Olivers Insights

Earlier this year the big fear was that inflation was going to surge led by the US and that this was going to drive aggressive interest rate hikes by the US Federal Reserve and much higher bond yields, which in turn would pressure other asset classes. Such fears saw a significant correction in global share markets with US shares falling 10%, global shares falling 9% and Australian shares falling 6%. Since then, inflation fears seem to have taken a back seat. While in most major countries 10-year bond yields are well up from their 2016 multi decade lows, US bond yields have struggled to stay above 3%, German bond yields are around 0.3%, Japanese bond yields are around 0.09% and Australian bond yields are around 2.58%, with most well below their highs seen earlier this year. So, what happened? Should we still worry about inflation?

What happened? 

A whole bunch of things have helped bond yields remain low and kept investors focused elsewhere:

• First, although US inflation has moved up it remains relatively benign with the core private final consumption deflator around 2% year on year which is the Fed’s inflation target. It seems every US jobs report has seen the same “Goldilocks” (not too hot/not too cold) combination of strong jobs growth and falling (now sub-4%) unemployment but low wages growth of around 2.7-2.8% year on year implying low inflation pressures. See the next chart.

Source: Bloomberg, AMP Capital

• While the Fed has continued its drip feed of rate hikes consistent with strong economic conditions, the lack of any inflation break-out has meant that they have been able to remain gradual, with one hike every three months and monetary policy remains very easy.

• Strong US earnings growth has helped distract share market investors. June quarter earnings results have seen 84% of companies surprise on the upside regarding earnings and 71% beat revenue expectations, both of which are above normal levels. Reflecting this, June quarter earnings growth has come in around 27% on a year ago, up from expectations for 20% earnings growth in early July.

Source: Bloomberg, AMP Capital

• The trade war threat has tended to dominate, leading to fears of a hit to global (and US) growth and safe haven demand for assets like bonds (which has helped keep their yields down).

• Worries about Italy’s new populist government blowing out its budget deficit and already high level of public debt, or worse still threatening to leave the Euro resulting in bond holders taking a hit on their investment in Italian bonds, have boosted demand for German bonds depressing their yields and helped extend expectations of easier for longer European Central Bank monetary policy.

• Other geopolitical events like the crisis in Turkey have kept investors on edge for deflationary shocks. The latest worries about contagion from Turkey as its currency plunged anew are likely overdone. Yes, there will be some impact on Eurozone banks that are exposed to Turkish debt (which will keep the ECB cautious), but it’s unlikely to be economically significant. More fundamentally, Turkey is not indicative of the bulk of emerging countries. Its currency has crashed 40% or so this year because of current account and budget deficit blowouts, surging inflation, political interference in its central bank and populist economic mismanagement generally. In addition, political tensions with the US following the imprisonment of an American pastor resulting in US sanctions on Turkey including tariff hikes on steel and aluminium have made things even worse. The crisis is now being intensified by Turkish PM Erdogan’s rejection of higher interest rates and an international bailout. While Brazil, Argentina and South Africa also have particular problems, most of the rest of the emerging world is in far better shape. That said, emerging markets will remain vulnerable until the US dollar stops rising (as a rising $US boosts US dollar denominated debt servicing costs for emerging countries that have high foreign debt), the global trade threat ends and uncertainty regarding Chinese growth fades. And upwards pressure on the US dollar is likely to continue as the Fed is unlikely to stop its process of gradual rate hikes anytime soon.

Source: IMF, AMP Capital

• Finally, while growth in the US has accelerated this year, in other major countries it looks to have slowed. So, while there was talk of the Bank of Japan, the European Central Bank and even the Reserve Bank of Australia following the US into tightening this has been pushed out further. Similarly, some signs of a softening in growth in China and the tariff threat have seen the PBOC (China’s central bank) move towards monetary easing.

Implications – another extension to the cycle?

These considerations have combined to help fade the inflation/Fed tightening fears of earlier this year with the result that bond yields have been contained and most share markets have been able to recover from their February inflation-scare lows. In some ways it’s more of the same because the whole post global financial crisis (GFC) experience has been one of two or three steps forward towards stronger global growth followed by one or two steps back (with eg the Eurozone debt crisis, the 2015 growth scare and various deflation fears along the way). What we have seen this year is effectively a continuation of that.

By delaying or slowing monetary tightening this has all helped extend the economic and investment cycle. The implications have been:

• A continuation of low returns from cash and low bank deposit rates.

• Yield-sensitive share market listed investments like real estate investment trusts have been able to rebound.

• Unlisted assets like infrastructure and commercial property have continued to benefit from a search for yield by investors.

With global monetary conditions remaining easy and US recession warning indicators still not flashing red (although the yield curve is worth keeping an eye on) our assessment remains that the investment cycle has more upside and that a US recession remains a way off yet. However, the main risks around this relate to the threat of a global trade war should the tariff threat from the US continue to escalate.

But should we still worry about inflation?

However, while the investment cycle has been extended it would be wrong for investors to dismiss the inflation threat – particularly in relation to the US:

• First, while it has taken a long time to get there resulting in numerous deflation scares along the way, spare capacity in the US economy has been mostly used up.

