Olivers Insights

Introduction

After hitting an almost seven year low of $US0.6827 in January the Australian dollar has rebounded by 12% or so hitting a high of $US0.7680. The rebound begs the question as to what is driving it and more fundamentally whether the 38% decline from its 2011 high against the US dollar has now run its course. This note looks at the main issues and what it means for investors.

Why the rebound?

A classic aspect of investing is to be wary of the crowd. When investor sentiment and positioning in an asset reaches extremes it often takes only a slight change in the news to drive a big reversal in the asset’s price. And so it is with the Australian dollar. After its large fall to below $US0.70 big speculative short (or underweight) positions had built up. This coincided with a lot of talk about a “big short” in Australian property, banks and the $A. This can be seen in the next chart.

Source: Bloomberg, AMP Capital

And then over the last month or so the news for the Australian dollar has turned more positive with commodity prices bouncing back (from their recent lows oil is up 50%, copper is up 15% and iron ore is up 45%), the Fed sounding more dovish and delaying rate hikes which has pushed the $US down generally and Australian economic growth holding up well. The combination of a more dovish Fed and better Australian data has seen a widening in expected interest rate differentials between Australia and the US, which makes it relatively more attractive to park money in Australia. So with more positive news on Australian export earnings and the relative interest rate in favour of Australia, speculators and traders have closed their short positions and the Australian dollar has rebounded.

More broadly the rebound in the $A has been part of a return to favour by growth assets since January/February that has seen shares, commodities, corporate debt and growth sensitive currencies rebound as worries about a global recession receded. This is often referred to as “risk on”.

Will the rebound in the $A be sustained?

In the very short term the $A could still go higher yet as long positions in it are still not extreme and the Fed’s new found dovishness could linger. A rise to $US0.80 is possible. However, it’s premature to say that the $A has seen its lows and the trend is now up. In fact my view remains that the trend is still down. First, just as the long term upswing in the value of the $A from $US0.48 in 2001 saw multiple setbacks, including a 39% plunge in 2008, on its way to the 2011 high of $US1.10 the secular down trend that started in 2011 is likely to have several reversals too. There will always be short term/cyclical swings.

Second, the recent rally looks a bit like the 9% short covering rally that occurred in early 2014. After falling through parity in 2013 the $A hit a low of $US0.8660 in January 2014 by which time large short positions had been built up. These were then closed as the RBA saw it prudent to opt for an extended “period of stability” in interest rates and commodity prices bounced higher which pushed the $A up and left it stuck around $US0.94 for five months. Once short positions had reversed, commodity prices resumed their downswing and it looked like the RBA would have to cut rates again the $A resumed its downswing.

Third, fundamental drivers still point south for the $A:

• Commodity prices – while the worst is probably behind us, commodity prices likely remain in a long term, or secular downswing thanks to a surge in supply after record investment in resources for everything from coal and iron ore to gas and slower global demand growth. As can be seen in the next chart raw material prices trace out roughly 10 year long term upswings followed by 10 to 20 year long term bear markets. This long term cycle largely reflects the long lags in supply adjustments.

  

  Source: Global Financial Data, Bloomberg, AMP Capital

  Plunging prices for commodities have resulted in a collapse in Australian export prices and hence our terms of trade and this weighs on the value of the $A. This is highlighted by the iron ore price which at the start of last decade was below $US20/tonne rising to over $US180/tonne in 2011 and is now running around $US55/tonne.

• Interest rates – the interest rate differential in favour of Australia is likely to continue to narrow, making it relatively less attractive to park money in Australia as part of the so-called “carry trade”. While Fed hikes have paused recently in response to global growth worries, they are likely to resume at some point this year in line with the so-called “dot plot” of Fed officials interest rate expectations pointing to two 0.25% hikes this year.

  Meanwhile, although it’s a close call we remain of the view that the RBA will cut interest rates again in the months ahead: as mining investment continues to unwind; the contribution to growth from the housing sector via building activity and wealth effects starts to slow over the year ahead making it critical that $A sensitive sectors like tourism and education are able to fill the gap; to offset possible further out of cycle bank interest rate hikes; and as inflation remains at the low end of the target range. The strengthening $A also adds to the case for another rate cut.

A final critical driver of the Australian dollar is the US dollar itself – but it has become more ambiguous. The ascent of the US dollar from 2011 was a strong additional drag on the $A both directly and via its impact on commodity prices. However, it also added to concerns about the emerging world (as a rising $US makes it harder to service US dollar denominated loans raising the risk of some sort of financial crisis) and as a rising $US constrains US economic growth, doing part of the Fed’s job for it. Consequently, the sharp upwards pressure on the value of the $US may have run its course. But with the Fed still gradually tightening a sharp fall in the $US is unlikely either. Rather it’s likely to track sideways.

