Olivers Insights

I am regularly called on to provide forecasts for economic and investment variables like growth, interest rates, currencies and the share market. These usually come in the form of point forecasts as to where the variable that is being forecast will be in, say, a year’s time or its rate of return. Such point forecasts are part and parcel of the investment industry. In fact, forecasts about all sort of things – from the environment to economics to politics to sport – have become part of everyday life.

Economic and investment-related forecasts are useful as a means of communicating a view, as an input to the construction of budgets and as a base case against which to assess risks and formulate economic policy. But one of the big lessons I have learnt over the years is that relying too much on precise forecasts when making investment decisions regarding the asset allocation of multi asset funds (ie, funds that have exposure to a range of assets like cash, bonds, property, infrastructure and equities) can be dangerous. This was amply demonstrated during the global financial crisis (GFC), but has always been apparent.¹ In particular, there is often a big difference between being right – ie, getting some forecast right – and making money. And of course, as Ned Davis has pointed out, for investors the key is to make money, not to be right.

If forecasting was easy I wouldn’t be writing this…

…and you wouldn’t be reading it! We would be very rich and sipping champagne in the south of France (or something like that!). As my first manager used to tell me “forecasting is difficult because it concerns the future”. The difficulty of getting economic forecast right is reflected in the long list of jokes about economists and their forecasts. Here’s some:

• Three economists went target shooting. The first missed by a metre to the right, the second missed by a metre to the left and the third exclaimed “we got it”.

• Economists were invented to make weather forecasters and astrologers look good.

• An economist is a trained professional paid to guess wrong about the economy.

• An economist will know tomorrow why the things she or he predicted yesterday didn’t happen.

• Economic forecasting is like driving a car blindfolded and getting instruction from a person looking out the rear window.

• Economics is the only field in which two people can share a Nobel Prize for saying the complete opposite.

• For every economist there exists an equal and opposite economist.

• Economists have predicted six of the last two recessions.

• There are two classes of forecasters: those who don’t know and those who don’t know they don’t know (J.K. Galbraith).

Hit and miss

Surveys of economic forecasts are regularly compiled and published in the media. It is well known that when the consensus (or average) forecast is compared to the actual outcome, it is often wide of the mark. This is particularly so when there has been a major change in direction for the variable being forecast – such as around events like the tech wreck in the early 2000s and the GFC. This applies not only to economists’ forecasts for economic variables, but also to share analysts’ forecasts for company profits and to most forecasts across most disciplines except those where precise linear relationships apply (where A = B, eg in predicting the date and time of the next eclipse as opposed to the non-linearity in economics and investing and most things people like to forecast where a slight shift in the balance can result in A = B or C or…).

And of course the bigger the call, invariably the bigger the miss. There are numerous examples of gurus using grand economic, demographic or financial theories – usually resulting in forecasts of “new eras” or “great depressions” – who may get their time in the sun but who also usually spend years either before, or after, losing money. For example, the gurus who foresaw a “new era” in the late 1990s – with books like Dow 36,000 – looked crazy in the tech wreck bear market of the early 2000s. And many of those who did get the tech wreck or GFC “right” were bearish years before and would have lost their fortune if they had shorted shares when they first got bearish.

Grand prognostications of doom can be particularly alluring, and wrong. Calls that the world is about to bump into some physical limit, causing some sort of “great disruption” (famine, economic catastrophe – all those sort of things!), have been made with amusing regularity over the last two hundred years: Thomas Malthus, Paul Ehrlich’s The Population Bomb of 1968, the Club of Rome report on The Limits to Growth in 1972, the “peak oil” fanatics who have been telling us for decades that global oil production will soon peak and when it does the world will be plunged into a Mad Max-style chaos. Such Malthusian analyses underestimate resources, the role of price increases in driving change and human ingenuity in facilitating it. And when you’re reading books like those from Harry S Dent about The Great Depression Ahead (2009), The Great Crash Ahead (2011) and The Demographic Cliff (2014), all of which had disaster happening well before now, just recall that there has been a long list of prognostications for a great depression, often linked to a debt-related implosion, the bulk of which turned out to be wrong. Amongst my favourites are Ravi Batra’s The Great Depression of 1990 – well, that didn’t happen so it was just delayed to The Crash of the Millennium that foresaw an inflationary depression, which didn’t happen either. Google “the coming depression” and you’ll find 72.3 million search results!

Psychology and forecasting

Forecasts for economic and investment indicators can be useful but quite clearly need to be treated with care:

• Like everyone, forecasters suffer from psychological biases including the tendency to assume the current state of the world will continue, the tendency to look for confirming (not contrary) evidence in new information, the tendency to only slowly adjust forecasts to new information and excessive confidence in their ability to foresee the future.

• Quantitative point forecasts – eg, that the S&P 500 will be 2450 by December 31 – convey no information regarding the risks surrounding the forecasts. They are conditional upon the information available when the forecast was made. As new information appears, the forecast should change. Setting an investment strategy for the year based on forecasts at the start of the year and making no adjustment for new information is often a great way to lose money.

• In investment management, what counts is the relative direction of one investment alternative versus others – precisely where they end up is of little consequence.

