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The search for yield and return – has it gone too far or is there more to go?

Posted On:Nov 06th, 2013     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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The collapse in short term interest rates and associated fall in long term bond yields has seen investors seek out decent investment yield in assets as diverse as corporate debt, property, infrastructure and shares. And more recently this has broadened into a general search for higher returns as confidence in the economic

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The collapse in short term interest rates and associated fall in long term bond yields has seen investors seek out decent investment yield in assets as diverse as corporate debt, property, infrastructure and shares. And more recently this has broadened into a general search for higher returns as confidence in the economic outlook has improved.

When assets are in strong demand their price goes up and their investment yield (or the cash flow the investment provides relative to its price) falls. This is certainly evident over the last two years. The chart below shows the yield available on various assets today versus what they offered 2 years ago. Bond yields have increased slightly after earlier sharp falls. But the yield on all other assets have fallen, although – corporate bond yields excepted – not quite as much as the plunge in term deposit rates.

 

Source: Bloomberg, REIA, RBA, AMP Capital

But what's driving this chase for yield? Has it gone too far? If it has further to go what warning signals should we watch? And what does it all mean for investors?

Drivers of the chase for yield

The search for yield, and more recently higher returns generally, is being driven by a range of factors:

  • Low interest rates have pushed bank deposit rates down and bond yields are very low, all of which is encouraging investors into higher yielding alternatives;

  • Reduced fear of an economic meltdown has helped investors feel comfortable taking on more risk. Initially, fresh memories of share market falls saw this concentrated on assets providing high yields as this provided a degree of certainty that returns would be positive. Assets such as property, infrastructure or high income shares like bank shares in Australia all benefitted.

  • However, as past sharp share market falls recede in time and are replaced by ongoing news of rising markets – and as indicators such as business conditions PMIs have started to signal stronger global growth – investors have started to focus more on shares for capital growth.

Source: Bloomberg, AMP Capital

  • Finally, interest in yield is receiving a longer term push from the aging population. This started last decade as the first baby boomers moved into their pre-retirement phase and is intensifying now as they are starting to retire. This is driving demand for investments paying decent income in the form of dividends, rent, interest payments, etc.

Demographic influences likely have a long way to go. However, the first three drivers noted above are a normal cyclical phenomenon. In other words in the early stages of an economic recovery it’s quite normal to see investors start to take on more risk by moving out of bank deposits as interest rates get lower and lower and the economic outlook brightens. Initially this focuses on investments providing a high yield given the certainty of return this provides but eventually investor interest moves on to growth oriented investments. In other words what we are seeing is nothing new. It’s just more pronounced this time around because interest rates are lower than normal and GFC related share market falls have been deeper.

Moving out of bank deposits & taking on more risk is exactly what central banks like the Fed and the RBA want investors to do, because by taking on more risk this helps make capital available for investment in factories and buildings. And the rise in value of risky assets like shares and property helps boost wealth and hence spending. So nothing new here.

It should also be recognised that part of the rebound in asset prices reflects a return to normality as the risk of economic catastrophe gets unwound. This has seen the price to earnings multiple of shares return to more normal levels.

The danger, of course, comes when it all goes too far.

Has it gone too far?

The typical investment cycle eventually sees the chase for yield and surge in asset prices pushed too far as rising levels of debt and overvalued asset prices leave investment markets vulnerable when central banks adopt tight monetary policy to head off inflationary pressures or other imbalances in the economy. Right now we are a long way from that point.

  • First, while Australian house prices are bit extreme, asset prices generally are not. The yield available on Australian investment grade debt still offers a spread over that available on cash and term deposits. Share market price to earnings multiples have increased significantly over the last two years but only to around their long term average for Australian shares (see chart below) or to still below long term averages in the case of global shares.

 

Source: Thomson Reuters, AMP Capital

The gap between the distribution yield on Australian real estate investment trusts remains above the negative levels reached in 2007, ie before the GFC. Unlisted nonresidential property yields also remain relatively high such that commercial property continues to offer an attractive prospective return premium over bonds. In fact it is substantially higher than in the early 1990s & in 1997 after which property values fell sharply. See next chart.

Source: Bloomberg, AMP Capital

  • Second, we are a long way from the sort of debt surge that was occurring prior to the 2008 global financial crisis. Credit growth remains very weak globally and in Australia suggesting little risk of another debt blow-up at present.