Source: Bloomberg, AMP Capital

$A likely to resume its downswing

So while the big picture outlook for the $US has turned neutral, the combination of soft commodity prices and the relative interest rate differential between Australia and the US set to narrow point to a resumption of the downtrend in the $A in the months ahead. How far it may fall is impossible to tell. One guide is via what is called purchasing power parity (PPP), according to which exchange rates should equilibrate the price of a basket of goods and services across countries. The next chart shows the $A/$US rate against where it would be if the rate had moved to equilibrate relative consumer price levels between the US and Australia since 1900.

Source: RBA, ABS, AMP Capital

Right now the $A is around fair value on this measure of $US0.75. But it can be seen from the chart that the $A rarely stays at the purchasing power parity level for long and is pushed to extremes above and below. Right now the commodity down cycle is likely to push the $A to overshoot fair value on the downside. In a way this could be seen as making up for the damage done to the economy during the period above parity. This is likely to take the $A towards $US0.60 on a 12 month horizon.

Implications for investors

There are a several implications for investors. First, the likely resumption of the downtrend in the $A highlights the case for Australian based investors to maintain a decent exposure to offshore assets that are not hedged back to Australian dollars (ie remain exposed to foreign currencies). Put simply, a declining $A boosts the value of an investment in offshore assets denominated in foreign currency one for one. This has been seen over the past five years to February where the fall in the value of the $A turned a 7.1% pa return from global shares measured in local currencies into a 12.9% pa return for Australian investors when measured in Australian dollars.

Second, having an exposure to foreign currency provides a useful hedge for Australian based investors in case we are wrong and the global growth outlook deteriorates significantly. The $A invariably falls (and foreign currencies rise) in response to weaker global growth.

Finally, the fall in the value of the $A to levels that offset or more than offset Australia’s relatively high cost levels is very positive for sectors that compete internationally including manufacturing, tourism, higher education, agriculture & miners. This in turn should continue to help the economy weather the mining downturn and is in turn positive for the Australian share market. Roughly speaking each 10% fall in the value of the $A boosts company earnings by 3%.

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.

Uncertainty regarding China has been a factor behind global growth worries and share market volatility since mid last year. Put simply the combination of a reversal of gains in Chinese shares, a fall in the Renminbi and uncertainty about the intentions of Chinese policy makers at a time of slowing Chinese growth have fanned fears China was heading for the “hard landing” that China bears have long predicted. The hard landing story for China has been around for as long as I have been analysing it and I suspect at the core of the China bears’ beliefs in it is scepticism that a so-called “communist” country can do well. But while Chinese growth has slowed the hard landing is yet to eventuate. This note looks at the main issues.

Five key themes of relevance to China at present

There are five key themes of relevance to China at present:

• Transition from manufacturing and investment to services and consumption. This is the long talked about rebalancing of the Chinese economy. As can be seen in the next chart the rising importance of the services sector started 20 years ago at the expense of primary production. Since 2010 it has come at the expense of manufacturing.

Source: Thomson Reuters, AMP Capital

• Sustainable growth over growth at any cost. Hence the focus on combating corruption & pollution, boosting growth in inland provinces, trying to wind back industries with excess capacity and the incremental approach to economic stimulus as opposed to the 4 trillion Renminbi GFC stimulus.

• A rapidly aging and slowing population. Thanks to the one child policy China’s working age population is now falling and the proportion of people aged 65 and over is rapidly rising. While there is now a two child policy it’s doubtful urban couples will want two children as attitudes have changed. This all means that China’s potential growth rate is slowing and more dependent on continued urbanisation (which at 56% is still low) and productivity.

• Reform aimed at avoiding the middle income trap. The Chinese Government is clearly aware of the “middle income trap” which has set in for many South American and some Asian countries where after an initial phase of rapid industrialisation, strong wage growth and slowing productivity see them trapped as middle income countries. It wants to avoid it by economic reform to boost productivity and move into higher value add production. Critical on this front are rural reform to remove subsidies, reforming state owned enterprises, financial sector reform, “Hukou” reform to make it easier for people to move around the country and welfare/tax reform. Progress on these has been mixed.

• Balancing growth and reform. However, at the same time the Chinese Government has little tolerance for social unrest that would flow from job losses that would occur if growth slows too quickly. So the reform process can often look like two steps forward and one step back when it looks like “free market forces” risk threatening economic growth. Recent examples of this include the intervention to support the share market and using foreign exchange reserves to prevent a sharper fall in the value of the Renminbi. More broadly, the focus has now swung back towards providing stimulus to help support growth. Since November 2014 there have been six interest rate cuts and the budget deficit is targeted to rise to 3% of GDP this year.

