Olivers Insights

Introduction

Way back in the early 1980s it was pretty obvious that the medium term (five year) return potential from investing was pretty solid. The RBA’s “cash rate” was averaging around 14%, 3 year bank term deposit rates were around 12%, 10 year bond yields were around 13.5%, property yields were running around 8-9% (both commercial and residential) and dividend yields on shares were around 6.5% in Australia and 5% globally. Such yields meant that investments were already providing very high cash income and for growth assets like property or shares only modest capital growth was necessary to generate pretty good returns. Well at least the return potential was obviously attractive in nominal terms as back then inflation was running around 9% and the big fear was it would break higher. As it turns out most assets had spectacular returns in the 1980s and 1990s. This can be seen in returns for superannuation funds which averaged 14.1% in nominal terms and 9.4% in real terms between 1982 and 1999 (after taxes and fees).

Source: Mercer Investment Consulting, Morningstar, AMP Capital

Now it’s not quite so clear as yields have fallen across the board. The RBA cash rate is just 2%, 3 year bank term deposit rates are just 2.7%, 10 year bond yields are just 2.9%, gross residential property yields are around 3% and while dividend yields are still around 6% for Australian shares (with franking credits) they are around 2.5% for global shares. While the recovery from the GFC and the Eurozone debt crisis and the fall in yields (which goes hand in hand with capital growth for bonds and growth assets) has seen solid double digit returns from a diversified mix of assets over the last few years, it would be dangerous to assume that we have now returned to a world where double digit annual returns are the sustainable norm

This note takes a look at the medium term return potential from a range of assets and what it means for investors.

Don’t look back – what drives potential returns?

We all know the disclaimer that past returns are not necessarily a guide to future returns. This applies just as much to investment markets as it does to managed funds. Simply taking a long term average of historical returns may be a guide to future returns, but it can be very misleading for the medium term as it ignores the significant impact of starting point valuations. Eg, if current yields – say bond yields and dividend yields – are lower than normal then this will potentially constrain returns relative to what has been seen over the long term.

Investment returns have two components: capital growth and yield (or income flow). The yield is the most secure component and generally speaking the level it starts at when you undertake the investment is key, put simply the higher the better. So our approach to get a handle on medium term return potential is to start with current yields for each asset and apply simple and consistent assumptions regarding capital growth. We also prefer to avoid a reliance on forecasting and to keep the analysis as simple as possible. Complicated adjustments can just lead to compounding forecasting errors.

• For equities, a simple model of current dividend yields plus trend nominal GDP growth (as a proxy for earnings and capital growth) does a good job of predicting medium term returns. This approach allows for current valuations (via the yield) but avoids getting too complicated. The next chart shows this approach applied to US equities, where it can be seen to broadly track big secular swings in returns.

• For property, we use current rental yields and likely trend inflation as a proxy for rental and capital growth.

• For unlisted infrastructure, we use current average yields and capital growth just ahead of inflation.

• For bonds, the best predictor of future medium term returns is the current five year bond yield. In other words, capital growth is zero because if a five year bond is held to maturity its initial yield will be its return.

Source: Thomson Reuters, Global Financial Data, AMP Capital

Projections for medium term returns

This approach results in the return projections shown in the next table. The second column shows each asset’s current income yield, the third their five year growth potential and the final column their total return potential. Note that:

• We assume central banks meet their inflation targets over time, eg 2.5% in Australia and 2% in the US.

• We allow for forward points in the return projections for global assets based around current market pricing – which adds 1.8% to the return from world equities.

• The Australian cash rate is assumed to average 3.25% over the next five years. Cash is one asset where the current yield is of no value in assessing the asset’s medium term return potential because the maturity is so short. So we assume a medium term average. Normally, for cash this would be around a country’s potential nominal growth rate, but adjusted for higher than normal bank lending rate margins over the cash rate and higher household debt to income ratios which have pulled down the neutral cash rate.

The return implied for a diversified growth mix of assets has now fallen to 7.3% pa and is shown in the final row.

Projected medium term returns, %pa, pre fees & taxes

Source: AMP Capital

Megatrends influencing the growth outlook

Several themes are allowed for in our projections for capital growth: low inflation; aging populations; slower household debt accumulation; a continued downtrend in commodity prices; ongoing technological innovation and automation; reinvigorated advanced countries versus emerging markets; increased geopolitical tensions in a multi-polar world; increased regulation and scepticism of free markets. Most of these will likely have the effect of constraining nominal economic growth and hence total returns. But not necessarily. Increasing automation is positive for profits and the downtrend in commodity prices is positive for commodity users such as the US, Europe, Japan and Asia but not so good for Australia (where we have lowered our real economic growth assumptions).

