Olivers Insights

Back in April this year when shares were riding high, it seemed the worry list investors had was relatively short and mild. Since those highs the worry list expanded dramatically. Reflecting this major share markets saw falls to their recent lows, viz US shares -12%, Australian shares -18%, Eurozone and Japanese shares -19%, emerging market shares -22%, Asian shares (ex Japan and China) -23% and Chinese shares -43%.

Two things regularly get me worried about investment markets. The first is May – recall the old saying “sell in May and go away” – and this got me concerned about a correction being on the way in May this year. See “Correction Time?” Oliver’s Insights, May 2015. And the second is whenever I go on holidays because it invariably coincides with falls in markets. Last week I took a few days off in Byron Bay and of course right on cue markets had a further tumble early in the week with the US share market testing its August low and several markets elsewhere falling to new lows. But as I went to the beach at Byron in the midst of this I saw a guy meditating with a crystal on his chest…maybe in an effort to quiet his mind in view of the “billions being wiped off share markets” that day. Later that day thinking there must be something in it my family and I paid a visit to the Crystal Castle in the hills above Byron Bay and we did our own meditation with a crystal! Maybe it all works, because now that I have returned to work shares have had a good bounce back. But is it sustainable?

From seasonal weakness to seasonal strength

A good place to start deciphering the share markets at present is the seasonal pattern in shares. Typically the period from May that we have just come through is the weakest period of the year. The September quarter has lived up to its reputation as being poor for shares with both global and Australian share prices down around 8%, the worst since the September quarter 2011. Worries about China, the emerging world, commodity prices, Greece and the Fed have clearly played a big role. However, October is known as a “bear killer” month, as it often sees market declines bottom ahead of seasonal strength into year end and the new year. See the next chart.

Bloomberg, AMP Capital

A further leg down in shares remains a risk in the weeks ahead. However, along with the more positive seasonal pattern in the months ahead there are fundamental reasons to see a resumption of the cyclical bull market.

• shares have become cheaper as a result of their falls;

• global monetary conditions remain very easy and in some cases are getting easier (with easing in China, Taiwan, Norway and India recently, the ECB threatening more easing and the Fed delaying tightening);

• this in turn should help ensure that the global recovery continues albeit at a sub-par and uneven pace; and

• investor sentiment is very negative, in fact falling to levels associated with share market bottoms, which is positive from a contrarian perspective. See the next chart.

Bloomberg, AMP Capital

It is worth noting that the US share market – which has been driving global markets – has so far been following a very similar pattern to both 1998 and 2011 that saw sharp falls into August, a bounce and then a retest or new lows around late September/October, followed by gains into year end. Time will tell. From a technical perspective the failure of commodity prices and emerging market shares to hit new lows with last week’s global share market falls is a positive sign suggesting risks on these fronts may be receding (at least for now).

Bloomberg, AMP Capital

But what to watch? We would nominate the following.

The Chinese economy

Chinese economic data has disappointed this year. However, there are reasons for optimism that risks regarding China may be receding. First, policy stimulus has stepped up with most recently a sales tax cut for small cars and another reduction in the required deposit ratio for first home buyers. Second, average home prices are now rising suggesting the risk of a property crash is rapidly fading. Third, recent business conditions PMIs have shown signs of stabilisation and consumer confidence has risen to its highest since May last year. Growth in the September quarter looks likely to have slipped below the 7% level, but the next few months are likely to see confidence improve that Chinese growth is under control. Fourth, Chinese mainland shares are trading on a forward price to earnings multiple of 11.2 times and Chinese companies listed in HK are trading on less than 7 times making them very cheap. Finally, September data on China’s foreign exchange reserves indicate capital outflows have slowed and hence worries about a crash in the Renminbi are receding.

Emerging countries

Growth in the emerging world has already slowed significantly. Business conditions PMIs in emerging markets (EMs) are weaker than in developed markets (DMs).

Bloomberg, AMP Capital

In 2011 emerging countries grew 6.2%, whereas this year it’s likely to be around 4%. Brazil and Russia are in recession. A lot of bad news has already been factored in for emerging markets with forward price to earnings multiples around 10 times (compared to around 14 in Australia) and a 40% fall in their currencies. But while valuations are good and extremely negative sentiment towards them is a positive, their economic cycle and liquidity backdrop reflecting high interest rates in some countries are bad. The main thing to watch for though is whether they start to drag down growth in advanced countries.

Commodity prices

Commodity prices are down 50-70% from their highs several years ago. With the supply of commodities still rising the secular decline in commodity prices may have further to run. However, the bulk of the price damage is likely behind us and they are due for a cyclical bounce.

An EM/commodity related accident

Perhaps the biggest risk associated with the collapse in emerging market currencies and commodity prices is the risk of an accident they might throw up. This was seen with the Russian default/LTCM crisis in in the 1998 emerging market crisis and Lehman’s collapse in the GFC. The fear of such I think largely explains investors’ twitchiness and worries about Glencore for example. Fortunately Glencore is not a Lehman Brothers – it’s much smaller and less connected to credit flows.