 

Source: Bloomberg, US Federal Reserve, AMP Capital

  • Finally, while global growth is improving and the US Federal Reserve may soon start to slow its monetary stimulus program – possibly starting next month – a shift to tight monetary conditions looks to be a long way off. Inflation in the US, Europe and Australia remains low at just 1.2%, 0.7% and 2.2% respectively. Moreover, spare capacity as measured by output gaps (or the difference between actual and potential GDP) remains significant suggesting little inflationary pressure ahead. As indicated in the next chart, the output gap in the US is a long way from where it was in 2007, just before the GFC. So interest rate hikes are still a fair way off. In fact rate cuts are still possible in Europe.

Source: Bloomberg, AMP Capital

In other words the chase for yield and returns has not pushed asset values to an extreme. It looks fine as long as interest rates remain relatively low and investment markets don’t become too overvalued or geared. At this stage we still look to be a long way from that, suggesting the chase for better yields and higher returns still has further to run.

What to watch?

The previous section basically highlighted the three key groups of indicators to watch for signs that the chase for yield and higher returns has gone too far:

  • Valuation indicators such as price to earnings multiples for shares, yield spreads for bonds and the return premium property offers over bonds;

  • The rate of growth in private sector credit or debt.

  • Indicators of inflationary pressure and hence future interest rate hikes.

So far so good, but they are all worth keeping an eye on.

What does it all mean for investors?

There are two key implications for investors.

First, while the yields and return potential across most assets have fallen following recent strong rallies, there are a range of assets providing more attractive income flows than available on cash and bank term deposits. These include corporate debt, real estate investment trusts, shares and unlisted non-residential property.

Second, with yield related investments having performed so strongly over the last year or two and bond yields likely to gradually trend up, there is a case for those who can take on a bit more risk to consider a higher exposure to parts of the share market that have underperformed and yet will benefit as global and Australian growth picks up, eg, resources shares.

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.

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Light at the end of the tunnel for Australian retail sales

Posted On:Oct 24th, 2013     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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Four years of poor retail sales

When looking for growth in non-mining investments to fill the gap left by the mining investment boom, retail sales are critically important accounting for nearly 20% of economic activity in Australia. As is well known Australian retailers have had it tough for nearly four years now. Nominal

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Four years of poor retail sales

When looking for growth in non-mining investments to fill the gap left by the mining investment boom, retail sales are critically important accounting for nearly 20% of economic activity in Australia. As is well known Australian retailers have had it tough for nearly four years now. Nominal retail sales growth has averaged 2 to 3% since 2010, which is less than half the 6% annual pace seen last decade.

Sluggish nominal retail sales growth 

Source: ABS, AMP Capital

Initially this was not a disaster for the overall economy as mining investment was booming which soft retail sales helped make way for, and demand for consumer services was holding up well such that overall consumer spending was okay. Recently it’s been more of a problem for the broader economy as mining investment has started to soften and so too has overall consumption growth. However, there are signs of light at the end of the tunnel for retailers and hence for the broader economy.

Drivers of the slump

The retail slump of the past four years has been driven by a range of factors including:

  • cautious consumer attitudes towards debt and savings post the GFC;

  • weakness in household wealth on the back of both falling house prices and share markets;

  • “excessively” high interest rates relative to debt levels and wealth expectations;

  • the impact of the strongly rising $A leading to more spending on overseas holidays and accelerating on-line penetration;

  • a surge in the cost of necessities such as electricity (of around 10 to 15% pa) and health which ate into household budgets. This has been particularly painful for low income households – the bottom 20% of households (in terms of income) spend around 9% of their disposable income on electricity;

  • a slowdown in household income growth recently; and

  • job insecurity associated with more cost conscious corporates, particularly since 2010.

Outlook

In the short term the rising trend in unemployment will act as a drag. However, a range of factors suggest that retail sales growth will pick up pace a next year.

First, while consumer caution clearly remains it appears to be fading a bit. The household savings rate is no longer rising, having stabilised at around 10 to 11%, but more interestingly the proportion of Australian's nominating paying down debt as the "wisest place for savings" has fallen to its lowest since 2007.

  Some fading in consumer caution

Source: Westpac/Melbourne Institute, AMP Capital

Second, the combination of now very low interest rates and strongly rising household wealth on the back of rising share markets and rising home prices is very positive for household finances and is likely a big factor behind fading consumer caution. Australian share prices are up 24% over the past year and average home prices are up 5.5% (or 8% in Sydney).

Third, the housing recovery is likely to see a solid pickup in housing construction over the year ahead which will help drive a pick-up in demand for household items.

Fourth, reflecting some of these factors along with the change of Government consumer confidence is well up from its lows. All the new Government needs to do is stay out of trouble for the next six months at least!

  Consumer sentiment is well from 2012 lows

Source: Westpac/Melbourne Institute, AMP Capital

Fifth, the fall in the $A from its highs (with further to go hopefully) will over time help slow the momentum towards offshore holidays and online purchases from foreign sites. At the same time, the downtrend in the $A along with improving global growth should lead to an improvement in offshore visitor arrivals. All of which should help local retail sales.