Observations

Several observations flow from these projections.

• The medium term return potential remains low. In fact the rally in most assets of the last few years has seen it steadily decline. The next chart shows projected medium term returns using this approach for a diversified growth mix of assets since 2008 over which time there has been a decline from 9.2% pa to 7.3% pa. In fact, at the GFC low point this approach was signalling an attractive 10.3% pa return.

Source: AMP Capital

• The starting point for returns today is far less favourable than when the last secular bull market in bonds and shares started in 1982, due to much lower yields. Our medium term return projections implying a 7.3 % pa return now from a diversified mix of assets, compare to an average 14% pa return by Australian balanced growth super funds over the 1982-2007 period (pre fees and taxes).

• Government bonds offer very low return potential – the combination of low yields and the risk they will rise causing capital loss implies low medium term return potential.

• Unlisted commercial property & infrastructure continue to come out well reflecting their relatively high yields.

• Australian shares stack up well on the basis of yield, but it’s hard to beat Asian shares for growth potential and falling commodity prices are a headwind for Australian shares.

Implications for investors

There are several implications for investors:

• First, have reasonable return expectations. The GFC is way behind us but the combination of low inflation, low starting point yields and constrained GDP growth indicate it’s not reasonable to expect year after year of double digit returns. In fact, the decline in the rolling 10 year moving average of superannuation fund returns (first chart) indicates we have been in a lower return world for some time now.

• Second, using a dynamic approach to asset allocation makes sense as a way to enhance returns when the return potential from the underlying markets is constrained. This is likely to be enhanced by continued bouts of volatility (eg, regarding the Fed and Greece) & as the correlation between bonds and equities remains low providing opportunities to enhance returns by varying the allocation between them.

• Third, there is still a case for a bias towards Australian shares for yield focused investors, but it makes sense to have a bit more offshore including in traditional global shares, which are looking a bit healthier after a long tough patch, and in Asian ex-Japan shares.

• Fourth, focus on assets providing decent sustainable income as it provides confidence regarding returns, eg commercial property and infrastructure.

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

After the political and economic failure of last year’s budget, this year’s Budget represents a significant change in focus for the Government. Not only was it relatively ‘boring’ with no major surprises, but the focus on dealing with a ‘budget emergency’ has been replaced with a new focus on ‘boosting jobs, growth and opportunity’ and ‘progressing budget repair in a responsible, measured and fair way’ (as if the Government now recognises that it wasn’t last year!). As a result, we are unlikely to see the big blow to confidence that last year’s fairness debate and Senate debacle caused. The danger is that the return to surplus is looking more distant than ever.

Key budget measures

As always, many of the key measures have already been pre-announced or leaked. The goodies include:

• More generous child care payments;

• Lower taxes and increased deductions for small business;

• Increased infrastructure spending in northern Australia.

New spending has been offset by various savings, including:

• A lowering in the asset test for the pension and an increase in withdrawal rates;

• Measures to cut tax avoidance by multinational companies;

• Extension of the GST to digital downloads from offshore;

• Dropping the proposed Paid Parental Leave scheme – announced pre-budget; and

• The Government is also tying the child care expansion to the Senate passing some of last year’s family welfare cuts.

The budget bottom line

While the Government has seemingly ditched the ‘budget emergency’ the budget is actually in worse state than a year ago as revenue has had a $52bn hit over four years due lower commodity prices and wages growth. As a result, the budget deficit projections have blown out by an average $13bn per annum compared to last year’s budget. The return to balance or surplus has therefore been delayed by another year to 2019-20 and even then its wafer thin at just 0.1% of GDP. After a 2014-15 budget deficit of $41bn (2.6% of GDP) the deficit for 2015-16 is forecast to be around $35bn (2.1% of GDP).

Underlying cash budget balance projections

* implied. Source: Australian Treasury, AMP Capital

With the Government offsetting all new spending with savings, the actual policy impact on the economy this year and next is trivial. See the red figures in the table above. However, the projected decline in the budget deficit in the years ahead (as revenue flows improve with the economy and some of last year’s measures put a lid on spending growth) means that fiscal policy will still be acting as drag on growth.

