Olivers Insights

Introduction

I have discovered after nearly 10 years that Taylor Swift is actually pretty good. Songs like Style and Shake it Off are right up there when it comes to great head candy. Not quite as good as say The Beach Boys of course but still up there. In my Holden, the next CD I had loaded after Taylor’s 1989 was a compilation of The Carpenters’ greatest hits (which got there after an obsession with the Johnny Depp film “Dark Shadows”) and I must admit that Taylor cannot generate the emotion inherent in The Carpenters’ songs where Karen’s voice and the production overlay of her brother can send me over the top.

So what’s this got to do with it? Not much really except that share markets are full of emotion and right now there seems to be a lot of nervousness around. In fact this has arguably been the case since April during which we have seen several major share markets have decent corrections, eg Chinese shares -32%, Asian shares (ex Japan) -17%, Emerging market shares -16%, Eurozone shares -13% and Australian shares. Of course the US share market has been relatively stable with at most a 4% pull back, although being virtually flat year to date it might be described as being in a “stealth correction”.

This note takes a look at the drivers of these declines and whether it’s just a correction or something more serious.

The short term worry list

In our view the correction could have further to run over the next few months with a reasonable worry list remaining in place.

• Uncertainty remains in relation to China following recent softer economic data, continuing volatility in Chinese shares and China’s move to devalue the Renminbi by 3% and allow market forces to play a greater role in its determination.

• Commodity prices are in a secular bear market reflecting a surge in supply in response to the super cycle price upswing last decade, slowing growth in China and the rising trend in the value of the $US (as most commodities are priced in US dollars). At present it seems the negative impact of falling commodity prices on producers (eg, US energy companies) is dominating the positive effect on commodity users (eg, US consumers). And China’s currency devaluation is seen as reducing demand for them particularly to the extent it makes Chinese producers more economic.

• The malaise in emerging markets is worsening. Their period of strength ended with the commodity boom and many of them have fallen victim to hubris that set in through the boom years last decade and so they are now suffering from populist policies. Slower growth in China is not helping and the devaluation of the Renminbi has helped accelerate the collapse in emerging market currencies (which are down 36% from their 2011 high). The problems in the emerging world are weighing on global growth (as they are now more than 50% of world GDP) and leading to fears of a re-run of the 1997-98 emerging market crisis.

• Greek related Eurozone risks could re-emerge, albeit briefly. While Greece and the Eurozone have agreed a third bailout program, Greece could be headed to new elections and the IMF is likely to insist that Greece’s debt burden is reduced before participating in the bailout with a decision due in October. Neither of these are likely to be major threats though. First, there is enough broad based support for the program in the Greek parliament and still popular Greek PM Tsipras looks like he will emerge as a more centrist leader. Second, Greece’s debt burden is likely to be relieved by lowering its debt servicing costs via interest rate grace periods, longer maturities, etc. However, uncertainty around either or both of these could cause short term nervousness.

• The combination of slower growth in China, falling commodity prices, weakness in the emerging world and the fragility of growth in developed countries indicate the risk of deflation globally remains high. In some ways this is good as a slower global recovery means less inflation and a longer global recovery. But it also poses risks for profits.

• The Fed appears to be heading towards a rate hike and this against the backdrop of deflationary forces globally is creating intense uncertainty. The start of a rising cycle in US interest rates is often associated with market volatility. How far will it go? Is the Fed going to crunch growth? The start of the last two major interest rate tightening cycles by the Fed in 1994 and 2004 were associated with falls in US shares of 9% and 8% respectively. Investors have now grown used to near zero interest rates for more than 6 years in the US and there is naturally fear that raising them will threaten the still fragile US and global economies.

• Some technical indicators for the US share market are looking a bit tired, particularly with declining breadth in terms of stocks keeping the market up.

• Australian shares are not being helped by a somewhat disappointing start to the local earnings reporting season. So far 46% of companies have beaten expectations and 61% have seen profits rise from a year ago which is okay, but it’s down on what was seen in the February reports, and given the tendency for good results to come early there is a risk of slippage as the reporting season continues.

Source: AMP Capital

Seasonal pain

Apart from these considerations it should also be recognised that the seasonal pattern for shares typically sees rougher returns over the period May to November. This is consistent with the old saying “sell in May and go away, buy again on St Leger’s Day (a UK horse race in September).”

Source: Bloomberg, AMP Capital

Is it a correction or something worse?

The important issue though is whether current weakness is just a correction or the start of a new bear market? Periodic sharp falls in the range of 5% to even 20% are quite normal and healthy in that they help the market let off steam and the rising trend resume. Of course it becomes more concerning if the rising trend in share prices gives way to a declining trend and a new bear market sets in. On this front our view remains that the cyclical bull market in shares likely has further to go. Put simply shares are not seeing the sort of conditions that normally precede a new cyclical bear market: shares are not unambiguously overvalued; they are not over loved by investors; uneven & below trend growth is extending the economic expansion cycle; and monetary conditions are likely to remain easy for a while yet. Looking at each of these in turn.

