Olivers Insights

2015 – a constrained year for investors

2015 has seen another long worry list for investors. Some of these – such as terrorist attacks in Paris, the escalating war in Syria, refugee problems in Europe, Greece’s latest tantrum and tensions in the South China Sea – have not had a lasting impact on investment markets. However, worries about deflation, falling commodity prices, fears of an emerging market (EM) crisis led by China and uncertainty around the Fed’s first interest rate hike have had a more lasting impact. In Australia the focus remained on the rebalancing of the economy after the mining boom as well on property bubbles. While it has not been a bad year for investors, overall returns have been constrained.

Key themes have been:

• Constrained global growth. This has been the story for the last few years. Global growth yet again failed to take off being constrained by a combination of a slowing manufacturing sector in the US, another downturn in Japan, a further slowing in China and deep recessions in Brazil and Russia. As a result global growth remained uneven and stuck around 3%. However, while this is causing ongoing skittishness amongst investors it’s not bad. Stronger growth would only bring inflation and interest rate worries.

• Deflation fears linger. Inflation remained low or fell in developed countries as excess capacity and falling commodity prices continued to impact.

• Falling commodity prices. The plunge in commodity prices continued as surging supply faced slower demand led by China. Bad news for commodity producers and related investments but good news for most developed countries.

• Further global monetary easing, but with the Fed diverging. While the Fed moved towards its first rate hike after seven years at zero, lift off was continuously delayed as central banks in China, Europe and Japan continued to ease in the face of sub-par growth and the deflation threat.

• More geopolitical threats. Terrorist attacks in Paris, the escalating war in Syria and tensions in the South China Sea all caused periodic fear, but without much lasting impact.

• Subdued growth and more rate cuts in Australia. The mining slump continued to weigh seeing growth remain sub-par. This saw the RBA cut the cash rate to a record low of 2%. But thankfully recession remains elusive as the economy has rebalanced with NSW and Victoria doing well.

While global growth remains in a “sweet spot”, its fragility & the associated skittishness of investors – particularly around China, EMs and the Fed – made for a volatile and disparate ride in investment markets.

Investment returns for major asset classes

* Yr to date to Nov. Source: Thomson Reuters, Morningstar, REIA, AMP Capital

• Share markets started 2015 well, as falling inflation & bond yields saw shares revalued only to see them correct under the weight of China/EM/Fed worries, before rebounding somewhat into year-end as such fears faded a bit.

• In the developed world US shares took a back seat relative to Japanese and European shares which benefitted from easier monetary policy and lower currencies.

• While Chinese shares had a strong start, they fell back on bubble fears. Emerging market shares performed poorly.

• Commodities had another bad year as supply surged, Chinese growth slowed and the $US rose.

• Australian shares underperformed yet again as the slump in commodity prices weighed and as the big banks faced slower growth and higher capital requirements. While the utility, industrial and health sectors did well this was offset by resources, banks and consumer staples.

• Global and Australian bonds had subdued returns reflecting low yields.

• Real estate investment trusts and unlisted assets like commercial property and infrastructure had strong returns as investors sought decent sources of income yield.

• Australian residential property had a good year, but mainly due to house price gains in Sydney and Melbourne. However, gains slowed significantly in the December quarter as official measures designed to slow property investor lending kicked in.

• Cash rates and bank term deposit returns were poor reflecting record low RBA interest rates.

• The $A fell another 10% and this helped boost the returns from global shares, once translated into Australian dollars.

• Balanced superannuation funds still exceeded cash and inflation but are on track for their softest returns since 2011.

2016 – another year of constrained growth

No doubt those who were looking for economic mayhem to break out in 2015, will simply roll their expectations for disaster into 2016. However, there are good reasons to believe we will simply see a continuation of the constrained uneven global growth that we have been seeing over the last few years.

• Major economic downturns are invariably preceded by either economic or financial overheating and there are no signs of that. There has been no major global bubble in real estate or business investment, inflation remains low, share markets are not unambiguously overvalued and global monetary conditions are easy. In terms of the latter while the Fed is likely to raise rates the process is likely to be gradual reflecting constrained US growth and still low inflation. And monetary easing is set to continue elsewhere, which in turn will also limit the extent of Fed tightening to the extent it puts upwards pressure on the value of the $US. As such, apart from a left field shock, it is hard to see what will drive a major global economic downturn at present.

• At the same time, it is hard to see what will drive a sharp acceleration in economic growth either. Rather, the structural combination of slower population growth, a more cautious approach to debt and structural problems in the emerging world will keep a lid on global growth.

Consistent with this leading growth indicators point to steady growth. Not collapsing, but not booming either.