The US and Fed rate hikes

The start of a tightening cycle in US official interest rates is often associated with market volatility. Fortunately, the Fed has not blindly increased rates and has signalled it is aware of global risks and the impact of this on US inflation. In fact, with US growth looking like it’s continuing to trend around 2-2.25% and inflationary pressures still very weak, the first Fed rate hike looks like it will be delayed into 2016. While some fret about a US recession, the historical experience tells us this is very unlikely in the absence of significant monetary tightening and we are a long way from that.

A US Government shutdown/debt ceiling crisis

The decision by US Congress to extend Government financing to December 11, averting an October 1 shutdown, means the issue will now come up again later this year when it will get rolled into the need to raise the debt ceiling, which will be reached around November 5. This could see more brinkmanship as ultra conservative house Republicans still seek to defund Planned Parenthood. However, the vast majority of Congressional Republicans are more focussed on winning next year’s elections so a shutdown/debt ceiling crisis is likely to be avoided. Expect nervousness around this next month though.

Spain’s general election

With Greece “settled” for now and the Catalonian election not really advancing their independence from Spain, the next big risk on the horizon in Europe is Spain’s general election later this year. The populist Eurosceptic party Podemos has lost support but polling points to an inconclusive result between the Governing Popular Party and the centre left Socialist Workers Party. However, most of the heavy lifting on reforms has already been done. So a Euro threatening outcome is unlikely.

Australia

Australian growth is sub-par at 2% and this could continue for a while yet requiring more help from RBA rate cuts and a lower $A. But we are already half way through the mining investment slump and the economy has not crashed as some feared. There are several reasons: the boom was managed better this time around with no inflation or trade blow out, which should mean a milder bust. While mining exposed parts of the country are struggling, non-mining sectors like housing, consumer spending, tourism, agriculture and higher education are benefitting from lower interest rates and the fall in the $A. We continue to see better opportunities in global shares, but the ASX 200 should make it back to 5500 by year end.

Concluding comments

There is plenty to keep an eye (what’s new!) with the main risk being some sort of accident flowing from the emerging market/commodity slump. However, our broad assessment remains that the cyclical bull market in shares is likely to reassert itself in the seasonally strong months into year end.

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.

Due to an obsession with Taylor Swift and then The Carpenters I decided I needed to have a Carpenters’ CD with the full Burt Bacharach medley they performed in the early 1970s. So I went to Amazon and found that it was only on a Japanese Carpenters’ Anthology CD which would set me back $US150 from the US or $65 for a “very good” second hand edition from Japan. The last time I got a “very good” second hand Elvis book from Amazon it had some pages missing but I decided to give the Japanese CD a go. When I put the order in I was told it would arrive sometime between October 2 to November 4. Immediately I received an email from Japan to say it had shipped then two weeks later it arrived in a huge box. After cutting through all the cardboard and bubble wrap there was a pristine version of The Carpenters Anthology still in its factory wrapping with handwritten note from a Mr Kinoshita from Kyoto in Japan saying amongst other things that a new version had been substituted…I was starting to wonder whether a “very good” second hand version of something from Japan meant it was purchased by someone but never opened. Needless to say I was very impressed and the Burt Bacharach medley was as good as I had hoped.

Anyway investment markets are rarely pristine. In fact the well-known advocate of value investing, Benjamin Graham, coined the term “Mr Market” (in 1949) as a metaphor to explain the share market. Sometimes Mr Market sets sensible share prices based on economic and business developments. At other times he is emotionally unstable, swinging from euphoria to pessimism. But not only is Mr Market highly unstable, he is also highly seductive – sucking investors (and forecasters) in during the good times with dreams of riches and spitting them out during the bad times when all hope seems lost.

So during periods when Mr Market is highly unstable – like the weakness and volatility in investment markets we have seen recently in shares – it is useful for investors to keep in mind a list of critical things that are essential for success in investing in order to avoid being seduced by Mr Market.

Obviously when it comes to investing there is much to debate regarding the key things to bear in mind. And I could add lots of other points as well, but here is a list of the nine considerations I find most useful. I hope it is of value to you too.

• Make the most of the power of compound interest. Although the average annual return on Australian shares (11.8% pa) is just double that on Australian bonds (6% pa) over the last 115 years, $1 invested in bonds in 1900 would today be worth $807 whereas $1 invested in shares would now be worth $406,816. Yes there were lots of rough periods along the way for shares just like through the GFC and its aftermath (eg the 1930s, 1970s, 1987-96), but the impact of compounding at a higher long term return is huge over long periods of time. The same applies to other growth related assets such as property, which over long periods has had a similar return to shares. So one of the best ways to build wealth is to take advantage of the power of compound interest and this means making sure you have the right asset mix in your investment strategy.

