Olivers Insights

Donald Trump as the Republican candidate for president makes the outcome of the 8 November US presidential election of greater significance than normal. Many would see Trump’s divisive and demeaning comments about certain groups of people, short fuse and erratic nature as rendering him as unqualified to be US president. This note looks at the main issues and implications for investment markets.

How did it come to this?

This presidential election is very much a contest between an establishment candidate (Clinton) and a populist outsider (Trump). There is much more at stake than in past US elections where the contest was between a centre right and centre left candidate. The success of Trump has its origin in the same forces that drove the Brexit vote – a backlash against stagnant median incomes, rising inequality, slow post GFC economic growth, a reduced ability to take on debt to boost living standards, rising immigration and the loss of jobs overseas that the political establishment is seen as having overseen.

As is often the case, aggrieved citizens can become attracted to populist politicians offering simple solutions. Trump’s support base is dominated by white non-college educated males who are aggrieved at the loss of manufacturing jobs in the US, feel they’ve been left behind by the progress of recent decades and don’t like becoming an ever smaller group in their own country.

Key policies

The key policies of Trump and Clinton are as follows:

Taxation: Trump promises significant personal tax cuts including a cut in the top marginal tax rate to 33% from 39%, a cut in the corporate tax rate to 15% from as high as 39% and removal of estate tax. Clinton promises higher more progressive marginal tax rates, a cap on deductions, increased estate and gift taxes and a tax on high frequency trading.

Infrastructure: Both want to increase infrastructure spending.

Government spending: Trump wants to reduce non-defence discretionary spending by 1% a year (the “penny plan”), but increase spending on defence and veterans. Clinton wants to increase non-defence discretionary spending.

Budget deficit: Clinton’s policies look less likely to blow the deficit out than Trump’s. Trump has spoken of using his business skills to negotiate with creditors if the deficit blows out and has also spoken of eliminating America’s $US19 trillion debt in eight years (oh yeah!).

Trade: Trump proposes protectionist policies, eg, a 45% tariff on Chinese goods, 35% on Mexican goods. Clinton largely supports free trade as long as America isn’t harmed.

Regulation: Trump wants to dismantle Dodd-Frank financial regulations, return to Glass-Steagall policies that limit the activities of large banks, audit the Federal Reserve and limit its independence and reduce industry regulation generally, particularly on US energy. Clinton promises tougher industry regulation, policies that favour clean energy and indicated some support for Glass-Steagall like policies for large banks.

Immigration: Trump wants to build a wall with Mexico, deport 11 million illegal immigrants, put a ban on Muslims entering the US and require firms to hire Americans first. Clinton tends to favour expanding immigration.

Healthcare: Trump wants to repeal Obamacare and cut drug prices in Medicare. Clinton has promised to defend Obamacare, expand access to healthcare and limit drug prices.

Foreign policy: Trump wants to reposition alliances to put “America first” and get allies to pay more, would confront China over the South China Sea and would bomb oil fields under IS control. Clinton wants to strengthen alliances and would continue the US “pivot” to Asia (being one of its architects).

Economic impact

First looking at Trump, many of his economic policies could actually provide a boost to the US economy. The Reaganesque combination of big tax cuts & increased defence and infrastructure spending will provide an initial fiscal stimulus and with reduced regulation, a bit of a supply side boost. Longer term though the budget deficit will likely blow out and protectionist tariff hikes would likely set off a trade war along with much higher consumer prices and immigration cut backs would slow labour force growth and boost costs. All of which could mean higher inflation, interest rates and a $US and a hit to growth. There may also be negative geopolitical and social consequences (tensions with US allies that have to pay more, reduced inflows into US treasuries in return, a more divided America) if Trump follows through with policies on these fronts.

Clinton’s policies would likely also provide a short term stimulus but higher marginal tax rates and more regulation may offset the short term boost. At least there is no risk of a trade war.

But of course this assumes that the winner is willing and able to implement all of their “policies”. Politicians are well known for dropping more extreme aspects of their policies once they attain power as economic and political realities set in, eg, Françoise Holland in France and Syriza in Greece. Clinton and Trump would be no different. But much depends on the outcome of the Congressional elections and the extent to which various checks and balances will click in (at least ultimately!).

Election scenarios and prospects

In this regard, there are four scenarios worth considering, with some indicative probabilities in brackets:

A.  Trump president, Republicans retain control of the House and Senate. In other words if Trump wins it is likely to rub off on support for Republicans in Congress (45% probability).
B.  Clinton president, Republicans retain control of House and Senate (30%).
C.  Clinton president, Republicans retain House but Democrats win a small but not controlling majority in Senate (20%).
D.  Clinton president, Democrat majorities in both House and Senate (5%).