Source: Thomson Reuters, AMP Capital

Implications and growth outlook

There are a number of implications that flow from all of this.

First, China won’t be the source of growth in commodity demand it once was with the focus shifting to services. This is where the big opportunities in China will be going forward.

Second, old guides to growth in China – such as industrial production and electricity consumption (what some China bears focus on to support their hard landing thesis) are less relevant as services become the focus.

Third, the steep learning curve associated with deregulation will sometimes lead to uncertainty – as seen with the share market and Renminbi in the last year. Bear in mind though that western countries went through a similar steep learning curve when they were deregulating in the 1980s at a time when their economies were more developed than China is today.

Fourth it is reasonable to expect growth to step down over time, but it should still remain okay. In terms of the latter, Chinese data has yet again started the year on a soft note with softish readings for PMIs, trade, retail sales and industrial production.

Source: Thomson Reuters, AMP Capital

However, this data needs to be treated with caution due to the distortions caused by the timing of China’s Lunar New Year holiday. More importantly stimulus is evident in stronger credit growth and some stabilisation in fixed asset investment. Our assessment is that growth will slow this year to around 6.5% which is not out of line with the Government’s target.

Expect further incremental fiscal and monetary stimulus. Low non-food inflation of around 1% and slowing capital outflows as investors get confident with the PBOC’s management of the Renminbi against a basket of currencies are consistent with there being further scope for monetary easing.

Threats

There are two key threats: property and debt.

• First, after cooling through 2014-15, the Chinese residential property market is picking up again led by Tier 1 cities threatening to renew concerns about a property bubble and potential crash and a continuation of investor see-sawing between shares and property.

  

  Source: Bloomberg, AMP Capital

  However, it’s worth noting that while property remains oversupplied in some cities this is not the case in first tier cities (Beijing, Shanghai, etc), household debt remains low at around 38% of GDP and it’s likely that renewed policies will be put in place in relevant cities to keep gains calm.

• The rapid rise in total debt of 20% pa over the last decade is a concern. While household and public debt in China are relatively low, corporate debt at around 160% of GDP on some measures is now very high. See the next table. Rapid debt growth can often bring problems in terms of rising bad debts and a period of deleveraging.

  

  * Includes local gov’t debt. Source: IMF, McKinsey, AMP Capital

  However, Chinese officials recognise the problem and there are some offsets that may make China’s debt accumulation less dangerous than it appears. First, strong growth in debt reflects China’s 46% savings rate with savings mainly being recycled via the banks and hence as debt. The solution is to reduce savings over time and channel more of that saving into equities rather than through banks as debt. This of course requires ongoing development of China’s share market to make it more stable and attractive to investors and this will take time. Lowering lending without first doing this will just risk recession and deflation. Second, China is only borrowing from itself not from foreigners so it’s a long way from the sort of problems that go with foreign debt. Third, problems associated with excessive local government borrowing appear to be being resolved by allowing such debt to be swapped into bonds, which will entail much reduced borrowing costs and longer maturities. Finally, given heavy state ownership corporate debt partly reflects an element of fiscal policy and would be subject to Government support in the event of a problem.

Our assessment remains that these risks are manageable. Much of what goes on in China is controlled by the Government and it has plenty of firepower to ensure growth holds up.

The Chinese share market

Chinese shares have been on a bit of a roller coaster over the last few years, with the Shanghai composite rising 163% from its 2013 low to last June’s high before falling 49% to its recent low. While the volatility is unnerving, it is very hard to argue Chinese shares are expensive. Chinese mainland (or A shares) trade on a forward PE of 12 times, compared to around 15 times for Australian shares, and Chinese shares listed in Hong Kong (or H shares) trade on a forward PE of around 6 times. In fact H shares are very cheap across most valuation indicators and across most sectors. While it may take a while for the dust to settle after the volatility of the last year in terms of the impact on investor confidence in Chinese shares, they should provide good medium term returns if we are right and Chinese growth remains solid.

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.

To modify Benjamin Franklin, it seems that in Australia nothing can be said to be certain, except death, taxes and endless debate about property prices. Why is it so unaffordable? Are foreigners to blame? Is it a good investment? Is negative gearing the problem? Are property prices about to crash?

Worries about a property crash have been common since early last decade. In 2004, The Economist magazine described Australia as “America’s ugly sister” thanks in part to a “borrowing binge” and soaring property prices which had seen it become “another hotbed of irrational exuberance”. At the same time the OECD estimated Australian house prices were 51.8% overvalued. Since the GFC, predictions of an imminent property crash have become more common with talk that a property crash will also crash the banks and the economy.

