Olivers Insights

Five lessons from 2017

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.

Two years after it first started raising interest rates in this cycle in December 2015, the Fed has increased rates for the fifth time, raising the Fed Funds rate another 0.25% to a target range of 1.25-1.5%. For the last two years, it has been right not to fear the Fed as tightening was conditional on better economic conditions, it would be gradual and we were only moving from very easy monetary policy to less easy. Despite a few ructions after the first move into early last year, this has been correct as the US and global recovery has accelerated and share markets and other growth assets have performed well. The question now is where to from here? Will the Fed get more aggressive? Should investors be more concerned?

Fed hike number 5

In raising the target range for the Fed Funds rate by another 0.25%, the Fed noted the continuing strengthening in the US labour market and solid growth and continues to expect inflation to pick up towards its 2% target. The Fed continues to refer to only “gradual” increases in interest rates going forward and the Fed’s so-called “dot plot” median of Fed meeting participants’ interest rate expectations is continuing to allow for three hikes in 2018 (the same as flagged in the September meeting). Quite clearly the Fed is confident that growth will remain strong with tax cuts providing an additional stimulus – it revised up its 2018 growth forecast from 2.1% to 2.5% – and that this will start pushing inflation back towards the 2% target. 

The transition to new leadership at the Fed in March from Janet Yellen to Jerome Powell (assuming he is confirmed by the Senate, which is most likely) isn’t expected to signal a big change at the Fed on monetary policy. Powell is likely to follow the broad path the Fed is already on in terms of rates hikes and quantitative tightening. There may be a more relaxed approach to regulation, though, but for now that’s a separate issue.

Market expectations for just two Fed rates in 2018 hikes remain below the Fed’s dot plot signal of three hikes. While the market has been right in expecting lower interest rates than the Fed has been signalling in recent years, it wrongly underestimated the Fed in 2017 and is likely to do so again 2018. I suspect that the risks for US inflation are now swinging to the upside with spare capacity in the US economy gradually diminishing. So just as the market proved too cautious in allowing for just two Fed hikes this year when it has actually done three, we suspect it will be surprised again next year. In fact, given our views of a pick-up in inflation risks, we are allowing for four rate hikes next year in 2018 (conditional on tax reform being passed).

Source: Bloomberg, 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.

2017 – a relatively smooth year

• Global growth continued the acceleration we had seen through the second half of last year. In fact, global growth looks to have been around 3.6%, its best result in six years, with most major regions seeing good growth. Solid global growth helped drive strong growth in profits.

• Benign inflation. While deflation fears faded further, underlying inflation stayed low and below target, surprising on the downside in the US, Europe, Japan and Australia. 

• Rising commodity prices. Better than feared global demand and a surprise fall in the $US helped commodity prices along with constrained supply in the case of oil.

• Politics turned out to be benign. Political risks featured heavily in 2017 but they turned out less threatening than feared: while political risk around Trump rose with the Mueller inquiry into his presidential campaign’s Russian links, business-friendly pragmatism dominated Trump’s first-year policy agenda and a trade war with China did not eventuate; Eurozone elections saw pro-Euro centrists dominate; North Korean risks increased but didn’t have a lasting impact on markets; Australian politics remained messy but arguably no more so than since 2010.

• Another year of easy money. While the Fed continued to gradually raise interest rates and started reversing quantitative easing and China tapped the monetary brakes, central banks in Europe and Japan remained in stimulus mode and overall global monetary policy remained easy. 

• Australia had okay growth hitting 26 years without a recession, but inflation remained below target. While housing construction started to slow and consumer spending was constrained, non-mining investment improved, infrastructure spending surged & export volumes were strong. Record low wages growth and low inflation kept the Reserve Bank of Australia (RBA) on hold, though.

  The “sweet spot” of solid global growth and low inflation/benign central banks helped drive strong investment returns overall.

Yr to date to Nov. Source: Thomson Reuters, Morningstar, REIA, AMP Capital

• Global shares pushed sharply higher supported by strong earnings, low interest rates and growing investor confidence. While Eurozone, Japanese and Australian shares saw 5-7% corrections along the way, US shares only saw brief 2-3% pullbacks. So volatility was very low.