• Share market valuations are mostly okay. Sure, measured in isolation against their own history some share markets are not cheap anymore. However, once the gap between share market earnings yields and bond yields is allowed for, shares still look cheap (see the next chart).

• While global economic growth is constrained, a slower recovery should mean a longer recovery as it means spare capacity remains significant and we are a long way from the sort of inflation and debt excesses that precede cyclical downturns/recessions. In terms of current specific concerns: China is unlikely to allow growth to slip much lower for the simple reason that it will lead to social unrest, lower commodity prices will ultimately be positive for growth in developed and Asian economies which are mostly commodity users and while parts of the emerging world will remain weak a re-run of the 1997-98 crisis looks unlikely as the conditions today are very different.

Source: Bloomberg, AMP Capital

• Global monetary conditions look set to remain easy. Continued spare capacity and the lack of inflationary pressure has seen global monetary conditions ease not tighten this year. And while the Fed may raise interest rates by year end, they will still remain very low (in a range of 0.25% to 0.5%) and the Fed is likely to signal that any further moves are likely to be gradual, unlike in past tightening cycles. So monetary conditions in the US and globally are likely to remain easy for a long while.

• Finally, shares are a long way from being over loved. Sir John Templeton once observed that “bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria”. There still looks to be a lot of scepticism out there and in my travels in recent times I am yet to find a cabbie piling into shares (one of the best guides to when we have hit euphoria). In fact various measures of investor sentiment that we track are showing high levels of pessimism which is a bullish sign from a contrarian perspective. (See the next chart.) This is particularly the case in relation to Asian and emerging market shares.

Source: Bloomberg, AMP Capital

Concluding comments

First, while there is a high risk of a further correction in share markets in the next month or so, from a broad brush perspective we are not seeing the signs normally seen at major cyclical peaks in shares and so the cyclical bull market in shares looks like it has further to go.

Second, China and the Fed are probably the key risks worth keeping an eye on.

Third, while there will be cyclical bounces in commodity prices and emerging market shares the time to “blindly overweight them” was last decade and until supply imbalances in the case of commodities and structural problems in parts of the emerging world are resolved it makes sense to be selective and cautious when investing in them.

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

Through the secular bull market in shares that went from 1982 through to 2000 (or up to 2007 in Australia) most asset classes did well and so getting the asset mix right – ie the relative exposure to each of the major asset classes like shares, bonds and cash – was seen as less important and many thought that actively managing it was too hard. This all changed with the GFC and its aftermath of messy markets providing a reminder of just how important asset allocation is. As a result the importance of asset allocation, and specifically active approaches to managing the asset mix over time, has made a comeback. See “The critical role of asset allocation”, Oliver’s Insights, March 2014 for a broader discussion around asset allocation.

However, in saying that actively managing asset allocation is important it also needs to be recognised that this can be very difficult for many investors and so rather than mess it up, the common view has been that for many it’s better to just adopt a long term strategy and stick to it. This note looks at this issue and in particular why investors need a rigorous approach to asset allocation if they are going to consider moving their asset mix around in relation to short term cyclical swings in markets. Let’s first go back to investing basics. 

Investing 101

Investors should always be aware of two fundamentals: the power of compound interest and that there is always a cycle. The power of compound interest, which is basically the compounding of investment returns in one year on top of those earned in previous years, is demonstrated in the next chart which shows the value of $1 invested in 1900 in Australian cash, bonds and shares over time assuming that interest and dividends are reinvested along the way. 

Source: Global Financial Data, AMP Capital

Whilst shares are more volatile than cash and bonds and can see significant periods of poor returns (shown with arrows in the chart), the compounding effect of their higher returns over time results in a much higher wealth accumulation from them. The average return since 1900 from Australian shares at 11.9% pa is only double that of Australian bonds at 6% pa but over the whole period $1 invested in shares would have compounded to $438,844 today versus only $802 if that $1 had been invested in bonds. Over all rolling 40 year periods and virtually all 20 year periods shares trump bonds and cash. This is basically the argument for a long term approach to investing.

The problem is that there is always a cycle. Cycles encompass both secular malaises like those seen in the 1930s, 1970s and last decade for global shares that can last a decade or so before giving way to better times, and normal business cycles that result in three to five year cyclical swings in share markets. The impact of this can be seen in the following chart that shows returns from a diversified mix of assets back to the 1920s.

Traditional diversified investment portfolios that underpin many superannuation funds aim to reduce the volatility associated with shares and other growth assets by having some exposure to cash and bonds. But despite this the historical record indicates that traditional diversified portfolios (cash, bonds, property, equities, etc) have negative returns every six years or so. The next chart shows returns for balanced growth super funds since 1982. Since balanced super funds only came into existence thirty years ago, the chart also shows a simulated balanced fund going back to the late 1920s. This is constructed on the basis of 70 per cent in Australian equities, 25 per cent in Australian bonds and five per cent in cash. The chart excludes exposure to global assets and property as we do not have a long term monthly return series for these. In any case, going by the last 86 years it’s doubtful that it would change the pattern of returns dramatically.