Implied from Budget papers from 2019-20. Source: Aust Treasury, AMP Capital

Economic assumptions

The major economic assumptions underpinning the Budget are shown in the next table. Like the Reserve Bank of Australia (RBA) the Government has downgraded its near-term growth and inflation forecasts. The iron ore price is now expected to average $US48/tonne over the next four years, compared to $US96/tonne assumed in the last budget. While the recent rebound provides confidence on this front, it’s not at all clear it will be sustained given surging supply.

Budget economic assumptions

Source: Australian Treasury, AMP Capital

Assessment and risks

The debate in Australia over the budget is no doubt leading some to despair. A year ago the Government tried to oversell the ‘budget emergency’ story. However, with the net public debt to Gross Domestic Product (GDP) ratio running around a quarter of the OECD average, this message was always over the top. With 95 quarters without a recession Australians and hence the populist Senate did not buy the emergency story, particularly after the Budget came to be perceived as unfair. What’s more, the Government did a terrible job of selling last year’s budget – with the cigar and wink episodes as standouts.

However, Australia does have a budget problem. Government spending surged 25% between 2006-07 and 2008-09 to combat the Global Financial Crisis. This has never been unwound and we are still spending the proceeds of the boom even though it’s gone away. While our public debt ratio is low compared to the US, Europe and Japan, comparing ourselves to a bad bunch may not be wise. In 2008, Ireland’s net public debt was close to where Australia’s is now. Yet it skyrocketed when its boom turned to bust and we know how that ended.

The 2015-16 Budget is projecting an 11 year run of deficits which swamps the seven years seen in the 1990s and the five years in the 1980s. What’s worse is that this time around it’s come despite the longest boom in our history – and we haven’t even had a recession. The continuing delay in returning to balance or surplus from a projection of 2012-13 in the 2012-13 Budget, to 2016-17 in the 2013-14 Budget, to 2018-19 in the 2014-15 Budget and now to around 2019-20 is cause for concern and begs the question whether we will ever get there.

There are real reasons for concern here because demographic pressures on the budget will start to build early next decade and we now don’t have a lot of flexibility to provide stimulus should our luck turn against us and the economy really turn down.

The good news is by adopting what might be seen as a fairer approach to repairing the budget, this year’s Budget should have a more positive impact on confidence. The proposed measures should benefit the economy and stand a greater chance of getting through the Senate. This is positive for growth generally and should help undo some of the damage done through last year.

What’s more, the ongoing focus on boosting infrastructure spending, the help for small business and the boost to childcare spending are also positive for growth. The enhanced child care assistance is a far better use of public funds than the Government’s costly and now dumped Parental Leave Scheme.

However, there are three main risks. First, the Government’s projected 7% plus revenue growth from 2017-18 is at risk of being too optimistic particularly as it’s based on economic growth returning to 3.5%. Similarly, the commodity price assumptions could yet prove to be too optimistic. Consequently, we may still see more deficit blow outs in the years ahead.

Second, while our base case is that Australia’s AAA sovereign credit rating is secure, the ongoing uncertainty around the deficit outlook and return to surplus could prompt credit ratings agencies to look at it more closely at some point.

Finally, there remains a risk that some of the measures may not pass the Senate, particularly given the Government has tied some of this year’s goodies to the passage of some of last year’s welfare cuts.

Implications for the RBA

While this Budget could provide a boost to confidence, ongoing fiscal tightening will act as a mild drain on growth in the years ahead. As such, it’s hard to see major implications for the RBA. Our view remains that we have probably seen the low for the cash rate but that the risks are skewed to more cuts and a rate hike is a long way off.

Implications for Australian assets

Cash and term deposits – with interest rates expected to remain low for an extended period, returns from cash and bank term deposits are expected to remain very low at around 2%.

Bonds – a major impact on the bond market from the Budget is unlikely. With five year bond yields at 2.4%, it’s hard to see great returns from Australian sovereign bonds over the next few years.

Shares – the potential boost to confidence from this Budget could be a small positive for the Australian share market. However, it’s offset by the ongoing drag coming from fiscal policy. Overall, the Budget’s impact is unlikely to be huge. Stocks that benefit from infrastructure and child care spending may be beneficiaries.

Property – the Budget is unlikely to have much impact on property markets where the dominant impact remains very low interest rates. Expect further modest gains in most cities although momentum may slow over the year ahead in Sydney.

The Australian dollar – the announcements in the Budget alone are not radical enough to have much impact on the $A. With the commodity price boom fading, the interest rate differential in favour of Australia having fallen and the $A still too high, the trend in the $A is likely to remain down.