• The big surprise was that the US dollar fell rather than rose as low inflation kept expectations for Fed rate hikes depressed. This helped boost US shares but dragged on Eurozone shares as the Euro rose.  

• Asian and emerging market shares were star performers thanks to leverage to global growth, rising commodity prices and a weaker $US, which reduced debt servicing costs.  

• Australian shares had good returns but were relative laggards as has generally been the case this decade with weaker underlying profit growth. 

• Bonds had mediocre returns. While inflation surprised on the downside, ultra-low yields constrained returns. 

• Real estate investment trusts had a somewhat constrained year as investors remained a bit wary of listed yield plays.

• Unlisted commercial property and infrastructure continued to do well as investors sought their still relatively high yields.

• Australian residential property returns slowed as the heat came out of the Sydney and Melbourne property markets.    

• Cash and bank term deposit returns were poor reflecting record low RBA interest rates. 

• Reflecting US dollar softness, the $A actually rose helped by modest gains in commodity prices. 

• Reflecting strong returns from shares and unlisted assets, balanced superannuation fund returns were strong.

2018 – looking ok but expect more volatility

• Global growth to remain strong. Global growth is likely to move up to 3.7%, ranging from around 2% in advanced countries to around 6.5% in China, with the US receiving a boost from tax cuts. Leading growth indicators such as business conditions PMIs point to continuing strong growth, but just bear in mind that they don’t get much better than this. Overall, this should mean continuing strong global profit growth albeit momentum is likely to peak.

Source: Bloomberg, IMF, AMP Capital

• US inflation starting to lift. Global inflation is likely to remain low, but it’s likely to pick up in the US as spare capacity is declining, wages growth is picking up and as higher commodity prices feed through. We don’t expect a surge and the flow through in other major countries will be gradual. But higher US inflation may disrupt the yield trade at times and cause some nervousness.

• Monetary policy divergence to continue. The Fed is likely to hike four times in 2018 (which is more than markets are allowing) and to continue with quantitative tightening but other central banks are likely to lag.• Political risk may have more impact after a relatively benign 2017. US political risk is likely to become more of a focus again (with the Mueller inquiry getting closer to Trump, the November mid-term elections likely to see the Republicans lose the House and the risk that Trump may resort to populist policies like protectionism to shore up his support), the Italian election is likely to see the anti-Euro Five Star Movement do well (albeit not well enough to form government), North Korean risks are unresolved and there is the risk of an early election in Australia. 

Fortunately, there is still no sign of the sort of excesses that drive recessions and deep bear markets in shares: there has been no major global bubble in real estate or business investment; there is the bitcoin mania but not enough people are exposed to that to make it economically significant globally; inflation is unlikely to rise so far that it causes a major problem; share markets are not unambiguously overvalued and global monetary conditions are easy. So arguably the “sweet spot” remains in place, but it may start to become a bit messier. p  

For Australia, while the boost to growth from housing will start to slow and consumer spending will be constrained, a declining drag from mining investment and strength in non-mining investment, public infrastructure investment and export volumes should see growth around 3%. However, as a result of uncertainties around consumer spending along with low wages growth and inflation, the RBA is unlikely to start raising interest rates until late 2018 at the earliest. 

Implications for investors

Continuing strong economic and earnings growth and still-low inflation should keep overall investment returns favourable but stirring US inflation, the drip feed of Fed rate hikes and a possible increase in political risk are likely to constrain returns and increase volatility after the relative calm of 2017:  

• Global shares are due a decent correction and are likely to see more volatility, but they are likely to trend higher and we favour Europe (which remains very cheap) and Japan over the US, which is likely to be constrained by tighter monetary policy and a rising US dollar. Favour global banks and industrials over tech stocks that have had a huge run.

• Emerging markets are likely to underperform if the $US rises as we expect.

• Australian shares are likely to do okay but with returns constrained to around 8% with moderate earnings growth. Expect the ASX 200 to reach 6200 by end 2018. 

• Commodity prices are likely to push higher in response to strong global growth. 

