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What does the Federal Budget mean for the economy and your investments?

Posted On:May 14th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

With the Government winning the election with a mandate to fix the budget, a bout of fiscal austerity was inevitable. Against this backdrop and the fears of the last few weeks, the Budget is not as tough as feared. Many of the budget savings will only build over time.

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With the Government winning the election with a mandate to fix the budget, a bout of fiscal austerity was inevitable. Against this backdrop and the fears of the last few weeks, the Budget is not as tough as feared. Many of the budget savings will only build over time.

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Watch video commentary

Key budget measures

Many of the measures announced in the budget come as no surprise. The key savings measures are as follows:

  • a tightening in eligibility for family tax benefits (FTB), eg the income threshold for FTB-B reduced to $100,000 from $150,000 and to end when the youngest child is six;

  • pensions to be indexed to inflation not wages, a pause in eligibility thresholds;

  • a further increase in the pension age to 70 by 2035;

  • a $7 co-payment for GP visits;

  • a further 16,500 public sector jobs to go and the merging or elimination of numerous government agencies;

  • the resumption of fuel excise indexation from August;

  • a 2 percentage point increase in the top marginal tax rate which kicks in at $180,000 for three years;

  • reintroduction of the work for the dole scheme;

  • moves to increase the cost of higher education;

  • the increase in the Superannuation Guarantee beyond 9.5% delayed till 2018; and

  • reduced foreign aid spending.

There are several sweeteners though, eg using asset sales to fund infrastructure spending, the start of a new paid parental leave (PPL) scheme, funding for medical research, the planned abolition of the mining and carbon taxes, and a 1.5% cut to corporate tax next year to offset the PPL levy.

The budget bottom line

Beyond the projections for the current financial year (which look a bit too pessimistic), the budget deficit projections now look much healthier than those seen in MYEFO, with the budget deficit for 2014-15 now projected to be $30bn, down from $34bn in MYEFO.

Interestingly, despite all the talk of a tough budget, the actual additional policy tightening for 2014-15 is just 0.1% of GDP, but as the spending cuts build the impact rises to 0.6% of GDP by 2016-17 rising dramatically beyond that. See the red rows. Reflecting this, the turnaround in the 2017-18 deficit from 1.5% of GDP to now just 0.2% is substantial. The end result is that the budget is now projected to be in surplus by 2019-20 (versus deficits indefinitely in MYEFO).


Source: Australian Treasury, AMP Capital

Relative to MYEFO, the improvement initially reflects increased revenue and lower spending, but from 2018-19 owes mainly to spending (as savings build, the income tax hikes end and fiscal drag is assumed to be handed back).


Source: Australian Treasury, AMP Capital

Economic assumptions

The major economic assumptions underpinning the Budget are shown in the next table.

There is only fine tuning since the MYEFO forecasts and nominal GDP growth is projected to remain soft as the terms of trade weakens. We continue to think that the 2014-15 growth assumptions are a bit too pessimistic and they remain below the RBA’s 2.75% mid-point forecast. This partly explains why we are a bit more optimistic on unemployment.

Assessment and risks

Australia does not really have a ’budget emergency‘: the budget deficit has not come anywhere near the 10% of GDP plus levels that sparked concern in the US, parts of Europe and Japan. Net public debt at 16% of GDP is a fraction of what it is in the US (82%), the Eurozone (73%) and Japan (137%); ratings agencies are not downgrading our AAA rating and bond yields remain low.


Source: IMF, AMP Capital

That said, the budget is always about balance and Australia does have a budget problem. After the biggest boom in our history, the budget should be in far better shape. Comparing ourselves to a bad bunch is not necessarily wise. In 2006 Ireland’s net public debt was close to where Australia’s is now and yet it skyrocketed when its boom turned to bust. Given our (albeit shorter) resources boom but 20 plus years with no recession we should be much closer to Norway which is running huge surpluses and negative net public debt (-205% of GDP). This was a major and valid criticism of the last few years’ budgets.

Against this backdrop, the 2014-15 Budget is a step in the right direction with the measures put in place to control spending growth over the medium to long term likely to put it on to a sustainable path. The Budget also gets a tick in terms of its focus on boosting infrastructure, reducing public sector duplication and renewed privatisation – all of which should help boost productivity over the long term.

There are three main risks though. First, the tax hikes and welfare cutbacks could drag on consumer spending. Fortunately, the Government has not front-loaded its savings and partly offset them initially by infrastructure spending.

Second, taking the top marginal tax rate to 49% (which will put it as the world’s 15th highest and way above our neighbours, eg NZ 33%, Singapore 20%, HK 15%) is a backward step in terms of incentive and trying to discourage tax minimisation efforts. However, I have sympathy with the fairness rationale (although there would have been better alternatives such as reducing the capital gains tax discount).

Finally, there is a big risk that many of the budget measures will not pass through the Senate.

Implications for interest rates

While the fiscal tightening in the year ahead is less than feared at about 0.1% of GDP, it comes on top of 0.3% of tightening already in train from the previous Government (mainly the 0.5% NDIS levy). In addition, the scaling back of welfare access and the public sector could negatively impact confidence. So while we still see the RBA raising interest rates around September/October, there is some risk that rate hikes may be delayed into next year.