• The difficulty in forecasting financial variables is made harder by the need to work out what is already factored in to markets. And rules of logic often don’t apply. Benjamin Graham coined the term “Mr Market” (in 1949) as a metaphor to explain the share market. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from years of euphoria to years of pessimism. Trying to get a handle on that and presenting it as a precise forecast or a grand market call is not easy.

In the quest to be right, the danger is that clinging to a forecast will end up losing money.

Why are forecasts treated with such reverence?

So why are forecasts seen by many as central to investing? First, many see the world through the rear view mirror where everything seems clear and assume that the future must be easy to forecast too for anyone who has the expertise. Second, and more fundamentally, precise quantified forecasts seem to provide a degree of certainty in an otherwise uncertain world. People hate uncertainty and will try to reduce or remove it however they can. And if we don’t have the expertise, the experts must know. And finally, prognostications of doom can be alluring because investors suffer from a behavioural trait known as “loss aversion” in that a loss in financial wealth is felt much more distastefully than the beneficial impact of the same sized gain. This leaves us more risk averse and it also leaves us more predisposed to bad news stories as opposed to good news stories. Flowing from this, prognosticators of gloom are more likely to be revered as deep thinkers than are optimists.

What to do? Three things to consider

While I like to think that I and my colleagues are better than the market, I know that if we simply relied on point forecasts for key investment market variables (like the share market, bond yields and the exchange rate) to set our investment strategy, it may not be the best way to make money for our clients. So in embarking upon investing, what should one do? In my opinion, there are three things to consider in the light of this note.

First, don’t over rely on expert forecasts. While point forecasts can help communicate a view, the real value in investment experts – the good ones at least – is to provide an understanding of the issues around investment markets and to put things in context. While financial history does not repeat, it does rhyme and so in many cases we have seen a variant of what may be currently concerning the market before. This is particularly important in being able to turn down the noise and focus on a long-term investment strategy designed to meet your investment goals.

Second, invest for the long term. In the 1970s, Charles Ellis, a US investment professional, observed that for most of us investing is a loser’s game. A loser’s game is a game where bad play by the loser determines the victor. Amateur tennis is an example where the trick is to avoid stupid mistakes and thereby win by not losing. The best way for most investors to avoid losing at investments is to invest for the long term. Get a long-term plan that suits your level of wealth, age, tolerance of volatility, etc, and stick to it. Alternatively, if you can’t afford to take a long-term approach or can’t tolerate short-term volatility, then it is worth considering investing in funds that use strategies like dynamic asset allocation to target a particular goal – be that in relation to a return level or cash flow.

Finally, if you are going to actively manage your investments, make sure you have a disciplined process. Ideally, this should rely on a wide range of indicators – such as valuation measures (ie, whether markets are expensive or cheap), indicators that relate to where we are in the economic and profit cycle, measures of liquidity (or some guide to the flow of funds available to invest), measures of market sentiment (the crowd is often wrong) and technical readings based on historic price patterns. The key to having a disciplined process is to stick to it and let the “weight of indicators” filter the information that swirls around financial markets so you are not distracted by the day-to-day soap opera engulfing them. Forecasting should not be central to your process. My preference is to focus on key themes as opposed to precise point forecasts.

Conclusion

It is always tempting to believe that you or someone else can perfectly forecast the market. However, as Ringo Starr said “it don’t come easy”! There are plenty of investors who have been “right” on some particular market call but lost a bundle by executing too early or hanging on to it for too long. The key is to know where expert views can be of use, but stick to a strategy designed to attain your goals and if you are going to actively manage your investments have a disciplined process.

If you would like to discuss anything in this article, please call us on |PHONE|.

¹This note is an update of “Making money versus being right in the loser’s game”, Oliver’s Insights, September 2006.

Source: AMP Capital 31 May 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.

Around May each year I normally get a bit wary about the risks of a pullback in shares. It seems the old saying “sell in May and go away…” is permanently stuck in my mind. And of course shares have had a great run since their global growth scare “bear market” lows in February last year to their recent highs with global shares up 31% and Australian shares up 25%, and both saw good gains year to date to their recent highs of 7% and 5% respectively. Meanwhile, although there have been several calls this year that the so-called “Trump trade” – anticipation of his pro-business policies that supposedly drove the surge in shares since the US election – is over, the risks have intensified lately given the issues around Trump, the FBI and Russia with some fearing the Trump trade is now set to reverse. This note looks at the main issues.

Trump trade or Trump bump

It’s now six months since Donald Trump was elected President of the US and four months since he was inaugurated. In many ways, it has gone better than feared: he has not withdrawn the US into isolationism, there has been no trade war with China, he has appeared more focussed on pro-business policies such as deregulation and tax reform than populist policies, and he appears far more supportive of the Federal Reserve under Janet Yellen than feared. But by the same token, many would see the events of the last two weeks – his firing of FBI director James Comey when it’s in the midst of looking into the links between Trump’s campaign and Russia, claims he may have attempted to influence the FBI to stop its investigation and reports he shared classified material with Russian officials all surrounded by a barrage of tweets and leaks – as confirming that his narcissism, short fuse, erratic nature and divisive approach render him unfit to be president. Comparisons to Nixon and talk of impeachment seem to be growing by the day.