Source: IMF, AMP Capital

For Australia, the economy is likely to continue to rebalance away from mining. However, in the face of a further fall in mining investment, falling national income, a slowing contribution from housing and upwards pressure on bank mortgage rates from increasing capital requirements, further monetary stimulus in the form of more RBA interest rate cuts and a lower $A are likely to be needed. If this occurs then improving conditions in sectors like consumer spending, tourism, manufacturing and higher education should see GDP growth move up to around 3% by year end. At the same time

Implications for investors?

The combination of okay global growth, still low inflation and easy money remains positive for growth assets. But ongoing emerging market uncertainties combined with Fed rate hikes and geopolitical flare ups are likely to cause volatility.

• Global shares are likely to trend higher helped by a combination of relatively attractive valuations compared to bonds, continuing easy global monetary conditions and continuing moderate economic growth.

• For shares we favour Europe (which is still unambiguously cheap and seeing continued monetary easing), Japan (which will see continued monetary easing) and China (which will also see more monetary easing) over the US (which may be constrained by the Fed and relatively high profit margins) and emerging markets generally (which remain cheap but suffer from structural problems).

• Australian shares are likely to improve as the drag from slumping resources profits abates, interest rates remain low and growth rebalances away from resources, but will probably continue to lag global shares again as the commodity price headwind remains. Expect the ASX 200 to rise to around 5700 by end 2016.

• Commodity prices may see a bounce from very oversold conditions, but excess supply for many commodities is expected to see them remain in a long term downtrend.

• Very low bond yields point to a soft return potential from sovereign bonds, but it’s hard to get too bearish in a world of too much saving, spare capacity & low inflation.

• Commercial property and infrastructure are likely to continue benefitting from the ongoing search by investors for yield.

• National capital city residential property price gains are expected to slow to around 3-4%, as the heat comes out of the Sydney and Melbourne markets.

• Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 2.5%.

• The downtrend in the $A is likely to continue as the interest rate differential in favour of Australia narrows, commodity prices remain weak and the $A undertakes its usual undershoot of fair value. Expect a fall to around $US0.60.

What to watch?

The main things to keep an eye on in 2016 are:

• how aggressively the Fed raises rates – continued low inflation is likely to keep the Fed gradual (as we expect), but a surprise acceleration in inflation would speed it up;

• whether China continues to avoid a hard landing;

• whether non-mining investment picks up in Australia – a failure to do so could see more aggressive RBA rate cuts;

• ongoing geopolitical flare ups, including in the South China Sea; and

• whether the global economy can finally throw off the worry list and constraints seeing growth perk up.

AMP Capital Markets 3 December 2015

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

For much of this year the big debate (or obsession) for investors has been about when the Fed would start to raise interest rates after nearly seven years of being near zero. After delays in June and September attention is now focussed on the December 15-16 Fed meeting following the Fed’s indication at its October meeting that it will consider a hike then and much stronger than expected jobs data for October. US money markets are pricing in a 66% chance of a move in December.

The Fed’s inclination to start hiking is understandable. The extraordinary monetary easing since the GFC (zero interest rates and three rounds of quantitative easing) have done their job in restoring US growth. Jobs are well up on 2008 levels, unemployment is down to 5%, confidence is up, the housing sector has recovered and business is investing again. And since inflation normally only turns up with a lag the Fed feels there is an argument to get going.

Source: Bloomberg, AMP Capital

However, heightened expectations of a hike in December have seen a return to the sort of worries that drove share markets lower into August/September with investors fearful a Fed hike will put upwards pressure on the $US which in turn will drive commodity prices lower, accentuate the risk of problems in the emerging world and adversely affect US economic growth. As a result shares, commodity prices and emerging market currencies have seen some renewed volatility or outright falls so far this month. More broadly it’s understandable for investors to be wary as they have become used to zero interest rates and the fragile state of US and global growth along with deflationary risks suggest that there is a risk that the Fed may make a mistake in hiking. There is long list of countries that have raised interest rates since the GFC only to cut them again. This includes Australia, Canada, Norway, New Zealand, Sweden and the Eurozone. Japan had a similar experience in the 2000s. So there is a risk that the Fed could make a similar mistake.

Given all this, Fed related uncertainty/nervousness could continue at least until the Fed’s December decision is out of the way. However, there are several reasons not to be too concerned about the Fed.

Reason #1- Fed hikes conditional on a stronger US

The Fed has clearly made its first interest rate hike conditional on the economy moving in line with its relatively upbeat expectations, specifically “that unanticipated shocks do not adversely affect the economic outlook and that incoming data support the expectation that labor market conditions will continue to improve and that inflation will return to the [Fed’s] 2% objective over the medium term.” By delaying in September the Fed clearly indicated that its conditionality was serious and that the conditions had not yet been met. This all means that if the Fed does hike in December or whenever, it will only be because the economy is stronger and the Fed is confident that this will continue – in other words it will be a “good hike”. And subsequent moves will also be conditional on further improvement in the US economy. Given ongoing constraints on growth and inflation I expect that rate hikes will be very gradual, ie below Fed members’ expectations for the Fed Funds rate (commonly called the “dot plot”) to reach 1.5% by end 2016 and 2.6% by end 2017. In fact the Fed’s December meeting is likely to see these expectations revised down again. Periodic growth scares – like bad weather, China worries and terrorist attacks only add to this.

