Olivers Insights

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.

The malaise affecting equity markets and risk assets generally has shown no let up with Australian shares slipping into bear market territory yesterday (defined as a 20% or greater decline from the most recent high). In some ways it is reminiscent of 2008 with tightening credit markets, bank shares under pressure and worries central banks are powerless.

From their highs last year to their latest lows US shares have now had a fall of 13%, Australian shares -20%, Japanese shares -25%, European shares -26%, Emerging market shares -27% and Chinese shares -49%. So Australia is not alone – in fact the drivers of the fall from last year’s high are global and many markets have had deeper falls. With global growth worries likely to linger we could still see more downside in the short term. However, a critical differentiator between whether that further downside is say 5-10% and short versus say another 25% and drawn out is likely to be whether the US/global economy has a recession and whether central banks can provide more helpful policy support.

Fault lines in the global economy

What started in January as mainly China based worries has clearly broadened back out to concerns about global growth. At its core there are five fault lines running through the global economy. The first is the malaise in emerging markets that began earlier this decade, with Brazil and Russia in recession. The second is the ongoing concern about China and its intensions regarding the value of the Renminbi. The third is the collapse in commodity/oil prices which is weighing on energy producers and hence business investment, credit markets and driving selling by sovereign wealth funds. The fourth is the strong $US which has made the fall in the oil price worse, raised debt servicing concerns in the emerging world and weighed on the US economy. Finally, there is fear itself as financial market turmoil drives fears that this will cause a global recession (via reduced confidence, lower wealth and tighter credit conditions) which in turn is reinforcing selling pressure and pushing share markets even lower. Worries about banks – and their exposure to energy loans & higher bad debts if there is a recession – seem to be at the centre of this.

These are all feeding on each other to a degree. However, there are some positives: Chinese economic data has been more mixed rather than negative lately; the Renminbi has settled and the $US looks to have peaked; and central banks are becoming more dovish. But I think there are three key issues. How serious is the problem regarding banks? Will the US have a recession? And are central banks out of ammo?

What is the risk of another bank crisis/credit crunch?

While the risks have risen, there are several reasons for believing that a GFC style credit crisis is unlikely. Banks are better capitalised now, US and European bank exposure to energy loans at around 2-4% of total assets is a fraction of their exposure to housing loans (at the centre of the GFC), new restrictions on proprietary trading have limited banks’ exposure to riskier corporate debt and the issues of low transparency and complexity that bedevilled the sub-prime mortgage market are not really an issue in corporate debt markets now. So far we are not seeing any blow out in interbank lending rates.

Is the US economy headed for recession?

This is a critical question as the US share market sets the direction for global shares including the Australian share market and the historical experience tells us that slumps in shares tend to be shallower and/or shorter when there is no US recession and deeper and longer when there is (eg the tech wreck and GFC). See the next table.

Falls in US shares greater than 10% since 1989

Bear markets highlighted in black. Source: Bloomberg, AMP Capital.

A range of considerations have raised the risk of a US recession: December quarter GDP growth slowed sharply; credit spreads (ie, the interest rates on corporate bonds relative to government bonds) have blown out to levels associated with recessions; and falling energy related investment is weighing on manufacturing. But against this:

• US growth has regularly run hot and cold since the GFC.

• We have seen none of the excesses that precede recessions – like excessive growth in private debt, over investment in housing or capital goods, high inflation or a speculative bubble in shares or housing.

  

  Source: Thomson Reuters, AMP Capital

• Some of the softness in recent US economic data has been due to falling energy related investment. But with resource investment having fallen from 0.9% of US GDP to just 0.4% the bulk of the damage from this may already be behind us.

  

  Source: Thomson Reuters, AMP Capital

• While the collapse in oil prices is a big drag on energy producers, it is a huge boost to household spending power. This is very different to the loss of household wealth that flowed from the housing collapse at the centre of the GFC.

• Nor have we moved to an inverted yield curve (where short term interest rates exceed long term interest rates) driven by aggressive monetary tightening like the 17 Fed interest rate hikes seen prior to the GFC. Inverted yield curves have regularly warned of recession.

  

  Source: Bloomberg, AMP Capital

We would put the risk of a US/global recession at around 25%.

Are central banks out of ammo?