Implications for Australian assets

Cash and term deposits – the ongoing fiscal tightening means that interest rates will remain pretty low (even when they do eventually start to rise). Expect term deposit rates to remain at 4% or below in the months ahead.

Bonds – the measures to bring spending under control and provide confidence the budget will be returned to surplus will help ensure Australia’s AAA rating remains secure. This, plus additional fiscal tightening, albeit spread over time, and the risk rate hikes will be delayed till next year should help ensure bond yields remain low. But with five year bond yields at 3.2% it’s hard to see great returns from Australian sovereign bonds over the next few years.

Shares – the fiscal austerity in the Budget is only a minor headwind for profits. And against this, the increase in infrastructure spending, the reform inherent in public sector downsizing and privatisation and putting the budget on a sounder footing are long term positives and the Budget will help keep interest rates down. Overall, its impact is unlikely to be huge. Construction and building material stocks are likely to benefit, whereas it’s a slight drag for retailers.

Property – property prices are likely to continue gaining on the back of low interest rates, although momentum may slow a bit from last year’s surge in Sydney and Melbourne.

The $A – the announcements in the Budget alone are not radical enough to have much of an impact on the Australian dollar. Affirmation of the AAA rating is a positive while the dampening impact on long term growth from fiscal austerity is a drag. Not much in it really though. With the commodity price boom fading, the interest rate differential in favour of Australia having fallen and the Australian dollar overvalued on a purchasing power parity basis, the trend in the Australian dollar is likely to remain down. 

Concluding comments

The 2014-15 Budget goes a fair way to getting the budget heading back towards surplus without going overboard with fiscal austerity for the next financial year. Better to start down the path though before any crisis hits, so when it does we will have greater fiscal flexibility.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

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.

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The US economy, the Fed and interest rates

Posted On:May 07th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

A constant for investors over the last five years has been very easy global monetary conditions, with near zero interest rates and quantitative easing programs in the US, Europe and Japan. This has helped the global economic and share market recoveries since the GFC. But with the US economy on the mend the time will come when it will be

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A constant for investors over the last five years has been very easy global monetary conditions, with near zero interest rates and quantitative easing programs in the US, Europe and Japan. This has helped the global economic and share market recoveries since the GFC. But with the US economy on the mend the time will come when it will be appropriate to start unwinding the monetary stimulus. Already the Fed has been winding down its quantitative easing program. And with it likely to end later this year and the US economy picking up from a winter slumber, the next big issue for investors may well be when the Fed will start to raise interest rates.

This note looks at the key issues, taking a Q&A approach.

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Why were interest rates cut to zero?

By way of background, it’s first worth thinking about how we got here. Put simply it was just part of the cycle: growth weakened and so monetary conditions were eased. But of course the GFC related slump in the US and most developed countries was deeper than normal downturns with companies and households more focused on reducing debt. So once interest rates hit zero and it was apparent the recovery was still sub-par, the focus shifted to measures to boost the supply of money. This became known as quantitative easing (QE) and involved the Fed printing money and using this to buy government bonds and mortgage backed debt. It helps growth by reducing borrowing costs, injecting cash into the economy, forcing investors to take on more risks, and to the extent it drives shares higher, it helps build wealth that helps spending.

Is the US economy on the mend?

The short answer is yes. A range of indicators suggest that the headwinds to growth in the US have abated and the economy is now on a sounder footing:

  • companies and businesses look to have stopped trying to reduce their debt;

  • bank lending growth is trending higher;

  • house prices have been recovering and housing construction has picked up;

  • consumer spending has picked up;

  • business investment looks stronger;

  • business conditions indicators (often called PMIs) are running around levels consistent with solid growth; and

  • the level of employment is nearly back to its early 2008 high and unemployment has fallen to 6.3%.


Source: Bloomberg, AMP Capital

In particular, a range of indicators for confidence, jobs, durable goods orders, etc, suggest that growth is picking up after a winter soft patch. Finally, while inflation remains very low at 1.5%, it appears to be bottoming.

When will QE end & what happens after that?

The continuing improvement in the US economy suggests that the Fed will keep tapering its QE program by $US10bn a month at its six weekly meeting. QE3 started at $US85bn a month in bond purchases in late 2012 and following the start of tapering in December last year has now been cut to $US45bn a month. At the current rate it will have fallen to just $US5bn in October and to zero at the December meeting. In other words it’s on track to end late this year.

After QE has ended the next step would be for the Fed to actually start tightening monetary policy. This could come in the form of reversing its QE program (ie unwinding the bonds it holds) or raising interest rates or a combination of the two. Raising interest rates is simple, but unwinding its bond holding is a bit more complicated. It could do this by: not replacing the bonds as they mature – ie the Fed gets paid back just like any bond investor; or actively selling them back into the market. I suspect more of a reliance on the former as it’s less disruptive but of course it may take 5 to 10 years.

How long before the Fed raises interest rates?

While US economic growth looks to be picking up, US interest rate hikes are still probably 12 months or so away:

  • Growth is still far from booming.

  • Spare capacity remains significant with a wide output gap, ie the difference between actual and potential GDP. See the next chart.


