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Olivers Insights

The Fed cuts rates

Posted On:Aug 01st, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

As widely anticipated, the US Federal Reserve has cut its key Fed Funds cash rate by 0.25% to a range of 2-2.25%. This is the Fed’s first rate cut since December 2008 and follows nine 0.25% rate hikes between December 2015 and December last year. The Fed also announced that quantitative tightening (ie the process of reversing its quantitative easing

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

Taking out some insurance

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

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

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


Source: Thomson Financial, AMP Capital Investors

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

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

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

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


Source: NBER, Bloomberg, AMP Capital

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

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

The Fed and shares

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


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

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

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


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

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

Implications for Australian interest rates

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

What about the role of President Trump?

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

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

 

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

Source: AMP Capital 01 August 2019

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

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The longest US economic expansion ever – does this mean recession is around the corner?

Posted On:Jul 24th, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

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

 

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

Longest but not the strongest

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


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


Source: National Bureau of Economic Research, AMP Capital

Absence of excess

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


Source: NBER, Bloomberg, AMP Capital

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

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


Source: NBER, Bloomberg, AMP Capital

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


Source: NBER, Bloomberg, AMP Capital

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

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

But what about the inverted yield curve?

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


Source: NBER, Bloomberg, AMP Capital

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

The bottom line

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

Shares up and bond yields down – which is right?

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

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

 

Source: AMP Capital 23 July 2019

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

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2018-19 saw a rough ride for investors but it turned out okay

Posted On:Jul 02nd, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

 

A volatile but good year for diversified investors

The past financial year saw pretty good returns for investors. But it didn’t

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

 

A volatile but good year for diversified investors

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

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

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


Source: Thomson Reuters, AMP Capital

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

Key lessons for investors from the last financial year

These include:

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

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

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

The negatives which will likely constrain returns…

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

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

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


Source: Bloomberg, AMP Capital

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

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

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

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

…but a bunch of things should keep returns positive

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

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

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

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

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

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

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

What about the return outlook?

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

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


Source: RBA; AMP Capital

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

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

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

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

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

Things to keep an eye on

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

Concluding comments

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

 

Source: AMP Capital 2 July 2019

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

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Don’t fight the Fed… or the ECB or RBA

Posted On:Jun 21st, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Source: Bloomberg, AMP Capital

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

Source: Bloomberg, AMP Capital

All have seen central

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


Source: Bloomberg, AMP Capital

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


Source: Bloomberg, AMP Capital

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

Central banks go from tightening to neutral to easing

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

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

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

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


Source: US Federal Reserve, Bloomberg, AMP Capital

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

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

Presidents Trump and Xi to meet

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

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

Implications for investors

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

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

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

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

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

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

 

Source: AMP Capital 20 June 2019

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

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Australian growth will be constrained but here’s nine reasons why recession is unlikely

Posted On:Jun 18th, 2019     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

For some time our view has been a less upbeat on the Australian economy than the consensus and notably the RBA. The reasons were simple. The housing cycle has turned down and this is weighing on consumer spending. And this is at a time when the risks to the global economy have increased as the trade war threat has ramped

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For some time our view has been a less upbeat on the Australian economy than the consensus and notably the RBA. The reasons were simple. The housing cycle has turned down and this is weighing on consumer spending. And this is at a time when the risks to the global economy have increased as the trade war threat has ramped up again. All at a time when high levels of underemployment are keeping a lid on wages growth and, along with technology and competition, inflation. Consequently we have been expecting rate cuts this year which have now commenced and have further to go. We see a strong case for more fiscal stimulus to help the RBA in boosting growth and see an increasing risk that the RBA may have to use some form of quantitative easing to achieve its inflation target.

But the gloom around the Australian economy seems to have gone over the top lately with all the talk around rate cuts adding to the sense of malaise and more and more talk about a recession being inevitable. Surely it can’t be that bad! And why despite all this doom and gloom is the share market at an 11-year high, up 16% year to date and just 4% shy of its 2007 resources-boom high. There must be some positives around. And there are! So, to inject some balance into the debate around Australia here is a list of positives. They are partly why we don’t see Australia as being about to plunge into recession.