This is a common concern with interest rates already at or around zero for major central banks. However, they 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; the ECB could provide more cheap short term funding for banks; both the ECB and Bank of Japan could expand their quantitative easing programs; and quantitative easing programs could be focused on buying corporate debt to bring down corporate borrowing rates. More negative interest rates are also an option but central banks may be wary of this after the negative impact of Japan’s move on banks. Perhaps the ultimate option is for central banks to provide direct financing of government spending or tax cuts.

If credit markets and bank share prices don’t settle down soon many or all of these measures are likely to be adopted with the ECB potentially launching a QE program focussed on buying corporate debt as early as next month.

Meanwhile, the People’s Bank of China (with an official benchmark rate of 4.35%) and the RBA (with an official cash rate of 2%) still have a long way to go before they even have to consider unconventional monetary policies.

What should investors do?

Times like the present are very stressful as no one likes to see the value of their investments decline. Investors need to allow for several things though:

• First, sharp falls are regular occurrences in share markets – we have seen it all before. Shares literally climb a wall of worry over many years with numerous events dragging them down periodically, but with the trend ultimately rising and providing higher returns than other more stable assets.

• Second, selling after a major fall just locks in a loss.

• Third, when shares and growth assets fall they are cheaper and offer higher long term return prospects. So the key is to look for opportunities that the pullback provides – shares are getting cheaper, investment yields on shares and corporate debt are rising. It’s impossible to time the bottom but one way to do it is to average in over time.

• Fourth, while shares may have fallen in value the dividends from the market haven’t. So the income flow you are receiving from a well-diversified portfolio of shares continues to remain attractive, particularly against bank deposits.

  

  Source: RBA, Bloomberg, AMP Capital

• Fifth, shares and other related assets will bottom at the point of maximum bearishness, ie just when you and everyone else feel most negative towards them. So the trick is to buck the crowd. As Warren Buffett once said: “I will tell you how to become rich…Be fearful when others are greedy. Be greedy when others are fearful”.

• Finally, turn down the noise. At times like the present the flow of negative news – via traditional and social media – reaches fever pitch, making it harder to stick to an appropriate long term strategy let alone see the opportunities that are thrown up.

AMP Capital Markets 15th 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

The renewed turmoil in global financial markets on worries about global growth has provided a reminder that we remain in an investment environment of constrained capital growth and high volatility. This has several implications for investors around interest rates and the yield investments provide. First, interest rates are likely to remain low for longer: the Bank of Japan has cut interest rates on excess bank reserves to -0.1%, the ECB is likely to ease further, the Fed is backing away from rate hikes and the RBA is more likely to cut rates than increase them. Second, it reminds us about the importance of the yield an investment provides as opposed to just relying on capital growth. Third, while a fall in the capital value of an investment is unsettling, the cash flow it provides is generally a lot more stable and becomes relatively more attractive during periods of market declines. But what do we mean by yield? Why is it so important? And where can it be found?

What is investment yield?

The yield an investment provides is basically its annual cash flow divided by the value of the investment.

• For bank deposits the yield is simply the interest rate, eg bank 1 year term deposit rates in Australia are around 2.4% and so this is the cash flow they will yield in the year ahead.

• For ten year Australian Government bonds, annual cash payments on the bonds (coupons) relative to the current price of the bonds provides a yield of 2.5% right now.

• For residential property the yield is the annual value of rents as a percentage of the value of the property. On average in Australian capital cities it is about 4.2% for apartments and around 2.8% for houses. After allowing for costs, net rental yields are about 2 percentage points lower.

• For unlisted commercial property, yields are around 6% or higher. For infrastructure investment it averages around 5%.

• For a basket of Australian shares represented by the ASX 200 index, annual dividend payments are running around 5.3% of the value of the shares. Once franking credits are allowed for this pushes up to around 6.9%.

Yield and total return

The yield an investment provides forms the building block for its total return, which is essentially determined by the following.

Total return = yield + capital growth

For some investments like term deposits the yield is the only driver of return (assuming there is no default). For fixed interest investments it is the main driver – and the only driver if bond investments are held to maturity – but if the bond is sold before then there may be a capital gain or loss.