Source: Bloomberg, AMP Capital

  • While the unemployment rate has fallen to 6.3%, the labour market is a long way from being back to normal. A slump in labour force participation has exaggerated the fall in the unemployment rate. While much of this is structural, some is cyclical and at some point will bounce back slowing the fall in unemployment. Labour force underutilisation, which includes unemployment and those who want to work longer, at 12.3% is well above its average of 8.8% when the Fed was last raising rates

  • Wages growth is up from its 2009 low, but it remains very weak currently running at just 1.8% year on year.


Source: Thomson Reuters, AMP Capital

What about the impact on the share market?

Just like talk of tapering upset shares around the middle of last year, so too a move towards the first monetary tightening could cause a similar upset. However, beyond a short term upset, when the initial monetary tightening comes it is unlikely to be a huge problem for shares.

First, the historical experience tells us the start of a monetary tightening cycle is not necessarily bad for shares. The next table shows US shares around the first rate hikes in the past 8 Fed tightening cycles. The initial reaction after 3 months is mixed with shares up half the time and down half the time. But after 12 and 24 months a positive response dominates.


Source: Thomson Reuters, AMP Capital

The reason for this lies in the improvement in growth and profits that normally accompanies an initial monetary tightening. It’s only later in the cycle when rates interest rise to onerous levels to quell inflation that it’s a worry. At this point short term interest rates have invariably pushed above long term bond yields. Right now we are a long way from that.

Secondly, the rally in shares over the last five years is not just due to easy money. Easy money has helped, but the rally has been underpinned by record profit levels in the US.


Source: Bloomberg, AMP Capital

Finally, shares are likely to benefit from long term cash flows as the mountain of money that has gone into bond funds since 2008 continues to gradually reverse.

So while talk of Fed rate hikes and their eventual reality could cause a correction as bond yields rise, they are unlikely to be enough to cause a major share market slump.

What about other economies?

The global economy is far from a synchronised cycle regarding interest rates. While the US is gradually heading towards monetary tightening, the rest of the world is different:

  • The Eurozone may still require further monetary easing as bank lending and inflation remains extremely low;

  • Japan is in a similar situation with the April sales tax hike having disrupted growth and a stalling in the decline of the Yen threatening progress towards the Bank of Japan’s inflation objective;

  • Many parts of the emerging world have already been through a tightening cycle which has seen a cooling in growth and so could see an eventual monetary easing over the next 12-18 months.

In other words, global monetary conditions are likely to remain relatively easy for some time.

What about Australia?

For Australia, an eventual move towards monetary tightening in the US may come as a relief as it will help remove upwards pressure on the $A, allowing it to fall towards $US0.80 which we judge to be necessary to deal with Australia’s relatively high cost base.

Concluding comments

With the US economy recovering from its winter slumber the next big issue for investors may well be when the Fed will start to raise interest rates. While this could contribute to a significant correction, even when US interest rates do start to rise we are a long way away from tight monetary conditions that will seriously threaten the cyclical rally in shares.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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.

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21 great investment quotes

Posted On:Apr 30th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

Investing can be scary and confusing at times. But the basic principles of successful investing are timeless and quotes from some experts help illuminate these. This note looks at those I find most insightful.  

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Aim

“How many millionaires do you know who have become wealthy by investing in savings accounts?” Robert

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Investing can be scary and confusing at times. But the basic principles of successful investing are timeless and quotes from some experts help illuminate these. This note looks at those I find most insightful.  

  Download pdf         

 

Aim

“How many millionaires do you know who have become wealthy by investing in savings accounts?” Robert G Allen

Cash and bank deposits are low risk and fine for near term spending requirements and emergency funds but they won’t build wealth over long periods of time. The chart below shows the value of $1 invested in various assets since 1900. Despite periodic setbacks (see the arrows) shares and other growth assets provide much higher returns over the long term than cash and bank deposits.


Source: Global Financial Data, AMP Capital

“The aim is to make money, not to be right.” Ned Davis

There is a big difference between the two. But many let their blind faith in a strongly held view (eg “the US borrows too much”, “aging populations will destroy share returns”, “global oil production will soon peak”, “the IT revolution means this time it’s different”) drive their decisions. They could be right at some point, but end up losing a lot of money in the interim.

Process

“I buy on the assumption they could close the market the next day and not reopen it for five years” and “Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.” Warren Buffet

Unless you really want to put a lot of time into trading, it’s advisable to only invest in assets you would be comfortable holding for the long term. This is less risky than constantly tinkering in response to predictions of short term changes in value and all the noise around investment markets.

“Investing should be like watching paint dry or watching grass grow. If you want excitement…go to Las Vegas.” Paul Samuelson

Investing is not the same as gambling, and requires a much longer time frame to payoff.

“Successful investing professionals are disciplined and consistent and they think a great deal about what they do and how they do it.” Benjamin Graham

Having a disciplined investment process and consistently applying is critical for investors if they wish to actively manage their investments successfully in the short term.

“Never invest in a business you can’t understand” and “Beware geeks bearing formulas.” Warren Buffett

Many lost a fortune through the GFC in investments that were not understandable and involved excessive complexity.

The market

“Remember that the stock market is a manic depressive.” Warren Buffett

Rules of logic often don’t apply in investment markets. 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 in during the good times with dreams of riches and spitting them out during the bad times when all hope seems lost. Investors need to recognise this.