• Second, numerous indicators point to a very tight labour market in the US – with more vacancies than there are unemployed, very high hiring and quits rates, companies nominating finding suitable labour as a bigger problem than weak demand – suggesting that sooner or later wages growth will start to pick up more significantly.

• Third, inflation is well known to be a lagging indicator and it often appears as a problem after the pace of economic growth has peaked.

• Finally, from a longer-term perspective there is a risk that the lessons of the break out in inflation from the late 1960s into the 1970s are being forgotten and that populist politicians will seek to weaken the institution of an independent central bank targeting low inflation. President Trump’s tweets critical of the Fed raising interest rates are concerning in this regard. 

As a result, we remain of the view that (absent a full-blown global trade war) the drip feed of Fed rates hikes will continue well into next year, that the 35 year bull market in bonds that began in the early 1980s is over and that the risks to US and by implication global bond yields into next year are still on the upside. This suggests investors need to be a little more wary of yield-sensitive globally-exposed investments that don’t offer inflation protection (like inflation-linked bonds do and the potential for rising rents do in the case of commercial property and infrastructure) than was the case a few years ago when there was still plenty of spare capacity in the US. Ongoing Fed rate hikes also point to ongoing upwards pressure on the US dollar which in turn suggests that investors should remain cautious in relation to emerging market shares.

The upside risks for bond yields is less in Australia given much higher unemployment and underemployment and that the RBA is likely to remain well behind the US in raising interest rates. With the Fed hiking and the RBA holding, this is all consistent with ongoing downwards pressure on the Australian dollar which we still see falling to around $US0.70, having recently broken below $US0.73.

Source: AMP Capital 14 August 2018

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) 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.

In the rough and tumble of investment markets its very easy to get distracted: by talk of the next best thing that will make you rich, by the ever-present predictions of an imminent crash, by the worry list that constantly surrounds investment markets relating to growth, profits, interest rates, politics, etc.

The investment world is far from neat and predictable. The well known advocate of value investing, Benjamin Graham, coined the term “Mr Market” in 1949 as a metaphor to explain the share market, but it also applies to most other investment markets. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from euphoria to pessimism. Mr Market is highly seductive – sucking investors in during the good times with dreams of riches and spitting them out during the bad times when all hope seems lost.

This is particularly the case at present where noise around President Trump – often set off by a late night tweet – can set off market volatility and where this can be magnified by digital media in which it seems everyone is vying for attention leaving the impression we are in a constant state of crisis and volatility.

To help investors avoid being seduced by Mr Market there are nine key things to bear in mind. I haven’t written on this for a while but here is my list of the nine keys to successful investing.

• Make the most of the power of compound interest. One dollar invested in Australian cash in 1900 would today be worth $236, but if it had been invested in bonds it would be worth $877 and if it was allocated to Australian shares it would be worth $559,281. Although the average annual return on Australian shares (11.8% pa) is just double that on Australian bonds (5.9% pa) over the last 118 years, the magic of compounding higher returns over long periods leads to a substantially higher balance over long periods. Of course the price for the higher returns from shares is higher volatility – evident in rough patches like the Great Depression, 1973-74 after Elvis appeared via satellite from Hawaii to when The Brady Bunch was canned, 1987 and the GFC – but the impact of compounding at a higher long term return is huge over long periods of time. The same applies to other growth related assets such as property. So one of the best ways to build wealth is to take advantage of the power of compound interest and this means making sure you have the right asset mix in your investment strategy. (Speaking of The Brady Bunch – their house in Studio City LA was recently “sold” for over $US2m by the one family who bought it in 1973 for $US61,000. NSYNC bass singer Lance Bass offered “WAY over” the asking price of $US1.9m and was accepted but then got gazumped by a Corporate Buyer (likely a studio) who wanted the house at any price. Assuming the sale price is $US2.1m which is conservative and there was a net rental yield of 3.5% along the way this implies a compound annual return of 11.7%pa!)

Source: Global Financial Data, AMP Capital

• Be aware of the cycle. Investment markets – bonds, shares, property, infrastructure, whatever – constantly go through cyclical phases of good times and bad. Some are short term, such as occasional corrections. Some are medium term, such as those that relate to the 3 to 5 year business cycle. Some are longer, such as the secular swings seen over 10 to 20 year periods in shares. Some are even longer like the 35 odd year bull market in bonds since the early 1980s. But all eventually set up their own reversal. The trouble is that cycles can throw investors out of a well thought out investment strategy that aims to take advantage of long term returns and can cause problems for investors in or close to retirement. But they also create opportunities.

• Invest for the long term. One of the best articles on investing I ever read was by a US investment guy named Charles Ellis in the 1970s who observed that for most of us investing is a loser’s game. A loser’s game is a game where bad play by the loser determines the victor. Amateur tennis is an example, where the trick is to avoid stupid mistakes and win by not losing. The best way for most investors to avoid losing is to invest for the long term. Get a long term plan that suits your level of wealth, age, tolerance of volatility, etc, and stick to it. This may involve a high exposure to shares and property when you are young or have plenty of funds to invest when you are in retirement and still have your day to day needs covered. Alternatively, if you can’t afford to take a long-term approach or can’t tolerate short term volatility then it is worth considering investing in funds that target a particular goal.