Concluding comments

The 2015-16 Budget with its more measured & fairer approach goes some way to undoing the hit to confidence from last year’s budget debacle. However, risks remain around the revenue assumptions, when we will get back to surplus and the Senate.

About the Author

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

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

Introduction

The last few weeks have seen the investment scene hit another rough patch: US shares have had a fall of less than 2%, but for Japanese shares it was 4%, Australian shares 6%, Eurozone shares 7% and Chinese shares 9%. This note takes a look at the key drivers, whether it’s a correction or something more serious and some of the key threats and risks investors should keep an eye on.

Wobble drivers

Several factors have contributed to the recent wobble.

• First, deflation fears have abated, which is good but it’s pushed up bond yields, after sharp falls earlier this year. This partly reflects the fall back in the $US as expectations for the first Fed interest rate hike have been pushed out – which has allowed commodity prices and notably oil prices to rebound as they move in the opposite direction to the $US as they are priced in US dollars. And so the acute oilprice- collapse-driven-fear of deflation seen earlier this year has receded allowing bond yields to move higher. This has been given a push in Europe by stronger growth and higher German bond yields have also removed a lid on US and Australian bond yields. Over the last few weeks 10 year bond yields have gone from lows of 0.07% in Germany to 0.55%, in the US from 1.86% to 2.14% and in Australia from 2.28% to 2.84%. The rise in bond yields has made shares, notably high yield shares like banks, look less attractive.

• Second, some share markets were due for a correction – notably Europe, Japan and China – after very strong gains so far this year and were thus vulnerable.

• Third, we’ve entered a seasonally tougher part of the year.

• Finally, apart from the global lead, Australian shares have also been hit by perceptions the RBA may have finished easing, fears about a stronger $A and talk (reality in NAB’s case) of bank capital raisings.

Is it a correction or something worse?

Our view is that while shares have rallied a long way from their global financial crisis lows we are still a long way from the peak in the investment cycle. 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 economic growth is extending the economic expansion cycle; and monetary conditions are likely to remain easy for a while yet.

However, periodic corrections are healthy and normal. For example, Australian shares had a 9% pullback last September- October, an 11% pullback in mid 2013 (remember the taper tantrum?) and 10% decline in mid-2012 all against a rising trend – so what’s new? In fact, viewed in this context recent volatility barely registers – see the next chart.

Source: Bloomberg, AMP Capital

While a benign April US jobs report – strong enough to support confidence in US growth, but not so strong as to invite fears of an earlier Fed tightening – has helped sooth nerves, it’s too early to say whether the recent wobble has run its course.

Seasonal patterns

As we come into May I get kind of nervous given the old saying “sell in May and go away, buy again on St Leger’s Day.” The seasonal pattern for shares typically sees rougher returns over the period May to November. See the next chart.

Source: Bloomberg, AMP Capital

As can be seen in the following chart, most of the returns from share markets occur in the November to May period. Note this chart shows total returns including dividends.

Source: Bloomberg, AMP Capital

Anecdotally, most major share market falls and corrections have occurred in the May to October period: the 1929 crash, the October 1987 crash, the post Lehman Brothers collapse in October 2008 and the worst of the Eurozone.

So what are the main known threats? Those worth keeping an eye on are: the Fed; bonds; Greece; China; geopolitical threats; and the risk of recession in Australia post the mining boom.

Fed rate hikes

The start of a rising cycle in US official 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%. So it would be reasonable to expect a bit of volatility around the start of rate hikes this time as well, particularly as they have been at the current record lows for six years. However, this year has seen the US share market significantly underperform on fears the Fed will tighten prematurely and will ignore the dampening impact of the stronger $US. So maybe it’s already anticipated.

More importantly, the Fed is not stupid. It’s clear from recent Fed commentary that it is aware that the rise in the value of the $US (by slowing inflation and growth) is doing part of its job and that it will not mindlessly raise interest rates but rather that it will be dependent on growth continuing to improve and confidence that inflation will head back to around the 2% target. Our base case is that the first Fed hike won't come till September but the risks are skewing into 2016. And when the Fed does start to hike it will likely be gradual. But anticipation of hikes will likely cause more bond and share market wobbles.

A bond rout – like 1994 all over again?