“Markets can remain irrational longer than you can remain solvent.” John Maynard Keynes

A key is to respect the market and recognise that it can be fickle rather than try and take big bets that can send you bust if you get the timing wrong. Eg, by heavily selling shares short if you think a crash is about to happen or gearing in too heavily via margin debt. Such approaches can often undo investors and send them bust as they are too dependent on accurately timing the market.

“Unless you can watch your stock holding decline by 50% without becoming panic stricken, you should not be in the stock market.” Warren Buffett

Recessions and bear markets are a normal aspect of investing. But history tells us markets eventually recover. The worst thing an investor can do is get in during good times only to get out after a bear market & miss the recovery.

Cycles and contrarian investing

“Bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria.” John Templeton

This is one of the best characterisations of how the investment cycle unfolds. It follows that the point of maximum opportunity is around the time most are pessimistic and bearish and the point of maximum risk is when all are euphoric, but unfortunately many don’t realise this because it involves going against the crowd. 

“The four most dangerous words in investing are: ‘this time it’s different’.” John Templeton

History tells us that that there are good times and bad and assuming that either will persist indefinitely is a big mistake. Whenever you hear talk of “new paradigms”, “new eras”, “new normals” or “new whatevers” it’s usually getting time for the cycle to go in the other direction.

“History doesn’t repeat but it rhymes.” Often attributed to Mark Twain (although I am not sure he actually said it)

No two cycles are the same but they do have common elements which make them rhyme. In upswings investment markets are pushed to the point where the relevant asset has become overvalued, over loved (in that everyone is on board) and over bought and vice versa in downturns. Recognising these common elements is necessary if you are to get a handle on cyclical swings in investment markets.

“If it’s obvious, it’s obviously wrong.” Joe Granville

This doesn’t apply to everything (eg if it is obviously sunny outside according to the usual definition, then it is!), but investing can be perverse. When everyone is saying “it’s obvious that the recession will continue” or “it’s impossible to see a recession as things are obviously good” then maybe the crowd is already on board and the cycle will soon turn.

“I will tell you how to become rich…Be fearful when others are greedy. Be greedy when others are fearful.” Warren Buffett

This is another quote on contrarian investing that follows on from those above.

“Sell in May and go away, buy again on St Leger’s Day.” Anon

Shares have long been observed to have a seasonal pattern that sees strength from November through to May and then relative weakness through to around October. This is evident in the next chart for US and Australian shares. (St Leger’s Day in terms of the UK horse race on the second Saturday in September may be a bit early, but not to worry!)


Source: Thomson Reuters, AMP Capital

Pessimism

“To be an investor you must be a believer in a better tomorrow.” Benjamin Graham

This is a pre-requisite. If you don’t believe the bank will look after your term deposits, that most borrowers will pay back their debts, that most companies will see rising profits over time, that properties will earn rents etc then there is no point investing. This is flippant but true – to be a successful investor you need a favourable view of the future.

“More money has been lost trying to anticipate and protect from corrections than actually in them.” Peter Lynch

Preserving capital is important, but this can be taken too far and often is in the aftermath of bad times with the result that investors end up so focused on trying to avoid capital losses in share markets that they miss the returns they offer.

“I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.” J.S. Mill

It invariably seems that higher regard is had for pessimists predicting disaster than optimists seeing better times. As JK Galbraith once observed “we all agree that pessimism is a mark of a superior intellect.” And we all know that bad news sells. There may be a neurological reason for this as the human brain evolved in the Pleistocene era when the key was to dodge woolly mammoths and sabre tooth tigers, so it has been hard wired to always be on guard and so naturally attracted to doom sayers. But for investors, giving too much attention to pessimists doesn’t pay long term.

Risk

“There is nothing riskier than the widespread perception that there is no risk.” Howard Marks (I think)

Many like to measure risk by looking at measures of volatility, but the riskiest time in markets is invariably when the common view is that there is no risk for it’s often around this point that everyone who wants to invest has already done so leaving the market vulnerable to bad news.

Debt

“It’s not what you own that will send you bust but what you owe.” Anon

Always make sure that you don’t take on so much debt that it may force you to sell all your investments and potentially send you bust, just at the time you should be buying.

Self-perception

“The investor’s chief problem and even his worst enemy is likely to be himself.” Benjamin Graham

This may sound perverse as surely it is events which drive investment markets down and destroy value. But the trouble is that events and bear markets are normal. Rather what causes the greatest damage is our reaction to events – selling after markets have already plunged and only buying back in after euphoria has returned. Smart investors have an awareness of their psychological weaknesses and their tolerance for risk and seem to manage them.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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.

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Crash calls for share markets

Posted On:Apr 17th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

The past few weeks has seen several predictions of a share market crash by some perennial high profile bears. The broad claim is that share markets – namely US shares – have disconnected from fundamentals and that the Fed is to blame for a poor recovery and/or doesn’t know what it is doing. And of course this is all against

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The past few weeks has seen several predictions of a share market crash by some perennial high profile bears. The broad claim is that share markets – namely US shares – have disconnected from fundamentals and that the Fed is to blame for a poor recovery and/or doesn’t know what it is doing. And of course this is all against the background of talk of some sort of “demographic cliff” that will contribute to a “great crash ahead.” This note takes a look at the risks.

 

  Download pdf     

A tougher, more volatile year for shares..