Source: Global Financial Data, AMP Capital

• Be aware that there is always a cycle. The historical experience of investment markets – be they bonds, shares, property, infrastructure, whatever – constantly reminds us they go through cyclical phases of good times and bad. Some are short term, such as occasional corrections. Some are medium term, such as those that relate to the 3 to 5 year business cycle. Some are longer, such as the secular swings seen over 10 to 20 year periods in shares. But all eventually contain the seeds of their own reversal. The trouble with cycles is that they can throw investors out of a well thought out investment strategy that aims to take advantage of long term returns and can cause problems for investors when they are in or close to retirement. But they also create opportunities.

• Invest for the long term. In the 1970s a US investment professional named Charles Ellis observed that for most of us investing is a loser’s game. A loser’s game is a game where bad play by the loser determines the victor. Amateur tennis is an example, where the trick is to avoid stupid mistakes and thereby win by not losing. The best way for most investors to avoid losing at investments is to invest for the long term. Get a long term plan that suits your level of wealth, age, tolerance of volatility, etc, and stick to it. This may involve a high exposure to shares and property when you are young or have plenty of funds to invest when you are in retirement and still have your day to day needs covered. Alternatively if you can’t afford to take a long term approach or can’t tolerate short term volatility then it is worth considering investing in funds that use strategies like dynamic asset allocation to target a particular goal – be that in relation to a return level or cash flow. Such approaches are also worth considering if you want to try and take advantage of the opportunities that volatility in investment markets through up.

• Diversify. This is another no brainer. Don’t put all your eggs in one basket as the old saying goes. But plenty do. Through last decade many wondered what was the point of having global shares in their investment portfolios as Australian shares were doing so well. But for the last five years or so global shares have been far better performers and have proved their worth. It also seems that common approaches in SMSF funds are to have one or two high yielding and popular shares and a term deposit. This could potentially leave an investor very exposed to either a very low return or if something goes wrong in the high yield share they are invested in. By the same token don’t over diversify with multiple – say greater than 30 – shares and/or managed funds as this will just complicate for no benefit.

• Turn down the noise. Once you have worked out a strategy that is right for you, it’s important to turn down the noise on the information flow surrounding investment markets. We are now seeing an explosion in the volume and ease of access to information and opinions surrounding economies, investment markets and individual investments. This is great in a way. But there is little evidence that it’s helping investors make better decisions and hence earn better returns. We seem to lurch from worrying about one crisis to another. Just like every year now it seems, this year is seeing the usual long worry list with worries about soft US growth earlier this year, Fed tightening, Greece, China, Korean tensions, the emerging world, US budget funding, etc. And as “bad news sells” the negative commentary around this noise gets the loudest airing. The “perma bears” have had a field day since the GFC in simply rolling their predictions of global meltdown from the US (which was supposed to have a debt driven or hyperinflation meltdown), to Europe (where the Euro was supposed to blow itself apart) to now China. The combination of too much information has turned investing into a daily soap opera – as we go from worrying about one thing after another. This is all leading to heightened uncertainty and shorter investment horizons which in turn can add to the risk that you can be thrown off well thought out investment strategies. The key is to turn down the volume on all the noise. This also involves keeping your investment strategy relatively simple – lots of time can be wasted on fretting over individual shares or managed funds – which is just a distraction from making sure you have the right asset mix as it’s your asset allocation that will mainly drive the return you will get.

• Buy low, sell high. One reality of investing is that the price you pay for an investment or asset matters a lot in terms of the return you will get. It stands to reason that the cheaper you buy an asset the higher its prospective return will be and vice versa, all other things being equal. So if you do have to trade or move your investments around then remember to buy when markets are down and sell when they are up. This seems like a no brainer, but most people do the opposite. There’s an old saying in investment markets: “flows follow returns”! In other words inflows are strongest after periods of strong returns and outflows are strongest after weak returns. It should be the other way around.

• Beware the crowd at extremes. For periods of time the crowd can be right and safety in numbers provides a degree of comfort. However, at extremes the crowd is invariably wrong. Whether it’s lemmings running off a cliff, or investors piling into Japanese shares at the end of the 1980s, Asian shares into the mid 1990s, IT stocks in the late 1990s, US housing and dodgy credit in the mid-2000s. The problem with crowds is that eventually everyone who wants to buy will do so and then the only way is down (and vice versa during crowd panics). As Warren Buffet once said the key is to “be fearful when others are greedy and greedy when others are fearful”.

• Focus on investments offering sustainable cash flow. This is very important. There’s been lots of investments over the decades that have been sold on promises of high returns or low risk but were underpinned by hope based on hot air (eg, many dot com stocks in the 1990s, resources stocks periodically) or financial alchemy where rubbish was supposedly turned into AAA yield generators (the sub-prime CDOs of last decade). But the key is that if it looks dodgy, hard to understand or has to be based on obscure valuation measures to stack up then it’s best to stay away. There is no such thing as a free lunch in investing – if an investment looks too good to be true in terms of the return and risk on offer then it probably is. By contrast, assets that generate sustainable cash flows (profits, rents, interest payments) and don’t rely on excessive gearing or financial engineering are more likely to deliver.

