Olivers Insights

Introduction

Recently I was asked where we are in the cycle of investor emotion between the extremes of “euphoria” and “depression”. This is a good question, as knowing where the investment crowd is at and being wary of it is essential to successful investing. The late 1980s Japanese bubble, the Asian miracle of the mid-1990s, US tech stocks in the late 1990s, US housing and dodgy credit in the mid 2000s and arguably the commodity boom early this decade all had one thing in common: investors had jumped on a bandwagon, resulting in assets that became overvalued, over loved and ripe for a crash. But how do crowds get into such a muddle and what are they telling us now?

Investor psychology and the madness of crowds

The trouble with crowds from an investment perspective has its source in investor psychology. Individuals suffer from various lapses of logic. In particular, they:

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

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

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

• Tend to regard events as obvious in hindsight – by fostering the illusion that the world is more predictable than it really is this tends to promote overconfidence;

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

• Tend to ignore information conflicting with past decisions.

Naturally the result is magnified if many investors make the same lapses of logic at the same time, as part of a crowd. This can easily arise when several things are present:

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

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

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

The combination of lapses of logic by individuals in making investment decisions being magnified by crowd psychology go a long way to explaining why speculative surges in asset prices develop (usually after some good news) and how they feed on themselves (as individuals project recent price gains into the future, exercise “wishful thinking” & get positive feedback via the media, their friends, etc). Of course the whole process goes into reverse once buying is exhausted, often triggered by contrary news to that which drove the rise initially. Investor psychology through a market cycle looks like what Russell Investments called the roller coaster of investor emotion.

Source: Russell Investments, AMP Capital

In a bull market ‘optimism’ gives way to ‘excitement’, then ‘thrill’ and eventually ‘euphoria’ as the actions of investors push the asset class – be it shares or whatever – ever higher. It is at this point that investors are most bullish. Unfortunately it’s usually at this point that the market has become overvalued and with the crowd fully on board everyone who wants to buy has, so it only takes a bit of bad news to tip the market down.

When a bear market begins investors initially see it as a short term setback. But as ‘anxiety’ gives way to ‘fear’ investors eventually ‘capitulate’ and become ‘despondent’, selling their investments. However, the point of maximum crowd pessimism, when the crowd has sold and the asset class is cheap and unloved is the time when it provides its best opportunity. It then only takes a bit of good news to push the market higher.

So the behaviour of the crowd gives a great guide to investment market opportunities. Tops are usually associated with some form of crowd euphoria and market bottoms are associated with mass depression and despondency. So being a contrarian and doing the opposite to the crowd at extremes makes sense.

As always there are qualifications. Ideally, one needs to look at what investors are thinking (sentiment) and what they are actually doing (positioning). Secondly, negative crowd sentiment at market bottoms can tend to be associated fairly quickly with market bottoms reflecting the steep declines associated with panics as a market falls. But during bull markets positive sentiment or even euphoria can tend to persist for a while as it takes investors longer to build exposures to assets than to sell them.

So where are we in the emotion roller coaster?

For shares crowd sentiment ranges from very cautious to neutral. According to the American Association of Individual Investors bullish sentiment amongst retail investors has been averaging around 20% over the last few weeks, which is about as low as it ever gets and half its long term average.

Source: Bloomberg, AMP Capital

A broader composite measure of US investor sentiment that includes surveys of investment newsletter writers, the ratio of puts (options to sell shares) to calls (options to buy) amongst retail investors is more positive but a long way from euphoria.

Source: Bloomberg, Sentimentrader, Investors Intelligence, AMP Capital

Finally, in terms of positioning, US share market mutual funds and exchange traded funds have been seeing outflows.

In Australia, the proportion of those surveyed by the Westpac / Melbourne Institute consumer survey nominating shares as the wisest place for savings is just 7.6%, half its long term average. See the next chart.

Source: Westpac/Melbourne Institute, AMP Capital

Overall this suggests that crowd sentiment towards shares is a long way from the sort of euphoria that normally characterises major market tops. In fact it sometimes feels as if we are stuck between ‘hope’ and ‘relief’ in the roller coaster. What about other asset classes?

Australians’ interest in residential property appears to have taken a hit recently as indicated in the last chart. Sentiment towards property seems a lot more cautious than was the case around 2013-15. However, an increasing supply of units, restrictions on bank lending to housing and the fact that Sydney and Melbourne have already seen huge price gains cautions against treating this too positively.

From the above chart, in Australia the most popular asset class continues to be bank deposits with 27% of those surveyed seeing them as the wisest place for savings. With term deposit rates now pushing 2% this may prove to be another example where the crowd gets its wrong – in this case in terms of their relative returns.

Implications for investors

There are several implications for investors. The first thing to do is recognise that investment markets are not only driven by fundamentals, but also by the often-irrational and erratic behaviour of an unstable crowd of other investors. The key here is to be aware of past market booms and busts, so that when they arise in the future you understand them and do not overreact (piling into unstable bubbles near the top or selling everything during busts and locking in a loss at the bottom).