The $A has had a strong bounce from its August low of $US0.89 as a result of the Fed deciding to delay tapering its monetary stimulus program and signs Australian interest rates are near the bottom. In the short term the $A could rise further as “short” positions remain extreme. However, it is likely to resume its downtrend next year as Fed tapering eventually gets underway, emerging country growth remains constrained by the standards of the last decade and the supply of commodities increases.

Sixth, the surge in the price of electricity looks to be slowing after 5 or so years of 10 to 15% gains. Over the year to the September quarter it had slowed to a 6.1% gain and it could even go backwards by 5% or so in 2014-15 if the carbon tax/ETS is abolished. This could provide a huge psychological boost to perceptions of household finances.

Finally, the rise in unemployment over the next six months may not be as much of a drag as feared as falling workforce participation of older workers (on the back of the aging population along with the rebound in wealth which has made retirement feasible again) takes the edge off the rise in the headline unemployment rate. It could end up peaking around 6% rather than the 6.25% the Treasury has forecast. This could mean that job insecurity may not be quite as bad as feared.

With some constraints remaining, eg household income growth is likely to only pick up slowly, a return to last decade's pace of retail sales growth looks unlikely. But some improvement next year is looking likely which is expected to see nominal retail sales growth pick up to around 4-5%. No boom, but at least a let up in the gloom.

Good news for the rest of the economy

An improvement in the pace of retail sales would be good news for the rest of the economy. Interest rates typically work through the economy with a lag: by first boosting housing, then consumer spending and eventually business investment. To date we have seen a clear pick up in housing related indicators both prices and to a lesser degree housing construction indicators. Signs that it is flowing through to forward indicators of retail sales suggest the recovery may be starting to broaden and add to confidence that the softness in mining investment will be at least partly offset through next year leading to a pick up in overall economic growth from the recent 2.5%pa pace. There is still a way to go yet but the signs are positive.

One outworking of this is that official interest rates have likely seen their bottom, or if not are pretty close to it.

Implications for investors

There are a number of implications for investors.

First, the prospective recovery in retail sales growth combined with the housing recovery already underway is a positive sign for profit growth in the year ahead and this is in turn supportive of the outlook for shares.

Second, the likelihood of stronger profit growth and hence a further rise in the local share market highlights that cash rates and bank term deposit rates of now 4% or less are unattractive for investors looking to grow their long term wealth.

Finally, while consumer discretionary shares have run hard – up 40% over the last 12 months – they should be reasonably supported if retail sales start to pick up as expected.

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.

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US budget crisis over

Posted On:Oct 18th, 2013     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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Back to work and no debt default

In a rerun of past fiscal debates the US Congress has agreed a last minute increase in the US Government’s debt ceiling and an end to the partial Government shutdown. Although this was already partly anticipated, share markets have naturally celebrated as the threat of a

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Back to work and no debt default

In a rerun of past fiscal debates the US Congress has agreed a last minute increase in the US Government’s debt ceiling and an end to the partial Government shutdown. Although this was already partly anticipated, share markets have naturally celebrated as the threat of a US debt default hitting confidence and global economic growth has been averted.

The agreement has seen Republicans achieve almost none of their demands but the big negative of the deal is that it only funds the Government through to January 15 and raises the debt ceiling to February 7. So expect a lot of talk about “kicking the can down the road yet again”.

Some positives

However, it’s probably not that simple and there is more reason for optimism.

  • Firstly, while the run up to the decision indicated that brinkmanship is alive and well in the US, the clear message is that at the end of the day the majority of US politicians will not let the US default on its debt servicing or broader spending commitments. As Winston Churchill once said “you can always rely on the American’s to do the right thing – after they’ve tried everything else.”

  • Second, while the brinkmanship seen in the US on a semi-regular basis is not good for confidence it is not all bad as it has led to a more balanced solution to US budget and debt problems than would have been the case if either side of politics had complete control.

  • Thirdly, the legislation for the temporary fix appears to include the so-called McConnell Rule that would allow the President to increase the debt ceiling unless Congress voted against it with a 2/3rds majority in each chamber. Such an approach could allow the Republicans to vote against a debt ceiling increase in February but not stop it.

  • Finally, having been so badly burned over the last few weeks Republicans may not be so willing to set off another Government shutdown and/or debt ceiling crisis early next year. Americans appear to have largely blamed them for the latest crisis and their favourable rating dropped to the lowest level in the last 20 years at just 28% according to a Gallup poll. With the mid-term Congressional elections coming up next year they may not be prepared to risk a re-run or worse as it could mean they will lose control of the US House of Representatives. So another shutdown and/or extreme bout of debt ceiling brinkmanship may end up being avoided early next year.