• Seek advice. Given the psychological traps that we are all susceptible to (in particular the tendency to over-react to the current state of investment markets) and the fact that it is not easy, a good approach is to simply seek the advice of a coach such as a financial adviser, in much the same way you might use a specialist to look after other aspects of your life like fixing the plumbing, your medical needs or helping you get fit. Even I have one.

By AMP Capital Markets

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

Uncertainties regarding the emerging world and specifically China and the US Federal Reserve’s much talked about first interest rate hike have continued to result in volatile share markets over the last few weeks even though most have not made new lows for this downturn. From their highs earlier this year to their recent lows, which were mostly a few weeks ago, major share markets have had the following falls: Chinese shares -43%, Asian shares (ex Japan) -23%, emerging markets -22%, Eurozone shares -18%, Australian shares -16%, Japanese shares -16% and US shares -12%.

I feel more comfortable when shares are rising than falling as it’s a positive sign for economic growth, long term prosperity and of course individual wealth. But I also know that periods of decline and volatility are a necessary part of the way the share market works. This note takes a look at past significant share market falls as they help put the current weakness in context.

Recent falls in context

We’ll start with the US, as while other markets are important at times, the US remains the world’s biggest and most watched share market and it invariably sets the big picture swings in most other major markets. The next table shows 10% plus falls in US shares since the end of the 1980s.

Much of the debate around share market declines concerns whether they are a correction or 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, up to 20% or so, 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 and it takes shares more than a year to gain new highs. Following this definition bear markets are highlighted in bold, corrections in blue. Falls less than 10% are not shown as they occur too frequently to be of interest.

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

Excluding this year, since 1989 the US share market has experienced 10 falls of 10% or more. Of these, only the 49% fall between March 2000 & October 2002 and the 57% fall between October 2007 and March 2009 were bear markets, whereas those in 1990, 1997, 1998, 1999, 2010, 2011 and 2012 were corrections as a rising trend quickly resumed. Since December 1988 US shares have returned 10.3% pa (including dividends).

The next table shows the same analysis for Australian shares.

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

Over the same period, the Australian share market has returned 9.3% and has had 15 falls greater than 10% (excluding that seen this year). Of these five were bear markets according to our definition.

Observations

There are several points to note about all this:

• Falls of 10% or more are not unusual. Most of these occur within a still rising trend which is re-established reasonably quickly. Only a small proportion become bear markets. Australian shares had a decent (10% plus) correction in every year from 1996 to 2001 and yet made new highs within 6 months each time and each year saw shares deliver a positive return. In fact most of the years which saw corrections as highlighted in the above tables saw positive calendar year total returns (ie, capital growth plus dividends) – see the final columns.

• Short term corrections and bear markets don’t equate to poor longer term returns from shares. Since December 1988 US shares have returned 10.3% pa and Australian shares 9.3% pa despite numerous corrections and bear markets. So while shares are highly volatile over short term periods their returns are more consistent and solid over long run periods. This can be seen in the next chart comparing annualised returns on Australian shares over rolling 12 month and 20 year periods. Whereas the rolling 12 month return bounces around violently, the rolling 20 year return is relatively stable.

Source: Global Financial Data, AMP Capital

• While it is reasonable to worry that recent share falls might be a warning of an approaching economic slump, the track record of share markets in foreshadowing recessions is not good. Of the ten share market falls in excess of 10% in the in the US noted above (excluding the present) only three were associated with recessions. Similarly in Australia of the 15 share market falls greater than 10% or more in the table above only one was associated with a recession. Hence Paul Samuelson’s quote that “Wall Street indexes predicted 9 of the last five recessions.”

• Recessions do make a difference, particularly in the US where share market falls associated with recessions averaged 42% versus an average of 14% for those that do not. And of course Australia’s deepest share market fall in the last 25 years or so, ie the 55% plunge over November 2007 to March 2009, was associated with a US recession.

• Once share market falls run their course they are usually followed by a strong rebound in the subsequent 12 months. This is evident in the second last column of the tables above which shows capital growth in the 12 months following the share market lows.

• Finally, while it is natural for investors to prefer rising share markets than falling, periods of decline and volatility are a necessary part of the way the share market works given the investor psychology that plays a huge role in pushing the share market to extremes at times relative to its long term rising trend. Essentially, periods of share market weakness stop investors from getting too euphoric, they provide a reminder that the outlook is not risk free and they help reset starting point values to provide a reasonable medium term return potential after periods when returns have run above average. In terms of the latter, the recent decline in share markets has pushed up the medium term (5 year) return potential from a diversified mix of assets from around 7% pa earlier this year to around 7.6% pa now. See the next chart. This is because when share prices are lower their return potential improves as dividends yields rise and shares trade on a lower price to earnings ratio. (Of course the return potential boost for a diversified mix of assets does not go up by more as the return potential from non-share asset classes are not or little affected by share market moves.)

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Source: AMP Capital

Concluding comments

There are several implications for investors from all this:

First, while share market falls can be distressing they are a normal part of the way the share market works.