• Low yields and capital losses from a gradual rise in bond yields are likely to see low returns from bonds.

• Commercial property and infrastructure are likely to continue benefitting from the ongoing search for yield by investors. 

• National capital city residential property price gains are expected to slow to around zero as the air comes out of the Sydney and Melbourne property boom and prices fall by around 5%, but Perth and Darwin bottom out, Adelaide and Brisbane see moderate gains and Hobart booms. 

• Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.2%.

• The $A is likely to fall to around $US0.70, but with little change against the Yen and the Euro, as the gap between the Fed Funds rate and the RBA’s cash rate goes negative.

What to watch?

• •The risks around Trump – the Mueller inquiry and the mid-term elections. We don’t see the Republicans impeaching Trump (unless there is evidence of clear illegality) but he could turn to more populist policies such as a trade war with China, a spat over the South China Sea or a clash with North Korea to boost his support.

• How quickly US inflation turns up – a rapid upswing is not our base case but it would see a more aggressive Fed, more upwards pressure on the $US, which would be negative for US and emerging market shares and a rapid rise in bond yields.

• The Italian election – the anti-Euro Five Star Movement is likely to do well and, even though it’s hard to see them being able to form government, this could cause nervousness; 

• Whether China post the Party Congress embarks on a more reform-focussed agenda resulting in a sharp decline in economic growth – unlikely but it’s a risk.

• Whether non-mining investment, infrastructure spending and export volumes are able to offset constrained consumer spending and a downturn in the housing cycle and how far Sydney and Melbourne property prices fall.

Source: AMP Capital 7 December 2017

Author: Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.

At the start of last year, with global and Australian shares down around 20% from their April/May 2015 highs, the big worry was that the global economy was going back into recession and that there will be another Global Financial Crisis (GFC). Now, with share markets having had a strong run higher, it seems to have been replaced by worries that a crash is around the corner and this will give us the global recession and new GFC that we missed last year!

Australians seem particularly vulnerable to worries these days. On the weekend I read that Australians are suffering from an “epidemic of anxiety” and that out of a survey of 24 nations Australians ranked in the upper half in terms of worries about a health epidemic (9^th highest), a terrorist attack (8^th highest) and a nuclear attack (5^th highest) – way above South Korea in terms of the latter despite Kim Jong-un’s new found nuclear capability just across the border! And a Roy Morgan survey has found that only 31% of surveyed Australians expect next year to be a better year than 2017, which is the lowest on record and only just above the 30% who expect next year to be worse. See the next chart.

No survey results for 1996, 2010-2016, Source: Roy Morgan, AMP Capital

In fact, it’s the lowest net balance of “better” less “worse” expectations for the year ahead since Australia was in the midst of the last recession in 1990. Whatever happened to the “she’ll be right” approach? Surely it’s not that bad!

At a broader global level, there seems to be a never ending worry list which since the GFC has rolled on through worries about a new collapse in the US (on the back of too much debt, hyperinflation on the back of money printing, deflation after the hyperinflation failed to materialise, a slump when monetary stimulus ends, or whatever), to worries the Eurozone will blow (or vote) itself apart, to worries that China will collapse as a result of too much debt and/or a property crash, interspersed by worries about the emerging world, Ebola, Ukraine, deflation, North Korea and various elections including the advent of President Trump along the way. And of course, the worries about Australia collapsing keep rolling on with the focus switching from a commodity crash to a housing crash.

Despite this ongoing worry list, investment returns have generally been good. Most assets have had good returns over the last year and the last five years, and balanced growth superannuation funds after fees and taxes returned an average 8.2% over the year to September and 9.3% per annum over the last five years.

So why the persistent gloom?

Some might argue that post the GFC, the world is now a more negative place and so gloominess is understandable today. But given the events of the last century – ranging from flu pandemics, the Great Depression, several major wars and revolutions, numerous recessions and financial panics – it’s doubtful that this is the case.