1. Australia’s current accounts deficit has collapsed

As a share of GDP, it’s the lowest since the 1970s as high iron ore prices have combined with solid growth in export volumes and pushed the trade balance into a record surplus. The current account deficit is the gap between what we spend as a nation and what we earn – so its near disappearance means we are less dependent on foreign capital. This is a big one given that a big scare of the 1980s in Australia was that the large current account deficit and rising foreign debt would lead to a major crisis, collapse the economy and require an IMF bailout. Like with most doomster stories on Australia, we are still waiting!


Source: ABS, AMP Capital

2. The Australian dollar helps stabilise the economy

The $A is down 38% from its 2011 high and is likely to fall further and this provides a shock absorber for the Australian economy as a lower $A makes Australian businesses that compete internationally more competitive – eg higher education, tourism, mining, manufacturing, agriculture.

3. The drag from falling mining investment is over

The big drag on growth (which was up to around 2 percentage points at one stage) as mining investment fell back to more normal levels as a share of GDP is likely over and mining investment plans look to be moving up again.

4. There is scope for extra fiscal stimulus

The Federal budget is nearly back in surplus and while we have had a long run of deficits our public finances are in good shape compared to the US, Europe and Japan.


Source: IMF, AMP Capital

Some fiscal stimulus is already on the way with tax refunds for low and middle income earners. While the Government is focussed on achieving a surplus it seems to be recognising the case to do more to help the economy with talk of bringing forward infrastructure spending.

5. Infrastructure spending is booming

Infrastructure spending is booming. While growth in public capex may peak this year, NSW has flagged another round of asset sales to fund new infrastructure spending and suggestions to bring back Joe Hockey’s asset recycling program (that saw the Federal Government provide a financial incentive to states to sell existing assets and use the proceeds to plough back into new infrastructure spending).

6. There is no sign of panic property selling

Despite the falls in property prices we have seen no sign of a “crash”. Non-performing loans are still relatively low even in Perth where prices are down nearly 20%. There has been no significant panic selling. The switch for many from interest only loans to principle and interest has not seen mass defaults or mass selling. And the combination of the removal of the threat to negative gearing and the capital gains tax discount along with rate cuts has seen buyer interest return.

7. The political environment remains sensible

While the Federal election has been analysed to death, the bottom line is that Australians as a whole were not prepared to support a populist agenda of higher taxes on the “top end of town”, substantially increased public spending and redistribution. Just like they weren’t prepared to support a more right-wing free market agenda in 1993. Australia is not immune to the populism seemingly sweeping the world, but it seems to be limited to a relatively minor influence. Maybe it’s the moderate climate, maybe it’s the lack of extreme inequality, maybe it’s the compulsory voting system that keeps motivated extremists in their place in favour of a sensible centre.

Whatever it is – economic policy making in Australia could always be better (economists would love to see a greater focus on economic reform) but it’s generally pretty sensible.

8. Population growth remains strong

Australia’s population growth at around 1.5% pa is strong and supported by a high fertility rate and high levels of immigration. While it’s far from a world beater – with the top 10 countries by population growth seeing growth of between 3 to 5% pa – it is at the high end of comparable countries and roughly double the OECD average and of the US and UK and is faster than India.

Of course, strong population growth is not without issues –around integration, congestion, the environment, adequate housing and infrastructure. And ultimately in terms of living standards it is economic growth per person (or per capita) that matters not total growth and lately per capita GDP has gone backwards. But solid population growth also has significant benefits in terms of supporting demand growth in the economy, preventing lingering oversupply (as today’s excess – say Sydney apartments – can quickly turn into tomorrow’s shortfall) and keeping the economy dynamic. It also means that while Australia’s population is ageing, the problem is far less challenging than in most advanced countries as by comparison Australia with a median age of 37 is relatively young and it has a relatively low old age dependency ratio.

9. The RBA can still do more

While the official cash rate is at a record low of 1.25%, it can still go lower and we think it will, whereas in Europe and Japan rates are already at zero (or just below). Our view remains that the RBA will cut the cash rate to 0.5% beyond which it will probably conclude it’s of little benefit as it will make it harder for banks to pass on rate cuts as they will have more bank deposits at zero and so cutting mortgage rates would mean reduced profit margins and probably less lending.