Second, try and recognise your own emotional capabilities. In other words, be aware of how you are influenced by lapses in your own logic and crowd influences like those mentioned above. For example, you could ask yourself: “am I highly affected by recent developments (positive or negative)? Am I too confident in my expectations? Can I bear a paper loss?”

Thirdly, to guard against this choose an investment strategy which can withstand inevitable crises whilst remaining consistent with your financial objectives and risk tolerance. Then stick to this broad strategy even when surging share prices tempt you into a more aggressive approach, or when plunging values suck you into a highly defensive approach.

Fourthly, if you are tempted to trade, do so on a contrarian basis. Buy when the crowd is bearish, sell when it is bullish. Extremes of bullishness often signal market tops, and extremes of bearishness often signal market bottoms. Successful investing requires going against the crowd at extremes. Various investor sentiment and positioning surveys provide a guide.

Finally, investor sentiment right now towards shares still seems to be relatively cautious – nothing like the ‘euphoria’ seen at major market tops.

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

Since the global growth panic in January/February share markets and commodity prices have seen a decent rebound. and the stress in credit markets has receded. This has been helped by a combination of Fed assurances that it will not be reckless and ignore global risks in determining US interest rates, somewhat better economic data in the US and China, more monetary easing in Europe and a rebalancing in the global oil market that has allowed oil prices to stabilise which has helped reduce the risk of default by energy producers. However, the big question is whether it is sustainable or just a bounce. This note looks at the main issues.

Seasonal strife

But let’s first take a look at seasonal patterns. It’s well known that the best time for shares is from November to May and that 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 (after removing the underlying rising trend).

Source: Bloomberg, AMP Capital

Most major share market falls have occurred in the May to October period: the 1929 crash; the 1987 crash; the post Lehman Brothers collapse; the various iterations of the Eurozone crisis; and last year’s share market falls around the September quarter. Hence the old saying “Sell in May and go away, come back on St Leger’s Day” still resonates.

The seasonal pattern appears to reflect some combination of 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 their clients’ capital gains bill, 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 the Christmas/New Year period 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, etc. Of course this may not be the whole story because the seasonal pattern may date back to agricultural crop cycles which saw merchants withdraw their money from financial assets at the end of summer to pay for the summer crop and then having to reinvest into year end.

Reasons for short term caution

Apart from the risk of seasonal weakness in the months ahead, there are several risks in the short term.

• The month or so ahead sees “event risks” with the June 14-15 Fed meeting “live” for consideration of another interest rate hike, the Brexit vote on June 23 with a “leave” vote likely to be taken badly for the UK and posing the more significant risk that it might trigger renewed debate about a break-up of the Eurozone, another Spanish election on June 26 where a left wing victory could be taken badly, and the Australian election on July 2 where the left/right divide seems more extreme than at any election since the 1970s.

• Uncertainty around how much the Fed will ultimately hike will likely cause ongoing angst in terms of its impact on the US economy and globally if a rising $US dollar puts renewed pressure on commodity prices, emerging countries and the Chinese Renminbi.

• Nervousness may rise in the run up to the US Presidential election in November if Trump continues to rise in the polls.

• The global growth environment remains fragile and China remains a source of uncertainty.

• The US share market while arguably the most at risk on some value measures had the smallest fall from its high last year to its low in February (-14% compared to 20% plus falls in other major share markets) so may have more work to do.

Seven reasons for optimism

However, against this there are reasons for optimism particularly beyond near term risks. First, some of the above mentioned risks may not be as threatening as they look:

• Whether the Fed hikes in June or July, Fed Chair Janet Yellen and other key decision makers have repeatedly stressed that it takes account of global risks and that it is likely to be “gradual” in raising rates. In other words it won’t be reckless – the last thing the Fed wants is to prematurely snuff out US growth that it has spent so long to nurture.

• Even if the UK vote is to “leave”, the response in Eurozone countries (of which the UK is not a member) may be more integration just as every other Eurozone crisis has driven.

• Recent polls suggest non-centrist left wing parties won’t win enough support in the Spanish election to reverse the economic reforms the Spanish Government implemented.

• The above mentioned risks are arguably well known and should be allowed for at least to some degree. After all most share markets are down on year ago levels. Remember the old saying “shares climb a wall of worry” which is certainly what they have done since February.

• And it could be worse – the recent agreement between Greece and its creditors on its aid deal means that another Grexit scare is unlikely this summer.

Second, valuations for most share markets are not onerous. While price to earnings multiples for some markets are a bit above long term averages, valuation measures that allow for low interest rates and bond yields show shares to be cheap.

Source: Thomson Reuters, AMP Capital

Third, while the US share market may be vulnerable on some measures other share markets are not. Specifically if US shares are compared to a 10 year moving average of earnings (which is often referred to as a Shiller or cyclically adjusted PE) then they are a bit expensive and of course monetary conditions in the US are gradually tightening. However, the so-called Shiller PE is actually cheap for most markets globally including Eurozone, Chinese and Australian shares (see the next chart).