Following Mitt Romneys defeat in 2012, the Republican’s concluded that they had to appeal more to Hispanics and African Americans. Trump turned this on its head and went after votes from whites. While he polls well amongst white non-college educated males he polls poorly amongst females and non-whites. So a lot depends on turn out and who is more motivated. So far Clinton has generally polled above Trump with a few ups and downs. Recently her lead has narrowed and on some polls has closed to give an average lead across leading polls of 44.9% versus 44% as Trump has limited his outbursts and her health scare has had an adverse impact on her polling. But much depends on so-called battle ground states where Clinton has tended to lead and the Electoral College (through which the president is ultimately decided and which tends to favour the Democrats as it concentrates political power in diverse, wealthier, educated urban areas). The Democrats also have a superior voter turnout operation. But while these things favour Clinton it has become a very close call which I would rate as only 55/45 in favour of Clinton.

Furthermore, Trump and Clinton are extremely unpopular candidates compared to past presidential contenders so even if Clinton wins its most likely to be in a scenario where the Democrats lack control of Congress (Scenario B or C). So a Clinton presidency would most likely see a continued divided government. So she would have to compromise and work with Republicans. This would mean that her more left wing policies (more regulation, tax hikes) would not be passed and it would just be “more of the same” (which has not been bad under the last three Obama years and under Clinton in the 1990s).

By contrast a Trump presidency may go hand in hand with retention of Republican majorities in both the House and Senate. This could provide an opportunity for significant tax reform and reduced regulation, but conservative Congressional Republicans would have to be relied upon to prevent a budget deficit blow out and aggressive protectionism. While the US President is more limited by Congress on tax and spending he/she has greater flexibility on trade policy and war powers. – it’s in relation to the latter two that the risks would be greatest under a Trump presidency (although it’s doubtful Trump could go as far as raising tariffs on China by 45% indefinitely).

The election and the share market

Firstly, some facts. The election year, or Year 4, in the 4 year presidential cycle is normally an okay year for US shares with an average total return for such years since 1927 of 11.2%.

Source: Bloomberg, AMP Capital

Historically US shares have actually done better under Democrat presidents with an average return of 15.2% pa since 1945 compared to an average return over the same period under Republican presidents of 10.1% pa. See the next chart. This has certainly been the case in recent years with good returns under President’s Obama and Clinton but terrible returns under President G W Bush.

Source: Bloomberg, AMP Capital

At present the US share market does not appear to have focussed too much on the US election. If betting markets are any guide investors are assuming roughly a two thirds probability that Clinton will win and I suspect beyond that the Democrats won’t win control of Congress (Scenarios B and C above). In other words, this would be a continuation of the current situation. But as we saw with Brexit (and even in the Australian election) betting markets have not been so accurate lately. So if Clinton wins and Democrats gain control of Congress (Scenario D – unlikely) or the more realistic risk that Trump wins with Republicans continuing to dominate Congress (Scenario A) then it will come as a shock to investors and could cause turbulence in markets at least initially. For this reason the volatility we have seen in share markets lately could continue in the weeks ahead if Trump continues to rise in the polls as investors fret about his trade and foreign policies in particular.

Beyond the initial nervousness around a Trump victory, share markets could then settle down & get a boost to the extent that his Reaganesque economic policies look like being supported by Congress, but much would ultimately depend on where America goes on trade and foreign policy. I suspect Congress can be relied on to ensure that Trump does not go off the rails in these areas and economic and political reality would force him to the centre but this would take time.

A “more of the same” victory would likely ensure a smoother ride for investment markets (and be a preferable outcome for the Australian economy given its high trade exposure). Interestingly since the early 1970s the best outcome for US shares has been a Democrat president with a Republican controlled House of Representatives.

Source: AMP Capital

About the 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.

Ever since the mining boom ended several years ago it seems a sense of gloom has pervaded debate regarding Australia. There is constant talk of recession whether we don’t do something (like control the budget) or even if we do nothing (with reports titled “Australian Recession 2016 – Why it’s unavoidable and the quickest way to protect your wealth”). This sense of gloom makes me wonder whether it could be harming us – by dulling innovation, investment and a “can do” spirit. This note looks at seven reasons for optimism on Australia.