Our view since around 2003 has been that overvaluation and high levels of household debt leave the housing market vulnerable. As such it could be seen as Australia’s Achilles heel. However, in the absence of a trigger it’s been hard to see a property crash as a base case. Not much has really changed. This note takes a look at the key issues and what it means for investors.

Overvalued, over loved and over indebted

The two basic problems with Australian housing are that it is expensive and household debt is high. Overvaluation is evident in numerous indicators:

• According to the 2016 Demographia Housing Affordability Survey the median multiple of house prices in cities over 1 million people to household income is 6.4 times in Australia versus 3.7 in the US and 4.6 in the UK. In Sydney it’s 12.2 times and Melbourne is 9.7 times.

• The ratios of house prices to incomes and rents are at the high end of OECD countries and have been since 2003.

• Real house prices have been above trend since 2003.

Source: ABS, AMP Capital

The shift to overvaluation more than a decade ago went hand in hand with a surge in the ratio of household debt to income, which took Australia’s debt to income ratio from the low end of OECD countries to now being around the top.

Source: ABS, RBA, AMP Capital

Overvaluation and high household debt are central elements of claims that Australian house prices will crash. These concerns get magnified whenever there is a cyclical surge in prices as we have seen recently in Sydney and Melbourne.

But a crash seems elusive

However, given the regularity with which crash calls for Australian property have been made over the last decade and their failure to eventuate, it’s clear it’s not as simple as it looks.

First, the main reason for the persistent “overvaluation” of Australian home prices relative to other countries is constrained supply. Until recently Australia had a chronic under supply of over 100,000 dwellings, as can be seen in the next chart that tracks housing completions versus underlying demand. Completions are at record levels but they are just catching up with the undersupply of prior years.

Source: ABS, AMP Capital

Consistent with this, vacancy rates while rising are below past cycle highs. In fact, in Sydney they are still quite low.

Source: Real Estate Institute of Australia, AMP Capital

Secondly, Australia has not seen anything like the deterioration in lending standards other countries saw prior to the GFC. There has been no growth in so-called low doc and sub-prime loans which were central to the US housing crisis. In fact in recent years there has been a decline in low doc loans and a reduction in loans with high loan to valuation ratios. See the next chart. And much of the increase in debt has gone to older, wealthier Australians, who are better able to service their loans.

Source: APRA, AMP Capital

Third, and related to this, there are no significant signs of mortgage stress. Debt interest payments relative to income are low thanks to low interest rates. See the next chart.

Source: RBA, AMP Capital

By contrast in the US prior to the GFC interest rates were starting to rise. Yet in Australia bad debts and arrears are low. While new loan sizes have increased, Australians seem focussed on cutting their debt once they get it.

Finally, while some seem to think that because property prices in mining towns like Karatha are now crashing this is a sign that other cities will follow. This is non-sensensical. Property prices in mining towns surged thanks to a population influx that flowed from the mining boom. This is now reversing. Perth and Darwin are also being affected by this but to a less degree. By contrast the surge in property prices in cities like Sydney and Melbourne that occurred into early last decade predated the mining boom and their latest gains largely occurred because the end of the mining boom allowed lower interest rates.

The current state of play

Our assessment is that the boom in Sydney and Melbourne is slowing thanks in large part to APRA’s measures to slow lending to property investors. However, house price growth is likely to remain positive this year. Price growth is likely to remain negative in Perth and Darwin as the mining boom continues to unwind. Hobart & Adelaide are likely to see continued moderate property growth, but Brisbane may pick up a bit. Nationwide price falls are unlikely until the RBA starts to raise interest rates and this is unlikely before 2017. And then in the absence of a recession or rapid interest rate hikes price falls are more likely to be 5-10% as was seen in the 2009 and 2011 down cycles rather than anything worse.

Source: CoreLogic RP Data, AMP Capital

What to watch for a property crash?

To see a property crash – say a 20% average fall or more – we probably need to see one or more of the following:

• A recession – much higher unemployment could clearly cause debt servicing problems. At this stage a recession looks unlikely though.

• A surge in interest rates – but the RBA is not stupid; it knows households are now more sensitive to higher rates.

• Property oversupply – this is a risk but would require the current construction boom to continue for several years.

Implications for investors

There are several implications for investors:

• While housing has a long term role to play in investment portfolios it is looking somewhat less attractive as a medium term investment. It is expensive, offers very low income (rental) yields compared to all other assets except bank deposits and Government bonds and it’s vulnerable to possible changes to taxation arrangements around property.

• There are pockets of value, eg in regional areas. You just have to look for them.

• As Australians already have a high exposure to residential property (directly and via bank shares and property trusts), there is a case to maintain a decent exposure to say unhedged global shares because it could provide an offset if it turns out I am wrong and the Australian property market does have a crash.