Source: Global Financial Data, AMP Capital

Fourth, global monetary conditions are very easy and likely to remain so, with further easing in Europe, Japan, Australia and probably China likely to ensure that liquidity conditions for shares and growth assets remain favourable.

Fifth, there are no signs of a US, Australian or global recession. US economic growth appears to have picked up after a seasonal soft spot early this year, Chinese economic growth appears to have stabilised, global business conditions surveys or PMIs have slowed but are not pointing to anything approaching recession (see the next chart). Australia is continuing to grow with consumer spending, housing construction, a resurgence in services like tourism and higher education exports and booming resource export volumes (the third phase of the mining boom) keeping the economy going.

Source: Bloomberg, AMP Capital

This is very important. Ignoring the most recent fall, since 1900 there have been 17 bear markets in Australian shares (defined as a 20% plus falls). Of these 11 saw shares higher a year after the initial 20% decline with an average gain of 14%. Of course the remaining 6 pushed further into bear territory with average falls over the next 12 months, after having declined by 20%, of an additional 22.5%. Stockbroker Credit Suisse, albeit focussing only on the period from the 1970s, called these Gummy bears and Grizzly bears respectively.

Source: ASX, Global Financial Data, Bloomberg, AMP Capital

The big difference between them is whether there is recession (in Australia or the US) or not. Grizzly bears tend to be associated with recessions but Gummy bears tend not to be.

Sixth, if recession is avoided as appears likely, the profit outlook should start to improve. There are some pointers to this: US earnings are likely to have bottomed as the negative impact of the fall in oil prices and the rise in the $US has abated; and Australian earnings momentum will start to improve in the next financial year as the impact of last year’s plunge in commodity prices – which drove resource profits down 60% – falls out.

Finally, there still seems to be a lot of pessimism around. According to the American Association of Individual Investors bullish sentiment amongst US retail investors is 18%, less than half the long term average. The proportion of Australians interviewed by the Westpac/Melbourne Institute consumer survey who nominated shares as the wisest place for savings is just 7.6%, also half the long term average. This is positive from a contrarian perspective. As Warren Buffett advised, “Be fearful when others are greedy. Be greedy when others are fearful”.

Concluding comment

After a strong 12 to 14% rebound in share markets from the February lows we could be in for a rough patch over the months ahead. However, many of the current threats are well known and with most share markets offering reasonable value, global monetary conditions remaining easy, and no sign of the much feared recession, the trend in shares is likely to remain up.

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

This year has seen a growing concern that central banks are out of ammo when it comes to reinvigorating global growth and preventing deflation. And the Reserve Bank of Australia’s latest rate cut has some fearing that it’s going down the same “failed path” as other major central banks. But is it really that bad? Have central banks really failed? Are they really out of ammo?

Why did the RBA ease again?

The latest RBA rate cut, which took the official cash rate to a record low of 1.75%, surprised many because recent economic data in Australia has been OK. But the reason for the cut is simple. Inflation has fallen well below the RBA’s 2-3% target, the weakness in prices was broad based and inflation is expected by the RBA to remain below target or at the low end of the target for some time.

Source: ABS, RBA, AMP Capital

Naturally, the RBA worried that if it didn’t provide more stimulus to the economy low inflation could become entrenched and could give way to deflation. With the $A pushing up towards $US0.80 prior to the cut and the Fed continuing to delay rate hikes, the RBA was no doubt also concerned that if it didn’t ease the $A would push even higher, putting more downwards pressure on inflation.

Why not just lower the inflation target?

Since the last RBA cut, some have said that the RBA should just lower its inflation target because it cannot fight falling global commodity prices and what’s wrong with very low inflation anyway. This reminds me of a similar argument back in 2007-08, when inflation had pushed above 4%, that the RBA should not worry but just raise its inflation target as it cannot fight rising global commodity prices. Such arguments are nonsense.

First, the whole point of having an inflation target is to anchor inflation expectations. If the target is just raised or lowered each time it looks like being seriously breached then those expectations – which workers use to form wage demands and companies use in setting wages and prices – will simply move up or down depending on which way the target is changed. And so inflationary or deflationary shocks from things like commodity prices will turn into permanent shifts up or down in inflation. Second, there are problems with allowing too-low inflation. Most central bank inflation targets are set at 2% or so because statistical measures of inflation tend to overstate actual inflation by 1-2% because statisticians have trouble actually adjusting for quality improvements and so some measured price rises really reflect quality improvements. In other words, 1.5% inflation could mean we are actually in deflation. And there are problems with deflation – see below.

How far will the RBA cut rates?

To the extent that the minutes from the RBA’s May meeting indicate the RBA had considered “waiting for more information”, it may choose to sit tight at its June meeting. However, given the downside risks to inflation, particularly with wages growth falling to a record low 2.1%, constrained growth and the still high $A more rate cuts are likely. We are allowing for two more rate cuts this year, taking the cash rate to 1.25% by year end.

What’s wrong with falling prices (deflation) anyway?