Source: Global Financial Data, Mercer Investment Consulting, Morningstar, AMP Capital

It’s clear from the chart that, while the losses around 2008 through the GFC were extreme they were comparable to experiences in the 1930s and 1970s, and more broadly it’s clear that negative returns every few years are a normal cyclical phenomenon. Negative returns occurred in 1929-31 (Great Depression), 1938-39, 1941-42 (World War II), 1949, 1952, 1956, 1960-61, 1964-65, 1970-71, 1972-74 (oil crisis, stagflation, Watergate, etc), 1981-82, 1987-88 (share market crash), 1990, 1994 (bond crash) and 2001-03 (tech wreck, terrorist attacks), 2008 (GFC) and 2011 (Eurozone crisis). Equity market falls were a key factor in most of these episodes as were recessions.

But while cycles are normal, the problem with them is that they can throw investors out of a well thought out investment strategy that aims to take advantage of compounding long term returns and can cause problems for investors when they are in or close to retirement. Cycles also create opportunities for investors to enhance returns. So for these reasons cyclical variations in asset class returns ideally need to be managed.

A constrained and volatile return world

The case for adopting some sort of process to manage asset allocation is also highlighted by the likelihood that the return potential from major asset classes is now much lower than was the case say 30 years ago. This simply reflects the fall in cash rates, term deposit rates, bond yields and property yields and higher price to earnings multiples on shares. See “Where will returns come from?” Oliver’s Insights, May 2015. At the same time the return potential between asset classes is likely to be wide and volatility is likely to be relatively high reflecting high public debt levels, extreme monetary policy settings and a greater reliance now on the more volatile emerging world for global growth. So in this environment getting the asset mix right will be far more important than it was prior to the GFC.

You know AA ain’t easy

However, in highlighting the importance of actively managing the asset mix over time it’s worth recognising that it’s not easy. The temptation for many investors is simply to move in response to recent developments. So if returns have been bad for a while then a typical response is to reduce exposure to growth assets and vice versa when returns have been good. This approach is well grounded in findings from behavioural finance which shows that investors tend to down play uncertainty and project the current state of the world into the future and that this is reinforced by the “safety in numbers” aspect of crowd psychology. The problem though is that after a period of share market weakness this will just lock in the loss and will invariably result in lower long term returns.

The following chart shows the cumulative return of two portfolios since July 1928.

• A fixed balanced mix of 70 per cent Australian equities, 25 per cent bonds and five per cent cash as per the last chart;

• a portfolio which starts off with the above but moves 100 per cent into cash after any negative calendar year and doesn’t move back until after the balanced portfolio has a calendar year of positive returns (assuming an investor will require a year of positive returns to get confident again). We have assumed a two-month lag. This is called the “switching portfolio”.

Source: Global Financial Data, AMP Capital

The switching strategy does produce better short term results when there are two consecutive calendar years of negative returns from the fixed balanced mix as in the early 1930s and mid-1970s. However, over the long run it produces an average return of 9% pa versus 10.3% pa for the balanced fund. On a $100 investment in 1928 the switching portfolio would have grown to $173,656 now compared to $518,009 for the constant balanced mix. (It doesn’t look so dramatic in the chart as I have used a log scale because otherwise it would just show two exponential curves.) Over the same period $100 invested in cash would have grown to $11,280 and $100 invested in bonds would have grown to $34,830. Out of interest while the constant balanced mix portfolio is now well above its pre GFC high, the switching portfolio is yet to fully recover.

The conclusions are clear. Over the long term, cash and government bonds will generate much lower returns than a diversified mix of assets and switching to cash after a bad patch is not the best strategy for maximising wealth over time. But many do. This leaves investors with two choices:

• Adopt a long term strategy and effectively rely on the power of compound interest to deliver over time and look through short term cyclical swings. This is okay for true long term investors but maybe not for those with a shorter term focus.

• Use a rigorous approach to dynamically vary the asset mix (ie what is increasingly referred to as dynamic asset allocation or DAA) in anticipation of cyclical swings.

The key underpinnings of a rigorous DAA approach

While investment cycles do not repeat precisely they do rhyme. Each cycle has common elements – eg, downswings in equities are usually preceded by shares becoming overvalued, over loved with investors piling into them and with tight monetary conditions threatening weaker economic conditions or a recession. These rhyming elements can be captured and combined to provide warning of swings in the cycle and hence are a solid foundation for a dynamic asset allocation process. This is our approach.

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

As widely expected the RBA left interest rates on hold at their August Board meeting. While it appears to retain an easing bias with its assessment that growth is “below longer-term averages” and that the economy is likely to have “a degree of spare capacity for some time yet”, it appeared to soften this bias by removing its previous reference to a further fall in the $A seeming “both likely and necessary”.

I am not in the gloomy camp on the Australian growth outlook. Low interest rates and the collapse in the value of the $A are helping the economy to rebalance which is seeing those sectors of the economy that were repressed through the mining boom return to strength. This is reflected in a reversal of the “two speed economy” which has seen Western Australia drop to the low end of a comparative ranking across the states and territories and Victoria and NSW push to the top.