AMP Capital Markets 2nd March 2016

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

The Australian economy performed better than expected in 2015. The mining boom ended around four years ago and yet the Australian economy has still not fallen into the recession that many feared, with non-mining activity helping the economy continue to grow. In fact at 3% GDP growth through 2015, Australian was a star performed compared to the US with 1.9%, the Eurozone with 1.5% and Japan with 0.5%. This note looks at the outlook and what it means for investors.

Growth perks back up to 3%

December quarter growth was a stronger than expected 0.6% quarter on quarter as strength in consumer spending, public spending, dwelling investment and inventories more than offset weakness in business investment and a zero contribution from trade volumes. This combined with an upwards revision to September quarter growth pushed growth for the year to December up to 3%.

Source: ABS, AMP Capital

Looking ahead the drag on growth from the unwind of mining investment is set to continue, with the latest business investment (capex) plans from the ABS point to mining investment falling at the rate of 35% or so over this financial year and next and continued softness in investment overall. This is knocking around 1 percentage point off annual economic growth. While slumping mining investment is no surprise what is concerning is that the outlook for non-mining investment remains weak. Taken together the investment outlook remains poor – although not quite as weak as the next chart suggests as the ABS capex plans exclude several key stronger sectors of the economy (like health) and tend to exaggerate weakness.

Source: ABS, AMP Capital

More broadly, several other factors are likely to weigh on growth going forward, including: steep falls in commodity prices that continue to cut into national income growth; household reluctance to take on more debt; and subdued levels of confidence. And peaking building approvals point to a slowing contribution to growth from housing construction in 2016-17, at the same time that mining investment will be continuing to fall.

As a result of these considerations economic growth is likely to slip back to around 2.5% over the year ahead.

Reasons not to be gloomy

However, apart from the reality of growth holding up despite the mining boom ending several years ago, there are several other reasons not to be gloomy on Australia.

• First, consumer spending is growing at 2.9% supported by borrowing rates at generational lows (don’t forget that Australian’s owe the banks about $1.3 trillion more than the banks owe them – so the household sector remains a net beneficiary of low interest rates), the fall in petrol prices is saving the average household about $15 a week compared to two years ago and the support from a relatively high household savings rate.

• Second, the fall in the $A is a big positive for manufacturing, tourism, higher education, services, farming and mining. Export earnings from tourism and higher education are running at record levels after earlier getting flattened by the surge in the $A to above parity.

  

  Source: ABS, AMP Capital

• Third, Australia managed the boom better than it has in the past when booms led to inflation or trade deficit blow-outs or both and all sectors of the economy boomed together and went bust together. This time there was no major build-up of imbalances in the economy and sectors suppressed by the mining boom have bounced back.

• Consistent with this, while growth in the resource rich states of WA and NT has crashed, it’s strong in the population rich states of NSW and Victoria. Annual growth in state final demand is running at 3.3% in NSW and 4.6% in Victoria compared to -4.7% in WA and -17.7% in NT.

• Finally, by mid next year mining investment as a share of GDP will have fallen to around 2% from its boom time peak of near 7%, meaning that the mining investment boom and its drag on growth will largely be behind us.

Source: ABS, AMP Capital

More help from the RBA may still be needed

This should all mean that the risk of a recession remains relatively low. However, with growth likely to slip back to around 2.5% this year (which is less than anticipated by the RBA) and inflation likely to remain low we remain of the view that the Australian economy will require further help. As such, we continue to expect that the RBA will cut the cash rate again in the months ahead. However, with growth exceeding expectations last year and the job market holding up well it’s now a close call.

Profits reflect the economy – better than feared

The just completed December half profits reporting season provided a good reflection of the state of the economy:

• Overall results were much better than feared. 47% of results have bettered expectations (against a norm of 44%) with only 20% coming in worse than expected (against a norm of 25%);

• 64% have seen profits up on a year ago;

• 62% have raised their dividends (which is in line with the norm). While the big miners are cutting their dividends this is hardly a surprise and in any case BHP is now just 4% of the market and RIO just 1.5%.

• While resources profits are likely to fall 65% this financial year, most of the big banks are seeing reasonable results and stocks exposed to the Australian economy, led by housing and the consumer, are doing well.

• The better than feared nature of the results has been reflected in 65% of stocks seeing their share price outperform the market the day results were released.

Source: AMP Capital

Overall profits are likely to fall around 5% this financial year, but outside of resources, profits are rising modestly. The continuing low Australian dollar and low interest rates will help

Source: UBS, AMP Capital

Implications for investors

With Australian economic growth likely to slow back to around 2.5% interest rates are set to remain very low and likely to fall further. So bank deposits are likely to continue to provide low income flows.