Deflation refers to persistent and generalised price falls. It occurred in the 1800s, 1930s and the last 20 years in Japan. Most people would see falling prices as good because they can buy more with their income. However, deflation can be good or bad depending on the circumstances. In the period 1870-1895 in the US, deflation occurred against a background of strong economic growth, reflecting rapid productivity growth and technological innovation. This can be called “good deflation”. However, falling prices are not good if they are associated with falling wages, rising unemployment, falling asset prices and rising real debt burdens. For example, in the 1930s and more recently in Japan. This is “bad deflation”.

In the current environment of high debt levels, sustained deflation could cause big problems. Falling wages and prices would make it harder to service debts. Lower nominal growth will mean less growth in tax revenues making high public debt levels harder to pay off. And when prices fall people put off decisions to spend and invest, which could threaten economic growth. This could risk a debt deflation spiral of falling asset prices and falling incomes leading to rising debt burdens, increasing defaults, spurring more falls in asset prices, etc. There are good reasons why central banks want to avoid that.

As can be seen in the next chart, there are still more countries experiencing deflation than hyperinflation.

Source: Thomson Reuters, AMP Capital

What has been driving deflation?

Several factors have driven the plunge in global inflation and some countries dipping into deflation: commodity prices have been in a downtrend since 2011 as their supply surged; and the sub-par global recovery since 2009 means the world has plenty of spare capacity. Global economic activity is around 2.5% below potential. Excess capacity means companies lack pricing power and workers lack bargaining power.

But are rate cuts actually working?

Some worry that rate cuts have just made things worse by cutting into the spending power of retirees and forcing those nearing retirement to save more. However, there are several points to note in relation to this. First, the level of household deposits in banks in Australia at around $0.9 trillion is swamped by the level of household debt at $2.2 trillion. So the household sector is a huge net beneficiary of lower interest rates. Second, the responsiveness to changes in spending power for a family with a mortgage is far greater than for retirees. Third, the proof is in the pudding. The fall in interest rates has helped the economy rebalance as mining investment has collapsed: first via a pick-up in housing construction and more recently via growth in consumer spending of close to 3% per annum (pa). 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 late 2011. And of course RBA rate cuts have helped push the $A lower. So overall, rate cuts do work.

Have non-traditional monetary policies failed?

This is a relevant question with many saying that zero interest rates and quantitative easing in developed countries have not worked. But actually in the US they have as growth there has been averaging around potential at 2% pa, unemployment has fallen from 10% to below 6%, wages look to be picking up and underlying inflation is close to the Fed’s 2% inflation target. Sure, the Eurozone and particularly Japan are less clear but this may be because they waited too long before acting by which time low inflation or deflation had become entrenched. The lesson from this is that central banks need to act quickly and not that non-traditional monetary policy doesn’t work.

Are central banks out of ammo?

This is a common concern. However, central banks are a long way from being unable to do anything: the Fed can reverse last year’s interest rate hike and launch another round of quantitative easing if needed; and both the ECB and Bank of Japan could expand their quantitative easing programs further both in terms of size and the type of assets. More negative interest rates are an option but central banks are wary of this after the adverse impact of Japan’s experience regarding negative rates.

The ultimate option is for central banks to provide direct financing of government spending or tax cuts using printed money. This is often referred to as “helicopter money”. Unlike quantitative easing, which requires banks to lend their newfound cash to borrowers who want to borrow, it would yield an almost guaranteed response as the recipients of government spending/tax cuts will spend at least some of it. It won’t add to government debt either. As the examples of Zimbabwe and the Weimar Republic demonstrate, such an approach would make no sense if supply is constrained relative to demand and inflation is already high and rising. But that is not the case now and deflation remains the main threat, not inflation.

Of course none of these are an issue for the RBA as it still has plenty of scope to cut interest rates if needed.

Ideally, central banks should be getting more help from governments in terms of fiscal stimulus and supply side reforms but there are all sorts of constraints around this.

Implications for investors?

There are a number of implications for investors. First, while the worst may be over in terms of commodity price falls so the threat from deflation may be receding globally, the risk remains thanks to spare capacity and low wages growth, so low interest rates will remain in place for some time. While the Fed may continue down its path of gradual rate hikes, elsewhere rates are likely to stay low and, in Australia, fall further. Australian term deposit rates at around 2% are at their lowest since the early 1950s. So don’t expect great returns from them.

Second, given the absence of significant monetary tightening, a 1994-style bond crash remains as distant as ever. The most likely outcome is just low returns from government bonds.

Third, the low interest rate environment means the chase for yield is likely to continue supporting commercial property, infrastructure and shares offering sustainable high dividends.

Finally, as can be seen in the next chart, low inflation is generally good for shares as it allows shares to trade on higher price to earnings multiples. But it would be preferable not to see low inflation slip into deflation as this could be bad for shares given it tends to go with poor growth and profits and as a result shares trade on lower PEs. The same would apply to assets like commercial property and infrastructure.