For shares, property and infrastructure, capital growth is a key component of return, but dividends or rental income form the base of the total return. Prior to the 1960s most investors focused on yield, particularly in the share market where most were long term investors who bought stocks for dividend income. This changed in the 1960s with the “cult of the equity”, as the focus shifted to capital growth. It was pushed further through the bull markets of the 1980s and 1990s. Similarly at various points in the cycle real estate investors have only worried about price gains and not rents.

Why yield matters?

In times like the present a focus on the income an investment provides is important. First, with interest rates set to remain low or fall further, bank deposit rates – already at their lowest in Australia since the 1950s – are likely to remain low or go lower. Our view is that further falls are likely as the RBA is likely to cut official interest rates to 1.75% in the next six months on the back of global uncertainties, sub-par growth and benign inflation. This in turn means an ongoing need to understand and consider alternative sources of yield on offer.

Source: RBA, AMP Capital

Second, a high and sustainable starting point yield for an investment provides some security during volatile times like the present. For example since 1900 dividends have provided more than half of the 11.6% total return from Australian shares and as can be seen in the next chart their contribution has been stable in contrast to the swings in the capital value of shares.

Source: Global Financial Data, AMP Capital

Dividends are relatively smooth over time. Companies hate having to cut them as they know it annoys shareholders so they prefer to keep them sustainable.

Finally, as baby boomers retire, investor demand for income will likely be high as the focus shifts to income generation.

Alternatives to term deposits for yield

The chart below shows the yield on a range of Australian investments. Yields on global investments tend to be lower.

Source: Bloomberg, AMP Capital

All of these yields have fallen over the last few years as interest rates have fallen, but as can be seen several of the alternatives do offer much more attractive yields than term deposits

• Australian ten year bond yields are now around 2.5%. This will be the return an investor will get if they hold these bonds to maturity. They can generate a higher return if yields continue to fall, but they are already very low. Global bond yields are lower, averaging around 1%.

• After the house price boom of the past twenty years the rental yield on capital city houses is just 2.8% and that on apartments is around 4.2% and even lower after costs.

• Corporate debt is an option for those who want higher yields than term deposits but don’t want the volatility of shares. For Australian corporates, investment grade yields are around 6.5% or less and lower quality corporate yields are higher. Sub investment grade corporate bond yields in the US are actually now yielding around 9% as worries partly about loans to energy companies have pushed them higher.

• Following the turmoil of the GFC Australian real estate investment trusts (A-REITs) have refocussed on their core business of managing buildings, collecting rents and passing it on to their investors, with lower gearing. While their distribution yields have declined as rental growth has not kept up with total returns of 15% over the last 5 years, they are still reasonable at 4.8%.

• Unlisted commercial property also offer attractive yields, around 6% for a high quality well diversified mix of buildings, but higher for smaller lower quality property. And it doesn’t suffer from the overvaluation of residential property.

• Unlisted infrastructure offers yields of around 5%, underpinned by investments such as toll roads and utilities where demand is relatively stable.

• Australian shares also fare well in the yield stakes. The grossed up dividend yield on Australian shares at around 6.9% is well above term deposit rates meaning shares actually provide a higher income than bank deposits. In fact the gap is now back to levels seen during the GFC.

Source: Bloomberg, RBA, AMP Capital

Investing in shares of course entails the risk of capital loss. But a way to minimise this risk is to focus on stocks that provide sustainable above average dividend yields as the higher yield provides greater certainty of return. The next chart compares initial $100,000 investments in Australian shares and one year term deposits in December 1979. The term deposit would still be worth $100,000 (red line) and last year would have paid $3200 in interest (red bars). By contrast the $100,000 invested in shares would have grown to $1.04 million (blue line) and would have paid $50,770 in dividends before franking credits (blue bars). The point is that dividends tend to grow over time (because an investment in shares tends to rise in value) and to be relatively stable compared to income from bank deposits which vary with interest rate settings.

Source: RBA, Bloomberg, AMP Capital

Key issues for investors to consider

While there is a strong case for investors to focus on investments offering a decent yield there is no such thing as a free lunch. All of the alternatives come with a risk of volatility in the value of the underlying investment. In the case of shares the key for an investor is to work out whether they want a stable value for their investment in which case bank deposits win hands down or a higher/more stable income flow in which case Australian shares win hands down.