More fundamentally, it’s well known that humans are naturally attracted to bad news stories. The evolution of the human brain through the Pleistocene age where the trick was to dodge woolly mammoths and sabre toothed tigers means that much more space in our brains is devoted to threat than reward. This means that we are constantly on the lookout for risks and so more disposed to check out bad news stories as opposed to good news. In the investment world, an outcome of this is known as “loss aversion” in that a financial loss is felt far more keenly than a same-sized gain. As a result, doomsters are far more likely to be seen as deep thinkers than optimists and “bad news sells”.

But there is nothing new here. What has changed is the flow of information from a trickle to an avalanche. This is the case everywhere and the investment world is not immune. As the well-known US stock picker Peter Lynch observed “stock market news has gone from hard to find (in the 1970s and early 1980s), then easy to find (in the late 1980s), then hard to get away from”. This can be great in a way, but it can also just add to confusion.

But more significantly, the information age has led to not just greater access to information but also an explosion of media begging for attention. And in the scramble to get me and you to tune in, bad news and gloom beats good news and balance. I just have to swipe right (no, not Tinder!) on my smart phone to see an updated list of links to bad news stories and celebrity gossip (but rarely anything positive!).

Arguably, the political environment has added to this in some countries with politicians becoming more polarised to the left and the right and more willing to scare the electorate into supporting them.

Despite the improvement in the global economy over the last year, Google the words “the coming financial crisis” and you’ll still get 49.3 million search results including such gems as:

• “The next financial crisis is coming ‘with a vengeance’.”

• “The next financial crisis is coming, I just don’t know when.”

• “Financial crisis coming by end 2018: Prepare urgently.”

• “Trump can’t stop the next financial crisis.”

• “It’s a scary time with a global crisis on the way.”

• “Major crisis coming, bigger than 2008 financial crisis.”

And on and on.

Of course, people have always been making such predictions of imminent disaster – my favourite was Ravi Batra’s The Great Depression of 1990, which didn’t happen so it morphed into The Crash of the Millennium, which saw an inflationary depression that didn’t happen either.  It’s just that it’s now a lot easier and cheaper to access it and be scared by it.

So with all the talk of another global financial crisis and some sort of collapse in Australia, it’s not that surprising that people are apprehensive and Australians are less positive about the future. 

But the world is actually looking good

While all countries have their challenges, the global economy is in its best shape in years:

• After years of downgrading its global growth forecasts, the IMF has been revising them up this year.

Source: IMF, AMP Capital

• Global profits are up around 15% over the last year.

• Unemployment has been falling virtually everywhere (except Japan where it’s just 2.8%!).

And while Australia could be doing a lot better and is not without its issues (notably around record low wages growth, high underemployment, expensive housing and high household debt), the economy has managed to keep growing despite the mining investment boom going bust and should benefit from stronger global growth and the end of the drag from falling mining investment. All of which should be able to keep it growing, albeit we don’t see strong enough growth or inflation for the RBA to start raising rates for a while yet.

The case for optimism as an investor

Dr Don Stammer – a doyen of Australian economists and investing – has said there are six things we owe our children or grandchildren: a sense of humour; a reasonable education; an early understanding of the magic of compounding; an awareness the cycle lives on; some help when they buy their first house or apartment; and a feeling of optimism. I completely agree.  I have written lots on the importance of compounding and the cycle but I think a degree of optimism is essential if you wish to succeed as an investor.

Benjamin Graham once said: “To be an investor you must be a believer in a better tomorrow.” If you don’t believe the bank will look after your term deposits, that most borrowers will pay back their debts, that most companies will see rising profits over time, that properties will earn rents etc then there is no point investing. This is flippant but true – to be a successful investor you need a favourable view of the future.

Of course this does not mean blind optimism where you get sucked in with the crowd when it becomes euphoric or into every new whiz bang investment obsession that comes along (with bitcoin the latest in a long list of manias that goes back to Dutch tulip bulbs and includes the dot com stocks of the late 1990s). If an investment looks and feels too good to be true and the crowd is piling in, then it probably is… particularly if the main reason you are buying in is because of huge recent gains and their extrapolation off into to the future. So the key is cautious optimism, not blind optimism.

But when it comes to conventional investments like shares, since 1900 shares in the US have had positive returns around seven years out of ten and in Australia it’s around eight years out of ten. So getting too hung up in permanent pessimism on the next financial crisis and when it will come and what will on the basis of history inevitably drive the market down in the two or three years out of ten may mean missing out on the years it rises.