In terms of investment markets, a common view seems to be that the “Trump trade” drove the surge in global share markets since the US election and that this will now reverse because of the political crises now surrounding Trump. However, this is too simplistic. First, the main reason for the rally in shares since last November has been the improvement in economic conditions and surging profits that has occurred globally and which had little to do with Trump. Second, unless things become terminal for Trump quickly the political crisis around him is more likely to speed up his pro-business reform agenda than slow or stop it. In this regard, the following are worth bearing in mind:

• The process to remove a president by impeachment is initiated by the US House of Representatives and can be for whatever reason the majority of the House decides and conviction, removal from office, is determined by the Senate and requires a two-thirds majority.¹

• At present, Republicans control the House with a 21-seat majority and won’t vote for impeachment unless it’s clear that Trump committed a crime (and so far it isn’t obvious that he has) and/or support for him amongst Republican voters (currently over 80%) collapses.

• However, Trump’s overall poll support is so low that if it does not improve the Democrats will gain control of the House at the November 2018 mid-term elections and they will likely vote to impeach him (they will almost certainly find something to base it on much like the Republican Congress found reason to impeach President Clinton) and then it’s a question of whether Trump can get enough support amongst Republican Senators to head off a two-thirds Senate vote to remove him from office (as Clinton did).

In short, Republicans only have a window out to November next year to get through their pro-business reforms. And the more the politics around Trump worsens, the more they need a win. So if anything, the current mess speeds up the urgency to get tax and other pro-business reforms done because after the mid-terms they probably won’t be able to. On this front, work on tax reform is continuing and Trump’s infrastructure plan looks likely to be announced soon.

The impact of past impeachments on the US share market is mixed and proves little. The unfolding of the Watergate scandal through 1973-74 occurred at the time of a near 50% fall in US shares but this was largely due to deep recession and double-digit inflation at the time. (President Nixon resigned before impeachment.) President Clinton’s impeachment had little share market impact but was in the midst of the tech bull market.

Correction risks and seasonality

Share markets have had a great run and are arguably due a decent (5% or so) correction as a degree of investor complacency has set in. The latest scandals around Trump along with various other risks – North Korea and the ongoing march of Fed rate hikes – could be the trigger. (Corruption scandals in Brazil are a sideshow and are unlikely to have much impact beyond Brazil.) And it’s well known that the best time for shares is from November to May and the worst time is from May to November. This can be seen in the next chart, which shows the seasonal pattern in share markets since 1985.

Source: Bloomberg, AMP Capital

Most major share market falls have occurred in the May to October period (1929, 1987, worst of GFC, etc). Hence the old saying “sell in May and go away, come back on St Leger’s Day” still resonates. The seasonal pattern reflects tax loss selling by US mutual funds around the end of their tax year that sees them sell losing stocks around September in order to reduce capital gains tax bills, followed by having to buy shares back in November, the investment of year-end bonuses, New Year optimism and the absence of capital raising over Christmas and New Year all serving to drive shares higher from around October/November, which then peters out around May giving way to weakness that’s accentuated by tax loss selling in the September quarter. The only difference in Australia is that July tends to see a strong boost (as investors buy back after tax loss selling), but it otherwise follows the same pattern as the US.

Five reasons for optimism

However, beyond current short-term risks and threats, there are several reasons for optimism. First, valuations for most share markets are not onerous. While price to earnings multiples for some markets are a bit above long-term averages, that is not unusual in an environment of low inflation. Valuation measures that allow for low bond yields show shares to no longer be as cheap as a year ago but they are still not expensive.

Source: Thomson Reuters, AMP Capital

Second, while the US share market may be vulnerable on some measures, other share markets are not. If US shares are compared to a ten-year moving average of earnings (referred to as a Shiller or cyclically adjusted PE) then they are expensive and of course monetary conditions in the US are gradually tightening. However, the so-called Shiller PE remains cheap for most markets globally including Eurozone and Australian shares (next chart). Note also the last ten years include the GFC earnings slump and this will drop out next year, which will see the Shiller PE fall in most countries including the US.

Source: Global Financial Data, AMP Capital

Third, global monetary conditions remain easy and in the absence of broad-based excess (in growth, debt or inflation) look likely to remain so. The Fed is likely to hike rates two more times this year and start allowing its balance sheet to run down later this year but it’s still from a very easy base & other central banks are either on hold or easing. So a shift to tight money bringing an end to the economic cycle looks a fair way off.

Fourth, global economic growth is looking healthier. Global business conditions indicators (or PMIs) are strong (next chart), the OECD’s leading economic indicators have turned up, jobs markets are tightening and for the first time in years the IMF has been revising up (not down) its estimates of global growth. US growth looks to be bouncing up again after a seasonal soft spot early this year, Chinese economic growth appears to be stabilising around 6.5% after an earlier upswing, Japanese growth looks to be good, the Eurozone looks strong and Australia is continuing to muddle along (not great but not bad – but nevertheless highlighting the ongoing case for Australian investors to have a decent global equity exposure).

Source: Bloomberg, AMP Capital

Fifth, profits are strong: US profits are up 14% year on year, Japanese profits are up 15%, Eurozone profits are up 24% and Australian profits look set to rise 20% this financial year.