More broadly, in searching for a higher yield investors need to keep their eyes open. It’s critical to focus on opportunities that have a track record of delivering reliable earnings and distribution growth and are not based on significant leverage. In other words make sure the yields are sustainable. On this front it might be reasonable to avoid relying on some Australian resources stocks where current dividends look unsustainable unless there is a rapid recovery in commodity prices.

AMP Capital Markets 4th 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.

Our view on the financial market turmoil has been covered in the last two Oliver’s Insights – except to add that central banks are now sounding more dovish. This started with the ECB which is now expected to ease at its March meeting and is also evident from the Fed which last night was less positive on the growth outlook and indicated it was monitoring recent economic and financial developments. The probability of a March Fed hike is now just 20% and rather than four Fed rate hikes this year I see only one or none. The Reserve Bank of NZ has also turned more dovish and I expect the RBA to do the same.

The one big surprise in the ongoing turmoil in financial markets is the role played by oil. Past experience tells us surging oil prices are bad and plunging oil prices are good. But that has not been the experience lately. It seems there is a positive correlation been oil prices and share markets (“shares down on global growth worries as oil plunges” with occasional “shares up as oil rallies as growth fears ease”). So what’s going on?

Why the oil price plunge?

The oil price has collapsed because the global supply of oil has surged relative to demand. Last decade saw the price of oil go from $US10/barrel in 1998 to $US145 in 2008. After a brief plunge during the GFC it average around $US100 into 2014.

Black lines show long term bull & bear phases. Source: Bloomberg, AMP Capital

This sharp rise in the oil price last decade encouraged fuel efficiencies (use of ethanol, electric cars, etc) and more importantly encouraged the development of new sources of oil (offshore, US shale oil, etc) that were previously uneconomic.

Source: Bloomberg, AMP Capital

This is similar to what occurred in response to sharp rises in oil prices in the 1970s. But other factors are playing a role too:

• Slowing emerging world growth. Chinese economic growth has slowed to around 7% compared to 10% or so last decade and more of this is now being accounted for by services and consumption so it’s less energy intensive.

• Middle East politics – Iran coming back on stream this year and OPEC no longer functioning as a cartel but rather driven by Saudi Arabia’s desires to put pressure on Iran and assure its long term oil market share (by squeezing alternative suppliers and slowing the switch to alternative/more efficient energy sources).

• Technological innovation has enabled some producers to maintain production despite the sharp fall in oil prices.

• A rise in the $US, which has weighed on most commodities as they are priced in US dollars. However, the oil price has also plunged in euros, Yen and the $A.

Last year the world produced a near record 96.3 million barrels of oil a day, which was 1.8m more than was used. More broadly oil is just part of the commodity complex with all major industrial commodities seeing sharp price falls over the last few years.

Are we near the bottom for the oil price?

How much further the oil price falls is really anyone’s guess. Oddly enough having fallen 77% from its 2011 high the plunge is similar to past falls after which supply started to be cut back (see the next chart). I suspect we have now reached or are close to the point where, baring a global recession, it will start to become self-limiting but the oil price could still push down to $US20/barrel which in today’s prices marked the lows in 1986 and 1998.

Source: Bloomberg, AMP Capital

At current levels, even oil futures prices are likely below the level necessary – thought to be around $US50/barrel – to justify new shale oil drilling in the US. And prices at these levels are seeing consumer demand in the US shift back to more gas guzzling vehicles. So I suspect we are near the bottom. By the same token the ease with which shale oil production can be brought back on stream and rapid technological innovation in alternatives suggests a cap is likely to be in place on oil prices during the next secular upswing (maybe around $US60).

Why has the oil prices plunge been a big negative?

There are several reasons why the negatives may have predominated this time around. First, Middle East oil producers consume more of their oil revenues now than in the past and so a collapse in the latter may have forced a cutback in their spending compared to oil price plunges of the 1980s & 1990s.

Second, consumers in developed countries are more cautious than in the past & so respond less to lower energy costs.

Third, the plunge in oil prices at the same time the US dollar has increased has added to the stress in many emerging countries, causing funding problems in such countries and raising fears of a default event in the emerging world.

Finally, much recent corporate borrowing in the US and growth in investment has come from energy companies developing shale oil. They are now under pressure leading to worries of a default event and causing a fall back in investment.

But will the negative impact continue to predominate?

Many of these worries will persist but at some point the positive impact flowing from reduced business and consumer costs will become evident. The historical relationship indicates that the positive impact of lower oil prices and developed country growth takes a while to flow through, with the next chart suggesting the bulk of it is likely to show up this year.