Implications

The ending of the shutdown and the raising of the debt ceiling have a number of implications.

First, the shutdown is only likely to have a minor impact on US economic growth. Probably only 0.2% or so shaved off December quarter GDP as only 450,000 workers were furloughed in the end and they will receive full back pay. Government spending will now play catch up and the negative flow on to confidence should reverse fairly quickly.

Second, even though the impact on growth from the shutdown is likely to be minor wariness of another round of fiscal debates in the US in January and February may see the Fed further delay tapering its monetary stimulus to its March meeting, particularly if economic data is still weak. In other words US monetary stimulus is likely to continue for a long while yet.

Third, the resolution of US fiscal issues for now has averted yet another threat to global growth. Just as issues and threats regarding Italy, Syria, the replacement of Ben Bernanke at the Fed, the Fed’s taper decision, the German election, etc, have all come and gone this year without causing major problems. This suggests that the global recovery can continue to strengthen.

 

Source: Bloomberg, AMP Capital

Fourthly, to the extent that the deal shows US politicians are not prepared to let America default and/or force an immediate balancing of its budget, it’s positive for investor confidence and hence positive for share markets and growth assets generally.

 

Source: Bloomberg, AMP Capital

With the worry list for investors continuing to diminish and US politicians showing yet again that they can work constructively when push comes to shove, our assessment is that shares will have a solid rally into year end with further gains next year. Share market valuations remain reasonable, monetary conditions are set to remain easy and profits are likely to improve next year as global and Australian growth picks up. Australian shares look they could hit 5500 by year end, with a little help from a Santa rally.

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.

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The US budget and debt ceiling standoff

Posted On:Oct 08th, 2013     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
  Download PDF copy Here they go again

Political dysfunction around fiscal policy is a regular occurrence in the US, with regular bouts of uncertainty over government shutdowns, debt ceiling increases, etc. The annoying thing for me is that often they take place when I have gone on holidays, and the shutdown that commenced last week was

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Here they go again

Political dysfunction around fiscal policy is a regular occurrence in the US, with regular bouts of uncertainty over government shutdowns, debt ceiling increases, etc. The annoying thing for me is that often they take place when I have gone on holidays, and the shutdown that commenced last week was no exception! Such conflicts invariably arise because different political parties to the President control part or all of Congress. At present it’s the Republican controlled House against the Democrat controlled Senate and President Obama. Such conflicts seem worse lately because the GFC and the response to it seems to have polarised many politicians to extreme positions.

The current dispute is around the failure to pass a new budget for the financial year beginning October 1 (hence the shutdown) and the need to raise the US Government’s debt ceiling (which is expected to be reached by October 17). It has its origins in the Republican dislike for President Obama’s health care reforms (Obamacare) and the failure of the fiscal cliff resolution early this year to embrace a ‘grand bargain’ reducing America’s long term budget deficit by closing tax loopholes and cutting back on the growth of entitlements.

Obviously the consequences of the US not increasing its debt ceiling and defaulting on its debt would be bad – many have said catastrophic. Failure to make a debt servicing obligation will see the US sovereign rating lowered to ‘Selective Default’ (according to Standard and Poors) as Greece was recently. Such an event would likely see a sell-off in US Government bonds, a flow on to the borrowing costs of all US corporates and a stigma that may take the US years to recover from – as Argentina and Russia have found. And of course not increasing the debt ceiling would mean the budget deficit of 4% of GDP would have to be eliminated immediately resulting in massive fiscal drag. All of which would affect confidence and hence economic growth.

However, the odds strongly favour a solution being found and a debt default being avoided, but the next few weeks could be uncertain

Shutdowns are nothing new in the US

US Government shutdowns are far from new and arise when Congress fails to pass laws funding Government spending. In fact there were 17 shutdowns between 1976 and 1996, lasting an average 7.4 days, with the median shutdown lasting 4 days.

Since they involve non-essential government services (ie, not the whole Government as many items of spending have separate streams of funding) their economic impact is small.

  Shutdowns are nothing new in the US

Source: Bloomberg, Ned Davis Research, AMP Capital

The current shutdown is estimated to be costing the US economy around 0.1% of GDP a week. But this will be significantly reversed once the shutdown ends and Government spending plays catch-up and currently furloughed workers get back pay. A return to work of around 350,000 civilian defence workers will also reduce the impact. This means only 450,000 Federal workers will remain on furlough, not the 800,000 referred to last week.