Reason #2 – history

US economic downturns/recessions have historically only come three years after the first Fed rate hike in a cycle. In fact, recession did not come until seven years after the February 1994 first hike and for three and a half years after the June 2004 first hike. This is because the first rate hike only takes monetary policy from very easy to a bit less easy and it’s only when monetary policy becomes tight after several rate hikes that the economy gets hit. This is often signalled by long term bond yields falling below short term interest rates (ie an inverted yield curve). And we are a long way from that.

Flowing from this, while there can be share market wobbles around the first Fed rate hike after major easing cycles, sustained problems usually only set in when interest rates/monetary policy has become tight. This can be seen in the next chart. Shares had wobbles when interest rates first started to move up in February 1994 (US shares had a 9% correction at the time) and in June 2004 (US shares had a 8% correction at the time) but bear markets did not set in till 2000 and 2007 after multiple hikes and with recessions around the corner.

Source: Bloomberg, AMP Capital

Reason #3 – Other major countries are still easing

Although the US may start raising interest rates, other major central banks are still moving in the direction of monetary easing or at least are a long way from hiking. This includes the People’s Bank of China (which is expected to cut interest rates further), the ECB and Bank of Japan (which are biased to expanding their quantitative easing programs) and the Reserve Bank of Australia (which still has a bias to cutting interest rates further). In other words, even when the Fed moves global monetary policy will remain easy. This divergence is very different to the period prior to the GFC.

Source: Bloomberg, AMP Capital

Reason #4 – the $US will constrain the Fed

Since the start of last year the $US has risen by just over 20% against a trade weighted basket of currencies. This has largely reflected expectations that the US is moving towards monetary tightening at a time when other key central banks are still easing, which in turn has made the $US relatively more attractive. A rising currency is a form of monetary tightening because it bears down on economic growth (by making the US less competitive) and inflation (by reducing import prices). According to a Fed model of the US economy the 20% rise in the value of the $US since the start of last year is equivalent to around 150 basis points of rate hikes. In other word, the rise in the US dollar has done much of the Fed’s job for it.

A rising $US also puts downwards pressure on commodity prices because most commodities are priced in US dollars, which in turn weighs on US inflation.

So with US growth still being relatively fragile (it has averaged just 2% since the GFC ended whereas a period of much stronger growth would normally have been seen after such a severe recession) and its preferred measure of inflation still running well below target (the private final consumption deflator is running at 1.3% year on year versus a target of 2%) the Fed is unlikely to want to see a further sharp increase in the $US.

As a result with other major central banks still easing, upwards pressure on the value of the $US will act as a brake on how much the Fed can raise interest rates. And in order to stop the $US rising too much the Fed is likely to talk dovish in stressing a gradual tightening cycle. This has indeed been seen in recent Fed comments and is likely to remain the case.

Reason #5 – non-US shares are cheap

While US shares are expensive on some measures – particularly if low bond yields are not allowed for – this is not the case for non-US share markets which are cheap whether low bond yields are allowed for or not. For example, while the so-called Shiller price to earnings multiple or cyclically adjusted PE – which compares share prices to a rolling ten year moving average of earnings to smooth out the earnings cycle – puts US shares at 26 times, global shares excluding the US are only trading on 15 times. See the next chart.

Source: Global Financial Data, AMP Capital

In fact, global shares excluding the US are about as cheap as they ever get on this measure. This includes Australian shares. This is very different to 2000 or 2007 when most share markets were expensive on this measure. This tells us that there are still plenty of opportunities in global shares for investors (even if Fed hikes continue to put a brake on US shares).

Concluding comments

The anticipation of and worries about the Fed’s first interest rate hike in seven years have been a major driver of investment markets for at least the last year. These worries could have further to go. However, it may be overkill to take this took far. First, when it does hike (with December now looking likely) it will be the most anticipated Fed rate hike in history. When it comes it will hardly be a shock to anyone. Second, there are several fundamental reasons not to be too concerned about the Fed: the first and subsequent rate hikes will be conditional on the US economy continuing to improve and given constrained growth and deflationary pressures the process is likely to be very gradual; history tells us that its only when monetary policy becomes tight that it becomes a real problem and that is a long way off; global monetary conditions will remain easy as other major countries are still easing; the strength of the $US will constrain how much US rates will go up; and, while US shares are expensive on some measures, shares outside the US are cheap indicating that there are still plenty of opportunities for investors.