Concluding comment

After strong gains over the last year and a strong start to the year until their recent highs, shares are vulnerable to a short-term correction as we go through seasonally weaker months. The political scandal around Trump, North Korea and Fed worries could all be a trigger. However, with most share markets offering reasonable value, global monetary conditions remaining easy and global growth and profits looking good, the trend in shares is likely to remain up.

If you would like to discuss anything in this article, please call us on |PHONE|.

Source: AMP Capital 23 May 2017

¹The alternative to impeachment would be where Vice President Pence and Trump’s Cabinet remove him from office under the 25th Amendment of the Constitution which is aimed at dealing with a President who has become mentally incapable. While some may claim this should have happened from the start, it’s doubtful that Pence and Trump’s Cabinet see it that way!

About the Author

In January 2016 the Australian dollar fell to just above $US0.68, its lowest level since 2009 and down 38% from its 2011 high. But since then, after a brief rebound, it has been stuck in a range between $US0.72 and $US0.78, defying our expectations for a decline. This note looks at why the $A has been so resilient over the last year, why we still think its longer term downtrend will resume and what it all means for investors.

What drives the $A?

Over the long term, the Australian dollar tends to move in line with relative price differentials. This is the theory of purchasing power parity (PPP) according to which exchange rates should equilibrate the price of a basket of goods and services across countries – see the next chart. So if over time Australian inflation and costs rise relative to US inflation and costs, then the value of the $A should fall relative to the $US to maintain its real purchasing power and competitiveness. But in the short to medium term, swings in the $A are largely driven by swings in the prices of Australia’s key commodity exports and hence the terms of trade (when they go up the $A tends to rise and vice versa) and relative interest rates such that a rise in US rates relative to Australian rates makes it more attractive to park money in the US and hence pushes the $A down and vice versa. The positioning of investors also has an impact in the short term. Suppose investors are underweight the $A and then commodity prices rise encouraging them to close their underweights – this can add to upwards pressure on the $A.

Why the bounce a year ago & relative “stability” since?

These shorter-term forces were evident in the Australian dollar’s bounce back from below $US0.70 in January last year and relative stability in the $A since.

First, late in 2015 and early last year there was a lot of negative sentiment towards Australia with talk about a “big short” in property, banks and the $A as another round of calls for a crash in property prices did the rounds. This contributed to a big build up in speculative short or underweight positions, which left the $A vulnerable to positive news and set the scene for a rebound.

Second, the prices for Australia’s key industrial commodity exports – iron ore, coal, metals and energy – all rose sharply pushing Australia’s terms of trade up significantly.

Third, the US Federal Reserve delayed raising interest rates last year and this reduced upwards pressure on the $US.

Fourth, while RBA rate cuts last year helped prevent the $A from rising through $US0.78, so far this year there has been a feeling that Australian interest rates have bottomed and the next move is up with some saying later this year.

Finally, the rebound and then relative resilience in the $A has been consistent with a “risk on” environment as the $A is seen as a “risk on” currency, ie it’s strong when global conditions and growth assets improve and it’s weak when they deteriorate.

Three reasons why the $A is likely to fall

At current levels, the Australian dollar is roughly where it should be against the $US on a purchasing power parity basis. This is apparent in the next chart which shows where the $A should have been over time if it had moved to equilibrate relative consumer price levels between the US and Australia.

Source: RBA, ABS, AMP Capital

Right now, fair value on this measure is around $US0.75, which is not far from the current level for the $A. But as can be seen, the $A rarely spends much time at the purchasing power parity level and tends to be pushed to extremes above and below it.

Our assessment is that a resumption of the downtrend in the $A seen since 2011 is likely for three reasons.

First, commodity prices likely remain in a long-term downtrend thanks to a surge in supply after record investment in resource projects. Raw material prices go through roughly 10 year upswings followed by 10 to 20 year downswings. These long-term moves reflect long lags in supply. For example, if commodity prices surge after years of undersupply, producers initially don’t believe it’s sustainable but, after several years, start to invest in new supply by which time the cycle is peaking. Then, when the new supply comes on stream it accentuates the downswing and it all repeats in reverse.

Source: Global Financial Data, Bloomberg, AMP Capital

Of course there are cyclical swings in commodity prices within these long-term moves and the recent bounce in commodity prices was one of those, but the iron ore price has since come back down again and oil prices have struggled to maintain upwards momentum with rising supply constraining both.

Second, the interest rate differential in favour of the $A is likely to narrow further as the Fed continues to hike rates and the RBA remains on hold or maybe even cuts rates. This will make it relatively less attractive to park money in Australia putting downwards pressure on the $A. The Fed is on track to hike rates again in June and September as the US economy continues to improve as highlighted by a tightening jobs market. This will take the Fed Funds rate to a range of 1.25-1.5%. If the RBA leaves rates on hold at 1.5%, which is our base case, then the gap between Australian and US official interest rates will have virtually closed by September, from 4.5% in 2011. As the next chart shows, periods of a low and falling official interest rate differential between Australia and the US usually see a low and falling Australian dollar.

Source: Bloomberg, AMP Capital

While our base case is that the RBA is on hold, there is a high risk that it may have to cut rates again later this year as we may go through a bit of a soft patch in growth, which is contrary to the RBA’s own forecasts. The contribution to growth from housing is set to slow as falling building approvals flows through to slowing housing construction and slowing home price gains in Sydney and Melbourne dampen wealth effects, at a time when consumer spending is subdued, mining investment is still falling and cyclone Debbie has disrupted coal export volumes.