Talk of another 1994 style bond crash has been with us ever since the end of the GFC and so every time there is a backup in bond yields it re-emerges. Like now. However, a sharp sustained bond sell-off is unlikely: global growth remains below trend with recent PMIs slowing a bit, so spare capacity will remain; core inflation in the US, Europe and Japan remains too low; the US looks like having another year of okay but disappointing growth; even when the Fed does start rate hikes it will be dampened by a stronger $US which will bear down on oil prices and hence act as a drag on inflation taking off. So while I can’t see great returns from government bonds because yields are so low, it’s hard to see a bond crash just yet either.

Greece – this is not 2011

Greece is annoying. That said, it’s unlikely to drive a return to the Eurozone crisis. Agreement needs to be reached quickly between Eurozone finance ministers and Greece to allow the disbursement of funds soon or else a Graccident (Greece defaulting on either debt servicing payments) sometime in June will be likely. This need not mean that a Grexit (Greek exit from the Euro) will be inevitable and in fact it could help focus the mind of the inexperienced and unstable Greek Government on the tenuous situation they are in. The good news is that the rest of Europe remains far stronger than it was in 2010-2012 with significant budget repair and economic reforms and the ECB's quantitative easing program. So a Graccident or even a Grexit is unlikely to derail the Eurozone economic recovery. But it could cause volatility.

China slowdown

Growth in China is starting to fall below the Government's comfort zone. However, the authorities appear to have realised that monetary conditions are overly tight and so have now started to ease more aggressively, with another interest rate cut just announced. More policy easing is likely. This should help ensure growth comes in around the Government’s target of 7%. An easing in property price declines also suggests that the threat from a property collapse may be abating.

There is of course another possibility. Chinese shares have more than doubled over the last year and while it’s well known to be a highly speculative market its last three big swings were associated with turning points in growth: the 2007-2008 bear market was associated with a collapse in growth; the 2008- 2009 bull market led a growth surge from around 6% to 12%; and the 2009-2013 bear market led a slump in growth from around 12% to 7%. So it begs the question whether the current share surge is presaging a growth upturn. It’s worth a thought.

Source: Bloomberg, AMP Capital

Geopolitics

Geopolitical threats remain but have faded a bit. The battle over Ukraine looks like becoming a frozen conflict. The terror threat from IS remains but its military progress in the Middle East looks to have been checked. Tensions continue in the South China Sea (and are worth watching) but this could drift on for years. The threat from Ebola has receded (at least for now).

Australia

Australian growth this year is likely to remain sub-par. Worries about impending recession in Australia have been common ever since the mining boom ended around 3 or 4 years ago. The risk remains. But it is dangerous to overstate these risks. The boom was managed better this time around with no inflation or trade blow out, which should mean a milder bust. While mining exposed parts of the country are struggling, nonmining sectors like housing, consumer spending, tourism, agriculture and higher education will benefit from lower interest rates and the fall in the $A. In other words we will see a more balanced economy. We continue to see better opportunities in global shares, and the Australian share market has recently got ahead of itself but the ASX 200 should make 6000 by year end.

Concluding comments

First, Greece and more significantly the Fed are the key risks to keep an eye in the short term. Both could cause wobbles.

Second, most threats look to be manageable at this stage, and unlikely to threaten the broader cyclical bull market in shares.

Finally, given the risk of a correction in bonds and shares we have been running a higher cash allocation and see recent moves as healthy and as setting up investment opportunities.

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.

Key points:

• The RBA's latest rate cut along with downwards pressure on the value of the $A should help Australian economic growth pick up to around trend next year.

• While 2% is likely to be the low, further cuts cannot be ruled out, particularly if the $A remains too strong.

• For investors: expect bank term deposits to offer poor returns; consider asset classes providing higher and more stable yields; and expect the $A to continue to trend down.

Introduction

As widely expected, the Reserve Bank of Australia has cut the official cash rate to 2% from 2.25%. This has taken the official cash rate to its lowest level ever and will push mortgage rates down to levels not seen since the mid-1950s. The latest rate cut if fully passed on to mortgage holders should save a borrower with a $300,000 mortgage about $12 a week or $625 a year.

Mortgage rates assumed to fall in line with the latest cash rate cut. Source: RBA, AMP Capital

This note looks at the implications for the economy and investors.

Why the cut?

The latest RBA rate cut makes sense. National income is still falling with lower commodity prices. Household demand has picked up but the business investment outlook is bleak and public spending is likely to be soft. And at the same time inflation is benign providing no barrier to a cut and the Australian dollar remains too strong.

Sure the Sydney residential property market remains too strong, but home price growth in the other capital cities is weak at just 1.7% year on year, and so it is right to put Sydney aside and set rates for the average of Australia as a whole which needed a cut. Exactly the same was done a decade ago when the RBA was raising interest rates despite falling Sydney property prices.