But the RBA can still do quantitative easing – if needed. This basically involves seeking to boost the economy by injecting more cash into the economy using printed money. The lesson from the US, Europe and Japan was to go early and go hard. Japan and then Europe left it a bit too late, but the US went early and has achieved more success with QE.

QE as practiced there – using printed money to buy assets on the hope that banks would use the cash to lend, people would borrow and investors would help the economy by taking on more risky investments – may help. But it may not be the most efficient approach (as much of the cash just ended up in bank reserves) or the most equitable (to the extent it boosted prices for shares and other risky assets that are disproportionately held by high income/wealthier people).

A better option in terms of QE may be to use printed money to finance fiscal stimulus – maybe by directly buying bonds issued by the government. This is a radical step. The Austrian economists would scream hyperinflation! But they did with QE in the US a decade ago too and we are still waiting. In any case the problem is a lack of inflation and the risk of deflation. But it would work in terms of boosting spending in a fair way. It could involve either government spending on things like infrastructure (which both adds to demand and the economy’s productive potential) or tax cuts or “cheques in the mail” with use by dates.

But bear in mind Australia is a long way from needing to do this – we are not in recession so it’s really a debate about what can be done ahead of time which is actually healthy. Better this than wait for a crisis to hit then scramble on what to do.

Australian shares – what’s going on?

Which brings us to the strong Australian share market. Much of the recent surge in the Australian share market reflects strong gains in mining stocks on the back of the strong iron ore price, strong demand for high yielding stocks as bond yields have plunged and the post-election bounce. And if global shares have a further setback on the back of trade fears then Australian shares will be impacted too. But it’s also worth noting that the Australian share price index has underperformed global share markets for almost a decade now reflecting tighter monetary policy from October 2009, the surge in the $A into 2011, the end of the commodity price boom, worries about a property crash and a mean reversion after Australia’s 2000 to 2009 outperformance. Many of these factors have run their course, have reversed or have been factored in by the share market so maybe the decade-long underperformance by Australian shares is coming close to an end.


Source: Thomson Reuters, AMP Capital

Concluding comment

The point about all this is that while Australian growth may be going through a rough patch and this could go on for a while yet, there is a bunch of things going well for the Australian economy and there is plenty of scope for more monetary and fiscal stimulus. So – barring a significant global downturn threatening our export earnings big time – recession is unlikely, and it would be wrong to get too gloomy on Australia.

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

 

Source: AMP Capital 18 June 2019

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

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The $A still has more downside, but a lot of the weakness is behind us

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

While some have expressed surprise at the recent resilience in the value of the Australian dollar around the $US0.69-0.70 level despite weak Australian growth and Reserve Bank rate cuts, from a big picture sense it has already fallen a long way. It’s down 37% from a multi-decade high of $US1.10 in 2011 and it’s down 15% from a high in

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While some have expressed surprise at the recent resilience in the value of the Australian dollar around the $US0.69-0.70 level despite weak Australian growth and Reserve Bank rate cuts, from a big picture sense it has already fallen a long way. It’s down 37% from a multi-decade high of $US1.10 in 2011 and it’s down 15% from a high in January last year of $US0.81. So, having met our long-held expectation for a fall to around or just below $US0.70 and given its recent resilience now is an appropriate time to take a look at its outlook.

 

The $A is slightly undervalued long term

The first thing to note is that from a very long-term perspective the Australian dollar is around or just below fair value. This contrasts to the situation back in 2011 when it was well above long-term fair value. 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.


Source: RBA, ABS, AMP Capital

If over time Australian inflation and costs rise relative to the US, then the value of the $A should fall to maintain its real purchasing power and competitiveness. And vice versa if Australian inflation falls relative to the US. Consistent with this the Australian dollar tends to move in line with relative price differentials – or its purchasing power parity implied level – over the long term. And right now, it’s around or just below fair value.

But as can be seen in the last chart, it rarely spends much time at the purchasing power parity level. Cyclical swings in the $A are largely driven by swings in the prices of Australia’s key commodity exports and relative interest rates, such that a fall in Australian rates relative to US rates makes it more attractive to park money in the US and hence pushes the $A down. “Investor” sentiment and positioning also impacts – such that if the $A is over-loved with a lot of long positions then it becomes vulnerable to a fall and vice versa if it’s under-loved.

