” (The answer being that waiting for a real recession is likely leaving it too late.)

Consistent with this, consumer and business confidence was bouncing around average levels in 2000, 2006 and more recently in contrast to the slump of the early 1990s.

Source: NAB, Westpac/MI, AMP Capital

It’s not just strong population growth

While strong population growth helps grow the Australian economy as the Fed Reserve Bank of St Louis notes, it didn’t stop real recessions in 1981-83 and 1990-91. Going into the early 1980s recession population growth was 1.8% year on year and going into the early 1990s recession it was 1.5% year on year. So, if strong population growth didn’t stop conventional recessions in the past, other factors must have been playing a roll in heading off conventional recessions over the last 28 years. These include:

• economic reforms of the 1980s and 1990s that made the economy more flexible;

• the floating of the $A that has seen it fall whenever there is a major economic problem providing a shock absorber for the economy;

• desynchronised cycles across industry sectors and states;

• strong growth in China that helped export demand through the GFC;

• counter cyclical economic policy – like stimulus payments and monetary easing that helped in the GFC; and

• good luck – which can never be ignored lest hubris set in!

But what about through the GFC?

To be sure, Australian confidence had a recession-like fall through the global financial crisis (GFC) reflecting the dyer global news at the time and annual growth in GDP per capita fell, but there was only one quarter of contraction in both GDP and GDP per capita and there was no recession like slump in employment or rise in unemployment. What’s more the fall in per capita GDP at the time of the GFC was trivial compared to that in the US, Europe and Japan suggesting again that other things must have helped Australia beyond strong population growth.

Source: ABS, Bloomberg, AMP Capital

Concluding comment

The slowdown in Australian growth to below the level of population growth at a time of weak wages growth and high underemployment is a real concern and highlights the need to boost growth and productivity. However, a per capita recession on its own is not the same as a real recession, and the three seen over the last 28 years do not compare to the recessions of the early 1980s and early 1990s in terms of their impact on jobs, economic welfare and confidence. Which is why they are normally just referred to as growth slowdowns as opposed to being recessions. To be sure the risk of conventional recession in Australia has increased – although for the reasons noted here I think it remains unlikely. But there is clearly more to Australia’s 28 years without a conventional recession than just strong population growth.

Source: AMP Capital 30 September 2019

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

The past 10 years have seen pretty good returns for well-diversified investors. The median balanced growth superannuation fund returned 7.3% pa over the five years to July and 8.2% pa over 10 years and that’s after fees and taxes. This is impressive given that inflation has been around 2%. 

Source: Mercer Investment Consulting, Morningstar, AMP Capital

Shares and growth assets have literally climbed a wall of worry this decade with a revolving door list of worries around public debt, the Eurozone, deflation, inflation, rate hikes, Trump, North Korea, China, trade wars, growth, house prices, etc. But returns benefitted from the recovery after the GFC and a search for yield as interest rates have collapsed depressing yields on most assets. But – while it sounds like a broken record – the decline in yields points to eventually more constrained returns ahead.

Declining yields = falling medium-term return potential

Investment returns have two components: yield (or income flow) and capital growth. Looking at both of these components points to lower average investment returns over the next five years compared to the last five years. It’s basic to investing that the price of an asset moves inversely to its yield all other things being equal. Suppose an asset pays $10 a year in income and suppose its price is $100, which means an income flow or yield of 10%. If interest rates are cut resulting in increased demand for the asset, as investors search for a higher yield, such that its price rises to $120 given the $10 annual income flow its yield will have fallen to 8.3% (ie $10 divided by $120) as its price has gone up by 20%. So, yield moves inversely to price. But as yields decline it means a lower return potential going forward.

Since the early 1980s investment yields have collapsed. Back then the RBA’s “cash rate” was around 14%, 1-year bank term deposit rates were nearly 14%, 10-year bond yields were around 13.5%, commercial and residential property yields were around 8-9% and dividend yields on shares were around 6.5% in Australia and 5% globally. This meant that investments were already providing very high income so only modest capital growth was needed for growth assets to generate good returns. So, most assets had very strong returns and balanced growth super fund returns averaged 14.1% in nominal terms and 9.4% in real terms between 1982 and 1999 (after taxes and fees).

Over the last four decades, investment yields have mostly fallen quite sharply. See the next chart.

Source: Bloomberg, REIA, JLL, AMP Capital

Today the cash rate is 1%, 1-year bank term deposit rates are 1.5%, 10-year bond yields are 0.9%, gross residential property yields are around 3%, commercial property yields are just below 5%, dividend yields are still around 5.5% for Australian shares (with franking credits) but they are 2.5% for global shares. This points to a lower return potential for a diversified mix of assets.