Ranking the states, annual % change to latest

Source: ABS, CoreLogic RP Data, AMP Capital

However, it’s likely that the economy will still need more help. There are five main reasons why the RBA will likely move to cut interest rates again, probably before year end.

Reason #1 – The outlook for business investment remains poor

This was clear from the last ABS survey of investment intentions that was released after the RBA last cut rates back in May. Comparing the latest estimate of investment for 2015-16 with that made a year ago for 2014-15 points to a 25% fall in business investment in 2015-16 (see the next chart) and another approach points to a 23% fall.

Source: ABS, AMP Capital

Resource investment is now falling rapidly back to 2% of GDP as large projects complete. To offset this we need to see growth in other parts of the economy pick up and we have seen some success with housing and consumer spending. However, non-mining investment remains poor, with capex plans pointing to renewed weakness this financial year. There are several reasons why non-mining investment remains weak including non-mining corporate scepticism after the battering they took through the mining boom (thanks to the strong $A, high interest rates and competition for labour), post GFC caution and excessive project hurdle rates for a very low inflation world. High dividend payout ratios are not a factor because for industrial companies payout ratios are within their normal range – they are up for the whole share market but this is due to resources companies and it is hard to expect them to invest more! At its core, the weakness in non-mining investment partly reflects the degree to which the natural rate of interest has fallen and the RBA has yet to fully reflect this.

Reason #2 – Commodity prices are weaker than anticipated

The continuing decline in commodity prices that is rolling though iron ore and coal, metals and energy prices, largely on the back of increased supply, is taking Australian export prices and the terms of trade far lower than has been anticipated by both the Government and the RBA. Goods exports prices fell by another 4.4% alone in the June quarter. This is resulting in a greater than expected drag on national income.

Reason #3 – The $A remains too high

It’s typical during a commodity slump for the $A to fall way below the fair value level suggested by purchasing power parity, which is currently around $US0.75. This is necessary to help sectors that were harmed through the prior mining boom by the high $A including tourism, education, manufacturing and farming. This is now starting to happen, but at $US0.73 its early days. While the US Fed is on track to raise rates later this year, still moderate US economic growth and weak wages growth and inflation pressures indicate it could be delayed and/or it could do just one move and wait a while. To ensure the $A continues on its downwards trajectory the RBA needs to keep jawboning it lower and likely cut rates again. In this regard it was disappointing and risky to see the RBA drop its reference to a further depreciation in the $A being “likely and necessary” in its August post meeting statement.

Reason #4 – House price momentum is likely to slow in Sydney and Melbourne

Bank moves to tighten conditions for property investors via tougher income tests, lower loan to valuation ratios and higher mortgage rates in response to pressure from APRA are likely to weaken investor property demand and result in lower growth in home prices in Sydney and Melbourne. With property price growth comatose in the rest of Australia, at just 0.9% on average over the 12 months to July, this will help reduce a major barrier to further RBA easing.

Source: RP Data, AMP Capital

Reason #5 – Monetary policy has recently been tightened

Bank interest rate hikes for both new and existing property investors amount to a de facto monetary tightening. While it’s only modest after tax it could become serious if banks respond to the increase in their funding costs as they move to put more capital aside for property lending as directed by APRA and raise interest rates for owner occupiers. With economic growth still soft, higher mortgage rates across the board is certainly something that the RBA won’t want to see at this point in the cycle. The best way for the RBA to offset or neutralise this is to cut interest rates again.

Implications for investors

There are several implications for investors.

• First, bank term deposit rates are likely to remain unattractive and could fall even further. We have to get used to ongoing low interest rates and investors still relying heavily on bank deposits need to consider what is most important to them: capital stability (in which case stick with bank deposits) or decent and more stable income flows (in which case various alternatives are arguably much more attractive).

Source: RP Data, AMP Capital

• Second, ongoing low interest and deposit rates mean that growth assets providing decent yields will remain attractive. This includes commercial property and infrastructure but also Australian shares which continue to offer much higher income yields – and more stable income flows – than bank term deposits

Source: RBA, Bloomberg, AMP Capital
 

• Finally, despite the 1% post August meeting bounce in the value of the $A, it is likely to remain in a declining trend as the interest differential in favour of Australia continues to narrow. So it makes sense to continue to have a greater exposure towards unhedged international assets than would have been the case say a decade ago when the trend in the $A was up.

Source: RBA, Bloomberg, AMP Capital

About the Author

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

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

Since its 2011 high, the Australian dollar has fallen 34% in value against the US dollar. For some time our view has been that it will fall to $US0.70 by year end with probably an overshoot into the $US0.60s. However, as we all know forecasting precise currency levels is a mug’s game. The key is that the direction remains down and we are likely to see a classic overshoot. This note looks at why and what it means for investors.

Drivers of the lower $A

There are essentially three drivers of the falling $A.