There is always something to worry about

To be sure Australia does have its problems. Unemployment at 5.7% and labour underutilisation at over 14% are too high. Housing is too expensive, the Sydney and Melbourne property markets are too hot, we are likely to see an oversupply of apartments and household debt levels are very high. The biggest boom in our history has ended, hitting investment and national income. Given this the $A is arguably still too high. Profits of listed companies fell around 7% over the last financial year. Wage growth and inflation are arguably too low for comfort. And we seem to be in perpetual political grid lock with a difficult Senate and no political ability to control the budget and undertake hard economic reforms.

But these worries are well known and have been done to death. Of course there is always something to worry about, but the endless whinging we hear in Australia leaves the impression we are in a constant state of crisis & distracts from the good news.

Seven reasons for optimism on Australia

There are in fact several reasons for optimism on Australia.

• First, economic growth is pretty good with the economy expanding 3.1% over the year to the March quarter and looking similar for the June quarter. This is in line with Australia’s long term average. It’s also way above most other advanced countries. Latest annual GDP growth rates are 1.2% in the US, 1.6% in the Eurozone and 0.6% in Japan. Of course I could add that the economy hasn’t had a recession in over 25 years, but that one gets a bit overdone and owes a little bit to luck with statistics!

• Second, the economy has rebalanced. The slump in mining investment and national income due to the collapse in our export prices has been offset by a surge in housing construction, solid consumer spending, a pick-up in services exports and a surge in resource export volumes.

Source: ABS, AMP Capital

As a result of all this, post mining boom weakness in WA & NT is being offset by strength in NSW and Victoria as the much talked about two speed economy has just reversed.

State of the states, annual % change to latest

Source: ABS, CoreLogic, AMP Capital

The bottom line is that the recession many said was inevitable as a result of the mining bust hasn’t happened.

• Third, the worst of the slump in commodity prices and mining investment looks to be behind us. After sharp falls from their highs around the turn of the decade global prices for iron ore, metals and energy have stabilised as greater balance has started to return to commodity markets and the $US has stopped surging higher. While a new commodity price boom is a long way away the stabilisation should help our terms of trade and national income.

• Furthermore, after falling for three years from a peak of 7% of GDP, mining investment intentions indicate that mining investment will have fallen back to around its long term norm of around 1-2% of GDP by mid next year. Reflecting the slump in mining investment, engineering construction has now fallen back to near its long term trend indicating that the wind down in the mining investment boom is almost complete and that it will be less of a drag on growth next year. This is important because the slump in mining investment has been knocking 0.5 to 1 percentage points of annual GDP growth over the last three years.

Source: ABS, AMP Capital

• Fourth, public infrastructure investment is ramping up strongly. This is partly driven by former Federal Treasurer Joe Hockey’s Asset Recycling Initiative that is seeing new state infrastructure spending particularly in NSW and the ACT financed from the privatisation of existing public assets. The upshot of a fading growth drag from mining investment and rising public capital spending is that it will offset the inevitable slowing in housing construction that we will see next year.

• Fifth, despite all the gloom consumer and business confidence are actually around their long term averages. Would be nice to be higher but it ain’t bad.

Source: National Australia Bank, Westpac/MI, AMP Capital

• Sixth, share market profits have likely bottomed. 2015-16 was not great for listed company profits with earnings per share down around 8% driven by a 47% slump in resources profits and a 4% fall in bank profits. But it is notable that 62% of companies have seen their profits rise on a year ago and the typical or median company has seen profit growth of around 4%. 54% have seen their share price outperform the market the day results were released which suggests results haven’t been worse than expected. While aggregate dividends fell 10% mainly due to a cut in resources company dividends (which were never sustainable anyway), 86% of companies actually increased or maintained their dividends indicating that the median company is doing okay.

Source: AMP Capital

Overall profits are on track to return to growth in 2016-17 as the slump in resources profits reverses (thanks to higher commodity prices, cost and supply controls) and non-resource stocks see growth. 2016-17 earnings growth is expected to be around 8%.

Source: UBS, AMP Capital

• Finally, there are lots of social reasons to be optimistic about Australia. For example, we are living longer, healthier lives – in fact we rank 4th in the world in terms of life expectancy (at 82.8 years). Our cities regularly rank amongst the world’s most liveable cities – with Sydney and Melbourne at 10 and 15 respectively according to one survey. Unlike many developed countries our population is still growing solidly and we seem to do a better job at integrating immigrants than many countries. We are not wracked by the problems of a sharp rise in inequality seen in the US and UK. Despite the usual post-Olympic whinging we outperformed all the other top 10 2016 Olympic medal winning countries with 1.2 medals per million people (with the UK being the closest at 1 and the US at just 0.4).