Source: Core Logic RP Data, AMP Capital

Will it work?

Interest rate cuts are not as potent as they used to be (as Australians are much more cautious regarding debt post the GFC). This is partly why they have had to go to record lows. But the interest savings for households with mortgages and businesses combined with ongoing downwards pressure on the value of the $A should provide further support to demand in the economy. Home construction has already received a boost from the rate cuts seen since 2011, but the latest cuts should help ensure that household demand remains strong and eventually encourages a pick-up in non-mining investment. Which in turn should see economic growth pick up to around 3% or just over next year.

Won’t the hit to self-funded retirees’ income offset the boost to the economy?

Deposit rates assumed to fall in line with the latest cash rate cut. Source: RBA, AMP Capital

However, in total Australian households have around $850bn in bank deposits but owe $2050bn in debt, so the household sector as a whole is clearly a net beneficiary of lower interest rates. It also tends to be the case that spending by families with mortgages is more sensitive to changes in their spending power than that of retirees…though I don’t want to generalise here too much!

RBA rate cuts are also just as much about keeping the $A low and pushing it lower as boosting domestic spending. Lower Australian interest rates help push the $A down by making it less attractive for foreign investors to park their money in Australia. And a lower $A helps boost sectors like farming, tourism, manufacturing and higher education and helps offset lower commodity prices for resources companies.

Is this the low for interest rates?

Our base case is that 2% for the cash rate will be the low for this cycle. However, with the mining investment boom continuing to unwind and confidence still subdued (hopefully next week’s Budget might mark a turning point on this front!), the risks are still skewed towards a fall in the cash rate below 2%.

On this front, while the RBA’s post meeting Statement contained no explicit easing bias this was also the case when it last cut in February. Moreover, the RBA’s commentary on the $A was much more strident than anything seen over the last year with it stating that further depreciation is both likely and necessary. So if the $A does not oblige and head lower, then the RBA is likely to be back cutting interest rates again.

What does it mean for investors?

There are several implications for investors.

• First, bank term deposit rates are becoming less and less attractive. We have to get used to ongoing low interest rates and investors still relying on bank deposits could consider alternative sources of yield and return.

• Second, falling 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.

Deposit rate assumed to fall in line with the latest cash rate cut. Source: RBA, Bloomberg, AMP Capital

• Finally, notwithstanding the kneejerk bounce in the $A on the lack of an explicit easing bias from the RBA, the broad trend in the $A is likely to remain down. 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.

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 is now six years since the global financial crisis ended. From their 2009 lows US shares are up 212%, global shares are up 159% and Australian shares are up 91% (held back by higher interest rates, the commodity collapse & the high $A). Despite this, there seem to be constant predictions of a new disaster. This note looks at where we are in the investment cycle.

Time and magnitude

A concern expressed by many it seems is that the cyclical bull market in the influential US share market is now more than six years old and this leaves it (and hence us) vulnerable to a cyclical bear. The next table shows the record of cyclical bull markets in US shares since World War 2. I have applied the definition that a cyclical bull market is a rising trend in shares that ends when shares have a 20% or more fall (ie a cyclical bear market) that takes more than 12 months to be reversed.

Source: Bloomberg, AMP Capital

The average cyclical bull market in the US has seen shares rise 177% and last 64 months. So far we have surpassed this with shares up 212% over 73 months. While not the longest, some fear this means the US share market is at risk of another bear market. However, there are some points to make in relation to this. First, there is no hard and fast rule regarding the timing of bull and bear cycles so it could be argued that the 19% fall in US shares in mid 2011 was a bear market. This would put the current cycle at a gain of 92% and 42 months duration, which is below average.

Second, global and Australian shares did have a bear market in 2011. As such, for their current bull market since the 2011 low global shares are up 81% over 42 months which is below the average since 1970 of 133% over 55 months. Similarly, Australian shares in the current bull market are up 51% over 43 months versus an average gain of 126% over 47 months. See next table.

Source: Bloomberg, AMP Capital

Finally, there is more to bull markets than time and magnitude.

The investment cycle

The next chart shows a stylised version of the investment cycle.

Source: AMP Capital

A typical cyclical bull market in shares has three phases:

• Phase 1 normally starts when economic conditions are still weak and confidence is poor, but smart investors start to see value in shares helped by ultra easy monetary conditions, low interest rates and low bond yields.