Public infrastructure spending will provide an offset but there is a risk of another negative quarter for GDP in either the March quarter just passed or the current June quarter or at least subdued growth in both. Which in turn points to continuing high underemployment and record low wages growth. All of which suggests downside risks to inflation. Against this backdrop, we ideally need the $A to fall further to help support growth in export-oriented sectors like tourism and higher education to help boost overall economic growth. The bottom line though is that there is more risk that the RBA will cut rates than hike them by year end and if the RBA does cut, the interest rate differential in favour of the $A will go negative this year.

Of course the financial stability risks associated with continued strength in the Sydney and Melbourne residential property markets have been cited as a significant constraint on the RBA cutting rates again, but this constrain looks like it will fade over the next six months. The peak in home price growth in these cities has likely been seen with the combination of bank rate hikes, tightening lending standards, surging unit supply and a reduction in expenses that can be claimed under negative gearing all likely to help drive a slowing going forward.

Third, speculative positioning in the $A has gone from short at the lows early last year to long now, which leaves the $A vulnerable to any further commodity price softness, Fed rate hikes and or RBA cuts.

Source: Bloomberg, AMP Capital

In short, our assessment is that the $A will resume its downswing and will likely fall below $US0.70 by year end.

What does it mean for investors?

With the risks skewed towards more downside in the value of the $A, there are several implications for investors.

First, there remains a strong case to maintain a decent exposure to offshore assets that are not hedged back to Australian dollars. A decline in the value of the $A boosts the value of an investment in offshore assets denominated in foreign currency by one for one. This can be seen over the last five years where the fall in the value of the $A turned a 12.2% per annum (pa) return from global shares measured in local currencies (US dollars, Yen, Euros, etc) into a 17.7% pa return for Australian-based investors when measured in Australian dollars. Over the same period, Australian shares returned 11% pa which is good, but it paid to have money in global shares, particularly on an unhedged basis.

Second, if the global outlook turns sour, having an exposure to foreign currency provides a useful hedge for Australian-based investors as the $A usually falls (and foreign currencies rise) in response to weaker global growth.

Finally, a further leg down in the value of the $A would be positive for Australian sectors that have to compete internationally like tourism, higher education, manufacturing, agriculture and mining.

If you would like to discuss anything in this article, please call us on |PHONE|.

Source: AMP Capital 17 May 2017

What is the equity risk premium?

To compensate for their greater short-term volatility and risk of loss, shares should provide a return differential over a ‘risk free’ asset like government bonds over the long term. This return differential is referred to as the equity risk premium (ERP) and used to be thought of as being around 5% pa or more as this is what it had been for much of the post World War Two war period. But thanks largely to the 2007-09 global financial crisis (GFC), global shares have underperformed global bonds by around 1% pa over the last decade and Australian shares have underperformed Australian bonds by around 2.1% pa. Does this mean the equity risk premium concept is meaningless and that shares are a dud? The answer is no.

As the ERP concept relates to the very long term, the last decade or so proves nothing about its merits. Unfortunately, much confusion and disagreement surrounds the ERP. This is largely because it can refer to three different things: the historically realised return gap between equities and bonds; the gap required by investors to attract them to invest in equities; and the prospective (or likely) long-term gap based on current valuations. A key issue is not what equities have done relative to bonds in the past but what their potential is going forward. These concepts can move in opposite directions.

The historical (or ex post) equity risk premium

Many analysts tend to focus on historical data as a guide to what sort of return premium investors require for shares over bonds and to what it will be in future. However, while a useful starting point, this approach has limitations. Firstly, the historically realised return differential between equities and bonds varies significantly over time. As can be seen in the next table, between 1950 and 1999 the ERP was 8.4% pa in the US. But if the period is extended to 2016, the ERP falls to 6.2% pa. Similarly the realised ERP for Australian shares was 5.4% pa over the 50 years from 1950, but if the period is extended to 2016 it drops to 4.4% pa.

Nominal returns, % pa

Source: Global Financial Database, Thomson Financial, AMP Capital

The instability of the realised ERP is highlighted below. Over rolling 10-year periods, the excess return from shares over bonds has varied from around -10% to +20% pa in the US and from around -7% to +17% pa in Australia. So the negative or low equity risk premium experienced in recent times is not unusual in an historic context. There is also a degree of mean reversion in the chart, with periods of low excess returns from shares being followed by periods of high excess returns, and vice versa. So the poor performance of shares versus bonds over the last decade globally and in Australia suggests there is a good chance of shares outperforming bonds over the decade ahead (just as the US share market has already shown).

Source: Global Financial Data, Thomson Reuters, AMP Capital

Obviously, the starting and end point valuation for markets for any period can heavily affect the size of the realised risk premium, even over long periods. For example, over the 50 years from 1950, equity returns were boosted by the fact that shares were depressed relative to earnings in 1950 (in the aftermath of the Great Depression and WWII) and so generated strong capital gains over the next 50 years as share prices rose relative to earnings. As a result, over the 1950 to 1999 period shares outperformed bonds by a very wide margin. However, by changing the end point to the end of 2016, the return from shares has been reduced thanks to the tech wreck and GFC. The point is that even when measuring over long periods the starting point and end point have a big impact on the measured equity risk premium.