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.

I don’t normally comment directly on articles by others but an article by Matt Barrie with Craig Tindale called “Australia’s economy is built on shaky foundations, and it’s about to collapse,” has been sent to me several times for comment so I thought I would make an exception this time. 

The gist of the article seems to be that growth in the Australian economy has been built on “a property bubble inflating on top of a mining bubble, built on top of a commodities bubble, driven by a Chinese bubble” and that “Australia has relied on China for too long – our whole economy is built on China buying our stuff. And it’s about to collapse.”

This note takes a look at this risk.

Crash calls for the Australian economy are like a broken record

The first thing to note is that there is nothing really new in the latest call for a collapse in the Australian economy. In fact, for as long as I have been an economist there have been calls for the Australian economy to collapse. Back in 1985, I recall going to presentations on fears the economy might soon “default” and require a rescue by the IMF. The crash calls have accentuated post the Global Financial Crisis (GFC). The Australian economy was supposed to have crashed when the mining investment boom ended in 2012-13 and every year since then there has been an ad on the internet titled “Australian recession 2014: why it’s coming, what to do and how you can profit” but the year just keeps getting updated to the current year. I guess it will be right one day. 

Is China about to collapse?

China is Australia’s number one trading partner so Australia is more vulnerable to the Chinese economy than in the past. But warnings of a Chinese collapse have been around for years now and I continue to regard it as unlikely. The most common concerns about high and rising debt in China miss the reality that China’s high debt growth reflects its high saving rate (of around 46% of GDP compared to around 22% in Australia), which in turn gets largely channelled through the banking system as its capital markets remain underdeveloped. China does not rely on foreign capital (in fact it supplies savings to the rest of the world) and to slow its debt growth, it actually needs to save less and spend more (so very different to countries that normally have debt problems!) and broaden its capital market beyond the banks. But this will take time and the Chinese authorities will not act precipitously. And in the meantime, yes, there is a risk that some corporate loans will go bad but don’t forget much of the growth in debt has gone from state-owned banks to state-owned businesses and will be supported by the Government if there is too much trouble (just like the Chinese Government solved its local government debt problem of a few years ago).

But isn’t China at peak commodity demand?

Similarly, concerns about China’s property market and commodity demand are misplaced. The Chinese property cycle has regular ups and down as the property market is generally undersupplied but the Government periodically tries to keep a lid on prices. But every time there is a downturn in the property cycle (usually after Government moves to cool it down), out comes new crash stories. The “ghost cities” stories of a few years ago were evident of this but were literally just scary stories – they are part of an effort to decentralise away from crowded cities and the biggest “ghost city” (Ordos Kangbashi) is now almost full. The reality is that much of China continues to have a housing shortage as the population urbanises and many of the apartments built 20 years ago are now substandard and need to be replaced. So demand for steel and concrete from the property market is likely to remain strong for many years to come. Similarly, much of China remains under developed in terms of infrastructure. So yes, China is trying to wind back excess capacity in some sectors that have got ahead of themselves but peak raw material demand from China is a long way off. Yes, Chinese growth could slow towards 6% over the next few years but I doubt a hard landing any time soon. Certainly there was no sign of any hard landing in China when I visited it again in the last week – things were just as frantic as ever!

Australia has always had some export dependence

It’s worth noting that over the years Australia has always seemed to have some dependence on some foreign country in terms of export demand – the UK, Japan, it’s now China but as China’s industrialisation phase slows I suspect other countries will just jump into the commodity demand space (Vietnam, India, Pakistan) and in any case our relationship with China is also shifting across to services.

But the mining boom has long ended so why hasn’t the Australian economy collapsed already?

If Australia is so dependent on the commodity price boom and mining investment boom, why didn’t it crash when they crashed after 2011 and 2012-13 respectively? The simple answer is that the Australian economy is actually less dependent on mining and hence China than many commentators claim. In reality, mining activity is only 7% of Australian economic activity (or GDP) and agriculture is 3%, which taken together hardly suggests an excessive reliance on exports and China.