• Diversify. Don’t put all your eggs in one basket. A common approach in SMSF funds has been to have one or two high yielding popular shares and a term deposit. This could leave an investor exposed to a very low return or if something goes wrong in the share. Through last decade many Australian investors wondered why hold global shares as Australian shares were doing so well. But this decade global shares have been the place to be reflecting stronger growth and the fall in the $A which enhances the value of offshore investments. Trying to get such swings precisely right can be hard so the trick is to have a diversified mix. But also, don’t over diversify as this will just complicate for no benefit.

• Turn down the noise. After having worked out a strategy thats right for you, it’s important to turn down the noise on the information flow surrounding investment markets and stay focussed. The trouble is that the digital world we now live in is seeing an explosion in information and opinions about economies and investments. But much of this information and opinion is of poor quality. As “bad news sells” there has always been pressure on editors to put the most sensationalised negative news on the front page of newspapers but there was hopefully some balance in the rest of the paper. But in a digital world each story can be tracked via clicks so the pressure to run with sensationalised and often bad news stories has been magnified. Hence click bait and all the talk about fake news. President Trump’s tweets are adding to the noise with markets sometimes jumping in response. He recently tweeted that “Tariffs are the greatest!” only to tweet 12 hours later in relation to the European Union that “I have an idea for them. Both the US and EU drop all tariffs.” Now I kind of get what he is saying and much of his utterances are bluster designed to get what he wants, but such gyrations cause confusion for investors. 

  Of course, economists like to say more is preferred to less but when it comes to information and opinion around investment markets this is not necessarily the case. There is little evidence that the ramped-up news flow is helping investors make better decisions and hence earn better returns. We seem to lurch from worrying about one crisis to another. This year is seeing the usual worry list with worries about: US inflation, Fed tightening, global trade, Trump and the Mueller inquiry, the US mid-term elections, Chinese debt, Italy, the emerging world, increasing tension with Iran, tech stocks, etc. Investing now seems like a daily soap opera – as we go from worrying about one thing after another. This is all leading to heightened uncertainty and shorter investment horizons which in turn can add to the risk that you could be thrown off well thought out investment strategies. The key is to turn down the volume on all the noise. This also means keeping your investment strategy relatively simple. Don’t waste too much time on individual shares or funds as it’s your high-level asset allocation that will mainly drive the return and volatility you will get.

• Buy low, sell high. What you pay for an investment matters a lot in terms of the return you will get. The cheaper you buy an asset (or the higher its yield), the higher its prospective return will likely be and vice versa, all other things being equal of course. So if you do buy or sell try to buy when markets are down and sell when they are up. Unfortunately, many do the opposite which explains the old saying that “flows follow returns”! Inflows to investment funds or markets are strongest after periods of strong returns and outflows are strongest after weak returns’ which is the wrong way around.

• Beware the crowd at extremes. At various points in time the crowd can be right and being in a crowd can feel safe. However, at extremes the crowd is invariably wrong. Whether it’s lemmings running off a cliff, or investors piling into Japanese shares at the end of the 1980s, Asian shares into the mid 1990s, IT stocks in the late 1990s, US housing and dodgy credit in the mid-2000s or most recently with Bitcoin which peaked last December just when everyone was talking about it. The problem with crowds is that eventually everyone who wants to buy will do so and then the only way is down (and vice versa during crowd panics). As Warren Buffet once said the key is to “be fearful when others are greedy and greedy when others are fearful”.

Source: Bloomberg, AMP Capital

• Focus on investments offering sustainable cash flow. Lots of investments have been sold on promises of high returns or low risk but were underpinned by hope based on hot air (eg, many dot com stocks in the 1990s) or financial alchemy (eg sub-prime CDOs). But if it looks dodgy, hard to understand or has to be based on obscure valuation measures to stack up then it’s best to stay away. There is no such thing as a free lunch in investing – if an investment looks too good to be true then it probably is. By contrast, assets that generate sustainable cash flows (profits, rents, interest) and don’t rely on excessive gearing or financial engineering are more likely to deliver.|

• Seek advice. Given the psychological traps we are all susceptible too (like the tendency to over-react to the current state of investment markets) and the fact that it is not easy, a good approach is to seek advice via an investment service or a coach such as a financial adviser, in much the same way you might use a specialist to look after other aspects of your life like the plumbing or your medical needs. As with plumbers and doctors it pays to shop around to find a service or adviser you are comfortable with and can trust. But its worth it in the end. Even I have a financial adviser to help deal with the complexity of investing.

Source: AMP Capital 7 August 2018

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) 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.

Since Donald Trump was elected President back on November 8, 2016 we have focussed on whether we will see Trump the rabble-rousing populist or Trump the business-friendly pragmatist. Despite lots of noise – particularly via Trump’s frequent tweets – for the most part Trump the pragmatist has dominated so far. But we have clearly seen a swing to Trump the populist this year – raising risks for investors.

So far Trump has been good for markets

In the period since his election US shares are up 34%, global shares are up 28% and Australian shares are up 21%. While the strength in share markets would have occurred anyway given stronger global growth, US tax reform, fiscal stimulus and deregulation have clearly helped and contributed to the US share market’s outperformance. While US tax reform and tax cuts have received much focus, the Trump administration’s focus on deregulation is equally as significant with the US under Trump seeing the least amount of new economically significant regulation since the Reagan Administration in the early 1980s.