Secondly, to the extent valuation changes (rising price to earnings multiples) boosted the realised ERP over the post-war period, this would have not been expected by investors and hence the measured ERP over that period is not a good guide to what they would have required to invest in shares.

Thirdly, in any case it is difficult to justify why investors would have demanded such a large premium (ie, 8.4% pa in the US and 5.4% pa in Australia over the 50 years from 1950). This would imply an implausibly high degree of risk aversion. It’s interesting to note that if we go way back to 1810, the US equity risk premium is just 3.1% pa.

Finally, historical equity data for countries like the US and Australia suffers from a survival bias. An investor who bought into German and Japanese shares in 1900 would have been wiped out along the way.

For these reasons, while an analysis of the past is a good starting point it does not provide a definitive guide as to what the equity risk premium should be or will be.

The required equity risk premium

We have already noted the historically realised ERP is not a good guide as to what investors actually require to invest in shares. The 5% plus ERP achieved in much of the post-war period was in large part due to a windfall gain to equity investors they were not expecting or requiring. Several considerations suggest that the required ERP has fallen and is now well below this, including:

• improved regulatory and legal protection for investors, which means less risk from investing in shares;

• lower trading costs in equities, greater scope to spread risk via diversification and improved market liquidity making it much easier to get out when desired;

• increased demand for shares from pension funds helped by tax concessions on retirement savings;

• the fall in inflation from the 1970s and 1980s, which has likely resulted in a higher quality of earnings;

• this and less regular recessions should have reduced economic uncertainty – although this may have been partly reversed following the GFC and the constrained and fragile growth profile seen since then;

• a greater feeling of global political security with no major wars since the end of WW2 and the end of the Cold War – although again this may have been partly reversed following the rise of terrorism and populist/nationalist politics.

While the GFC, the rise of terrorism and populism and a more risk-averse older population may have partly offset some of these favourable factors, the broad trend is still positive and suggests investors should demand a lower risk premium than, say, 50 or 100 years ago. Our assessment is that the appropriate equity risk premium going forward for US and global equities is somewhere around 3%. For Australian shares, fewer opportunities for diversification justify a slightly higher premium of around 3.5%, and for Asian shares greater economic and market volatility suggest a required ERP of around 4%. However, what will actually be delivered going forward is a different matter.

The prospective (or ex ante) equity risk premium

A simple way to think of the prospective (or likely) ERP for the next five to 10 years at any point in time is as follows:

Likely ERP = Dividend Yld plus Growth Rate less Bond Yld

The Growth Rate is the growth rate in share prices and this is assumed to equal the long run growth rate in listed company earnings. This in turn is assumed to equal long-term nominal growth in the economy (with some adjustments). This approach makes sense as the return on shares equals dividend income plus capital growth. The table below provides current figures for each of these, the prospective ERP in the second last column and our estimate of the required ERP in the final column.

* Average of Germany, France, Italy & Spain. ** US bond yield. Source: Bloomberg, AMP Capital

This suggests that likely ERPs for shares are above what we think is required. This is particularly so for Europe, Asia and Australia but less so for the US (which has outperformed in recent years) and Japan (thanks to poor growth prospects). Of course, this calculation of the prospective risk premium assumes that bond yields are unchanged. The risk over the next few years is that bond yields rise towards more normal levels as central banks raise interest rates and inflation picks up. This will result in capital losses on government bond investments and hence a potentially higher excess return from shares over bonds. Of course if bond yields rise rapidly this could negatively impact share markets but this is unlikely given still low underlying inflation pressures globally and only a gradual removal of still easy monetary conditions. And the positive gap between the prospective and required equity risk premiums indicates shares have a bit of a buffer on this front.

Concluding comments

• The historical record does not provide a definitive guide as to the risk premium that shares should or will offer over bonds. Just as the recent negative excess return from global and Australian shares over the last decade understates the return from shares over bonds, longer-term perceptions of a 5% plus return excess based on history exaggerate it;

• A range of factors suggests the required ERP is somewhere around 3-4% pa;

• Current estimates suggest the prospective ERP is above this, particularly for European, Asian and Australian shares.

While stocks are vulnerable to a correction after their sharp gains since February last year, their attractive risk premium compared to bonds along with the favourable outlook for growth and profits suggests that any short-term pullback in shares will simply be a correction in a still rising trend.

If you would like to discuss anything in this report, please call us on |PHONE| or email |STAFFEMAIL|.

Source: AMP Capital 3 May 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.

Despite numerous geopolitical threats (Eurozone elections, tensions between the US and China, North Korea, etc.), worries about the demise of the so-called “Trump trade” and shares being overbought and due for a correction at the start of the year, share markets have proved to be remarkably resilient with only a minor pull back into their recent lows. This despite a more significant fall back in bond yields. Partly this is because the geopolitical threats have not proven to be major problems (at least so far) and Trump remains focussed on his pro-business policy agenda (he has already embarked on deregulation and his tax reform proposals – while lacking in details – indicate that tax reform remains a key objective). More fundamentally though, markets have been underpinned by an improvement in global growth. This is likely to continue.

Global economy best in years

Numerous indicators point to a stronger global economy.