Interestingly the impact on share markets is mixed: US shares fell through 8 of the last 15 shutdowns (affecting market trading days) and rose through 7 including the longest in 1995-96. Shares experienced above average gains once shutdowns ended though.

The debt ceiling is a greater risk

The risks are a bit greater this time though as the US economy is somewhat fragile. More importantly, the budget debate is rolling into the need for Congress to increase the US Government’s debt ceiling later this month. The US Government will reach its $US16.7trn debt ceiling on October 17 and will run out of an estimated remaining $US30bn in cash by November 1, when it has roughly $US67bn in Social Security and Medicare payments due.

Given that the US Government is running a budget deficit equal to around 4% of GDP, if the debt ceiling is not increased spending would have to be cut back to be in line with revenue. As a result there are obvious fears that this may result in the US defaulting on its debt servicing obligations. On this front the US Treasury has about $US30bn in debt interest payments due on November 15.

However, there are several points to note on all this. First, we have been here before and solutions have always been found. The debt ceiling has been increased 17 times since 1993, most recently in August 2011 when the debt ceiling was last increased but at the last minute and after a round of brinkmanship. And it is worth noting that at Christmas last year the prospects for heading off the fiscal cliff of spending cuts and tax hikes looked bleak only to see agreement reached in the early hours of New Year’s Day.

Second, both sides of US politics are aware of the longer term consequences of the US defaulting on its debt servicing. House Speaker John Boehner has repeated that he won’t allow this to happen, even if it involves relying on Democrat votes, albeit it will likely require measures to reduce the long term growth in debt. And while President Obama has said he won’t negotiate on the debt ceiling, it’s hard to see him wanting his legacy marred by letting the US default while on his watch. So a last minute solution remains the most likely outcome for the debt ceiling.

Third, while a last minute solution will likely be found it’s a bit too early for it just yet as the political pressure is not great enough. On this front, while it would be good for the shutdown to end soon, the longer the shutdown lasts the greater the odds the Republicans will cave in earlier on the debt ceiling as it’s likely they will be politically weakened as Americans will probably mostly blame them for the shutdown. Similarly if President Obama is to back down and negotiate on the debt ceiling he probably won’t do so until the very last minute.

However, there are some positive noises starting to appear with some on both sides of politics raising points of negotiation that may lead to a solution. There is further to go though. But after playing hardball for a while (to appease their extremes) Republicans and Democrats are likely to arrive at a solution for the shutdown and debt ceiling that involves some tax reform in return for the start of a process of slowing the growth in entitlements and removing the medical devices tax that is part of Obamacare.

An alternative approach now being considered by the US Senate is to allow President Obama to increase the debt ceiling unless Congress voted against it by a 2/3rds majority in each chamber. Such an approach would allow the Republicans to vote against it but the debt ceiling to be raised anyway as they would not have a 2/3rds majority.

Fourth, even if the debt ceiling is not increased in time, the US Treasury is almost certain to prioritise debt servicing so a partial debt default is very unlikely. In other words the 4% of GDP cut to Government spending that would be required would fall on other areas than debt servicing.

A better position than in 2011

There is no doubt that the political brinkmanship that the US regularly finds itself in has not been helping its economic recovery. As Standard and Poors recently pointed out “this sort of political brinkmanship is the dominant reason the [US sovereign] rating is no longer AAA. Fitch and Moody’s may well be tempted to similarly cut the US rating one notch.

However, it is not all bad and has been leading to a more balanced solution to America’s debt problem than would have been the case if either side of politics had complete control. We have been seeing a mix of revenue increases and spending cuts in recent years. For example, the fiscal cliff deal ultimately saw the Bush era tax cuts for high earners end and the so-call ‘sequester’ spending cuts commence. And the budget deficit has now fallen to 4% of GDP from a peak of 10% in 2010 and the ratio of public debt to GDP actually stopped increasing in the June quarter.

More importantly, it’s worth noting that there are now several positives compared to the situation around the August 2011 debt ceiling/sovereign rating downgrade in the US.

First, as already noted the budget deficit is much smaller, such that any forced and immediate budget balancing wouldn’t be as bad for the economy.

Second, Fed monetary policy is far more stimulatory with QE3 continuing whereas back in August 2011 the US was suffering from the premature ending of QE2 in June 2011.

Third, global growth is picking up as is clearly evident in an uptrend in business conditions PMIs, in contrast to the situation in August 2011 when they were falling. This included the US where there were fears of a double dip recession at the time whereas now the US seems to be on a stronger path led by private sector activity – notably housing and business investment.

  A better position than in 2011

Source: Bloomberg, AMP Capital

Finally, the Eurozone is no longer threatening to implode whereas back in the second half of 2011 the Eurozone crisis was at its peak.