Source: Deutsche Bank, Thomson Reuters, AMP Capital

Lower oil and energy prices also mean a usually one-off hit to inflation as the oil price level falls. This largely impacts headline inflation and is generally thought to be temporary. But the longer it persists the greater the chance that it will flow through to underlying inflation and inflation expectations. This is something that central banks are now grappling with as it makes it harder for them to get inflation back to their target levels, which in turn will mean low interest rates for longer.

What are the implications for Australia?

While Australia is a net oil importer, it is a net energy exporter which means that to the extent that lower oil prices flow through to oil and gas prices it means a loss of national income and tax revenue. For Australian households though lower oil prices mean big savings. The plunge in the global oil price adjusted for moves in the Australian dollar indicates average petrol prices should be around $0.90/litre (see next chart). While prices haven’t dropped this far – apparently due to high refinery margins based on Singapore petroleum prices – the price at the bowser is still well down on 2014 levels.

Source: Bloomberg, AMP Capital

Current levels for the average petrol price of around $1.10/litre represent a saving for the average family petrol budget of around $14 a week compared to two years ago, which is a saving of $750 a year. Some of this saving will likely be spent.

Source: AMP Capital

What happened to “peak oil”?

Last decade there was much talk of an imminent “peak” in global oil production based on the work of Dr M. King Hubbert and that when it occurs it will cause all sorts of calamities ranging from economic chaos to “war, starvation, economic recession and possibly even the extinction of homo sapiens”. The film “A Crude Awakening” helped popularise such fears. Such claims have in fact been common since the 1970s, but they have been wide of the mark with global oil production continuing to trend higher. With the real oil price once again plumbing the lows of the 1980s and 1990s it’s clear that such claims remain way off. While the world’s oil supply is limited, “peak oil” claims ignore basic economics which, via higher prices combined with new technologies, will make alternatives viable long before we run out of oil.

Implications for investors

As long as the oil price remains in steep decline the negative impact on producers is likely to predominate the positive impact on consumers at least as far as share markets are concerned. However at some point in the year ahead, it’s likely the boost to consumers and to economic growth in developed countries and in energy importing countries in Asia will predominate. In the meantime weak oil prices mean that deflationary risks remain and interest rates will remain low for longer.

AMP Capital Markets 28th January 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

2015 saw subdued returns for diversified investors as the global economy continued to grow and monetary conditions remained easy, but worries about deflation, plunging commodity prices, fears of an emerging market crisis led by China and uncertainty around the Fed’s first interest rate hike after seven years with near zero interest rates along with continued soft growth in Australia, saw volatile and soft returns from share markets. Balanced super funds had returns of around 5%, which was not disastrous given that returns have averaged 10.1% pa over the last three years, but still disappointing. 2016 has started with many of the same fears seen in 2015. This note provides a summary of key insights on the global economic and investment outlook in simple point form.

Four lessons from 2015

• Global growth remains fragile and constrained and this is continuing to drive bouts of volatility in investment markets.

• Deflation still remains a bigger threat than inflation – this is flowing from the secular plunge in commodity prices but also from slower potential economic growth. It reinforces the view that interest rates will remain low for longer.

• Turn down the noise – despite talk of recessions & crashes, returns from a well-diversified mix of assets were still better than cash or bank deposits.

• Diversification and active asset allocation are critical – the uneven and volatile return environment (with Australian shares underperforming again) provided a reminder of the benefits of diversification.

Key themes for 2016

• Global growth of 3% or just above, with the US around 2%, Europe and Japan lagging and China running around 6.5%, but Brazil and Russia still in recession.

• Scope for a cyclical bounce or at least stabilisation in commodity prices, but in the context of a continuing secular downtrend in response to excess supply.

• Continuing low inflation on the back of global spare capacity and weak commodity prices, notably oil.

• Continuing sub-par growth in Australia of around 2.5% for most of the year in response to falling mining investment, the commodity price slump and budget cuts but with the hope of some improvement by year end.

• Easy monetary conditions with the US very gradually raising rates (two hikes at best, but the risk is one or none), but on going easing in Europe, Japan, China and Australia.

• A further rise in the $US but at a slower rate than seen over the last two years, with the $A falling to around $US0.60.