• Business condition indicators – commonly called purchasing managers’ indexes or PMIs – have moved up to their highest since the post GFC bounce.

Source: Bloomberg, AMP Capital

This is the case for manufacturing and services sectors and for advanced and emerging countries. This generally points to stronger growth ahead. Believe it or not the Eurozone currently looks to be the star performer on this front.

Source: Bloomberg, AMP Capital

• The OECD’s leading economic indicators (basically a combination of economic indicators that lead economic growth) have turned up decisively.

Source: OECD, Bloomberg, AMP Capital

• Consistent with improving global economic conditions, measures of unemployment are heading down in the major advanced countries (albeit they still have further to go in Europe).

Source: Bloomberg, AMP Capital

• Asian economies which are always a good barometer of the health of the global economy are seeing a solid rebound in export growth. So much for all the talk that world trade and globalisation had peaked!

Source: Bloomberg, AMP Capital

• Reflecting the improvement in global growth, for the first time in years the IMF’s latest World Economic Outlook update revised up its global growth forecast for the current year (2017) to 3.5% from 3.4% rather than revised it down as had become the norm.

Source: IMF, AMP Capital

Of course, there is one qualification to all these positive signs (there is always something!) and that is that the US economy looks to have seen a soft start to the year as measured by GDP growth. However, March quarters in the US seem to regularly come in on the soft side initially only to get revised up later and be followed by a bounce back in growth suggesting a seasonal adjustment problem. US unemployment claims running around their lowest since the early 1970s – no mean feat given that the US economy and population are much bigger today – tell us that the US economy remains strong despite a soft March quarter.

So why the turn for the better in global growth?

There are a bunch of factors driving healthier global growth including:

• Years of ultra-easy monetary policy – zero and even negative rates and money printing – have finally got traction.

• Fiscal austerity has largely come to an end.

• Memories of the global financial crisis (GFC) and hence fears of another re-run are gradually receding – after all it is now 9-10 years ago (shares peaked in 2007!) – and so the negative impact on confidence is gradually receding too.

• Deleveraging (or the desire to reduce debt ratios) post the GFC – to the extent that it occurred – has arguably run its course.

Investment implications

The pick-up in global growth is not so strong as to tell us that we are near the peak of the cycle. Spare capacity remains in labour markets, factories are still not running at full capacity, wages growth remains relatively weak (albeit it’s trending up a bit in the US) and core inflation remains low (just 0.7% year on year in the Eurozone, 0.1% in Japan, 1.8% in the US and 2.3% in China). Out of interest the US Leading Economic Indicator has only just surpassed its pre GFC high and historically it’s then taken six years on average for the next recession to start.

In other words we are a long way from boom times that then give way to a bust. Nevertheless, the implications of the healthier global economy are likely to be:

• Ongoing support for share markets – as stronger growth underpins further gains in profits – which should mean reasonable returns from shares.

• Support for commodity prices – although it’s doubtful they will take off given the lagged impact of rising supply but it should mean we have seen the lows.

• A bottoming in the global interest rate cycle. The Fed will continue its gradual tightening in monetary policy in the US with two more rate hikes likely this year and a start to reversing quantitative easing later this year via a phased reduction in the Fed rolling over its bond holdings as they mature. China is likely to continue tightening gradually as well. Other countries will eventually follow (albeit very slowly in Europe and then in Japan – but that could be years away).

• A resumption of the rising trend in government bond yields – after the pause seen since December – which is likely to mean low returns from government bonds.

• A rising trend in bond yields – albeit a gradual one – will weigh on bond proxies such as global real estate investment trusts and listed infrastructure assets constraining their returns relative to the double digit gains they have seen over the last five years in response to the prior plunge in bond yields.

For Australia, the stronger global growth back drop is a positive in supporting export demand and confidence which in turn should help support Australian economic growth pick up towards 3%. Which in turn adds to confidence that the official cash rate has bottomed. However, with downside risks to growth remaining as mining investment is still falling, underemployment remaining very high, wages growth still ultra-weak, the $A remaining relatively strong and core inflation remaining below target we remain of the view that an RBA rate hike is unlikely until the second half of 2018.

If you would like to discuss anything in this report, please call us on |PHONE| or email |STAFFEMAIL|.

Source: AMP Capital 27 April 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.

The RBA provided no surprises following its April board meeting leaving the official cash rate on hold at 1.5%.The RBA remains more confident regarding global growth, sees Australian economic growth as moderate, regards the labour market as being mixed, sees a gradual rise in underlying inflation and continues to see conditions in the housing market as varying considerably across the country, but sees recent regulatory measures as reducing the risks associated with high and rising household debt. This note looks at the outlook for the cash rate, the impact of bank rate hikes and the implications for investors.

RBA likely on hold well into 2018

Our assessment is the cash rate has probably hit bottom after falling from 4.75% in 2011 to a record low of 1.5% last year and that the next move will be a rate hike but not until second half 2018. Another rate cut looks unlikely because:

• economic growth is okay – having bounced back in the December quarter after a temporary slump;

• national income is up from its lows thanks to higher commodity prices;

• the RBA expects underlying inflation will gradually rise; and

• the Sydney and Melbourne residential property markets are uncomfortably hot with prices up 19% and 16% respectively over the last year and 75% and 50% respectively over the last five years posing financial stability risks if prices and household debt continue to rise.