The mining boom basically meant that south east Australia – and sectors like manufacturing, tourism and higher education along with housing – was suppressed by high interest rates and the high Australian dollar. Once the commodity and mining investment booms went away and interest rates and the $A fell, south east Australia was able to bounce back offsetting the slump in Western Australia and the Northern Territory and parts of Queensland. So Victoria, NSW and even Tasmania were able to go from near recessionary conditions and at the bottom of state rankings a decade ago to now being at the top.   

More than housing

This has not just been driven by housing-related activity, smashed avocados and flat whites (how come Chai tea brewed with soy never gets a look in?) but also in services like tourism and higher education (our third biggest export earner), which are booming. Even manufacturing is looking better. In fact, for many Australians the China driven mining boom was more a curse than a blessing – the saying in Sydney was that the people of western Sydney were paying the price for the mining boom in Western Australia.

Housing construction is starting to slow causing many to wheel out the disaster scenarios again. But the contribution to economic growth from growth in housing construction is regularly exaggerated. Last year it contributed around 0.3% directly to growth and indirect effects are likely to have taken that contribution to around 0.6%. In other words its relatively modest and a housing construction slowdown should be easily offset as the drag on growth (of around 1-1.5% per annum) from slumping mining investment is nearly over, infrastructure spending is booming (partly on the back of the asset swap program), non-mining investment looks to be bottoming at last and export volume growth is strong.

What about a house price crash?

Yes, there is a risk of a house price collapse but it’s a lot more complicated than most people think as pointed out in my last house price note http://bit.ly/2y97kCE . Basically: we have not built enough housing to keep up with strong population growth since mid-last decade (see the next chart); the boom lately has been confined to Sydney and Melbourne (which were more harmed than helped by the mining/China-related boom); and the deterioration in lending standards has been modest with, for example, little in the way of the NINJA (no income, no jobs, no assets) loans that caused so much trouble in the US. 

Source: ABS; AMP Capital

Sydney and Melbourne home prices are likely to fall by 5-10% (like in 2008 and 2011-12) but a crash is unlikely unless unemployment goes up a lot (unlikely), the RBA raises rates aggressively (again unlikely) or the current unit supply surge continues for several more years (again unlikely with approvals off their peak). 

More than “dumb luck” in Australia’s 26-year expansion

While luck has played a role in Australia’s 26 years of economic expansion, it’s worth noting that the China-related boom only really ran for eight or nine years of it (from 2004-2012), and a significant contribution came from the economic reforms of the 1980s and 1990s that made the Australian economy more flexible in responding to shocks. Also, sensible economic policy meant that we managed the China boom well (by avoiding an overheating economy and running budget surpluses), which meant we were better placed to ride out the global shock from the GFC and the subsequent end to the commodity and mining investment booms.

26 years of economic expansion has left the Australian economy with lots to show for it: the economy is 129% bigger in real terms than it was when the 1990-91 recession ended, per capita GDP is up 61%, unemployment is less than half its early 1990s high and our dependence on foreign capital as measured by the current account deficit relative to GDP is about one third smaller than it was 26 years ago. Sure we can do better – underemployment, weak wages growth and poor housing affordability are serious problems and we seem to have given up on serious economic reform – but the economy is in better shape than some give it credit for.

Australia versus the world

Finally, I should note that while we are not in the crash camp for Australia, we remain of the view that it will be a while before interest rates can rise and that Australian economic and profit growth will be subpar compared to other countries for a while yet. As a result, we remain of the view that while Australian shares have more upside they are likely to remain relative underperformers versus global shares for some time yet and that the Australian dollar still has more downside. This is really just a continuation of the “mean reversion” of the huge outperformance in Australian shares versus global shares and in the Australian dollar seen last decade. 

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.

Introduction

The surge in bitcoin has attracted much interest. Over the last five years, it has soared from $US12 to over $US8000; this year it’s up 760%. Its enthusiasts see it as the currency of the future and increasingly as a way to instant riches with rapid price gains only reinforcing this view. An alternative view is that it is just another in a long string of bubbles in investment markets.