• Modest gains in shares, with global shares outperforming Australian and emerging market shares again.

• Solid returns from commercial property and infrastructure, but soft gains of around 3% for Australian residential property prices as Sydney and Melbourne slow.

• Low returns from low yielding cash and bonds.

Key risks for 2016

• The Fed could prove to be too aggressive in raising rates, and even if it isn’t the fear of this could continue to weigh.

• The combination of the Fed and low oil prices causing ongoing problems for indebted US energy producers could cause more weakness in credit markets.

• Political uncertainty could remain a threat in the Eurozone, particularly in relation to Spain (after its messy election) and around populist/extremist parties gaining support.

• Chinese growth could disappoint with policy uncertainty around Chinese shares and the Renminbi continuing to unnerve investors.

• Plunging emerging market currencies (and commodity prices) could trigger a default event somewhere in the emerging world on US dollar debt.

• The loss of national income from lower commodity prices and the continuing unwind in mining investment and a loss of momentum in the housing sector could result in much weaker Australian economic growth.

• More geopolitical flare ups – eg, South China Sea, tension between Sunni Saudi Arabia & Shia Iran, terrorist threat.

• Factor X – there is always something from left field. Last year it was China fears.

Five things to watch

• The Fed – US inflation is likely to be key here.

• The $US – a continued surge in the $US, particularly via the Chinese Renminbi, will be negative for commodities and emerging currencies raising the risk of an emerging market crisis (eg, a default on US dollar debt).

• Global business conditions indicators (or PMIs) – these have been slowing for manufacturers but ok for services.

• Chinese manufacturing conditions PMIs – these need to stabilise around 50.

• Business confidence and non-mining investment in Australia – these still need to improve.

Three reasons why low inflation/deflation is still more likely than a surge in inflation

• Sub-par global and Australian growth means there is still plenty of spare capacity globally, which means ongoing low pricing power.

Source: IMF, AMP Capital.

• The fall in commodity prices is still feeding through.

• The strong $US will import low inflation into the US.

Four reasons why the Fed will likely be very gradual in raising rates (with maybe even no hikes this year)

• US economic growth remains fragile, particularly manufacturing.

• Spare capacity remains in the US economy, eg unemployment plus underemployment is still 9.9%.

• The Fed will be keen to avoid a further strong rise in the $US as it is slowing US growth.

• Global growth is likely to remain sub-par keeping global inflation & commodity prices soft which impacts US inflation.

Five reasons why the RBA will likely cut rates further

• The outlook for business investment is still weak.

• To offset a slowing contribution to growth from housing.

• Commodity prices are weaker than expected.

• The $A needs to fall further.

• To offset the monetary tightening from bank mortgage rate hikes for existing home owners.

Four reasons why Chinese growth will likely come in around 6.5% and not lower

• The Chinese property market is continuing to rebalance, removing the threat of a property crash.

• Stimulus measures over the last two years highlight the Government has no tolerance for a collapse in growth.

• The services sector is taking over from manufacturing.

• Chinese inflation is very low (with producer prices deflating) indicating still plenty of scope for further monetary easing.

Three reasons why a US/global recession is unlikely

• We have not seen the normal excesses – massive debt growth, overinvestment or inflation – that normally precede recessions.

• Nor have we seen the monetary tightening/multiple interest rate hikes that normally precede recessions.

• Normal lags suggest a big boost to consumers from lower oil prices over the year ahead.

Four reasons Australia won’t have a recession

• Low interest rates and petrol prices are resulting in big savings to household budgets.

• The fall in the $A is removing a major drag on growth.

• Non-mining sectors of the economy beyond just housing are starting to do well: retailing, tourism, higher education and manufacturing is also likely to see a boost.

• Stronger export volumes (from resource projects) will provide a partial offset to lower commodity prices.

Four reasons why shares are likely to provide decent returns by year end…

• Share valuations are good, particularly against low bond yields and interest rates.

• A global recession is unlikely – deep and long bear markets normally require a recession (in the US at least).

• Monetary conditions are very easy and likely to get easier still as while the Fed may start to tighten other central banks are still easing.

• There is a lot of pessimism around.

…but three reasons to expect continued volatility

• Global growth remains fragile.

• The risk of an emerging market crisis remains high, particularly with China still depreciating the Renminbi versus the $US and commodity prices remaining weak.