First the US dollar is undergoing a longer term upswing. After falling through much of last decade, from 2008 it started tracing out a broad bottom and now looks to have commenced a rising trend. This is supported by relative strength in the US economy pointing to the Fed being closer to monetary tightening in contrast to Europe, Japan and China which are continuing to ease monetary conditions and at the same time that much of the emerging world is beset by various structural problems. While the rate of increase in the $US has slowed from the pace seen last year – particularly as the Fed will allow for the dampening impact on the US economy when considering interest rate hikes – the trend is likely to remain up.

Second, commodity prices are now in a long term, or secular downswing. Their secular upswing that ran through last decade is now in reverse thanks to a combination of:

• Surging supply and slower demand. Last decade demand for industrial commodities was surging led by industrialisation in China and strong demand growth in other emerging countries as supply (after years of commodity weakness) struggled to catch up. Now it’s the other way around as demand growth in China has slowed, many emerging markets are weak and supply is surging after record investment in resources for everything from coal and iron ore to gas. The surge in iron ore supply is well known. Over the last 12 months global oil production rose by 3.1 million barrels per day but consumption rose by just 1.4 mbd.

• The rising value of the $US. Since commodities are priced in US dollars they move inverse to it. They rose last decade when the $US was in decline and are now heading down as he $US is on the way up.

Gold is also caught up in this as its part of the commodity complex. But each commodity has its own specific factors. It seems like only yesterday that gold bugs dreamt of quantitative easing causing a crash in the $US and hyperinflation, central banks were reportedly piling into gold for their reserves and the gold price was supposedly on its way to infinity and beyond. Well as it turned out the $US didn’t crash, hyperinflation never arrived and when it comes to central banks and gold the best thing to do is the opposite to what they are doing (just as it was when they were dumping gold 15 years or so ago!). And so the gold price has plunged more than 40% from its 2011 high to a five year low. While there will be bounces with gold being part of the commodity complex which is in a secular downtrend I find it hard to be optimistic on gold for the next few years.

As can be seen in the next chart raw material prices trace out roughly 10 year long term upswings followed by 10 to 20 year long term bear markets. After an upswing last decade, they now look to have embarked on a secular downtrend.

Source: Global Financial Data, Bloomberg, AMP Capital

This is bad news for Australia as plunging prices for commodities have resulted in a collapse in export prices and hence our terms of trade. This is highlighted by the iron ore price which at the start of last decade was below $US20/tonne rising to over $US180/tonne in 2011 and is now running around $US51/tonne.

Source: Bloomberg, AMP Capital

Finally, the relative performance of the Australian economy has deteriorated and this is seeing the interest rate differential in favour of the $A decline, making it relatively less attractive to park money in Australia as part of the so-called “carry trade”. The Fed has ended quantitative easing and is getting closer to monetary tightening whereas there is a 50% chance the RBA will ease rates again – particularly with the business investment outlook remaining bleak, signs emerging that APRA’s efforts to cool property investment are biting and inflation remaining benign. More broadly, perceptions of global investors about the Australian economy are becoming less favourable. Over much of the last decade it was positive reflecting Australia’s favourable fundamentals tied to growth in the emerging world and through the Eurozone crisis as an AAA rated safe haven. Now there is a bit more wariness as emerging country growth has slowed, the commodity cycle has gone from a tailwind to a headwind for the Australian economy and Australia has struggled to get its budget deficit back under control.

Big picture for the $A not flash

Against this backdrop, the big picture outlook for the $A is poor. Perhaps one way to see this is via what is called purchasing power parity (PPP), according to which exchange rates should equilibrate the price of a basket of goods and services across countries. In other words, the exchange rate should be at the level that would make a country’s competitiveness neutral internationally. If the exchange rate is above this level then the country would be uncompetitive internationally and vice versa if it is below. A guide to this is in the next chart which shows the $A/$US rate against where it would be if the rate had moved to equilibrate relative consumer price levels between the US and Australia since 1900.

Source: RBA, ABS, AMP Capital

Right now the $A at around $US0.73 has just fallen below fair value on this measure of around $US0.75. But it can be seen from the chart that the $A rarely stays at the purchasing power parity level for long and long periods of overvaluation are followed by long periods of undervaluation. A driver of this in recent decades has been commodity prices and the relative performance of the Australian economy. These were positive last decade and so over the 2001 to 2011 period the $A went from well below PPP at $US0.48 to well above at $US1.10. Now the reverse is underway. Given the damage done to Australian industry through the boom years as Australia’s international competitiveness collapsed into early this decade as the $A surged, a period well below the purchasing power parity level now looks likely in order to reinvigorate Australian businesses again. In other words, this is necessary to make up for the damage done by the high $A. This is likely to take the $A into the $US0.60s but it could easily go lower.

In the very short term, the Australian dollar has fallen a bit too fast and it seems everyone is bearish about the Aussie again (with economists seemingly falling over themselves to revise their $A forecasts lower), so a short term bounce could well emerge. However, for the reasons noted above the broad trend in the $A is likely to remain down. I remain of the view that it will fall to around $US0.70 by year end and then move even lower.

Of course, it’s worth noting that the fall in the $A on a trade weighted basis won’t be as pronounced as against the $US, as the Yen and Euro are also likely to remain soft against the $US.