Source: Global Financial Data, Bloomberg, AMP Capital

So, combined with the social damage that a bout of debt deflation could cause, I would much prefer to see central banks continue to do all they can to avoid deflation.

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.

With the Federal election now confirmed for July 2 it is natural to wonder what the implications for investment markets and the economy might be. At present opinion polls give the Coalition a slight lead over Labor but it’s very close at around 51%/49%. That said according to bets placed on online betting agencies the Coalition is the favourite at around 72% probability of victory, albeit this is down from around 87% earlier this year.

Elections, the economy & markets in the short term

There is anecdotal evidence that uncertainty around elections causes households and businesses to put some spending decisions on hold – the longer the campaign the greater the risk. This campaign is eight weeks and arguably longer given the change in budget timing announced in March to make way for a July 2 election. Qantas has already suggested that election uncertainty may be affecting spending. However, hard evidence regarding the impact of elections on economic indicators is mixed and there is no clear evidence that election uncertainty effects economic growth in election years as a whole. Since 1980 economic growth through election years averaged 3.7% which is greater than average growth of 3.2% over the period as a whole. That said growth was below average at 2.3% in 2013 which also saw a long de facto election campaign.

In terms of the share market, there is some evidence of it tracking sideways in the run up to elections, which may be because investors don’t like the uncertainty associated with the prospect of a change in economic policies. The next chart shows Australian share prices from one year prior to six months after federal elections since 1983. This is shown as an average for all elections (but excludes the 1987 and 2007 elections given the global share crash in late 1987 and the start of the global financial crisis in 2007), and the periods around the 1983 and 2007 elections, which saw a change of government to Labor, and the 1996 and 2013 elections, which saw a change of government to the Coalition. The chart suggests some evidence of a period of flat lining in the run up to elections, possibly reflecting investor uncertainty beforehand, followed by a relief rally soon after.

Source: Thomson Reuters, AMP Capital

However, the elections resulting in a change of government have seen a mixed picture. Shares rose sharply after the 1983 Labor victory but fell sharply after the 2007 Labor win, with global developments playing a role in both. After the 1996 and 2013 Coalition victories shares were flat to down. So based on historical experience it’s not obvious that a victory by any one party is best for shares in the short term and historically the impact of swings in global shares arguably played a bigger role than the outcomes of Federal elections.

The next table shows that 8 out of 12 elections since 1983 saw shares up 3 months later with an average gain of 4.8%.

Based on All Ords index. Source: Bloomberg, AMP Capital

The next chart shows the same analysis for the Australian dollar. In the six months prior to Federal elections there is some evidence the $A experiences a period of softness and choppiness which is consistent with policy uncertainty, but the magnitude of change is small. On average, the $A has drifted sideways to down slightly after elections.

Source: Thomson Reuters, AMP Capital

Australian bond yields have tended to fall over the six months prior to Federal elections since 1983, which is contrary to what one might expect if there was investor uncertainty. However, this may be related to the aftermath of recessions, slowdowns and/or falling inflation prior to the 1983, 1984, 1987, 1990 and 1993 elections and the secular decline in bond yields since the 1980s. Overall, it’s hard to discern any reliable effect on bond yields from federal elections themselves.

Political parties and shares

Over the post-war period shares have returned 12.8% pa under Coalition Governments & 10.7% pa under Labor Governments.

Source: Thomson Reuters, AMP Capital

It may be argued that the Labor governments led by Whitlam in the 1970s and Rudd and Gillard more recently had the misfortune of severe global bear markets and, if these periods are excluded, the Labor average rises to 15.8% pa. Then again that may be pushing things a bit too far. But certainly the Hawke/Keating government defied conventional perceptions that conservative governments are always better for shares. Over the Hawke/Keating period from 1983 to 1996 Australian shares returned 17.3% pa, the strongest pace for any post-war Australian government.

Once in government, political parties are usually forced to adopt sensible macro-economic policies if they wish to ensure rising living standards and arguably there has been broad consensus on both sides of politics regarding key macro-economic fundamentals – eg, low inflation and free markets.

Policy differences starker than since the 1970s

However, this time the policy differences between the Coalition and Labor are arguably starker than they have been since the 1993 election (when the Coalition proposed an even more significant reform of the economy than Hawke and Keating had been pursuing) or arguably since the 1970s (when there used to be more of a focus around “class warfare”). And so the economic uncertainty around this election may be greater than usual. While the focus on reducing the budget deficit is still there, it has softened, with each side of politics now offering very different visions for the size of government:

• Labor is focussed on spending more on health and education and in the process allowing the size of the public sector to increase, funded by tax increases on higher income earners (retention of the budget deficit levy, cutbacks in access to negative gearing, the capital gains tax discount and superannuation). Intervention in the economy is likely to be higher than under a Coalition government.

• By contrast the Coalition is focussed more on containing spending, and encouraging economic growth via company tax cuts and mild reforms. Despite the Coalition’s tilt to “fairness” with its super reforms it’s committed to keeping taxes down.