AMP Capital Markets 19 November 2015

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

A decade or so ago a large Australian fund manager ran a campaign urging Australians’ to pay more attention to their superannuation (pension) savings. This initially struck me as good advice – after the family home for most of us it will end up being our biggest pot of savings so it makes sense to keep a close eye on it. And surely the closer we look at it the better the outcome? But over the years I have come to the view that we need to be careful here. In fact the avalanche of information around investing if not properly managed may be making us worse, not better, investors: more fearful, more jittery and more focussed on the short term than ever. I have looked at this theme before and the more I look into it the more convinced I have become that investors need to try and turn down the noise around investing. (See “The end is nigh, or is it? Try to turn down the noise,” Oliver’s Insights, November 2014.)

The permanent worry list

The technology revolution has made it easier and easier to track our investments. And with this has come easier and easier access to information and views around the outlook for investment markets. Some of this is balanced, but a lot of it is not. For the last few years it seems there has been a constant worry list with a range of things about to drag us down into the next financial crisis: budget deficits, debt, money printing, the Euro, Greece (every six months!), hyperinflation, deflation, taxes, welfare spending, banks, retiring baby boomers, the government, peak oil, low oil, pollution, global warming, the Middle East, terrorism, Russia, a pandemic, China, the South China Sea, emerging markets and of course the current fascination being the Fed (will she or won’t she?). And of course the perennial worry in Australia relates to the residential property market.

Big picture macro concerns have always been around. And I find it very hard to believe that things are any worse today than they were 100 years ago (when Europe had entered World War 1, living standards and life expectancy were a fraction of today’s and pandemics were a regular phenomenon). But the communication revolution means that such concerns are now regularly in our face. I cannot google something without links popping up to new disasters. The fascination with financial news has exploded – with several financial TV channels with 24/7 finance updates interspersed with constant debate about what it all means. And this is now all accessible via apps we can have at our fingertips on smart phones.

Loss myopia

In a way this is all fun. But there are several risks. Human nature is naturally cautious because our brains evolved at a time when we had to be on the lookout for physical threats. As a result bad news always attracts more interest and so “bad news sells”. Of course, this also applies to financial news.

But it also feeds into a common behavioural trait called “myopic loss aversion.” And here lies the threat to our long term financial health. Oddly enough I was reminded of this by a great Wall Street Journal article I saw recently – “Keep Stock-Market Apps Off Your Phone”, by Dr Shlomo Benartzi – that I actually found on a stock market app on my phone! It’s long been observed that a loss in financial wealth is felt much more distastefully by investors than the beneficial impact of the same sized gain and in the world of behavioural economists – who study how people behave in relation to economic and finance considerations – this has come to be known as “myopic loss aversion”.

When the value of an investment falls it makes sense that unless something has fundamentally gone wrong investors should be thinking about increasing their allocation to it to take advantage of it now being cheaper and better value and therefore offering better return prospects. The reality though is that many are motivated to do the opposite as the distaste for loss combines with another well-known behavioural trait called “recency bias” that causes investors to give more weight to recent events than they should so they project recent news of falls in their investment into the future.

The information overload we are now seeing is likely to be reinforcing this because it is increasing our exposure to news about our investments. And this constant feedback is likely adding to “myopic loss aversion”. (Hopefully this is not getting too technical!)

The shorter the horizon the worse shares look

In a family discussion about shares versus bank term deposits a relative once observed to me that there is no point investing in shares as they just go down about as much as they go up. I thought this odd as my experience has been a lot more positive. But then it occurred to me that for many people their perception of what shares do likely comes from daily updates – from the media or increasingly via an app. And this can lead to a very jaundiced experience.

For example, if you track the daily movements in the Australian All Ordinaries share price index, measured over the last twenty years it has been down almost as much as it has been up with falls 47% of the time and gains 53% of the time. It’s little different for the US S&P 500 share index which has seen falls 46% of the time on a daily basis versus gains 54% of the time. So from day to day it’s pretty much a coin toss with bad news nearly half the time.

By contrast if you only look at how the share market has gone each month and allow for dividends the historical experience tells us you will only get bad news (ie a loss) 35% of the time in Australia and the US. Looking only on a calendar year basis, data back to 1900 indicates that the probability of bad news in the form of a loss slides further to just 19% for Australian shares and 27% for US shares. And if you can stretch it out to once a decade, again since 1900, positive returns have been seen 100% of the time for Australian shares and 82% of the time for US shares. See the next chart.

Daily and monthly data from 1995, data for years and decades from 1900. Source: Global Financial Data, AMP Capital

The point is that the less frequently you look the less you will be disappointed and so the lower the chance that a bout of “myopic loss aversion” will be triggered which causes you to adopt an investment strategy which is too cautious to meet your goals or leads you to sell at precisely the wrong time.

