Olivers Insights

Introduction

What is risk? Surely that is a stupid question as everyone knows what risk is when it comes to investing. Investopedia (www.investopedia.com) defines risk as “the chance that an investment’s actual return will be different than expected”. It’s actually quite a complex concept because it could mean different things to different people depending on their circumstances and tolerance to it. And it can be highly perverse often being very different to what backward looking statistical measures and common sense might suggest. But it’s worth thinking about because it can impact how you invest. 

Volatility

The conventional approach to measuring investment risk is to look at volatility. This is usually done with a statistical concept called standard deviation which shows how tightly clustered past returns have been around their average in a certain period. The higher the standard deviation the greater the volatility. The standard deviation of monthly returns based on very long term data for major asset classes is shown in the next table. 

Source: Global Financial Data, Bloomberg, AMP Capital

A basic idea in investments is that the higher the volatility (or risk) the higher the return should be over time as investors need to be compensated for taking on additional risk. If more risky assets do not offer this then their prices will fall until their prospective returns do. From the standard deviation and return assumptions, statistics on things like the chance of a negative year for an asset or fund can be calculated. However, to get a real handle on risk there is much more involved than this.

The risk of capital loss

What really concerns investors is not the volatility to the upside (as most of us like stronger returns) but capital loss. Various attempts have been made to measure the risk of capital loss. However, it’s not clear that these are much better than standard deviation. More fundamentally there are several problems with simple statistical measures.

First, standard deviation and related measures of risk are backward looking and when measured over short periods can give a misleading picture as to the potential for capital loss. This is because during solid periods for returns markets tend to be relatively stable and so measured volatility and hence risk looks low. And vice versa during bad periods. For example, the next chart shows the rolling 12 month standard deviation of US shares against the US share market. 

Source: Bloomberg, AMP Capital

It can be seen the standard deviation often indicates high risk when the market is low after a big fall and low risk when it’s high. This is around the wrong way. The risk of capital loss actually rises as markets go up and goes down as they fall. Trying to manage a fund based on such backward looking indicators is about as sensible as driving a car through the rear view mirror (unless you look at them as contrarian indicators).

Second, the risk regarding an asset can be perverse and radically different to what the statistics show and common sense would suggest. The well-known corporate bond investor Howard Marks is reputed to have once said that “there is nothing riskier than the widespread perception that there is no risk”. This usually comes after a period of strong returns, when economic and profit growth is solid and those investors who want to invest have. Perhaps the best way to demonstrate this is with one of my favourite charts – what Russell Investments called the roller coaster of investor emotion. 

The roller coaster of investor emotion

Source: Russell Investments, AMP Capital

During a bull market ‘optimism’ gives way to ‘excitement’, ‘thrill’ and eventually ‘euphoria’ as investors push the asset class up in value. It’s at this point investors are most bullish and most confident and relaxed. The reality though is this is actually around the point of maximum financial risk. That’s because it’s at this point that the market has become overvalued and with the crowd fully on board everyone who wants to buy has and so it only takes a bit of bad news to tip the market down. 

On the flip side after a bear market when shares have become cheap and investor sentiment has collapsed to ‘depression’, the market will then reach the point of minimum risk and maximum opportunity. It then usually only takes a bit of good news to tip the market higher. Unfortunately, this is the point when both statistical measures and common sense indicate risk is high. 

A classic example of the latter was in 2009 at the end of the bear market driven by the GFC. At this point statistical measures of risk were high (see the first chart), investors were scared and had retreated to cash and all the buzz was about the need to focus on capital preservation. Of course history speaks for itself on this one as 2009 provided a huge investment opportunity after which followed very strong returns.

The way to get a handle of the risk of capital loss is therefore not to look at backward looking statistics but rather at forward looking indicators such as valuation measures and indicators as to how optimistic and invested the crowd is. Maximum risk is when an asset is unambiguously overvalued and over loved. 