Nobel Economics Laureates Daniel Kahneman, Robert Shiller and Richard Thaler and many others shown that investors and hence investment markets can be far from rational and this along with crowd psychology can drive asset prices far from fundamentally justified levels. This note provides a refresher on the psychology of investing before returning to look at bitcoin.

Irrational man and the madness of crowds

Numerous studies show people suffer from lapses of logic. In particular, they:

• Tend to down-play uncertainty and project the current state of the world into the future – eg, resulting in a tendency to assume recent investment returns will continue;

• Give more weight to recent spectacular or personal experiences in assessing probabilities. This results in an emotional involvement with an investment – if it’s been winning, an investor is likely to expect it to keep doing so;

• Tend to focus on occurrences that draw attention to themselves such as stocks or asset classes that have risen sharply or fallen sharply in value;

• Tend to see things as obvious in hindsight – driving the illusion the world is predictable resulting in overconfidence;

• Tend to be overly conservative in adjusting expectations to new information – explaining why bubbles and crashes normally unfold over long periods; and

• Tend to ignore information conflicting with past decisions.

This is magnified and reinforced if many make the same lapses of logic at the same time giving rise to “crowd psychology”. Collective behaviour can arise if several things are present:

• A means where behaviour can be contagious – mass communication with the proliferation of electronic media are perfect examples of this as more than ever investors get their information from the same sources;

• Pressure for conformity – interaction with friends, social media, performance comparisons, fear of missing out, etc;

• A precipitating event or displacement which motivates a general investment belief – the IT revolution of the late 1990s or the rapid industrialisation of China which led to talk of new eras are examples upon which were built general believes that particular investments will only go up.

Bubbles and busts

The combination of lapses of logic by individuals and their magnification by crowds goes a long way to explaining why speculative surges in asset prices develop (usually after some good news) and how they feed on themselves (as individuals project recent price gains into the future, exercise “wishful thinking” and receive positive feedback via the media). Of course this also explains how the whole process can go into reverse once buying is exhausted, often triggered by bad news.

The chart below shows how investor psychology develops through a market cycle. When times are good, investors move from optimism to excitement, and eventually euphoria as an asset’s price moves higher and higher. So by the time the market tops out, investors are maximum bullish and fully invested, often with no one left to buy. This ultimately sets the scene for a bit of bad news to push prices lower. As selling intensifies and prices fall further, investor emotion goes from anxiety to fear and eventually depression. By the time the market bottoms out, investors are maximum bearish and out of the market. This sets the scene for the market to start rising as it only requires a bit of good news to bring back buying.

The roller coaster of investor emotion

Source: Russell Investments, AMP Capital

This pattern has been repeated over the years. Recent examples on a globally-significant basis have been the Japanese bubble and bust of 1980s/early 1990s, the “Asian miracle” boom and bust of the 1990s, the tech boom and bust of the late 1990s/early 2000s, the US housing and credit-related boom and bust of last decade and the commodity boom and bust of late last decade into this decade. History may not repeat but rhymes and tells us asset price bubbles & busts are normal.

Where are we now?

Our assessment in terms of global share markets is that we are still around “optimism”. Investor sentiment is well up from its lows last year and some short-term measures are a bit high, warning of a correction (particularly for the direction-setting US share market) but we are not seeing the “euphoria” seen at market tops. The proportion of Australians nominating shares as the “wisest place for savings” remains very low at 8.9%.

But what about bitcoin? Is it a bubble?

Crypto currencies led by bitcoin and their blockchain technology seem to hold much promise. The blockchain basically means that transactions are verified and recorded in a public ledger (which is the blockchain) by a network of nodes (or databases) on the internet. Because each node stores its own copy, there is no need for a trusted central authority. Bitcoin is also anonymous with funds just tied to bitcoin addresses. Designed to work as a currency, bitcoin therefore has much to offer as a low-cost medium of exchange with international currency transfers costing a fraction of what, say, a bank may charge.

However, bitcoin’s price in US dollars has risen exponentially in value in recent times as the enthusiasm about its replacement for paper currency and many other things has seen investors pile in with rapid price gains and increasing media attention reinforcing perceptions that it’s a way to instant riches.