Implications for investors

There are a several implications for investors.

First, and most significantly, the ongoing decline in the value of the Australian dollar highlights the case for Australian based investors to maintain a relatively greater exposure to offshore assets that are not hedged back to Australian dollars (ie remain exposed to foreign currencies) than was the case say a decade ago when the $A was in a strong rising trend. Put simply, a declining $A boosts the value of an investment in offshore assets denominated in foreign currency one for one. For example, a 10% fall in the value of the $A will boost a foreign share portfolio by 10% in value in Australian dollar terms. This has been seen over the last few years – the fall in the value of the $A over the 12 months to June turned an 8.5% return from global shares measured in local currencies into a 25.2% return for Australian investors when measured in Australian dollars.

Second, having an exposure in foreign currency (notably the $US) provides a hedge for Australian based investors should the global economic outlook deteriorate. Recent global economic data – eg, slowing OECD leading economic indicators, stalling world trade growth and soft Chinese business surveys – have led to renewed concerns regarding the global growth outlook. In our view this is likely to be just another growth scare, of which we have seen a few over the last few years. But if we are wrong then being short the $A and more exposed to foreign currency provides a bit of protection as the $A invariably falls (and foreign currencies rise) in response to weaker global growth.

Finally, the fall in the value of the $A taking it down to levels that more than offset Australia’s relatively high cost levels is very positive for sectors that compete internationally including manufacturing, tourism, higher education, agriculture & miners. This in turn should help the economy weather the mining downturn and is in turn positive for the Australian share market. Roughly speaking each 10% fall in the value of the $A boosts company earnings by 3%. That said in the current environment, Australian shares are likely to remain a relative underperformer in terms of total returns compared to global shares.

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.

Introduction

Despite the usual turmoil along the way and ending on a weak note with Greek and Chinese-related turmoil, 2014-15 provided another year of solid returns for investors who were prepared to move beyond cash. Most asset classes had reasonable returns resulting in average superannuation funds returning 9.9%, their third financial year in a row of returns around 10% or more.

Source: Thomson Reuters, AMP Capital

There’s been plenty to worry about as usual, but..

As always, the worry list over the last 12 months was long with:

• Concerns about the end of the US Fed’s quantitative easing and approaching Fed rate hikes, which has seen bond yields drift higher since their lows earlier this year.

• Geopolitical scares regarding Ukraine, the so-called IS and related terror threat and the West Africa Ebola outbreak.

• Deflation fears associated with the collapse in oil prices.

• Another soft start to the year for US/global growth.

• Recurring worries about China & recently its share market.

• A renewed soft patch in European economic growth late last year and the return of Greek-related contagion risk this year.

• Ongoing concerns about Australia post the mining boom.

But these concerns have been partly offset by a combination of:

• A delay in rate hikes in the US and further monetary easing globally – notably in Europe, Japan and China.

• Assurances that rate hikes in the US will be dependent on further improvement in economic growth and gradual.

• Further rate cuts and an ongoing slide in the $A helping drive a pick-up in non-mining economic activity in Australia.

• Progress towards another bailout package for Greece and Chinese Government support for its share market.

The end result has been an environment of continued but uneven and constrained economic growth with periodic deflationary shocks (low oil prices, Greece fears, the cautious consumer, etc) serving to keep monetary conditions easy (interest rates low) and investors cautious. Despite periodic corrections (eg Australian shares had top to bottom corrections of 9% last September and through April/June), such an environment of continuing growth and easy monetary conditions against a backdrop of reasonable valuations has been good for investment returns.

Key lessons for investors

The past year provides several lessons for investors, notably:

• Turn down the noise – the advent of social media has seen the noise around investing, in particular the constant talk of one problem after another, ramped up. But it’s essential to turn it down if you want to be a successful investor.

• Inflation remains missing in action – thanks to a combination of constrained global growth, excess capacity and commodity prices in a secular downtrend thanks to rising supply, the world is deflation prone. This means a continuation of low interest rates and the “search for yield”.

• Diversification and active asset allocation are critical – another year of underperformance by Australian shares provides a reminder of the importance of diversifying globally and the uneven/choppy return environment provides a reminder of the importance of asset allocation.

What about the macro investment outlook?

It is hard to see the outlook for investment markets differing radically from what we have seen over the last few years:

• Global growth is likely to remain uneven and constrained at around 3-3.5%. While the messy global growth outlook is often seen as a negative, it’s really a good thing. Sure, we don’t want to see a collapse back into recession but the best way to guarantee that would be to see a synchronised surge in economic growth bringing on inflation and interest rate concerns. So let’s hope global growth remains constrained!

Source: Bloomberg, AMP Capital

• Inflation is likely to remain low, thanks to the constrained global recovery leaving spare capacity in place and the secular downtrend in commodity prices.

• Commodity prices are likely to remain in a downtrend in response to rising supply.