However, there remains no need to get too gloomy on the outlook for Australian assets. The economy is likely to avoid recession as growth continues to gradually rebalance.

While the Australian share market ran ahead of itself early last year, pushing up to just below 6000, the slump we saw early this year saw it overshoot on the downside. We continue to see the Australian share market being significantly higher by year end.

AMP Capital Markets 2nd March 2016

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 US election – populists versus the establishment

First some facts. The election year, or Year 4 in the 4-year US presidential cycle, is normally an ok year for US shares. However, when it is in the eighth year of a presidency it has been poor with an average loss of -3.4% since 1927, albeit this is pushed down by the -37% outcome due to the GFC in 2008.

Source: Bloomberg, AMP Capital

Historically, US shares have actually done better under Democrat presidents with an average return of 15.4% pa since 1945 compared to an average return over the same period under Republican presidents of 10.5% pa.

US elections themselves show little sign of having a major impact on share markets. See the next slide, which shows the US share market performance from a year before till a year after all presidential elections since 1976. Of course, the share market around the 2008 election was dominated by the GFC.

Source: Thomson Financial, AMP Capital

This election is looming as significant for markets given the success of populist candidates – notably Donald Trump on the Republican side and to a lesser degree Bernie Sanders in the Democrats – which raises the risk of a less business and less market-friendly president. Bernie Sanders is left wing and he and Trump tend to be anti-free trade and tough on banks/Wall Street. A populist Republican like Ted Cruz may also be less inclined to intervene to support the economy in the event of a crisis. Against this, even if a populist does get up as president, the centrist or status quo dominance of the broad rump of Republicans and Democrats in Congress (with Republicans likely controlling both houses) should limit the power of the president to enact extreme or less market friendly policies. More importantly, it’s not clear the populists will get up anyway. Hillary Clinton appears to be beating Sanders. Meanwhile, Trump is winning but his vote appears stuck around 30-45%, meaning that most Republicans are voting for other candidates. As the Republican field narrows, it’s likely that the GOP establishment will swing in behind the last remaining candidate (likely to be Marco Rubio). Time will tell. March 1 or Super Tuesday is the next big day to watch in the primaries, but it’s likely that the contest in November will be between two establishment candidates (Clinton v Rubio?) who by then will have migrated to the centre of US politics in order to win with nowhere near the policy differences that are currently getting an airing. In time, a Clinton presidency is likely to drift to the centre given the reality of US politics with Republican control of Congress (just like Bill Clinton did in the 1990s) so a market unfriendly outcome is unlikely. There could be a few scares along the way though.

Brexit – should we stay or should we go?

Following the European Union agreement on the “special status” of the UK in Europe, the date for the Brexit referendum has been set as June 23rd. A vote to leave would be seen as a big negative for the UK given the threat it would pose to its access to EU markets, its financial sector and labour mobility. The size of this impact would depend on what sort of exit is negotiated with the EU but has been variously estimated at somewhere between -0.6% and -2.8% of UK GDP, which would also adversely affect UK assets (which explains sterling’s recent fall). However, Britain is not in the Eurozone currency union so a Brexit would not pose the existential threat to it that, say, a Grexit has in recent times. However, the real risk would be if a Brexit emboldened support for Marine Le Pen in France and a push towards a Frexit (French exit). This would seriously threaten the EU and the Eurozone (as France is a member of both). It seems unlikely though given the role of France and Germany at the core of the European Union and the Eurozone currency union. Polls suggest a Brexit is too close to call although I lean towards a stay vote.

Populism in Europe

The Eurozone is riven with political issues that occasionally flare up and cause market scares on fears that they might trigger a break-up of the Euro. High unemployment post the sovereign debt crisis is a key driver of increased support for populist parties & it’s been pushed along by the migration crisis.

• Spain is likely headed towards another election after the unclear result from its December election and the push for independence from Catalonia is yet to be resolved. However, Spain is not Greece. First, 65% of the electorate voted for pro-Euro parties in the December election so a Spexit (Spanish exit from the Euro) is not on the agenda. Second, left wing Podemos got only 21% of the vote leaving it a long way from being able to govern in contrast to Syriza in Greece. Unlike in Greece, much of the heavy lifting on reforms has already been done in Spain. Finally, the Catalonian issue could drag on for a while as a majority of Catalans don’t appear to support independence and constitutional issues will make a move out of Spain difficult.

• Greece is likely to continue to see occasional flare-ups with the Government only having a small minority in parliament. So we may not have heard the last of Grexit. Then again, staying in the Euro still has majority support in Greece.