The left right divergence between Labor and the Coalition was narrowed in recent decades by the reform oriented rationalist approach kicked off by Hawke and Keating in the 1980s in response to the economic failures of the 1970s. It now seems to have widened again with populist focus on issues of fairness after the 2014 Federal Budget debate and an electorate less averse to tax hikes. It’s also consistent with rising interest in populist policies in the US – as evident by the success of Sanders and Trump – which in turn reflects angst over job losses from globalisation & automation and widening inequality.

Perceptions that a more left leaning Labor Government will mean bigger government, more regulation and higher taxes and hence be less business friendly may contribute to more volatility in shares and the $A around the election. This may be partly offset by a firm commitment from Labor to bring the deficit under control (although both sides of politics have been saying that for years now). More broadly there are a number of risks in all this:

• The focus on economic reform needed to boost productivity seems to be falling by the wayside in the face of populism – eg, why aren’t we considering injecting more competition into the health sector rather than just spending more on it?

• There is a danger in relying on tax hikes on the rich (whether retention of the budget levy or cutting access to concessions) in that Australia’s top marginal tax rate of 49% is already high – particularly compared to our neighbours: 33% in NZ; 20% in Singapore; and 15% in HK. Australia’s income tax system is already highly progressive: 1% of taxpayers pay 17% of tax (with an average tax rate of 42%) and the top 10% pay 45% of tax compared to the bottom 50% who pay just 12% (with an average tax rate of 11%).

• While talk of a budget emergency in 2013 was over the top, the seeming relegation to second order of budget repair under each successive government is risky. The loss of our AAA rating would risk alienating foreign investors on whom we depend.

• While the Coalition is still banking on winding back growth in welfare spending, this still won’t be realised if the Senate doesn’t become friendlier – the track record of double dissolution elections is not good in this regard. Don’t forget that it was hoped that the last election would end minority government but in reality it didn’t.

In short, the widening left right divide in Australian politics suggests greater uncertainty going into this election potentially affecting all asset Australian classes, including residential property. But the bigger concern is the seeming dwindling prospects for productivity enhancing economic reform, which could be an ongoing dampener on growth in living standards.

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.

Australian shares lagging

Since the March 2009 Global Financial Crisis (GFC) low in share markets, Australian shares are up 65%, compared to a 145% gain in global shares in local currency terms and a 210% gain in US shares. In fact, both global and US shares reached record highs last year and still remain above pre GFC levels, whereas the Australian share market is around 24% below the record high of 6829 reached in November 2007.

Source: Bloomberg, AMP Capital

So what gives? When might it turn around?

Why has the Australian share market underperformed?

The relatively poor performance of Australian shares since 2009 reflects a combination of factors:

• Tighter monetary policy – whereas the US, Europe and Japan have had near zero interest rates and quantitative easing since the GFC, Australia has had much higher interest rates and no money printing. In fact, the relative underperformance really started in October 2009 when the RBA started to raise interest rates post GFC which was not followed by other major developed countries. While interest rates have since been cut they are still at 2% versus near zero in other developed countries.

Source: Thomson Reuters, AMP Capital

• The surge in the $A to $US1.10 in 2011 – this reduced the competitiveness of Australian companies; from which the damage can take a long time to reverse. By contrast, until a few years ago the US share market benefitted from the lagged effect of the big fall in the $US through last decade.

• The slump in commodity prices – this has clearly weighed on resources shares. US, European and Japanese share markets have a lower exposure to resources shares.

• Property crash phobia – foreign investor fear of a crash in Australia’s relatively expensive property market has been a constant theme for some time. Since 2010 the logic has been something like: “Australia’s massive property boom will crash following the end of the mining boom, crashing the banks and the economy”. Therefore many stayed away.

• Mean reversion – the relative performance of Australian shares versus global shares has a long term tendency to mean reversion, whereby periods of outperformance are followed by periods of underperformance & vice versa. See the next chart. In short, the strong performance of Australian shares last decade set it up for underperformance this decade. The 2007 high was a much higher high than seen in other major share markets. So it was much easier for global shares to make a new high post the GFC.

Source: ABN-Amro Global Investment Returns Yearbook, AMP Capital

Last decade was the time for commodities, emerging markets, Australian shares and commodity currencies, as opposed to traditional global shares dominated by the US, Europe and Japan and the US dollar. This de cade has been the opposite.

Are high dividend payouts to blame?

A common view is that Australian companies are not investing because shareholders are demanding high dividends and this could be causing poor earnings growth and poor share market returns. This is unlikely. The dividend payout ratio (ie dividends relative to earnings) is not significantly out of line with its historic norm. For industrials the payout ratio at around 75% is not significantly above where it was prior to the GFC. It’s mainly resources stocks that boosted payouts to above 100% from around 30% prior to the GFC. It’s hard to argue they should ramp up investment after having over-invested! In any case this is now being reversed as BHP and Rio cut their dividends.