Source: George Washington University, WSJ, AMP Capital

In terms of tax reform and deregulation the Trump Administration has much in common with Reaganomics.

Populism starting to dominate pragmatism

This year though the balance has shifted towards a greater emphasis on populist policies – notably protectionism and criticism of China, the return to sanctions on Iran and arguably recent criticism of the Fed for raising interest rates and pushing up the US dollar. There are several reasons for this shift in emphasis: the pro-business element of Trump’s policies were mainly completed last year; it’s a mid-term election year so Trump is back in campaign mode; Trump’s approval rating has improved despite this year’s controversial policies suggesting firm support for them from his Republican party base; and the strength of the US economy has also emboldened him. In fact, it could be argued that last year was all about bolstering the US economy ahead of this year’s more controversial policies.

The main risks around President Trump centre around five key issues: the rising risk of a full-blown trade war; the expanding budget deficit; the risk of interference in the Fed; the return of sanctions on Iranian oil exports threatening wider Middle East conflict; and the risk Trump ultimately comes into trouble with the Mueller inquiry. We will now look at each of these in turn.

Rising trade war risks

This issue has been done to death but won’t go away. So far the tariff increases actually implemented amount to just 3% of total US imports. While this has been met with proportional retaliation by other countries it’s a long way from a full-blown global trade war. However, the issue is what happens next. Another $US16bn of Chinese imports will likely be hit with a 25% tariff soon and the US is readying a 10% tariff on another $US200bn. Trump is also threatening to raise tariffs on all $US550bn of Chinese imports. China is threatening to retaliate proportionally although it will have to be with other means as it only imports $US130bn from the US. Trump is also threatening to put tariffs on auto imports and looking at Uranium.

News of a deal between the US and the EU to work towards zero tariffs on industrial goods is good news in terms of heading of a full-blown trade war between the two, but negotiations have a long way to go. There was hope of a deal with China in May – with Trump initially crowing about a May 20 trade deal, but since then both China and the US have dug in with Trump tapping popular support for protectionism and anti-Chinese sentiment. So, the trade threat could get still worse before it gets better which means it risks taking the edge off economic growth. Modelling by Citigroup of a 10% tariff hike by the US, China and Europe showed a 2% hit to global GDP after a year. Of course, we are not seeing a tariff hike on all goods but the impact could still be significant if negotiations with the EU and China fail and all the tariffs being talked about are implemented.
There are a few offsetting factors. First, China is moving to provide stimulus to support growth. Second, much of Trump’s approach still looks designed to apply “maximum pressure” to reach a negotiated outcome – and so far so good in relation to Europe. And Trump knows that the costs to US workers (from soybean farmers to Harley Davidson workers) and consumers will escalate as more tariffs are imposed. So, our base case remains that some form of negotiated solution will be reached, but in relation to China this may not occur until next year.

Interference in the Fed and US dollar

Trump’s recent comments criticising Europe, China and others for helping drive the US dollar up and the Fed for raising interest rates naturally raises concerns that he will intervene in foreign exchange markets and interfere with the Fed. The comments lack economic logic – if “making America great again” means stronger US economic growth then it also means higher US interest rates and a higher US dollar – and maybe the Fed came in for a serve after Fed Chair Powell observed that “countries that have gone in a more protectionist direction have done worse”! Trump’s annoyance may have been triggered by the slide in the value of the Chinese Renminbi. While this looks to be mainly a strong $US story (as the $US is up around 7% against its low earlier this year against a range of currencies compared to an 8% gain against the Renminbi) the Chinese authorities seem quite content to let it fall for now and this will obviously offset Trump’s tariffs on Chinese goods.

Source: Bloomberg, AMP Capital

Despite all this it’s unlikely in the short term that Trump will act on his opinions on rates and the $US. US Treasury Secretary Mnuchin said the administration would “not interfere with the decisions of the Fed or move to manipulate the value of the dollar.” Trump is well known to be a high debt/low interest rate guy so it’s no surprise he is not happy with rising rates. But the Fed answers to Congress, has a mandate to keep inflation down and will do what it sees best – which with strong growth and at target inflation means returning interest rates to more normal levels. However, longer term there is a risk that Trump will weaken the institution of an independent central bank targeting low inflation and may also seek to return to a more interventionist approach regarding the US dollar, particularly if America’s trade deficit refuses to fall. Based on past experience such political intervention would risk much higher inflation which would be a big negative for investment assets as the revaluation that occurred as we moved from high inflation to low inflation would reverse. Fortunately, we are not there yet.

The expanding US budget deficit

It’s been the norm for the US budget deficit to blow out when unemployment rises (as tax revenue falls and jobless claims go up) and decline when unemployment falls. Thanks to Trump’s fiscal stimulus it’s now blowing out when unemployment is collapsing and looks to be on its way to 5% of GDP. This raises three risks. First, it may mean higher than otherwise interest rates and bond yields as the Fed may have to raise rates more than would otherwise be the case to stop the economy overheating and the Government’s competition for funds results in higher bond yields. So far there is not a lot of evidence of this with US bond yields remaining relatively low – presumably held down by low global bond yields and trade war fears – but its still a risk as US inflationary pressures rise.