Our view is that this year will see more constrained returns from shares with increased volatility – including the likelihood of a 10-15% correction along the way – than we saw in 2012 and 2013. Shares are no longer dirt cheap, they are more dependent on earnings for gains, the prospect of Fed rate hikes are starting to loom and as usual there are numerous other “worries” that could give us that volatility: China, Ukraine, etc. And of course, the seasonal pattern in shares often sees corrections occur around mid-year.

..but the trend is likely to remain up

However, it’s too early in the economic and investment cycle to expect a new bear market or crash. A typical cyclical bull market goes through three phases.

  • Phase 1 is driven by an unwinding of very cheap valuations helped by easy monetary conditions as smart investors start to snap up undervalued shares as investor sentiment moves from pessimism to scepticism.

  • Phase 2 is driven by strengthening profits. This is the part of the cycle where optimism starts to creep in.

  • Phase 3 sees euphoria with investors backing their bullishness by pushing cash flows into shares to extremes. The combination of tightening monetary conditions, overvaluation and investor euphoria then sets the scene for a new bear market.

At present we are likely in Phase 2. Some optimism regarding the economic outlook and share markets has returned but we don’t see the signs of euphoria that become evident in Phase 3 as precursors to a new bear market:

  • Valuations aren’t dirt cheap, but they’re far from expensive. Price to earnings ratios are only at long term average levels of 14.4 times in Australia (average of 14.1 since 1992) and 15.1 in the US (average of 15.9). Some tech stocks have rich valuations, but the tech heavy Nasdaq trades on a price to earnings ratio that is one third of the tech boom peak and the broader US share market on 15x forward earnings is way below its tech boom peak of 24. So it’s hard to see a tech driven crash.


Source: Thomson Reuters; AMP Capital

The gap between earnings yields & bond yields, a proxy for the excess return shares offer, remains above pre GFC norms. This is reflected in our valuation indicators which show markets slightly cheap. See the next chart.


Source: Bloomberg, AMP Capital

  • Global economic indicators have been gradually heading higher which should be supportive of earnings growth. This is indicated in business conditions PMIs (next chart).


Source: Bloomberg, AMP Capital

There are now more indicators pointing upwards in Australia and profits are now helping share market gains, as evident in the following chart that breaks down annual changes in the All Ords into that driven by profits and that due to changes in the ratio of share prices to earnings.


Source: Bloomberg, AMP Capital

  • Inflation remains benign and monetary policy easy. Ample spare capacity has meant that global inflation remains low. As a result even though the Fed is slowing its quantitative easing program, interest rates will likely remain low for some time.

  • Finally, there is no sign of the investor exuberance seen at major market tops. Short term measures of investor confidence in the US are around neutral levels. See next chart. The mountain of money that built up in bond funds in the US has yet to fully reverse. In Australia, investors still prefer bank deposits over shares and the share of cash in the super system is double pre GFC levels.


Source: Bloomberg, Sentimentrader, Investors Intelligence, AMP Capital

Of course there could be a left field shock – an escalation in Ukraine, a policy mistake in China or the Fed. But if you worry too much about such things you would never invest.

Is the Fed to blame?

One thing I find many of the perennial bears seem to have in common is a hatred of the Fed. They argue the Fed should have stood by and done nothing through the Global Financial Crisis – as advocated by whacky disciples of Austrian economics – to allow a full “cleansing” of the economy and that it is in some way causing the slow recovery seen over the last few years. There are several points worth noting on this.

First, just standing by and doing nothing through the GFC could have led to a re-run of the Great Depression which left an unmeasurable human toll and scared a generation, many of whom were innocent bystanders during the excesses of the 1920s. Allowing the same so called “cleansing” to happen needlessly again after the GFC would have been immoral and pointless.

Second, while the Fed’s actions have not led to a boom in the US it has at least bought time to allow the economy to heal – much like keeping a coma patient on life support. The slow recovery is not the Fed’s fault but rather the desire to reduce debt and caution seen post the GFC.

Third, while the Fed’s quantitative easing program has helped support the US share market the main driver has been a surge in US company profits to record levels. In other words the rise in US shares has not detached from reality but reflects fundamental improvement. See the next chart.


Source: Bloomberg, AMP Capital

Fourth, the Fed’s move to wind down or taper its quantitative easing program and talk of eventual rate hikes is a sign of success. In other words, extreme monetary easing has done its job and so can now start to be withdrawn. This is a good thing, not bad. And of course even when US interest rates do start going up next year it will be a long time before they reach levels that seriously threaten economic growth.

Finally, misinterpretations of Fed communications are inevitable and are not a sign that it does not know what it is doing. The Fed under Bernanke and Yellen have made it pretty clear what they are looking at and in this context their policy moves have made sense.

What about the demographic cliff?

Some have long tried to link demographic trends with share markets, but it is very messy. The basic thesis is that as the baby boomer wave moves through the population it will stop being a big positive for shares (as they either run-down savings or consume less depending on which demographic thesis you follow) and that this should start around 2009-10. This approach predicted a big rally through the 1990s and 2000s and got it completely right in the former but disastrously wrong last decade in relation to US shares. Given shares never got anywhere near the levels they were supposed to reach last decade (the biggest advocate of the demographic model had the Dow Jones going to 40,000 through the 2000s) it’s hard to see why they will now crash.