In other words the US and the world is in a far better position today to withstand a debt ceiling crisis than it was the last time around in August 2011.

What does it mean for investors?

Even though a last minute solution remains most likely it won’t stop investors fearing the worst in the interim, so the next few weeks could see further weakness in share markets. After a long period of solid gains shares are vulnerable and October is often a messy month for shares anyway. However, while it’s too early just yet, weakness on the back of US debt ceiling fears should ultimately be seen as a buying opportunity as a last minute deal is likely to set the scene for a resumption of the bull market and the usual solid seasonal gains into year end.

Bonds are likely to benefit from safe haven buying in the short term but are likely to resume their gradual rising trend once a solution is in place.

US assets may be a relative loser in the short term as current events yet again highlight political dysfunction in the US. This could work against the $US (and boost the $A), US bonds and US shares in the short term. However, such an impact is not likely to last long as the US political system has functioned better through times of crisis than Japan or the Eurozone have.

 

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.

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The outlook for unlisted commercial property

Posted On:Sep 26th, 2013     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
  Download PDF copy Solid returns from commercial property

The past three years have seen solid 9-10% pa returns from unlisted commercial property. This has been driven by a recovery from the GFC related slump of 2008 and 2009, moderate economic growth and more recently the desire for decent income bearing investments from investors that has pushed

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Solid returns from commercial property

The past three years have seen solid 9-10% pa returns from unlisted commercial property. This has been driven by a recovery from the GFC related slump of 2008 and 2009, moderate economic growth and more recently the desire for decent income bearing investments from investors that has pushed down investment yields across the board, but particularly for retail property. The decline in yields has been an important driver of returns as each 0.25% fall in yields translates roughly to a 4% capital gain.

Source: AMP Capital

Reflecting the search for yield listed property, or Australian Real Estate Investment Trusts (A-REITs), have been even stronger with gains of around 17% over the last year and 11% pa over the last three years.

So where to from here? What does the mixed Australian economic outlook mean for property and has the decline in property yields run its course?

Space demand and supply

The biggest drag in the short term will be the soft Australian economy. While recession is expected to be avoided, economic growth is likely to remain sub-par at around 2 to 2.5% over the next six months or so and this is likely to push unemployment up to around 6.3% by mid next year. The soft economy will in turn mean subdued space demand into next year. Retail property is perhaps most vulnerable on this front, with retail property yields nearly back to pre GFC lows suggesting little return buffer.

However, economic growth, including retail sales, is likely to start picking up through next year as the benefit of lower interest rates, the fall in the $A, rising wealth levels, the benefits of increased housing construction and reduced consumer caution start to flow through to stronger demand. So growth in space demand should pick up from 2014-15.

Over the next few years, particularly around 2015 and 2016, the supply of office space is likely to increase (partly associated with Barangaroo in Sydney). As a result average office vacancy rates are likely to remain around 10% for the next few years acting as a negative for office rental growth.

Source: AMP Capital

Rising supply at a time of sluggish demand is also likely to be a drag on industrial and retail property rents and returns in the short term.

A-REITs lead

While the near term space demand and rental growth outlook is subdued, the strength in A-REITs is a positive sign for unlisted commercial property. While A-REITs are far more volatile, they tend to provide a good lead for unlisted commercial property. This can be seen in the next chart.

* Direct property is AMP Capital core direct property fund. Source: Bloomberg, AMP Capital

The search for yield by investors has seen A-REITs come back into favour pushing their yields down and boosting their returns. This augurs well for unlisted commercial property returns ahead. Unlisted commercial property continues to offer more attractive yields than A-REITs.

Source: Bloomberg, AMP Capital

Downwards pressure on yields

While the yields available on Australian unlisted commercial property have declined over the last three years, they remain attractive relative to most other assets. The next chart shows a composite of office, retail and industrial property yields versus an average of government bond, equity and housing yields. The gap between commercial property yields and other yields remains wide suggesting yields on commercial property are relatively attractive.

Source: REIA, Bloomberg, AMP Capital

This is particularly noticeable compared to residential rental property, as can be seen in the next chart. In the 1980s the rental yield on residential and commercial property was similar, but today commercial property has a rental yield which is far higher, ie just below 7% for commercial property compared to around 3.5% for residential property. With Australian residential property over-valued on most measures – albeit less than it was – this suggests that office, retail or industrial property is far more attractive for investors than housing on a medium term horizon as it is less dependent on capital growth going forward and less at risk of a correction, when say interest rates start rising again.