• Phase 2 is driven by strengthening profits as economic growth turns up and investor scepticism starts to give way to some optimism.

• While monetary policy may start to tighten it is from very easy conditions and remains easy as inflation remains low and so bond yields may be drifting higher but not enough to derail the cyclical upswing in shares.

• Phase 3 sees investors move from optimism to euphoria helped by strong economic and profit conditions which pushes shares into overvalued territory. Meanwhile, strong economic conditions drive inflation problems and force central banks to move into tight monetary policy, which pushes bond yields significantly higher. The combination of overvaluation, investors being fully loaded up on shares and tight monetary policy sets the scene for a new bear market.

Typically the bull phase lasts three to five years. But it varies depending on how quickly recovery precedes, inflation rises and extremes of overvaluation & investor euphoria appear. As a result “bull markets do not die of old age but of exhaustion”.

Current point – not there yet

So the big question is: are we at or near “exhaustion” for the cyclical bull market in shares? The best way to look at this is to assess market valuation, economic growth and inflation pressures, monetary conditions and investor sentiment.

• Share market valuations are mostly okay. Sure, measured in isolation against their own history shares are no longer dirt cheap. In fact, forward price to earnings multiples in the US and Australia are above long term averages.

Source: Thomson Reuters, AMP Capital

However, once the gap between share market earnings yields and bond yields is allowed for, shares still look cheap (next chart)

Source: Bloomberg, AMP Capital

• The global economy is continuing to grow at an okay pace. While growth is constrained by past standards, a constrained and slower recovery is a longer recovery. Year after year has seen growth remain below longer term trend levels globally and in Australia. However, there is a silver lining – spare capacity globally remains significant. This means we are a long way from the sort of inflation and debt excesses that precede cyclical downturns.

• 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 the Fed's first interest rate hike is rightly getting pushed out in response to the dampening impact of the strong $US. So a 1994 scenario where aggressive interest rate hikes pushes bond yields sharply higher and threatens shares still looks a long way off.

• Finally, while investor optimism is up it’s a long way from euphoria. In the US investor flows are still going into bond funds, not shares, and measures of investor sentiment are in the middle of their normal ranges. In Australia sentiment towards shares as a wise destination for savings remains low and more investors still prefer bank deposits.

Source: Westpac/Melbourne Institute, AMP Capital

So from a broad brush perspective we are not seeing the signs of exhaustion that come at cyclical peaks and so the cyclical bull market in shares looks like it has further to go.

Global divergences

Finally, for those who like to follow the Shiller or cyclically adjusted PE, while US shares are expensive on this measure most other major share markets are actually cheap because they have lagged the US over the last six years. In other words there are plenty of opportunities for investors outside the US.

Source: Global Financial Data, AMP Capital

Investment implications

First, while corrections should be anticipated – with Greece and the Fed being potential triggers – we appear to be a long way from the peak in the investment cycle.

Second, while the US shares register as expensive on some metrics this is not like 2000 when all markets were expensive.

Finally, while Australian shares should do okay this year better opportunities still lie abroad where the slump in commodity prices is not a drag on growth but rather a positive.

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.

Highlights:

• A housing recovery has been a necessary aspect of rebalancing the economy through the mining bust.

• While Australian property prices are overvalued, this should not be a constraint on the RBA. Expect another rate cut in May with the possibility of more to follow.

• The medium term return outlook for residential property is likely to be constrained.

The case for the RBA resuming interest rate cuts this year has been fairly clear: commodity prices have fallen more than expected; the $A has remained relatively high; while residential construction and consumer spending are okay the outlook for business investment has deteriorated pointing to overall growth remaining sub-par; and inflation is low. This has seen the cash rate fall to 2.25%. While the RBA left rates on hold at its April meeting, it retains an easing bias pointing to further cuts ahead.

However, the main argument against further rate cuts has been that the housing market is too hot and further rate cuts risk pushing home prices to more unsustainable levels resulting in a more damaging eventual collapse. But how real is this concern?

Housing construction doing its part

Economic upswings in Australia rarely start without a housing upswing. Lower interest rates drive housing demand resulting in higher house prices which boosts consumer spending via wealth effects and drives home building. The latter is happening with approvals to build new homes at record levels.

Source: Bloomberg, AMP Capital

…but what about overheated property prices?

But the big debate has been whether low rates are just fuelling an overheated property market. Its long been known that Australian housing is expensive and overvalued.