Concluding comments

While shares might see a brief 10-15% correction at some point this year, a new bear market is unlikely and as such returns should remain favourable through the year as a whole. The time to get really worried is when the topic of conversation with cabbies and at parties is about what a great investment shares are, but I have yet to find a cabbie talking about shares in recent years and at a party I attended last weekend the only person who mentioned shares told me he had just switched all his exposure to cash!

 

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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.

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Australian housing to the rescue – but is it too hot?

Posted On:Apr 03rd, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

Two years ago some (mainly foreign) commentators were convinced Australian housing was in a bubble that was in the process of collapsing as the China driven mining boom faded. Instead, lower interest rates have led to the usual response of rising house prices & approvals for new homes. But has it gone too far, taking us into another bubble?

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Two years ago some (mainly foreign) commentators were convinced Australian housing was in a bubble that was in the process of collapsing as the China driven mining boom faded. Instead, lower interest rates have led to the usual response of rising house prices & approvals for new homes. But has it gone too far, taking us into another bubble?

 

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Great news for the economy

While it took a bit longer than usual, the housing sector has responded just as it should to lower rates:

  • lower interest rates led to improved housing affordability;

  • which has led to increased home buyer demand (housing finance is up 23% year on year and new home sales are up 40% from their September 2012 low);

  • which in turn has led to higher house prices;

  • which has signalled to home builders to build new homes – with building approvals now about as high as they ever get pointing to a construction boom on the way; and

Source: Bloomberg, AMP Capital

  • rising house prices, which boost wealth, and stronger housing construction are positive for retail sales.

This is all good news as a stronger housing sector is critical if the economy is to rebalance away from mining investment.

But is it turning into bubble trouble?

While a housing recovery is necessary to rebalance the economy, a concern is whether it’s becoming another bubble. The home buyer market has started the year strongly with auction clearances high and house prices surging. According to RP Data capital city house prices are up 10.6% over the year to March with Sydney home prices up 15.6%.

Source: Australian Property Monitors, AMP Capital

Property prices are on the rise again in other comparable countries, eg the US and UK. The trouble is that Australian house prices are turning up from a high level.

Source: Case-Shiller, Nationwide, ABS, AMP Capital

Asset price bubbles normally see overvaluation, excessive credit growth and self-perpetuating exuberance. On these fronts the current readings for housing are mixed.

Australian housing is overvalued: Whilst real house price weakness through 2010 to 2012 saw this diminish the problem has returned again with a vengeance:

  • Real house prices are 13% above their long term trend.

Source: ABS, REIA, Global Financial Data, AMP Capital Investors

  • According to the 2014 Demographia Housing Affordability Survey the median multiple of house prices to household income in Australia is 5.5 times versus 3.4 in the US.

  • The ratio of house prices to incomes in Australia is 21% above its long term average, leaving it toward the higher end of OECD countries. This contrasts with the US.

  • On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average, Australian housing is 27% overvalued.

So Australian house prices meet the overvaluation criteria for a bubble. Other criteria are less clear though.

Credit growth is a long way from bubble territory: over the year to February housing related credit grew 5.8%. This is up from recent lows, with 7.6% growth in credit for investors leading the charge. But it is pretty tame compared to 2003-04 when housing related credit growth was running at 20% plus and 30% for investors. Related to this we have yet to see much deterioration in bank lending standards.

Similarly, the self-perpetuating exuberance that accompanies bubbles seems mostly absent at present:

  • House price strength is not broad based. Whereas prices in Sydney (+15.6% year on year) and Melbourne (+11.6% year on year) are very strong in every other capital city they are up 5% or less;

  • Related to this there has been only one year of strong gains, whereas the surge into 2003 ran for seven years;

  • Australian’s don’t seem to be using their houses as ATMs at present (ie where mortgages are drawn down to fund consumer purchases and holidays). Rather they still seem very focused on paying down debt.

  • We have yet to see property spruikers out in a big way.

  • There is little sign of buyers rushing in for fear of missing out.

  • The cooking shows are still out rating the home related shows on TV!

For these reasons I don’t think it’s a bubble yet. However, the acceleration in price gains means the risks are rising.

What’s to blame for high house prices?

Whenever house prices take off and affordability deteriorates there is a tendency to look for scapegoats. A decade ago it was high immigration and negative gearing. Now it looks to be foreign buyers (from China), self-managed super funds and as always negative gearing. However, none explain the relative strength in Australian house prices:

  • Foreign and SMSF buying is no doubt playing a role in some areas but looks to be relatively small overall. Chinese interest in Sydney seems to be concentrated away from first home buyer suburbs.

  • Such simplistic explanations ignore the fact that when interest rates go down, Australian’s borrow to buy houses and prices go up. We don’t need to resort to foreigners to find a reason why house prices have gone up!

  • Negative gearing has been around for a long time. It was removed in the 1980s but was reinstated as it was clear its removal worsened the supply of dwellings. Restricting it for property would also distort the investment market as it would still be available for other investments.

Rather the fundamental problem is a lack of supply. Vacancy rates remain low and there has been a cumulative construction shortfall since 2001 of more than 200,000 dwellings. The reality is that until we make it easier for builders and developers to bring dwellings to market – and hopefully decentralise our population in the longer term – the issue of poor affordability will remain.