• Growth in Australia is likely to remain sub-par at around 2.5% as the mining boom continues to unwind, offset by improving non-mining activity. Bad for mining and WA but good for home building, retailing, tourism, higher education, manufacturing, farmers and Australia’s eastern states. Some improvement in growth in prospect for 2016.

• Global monetary conditions are likely to remain easy. While the Fed is likely to raise interest rates starting later this year, it will likely be gradual but monetary conditions are likely to continue easing elsewhere. Quantitative easing in Europe and Japan is likely to continue well into next year and maybe beyond while Chinese benchmark interest rates are likely to fall below 4%. Another RBA rate cut is 50/50 and rate hikes are unlikely before 2017.

• Expect a further rise in the value of the $US, albeit at a more constrained pace, with the $A falling into the $US0.60s over the next 12 months.

The return outlook

The bottom line is that the world remains in a sort of messy sweet spot for investors. Growth is not flash but okay, inflation is low and monetary conditions overall are set to remain easy. For the main asset classes, this has the following implications:

• Cash and term deposit returns to remain poor. In Australia it’s likely to be 2% or less over the year ahead and bank term deposit rates are pushing down to around 2%. Investors need to decide what they really want: if capital stability is more important than a decent stable income flow, then stick with cash. If not, then consider the alternatives.

Source: RBA; AMP Capital

• Low sovereign bond yields of around 3% or less indicate that the return potential from bonds is low. A move to higher bond yields will mean even lower bond returns. However, unless global growth/inflation rises significantly then any rise in bond yields is likely to be very gradual.

• Corporate debt should continue to provide okay returns. A drift higher in bond yields is a mild drag but with continued modest global growth the risk of default should remain low.

• Hybrid growth assets like real estate investment trusts and listed infrastructure should benefit from the ongoing “search for yield” and modest economic growth driving higher rents. But think 8-9% pa returns rather than double digit.

• Unlisted commercial property is also likely to benefit from the “search for yield” and modest growth in rents, with returns around 8-9%. But it’s perhaps less vulnerable to short-term swings in bond yields.

• Residential property returns are likely to be mixed with many cities seeing zero capital growth and Sydney slowing to around 8% per annum. Very low rental yields are not good.

• The bull market in shares likely has further to go as: shares are not unambiguously overvalued and are mostly cheap if allowance is made for low bond yields; they are not overloved by investors with various surveys suggesting an ongoing degree of caution; uneven and below-trend growth is extending the economic cycle; and monetary conditions are likely to remain easy for some time. However, volatility is likely to remain with history telling us that the first Fed rate hike can cause corrections (8-9% in both 1994 and 2004).

Source: Bloomberg, AMP Capital

• Within shares, we favour global over Australian shares (unless it’s income you are after) and European and Chinese/Asian shares over US shares.

• Finally, the continuing downtrend in the $A enhances the case for global shares (unhedged) over Australian shares.

Things to keep an eye on

The key things to keep an eye on over the year ahead are:

• Global business conditions PMIs – these point to constrained growth but a sharp rise or fall could cause problems.

• When/if the Fed starts to raise rates later this year – with US wages growth being a guide to timing and aggressiveness.

• The spread of Italian and Spanish bond yields to German yields – a good guide to whether the Eurozone crisis is continuing to fade.

• Chinese economic growth readings.

• Whether Australian non-mining activity keeps improving.

Concluding comments

Investment returns are likely to slow from the double-digit average of the last few years. And the September quarter is historically a rough one for shares with a likely Fed hike still ahead. But looking beyond near-term uncertainties, the mix of reasonable share valuations, continued albeit constrained global growth, easy monetary conditions and a lack of investor euphoria suggest returns are likely to remain reasonable.

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

It seems western commentators can always find something to worry about regarding China. Last year it was shadow banking and the property market. Lately it’s been the sharp rise and pullback in its share market. The latter has indeed been severe – with a 32% fall over 3 and a half weeks. There have been many headlines regarding the share market volatility and efforts to stabilise the market. This note looks at the key issues.

Chinese shares – what happened?

Starting about a year ago the Chinese share market commenced a new bull market after the bear market that began in August 2009 came to an end. This made sense as Chinese shares were amongst the world’s cheapest and the Chinese authorities were gradually starting to ease economic policy. But as the market moved higher, expanding margin debt (ie buying shares using debt) helped accentuate the gains into its June 12 high. Since then to its low point last week the Chinese share market (as measured by the Shanghai Composite) had a fall of 32%. Essentially there have been three drivers of the pullback:

• Regulatory measures to stabilise the market – Chinese authorities tried to slow it down with tighter margin regulations and an increase in capital raisings (or initial public offerings (IPOs)).

• This started to bite last month at a time when shares had become overbought after a 150% gain over 12 months and ripe for profit taking.

• Just as the increased use of leverage via margin loans accentuated the upside, the unwinding of such positions – often triggered by margin calls as shares fell in value – appears to have accentuated the downside. As the pressure to unwind geared positions increased while the market fell, it made the decline somewhat self-reinforcing. From the high, total margin debt looks to have fallen by around 30%, which has taken it back to levels seen early this year.