Source: Bloomberg, AMP Capital

Second and more fundamentally it begs the question of debt sustainability when the next recession arrives given US public debt is already around 100% of US GDP. Finally, US fiscal stimulus by adding to the US savings-investment imbalance is adding to the US trade deficit and so is completely inconsistent with his trade policies. Even if there was a completely level playing field on world trade America will still have a trade deficit!

The return to sanctions on, and tensions with, Iran

Perhaps a big surprise this year for some has been that President Trump looks to have swapped a half decent deal with Iran for a dodgy one with North Korea. While the latter holds out the hope of (maybe) reducing the threat of a nuclear attack on the US, the return to sanctions and tensions with Iran risks higher oil prices. Since the lows of 2015 oil prices have increased by 70% reflecting increased demand and OPEC’s 2016 cutback. Global stockpiles and spare capacity have been rundown and supply from Libya and Venezuela is uncertain. Our base case is that demand growth will be more constrained from here and that a ramp up in US shale oil production will help contain oil prices around $US70-75 a barrel. The risk though is that the loss of around 800,000 barrels a day of Iranian oil exports and the renewed risk of wider conflict in the Middle East associated with Iran (eg, if Iran closes the Strait of Hormuz through which 20% of global oil supply moves in retaliation against US sanctions) results in higher prices.

The Mueller inquiry into Russian links

Our view in relation to the Mueller inquiry remains that unless Trump has done something very wrong the Republican controlled House will not move to impeach him and even if a Democrat controlled House post the mid-terms did, the Senate will not have the necessary two thirds of votes to remove him from office. However, his sensitivity over the issue, along with his comments seemingly favouring Russian President Putin’s word over US security agencies does remind a bit of Nixon in relation to Watergate. So his removal cannot be ruled out. But this would just mean VP Mike Pence would take over with basically the same economic policies (but with less tweet noise) and economic conditions are stronger than in 1974.

Trump tweet noise

The risks around Trump are real and need to be watched carefully. But Trump generates a lot of noise and much of it is contradictory and confusing – in the last week Trump tweeted “Tariffs are the greatest” only to tweet 12 hours later that “I have an idea for them. Both the US and EU drop all tariffs” – and often reflects bluster ahead of negotiations – recall his “fire, fury and frankly power” threat to North Korea. So the best approach for investors in relation to Trump is to turn down the noise.

Source: AMP Capital 26 July 2018

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) 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.

Ever since the Global Financial Crisis (GFC) there has been an obsession with looking for the next recession. In this regard, over the last year or so there has been increasing concern that a flattening yield curve in the US – ie the gap between long-term bond yields and short-term borrowing rates has been declining – is signalling a downturn and, if it goes negative, a recession in the US. This concern naturally takes on added currency given that the current US bull market and economic expansion are approaching record territory in terms of duration and given the trade war threat.

The increased volatility in shares seen this year, including a 10% or so pull back in global shares earlier this year, adds to these fears. Whether the US is about to enter recession is critical to whether the US (and hence global) bull market in shares is about to end. Looking at all 10% or greater falls in US shares since the 1970s (see the table in Correction time for shares?), US share market falls associated with a US recession are longer lasting and deeper with an average duration of 16 months and an average fall of 36% compared to a duration of 5 months and an average fall of 14% when there is no recession. Similarly, Australian share market falls are more severe when there is a US recession. So, whether a recession is imminent or not in the US is critically important in terms of whether a major bear market is imminent. This note assesses the risks.

The long US economic expansion and bull market

The cyclical bull market in US shares is now over nine years old. This makes it the second 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 is now 109 months old and compares to an average expansion of 58 months since 1945. See the next two tables. So, with the bull market and the economic expansion getting long in the tooth it’s natural to ask whether it will all soon come to an end with a major bear market.

The yield curve flattens – but it’s complicated

The yield curve is watched for two reasons. First, it’s a good guide to the stance of monetary policy. When short-term interest rates are low relative to long-term rates it indicates businesses can borrow short and lend (or invest) long & this grows the economy. But it’s not so good when short rates are above long rates – or the curve is inverted. And secondly an inverted US yield curve has preceded US recessions. So, when it’s heading in this direction some start to worry. However, there are several complications.

First, which yield curve? Much focus has been on the gap between 10-year bond yields and 2-year bond yields which has flattened to just 0.3%, but the Fed has concluded that the traditional yield curve based on the gap between 10-year bond yields and the Fed Funds rate is a better predictor of the economy and it has flattened but only to 1%. Moreover, a shorter yield curve based on the gap between 2-year bond yields and the Fed Funds rate predicted past recessions like the longer yield curves but has actually been steepening in recent years which is positive.

Second, the yield curve can give false signals – the traditional version flattened or went negative in 1986, 1995 and 1998 before rebounding – and the lags from an inverted curve to a recession can be long at around 15 months. So even if it went negative now recession may not occur until late 2020.

Third, various factors may be flattening the yield curve unrelated to cyclical economic growth expectations including still falling long-term inflation and real rate expectations, low German and Japanese bond yields holding down US 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.