What’s more, the capital growth potential from growth assets is likely to be constrained relative to the past reflecting more constrained nominal economic growth. Several megatrends are likely to impact growth over the medium term. These include:

• Continued slower growth in household debt. 

• An ongoing retreat from globalisation, deregulation and small government in favour of populist, less market friendly policies.

• A shift in corporate focus from profit to “balanced scorecards”.

• Rising geopolitical tensions – notably as the US attempts to constrain the rising power of China as evident in the trade war.

• Aging and slowing populations – resulting in slowing labour force growth and rising pressure on public sector budgets.

• Technological innovation and automation.

• Continuing rapid growth in Asia and China’s middle class. 

• Pressure to slow emissions & the impact of global warning.

• A large shift to sustainable energy as its cost continues to fall.

Most of these will constrain economic growth & hence returns.

Medium-term return projections

Our approach to get a handle on medium-term return potential is to start with current yields for each asset class and apply simple and consistent assumptions regarding capital growth reflecting the above-mentioned megatrends. We also prefer to avoid forecasting and like to keep the analysis simple.

• For bonds, the best predictor of future medium-term returns is current bond yields as can be seen historically in the next chart. If a 10-year bond yield is held to maturity its initial yield (0.93% right now in Australia) will be its return over 10 years (ie 0.93%). We use 5-year bond yields as they more closely match the maturity of bond indexes.

Source: Global Financial Data, Bloomberg, AMP Capital

• For equities, current dividend yields plus trend nominal GDP growth (a proxy for capital growth) does a good job of predicting medium-term returns.¹

• For property, we use current rental yields and likely trend inflation as a proxy for rental and capital growth.

• For unlisted infrastructure, we use current average yields and capital growth just ahead of inflation.

• In the case of cash, the current rate is of no value in assessing its medium-term return. So we allow for some rise in cash rates over time.

Our latest return projections are shown in the next table.

Projected medium term returns, %pa, pre-fees and taxes

# Current dividend yield for shares, distribution/net rental yields for property and duration matched bond yield for bonds. ^ Includes forward points. * With franking credits added in. Source: AMP Capital.

The second column shows each asset’s current income yield, the third shows their 5-10 year growth potential, and the final column their total return potential. Note that:

• We assume inflation averages around or just below central bank targets.

• For Australia we have adopted a relatively conservative growth assumption reflecting slower productivity growth.

• We allow for forward points in the return projections for global assets based around current market pricing.

Key observations

Several things are worth noting from these projections.

• The medium-term return potential has continued to fall due largely to the rally in most assets and fall in investment yields. Projected returns using this approach for a diversified growth mix of assets have fallen from 10.3% pa at the low point of the GFC in March 2009, to 8.6% five years ago, to 6.2% a year ago and to now just 5.6%.

Source: AMP Capital

• Government bonds offer low returns due to ultra-low yields. Yes, bond returns have been strong lately as yields have collapsed pushing up bond prices. But this is no guide to future returns, particularly if bond yields stop falling.

• Unlisted commercial property and infrastructure continue to come out relatively well, reflecting their higher yields.

• Australian shares stack up well on the basis of yield, but it’s still hard to beat Asian/emerging shares for growth potential.

• The downside risks to our medium-term return projections are that: the world plunges into a recession driving another major bear market in shares or that investment yields are pushed up to more normal levels as inflation rebounds causing large capital losses. Just allow that drawdowns in returns tend to be infrequent but concentrated and it’s been a while since the last big one. See the first chart. 

• The upside risks are (always) less obvious but could occur if we see improving global growth but inflation remaining low.

Implications for investors

• First, have reasonable return expectations. Low yields & constrained GDP growth indicate it’s not reasonable to expect sustained double-digit or even high single digit returns. In fact, the trend decline in the rolling 10-year average of both nominal and real super fund returns since the 1990s indicates we have been in a lower-return world for many years – it’s just that it only becomes clear every so often with bear markets and then strong returns in between.

• Second, remember that responding to a lower return potential from major asset classes by allocating more to growth assets does mean taking on more risk.

• Third, bear markets are painful, but they do push up the medium-term return potential of investment markets to higher levels and so provide opportunities for investors.

• Fourth, some of the decline in return potential reflects very low inflation – real returns haven’t fallen as much. 

• Finally, focus on assets with decent sustainable income flow as they provide confidence regarding future returns.

Source: AMP Capital 25 September 2019

¹Adjustments can be made for: dividend payout ratios (but history shows retained earnings often don’t lead to higher returns so the dividend yield is the best guide); the potential for PEs to move to some equilibrium level (but forecasting the equilibrium PE can be difficult and dividend yields send valuation signals anyway); and adjusting the capital growth assumption for some assessment regarding profit margins (but this is hard to get right). So, we avoid forecasting these things.

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.