• More broadly, the European migration crisis has seen a rise in support for populist anti-establishment parties. This could subside though given a harder line on immigration from centrist leaders like Angela Merkel.

None of these issues are likely to pose a serious threat to the Euro but the risk will remain if European economic growth slows again and unemployment rises again, triggering a further rise in support for populist parties. As such they are worth watching.

Iran v Saudi Arabia, IS versus them all

The Middle East has long been an area of tension and conflict. In recent times the dynamics have changed as the US has “pivoted” to Asia and trade bans on Iran have been eased or removed. As a result, a long-time tension between Sunni Saudi Arabia and Shia Iran has come to the fore. The defeat of IS could worsen this tension as it will further entrench Iran’s influence on Iraq along Saudi Arabia’s border. This in large part explains why OPEC has fallen apart as Saudi Arabia has sought to maintain its market share versus its Shia rivals of Iran and Iraq. All of which means that Saudi Arabia won’t be cutting back on its oil production anytime soon. At the same time Iran is ramping up its own oil production. None of which is good for the oil price. Against this. though, even though Saudi Arabia has been ramping up its defence spending as the US commitment in the region has declined, direct conflict between Saudi Arabia and Iran still looks unlikely.

Meanwhile the terror threat from IS remains and could intensify if it looks like being defeated in Iraq and Syria. Then again, the world has become used to this with the impact on financial markets of terrorist attacks since 9/11 seemingly declining.

South China Sea

Tension over disputed islands in the South China Sea involving China have been brewing for years. At its core, China feels a bit blocked in by the geography of the South China Sea and, as a rising geopolitical power, is seeking to flex its muscles and take a stand on the issue. Of course, this falls foul of its neighbours who also have claims on the islands and the declining geopolitical power, the US, which would prefer to contain China and of course guarantee sea traffic through the disputed area. Hopefully, common sense prevails but the risk of an escalation or occasional flare-up in this dispute is clearly there.

Australian election

Compared to all these issues, the Australian Federal election – which is due to be held later this year, but could come earlier – is likely to be relatively tame. So far, not enough has been released in terms of the campaign policies of the major parties. Perhaps the big disappointment in the last few weeks is that the debate around tax reform seems to have degenerated yet again into tit for tat scare mongering rather than focussing on visionary fundamental reform. However, two things are worth noting. First, Labor seems more focussed on addressing the budget deficit by looking for pots of money to raise revenue from (such as via curtailing access to negative gearing and the capital gains tax discount), whereas the Coalition still looks to be more focussed on containing government spending and using any wind back in tax concessions to cut income tax. Second, changes to Senate voting procedures (that will have the effect of cutting back on minor party representation) could have the effect of making the Senate and hence the business of government in Australia far more effective. In other words, Australia is one country where the populist influence could end up being substantially curtailed.

Historically, Australian shares have performed better under Coalition governments (with an average return of 12.7% pa since 1945) than under Labor (with an average 10.7% pa). During the last 30 years, Australian shares have generally risen after Federal elections. This is evident in the next chart, which shows Australian share prices from one year before till 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 1987 global share crash and the start of the global financial crisis in 2007). What is clear is that after elections shares tend to rise more often than they fall.

Source: Thomson Financial, AMP Capital

Implication for investors

Politics is looming large as an issue for investors this year. The bulk of the issues identified here should ultimately turn out okay for investors, but it’s worth keeping a close eye on them.

AMP Capital Markets 25th February 2016

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

News that the Australian share market as measured by the ASX 200 index briefly slipped into bear market territory last week as defined by a 20% decline from the most recent high – which in this case was April last year – has generated much coverage and interest and understandable concern. This note takes a look at what bear markets are, how deep & long they have been and points out that they are not all of the big bad grizzly variety.

What’s a bear market?

Unfortunately there is no agreed definition of a correction versus a bear market – and certainly no “official” who makes declarations on this. My preferred approach is that a correction is limited to sharp falls, across a few months after which the rising trend in share prices resumes, taking shares back to new highs within say six months of the low. By contrast, a bear market sees falls lasting many months or years with a pattern of falling lows and highs and it takes shares a year or more to regain new highs.

A common approach is to use a 20% or more decline to delineate a bear market from a correction. Of course this is rather arbitrary – and right now it puts the ASX 200 as having entered a bear market (because it fell 20% from its high in April last year to its low last week), but not the broader All Ordinaries index which has “only” had a 19% fall. But I guess the line has to be drawn somewhere.

How long do Australian bear markets last?

The following table shows bear markets in Australian shares since 1900 using the 20% rule.