Fourth, a flattening yield curve caused by rising short term ratesand falling long term rates is arguably more negative than aflattening when both short and long term rates go up like recently.

Finally, a range of other indicators which we will now look at are not pointing to an imminent US recession.

Watch for exhaustion, not old age

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 US economic recovery may be long, but it has been very slow such that average economic and employment growth has been around half that seen in post WW2 expansions. So as a result it has taken longer than normal for excesses to build up. Apart from flattening yield curves one area where the US is flashing warning signs is in relation to the labour market where unemployment and underemployment have fallen about as low as they ever go warning of a wages breakout and inflation pressure.

However, there is still arguably spare capacity in the US labour market (the participation rate has yet to see a normal cyclical rise) and wages growth at 2.7% remains very low. The last three recessions were preceded by wages growth above 4%. Secondly, while US GDP is now back in line with estimates of “potential”, what is “potential” can get revised so it’s a bit dodgy and more fundamentally, industrial capacity utilisation at 78% is still below normal of 80% and well below levels that in the past have shown excess and preceded recessions.

Thirdly, cyclical spending in the US as a share of GDP remain slow. For example, business and housing investment are around long term average levels as a share of GDP in contrast to the high levels in one or both seen prior to the tech wreck and GFC.

Finally, while the rising Fed Funds rate and flattening traditional yield curve is consistent with tightening US monetary policy, it’s a long way from tight. Past US recessions have been preceded by the Fed Funds rates being well above inflation and nominal economic growth whereas it’s still a long way from either now. See the next chart.

US likely to see overheating before recession

Apart from the amber lights flashing from the flattening yield curve and very low unemployment our assessment is that a US recession is still some time away as it will take time for excesses to become extreme and US monetary policy to become tight. Looked at another way, the US is still more likely to overheat before it goes into recession. We have been thinking recession is a 2020 risk. The end of the current fiscal stimulus around then would also be consistent with this. However, given the current slow pace in terms of building excess, that 2020 is a presidential election year – do you really think Trump will allow the US to go off a fiscal cliff then? – and with 2020 being the consensus pick for a downturn, the risk is that it comes later. Of course, an escalating trade war could mess things up earlier, although we still see a negotiated solution. The rising US budget deficit is a concern but it’s more of an issue for when the economy turns down as this is when investors will start to worry about its sustainability. And of course a 1987 style share market crash cannot be ruled out but probably requires a share market blow off before hand. In the meantime, the Fed has more tightening to do and while sharemarket volatility is likely to remain high as US inflation and short rates rise, excesses gradually build and given risks around Trump and trade, with recession still a way off the US and global share bull market likely still has some way to go.

Source: AMP Capital 19 July 2018

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) 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.

The past financial year saw solid returns for investors but it was a story of two halves. While the December half year was strong as global share markets moved to factor in stronger global growth and profits helped by US tax cuts, the last six months have been messier and more constrained – with US inflation and interest rate worries, trade war fears, uncertainty around Italy, renewed China and emerging market worries and falling home prices in Australia. But will returns remain reasonable or is the volatility of the past six months a sign of things to come? After reviewing the returns of the last financial year, this note looks at the investment outlook for 2018-19 financial year.

A good year for diversified investors

The 2017-18 financial year saw yet again pretty solid returns for well diversified investors. Cash and bank deposits continued to provide poor returns and the combination of low yields and a back-up in some bond yields saw low returns from bonds. The latter resulted in mixed returns from yield sensitive investments, but Australian real estate investment trusts performed well helped by the RBA leaving rates on hold.

Reflecting strong gains in the December half as investors moved to factor in stronger global growth and profits assisted in the US by tax cuts global shares returned 11% in local currency terms and 15% in Australian dollar terms. Australian shares also performed well with the ASX 200 rising to a 10-year high and solid dividends resulting in a total return of 13%. Unlisted assets have continued to benefit from “search for yield” investor demand and faster growth in “rents” with unlisted property returning around 12% and unlisted infrastructure returning around 13.5%.

As a result, balanced growth superannuation returns are estimated to have returned around 9% after taxes and fees which is pretty good given inflation of 2%. For the last five years balanced growth super returns have also been around 8.5% pa.

click to enlarge

*pre fees and taxes, except Balanced Funds which are post fees and taxes
Source: Thomson Reuters, AMP Capital

Australian residential property slowed with average capital city prices down 1.6%, with prices down in Sydney, Perth and Darwin. Average returns after costs were around zero.  

Key lessons for investors from the last financial year

These include:

• Be cautious of the crowd – Bitcoin provided a classic reminder of this with its price peaking at $US19500 just when everyone was getting interested in December only to then plunge 70% in price.

• Turn down the noise – despite numerous predictions of disaster it turned out okay.

• Maintain a well-diversified portfolio – while cash, bonds and some yield sensitive listed assets had a tougher time, a well-diversified portfolio performed well.

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

Expect more constrained returns and volatility

We expect returns to slow a bit over the new financial year and just as we have seen over the last six months volatility is likely to remain high. First the positives:

• While global growth looks to have passed its peak the growth outlook remains solid. Business conditions indicators –  such as surveys of purchasing managers (Purchasing Managers Indexes or PMIs) –  are off their highs and point to some moderation in growth, but they remain strong pointing to solid global overall.