Source: REIA, AMP Capital

Apart from soft near term demand and rising supply, the biggest concern regarding commercial property is probably that bond yields back up sharply as global growth improves. In fact bond yields have already backed up this year – with the 10 year government bond yield in Australia rising from 3.3% at the start of the year to 3.9% currently.

However, despite the back up in government bond yields the risk premium offered by commercial property over bonds remains well above average. The next chart shows a proxy for this. It assumes that rental and capital growth will average 2.5% pa over time (ie, in line with average inflation) and adds this to the average non-residential property yield to give a guide to potential total returns. The 10 year bond yield has been subtracted to show a property risk premium. It can be seen that even though it has fallen slightly recently it still remains at levels that are well above its historical average.

Source: REIA, Bloomberg, AMP Capital

The bottom line is that while rising bond yields on the back of recovering global growth may act as a bit of a constraint, the huge yield advantage commercial property offers over government bonds and other yield bearing assets like residential property suggests that investor demand is likely to remain strong. In fact this is a key message from surveys of global institutional investors.

It’s worth noting commercial property has been a beneficiary of investor flows during periods of rising bond yields in the past. This happened during the bond crash of 1994 and the more gradual backup in bond yields that occurred prior to 2007 as investors simply switched out of bonds into assets like commercial property that offered higher yields. Property only became vulnerable in 1990 and 2007 when the property risk premium in the previous chart had fallen to far less attractive levels than is currently the case.

Return outlook

The net result of these conflicting forces is that while soft demand and rising supply may result in average unlisted commercial property returns slowing to around 7.5% over the year ahead, they are likely to remain solid on the back of investor demand for the relatively attractive yields commercial property offers. Returns are likely to pick up from 2014-15 if economic growth improves as expected.

Within unlisted commercial property the main opportunities are likely to be in industrial property reflecting its relatively attractive yields and quality retail property in strong population corridors. Retail property in low growth areas is vulnerable and office property is likely to underperform thanks to rising supply and subdued office space demand. A-REITS having outperformed over the last few years are likely to perform in line or even lag unlisted property going forward. Distribution yields have fallen to 5.5% as they have benefitted the most from falling bond yields.

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.
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No Fed taper for now – implications for investors

Posted On:Sep 19th, 2013     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
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In what has perhaps been the biggest positive policy surprise for investors this year, the US Federal Reserve decided not to start tapering its quantitative easing (QE) program and leave asset purchases at $US85bn a month. This followed four months of almost constant taper talk which had led investment markets to factor

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In what has perhaps been the biggest positive policy surprise for investors this year, the US Federal Reserve decided not to start tapering its quantitative easing (QE) program and leave asset purchases at $US85bn a month. This followed four months of almost constant taper talk which had led investment markets to factor it in. As a result the decision not to taper combined with very dovish language from the Fed has seen financial markets celebrate. This note looks at the implications.

Ready, set…stop

With the Fed foreshadowing from late May, that it would start to slow its asset purchases “later this year”, financial markets had come to expect that the Fed would start tapering at its September meeting. In the event the Fed did nothing. Several factors explain the Fed’s decision:

  • The Fed always indicated that tapering was conditional on the economy improving in line with its expectations whereas recent data – particularly for employment and some housing indicators – has been mixed.

  • Second, the Fed has become concerned that the rapid tightening of financial conditions, mainly via higher bond yields, would slow growth.

  • Third, the upcoming budget and debt ceiling negotiations (with the risk – albeit small – of a Government shutdown or technical default) and accompanying uncertainty appear to be worrying the Fed.

  • Finally, the Fed may have concluded that any forward guidance it would have provided to help keep bond yields down may have lacked sufficient credibility given the coming leadership transition at the Fed.

Observing the run of somewhat mixed data lately and the back up in bond yields, I and most others concluded that the Fed would address this by announcing a small tapering, ie cutting back asset purchases by $US10bn a month, and issue dovish guidance stressing that rate hikes are a long way away in order to keep bond yields down. However, it turns out that the Fed is more concerned about the risks to the growth outlook from higher bond yields at this point than we allowed for particularly given the US budget issues.

The Fed’s announcement is ultra-dovish with tapering delayed till “possibly” later this year and the Fed further softening its guidance. For example, the mid 2014 target for ending QE is gone and the 6.5% unemployment threshold for raising interest rates has been softened with Bernanke saying rates may not be increased till unemployment is “substantially” below 6.5%. The median of Fed committee members is for the first rate hike to not occur until 2015, and for the Fed Funds rates to hit only 1% at the end of 2015 and 2% at the end of 2016.

The key message from the Fed is very supportive of growth. They won’t risk a premature tightening in financial conditions via a big bond sell off and tapering won’t commence until there is more confidence that its expectations for 3% growth in 2014 and 3.25% growth in 2015 are on track.