But is there any evidence backing this up? Yes there is. As the Wall Street Journal article sited above noted, a 1997 study by US behavioural economists Richard Thaler, Amos Tversky, Daniel Kahneman and Alan Schwartz showed that providing investors in an experiment “with frequent feedback about their [investment] outcome is likely to encourage their worst tendencies…More is not always better. The subjects with the most data did the worst in terms of money earned.” Basically what’s happening here is that investors tend to go for the safer lower returning investment options when more frequent feedback on their investment performance is provided.

Of course, the greater access to financial information we are now seeing in the media and via mobile devices is having the effect of encouraging us to look at our investments more frequently not less – via daily and even more frequent updates. And around this is an avalanche of news and other information that is often out of context, often irrelevant and often in the bad news category. This has the effect of exposing us to more frequent news of loss from our investments and reinforcing that news. Which in turn risks encouraging bad investment decisions. In particular a focus away from investments like shares that can grow wealth over time towards assets that may be safe in the short term but will lead to much lower wealth levels over the long term.

What can investors do to avoid this?

The key I think is to find ways to turn down the volume on financial news because if you are exposed to it less frequently you are less likely to make decisions that are contrary to your long term investment goals. Try to avoid looking at market updates so regularly and even consider removing related apps from your smart phones, tablets and watches. Or at the very least find a way to filter such news in a way that it doesn’t distort your investment decisions.

The traditional approach of adopting a long term investment strategy and sticking to it is arguably now more important than ever. Yes we are now in an environment of more constrained and volatile investment returns which has increased the importance of active asset allocation – but this is best left to experts who can put the time in to filter the noise from fundamental signals and avoid allowing “myopic loss aversion” from getting control.

By AMP Capital Markets 12 November 2015

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.

Since the end of the GFC in 2009, returns from unlisted commercial property have been strong and steady at around 9.5-10% pa. This initially reflected a recovery from the GFC related slump but more significantly a desire for decent income bearing investments from investors that has pushed down investment yields. Falling yields has been a big driver of returns as each 0.25% fall in yields translates to a 4% capital gain and since 2009 average commercial property yields have fallen from 7.3% to 6.1%. In a falling yield environment property prices move up relative to rents, providing capital gains for investors.

Source: AMP Capital

Australian Real Estate Investment Trusts (A-REITs), have been even stronger with gains of around 13% pa over the last six years. So where to from here? Has the chase for yield, at a time when concerns about rising property supply and mixed leasing conditions, gone too far or can it go further?

The demand and supply for space

Perhaps the biggest drag is the ongoing softness in the Australian economy. While recession has been avoided and this is likely to remain the case, economic growth is likely to remain sub-par at around 2-2.5% well into next year and this is keeping unemployment relatively high, albeit less than had been feared a few years ago. This in turn is keeping a lid on space demand, particularly outside Sydney and Melbourne.

At the same time, office supply has been picking up, with particular concerns about Perth, Brisbane and Sydney with Barangaroo. However, the peak increase in supply looks like being this year and while the Perth and Brisbane markets are in in a bad way, with Perth’s vacancy looking like running around 20-25% for a few years, leasing demand has been much stronger in Sydney and Melbourne resulting in falling vacancy rates. Overall vacancy rates are likely to peak this year.

Source: AMP Capital

Rising supply is less of an issue with industrial property, but space demand has remained subdued as has also been the case in relation to retail property.

A-REITs show the way

While A-REITs are far more volatile, they provide a good lead for unlisted commercial property and their recent gains point to still solid returns ahead for unlisted property. See the next chart.

* Direct property is Mercer direct property index. Source: Bloomberg, Mercer, AMP Capital

The search for yield by investors has pushed the yield on A-REITs below 5%, with the higher and more attractive unlisted commercial yields likely to continue to follow A-REIT yields lower.

Source: Bloomberg, AMP Capital

Yields remain under downwards pressure

Unlisted commercial property yields also remain attractive compared to most other assets. This is particularly noticeable compared to residential property, as can be seen in the next chart. In the 1980s the rental yield on residential and commercial property (as measured by a mix of office, retail and industrial property yields) was similar, but today commercial property has an average rental yield which is far higher, ie around 6% for commercial property compared to around 3% for residential property. With Australian residential property over-valued on most measures and the strong cities of Sydney and Melbourne now starting to slow, office, retail or industrial property is far more attractive for investors than housing on a medium term horizon as it is less dependent on capital growth going forward and less at risk of a correction.

Source: REIA, AMP Capital

The next chart compares the yield on commercial property versus an average of government bond, equity and housing yields. The gap between commercial property yields and these yields remains wide, again suggesting yields on commercial property remain relatively attractive, despite recent falls.