Implications for monetary policy

As things currently stand the risks to financial stability flowing from the surge in house prices are more than balanced by sub trend economic growth, falling mining investment and risks to Chinese economic growth. As such it remains appropriate for the RBA to keep interest rates on hold at 2.5% for now. However, our expectation is that the RBA is likely to step up its jawboning of the home buyer market by warning buyers not to take on too much debt and not to expect ever rising prices, ahead of a move to higher interest rates probably starting around September/October once economic growth has started to pick up.

While talk of so-called macro prudential controls, such as limits on loan to valuation ratios for mortgages may hot up, the RBA would probably prefer to avoid such retrograde approaches (they didn’t work in the days pre-deregulation) in favour of jawboning and an eventual rate hike.

Against this backdrop we expect further gains in house prices but at a slowing rate over the remainder of the year, particularly once interest rates start to rise again.

Longer term, the overvaluation of Australian housing will likely see real house prices stuck in a 10% range around the broadly flat trend that has been evident since 2010. This is consistent with the 10-20 year pattern of alternating long term bull and bear phases seen in real Australian house prices since the 1920s. See the fourth chart in this note.

Housing as an investment

Over long periods of time, residential property adjusted for costs has provided a similar return for investors as Australian shares. Since the 1920s housing has returned 11.1% pa compared to 11.5% pa from shares. Both have been well above the returns from bonds and cash.

Source: ABS, REIA, Global Financial Data, AMP Capital Investors

They also offer complimentary characteristics: shares are highly liquid and easy to diversify but more volatile whereas residential property is illiquid but less volatile and shares and property tend to be lowly correlated to each other. As a result of their similar returns and complimentary characteristics there is a case for investors to have both in their portfolios over the long term. At present though, housing looks somewhat less attractive as an investment being overvalued on several measures and offering lower (cash flow) yields. The gross rental yield on housing is around 3.3%, compared to yields of 6.5% on unlisted commercial property, 5.7% for listed property (or A-REITs) and 5.8% for Australian shares (with franking credits). So for an investor, these other assets continue to represent better value.

Concluding comments

The recovery in the housing sector is playing a key role in helping to rebalance the Australian economy. However, while the house price recovery does not appear to have entered bubble territory yet, the risks are rising. The RBA’s first line of attack is likely to be more intensive jawboning, warning home buyers not get too giddy in their house price expectations and not to take on too much debt. Later this year though this is likely to be followed up by a couple of interest rate hikes, all of which will likely see house price gains slow.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

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.

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Common myths and mistakes of investing

Posted On:Mar 27th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

The increasingly complex nature of investment markets leads many to adopt simple rules of thumb often based on common sense, when making investment decisions. Unfortunately though, the forward looking nature of investment markets means such approaches often cause investors to miss out on opportunities at best or lose money at worst. This note reviews some of the common myths and

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The increasingly complex nature of investment markets leads many to adopt simple rules of thumb often based on common sense, when making investment decisions. Unfortunately though, the forward looking nature of investment markets means such approaches often cause investors to miss out on opportunities at best or lose money at worst. This note reviews some of the common myths and mistakes of investing.

 

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Myth #1: Rising unemployment means growth can’t recover

Whenever there is a downturn this argument pops up. But if it were true then economies would never recover from recessions or slowdowns. But they do. Rather, the boost to household spending power from lower mortgage rates and any tax cuts or stimulus payments during recessions eventually offsets the fear of unemployment for those still employed. As a result they start to spend more which gets the economy going again. In fact, it is normal for unemployment to keep rising during the initial phases of an economic recovery as businesses are slow to start employing again fearing the recovery won’t last. Since share markets lead economic recoveries, the peak in unemployment usually comes after shares bottom. In Australia, the average lag from a bottom in shares following a bear market associated with a recession to a peak in unemployment has been twelve and a half months.

Based on All Ords. Source: Bloomberg, Thomson Financial, AMP Capital

 

Hence the current cycle where the share market has gone up despite rising unemployment and headline news of job layoffs is not unusual.

Myth #2: Business won’t invest when capacity utilisation is low

This one is a bit like the unemployment myth. The problem is that it ignores the fact that capacity utilisation is low in a recession simply because spending is weak. So when demand turns up, profits rise and this drives higher business investment which then drives up capacity utilisation.

Myth #3: Corporate CEOs, being close to the ground, should provide a good guide to where the economy is going

Again this myth sounds like good common sense. However, senior business people are often overwhelmingly influenced by their own current sales but have no particular lead on the future. Until recently it seemed Australian building material CEOs saw no sign of a pick-up in housing construction even though it was getting underway. Now it’s widely accepted. This is not to say that CEO comments are of no value – but they should be seen as telling us where we are rather than where we are going.

Myth #4: The economic cycle is suspended

A common mistake investors make at business cycle extremes is to assume the business cycle won’t turn back the other way. After several years of good times it is common to hear talk of “a new paradigm of prosperity”. Similarly, during bad times it is common to hear talk of a “new normal of continued tough times”. But history tells us the business cycle will remain alive and well. There are no such things as new eras, new paradigms or new normals.