Implications for investors

While the RBA may still need to cut rates again to help push inflation back up and keep the $A down, there is good reason for optimism regarding the overall Australian growth outlook making our call for one more rate cut a close one. Either way it’s unlikely that Australia will need zero interest rates or quantitative easing. But the key for investors is that there is reason for optimism regarding the outlook for Australian assets (Sydney and Melbourne residential property aside). Shares are due a short term correction with the next few months seeing various global event risks, but the broad trend is likely to remain up.

Source: AMP Capital

For the last two decades, advanced country central banks have been focussed on price stability and have played the first line of defence in stabilising the economic cycle whereas fiscal policy has played back up, focussing more on fairness and efficiency. This same approach has been applied since the global financial crisis with fiscal policy relegated to the back seat since 2010 because growth hadn’t collapsed and there has been a desire to stabilise public debt. But we are starting to see debate about whether a new approach is needed. The issue has been highlighted by San Francisco Fed President John Williams.¹

Why the debate?

Several factors are driving this debate including:

• Concerns that too much is being asked of monetary policy in the face of structural factors that may be depressing growth. These include aging populations, high private sector debt levels, rising levels of inequality (as high income earners save more of their income than low income earners – so a greater share of income going to high income earners means slower economic growth) and low levels of investment in an increasingly “capital lite” economy.

Data is after taxes and welfare transfers. Source: OECD, AMP Capital

• A fall in the natural (or equilibrium) rate of interest as slower population and productivity growth drive slower potential economic growth.

• Concerns that central banks may be scraping the bottom of the barrel in terms of useful monetary policy tools. The dubious experience with negative interest rates in Europe and Japan are an obvious example. (I struggle to see why anyone would want to lend or invest with a negative interest rate. It’s a disaster for those that have no choice such as European insurance companies or pension funds,).

• Concerns that relying too much on easy monetary policy may contribute to rising inequality as low interest rates disproportionally harm lower income earners but higher share markets help high income earners.

Monetary policy has worked

For what it’s worth, my view is that ultra easy monetary policy has worked during the last few years.

• In the absence of aggressive monetary easing, advanced countries would likely have faced depression, deep deflation and a complete financial meltdown after the GFC.

• On virtually all metrics – confidence, employment, unemployment, underemployment, consumer spending, business investment, bank lending, core inflation – the US economy has improved significantly in recent years. And the household savings rate has fallen from its post-GFC high.

• Similarly in Australia, the fall in interest rates since 2011 has helped the economy rebalance in the face of collapsing mining investment: via a pick-up in housing construction and growth in consumer spending. While those close to retirement may be saving more because of lower investment returns, the household saving rate overall has drifted down from 11% to around 8% since the first RBA rate cut in 2011. And the RBA rate cuts have helped push the $A lower, which has helped sectors like tourism and higher education.

• Japan and Europe have been less successful – perhaps because they were slower and less aggressive in easing initially. But even so, core inflation in both regions is up from its lows and unemployment has been falling.

• And much of the threat of deflation in recent years has been due to the plunge in commodity prices – which is mainly due to a surge in their supply – rather than any failure of easy monetary policy. This looks to have largely run its course.

However, it is right to ask whether too much is being asked of monetary policy.

Monetary versus fiscal policy

There are several aspects to this debate. First, some have suggested – mostly in Australia – that inflation targets should just be lowered but this “changing the goal post” approach will just lock in very low inflation and leave us vulnerable to deflation in the next downturn. Falling prices can be good if it reflects high productivity and where wages growth is strong. But in the current environment of high debt levels, it would most likely be bad because it would make it harder to service debt and further threaten economic growth. So lowering inflation targets makes no sense.

Second, it’s been suggested that the approach to inflation targeting should be changed to either a higher inflation rate target (as this might make achieving a lower real official rate of interest easier – eg getting a real interest rate of -3% if that is needed to boost the economy is much easier if inflation is 3% than if it is 2%) or switch to targeting either price levels or nominal GDP levels (which would mean that if there is underachievement in one period it would have to be made up in the next). While these sound nice in theory, they remind me of the joke about an economist on a deserted island with a can of baked beans who assumes he has a can opener. Neither approach actually gets inflation up.

Third, another approach is to adopt a larger role for government spending and taxation policy in areas that enhance economic growth, like infrastructure, in measures to reduce inequality and in terms of more countercyclical spending (such as public spending that automatically ramps up with rising unemployment and falls with falling unemployment).

Finally, there are policies that combine both monetary and fiscal policy using some form of monetary financing of public spending, often called “helicopter money”. It would have the benefit of a much bigger spending payoff than quantitative easing (much of which just sat in bank reserves), the spending could be targeted to reach fairness objectives and it could be wound back when inflation objectives are met.