Source: REIA, Bloomberg, AMP Capital

Commercial property offers a wide risk premium

The biggest risk regarding commercial property is if bond yields back up sharply as global growth improves. However, this has been a concern for the last five years now and so far it has failed to eventuate on a sustained basis as Australian and global growth has continued to disappoint and inflation has slipped lower forcing central banks to maintain very low interest rates. In addition, the risk premium offered by commercial property over bonds remains well above average. The next chart shows a proxy for this. It assumes that rental and capital growth will average 2.5% pa over time (ie, in line with average inflation) and adds this to the average non-residential property yield to give a guide to potential total returns. The 10 year bond yield has been subtracted to show a property risk premium. While off its recent highs it remains well above its historical average.

Source: REIA, Bloomberg, AMP Capital

The bottom line is that the huge yield advantage commercial property offers over government bonds and other yield bearing assets like residential property suggests that investor demand is likely to remain strong.

Commercial property has in fact been a beneficiary of investor flows during periods of rising bond yields in the past. This happened during the bond crash of 1994 and the more gradual backup in bond yields that occurred prior to 2007 as investors simply switched out of bonds into assets like commercial property that offered higher yields at a time when leasing conditions were strong. Property only became vulnerable in 1990 and 2007 when the property risk premium in the previous chart had fallen to far less attractive levels than is currently the case and then leasing conditions deteriorated dramatically against a backdrop of rising supply.

Return outlook and what to watch

While soft leasing conditions and supply concerns in some areas (notably Perth and Brisbane offices) are likely to constrain returns, overall returns from unlisted commercial property are likely to remain strong for the next few years at around 9.5-10% pa as investor demand continues to chase the attractive yields on offer from commercial property. Industrial property has already run relatively hard so office and retail property are likely to outperform.

A-REITS having outperformed over the last few years are likely to go through a period of relative underperformance at some stage in the period ahead.

The key threats to keep an eye on would be a recession in the Australian economy and/or a sharp back up in bond yields. So far there is little sign of the former, with the economy continuing to gradually rebalance towards non-mining related activity, or the latter as global and Australian economic growth and inflation remain constrained.

By AMP Capital Markets 5 November 2015

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.

A defining feature of the economic cycle we are now going through is the constrained and fragile nature of economic growth globally. After an initial bounce post the GFC to 5.4% in 2010, global economic growth has consistently disappointed. This can be seen in the progression of the IMF’s economic growth forecasts for each year since 2012. Typically the IMF has started off looking for global growth close to 4% for the year ahead but each year has had to revise it down to around 3%, pushing the 4% bounce off into the next year. This year has been no exception – see the line for 2015 in the next chart.

Source: IMF, AMP Capital

Consequently, global growth has been continuously disappointing. It’s been the same pattern in Australia, although much of the growth slowdown in Australia owes to the ending of the mining investment boom, with a pick-up in growth back to more normal levels being constantly pushed into the future. This in turn and the fragile nature of growth has seen investors regularly questioning the post-GFC rally in shares. This note looks at why growth is so constrained and what it means.

What’s driving slow growth?

Slow and uneven growth reflects a whole range of factors.

• It seems that we have been seeing a series of calamities acting to constrain global growth over the last few years such as the Eurozone debt crisis, Greece, the Japanese earthquake and tsunami, bouts of bad weather in the US, US debt ceiling, fiscal cliff and shutdown debacles, Ukraine, etc. Each of these should be seen as temporary but they seem to be coming with a regularity that makes them seem normal.

• While the GFC was seven years ago now, it appears to have had a more lasting impact on confidence and particularly businesses’ desire to undertake capital investment, which has a direct constraining effect on economic growth. This likely reflects the severity of the GFC and the drip feed of post-GFC calamities.

• Constrained capital spending has in turn been weighing on productivity growth.

• Slower growth in debt. Prior to the GFC. household debt to income ratios were trending up thanks to a combination of the increasing availability of debt and low interest rates. However, the GFC appears to have put an end to the willingness of households to take on ever higher levels of debt relative to their incomes and so we have seen debt to income ratios stabilise or decline in “Anglo” countries following an earlier lead in Japan and Germany and households running higher savings rates. While the relationship between debt and growth can be complex, this has essentially meant slower growth in consumer spending.

Source: IMF, AMP Capital

• Rising inequality weighing on consumer spending. There is increasing concern that globalisation, offshoring and now automation are driving increasing levels of inequality in advanced countries such as the US, which in turn is weighing on consumer spending as high income households who have been benefitting are less likely to make up for lost spending from low and middle income households. This is a rather contentious point, though, and it seems to be less of an issue in Europe and Australia where social safety nets are stronger.

• Slower labour force growth. Many countries are seeing slower population growth and in some cases falling populations, notably Japan, China and parts of Europe, but this is also the case in the US and Australia where population growth has slowed. Since an economy’s potential growth rate is determined by growth in its labour force and growth in output per hour worked (ie productivity, which has also been slowing), we have seen a slowing in potential growth. For Australia, we have revised our potential growth estimate down from 3-3.25% pa to around 2.75% pa.