Source: Bloomberg, AMP Capital

In Australia, growth is likely to remain between 2.5% and 3% with strong business investment and infrastructure helping but being offset by a housing slowdown and constrained consumer spending.

• Second, solid economic growth should continue to underpin solid profit growth from around 7% in Australia to above 10% globally

• Third, while we are now further through the global economic cycle there is still little sign of the sort of excess that normally brings on an economic downturn – 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.

• Fourth, global monetary policy remains very easy with the Fed continuing to raise rates gradually, the ECB a long way from raising rates and tightening in Japan years away.

• Finally, share valuations are not excessive. While price to earnings ratios are a bit above long-term averages, this is not unusual for a low inflation environment. Valuation measures that allow for low interest rates and bond yields show shares to no longer be as cheap as a year ago but they are still not expensive, particularly outside of the US.

Against this though there are a few storm clouds:

• First, the US economy is more at risk of overheating – unemployment is at its lowest since 1969, wages growth is gradually rising and inflationary pressures appear to be picking up. The Fed is aware of this and will continue its process of raising rates. While other countries are behind the US, its share market invariably sets the direction for global markets

• Second, global liquidity conditions have tightened compared to a year ago with central bank quantitative easing slowing down and yield curves (ie the gap between long term and short-term bond yields) flattening.

• Third, the risks of a trade war dragging on global growth have intensified. While the share of US imports subject to recently imposed tariffs is minor so far (at around 3%) they are threatened to increase. Our base case remains that some sort of negotiated solution will be reached but trade war worries could get worse before they get better.

• Fourth, emerging countries face various risks from several problem countries (Turkey, Brazil and South Africa), slowing growth in China, concerns the rising US dollar will make it harder for emerging countries to service their foreign debts and worries they will be adversely affected by a trade war.

• Finally, various geopolitical risks remain notably around the Mueller inquiry in the US, the US mid-term elections and Italy heading towards conflict with the EU over fiscal policy.

A problem is that various threats around trade and Trump, Italy and China have come along at a time when the hurdle for central banks to respond may be higher than in the past – with the Fed focussed on inflation and the ECB moving to slow its stimulus and less inclined to support Italy.

What about the return outlook?

Given these conflicting forces it is reasonable to expect some slowing in returns after the very strong returns seen in the last two years. Solid growth, still easy money and okay valuations should keep returns positive, but they are likely to be constrained and more volatile thanks to the drip feed of Fed rate hikes, trade war fears, China and Emerging Market worries and various geopolitical risks. In Australia, falling home prices in Sydney and Melbourne along with tightening bank lending standards will be drags. Looking at the major asset classes:

• Cash and bank deposit returns are likely to remain poor at around 2% as the RBA is expected to remain on hold out to 2020 at least. 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 then consider the alternatives with Australian shares and real assets such as unlisted commercial property continuing to offer attractive yields.

Source: RBA; AMP Capital

• Still ultra-low sovereign bond yields and the risk of a risking trend in yields, which will result in capital losses, are likely to result in another year of soft returns from bonds.

• Unlisted commercial property and infrastructure are likely to benefit from the ongoing “search for yield” (although this is waning) and okay economic growth.

• Residential property returns are likely to be mixed with Sydney and Melbourne prices falling, Perth and Darwin bottoming and other cities providing modest gains.

• Shares are at risk of a further correction into the seasonally weak September/October period given the storm clouds noted above, but okay valuations, reasonable economic growth and profits and still easy monetary conditions should see the broad trend in shares remain up – just more slowly. We continue to favour global shares over Australian shares.

• Finally, the $A is likely to fall as the RBA holds and the Fed hikes adding to the case for unhedged global shares.

Things to keep an eye on

The key things to keep an eye are: global business conditions PMIs for any deeper slowing; risks around a trade war; risks around Trump ahead of the US mid-term elections; the drip feed of Fed rate hikes; conflict with Italy over fiscal policy in Europe; risks around China and emerging countries; and the Australian property market – where a sharp slump in home prices (which is not our view) could threaten Australian growth.

Concluding comments

Returns are likely to remain okay over 2018-19 as conditions are not in place for a US/global recession. But expect more constrained returns (say around 6% for a diversified fund) and continued volatility.

Source: AMP Capital 4 July 2018

Important note: 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) 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.

It’s nearly two years since the Reserve Bank of Australia last changed interest rates – when it cut rates to a record low of 1.5% in August 2016. That’s a record period of inaction – or boredom for those who like to see action on rates whether it’s up or down. Of course, there are lots of views out that the RBA should be doing this or that – often held and expressed extremely – and so it’s natural that such views occasionally get an airing. This is particularly so when the RBA itself is not doing anything on the rate front.

And so it’s been this week with a former RBA Board member arguing that the RBA should raise rates by 0.25% to prepare households for higher global interest rates and that the RBA should consider ditching its inflation target in favour of targeting nominal growth.