Issues and constraints

Of these, the measures involving a greater role for fiscal policy make more sense. As noted, lower inflation targets would make no sense. Higher inflation targets have merit and it’s worth noting that when Australia introduced its relatively high (by New Zealand standards!) inflation target of 2-3% over 20 years ago, it was partly motivated by a desire for flexibility on the downside. So there is a case for the 2% targets in the US, Japan and Europe to be revised to 2-3% just like Australia!

Similarly price level or nominal GDP level targeting has merit. But a central bank targeting nominal GDP does leave it with too much responsibility for real GDP growth and could lead to years where, say, a nominal growth target of 5% is met but it’s made up of too much inflation. More broadly, as noted earlier, all these ideas do little to actually push inflation up.

Which brings us to a greater role for fiscal policy. An obvious constraint here is that public debt to GDP ratios remain way up from pre GFC levels – and in fact in most countries have increased over the last few years – despite several years of austerity. This can be seen in the next chart.

Source: IMF, AMP Capital

However, there is a danger in pushing this argument too far as fiscal austerity and the lack of fiscal stimulus so far this decade may be depressing nominal GDP growth and making it harder to reduce public debt to GDP ratios in advanced countries.

Well targeted public spending focussed on infrastructure, improving access to education and using tax policy to lower inequality could help boost nominal GDP growth.

Australia – via the Asset Recycling Initiative introduced by former Treasurer Joe Hockey – has shown that infrastructure spending can be boosted by privatising existing state-owned assets and recycling the proceeds into new infrastructure spending. This is helping to boost growth without actually adding to public debt.

However, where that is not possible or more radical action is needed, the best approach would be a coordinated use of monetary and fiscal policy. Quantitative easing programs which have depressed bond yields have arguably already given governments more latitude to expand fiscal policy because they can borrow at very cheap rates. Of course an objection is that it hasn’t technically reduced public debt levels so households or businesses may not respond much to any resultant fiscal stimulus because they think it will be replaced with tax hikes down the track (a phenomenon known as Ricardian Equivalence). A way around this of course is helicopter money. This could involve a government issuing perpetual bonds with a zero rate of interest (and hence no value) to the central bank or the central bank effectively cancelling some of the public debt it holds. Either way, a fiscal expansion – eg directly putting cash into the hands of low and middle income households – could be undertaken with no increase in public debt.

Will we get there?

There is already plenty of evidence of a shift away from fiscal austerity and towards fiscal stimulus: the European Commission is effectively ignoring budget deficit overruns by Spain and Portugal; in shifting to more “inclusive” policies, UK PM Theresa May is ditching plans for more fiscal tightening; in the US, Hillary Clinton and Donald Trump have been promising more infrastructure spending whereas in the 2012 campaign it was all about getting the budget deficit down. If mainstream politicians are too survive the populist backlash against economic rationalism, they will probably have little choice but to embark on more expansionary fiscal policies.

However, helicopter money looks a long way off (if at all) in the US, which looks close to achieving its inflation target. And in Australia it’s not an issue at all. While there has been some talk of quantitative easing in Australia I can’t see the case for it as business conditions are reasonable, the slump in mining investment will start to abate in 2017-18 just as housing investment tops out, and public investment looks like it will be strong in the years ahead. (And, as indicated in the first chart, the deterioration in income inequality in Australia over the last 30 years is marginal once the tax and welfare system is taken into account, which suggests less urgency to act on inequality.)

However, there is a stronger case for helicopter money in Japan as core inflation has been falling lately with the risk of a return to deflation and public debt ratios are extreme.

Implications for investors

For investors, a shift in emphasis away from monetary policy and towards a greater role for fiscal policy could be positive if it boosts inflation and nominal growth. This would mean bond yields will start to bottom out and drift higher over time, but it could help growth assets like property and shares to the extent that it boosts profit and rental growth.

¹ See John C. Williams, “Monetary Policy in a Low R-star World,” FRBSF Economic Letter, August 2016

Source: AMP Capital

About the 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.

While the high inflation of the 1970s and early 1980s was bad for investment returns at the time, it left a legacy of very high investment yields which helped set the scene for high investment returns through the 1980s and 1990s. Back in the early 1980s the RBA’s “cash rate” was averaging around 14%, 3 year bank term deposit rates were around 12%, 10 year bond yields were around 13.5%, commercial and residential property yields were running around 8-9% and dividend yields on shares were around 6.5% in Australia and 5% globally. Such yields meant investments were already providing very high cash income. So for assets like property or shares only modest capital growth was necessary to give good returns. As a result, back then the medium term (5-10 year) return potential from investing was solid. In fact most assets had spectacular returns in the 1980s and 1990s. Australian superannuation funds saw returns average 14.1% pa in nominal terms and 9.4% pa in real terms between 1982 and 1999 (after taxes and fees).