Bear markets in Australian shares since 1900

Based on the All Ords, excepting the ASX 200 for the latest. I have defined a bear market as a 20% or greater fall in shares that is not fully reversed within 12 months. Source: Global Financial Data, Bloomberg, AMP Capital

Since 1900, Australian shares have seen 17 bear markets. These have lasted an average 18 months with an average top to bottom fall of 33%. It’s then taken an average 37 months to exceed the previous high, although we are still waiting in relation to the November 2007 to March 2009 bear market. The average gain over the first 12 months following the bear market low has been 29%, highlighting the gains that can be made up front once bear markets end.

Not all bear markets are created equal

Of course this all masks a wide range. The worst bear market was the 1973-74 slump of 59%, which lasted 20 months, as stagflation (ie recession and high inflation) took hold in the Australian economy. This was followed by the global financial crisis driven slump of 55% that lasted 15 months. The 1987 crash saw a 50% plunge over two months and the Great Crash of 1929-31 saw a 46% plunge.

At the other extreme there’ve been several bear markets of just over 20% including those of 1994-95, 2002-03 and 2011. In fact of the 17 bear markets since 1900, 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, recently called these Gummy bears and Grizzly bears respectively and since it’s a useful way to think of it I will stick to the same terminology.

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

What determines how deep bear markets are?

Because of the role played by investor sentiment and the risk that it can make bear markets somewhat self-feeding there is no definitive answer to this. However, the next table provides some guide. The first two columns show bear markets since 1900 and the size of their falls. The third shows the percentage change in share prices 12 months after the initial 20% decline. The fourth indicates whether they are associated with a recession in the US, Australia or both. The fifth column shows associated top to bottom falls in profits and the final column shows a measure of share market valuation at the start of bear markets. Worse than average bear markets are in red.

Contributors to the depth of bear markets in Aust shares

Based on the All Ords, excepting the ASX 200 for the latest. I have defined a bear market as a 20% or greater fall in shares that is not fully reversed within 12 months. Source: Global Financial Data, Bloomberg, AMP Capital

Several observations can be made.

First, the deeper Grizzly bear markets are invariably associated with recession, whereas the milder Gummy bear markets and even the rather short (but shocking) 1987 share market crash tend not to be. Just less than half of the Gummy bears saw a recession compared to five of the six Grizzly bears.

Second, although we don’t have earnings data prior to the 1960s, the deeper Grizzly bears tend to be associated with sharp declines in company profits, notably those of the early 1970s, early 1980s and GFC bear market. By contrast the milder bear markets such as those beginning in 1964, 1976, 1994 and 2011 often see less earnings weakness.

Finally, valuations are not definitive but they appear to play a role. To give a guide to valuation I have compared share prices to a rolling 10 year moving average of earnings because it corrects for cyclical swings in profits (this is referred to as the Shiller PE or cyclically adjusted PE) and then added the inflation rate to because when inflation is high PEs tend to be lower and when inflation is low PEs tend to be higher. Basically the higher this measure is the more expensive shares are. The next chart shows this measure since the 1970s with vertical lines indicating the start of bear markets. Bear markets starting in 1980, 1987, 2003 and 2007 all began with higher readings than average (24.8). Grizzly bears started with an average reading of 30 versus an average of 28 for Gummy Bears suggesting there is not much in it but that it may be factor.

Vertical lines show the start of bear markets. Source: RBA, AMP Capital

Implications for investors

Out of the 17 bear markets in Australian shares since 1900, 11 have moved higher over the 12 months following a 20% decline, suggesting that based on history there is a 65% probability that shares will move higher over the year ahead.

Factors that play a role in determining whether a much deeper bear market may occur are: whether Australia or the US have a recession, whether there is a sharp fall in earnings and albeit with less reliability valuations. In regards to these:

• Our view remains that the US is unlikely to experience a recession given the lack of prior excesses (in terms of cyclical spending, debt growth or inflation) and the absence of significant monetary tightening.

• In Australia, we continue to see growth tracking along at around 2.5% pa, with recent economic indicators broadly consistent with this.

• On the earnings front, resources earnings have already crashed 80% or so and at 10% of the overall market their ability to do further damage is limited. Meanwhile, the profit reporting season underway suggests profit growth in the rest of the market is meandering along at around 5%.

• Finally, the cyclically adjusted PE + inflation valuation measure at 21 when the current bear market started was at the low end of the range for the start of past bear markets and at 18 now is close to as low as it ever gets.

These considerations provide some hope that Australian shares will be higher rather than lower in a year’s time. The main risk is that gloom and doom about the global outlook become self-fulfilling, dragging shares lower. The historical experience suggests that there is a limit to this though and global central banks seem to be awakening to the risks and so are moving in the direction of seeking to stabilise financial conditions.

AMP Capital Markets 18th February 2016

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.