Our view – rates on hold at least out to 2020

Our view for some time is that the RBA won’t raise interest rates until 2020 at the earliest. In terms of growth, a brightening outlook for mining investment, strengthening non-mining investment, booming infrastructure spending and strong growth in export volumes are all positive but are likely to be offset by topping dwelling investment and constrained consumer spending. As a result, growth is likely to average around 2.5-3% which is below RBA expectations for growth to move up to 3.25%. This in turn means that spare capacity in the economy will remain high – notably unemployment and underemployment at 13.9% – which will keep wages growth low and inflation down. On top of this house prices likely have more downside in Sydney and Melbourne over the next two years, banks are tightening lending standards which is resulting in a defacto monetary tightening and the risks of a US-driven trade war are posing downside risks to the global growth outlook. As such we remain of the view that a rate hike is unlikely before 2020 at the earliest and can’t rule out the next move being a cut.

Raising rates to prepare for higher rates makes no sense…

Against this backdrop, raising rates just to prepare households for higher global rates would be a major policy mistake:

• It would be like shooting yourself in the foot so you can practice going to hospital. Some might argue that given high household debt you might miss the foot and hit something more serious – but I wouldn’t go that far!

• What’s more it’s not entirely certain that outside the US higher global rates are on the way any time soon – particularly given the risks around a global trade war, the European Central Bank looks unlikely to be raising rates until 2020 and with Japanese inflation falling again a Bank of Japan rate hike looks years away.  

• The RBA needs to set Australian interest rates for Australian conditions not on the basis of other global economies that are in different stages in the cycle – notably the US which has unemployment and underemployment of just 7.6% in contrast to Australia where it’s 13.9%.

  
  Source: Bloomberg, AMP Capital

• Raising rates when there is still high levels of labour market underutilisation, wages growth is weak and inflation is at the low end of the inflation target would just reinforce low inflation expectations – causing businesses and households to question whether the RBA really wants to get inflation and wage growth back up to be more consistent with the inflation target and run the risk of a slide into deflation next time there is an economic slowdown.

• The RBA has already provided numerous warnings that sooner or later rates will go up, effectively helping to prepare households that such a move may come and in recent times banks have raised some mortgage rates, albeit only slightly. Last year’s bank rate rises were in response to regulatory pressure and recently they have been in response to higher short-term money market funding costs as the gap between bank bill rates and the expected RBA cash rate has blown out by around 0.35% relative to normal levels. This has further reminded households of the risk of higher interest rates.

…nor does changing the inflation target

Suggestions to change the inflation target or move to some other target for the RBA get wheeled out every time we run above or below the target for a while but its served Australia well. When it’s above for a while like prior to the Global Financial Crisis some wanted to raise it, when it’s below for a while some want to cut it. And there are regular calls to move to something else like nominal growth targeting. But the case to change the target is poor:

• The 2-3% inflation target interpreted as to be achieved over time has served Australia well. It’s low enough to mean low inflation, it’s high enough to allow for the tendency of the measured inflation rate to exceed actual inflation (because the statistician tends to understate quality improvement) and to provide a bit of a buffer before hitting deflation. And the achievement of it over time means the RBA does not have to make knee-jerk moves in response to under or overshoots because it can take time to get back to target.

• Shifting to a nominal GDP or national income growth target would be very hard for Australia for the simple reason that nominal growth in the economy moves all over the place given swings in the terms of trade which the RBA has no control off. It would have meant much tighter monetary policy into 2011 than was the case and even easier monetary policy a few years ago when the terms of trade fell. In short it would mean extreme volatility in RBA interest rates.

• And in any case, nominal GDP or income growth is made up of two different things – inflation and real growth – so targeting just the aggregate could lead to crazy results for example if the target is 4.5% the RBA could get 4.5% inflation and say it hit its target! Which would be nuts.

• Finally, while low rates risk inflating asset price bubbles it’s worth noting that apart from Sydney and Melbourne home prices, the period of low rates has not really led to a generalised asset price bubble problem in Australia. And in any case as we have seen recently in relation to Sydney and Melbourne property prices – which are now falling (despite still ultra-low interest rates!) – the asset price problem where it does arise can be dealt with via macro prudential controls on lenders. Arguably, if we had moved faster on the macro prudential front around 2014-2016 then the east coast housing markets would have been brought under control earlier and rates could have come down faster in Australia and we could now be in a tightening cycle…but that’s all academic!

Bottom line

The bottom line is that the RBA should stick to its inflation target and ignore those arguing for a premature rate hike. Our assessment is that this is just what it will do and that rates will be on hold for a long while yet. In the meantime, the debate about rates will no doubt rage on.

Continuing low interest rates in Australia will mean term deposit rates will stay low, search for yield activity will still help yield-sensitive unlisted investments like commercial property and infrastructure (albeit it’s waning) and an on-hold RBA with a tightening Fed is likely to mean ongoing downward pressure on the Australian dollar as the interest rate differential goes further into negative territory.

Source: Bloomberg, AMP Capital

While a crash in the $A may concern the RBA, we saw in both 2001 when it fell to $US0.48 and 2008 when it fell from $US0.98 to $US0.60 in just a few months that the inflationary consequences of a lower $A are not what they used to be and in any case the RBA would likely welcome a fall to around $US0.65-0.70.

Source: AMP Capital 28 June 2018

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

Important note: 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) 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.