Source: Mercer Investment Consulting, Morningstar, AMP Capital

But since the early 1980s the starting point in terms of investment yields has been moving progressively lower, resulting in slowing 10 year average nominal and real returns for superannuation funds as seen the chart above. Today the RBA cash rate is just 1.5%, 3 year bank term deposit rates are just 2.6-3%, 10 year bond yields are just 1.9%, gross residential property yields are around 3% and while dividend yields are still around 6% for Australian shares (with franking credits) they are around 2.5% for global shares. This note looks at the medium term return potential from major assets and the implications for investors.

Potential return drivers

In getting a handle on potential medium term returns from an asset class the key is its starting point valuation. For example, if current yields – say bond yields and dividend yields – are lower than “normal” then this will likely constrain returns relative to the past. Investment returns have two components; capital growth, and yield (or income). The yield is the most secure component and generally speaking, when you start your investment the higher it is the better. So our approach to assessing medium term return potential is to start with current yields for each asset class and apply simple and consistent assumptions regarding capital growth. We prefer to avoid a reliance on forecasting and to keep the analysis as simple as possible. Complicated adjustments just lead to compounding forecasting errors.

• For equities, a simple model of current dividend yields plus trend nominal GDP growth (as a proxy for earnings and capital growth) does a good job of predicting medium term returns. This approach allows for current valuations (via the yield) but avoids getting too complicated. The next chart shows this approach applied to US equities, where it can be seen to broadly track big secular swings in returns.

Source: Thomson Reuters, Global Financial Data, AMP Capital

• For property, we use current rental yields and likely trend inflation as a proxy for rental and capital growth.

• For unlisted infrastructure, we use current average yields and capital growth just ahead of inflation.

• For bonds, the best predictor of future medium term returns is the current bond yield. If a 10 year bond is held to maturity its initial yield will be its return over 10 years. The close relationship between 10 year bond yields and subsequent returns from bonds is clear in the next chart.

Source: Global Financial Data, Bloomberg, AMP Capital

Projections for medium term returns

Return projections using this approach are shown in the next table. The second column shows each asset’s current income yield, the third shows their 5-10 year growth potential, and the final column their total return potential. Note that:

• We assume central banks average around or just below their inflation targets, eg 2.5% in Australia & 2% in the US.

• For Australia we have adopted a relatively conservative growth assumption below nominal GDP growth potential reflecting the headwind from weak commodity prices & the impact of this on resource sector profits & sales growth.

• We allow for forward points in the return projections for global assets based around current market pricing – which adds 1.8% to the return from world equities.

• The Australian cash rate is assumed to average 2.75% over the medium term. Cash is one asset where the current yield is of no value in assessing the asset’s medium term return potential because the maturity is so short. So we assume a medium term average. Normally for cash this would be around a country’s potential nominal growth rate, but we have adjusted for higher than normal bank lending rates relative to the cash rate and higher household debt to income ratios which have pulled down the neutral cash rate.

Combining the return projections for each asset indicates that the implied return for a diversified growth mix of assets has now fallen to 6.9% pa and is shown in the final row.

# Current dividend yield for shares, distribution/net rental yields for property and duration matched bond yield for bonds. ^ Includes forward points. * With franking credits added in. Source: AMP Capital

Megatrends influencing the growth outlook

Several themes are allowed for in our projections: slower growth in household debt; the backlash against economic rationalist policies of globalisation, deregulation and small government; rising geopolitical tensions; aging and slowing populations; low commodity prices; technological innovation & automation; the Asian ascendancy & China’s growing middle class; rising environmental awareness; & the energy revolution. Most of these are constraining nominal growth and hence investor returns. However, technological innovation is positive for profits and some of these point to inflation bottoming. (See “ Megatrends…”, Oliver’s Insights, July 2016.)

Key things to note

Several things are worth noting from these projections.

• The medium term return potential using this approach continues to soften largely reflecting the rally in most assets of the last few years which has pushed investment yields lower. Projected returns using this approach for a diversified growth mix of assets has fallen from 10.3% pa at the low point of the GFC in March 2009 to 6.9% now.

Source: AMP Capital

• The starting point for returns today is far less favourable than when the last secular bull market in shares and bonds started in 1982, due to much lower yields.

• Government bonds offer low return potential thanks to ultra low bond yields.