Second, share market falls are usually made worse by recessions (notably US recessions) and a combination of prior overvaluation, investor euphoria and significant monetary tightening. While current share market falls could still have further to go as China and Fed worries linger, fortunately the risk of a recession in the US is low at present and one should still be avoided in Australia and prior to recent share market falls we didn’t see the combination of overvaluation, euphoria and significant monetary tightening that invariably precedes major bear markets.

Finally, share market falls boost the medium term return potential from shares – simply because they make shares cheaper – and once share markets bottom they are invariably followed by a strong rebound. Trying to time the bottom though is always hard, so averaging in after falls makes sense for those looking to allocate cash to shares.

By AMP Capital Markets

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

Whenever there are sharp falls in share markets like recently, there is a temptation to wonder whether we are seeing a re-run of the last major crisis. Fortunately, the conditions today are very different to the run-up to the global financial crisis (GFC) which originated in the developed world, notably the US. The developed world hasn’t seen the sort of excesses that preceded the GFC: there has been no generalised bubble in investment spending (housing or otherwise), there has been no asset bubble, there has been no easing in lending standards like that which occurred with sub-prime debt and there has been no build up in inflation pressures or monetary tightening. So it’s hard to see the sort of unravelling in global financial markets that started in interbank lending and credit markets, threatening a seizing up of the global financial system and spreading through all growth assets that we saw through the GFC.

If there is a historical comparison, perhaps it should be to the 1997-98 Asian/emerging market crisis. A big driver of the recent turmoil in global share markets is the growth downturn in China and the emerging world and the fear that this will ultimately affect developed countries. This is of course coming against a background of concerns about the Fed raising interest rates, but more specifically this is arguably exacerbating already existing emerging market problems by adding to downwards pressure on their exchange rates (and upwards pressure on the $US – which is something the Fed needs to be mindful of).

It seemed only yesterday that the emerging world was riding high. But in reality worries about emerging market (EM) countries have been brewing for a while now, with the relative performance of their share markets and currencies struggling since 2011. This note looks at the main issues, but first a bit of history to put EMs in context.

Emerging markets – all the way up…

In the mid-1990s there was much talk of an “Asian miracle”. Growth was thought to be assured by high savings and investment rates, strong export growth and a shift in labour to cities. However, as often occurs during good times, excesses set in including a reliance on foreign capital, current account deficits, excessive debt levels and over-valued fixed exchange rates. Eventually foreign investors had doubts. In mid-1997 Thailand experienced capital outflows that became a torrent and triggered a collapse in its fixed currency, which then led investors to search for countries with similar vulnerabilities. This led to the crisis spreading across the emerging world ultimately contributing to Russia’s debt default of 1998. The Asian/EM crisis, which saw EM shares lose 60%, dragged down global and Australian shares by between 10% to 23% in the midst of both 1997 and 1998 on fears it would drag down developed countries, but with both years going on to provide good returns.

In the 2000s, emerging countries came back into vogue thanks to a range of productivity enhancing reforms, less reliance on foreign capital and low and floating exchange rates and this, along with the industrialisation of China and a related surge in commodity prices (which benefited South America and Russia), saw their growth rates improve. The enhanced perception of emerging countries and a secular slump in the traditional advanced economies at the same time saw them once more come into favour amongst investors.

This reached a crescendo after the GFC with talk of a “new normal” of poor growth in advanced countries and their quantitative easing encouraging capital flows to the “stronger” emerging markets leading in fact to complaints of “currency wars” from EMs as their currencies rose. The rise in the value of Asian currencies versus the $US over the last decade as a result of strong capital inflows can be seen in the next chart.

Source: Bloomberg, JP Morgan, AMP Capital

…and then back down again

Since 2011, Asia and the emerging world have gone full circle back to being out of favour again. This can be seen in a downtrend in their exchange rates (the emerging market currency index is down 38% from its 2011 high) and a shift to relative underperformance of EM versus developed market (DM) shares.

Source: Bloomberg, AMP Capital

Several factors have led to this turnaround including:

• The downturn in commodity prices impacting South America and Russia.
• Slower growth in China, affecting Asian trading partners.
• A reversal in economic reform momentum as the success of the last decade led to hubris. Brazil and some of South America have reverted to old fashioned populism.
• Some EMs have political problems – eg, Turkey, Argentina & Thailand. Russia has shot itself in the foot over Ukraine.
• The process of reducing monetary stimulus in the US has led to a reversal in the money flow to the emerging world.
• This has all occurred at a time when the flow of news in developed countries has arguably improved with stronger growth in the US, economic reforms in Europe and Abenomics in Japan.

Emerging market problems were thrown into sharp focus when China devalued the Renminbi a month ago, which led to added concerns about Chinese growth and worries about more downwards pressure on EM currencies. The combination of these developments and higher interest rates in some EMs to combat inflation has been to push growth down and this is evident in emerging market PMIs (surveys of businesses regarding their conditions) falling below those in developed countries. Brazil and Russia are already in recession.