• Shares are not dirt cheap and there is a greater dependence on earnings.

Nine things investors should remember

• The power of compound returns – saving regularly in growth assets can grow wealth substantially over long periods. Using the “rule of 72” it will take 29 years to double an asset’s value if it returns 2.5% pa (ie 72/2.5) but only 9 years if the asset returns 8% pa.

• The cycle lives on – markets cycle up and down and we need to allow for it and not get thrown off by rough patches, like the one we are currently going through.

• Diversify – don’t put all your eggs in one basket and consider active asset allocation to enhance returns/protect against falls.

• Turn down the noise – the information revolution is making us more jittery and leading to worse investment decisions.

• Starting point valuations matter – so buy low and sell high. Selling after major falls (like those seen recently) just locks in losses.

• Remember that while share values can be volatile, the dividend or income stream from a well-diversified portfolio of shares is more stable over time (and now much higher) than the income flow from bank deposits.

• Avoid the crowd – because at extremes it’s invariably wrong.

• Focus on investments providing sustainable and decent cash flows – not financial engineering.

• Accept that it’s a low return world to avoid disappointment – low nominal growth & lower bond yields and earnings yields mean lower long term returns. When inflation is 2.5% an 8% return is pretty good.

AMP Capital Markets 21st January 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

2016 has started much where 2015 left off with basically the same worries driving another bout of share market falls. Geopolitical concerns have played a role but the main issues are uncertainty regarding the Chinese economy, wariness about the Fed raising interest rates and the impact of a rising US dollar and falling Chinese Renminbi.

Share markets have seen sharp declines so far this year (with US shares -5.2%, Eurozone shares -6.2%, Japanese shares -9.5%, Chinese shares -14.6% and Australian shares -6.8%) taking them back to around the lows seen during the second half of last year, commodity prices are down further with the oil price falling to its lowest since 2009 and bonds have rallied with safe haven buying. This note looks at the key issues.

Drivers behind of recent falls could linger for a while

The weakness seen so far this year started with declines in the Chinese share market and currency, sparking renewed concerns about the Chinese economy, not helped by some soft manufacturing data in the US and geopolitical concerns in the Middle East and around North Korea. The renewed depreciation in the value of the Renminbi is a key issue at present as its decline has helped drive upwards pressure in the $US by pushing down the value of other emerging market currencies, adding to weakness in oil and other commodity prices and keeping alive fears of some sort of emerging market crisis. Geopolitical issues have played a role – notably an intensification of tensions between Saudi Arabia and Iran along with a claimed H bomb test in North Korea.

There could still be more share market weakness to come in the short term: global growth worries centred on China and the US may linger; until the Fed starts to soften its stance on interest rate hikes market nervousness is likely to remain; it is not clear that the dynamic of a weaker Renminbi and tightening Fed putting upwards pressure on the $US and downwards pressure on commodities and hence emerging countries, is over; finally, some technical indicators can be interpreted as warning of further weakness.

Emerging markets have already fallen into a bear market, defined as a 20% decline. Further short term weakness could see more mainstream share markets fall into bear market territory as European and Australian shares are already down 18% from last year’s lows, Japanese shares down 17% and US shares down 10% from their 2015 highs.

Seven reasons not to be too concerned

But while risks remain high in the short term there are several reasons not to be too concerned. In other words, if we do go into a bear market in developed market shares it is likely to be relatively shallow unlike say the GFC falls of 50% plus and we continue to see shares having a better year this year than last.

First, the latest fall in Chinese shares arguably tells us more about regulatory issues and fears around the share market and currency rather than much about the economy. Recent economic data out of China has been mixed rather than outright negative. Rather the main drivers have been worries about new share supply following the end to a ban on selling by major shareholders, a new share market circuit breaker which perversely encouraged investors to bring forward selling, and a continuing depreciation of the Renminbi against the $US.

In terms of each of these: Chinese regulators have since announced a restrictive limit on the size of stakes that major investors can sell; the circuit breaker has now been suspended; and after a 6% plus depreciation in the value of the RMB since July the PBOC appears to be stepping up its effort to stabilise it and indeed some stability has returned in the last few days. Our view remains that Chinese growth this year will come in around 6.5% and ongoing stimulus measures appear to be gaining some traction in helping ensure this.