Finally, when it comes to investing time is on your side as it smooths out short term risk. For example, over rolling 12 month periods shares periodically have negative returns (since 1900 roughly two years out of ten are negative) and/or underperform cash. But over 10 year periods this has hardly ever occurred and has never occurred over 20 year periods. 

Source: Global Financial Data, Bloomberg, AMP Capital

The point is: when it comes to investing time is on your side.

Risk of insufficient income from investment

But sometimes it’s not really capital loss that should concern an investor but the risk that investment income falls short. This is now a big issue for those who have been relying on income from bank deposits. Bank deposits are safe, but the income they offer is not. Four years ago the income on $100,000 in a three year bank term deposit was running around $6150 a year. It’s now just $2750. What happened? The deposit is safe but the income has collapsed with interest rates. By contrast, a $100,000 Australian investment in shares 4 years ago that was providing annual dividend income of $4300 (or $5600 with franking credits) is now providing an income of roughly $5350 ($6950 with franking) & the investment has risen to $122,000.
 
The next chart compares the annual interest and dividend income on $100,000 investments in Australian shares and one year term deposits in December 2000. The annual dividend payment has trended higher over the period reflecting growth in the value of the share investment (to $166,000 by end last year) and relatively stable dividend yields over time. By contrast the annual interest payment has fallen sharply reflecting the collapse in interest rates and the term deposit remaining at $100,000. Of course if franking credits are allowed for annual dividend payments would be about 30% higher. Because dividend yields are relatively stable over time and shares tend to rise in value over time shares can provide a stronger and somewhat smoother income flow than bank deposits.  

Source: RBA, Bloomberg, AMP Capital

The same applies in relation to property rent. If diversified, it tends to be more stable than term deposit income and has growth potential.

Risk of not having enough in retirement

While investors may be focussed on short term wiggles, they can be distracted from what should really concern them and this is the risk of not having enough to last through retirement. We are living longer. A few generations ago male retirees at age 65 had just 12 years on average to live. Now it’s about 20 years and expected to stretch out further in the years ahead. But not only are we living longer post retirement but we are having more healthy active years which need to be funded. Against this backdrop there is a real danger that if we don’t have enough in growth assets our savings won’t provide sufficient growth and then ultimately income to last through our retirement years.

Wrapping up

The bottom line is that risk can mean different things – volatility, the risk of capital loss, the risk of not having enough income from your investment and the risk of not having enough in retirement. Each of these risks can be of greater or lesser importance depending on your stage in life, how much capital you have and your tolerance for risk. What’s more risk is perverse. The risk of capital loss is often highest when you think it is low (ie after good times) and lowest when you think it is high (ie after a bad patch). Trying to get a handle on this is critical to being a successful investor.

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.

Keypoints:

• Chinese economic data is off to a soft start this year.

• However, there are reasons for optimism that growth this year will still come in “around 7%”. Monetary policy is easing, the Government is alluding to more stimulus and the threat from the property slump is receding a bit.

• While a re-run of last year’s 50% gain is unlikely Chinese shares remain attractive.

• Slower Chinese growth isn’t a major threat to Australia. The main dampener on commodity prices is supply.

In some ways I find analysing China amusing. First, as long as I can recall numerous commentators have been calling for a Chinese hard landing. And for as long as I can recall they have been wrong. Second, Chinese economic data has been running hot and cold for years but each meaningless wiggle sees a breathless media, and sometimes an over-the-top market, response. Finally, the Chinese authorities themselves seem to sometimes add to a bit of confusion – the Peoples’ Bank of China of China (PBOC) is about the most opaque major central bank there is and numerous motherhood policy statements about “prudent monetary policy” and “deepening economic reforms” don’t help.

So the perpetual China worry list remains and recent Chinese data has been on the soft side. But last year Chinese shares were amongst the world’s strongest. What gives? Is China on the brink of a boom or a bust? Probably neither.

A soft start to the year (or just more noise)

Realising last decades’ 10% plus growth was not sustainable the Chinese leadership has been engineering a downshifting in growth to a sustainable pace. This can be seen in the next chart. Most of the growth slowdown occurred over 2010 & 2012.