• Real house prices have been running well above trend since the early 1990s and are now 14% above it.Source: ABS, AMP Capital

  
  
  Source: ABS, AMP Capital

• According to the 2015 Demographia Housing Affordability Survey the median multiple of house prices to household income in Australia is 6.4 times versus 3.6 in the US and 4.7 in the UK. In Sydney its 9.8 and 8.7 in Melbourne.

• The ratios of house prices to incomes and to rents are at the high end of comparable countries in the OECD.

While it’s generally agreed Australian property prices are high, the reasons for it are subject to much debate with many looking for scapegoats in the form of negative gearing and buying by foreigners and SMSF funds. However, these don’t really stack up: negative gearing has been around for a long time and while foreign and SMSF buying has played a role it looks to be small and foreign buying is concentrated in certain areas.

The shift to low interest rates since the early 1990s has clearly played a role. Consistent with this, the rise in price levels from below to above trend has gone hand in hand with increased household debt. The trouble is that other countries have lower levels of interest rates and most have lower household debt to income ratios and house price to income ratios. A more fundamental factor is constrained supply. Vacancy rates remain low and there has been a cumulative supply shortfall since 2001 of more than 200,000 dwellings. The main reason behind the slow supply response appears to be tough land use regulations in Australia compared to other countries.

High house prices compared to rents and incomes combined with relatively high household debt to income ratios suggest Australia is vulnerable on this front should something threaten the ability of households to service their mortgages. While this vulnerability has been around since the house price boom that ran into 2003 – with numerous failed predictions of property crashes! – the RBA is right to be concerned not to further inflate the property market. The renewed strength in auction clearance rates this year to record levels in Sydney is a concern.

Source: Australian Property Monitors, AMP Capital

However, there are some offsetting factors. First, home price gains are now narrowly focussed on Sydney. According to CoreLogic RP Data Sydney home prices rose 13.9% over the year to March. But growth across the other capital cities ranged from 5.6% in Melbourne to -0.8% in Darwin with an average of just 1.5%. So, the rest of the Australia is hardly strong.

Source: CoreLogic RP Data, AMP Capital

Second, growth in housing debt is running well below the pace seen last decade, and there are some signs of a loss of momentum in the last few months. Investor debt is up 10.1% year on year but reached around 30% through 2003 and in the last few months has slowed to an annualised pace of 9.3%.

Source: RBA, AMP Capital

Finally, the RBA and APRA have pushed down the macro prudential path to contain risks around housing. Tougher APRA expectations of banks were announced in December with the threat of sanctions if these expectations are not met.

So while the RBA is right to be mindful of the impact of low interest rates on the property market, the concentration of the property market strength in just Sydney, the signs of a possible topping in investor property loan growth and the heightened role of APRA indicates that the property market should not be a constraint on further RBA interest rate cuts. As the RBA has pointed out in the past it needs to set interest rates for the "average" of the economy. And the "average" still points to the need for lower interest rates as the slump in mining investment intensifies, non-mining investment remains weak, iron ore prices are down another 23% since the February RBA cut, the outlook remains for sub trend growth and ongoing spare capacity in the economy and inflation remains benign. This points to the need for further rate cuts to provide a direct boost to spending and an indirect boost via the inducement to a lower Australian dollar. Expect the cash rate to fall to 2% in May with a strong possibility rates will fall below that later this year.

Housing as an investment

Over the very long term 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. See the next chart.

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 property is illiquid but less volatile. And share and property returns tend to have low correlations with each other so including both offers diversification benefits. As a result there is a case for investors to have both in their portfolios over the long term.

In the short term, low interest rates point to further gains in home prices. However, this is likely to be constrained by the economic environment and the impact of tougher prudential scrutiny of bank lending by APRA. Over the next 12 months home price gains are likely to average around 5%, maybe a bit stronger in Sydney and Melbourne (key beneficiaries of the post mining boom rebalancing) but staying negative in Perth and Darwin (as the mining bust continues).

The residential property outlook for the next 5-10 years though is messy. Housing is expensive on all metrics and offers very low rental yields compared to all other assets except bank deposits and Government bonds. The gross rental yield on housing is around 2.9% (after costs this is around 1%), compared to yields of 6% on commercial property and 5.7% for Australian shares (with franking credits). See the next chart.

Source: Bloomberg, REIA, AMP Capital

This means that the income flow an investment in housing generates is very low compared to shares and commercial property so a housing investor is more dependent on capital growth to generate a decent return. So for an investor, these other assets continue to represent better value.

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.