By the same token it’s too early to be thinking about hikes as:

• unemployment and underemployment (ie. labour underutilisation) at over 14% are way too high;

• this is maintaining downwards pressure on wages growth which is at record low of 1.9% year on year (in terms of the historical record for the Wage Price Index);

Source: ABS, Bloomberg

• the $A remains too high and is up from January last year;

• underlying inflation risks staying below target for longer – reflecting low wages, the rise in the $A and competition;

• there are risks around economic growth as the contribution to growth from home building is likely to slow this year and retail sales growth is weak at a time when mining investment is still falling; and

• bank “out of cycle” mortgage rate hikes have delivered a (“modest”) de facto monetary tightening any way.

The RBA has to set interest rates for the average of Australia so raising interest rates just to slow the hot Sydney and Melbourne property markets would be complete madness at a time when overall growth is still fragile, underlying inflation is well below target and property price growth elsewhere is benign or weak. The best way to deal with the hot Sydney and Melbourne property markets and excessive growth in property investor lending into those markets is through tightening lending standards, which APRA has just moved again to do.

By the second half of 2018 the drag on growth from falling mining investment is likely to have ended, stronger global growth should have started to help Australian growth and stronger employment growth should have started to benefit full time jobs and wages and the threat around below target underlying inflation should have subsided. All of which should allow the RBA to start raising interest rates. But on current indications it’s hard to justify RBA rate hikes before then.

But what about bank out of cycle rate hikes?

The banks have recently raised rates for property investors and on interest only loans by around 0.25% and for principal and interest owner occupier loans by around 0.03%. The stated drivers were higher funding costs (presumably following the back up in global bond yields over the last six months) and regulatory pressure to slow lending to investors and higher risk borrowers. More moves may lie ahead if global borrowing costs rise further but again would be focussed on investors & interest only mortgages and in the absence of RBA rate hikes are likely to be small as only 20-30% of bank funding is sourced globally. But it’s worth putting “out of cycle” moves in context:

• The RBA is still in control. “Out of cycle” bank moves have been a regular occurrence since the GFC and yet this did not stop mortgage rates falling to record lows in response to RBA rate cuts. As can be seen in the chart below the virtually fixed 1.8% gap between the standard variable mortgage rate and the cash rate only applied from 1997 to 2007, prior to that the relationship was far less stable so “out of cycle” moves are nothing new. The chart shows that changes in the cash rate remain the main driver of mortgage rates. If the RBA wants to lower mortgage rates again it can just cut the cash rate till it gets the mortgage rates it wants.

Source: RBA, AMP Capital

• So far the changes in owner occupier rates are unlikely to have much economic impact because 3 basis points is trivial compared to the 200 basis point rise in mortgage rates that occurred in the 2009-10 monetary tightening cycle. So don’t expect much impact on consumer spending albeit there is negative psychological impact.

• Changes in investor rates have less impact on spending in the economy because they are tax deductible and investors are less sensitive to rate moves. That said investor rates have gone up by around 0.52% compared to owner occupier rates since 2015 and this will eventually have some dampening impact on investor demand.

House prices

While strong population growth means that underlying property demand remains strong, the threats to the hot Sydney and Melbourne property markets are building: more macro-prudential measures to slow lending to investors and to more risky borrowers have been announced; the banks are raising rates out of cycle particularly for investors; the May budget is likely to see a reduction in the capital gains tax discount; all at a time when the supply of units is surging; and home prices are ridiculous. Taken together these moves are likely to result in a significant dampening impact on home price growth.

Source: CoreLogic, AMP Capital

We continue to expect a significant cooling in price growth in Sydney and Melbourne this year followed by 5-10% price falls commencing sometime in 2018 after the RBA starts to hike rates. By contrast Perth and Darwin are getting close to bottoming (as the mining investment slumps nears its low) and other capital cities are likely to see continued moderate growth. Unit prices are most at risk given the increasing supply of units.

Will rate hikes crash the economy?

There seems to be a view that household debt is now so high that any hike in interest rates will cause mass defaults and crash the economy. This is nonsense. Yes household debt is up but not dramatically since the GFC and interest payments as a share of household disposable income are at their lowest since 2003. Mortgage rates would need to rise by nearly 2% to get the interest servicing ratio back to its most recent 2011 high – which slowed but did not crash the economy. And most Australians are ahead on their debt payments.

Source: RBA, AMP Capital

Finally, the RBA will move gradually when it does start to raise rates and knows households are now more sensitive to rate moves and so it probably won’t have to hike rates as much as in the past to cool any overheating in the economy.

Implications for investors

There are several implications for investors. First, bank term deposit rates are set to remain very low. As a result, there is an ongoing need to consider alternative sources of income. Second, be cautious of the Sydney and Melbourne property markets, particularly units. Third, remain a little bit wary of the $A as an on hold RBA at a time when the Fed is likely to hike rates another two or three times this year could put downwards pressure on the $A. So retain some exposure to unhedged global shares. Finally, with low interest rates growth assets providing decent yields will remain attractive. This includes unlisted commercial property and infrastructure but also Australian shares which continue to offer much higher income yields relative to bank term deposits.

Source: RBA, 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.