However, there are serious grounds for caution. First, because bitcoin produces no income and so has no yield, it’s impossible to value and unlike gold you can’t even touch it. This could mean that it could go to $100,000 but may only be worth $100.

Second, while the supply of bitcoins is limited to 21 million by around 2140, lots of competition is popping up in the form of other crypto currencies. In fact, there is now over 1000 of them. A rising supply of such currencies will push their price down.

Third, governments are unlikely to give up their monopoly on legal tender (because of the “seigniorage” or profit it yields) and ordinary members of the public may not fully embrace crypto currencies unless they have government backing. In fact, many governments and central banks are already looking at establishing their own crypto currencies.

Regulators are likely to crack down on it over time given its use for money laundering and unregulated money raising. China has moved quickly on this front. Monetary authorities are also likely to be wary of the potential for monetary and financial instability that lots of alternative currencies pose.

Fourth, while bitcoin may perform well as a medium of exchange it does not perform well as a store of value, which is another criteria for money. It has had numerous large 20% plus setbacks in value (five this year!) meaning huge loses if someone transfers funds into bitcoin for a transaction – say to buy a house or a foreign investment – but it collapses in value before the transaction completes.

Finally, and related to this, it has all the hallmarks of a classic bubble as described earlier in this note. In short, a positive fundamental development (or “displacement”) in terms of a high tech replacement for paper currency, self-reinforcing price gains that are being accentuated by social media excitement, all convincing enthusiasts that the only way is up. Its price now looks very bubbly, particularly compared to past asset bubbles (see the next chart – note bitcoin has to have its own axis!).

Because bitcoin is impossible to value, it could keep going up for a long way yet as more gullible investors are sucked in on the belief that they are on the way to unlimited riches and those who don’t believe them just “don’t get it” (just like a previous generation said to “dot com” sceptics). Maybe it’s just something each new generation of young investors has to go through – based on a thought that there is some way to instant riches and that their parents are just too square to believe it.

Source: Thomson Reuters, Bloomberg, AMP Capital

But the more it goes up, the greater the risk of a crash. I also still struggle to fully understand how it works and one big lesson from the Global Financial Crisis is that if you don’t fully understand something, you shouldn’t invest.

At this stage, a crash in bitcoin is a long way from being able to crash the economy because unlike previous manias (Japan, Asian bubble, Nasdaq, US housing in the chart above) it does not have major linkages to the economy (eg it’s not associated with overinvestment in the economy like in tech or US housing, it is not used enough to threaten the global financial system and not enough people are exposed to it such that a bust will have major negative wealth effects or losses for banks).

However, the risks would grow if more and more “investors” are sucked in – with banks ending up with a heavy exposure if, say, heavy gearing was involved. At this stage, I think it’s unlikely that will occur for the simple reason that being just an alternative currency and means of payment won’t inspire the same level of enthusiasm that, say, tech stocks did in the late 1990s (where there was a real revolution going on).

That said, it’s dangerous to say it can’t happen. There was very little underpinning the Dutch tulip mania and it went for longer than many thought. So it’s worth keeping an eye on. But as an investor I’m staying away from bitcoin.

What does this mean for investors?

There are several implications for investors.
 

1. The first thing investors need to do is recognise that investment markets are not only driven by fundamentals, but also by the often-irrational and erratic behaviour of an unstable crowd of other investors.

2. Investors need to recognise their own emotional capabilities. In other words, investors must be aware of how they are influenced by lapses in their own logic and crowd influences.

3. To help guard against this, investors ought to choose an investment strategy which can withstand inevitable crises & remain consistent with their objectives and risk tolerance.

4. If an investor is tempted to trade they should do so on a contrarian basis. Buy when the crowd is bearish, sell when it is bullish. But also recognise contrarian investing is not fool-proof – just because the crowd looks irrationally bullish (or bearish) doesn’t mean it can’t get more so.

5. Finally, while crypto currencies and blockchain technology may have a lot to offer bitcoin’s price is very bubbly.

Source: AMP Capital 21 November 2017

Author: Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

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.