Source: Bloomberg, AMP Capital

Comparisons to 1997-98

Despite the change in fortunes, the overall position of emerging countries is arguably stronger today than it was prior to the 1997-98 crisis. Current account balances are generally in better shape, foreign currency debt is lower, foreign exchange reserves are much higher, exchange rates are mostly floating rather than fixed which means they don’t have to be defended from speculative attacks and inflation is lower providing more flexibility to undertake monetary stimulus. China is critically important in the emerging world and fortunately it is arguably in a strong position to support growth in its economy (with plenty of scope to cut interest rates, little reliance on foreign capital, capital controls protecting against heavy capital outflows, manageable public debt and very strong foreign exchange reserves) and plenty of incentive to do so. Further stimulus measures are likely to be announced in China.

Source: IMF, Bloomberg, AMP Capital

However, several countries are vulnerable thanks to current account deficits, eg Brazil and Indonesia, there has also been a degree of overinvestment in parts of Asia which has created chronic deflationary pressures, the lack of reform and adoption of populist policies in several EMs looks here to stay (until a crisis forces a change in direction) and China and the emerging world are a lot more important globally than was the case in 1997 so their impact on developed countries and global growth has the potential to be greater. See the next chart.

Source: IMF, AMP Capital

So overall we don’t see a return to the 1997-98 Asian/emerging markets crisis, but it’s worth keeping an eye on.

Implications for investors

There are several implications for investors:

First, notwithstanding likely bounces along the way, the secular underperformance by emerging market shares relative to developed market shares could have a fair way to go yet given the extent of outperformance last decade.

Second, in the current environment emerging markets are best invested in on a selective basis focussing on those less vulnerable to capital outflows (eg with large current account surpluses), less vulnerable to weak commodity prices and with less pressing structural problems, eg Korea and Mexico over Brazil.

Third, given the greater importance these days of China and the emerging world the risk that problems in the emerging world affect developed country growth cannot be ignored. But if we are right and China manages to stabilise its growth then the impact should be minimal and limited to periodic scares as we saw in 1997 and 1998, rather than triggering a new global economic downturn & bear market in developed country shares.

By AMP Capital Markets

About the Author

Dr Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital is responsible for AMP Capital’s diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

Introduction

The Australian economy remains in a difficult period as the mining boom unwinds. Non-mining activity has bounced back but is far from strong enough to offset the headwinds coming from the mining downturn. This note looks at the outlook for growth, interest rates, profits and what it means for investors.

Growth remains poor

June quarter growth was anaemic at just 0.2% quarter on quarter or 2% year on year.

Source: ABS, AMP Capital

Were it not for a strong surge in public spending and a (likely temporary) bounce in investment in WA, June quarter growth would likely have been negative as consumer spending was soft, housing investment fell, underlying business investment was soft and net exports and inventories cut 0.6% points and 0.2% points from growth respectively.

Growth outlook

The growth detraction from net exports and inventories seen in the June quarter is payback for positive March quarter contributions and unlikely to be repeated in the current quarter, allowing growth to bounce back a bit to around 0.5% quarter on quarter, which is the average of the last two quarters.

However, this will not alter the tough position Australian now finds itself in. Mining investment, having risen from around 2% of GDP to 6%, is now falling back rapidly as large projects complete. This is detracting around 1 percentage point from growth per annum. To offset this we need to see growth in other parts of the economy pick up. We have seen housing and consumer spending springing back to life and improvement in tourism and higher education. However, non-mining investment remains disappointing.

The latest business investment (capex) plans from the ABS point to more weakness ahead. Comparing the third estimate of investment for 2015-16 with that a year earlier for 2014-15 points to a 23% fall in business investment this financial year.

Source: ABS, AMP Capital

While slumping mining investment is no surprise what is concerning is that the outlook for non-mining investment remains weak pointing to a 7.5% decline this financial year. More broadly, several other factors seem to be playing a role in sub-par growth in the economy, including: steeper than expected falls in commodity prices that continue to cut into national income growth (nominal GDP growth was just 1.6% year on year through last year); the ongoing threat of more budget austerity; household reluctance to take on more debt; delays in the fall in the $A (just over a year ago it was still around $US0.95); and subdued levels of confidence.

But there are several reasons not to get too negative.

• Borrowing rates are at generational lows. Australians owe the banks $1.2 trillion more than the banks owe them, so the household sector is a net beneficiary of low rates.

• The fall in the $A is a big positive for manufacturing, tourism, higher education, services, farming and mining.

• Petrol prices aren’t as low as they should be, but are down from their highs last year, delivering savings to households.

• The household savings rate remains relatively high at 8.8% and has scope to drift down supporting spending.

• Australia managed the boom a bit better than it has in the past when booms led to inflation or trade deficit blow-outs or both and all sectors of the economy boomed together and so went bust together. This time there was no major buildup of imbalances in the economy and sectors suppressed by the mining boom are bouncing back.

• Reflecting this, real state final demand is up 3.3% year on year on NSW & 3% in Victoria, while it’s down 1.8% in WA.