• Unlisted commercial property and infrastructure continue to come out well, reflecting their relatively high yields.

• Australian shares stack up well on the basis of yield, but it’s still hard to beat Asian shares for growth potential.

• The downside risks to our medium term return projections are referred to endlessly by financial commentators: namely that the world is plunged into another recession or that investment yields are pushed up to more normal levels causing large capital losses. The upside risks are (always) less obvious but could occur if global growth improves but inflation remains low which could see a continuing search for yield further pushing up capital values.

Implications for investors

There are several implications for investors:

• First, have reasonable return expectations. The combination of low investment yields & constrained GDP growth indicate it’s not reasonable to expect sustained double digit returns. In fact, the decline in the rolling 10 year moving average of superannuation fund returns (first chart) indicates we have been in a lower return world for many years.

• Second, allow that this partly reflects very low inflation. Real returns haven’t fallen as much and are still reasonable.

• Third, using a dynamic approach to asset allocation makes sense as a way to enhance returns when the return potential from investment markets is constrained. This is likely to be enhanced by continued bouts of volatility.

• Finally, focus on assets providing decent sustainable income as they provide confidence regarding future returns, eg; commercial property and infrastructure.

Source: AMP Capital

About the 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.

Introduction

Infrastructure is seeing solid interest from investors. Not only does it offer relatively attractive yields and return potential, it’s also a good diversifier. With ultra low bond yields and equities limited by constrained growth prospects, infrastructure can provide a source of relatively stable returns underpinned by reasonable yields and inflation linked revenues. This note reviews the key characteristics of infrastructure and its role in a diversified investment portfolio.

Infrastructure — what is it?

Infrastructure refers to assets used to satisfy general community, societal and economic needs and underpins the operation of society. These assets include utilities (electricity generation, transmission and distribution, telecommunications, gas and water distribution), transport infrastructure (toll roads, rail, airports and ports) and social infrastructure (such as schools, hospitals, prisons and public housing). The broad range of infrastructure assets means that it is not a generic asset class. It encompasses lower returning, lower risk social infrastructure through to regulated utilities and demand based infrastructure such as ports, airports and telecommunications.

Infrastructure assets typically follow a lifecycle that see them start off as greenfield assets where yield is low but capital growth is high, through to mature assets where yields are high and growth potential is more in line with the economy. As such infrastructure assets are subject to different risks at different stages of their lifecycle. Most investors are reticent to accept greenfield risk, where demand may not be assured. Consequently, many investors focus on mature operational assets, where patronage has already been proven.

Prior to the late 1980s most infrastructure assets, particularly in Australia and Europe, were owned by governments. Since then, the desire to reduce public debt and a focus on efficiency have seen a shift towards private sector ownership.

Characteristics of infrastructure assets

Infrastructure investments typically have high upfront capital commitments but low operating costs. They are long duration assets often with a life of 30 or more years, and can benefit from significant barriers to entry, a dominant market position and relatively predictable cash flows and operational risks. The predictability of cash flows is because consumer demand for their services is usually stable, growth in infrastructure tariffs is often regulated to link to the rate of inflation, huge capital requirements provide barriers to entry, operating costs are usually low and payment or credit risk is low. This results in the following characteristics:

• A relatively high income yield contribution to total return. Depending on the type of infrastructure asset, income yields can vary from around 3% for a growth asset such as an airport, with a total return of 10%-15%, to a yield only total return of 7%-9% for social public private partnerships (PPPs). This is high in a world where government bond yields range from just below zero to around 2%.

• A moderately low level of volatility, reflecting relatively steady earnings or cash flows often linked to inflation and periodic appraisal based valuations.

• A relatively low correlation with bond and equity markets. By having assets in an investment portfolio that have low correlations with other assets, the riskiness of the portfolio is reduced via diversification.

There is only a limited number of unlisted infrastructure funds with a long return history available, but the table below provides a rough guide to the performance history of unlisted infrastructure. It can be seen that unlisted infrastructure has provided solid returns, but with a modest level of risk (as measured by standard deviation). It can also be seen that unlisted infrastructure has a relatively low correlation with most assets, suggesting that it is a good diversifier and will help smooth out a portfolio in times of turbulence in equity and bond markets.