• Weaker growth in emerging countries. Post the GFC, the hope was that strong growth in the emerging world would keep global growth strong. But this hasn’t happened with the downwards revisions to the IMF’s global growth forecasts increasingly being driven by the emerging world, which has been hit by a combination of a desire for more sustainable growth in China, the slump in commodity prices which is weighing on South America & a reversal in economic reform momentum in favour of old fashioned populist policies. See the next chart. In fact, half of the BRICs – Brazil and Russia – are now in recession. This is having a bigger impact globally because the emerging world is now nearly 60% of world GDP compared to less than 50% prior to the GFC.

Source: IMF, AMP Capital

There are some qualifications suggesting that the problem may not be quite as severe as it looks. In particular, rapid technological innovation may be leading to growth being understated. For example, the increasing number of “free” or low cost apps on smart devices providing services that were previously non-existent or very expensive is arguably delivering a benefit to consumers that is not properly measured resulting in the under statement of GDP growth and productivity and overstatement of inflation. It would suggest that people are doing a lot better than low wages growth suggests. This is an issue for another day but it is unlikely to be enough to fully offset the list of growth drags above.

Some of these drags should be temporary or cyclical but many are structural – slowing labour force growth, slowing productivity growth, slower growth in debt and problems in the emerging world. It’s hard to see these ending anytime soon.

The economic and financial impact of low growth

Fragile and constrained growth is having a number of impacts that are likely to persist. In particular these include:

• Low inflation. Ongoing sub-par economic growth is seeing persistent spare capacity both in terms of unemployment and underemployment and factories not operating at their normal rate. This combined with the long-term downtrend in commodity prices in response to the surging supply of commodities is driving ongoing low inflation with periodic deflation scares. See the next chart.

• Low interest rates. Over the long term, interest rates roughly line up with nominal economic growth. And for good reason. If real economic growth and inflation are high, nominal rates of return on investment are high and so too are interest rates and vice versa. So if inflation and real growth are low, so too should be interest rates. But there’s another factor: when economies are operating below full capacity and inflation is below target, interest rates need to run below nominal growth to hopefully boost growth and use up spare capacity. This is exactly what we have been seeing since the GFC and continue to see now. So while many simply say “low interest rates are due to central banks” the reality is that they reflect low nominal growth and spare capacity. It’s hard to see this ending soon.

Source: Thomson Reuters, AMP Capital

• Periodic growth scares. When real economic growth is running around low levels and is fragile, periodic growth scares are likely to occur more often as the fear that adverse developments will trigger a return to recession is greater as there is less of a growth buffer. As we have seen since the GFC, these can be triggered by the normal fluctuation in economic indicators or external shocks (bad weather, military flare ups like in Ukraine, the Middle East, etc). Such growth scares keep investors nervous. So we have seen a sense of ongoing scepticism about the recovery in the global economy and in share markets that has occurred since the GFC. Investors have never quite fully bought the recovery story.

• A longer cycle. But it’s not all negative. There is an old saying that “economic expansions don’t die of old age but of excess”. The same applies to cyclical bull markets in shares. In other words economic recessions and bear markets in shares are usually preceded by economic and/or financial imbalances such as excessive business investment, a housing boom, excessive growth in private sector debt, a build-up in inflationary pressures or unambiguously overvalued share markets. But we haven’t seen any of these as low growth has kept businesses cautious in investing, households cautious in taking on too much debt, inflation too low and investors from getting euphoric in buying shares. Sure, there are pockets of excess such as the Sydney and Melbourne home buyers’ markets but these are far from the norm globally. The absence of excess suggests we have a way to go before the next global recession or major bear market in shares.

Implications for investors

The implications for investors are simple:

• Interest rates are likely to remain low. Sure, the Fed is itching to hike but this still looks like it could be delayed again and when it does come it is likely to be gradual and interest rate “cuts”/further monetary easing look more likely in Japan, Europe, China and Australia. This means bank deposits will remain a poor investment option except for those who can’t bear any capital loss. So the search for yield and better returns will remain.

• Average returns are likely to be constrained as low growth means constrained return potential.

• The cycle is likely to be longer than normal. Baring a shock – such as a major geopolitical event – the next major global economic downturn looks like being several years away yet. Which in turn suggests that the cyclical bull market in shares has a way to go.

By AMP Capital Markets 29 October 2015

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.

A pick-up in the housing sector was a necessary part of the adjustment in the Australian economy following the end of the mining boom. The RBA started cutting interest rates in 2011, home buyers returned, home prices rose and this has all encouraged a dwelling construction boom that has helped offset the mining investment slump. However, as always the surge in home prices has refocussed attention on whether there is a property bubble and how it might end.

Analysing the Australian residential property market is a bit like Groundhog Day as the big picture fundamental issues don’t really change much in that Australian housing is expensive, affordability is poor, household debt is high and there is a constant debate as to whether there is a crash around the corner. This has been the case ever since 2003.