• Most Australians don’t get paid export prices so hand wringing over the “national income recession” is overdone.

This should mean the risk of a recession remains relatively low and there is no reason to get overly gloomy on Australia. Rather growth is likely to continue to remain sub-par at around 2% as the negatives and positives balance out.

More RBA rate cuts and the $A heading to $US0.60

However, with the mining downturn having at least another two years to run the prospect of another few years of growth running well below potential is not appealing. While potential growth in the Australian economy may have slowed to around 2.75% thanks to slowing productivity and population growth, actual growth is running well below this at around 2%. This means spare capacity in the economy will continue to build, with a rising trend in unemployment and downwards pressure on inflation. What’s more, housing construction which has helped the economy looks to be at or close to peaking. Against this backdrop the economy is likely to need more help.

First, the combination of an extended period of below potential growth, a rising trend in unemployment and weak inflation is likely to ultimately drive the RBA to cut interest rates again. A slowing in Sydney and Melbourne home price growth (as APRA measures bite) should make it easier for the RBA to do this. The November RBA meeting is the next one to watch, failing that then expect a move early next year. While in an ideal world it would be good to see more of focus on economic reforms to drive stronger growth, the political reality means that this will be hard to achieve any time soon.

Second, the $A looks headed to around $US0.60. The primary driver is the ongoing secular bear market in commodity prices but the likelihood of a further narrowing in the interest rate differential versus the US adds to the case. This will be a typical overshoot in the value of the $A, but it’s necessary to help drive increased demand in non-mining industries like tourism and manufacturing and in turn help drive up non-mining investment.

Profits disappointing, but good outside resources

The recently completed profit reporting season was a good reflection of the state of the economy. 2014-15 profits were weak overall with June half results being a little disappointing. 43% of companies beat expectations and 59% saw their profits rise from a year ago which is okay, but it’s well down on what we saw in the last few reporting seasons.

Overall profits fell around 2% over the last financial year and guidance for the current financial year was cautious. However, several points are worth noting:

• The fall in profits owes to a 35% slump in resources profits.

• The rest of the market saw profits rise around 7.5% driven in particular by general industrials, building materials, retail and health care stocks.

• Profits for industrials ex financials rose 11.5%, and are now up four years in a row. See the next chart.

• Revenue growth remains subdued but is being helped by the lower $A with strength in companies connected to home building and NSW.

• Dividend growth remains solid at 4% in 2014-15 with 57% of companies raising dividends.

Source: UBS, AMP Capital

Consensus earnings growth expectations for 2015-16 remain soft at around 4%, driven by industrials ex financials with profit growth of 8.5% more than offsetting another 6% expected decline in resources profits. Low interest rates and the falling $A should help industrial profits.

Are high dividend payouts to blame for weak capex?

A common view is that companies are not investing because shareholders are demanding high dividends. This may be playing a role but it’s likely to be minor. Contrary to popular perception the dividend payout ratio (ie dividends relative to earnings) is not significantly out of line with its historic norm. For industrials the payout ratio at around 70% is around where it was prior to the GFC. It’s mainly resources stocks that have boosted payouts to around 70% from around 30-40% prior to the GFC) and it’s hard to argue they should ramp up investment after having over invested!

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

The real reasons for the lack of investment by non-mining companies is likely to be post GFC caution, wariness after getting smashed through the mining boom by the high $A, high interest rates and high labour costs (just four years ago now) and too high hurdle rates for a low inflation world.

Implications for investors

First, bank term deposit rates are likely remain low or fall even further. The search for decent income flows has further to run.

Second, the $A is likely to continue to fall. So continue to favour unhedged over hedged global shares.

Third, Australian economic growth is likely to disappoint relative to expectations for the US and Europe, suggesting a case to maintain a greater exposure to traditional global shares even though we expect Australian shares to end the year much higher than they are now.

By AMP Capital Markets

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 turmoil in global investment markets has continued into this week, although the last few days have seen a bit of stabilisation and improvement in several markets. From their highs to their recent lows major share markets have now had the following falls: Chinese shares -43%, Asian shares (ex Japan) -23%, emerging markets -22%, Eurozone shares -18%, Australian shares -16%, Japanese shares -15% and US shares -12%. Such falls are painful for investors. This note looks at some of the main issues.

What has driven the falls?

In a way we have seen a range of issues combine to create a perfect storm for share markets over the last few weeks with:

• China’s currency devaluation and weaker economic data raising concerns about the Chinese economy.

• This came at time when concerns about the emerging world have been building for several years as falling commodity prices have weighed on commodity producers particularly in South America and the Middle East, this has been made worse by a shift to populist/anti-reform economic policies and Russia has shot itself in the foot over Ukraine.

• China’s recent currency devaluation has triggered further falls in Asian and emerging market currencies, which have already been falling for four years now (and are down 37% from their 2011 high – just like the $A!).

• Tensions between North and South Korea.

• The bombing in Thailand.

• Worries about the Fed raising interest rates at some point after investors have got used to near zero interest rates for more than six years.