Second, a US recession is unlikely. This is critically important as the US share market sets the direction for global shares and the historical experience tells us that slumps in US shares tend to be shallower and/or shorter when there is no US recession and deeper and longer when there is (eg the tech wreck and GFC). See the next table. Sure US manufacturing is soft thanks to the strong $US and softening resource investment. But against this we have seen none of the excesses that precede recessions – like excessive growth in private debt, over investment in housing or capital good, high inflation or a speculative bubble. And most economic indicators in the US are okay highlighted by continuing strong jobs data which is serving to keep consumer spending firing even though the strong $US has damped US manufacturing. Nor have we seen 17 Fed interest rate hikes or the move to an inverted yield curve as we saw prior to the GFC.

Falls in US shares greater than 10% since 1989

Bear markets highlighted in black. Source: Bloomberg, AMP Capital.

Third, the combination of okay economic data in China and the US along with good Eurozone indicators lately indicate the global economy is unlikely to plunge into recession. Sure while manufacturing conditions PMIs globally have been a bit softer lately, services conditions indicators remain reasonably solid.

Source: Bloomberg, AMP Capital

Fourth, the current dynamic is very different to say the GFC as lower oil prices and commodity prices are providing a huge boost to consumers and most businesses. This is unlike the US housing slump at the time of the GFC that froze credit markets and led to a huge loss of household wealth or the surge in oil prices that preceded the GFC.

Fifth, monetary policy remains ultra easy. The Fed is very unlikely to undertake the four rate hikes it’s signalling for this year and other countries are still easing. This is very different to prior to the GFC when monetary tightening was the norm.

Sixth, renewed sharp falls have seen share market valuations become quite attractive. Our valuation measures for global and Australian shares have fallen back into very cheap territory. The gap between the grossed up dividend yield on Australian shares which is now nearly 7% and term deposit rates around 2.5% is back to around its highest level since the GFC.

Source: RBA, Bloomberg, AMP Capital

While confidence in Chinese shares is being tested again, it’s worth noting that Chinese companies listed in HK provide particularly attractive long term value trading on forward PEs close to 6 times, less than half that of Australian shares.

Finally, there is a lot of pessimism around. This is evident in headlines screaming “RBS tells investors to sell everything” to “Collapse 2016”. Then again you might say such extreme views always exist. True. But they are suddenly all landing in my inbox telling me that such headlines are getting much more interest and belief. In some ways this is a negative as it is creating more fear amongst investors, but the flipside though is that when everyone fears the worst, often the surprise is that things turn out to be better.

Implications for Australia

The latest bout of global growth worries warns that the global environment Australia faces remains messy. So while rebalancing away from mining will continue to help we may face another year with growth stuck around 2.5%. Ongoing commodity price weakness means ongoing pressure on the budget deficit, points to more downwards pressure on the $A and more pressure on the RBA to cut interest rates again. Expect the $A to fall to around $US0.60 by year end and the RBA to cut the cash rate to 1.75%.

Implications for Investors

Investors need to allow for several things:

• First, shares invariably go through volatile patches with corrections and bear markets that can linger for a while, but also provide solid returns over the long term. Shares literally climb a wall of worry over many years with numerous events dragging them down periodically, but with the trend ultimately rising. This can be seen in the next chart.

Source: ASX, AMP Capital

• Second, China will remain a source of volatility as it transitions from relying on manufacturing & investment to services & consumption and as the authorities remain on a steep learning curve as they deregulate the Chinese economy. But this does not mean the Chinese economy is about to plunge into recession.

• Third, selling after a major fall just locks in a loss. Shares may only be down say 6% year to date but measured against last year’s highs many developed markets including Australian shares are already down 15 to 20%. For those concerned, one way to protect against downside is to have an exposure in unhedged global shares because further worries about global growth will further depress the $A which will in turn boost the value of offshore investments.

• Fourth, when shares and growth assets fall they are cheaper and offer higher long term return prospects. Many don’t see it that way given the rush for the exits but the key is to try and take advantage of the value that emerges.

• Finally, while shares may have fallen in value the dividends from the market as a whole have continued to increase. So the cash income flow you are receiving from a well-diversified portfolio of shares has continued to remain attractive, particularly against bank deposits.

AMP Capital Markets 13 January 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.