The negatives for the $A…

For some time, our view has been that the $A would fall into the high $US0.60s and this has happened. But notwithstanding this and that the $A has already fallen a long way from its 2011 high, it could still face a bit more downside over the next six to 12 months. The main reason is that Australian growth is weaker than US growth and spare capacity is much higher in Australia. For example, labour market underutilisation is 13.7% in Australia versus just 7.1% in the US, growth in Australia is running at 1.8% year on year compared to 3.2% in the US and the drag on growth from the housing downturn is likely to keep growth relatively weak in Australia for the next year or so.


Source: Bloomberg, AMP Capital

This will keep inflation lower in Australia than in the US and so we see the RBA cutting rates more than the Fed. And the RBA is much closer to having to do quantitative easing or some variant of it (ie using printed money to boost growth) than the Fed. This will continue to make it relatively less attractive to park money in Australia. As can be seen in the next chart, periods of a low and falling interest rate differential between Australia and the US usually see a low and falling $A.


Source: Bloomberg, AMP Capital

So this all points to more downside for the Australian dollar.

…and the positives

Against this there are a bunch of forces acting to support the $A, and this has been evident in its relative resilience despite bad news in recent weeks. Firstly, global sentiment towards the Australian dollar has been negative for some time and this has been reflected in short or underweight positions in the $A being at extreme levels – see the next chart. In other words, many of those who want to sell the $A have already done so and this leaves it vulnerable to a rally if there is any good news.


Source: Bloomberg, AMP Capital

Secondly, there has been good news with the iron ore price pushing above $US100 a tonne and this combined with solid growth in export volumes has pushed the trade balance into a record surplus which has shrunk the current account deficit as a share of GDP to its lowest since the 1970s. Of course, the iron ore price will likely fall back somewhat when Vale gets production back to normal after its dam disaster, but Chinese economic stimulus may help keep it and other commodity prices supported. The smaller current account surplus means Australia has become less dependent on foreign capital inflows.


Source: ABS, AMP Capital

Finally, in response to the threat to growth from President Trump’s trade wars, mixed economic data and weak inflation, investors have moved to price in rate cuts from the Fed over the next year. And this is negative for the $US generally after a multi-year bull market since 2008.

So where to from here?

Overall, we expect that the weaker growth outlook in Australia relative to the US and the likely continuing decline in the interest rate differential versus the US will dominate and push the $A still lower. But with the $A having already had a big fall, short $A positions running high, the current account deficit having shrunk and the US dollar looking toppy we see the $A falling to around $US0.65 on a six to 12 month horizon as opposed to crashing down to say the 2001 low of $US0.48. Of course, if the global economy falls apart, causing a surge in unemployment in Australia as export demand and confidence collapses and another big leg down in house prices then all bets are off and the Aussie will fall a lot more…but that’s not our base case.

What does it mean for investors?

With the risks skewed towards more downside in the value of the $A, albeit less so than say a year ago, there are several implications for investors.

First, there remains a case – albeit not as strong as it was when the Australia dollar was much higher – to maintain a decent exposure to offshore assets that are not hedged back to Australian dollars. A decline in the value of the $A will boost the value of an investment in offshore assets denominated in foreign currency one for one. Meanwhile, the fall in Australian interest rates relative to global interest rates has reduced the incentive to hedge because when Australian rates are above global rates investors are “paid” to hedge.

Second, if the global outlook turns sour due to say Trump’s trade wars, having an exposure to foreign currency provides protection for Australian investors as the $A usually falls in response to threats to global growth. 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 associated with the emerging market/LTCM crisis in 1998, the tech wreck into 2001, the GFC, the Eurozone crises and the 2015-16 global growth scare saw sharp falls in the $A. So being short the $A and long foreign exchange provides good protection against threats to the global outlook.


Source: Bloomberg, AMP Capital

Finally, continuing softness in the $A will be positive for Australian industry sectors that compete internationally like tourism, higher education, manufacturing, agriculture and mining and this will benefit shares exposed to these areas.

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

 

Source: AMP Capital 14 June 2019

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

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