• The concerns in the emerging world have seen US shares break down through the technical chart ranges that have provided support of late.

• Even Greece got a look in with a new election on the way (although it’s unlikely to be a major threat as either the still popular Syriza will be returned in a coalition government (most likely) or the main opposition group New Democracy wins – but both sides support the three year bailout deal just agreed to with the rest of Europe).

All these issues have combined and we have seen something of a negative feedback loop with falls in Asian share markets leading to falls in European and then US shares and this then feeding back into Asian shares. At least until the last few days.

Are the share market falls just a correction or the start of a major bear market?

This remains the big question. (Note, I define a bear market as a 20% fall that is not recovered within 12 months, as we have seen examples of 20% of so falls in the past which are virtually forgotten about in a few months as shares quickly recover, eg in 1998.) Of course we can never know the answer in advance with certainty but there are good reasons to believe this is just a correction in major share markets as prior to recent falls shares lacked the conditions that normally precede bear markets: they were not unambiguously overvalued, they were not over-loved by investors, monetary conditions have not been tightened aggressively – in fact there had been no tightening at all – and cyclical growth indicators were pointing sideways.

Beyond these signs and put simply, if you believe the Chinese economy will collapse causing a severe global growth downturn/recession then shares are probably headed into a bear market. If alternatively you think this is unlikely then it’s likely to remain a correction. Our view is that the latter is more likely as the Chinese Government has a very low tolerance for social unrest that would flow from a hard landing as it knows that could pose a threat to the Government. To avoid this it needs to keep growth at a strong pace. Its monetary easing this week with a cut in interest rates and bank reserve requirements is a positive sign. China is the only major country that has the fire power for lots more easing and it’s really the only major country that needs to do it.

If it’s just a (severe) correction are we at/near the bottom?

Again this is impossible to know with certainty in advance. Our view remains that further falls and volatility in next few months could occur as worries regarding China and emerging markets linger, concerns about whether the Fed will raise interest rates soon will remain and seasonal weakness continues into September/October. However, there are some positive signs:

First, after sharp falls in share markets and falls in bond yields share valuations have become quite attractive. Our valuation measures for global and Australian shares have fallen back into very cheap territory.

Source: Bloomberg, AMP Capital

The gap between the grossed up dividend yield on Australian shares (which is now around 6.5%) and term deposit rates (around 2.5%) is now at its highest level since the GFC.

Source: Bloomberg, AMP Capital

Second, investor confidence has rapidly collapsed as evident by all the talk of global calamity. In fact a measure of investor sentiment based on various surveys and indicators of fear that we track has fallen to levels often associated with market bottoms. This is positive from a contrarian perspective.

Source: Bloomberg, AMP Capital

Third, China has provided additional monetary stimulus which may help provide a circuit breaker to the negative feedback loop that has been developing. Significantly more easing is still required with real interest rates still too high and the banks’ required reserve ratio also too high. But at least they are going in the right direction.

Finally, the US Federal Reserve has indicated it is aware of global growth risks and ongoing low inflation and looks like it will delay raising interest rates in September.

What is the risk of a re-run of the 1997-98 Asian/emerging market crisis?

This saw a 60% fall in Asian and emerging market shares and contributed to sharp 10% to 23% falls in the midst of both 1997 and 1998 in both global and Australian shares, but the latter markets quickly recovered after each setback and actually had good years in 1997 and 1998. A re-run is certainly a risk and there are some parallels. And the world is arguably more vulnerable that it was in the strong 1990s. However, while the risks are there, a re-run will likely be avoided as key emerging countries are now less dependent on foreign capital (with better current account balances and stronger foreign exchange reserves) and most Asian and emerging market currencies are now floating and so don’t have to be defended from speculative attacks which contributed to the Asian contagion of 1997 as investors speculated against one fixed currency after another (starting with Thailand).

What are the key things to watch?

To keep it simple there are four key things to watch:

• Further policy stimulus in China – this will likely be needed and come in the form of monetary stimulus and increased government spending.

• A stabilisation/improvement in Chinese economic data.

• The Fed not making a mistake with a premature rate hike – it now looks likely that it will delay raising rates in September.

• Global growth indicators, like business conditions PMIs, need to continue to track sideways like they have over the last few years rather than start to trend down.

What should investors consider?

In this uncertain environment investors need to allow for several things:

• First, shares invariably go through volatile patches in the short term with corrections and bear markets, 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 the trend ultimately rising. This can be seen in the next chart.

Source: ASX. AMP Capital

• Second, selling after a major fall just locks in a loss (and is just as bad as piling in only after a period of strong gains).

• Third, when shares and growth assets fall they are cheaper and offer higher long term return prospects. This is just like a sale at a supermarket, but we always seem to see it the wrong way around so after falls many investors actually to sell and fail to take advantage of the value that emerges.

• Finally, while shares have fallen in value over the last few months, the dividends from the market as a whole have continued to increase. In fact, dividend payments remain more attractive and more stable than interest payments on bank term deposits.

By AMP Capital Markets

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.