Infrastructure – past returns, risk and correlations to other assets, September 1995-June 2016

^ The AMP Capital unlisted Diversified Infrastructure Trust, which commenced in September 1995, has been used as a proxy for unlisted infrastructure. * A correlation coefficient ranges between +1 (meaning that returns move precisely together) and –1 (meaning that two assets move perfectly in opposite directions). Source: Thomson Reuters, AMP Capital

Prospective returns

Going forward, infrastructure returns are likely to be lower than they have been. As investor demand has been strong in response to falling interest rates and bond yields and a broader search for yield, many infrastructure assets are being acquired on more expensive valuations. This has led to lower return potential going forward. However, notwithstanding this, infrastructure remains attractive compared to the low returns on offer from bonds and cash. The next table provides a rough guide to prospective returns and risk for unlisted infrastructure versus other assets, over the next 5 years.

Indicative yields, returns (pre tax and fees) and risk

* Pre franking credits # Ultra low bond yields suggests that the risk for bonds may no longer be low – but that’s a separate issue! Source: AMP Capital.

The combination of relatively steady and attractive returns and a relatively low correlation to financial assets make unlisted infrastructure attractive for investors. Of course, a risk to infrastructure investments given their yield characteristics is a sharp rise in interest rates and bond yields. So far there is little sign of this, but its one factor investors must keep an eye on.

Accessing infrastructure investments

There are various ways of investing in infrastructure, via:

• Unlisted infrastructure funds. These are a bit like unlisted property funds and invest in a diversified range of infrastructure assets/projects. As they access infrastructure projects directly, they have the investment characteristics noted above, including low volatility and a low correlation with equity and bond markets. But they have relatively low liquidity, and are dependent on the fund manager getting exposure to assets (often by bidding for large public assets or projects). Several fund managers offer unlisted infrastructure funds, which can have a country-specific, regional or global focus. Traditionally unlisted infrastructure has only been available to institutional investors, though some fund managers have developed products offering unlisted infrastructure exposure to retail investors.

• Investing directly in listed infrastructure shares, such as Transurban and AGL. Since these are listed on the share market they are more volatile and can lead the performance of unlisted infrastructure.

• Listed infrastructure funds. These are now offered by a large range of fund managers and invest in a portfolio of listed infrastructure shares either in Australia or globally or both and hence provide easier access to infrastructure investments, liquidity and greater diversification because they can be exposed to a broader range of infrastructure assets than unlisted funds. On the down side they come with higher volatility and have a higher correlation to shares (as they are listed). Comparing listed and unlisted infrastructure is a bit like comparing listed and unlisted property. Some fund managers also offer funds investing in both listed and unlisted infrastructure.

• Debt based funds. These include investments in infrastructure debt (eg, debt issued by electricity distributors) – but at least for non-institutional investors this usually entails investing in funds with general corporate debt as well. This has the characteristics of debt investments.

Australia’s infrastructure deficiency

In common with most of the developed world, Australia is faced with an infrastructure deficit, which has the potential to negatively impact economic growth in the long term if not addressed. Public investment has tended to be limited by budgetary constraints and private investment has not filled the gap. An issue has been that a successful risk sharing model between the public and private sectors to accommodate greenfield demand risk has yet to evolve. Australia seems to be moving to an approach that would see public sector development of higher risk infrastructure assets, with subsequent sale to the private sector after demand is proven. The sale proceeds would then be recycled into new developments. Australia also has some of the best prospects for further privatising remaining publically owned utilities, in contrast to most other developed countries.

However, in a global context, the absence of a strong pipeline of investable projects, high institutional appetite for mature assets and constricted supply will continue to drive up prices.

Role of infrastructure in a diversified portfolio

The average exposure of Australian superannuation funds to infrastructure is around 2-4%, but this masks a wide range from zero to over 10%. Trading off expected returns, risk and liquidity, a balanced investment portfolio could justify up to 10% exposure in infrastructure depending on the allocation to unlisted property. The ideal allocation tends to rise as the risk profile of a diversified portfolio increases. One way to overcome the illiquidity associated with unlisted infrastructure is to consider a mix of listed and unlisted infrastructure. The infrastructure allocation should arguably come from a combination of bonds and equities. In the case of bonds, it is notable that infrastructure, like property, shares similar characteristics in terms of a yield focus and a low correlation to shares. So with bond yields being very low, there is clearly a case to consider infrastructure as a partial alternative. But this shouldn’t be taken to an extreme – given government bonds have zero (or at least near zero) “default” risk in contrast to infrastructure.

Conclusion

Infrastructure provides an attractive investment, offering solid yield based prospective returns and a relatively low correlation to shares making it a good diversifier. With ultra-low bond yields and shares constrained, and the likelihood that we will see continued higher than normal volatility in share markets, infrastructure, particularly unlisted infrastructure, is likely to play a rising role in investors’ portfolios.

Source: AMP Capital

About the 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.