Myth #5: Crowd support indicates a sure thing

This “safety in numbers” concept has its origin in crowd psychology. Put simply, individual investors often feel safest investing in a particular asset when their neighbours and friends are doing so and the positive message is reinforced via media commentary. But it’s usually doomed to failure. The reason is that if everyone is bullish and has bought into the asset there is no one left to buy in the face of more good news, but plenty of people who can sell if some bad news comes along. Of course the opposite applies when everyone is bearish and has sold – it only takes a bit of good news to turn the market up. And as we have often seen at bear market bottoms this can be quite rapid as investors have to close out short (or underweight) positions in shares. The trick for smart investors is to be sceptical of crowds.

Myth #6: Recent returns are a guide to the future

This is a classic mistake investors make which is rooted in investor psychology. Reflecting difficulties in processing information and short memories, recent poor returns are assumed to continue and vice versa for strong returns. The problem with this is that when its combined with the “safety in numbers” myth it results in investors getting into an investment at the wrong time (when it is peaking) and getting out of it at the wrong time (when it is bottoming).

Myth #7: Strong economic/profit growth is good for stocks and vice versa

This is generally true over the long term and at various points in the economic cycle, but at cyclical extremes it is invariably very wrong. The big problem is that share markets are forward looking, so when economic data is really strong – measured by strong economic growth, low unemployment, etc – the market has already factored it in. In fact the share market may then fret about rising costs, rising inflation and rising short term interest rates. As an example, when global share markets peaked in October/November 2007 global economic growth and profit indicators looked good.

Of course the opposite occurs at market lows. For example, at the bottom of the global financial crisis (GFC) bear market in March 2009, economic indicators were very poor. Likewise at the bottom of the mini-bear market in September 2011 economic indicators were poor and there was a fear of a “double dip” back into global recession. But despite this “bad news” stocks turned up on both occasions, with better economic and profit news only coming along later to confirm the rally. History indicates time and again that the best gains in stocks are usually made when the economic news is poor and economic recovery is just beginning or not even evident, as stocks rebound from being undervalued and unloved.

Myth #8: Strong demand for a particular product or stock market sector should see stocks in the sector do well and vice versa

While this might work over the long term, it suffers from the same weakness as Myth #7. By the time demand for a product (eg, new residential homes) is really strong it should already be factored into the share prices for related stocks (eg, building material and home building stocks) and thus they might even start to start to anticipate a downturn.

Myth #9 Countries with stronger economic growth will see stronger equity market returns

In principle this should be true as stronger economic growth should drive stronger revenue growth for companies and hence faster profit growth. It’s the basic logic why emerging market shares should outperform developed market shares over time. But it’s not always the case for the simple reason that often companies in emerging countries may not be focussed on maximising profits but rather may be focussed on growing their market share or social objectives such as strong employment under the influence of their government.

Myth #10: Budget deficits drive higher bond yields

Its common sense that if the government is borrowing more (higher budget deficits) then this should push up interest rates (the cost of debt) and vice versa, but it often doesn’t turn out this way. Periods of rising budget deficits are usually associated with recession or weak economic growth and hence weak private sector borrowing, falling inflation and falling interest rates so that bond yields actually fall not rise. This was evident in both the US and Australia in the early 1990s recessions and evident through the GFC that saw rising budget deficits and yet falling bond yields.

Myth #11: Having a well diversified portfolio means that an investor can take on more risk

This mistake was clear through the GFC. A common strategy had been to build up more diverse portfolios of investments with greater exposure to alternative assets such as hedge funds, commodities, direct property, credit, infrastructure, timber, etc, that are supposedly lowly correlated to shares and to each other. Yes, there is a case for such alternatives, but last decade this generally led to a reduced exposure to truly defensive asset classes like government bonds. So in effect, investors actually began taking on more risk helped by the “comfort” provided by greater diversification. But unfortunately the GFC exposed the danger in allowing such an approach to drive an increased exposure to risky assets overall. Apart from government bonds and cash, virtually all assets felt the blow torch of the global financial crisis, as supposedly low correlations amongst them disappeared.

Myth #12: Tax should be the key driver of investment decisions

For many, the motivation to reduce tax is a key investment driver. But there is no point negatively gearing into an investment to get a tax refund if it always makes a loss.

Myth #13: Experts can tell you where the market is going

I have to be careful with this one! But the reality is that no one has a perfect crystal ball. And sometimes they are badly flawed. It is well known that when the consensus of experts’ forecasts for key economic or investment indicators are compared to actual outcomes they are often out by a wide margin. Forecasts for economic and investment indicators are useful, but need to be treated with care. And usually the grander the call – eg prognostications of “new eras of permanent prosperity” or calls for “great crashes ahead” – the greater the need for scepticism as such strong calls are invariably wrong.

Like everyone, market forecasters suffer from numerous psychological biases and precise point forecasts are conditional upon information available when the forecast is made but need adjustment as new facts come to light. If forecasting the investment markets was so easy then everyone would be rich and would have stopped doing it. The key value in investment experts’ analysis and forecasts is to get a handle on all the issues surrounding an investment market and to understand what the consensus is. Experts are also useful in placing current events in their historical context and this can provide valuable insights for investors in terms of the potential for the market going forward. This is far more useful than simple forecasts as to where the ASX 200 will be in a year’s time.

Conclusion

The myths cited here might appear logical and consistent with common sense but they all suffer often fatal flaws, which can lead investors into making poor decisions. As investment markets are invariably forward looking , common sense logic often needs to be turned on its head when it comes to investing.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

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.

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