Source: Bloomberg, Global Financial Data, RBA, AMP Capital

The real reasons for the lack of investment by non-mining companies are likely to be: post-GFC caution, wariness after getting smashed through the mining boom by the high $A, high interest rates and high labour costs, and too high hurdle rates.

More fundamentally, Australia’s high dividend payouts are healthy from a long term perspective. There is evidence that high payouts actually drive higher (not lower) earnings growth and hence higher returns. There are several reasons this is the case: high dividend payouts mean less risk of poor investment decisions from retained earnings, they are indicative of corporate confidence about future earnings, and they indicate earnings are real and not an accounting fiction.

Not so bad if dividends are allowed for

In fact, after allowing for reinvested dividends (ie; looking at the ASX 200 accumulation index) the Australian share market has at least surpassed its 2007 high.

Source: Bloomberg, AMP Capital

What’s the outlook?

It’s too early to say the secular underperformance of Australian shares versus global shares has come to an end. The secular commodity bear market could have further to run and the ratio of Australian to global share prices has not yet fallen to the extreme lows that saw turning points in favour of Australian shares in 1983 and 2000. See the second chart in this note above. However, the call in favour of global shares (over and above diversification benefits) is getting a little bit weaker:

• While Europe and Japan are continuing to ease monetary policy, the US has ended quantitative easing and is “gradually” starting to raise interest rates at a time when we continue to expect the RBA to cut interest rates further.

• Although the $A has bounced recently and should ideally be lower, it’s still down 30% from its 2011 high, correcting much of the competitive disadvantage of Australian industry. This is evident in the resurgence in education and tourism related export earnings, and the rise in the Australian manufacturing conditions PMI to a reading of 58, well above readings for the US (50.8), Europe (51.5) and Japan (48).

• While supply continues to rise, meaning it’s too early to say that commodity prices have bottomed, their huge declines from their 2008-2011 highs – 82% for oil, 80% for iron ore & 54% for metals – suggest that the worst may be behind us. Related to this, the risks around China may be receding as fears of a hard landing have yet again not been realised.

• While mean reversion has not reached past extremes (as per the second chart in this note), Australian shares have already significantly underperformed global shares.

• Finally, the risks around the Australian economy may be receding. The drag from plunging mining investment is likely to have run its course by next year, completed resource projects are resulting in surging export volumes and the rebalancing of the economy in favour of other sectors is well advanced, albeit it may yet need some more help.

From a longer term perspective there are several supports for Australian shares. Over the period since 1900 Australian shares have had stronger real returns than most other global share markets, so they have a great track record. See the next chart.

Source: Credit Suisse Global Investment Returns Yearbook 2015, AMP Capital

Secondly, Australian shares still pay a higher dividend yield than traditional global shares: 4.8% versus 2.7%. This is important because dividend payments are a big chunk of the return an investor will get and so the higher the better.

Third, Australia’s potential growth rate is still higher than in the US, Europe and Japan thanks to higher population growth.

Finally, franking credits add around 1.5%pa to the post tax return from Australian shares for Australia-based investors.

Concluding comment

It remains too early to say that the period of underperformance of Australian shares is over, so there remains a case to have a greater exposure to global shares than at the start of last decade. However, the case against Australian shares is waning so investors should maintain a decent exposure or at least avoid moving further away from it.

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.

The spike in volatility

After a period of relative calm over 2012-2014 share market volatility has spiked over the last year as various worries about the global growth outlook intensified. With this renewed volatility a focus on risk in investing and a desire for safety has naturally come. But what is volatility? What drives it? Why does it come in cycles? Where are we now? And is it the same thing as risk?

What is volatility?

Volatility in investing refers to the degree to which an asset’s value fluctuates. The most common way to measure it is with a statistical concept called standard deviation which shows how tightly clustered past changes in the value of an asset or returns have been around their average in a certain period. The higher the standard deviation the greater the volatility. The standard deviation of monthly returns based on very long term data for major asset classes is around 0.5% for Australian cash, 3.5% for Australian government bonds, 12% for Australian real estate investment trusts, 16.5% for Australian shares and 15.5% for global shares. The following chart shows the standard deviation of monthly returns for Australian and US shares since 1990. As can be seen it has recently picked up.

Source: Thomson Reuters, AMP Capital

Another approach is to track the number of days when share markets move up or down by 1% or more. This is shown for shares over rolling 40 day trading periods in the next chart. Whereas this was running as low as 5 days in every 40 in 2014 earlier this year it had spiked to around 20 days in every 40.

Source: Bloomberg, AMP Capital

What drives volatility?

Investment market volatility is essentially determined by:

• Uncertainty around market fundamentals – economic growth, earnings, dividends, interest rates etc. It often arises when there is a surprise development or change in direction.

• Investor psychology or emotion – which pushes markets to extremes accentuating volatility.

In terms of the latter, the combination of lapses of logic (in particular the tendency of investors to extrapolate recent news and trends into the future) magnified by crowd psychology, where many investors end up thinking the same thing at the same time, can push markets to extremes resulting in volatility over and above that justified by fundamentals. Another way of thinking about this is that the share market is in large part influenced by stories that many investors buy into. Sometimes, eg through the tech boom of the late 1990s, these stories can be very positive and magnify uptrends. At other times like through the GFC or early this year these stories can be very negative and magnify negative trends.