Given that we also see US growth picking up tapering has only been delayed, but there is considerable uncertainty as to when it will commence. The Fed’s October 29-30 meeting looks unlikely as there is no press conference afterwards and US budget concerns may not have been resolved by then. The December 17-18 meeting is possible as it is followed by a press confidence but is in the midst of holiday shopping. So it could well be that it doesn’t occur till early next year.

Perhaps the main risk for the Fed is that by not tapering (when it had seemingly convinced financial markets that it would) it has created a lack of clarity around its intentions which will keep investors guessing as to when it will commence. This will likely add to volatility around data releases and speeches by Fed officials.

The US economy and inflation

In a broad sense though, the Fed is right to maintain a dovish stance:

  • Growth is on the mend thanks to improving home construction, business investment and consumer spending but it’s still far from booming and is relatively fragile as the private sector continues to cut debt ratios. This is also evident in the mixed tone of recent economic indicators with strong ISM business conditions readings but sub-par jobs growth and some softening in housing indicators on the back of a rise in mortgage rates to a still low level of around 4.6%.

  • Spare capacity is immense as evident by 7.3% official unemployment, double digit labour market underutilisation and a very wide output gap (ie the difference between actual and potential growth).

Source: Bloomberg, AMP Capital

  • A fall in labour force participation has exaggerated the fall in the unemployment rate. At some point participation will start to bounce back slowing the fall in unemployment.

  • Inflation is low at just 1.5%. There is absolutely no sign of the hyperinflation that the Austrian economists and gold bugs rave on about.

So while some will express annoyance that the Fed has confused them, at the end of the day the economic environment gives the Fed plenty of reason to be flexible.

Implications for investors

The Fed’s decision to delay tapering for now and its growth supportive stance is unambiguously positive for financial assets in the short term and this has been reflected in sharp falls in bond yields, gains in shares and commodity prices and a rise in currencies like the $A.

The sharp back up in bond yields since May when the Fed first mentioned tapering had left bonds very oversold and due for a rally. This could go further as market expectations for the first Fed rate hike push back out to 2015. However, the Fed has only delayed the start of tapering and as the US/global growth outlook continues to improve the upswing in bond yields is likely to resume, albeit gradually. This and the fact that bond yields are very low, eg 10 year bonds are just 2.7% in the US and just 3.9% in Australia, suggests that the current rally will be short lived and that the medium term outlook for returns from sovereign bonds remains poor.

For shares, the Fed’s commitment to boosting growth is very supportive. QE is set to continue providing a boost to shares going into next year even though sometime in the next six months it’s likely to start to be wound down. But it’s now very clear that the Fed will only do this when it is confident that economic growth is on track for 3% or more and this will be positive for profits. This is very different to the arbitrary and abrupt ending of QE1 in March 2010 and QE2 in June 2011, that were associated with 15-20% share market slumps at the time. See the next chart.

 

Source: Bloomberg, AMP Capital

With shares no longer dirt cheap, it’s clear that the easy gains for share markets are behind us. But by the same token shares are not expensive either and an “easy” Fed adds to confidence that profit growth will pick up next year driving the next leg up in share markets.

 

Bloomberg, AMP Capital

Shares are also likely to benefit from long term cash flows as the mountain of money that has gone into bond funds since the GFC is reversed gradually over time with some of it going into shares. See the next chart.

 

Source: ICI, AMP Capital

However, while the broad cyclical outlook for shares remains favourable, there will be some speed bumps along the way. The coming government funding and debt ceiling negotiations in the US could create uncertainty ahead of the usual last minute deal. And investors will now be kept guessing about when the first taper will come which means any strong economic data or hawkish comments from Fed officials could cause volatility. The May-June share market correction was all about pricing in the first taper and that process might have to commence all over again at some point.

For high yield bearing assets generally, eg bank shares, the Fed’s inaction and the rally in bonds will provide support. However, underperforming cyclical stocks, such as resources, may ultimately be more attractive as they offer better value and will benefit as the global and Australian economies pick up.

For emerging world shares, the Fed’s inaction takes away some of the short term stress, but it’s likely to return as US tapering eventually comes back into focus with current account deficit countries like India, Indonesia and Brazil remaining vulnerable.

Finally, the Fed’s decision not to taper does make life a bit harder for the Reserve Bank of Australia in the short term in trying to keep the $A down. It has added to the short covering bounce that has seen the $A rise from $US0.89 this month and so adds to the case for another interest rate cut. However, the rebound in the $A is likely to prove temporary as the Fed is expected to return to tapering some time in the next six months.

 

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.
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