Source: Bloomberg, AMP Capital

Government moves to stabilise the market

As the downturn accelerated, there were concerns it could destabilise the financial system and economy. So Chinese authorities took a number of measures to stabilise and support the market. These included: lower interest rates; relaxed rules around margin financing; a suspension of IPOs; a fund to buy shares set up by major stock brokers; investigations into short selling; the provision of liquidity by the People’s Bank of China (PBOC) to the China Securities Finance Corp, effectively enabling it to buy shares; various orders & commitments not to sell shares; and a ban on shareholders who own more than 5% of a company and insiders from selling the shares for six months. These measures have started to help, with the Shanghai Composite up 13% from its low.

What are the implications for the Chinese economy?

While the significant drop in Chinese share values is unsettling for some investors, the impact on the Chinese economy is likely to be limited:

• The 150% 12-month gain in Chinese shares to the high had limited economic impact so it’s hard to see why the fall will.

Source: Bloomberg, AMP Capital

• Second, Chinese shares are still up 90% from a year ago.

• Third, shares represent only around 12% of total household wealth in China so the wealth effect on spending is limited.

• Fourth, any systemic impact on the Chinese financial system is likely to be minor. Stock brokers and mutual funds are only 5% or so of total financial system assets and any negative effects will be offset by PBOC liquidity measures.

• Finally, equity financing is only a very small share of total financing – just 4% – with bank financing dominating.

Comparisons between China’s recent share market fall and the 1929 stock market dive in the US make entertaining headlines but are wide off the mark. The US share market boom of the 1920s went hand in hand with a booming economy whereas the bull market in Chinese shares only started a year ago, the economy has been slowing since last decade and the severity of the 1929-32 85% plunge in US shares and associated economic depression owed more to policy mistakes at the time such as initially tightening monetary and fiscal policies – mistakes that the Chinese authorities are not repeating. A better analogy might be 1987 where shares in the US, Australia, etc, surged, plunged and then resumed their rising trend without any significant economic impact.

In a broader sense, after a soft start to the year, Chinese economic growth has slowed to around 7%. With business conditions PMIs tracking sideways it looks like remaining around this level or maybe just a bit below. For the reasons stated above we don’t see the share market set back significantly impacting this.

Source: Bloomberg, AMP Capital

More broadly, there are some positive signs beyond the share market turmoil supporting the view that Chinese growth will still come in “around 7%” this year:,/p>

• The PBOC has now been easing monetary policy. With inflation running well below the Government’s target, there is still a need for further monetary easing (as real lending rates remain very high). This is likely with the 12-month benchmark lending rate likely to fall below 4% by year end.

Source: Bloomberg, AMP Capital

• Second, major spending programs around various infrastructure projects are starting to get rolled out as the focus has shifted back to maintaining growth.

• Third, the risks around the Chinese property market appear to be fading with price declines giving way to modest gains.

Implications for the global and Australian economies

With the share market fall in China unlikely to have a major impact on Chinese economic growth, it’s hard to see a huge impact on the global or Australian economies. However, Chinese growth around 7% is still a long way from the 10% plus seen last decade. At a time when the supply of commodities is continuing to ramp up, the secular trend in commodity prices is likely to remain down. So the risks to the iron ore price and Australia’s terms of trade remain on the downside.

Longer term reform prospects

While some have questioned the Chinese government’s intervention in its share market, it needs to be recognised that the intervention is not unique. The Hong Kong Monetary Authority bought HK shares in 1998 in a move that helped end the Asian crisis. The Bank of Japan is buying Japanese Real Estate Investment Trusts and Exchange Traded Funds as part of its quantitative easing (QE) program. And western central banks QE programs have helped support their share markets in recent years. This shouldn’t be seen as negative but rather a sensible response to prevent broader instability.

Also, reform is not a straight line in China but rather very pragmatic. This is just as well. Surely, after problems emerge, it’s better to back track a bit on reforms, learn from mistakes (for example to get margin lending under control) and then proceed again. Better that than let a systemic blow up unfold!

So what does all this mean for Chinese shares?

Some commentators have expressed concerns that the Chinese share market became a giant bubble. To be sure, it rose too fast from a year ago and valuations of small caps became excessive. For example, the price to earnings multiple of the small cap-dominated Shenzhen stock exchange rose to around 80 times. However, for large caps (which dominate the Shanghai exchange) valuations were less extreme. For example, the Citic 300 share price index (basically the top 300 stocks) saw its PE rise to around 22 times. It’s now back to around 17 times, which is well below the long-term average of 28 times and the forward PE has fallen to 14.7 times which is cheaper than Australia.

Source: Thomson Reuters, AMP Capital

Meanwhile, Chinese companies listed in Hong Kong have also been caught up in the recent correction and represent particularly good value at around 8 times forward earnings. Apart from reasonable valuations, both mainland and Hong Kong-listed Chinese shares will benefit from monetary easing.

Yes, it may take some time for some investors to fully get their confidence back but there have been numerous sharp falls in share markets throughout history only for share markets to resume their rising trend over time. And China’s share market is unlikely to be any different.

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.