Source: Thomson Reuters, AMP Capital

Over the last century or so fundamental drivers of volatility – like economic growth and inflation – have declined, as can be seen in the previous chart that shows the volatility of GDP growth. This decline in economic volatility has been driven by things like the growing role of the more stable services sector, better inventory control & macro management by central banks. This should have resulted in a decline in share market volatility, but the chart below shows that volatility in Australian and US shares is in the same range it’s been in over the last century.

Source: Thomson Reuters, AMP Capital

There may be a huge volume of more accessible information around investment markets today but if investors all get it at the same time from their screens (whether trading screens, TVs, smart phones, tablets etc) and end up having similar views and hence positions, then they are more likely to change their positions at the same time – resulting in additional volatility even though the fundamental drivers of volatility are less significant. The recency of the GFC and the Eurozone debt crisis has arguably driven investors from thinking extreme market falls happen every generation or so to occurring very 5 years or so and the desire to avoid getting burned again combined with an avalanche of information – often warning of imminent disasters – has resulted in a more short term focussed and twitchy investor base. So while fundamental drivers of volatility may have declined, investor sentiment or emotionally driven sources of volatility have arguably increased.

Volatility comes and goes – why the cycle?

So while investor psychology or emotional investing is arguably playing a bigger role in driving share market volatility, it’s also clear from the first two charts in this note that periods of volatility come and go. In a cyclical context:

• Volatility tends to be quite low during the mid-cycle phase of the business cycle – ie when growth has picked up after a downturn but before the economy is too strong – as this is when the economy is most stable and arguably predictable, corporate debt is low, interest rates are moderate and shares are not at extreme valuations.

• Volatility tends to rise during the boom, bust and then initial recovery phases in the business cycle. This tends to be when economic surprises – both good and bad – are at their greatest. It is also when share markets tend to become most misvalued and when investors take extreme positions.

So where are we now?

The relatively low level of share market volatility seen over the 2012-14 period is consistent with the global economy being in the relatively stable mid-cycle phase of the business cycle. Rounds of quantitative easing notably in in the US may have played a role in further suppressing volatility. It’s hard to put the recent volatility down to a move into the boom/bust phase of the cycle because there is little evidence to support it: global growth is far from booming, inflation is low, debt growth is low, shares are not overvalued, investors are not complacent and monetary policy is far from tight. These considerations suggest that we are not on our way to a re-run of the sort of volatility seen around the GFC. However, there are some reasons to expect volatility to remain higher than seen over the 2012-14 period: on some measures US shares are overvalued; corporate debt in the US has gone up; the Fed is still heading down a path of gradual rate hikes; the divergence between a tightening Fed and still easing other central banks is likely to create tensions in terms of currency shifts; the bust in commodity prices is likely to continue to impact; and with swings in investor sentiment continuing to play an outsized role.

Volatility is not the same as risk

So the bottom line is that we may have to get used to high levels of volatility for a while yet. But as my colleague Nader Naeimi has said “volatility is an unexpected deviation in the path to an investor’s destination (ie, the investment goal) which can lead to both risks and opportunities. Risk is the probability of not reaching the destination (ie, failing to achieve the goal)”. In other words there is much more to risk for investors than volatility. There are several points to note when thinking about volatility and the risk of not meeting your investment goals.

First, volatility often signals opportunity – high levels of investment market volatility often indicate opportunities for investors as it invariably surges during share market slumps like those seen into 2003 and 2009 as this is when shares are selling cheap. In fact, periods of low volatility when markets are smooth and investors relaxed can be periods of maximum risk.

Second, time is on your side when it comes to investing – as it smooths out short term volatility. For example, while share market returns can be highly volatile over short term periods they tend to be quite smooth over long periods. Since 1900 for shares roughly two years out of ten have had negative returns but there are no negative returns over rolling 20 year periods.

Source: Global Financial Data, AMP Capital

Third, make sure that volatility does not compromise your ability to bounce back – leveraged strategies that involve the risk of being forced to close positions after falls are particularly risky during periods of volatility because you can be left without the ability to participate in the subsequent recovery in markets. So manage leveraged strategies carefully.

Fourth, think about what is most important – complete avoidance of any fall in the value of your investment or achieving a decent & stable income flow? If it’s the former then bank deposits are the way to go. If it’s the latter then there are a number of alternatives to consider including corporate debt, commercial property, infrastructure and shares offering decent, sustainable dividends.

Finally, turn down the noise – during volatile times in markets the negative news flow via traditional and social media can reach fever pitch and this is when we are most prone to making emotional decisions regarding our investments and joining the crowd. So the trick is to turn down the noise around investing.

During volatile times the key is to avoid the emotional investing driving the crowd, look for the opportunities that volatility provides and stick to a long term investment strategy.

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.