So quite clearly the issues around the property market are much more complex than many would see them. This note takes a look at where we are now in the Australian residential property cycle and implications for investors.

Overvalued with too much debt…

At a big picture level it’s hard to get away from the view that Australian property is expensive and household debt is high:

• According to the 2015 Demographia Housing Affordability Survey the median multiple of house prices to household income is 6.4 times in Australia versus 3.6 in the US and 4.7 in the UK.

• On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average, Australian houses are 37% overvalued and units 14% overvalued.

• The ratios of house prices to incomes and rents in Australia are at the high end of OECD countries. By contrast the US is near the low end in the OECD.

• Real house prices have been running above trend since 2003. While the excess above trend eased from 2010 it has blown out again in the last two years.

Source: ABS, AMP Capital

The shift to overvaluation has come higher household debt. The next chart shows the deviation in house prices from their long term trend against the ratio of household debt to income.

Source: ABS, RBA, AMP Capital

Naturally all of this has led to concern that Australia is in a housing bubble that will inevitably burst.

…but not as simple as it looks

However, it’s not as simple as this:

• First, the big surge in home prices and household debt actually took place from the late 1990s into early last decade. Since then measures of overvaluation and the debt to income ratio haven’t changed much (esp after allowing for mortgage offset accounts). See the last chart. In other words the surge in home prices and debt was unrelated to the mining boom, except in some cities like Perth.

• Second, the claims around negative gearing, foreign and SMSF buying driving the problem don’t really stack up: negative gearing has been around for a long time and while foreign and SMSF buying has played a role it looks to be small and foreign buying is concentrated in certain areas.

• Third, a more fundamental factor explaining the persistence of “overvalued” home prices in Australia relative to other countries is constrained supply. Australia has had a chronic undersupply which has been worsening until recently. This can be seen in the next chart which tracks housing starts versus underlying demand. The cumulative undersupply on this measure reached above 100,000 dwellings last year. The main reason behind the slow supply response appears to be tough land use regulations in Australia.

Source: ABS, AMP Capital

• Fourth, while household debt has gone up a lot there has not been anything like the deterioration in lending standards seen in other countries. Much of the increase in debt has gone to older, wealthier Australians. Bad debts and arrears remain low. While loan size has increased, Australians’ seem focussed on cutting their debt once they get it.

• Finally, while Sydney and Melbourne have had all the characteristics of a bubble of late (overvaluation, rapid price gains, a desire to get in for fear of missing out), the rest of Australia has not. So it’s dangerous to generalise.

Source: CoreLogic, RP Data, AMP Capital

Despite all these qualifications, high house prices combined with high household debt to income ratios suggest Australia is vulnerable should something threaten the ability of households to service their mortgages. As such the RBA and APRA have been right to try and slow the property market down

So where are we now?

Our assessment is that the national property market is cooling.

• APRA’s measures to slow lending to property investors are clearly biting with lending to investors slowing.

• The Westpac-MI consumer sentiment survey shows a sharp fall in consumers’ assessment as to whether now is a good time to buy a dwelling, led by NSW.

• Auction clearance rates have slowed.

Source: Australian Property Monitors, AMP Capital

However, this slowdown is likely to be concentrated in Sydney & Melbourne, which are likely to see price growth slow to around 5% over the year ahead. 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 start to 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 than anything worse. In fact, the cooling in investor demand in Sydney and Melbourne are likely to provide greater flexibility for the RBA to cut interest rates again.

What to watch for a harder landing?

I would nominate the following:

• A recession – much higher unemployment could clearly cause debt servicing problems and hence forced sales. The risk at present looks manageable though at around 20%.

• A surge in interest rates – but the RBA knows about the increased debt sensitivity of households so this would require the RBA to get it wrong badly.

• 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:

• First, over the very long term residential property adjusted for costs has provided a similar return for investors as Australian shares, at around 11-11.5% pa. So there is role for residential property in investors’ portfolios.

• Second, housing is looking somewhat less attractive as a medium term investment. It is now expensive on all metrics and offers very low income (rental) yields compared to all other assets except bank deposits and Government bonds. The gross rental yield on housing is around 2.8% (after costs this is around 1%), compared to yields of 6% on commercial property and 6.7% for Australian shares (with franking credits). This means that a housing investor is more dependent on capital growth to generate a decent return.

Source: Bloomberg, REIA, AMP Capital

• Third, these comments relate to housing in aggregate. For those who want to look around there are pockets of value, eg in regional areas. You just have to look for them.

• Finally, investors need to consider their exposure to Australian residential property generally. As a share of total household wealth its nearly 60%. Once allowance is made for indirect property exposure via Australian shares (banks, property trusts, etc) it’s even higher. I am not in the property crash camp but the risk of it does reinforce our assessment that Australian investors should have a decent exposure to say unhedged global shares because it could provide an offset should something go wrong with Australian housing.

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.