Source: Bloomberg, AMP Capital

China grew 7.4% last year which was close enough to the Government’s 2014 target of “around 7.5%”. Well and good, but January and February data show a distinctly soft start to the year, with a range of indicators losing momentum including industrial production, retail sales, fixed asset investment, imports and money supply and credit. See the next chart.

Source: Thomson Reuters, AMP Capital

Of course, this data needs to be treated with caution due to the distortions caused by the timing of China’s New Year (best wait for March data before getting too excited) and strong exports look like providing a bit of an offset to soft domestic demand. Nevertheless, growth does appear to have slowed.

The Government’s 2015 growth target is “around 7%” with three factors posing downside risks. First, property has gone from boom to bust and this includes property investment. The slump in property investment and prices are all weighing on growth.

Second, the desire to slow lending outside the banking system and a fall in inflation to 0.9% year on year for non-food inflation and to -4.8% year on year for producer prices has led to a de-facto monetary tightening with a rise in real borrowing rates.

Source: Bloomberg, AMP Capital

This monetary tightening has been accentuated by a rise in the Renminbi on a trade weighted basis (due to a rising $US). But I won’t push this too far as Chinese exports have been solid.

Finally, Government reforms have been weighing on growth – notably crackdowns on corruption, pollution & excess capacity.

The policy response

However, while the Chinese Government faces a difficult balancing act there are reasons for confidence that growth this year will come in around the 7% target. First, the PBOC has cut interest rates twice starting in November and cut the banks’ required reserve ratio. Rate cuts will benefit private sector companies that have been paying very high interest rates and households with housing debt. It won’t stop a gradual structural slowing in Chinese growth (due to demographics and as the industrialisation phase slows) but it adds to confidence China will avoid a hard landing. Our assessment is that further rate cuts will be necessary to reduce real lending rates to more reasonable levels. This is likely to see the 12 month benchmark lending rate fall to 4% or possibly below by year end.

Source: Bloomberg, AMP Capital

Second, fiscal stimulus is likely. Premier Li Keqiang has indicated that China has “a host of policy tools at our disposal” should growth approach the lower limit which in the past he has said was around 7%, but is probably now 6.5%. This suggests that the various mini-stimulus measures of late could be added too. Premier’s Li’s comments suggest that the growth slowdown may be getting close to what is considered tolerable. Any more could threaten employment and spark social unrest. Reform remains a focus, but Premier Li has made clear it needs to be balanced against maintaining growth.

Third, while the property downturn is a key risk, it doesn’t seem to be spiralling out of control with the 1% monthly price declines seen last year slowing to around 0.4%. The relaxation of limitations on purchases and mortgages has helped.

Source: Bloomberg, AMP Capital

Update on the China worry list

So, where are we at regarding the other China worries? Our view remains that these problems are not as bad as they look:

The investment/consumption imbalance is exaggerated – as consumption is understated relative to investment in China, investment per capita is low and reducing investment too quickly will only risk China going down the same inflation/trade deficit path seen in many other emerging countries.

China is not losing its competitiveness – wages growth is being offset by rapid productivity growth, China is still gaining global export share and inflation is low and falling.

There was no generalised housing bubble – household debt is low at 30% of GDP, house prices didn’t keep up with incomes & there’s an undersupply of affordable housing. Yes there has been excessive supply in some cities, but not in first tier cities.

The rapid rise in debt of 22% pa over the last decade is a concern but – public and total debt relative to GDP is not excessive by global standards and strong growth in debt reflects China’s 50% savings rate with savings mainly being recycled via debt. Lowering lending and hence investment too quickly without first saving less will risk recession and deflation. Problems associated with excessive local government borrowing via local government financing vehicles at high interest rates with short maturities look like they will be resolved by allowing such debt to be swapped into bonds, which will entail much reduced borrowing costs and longer maturities.

Finally, China’s “shadow banking” system (lending outside the banks) has grown rapidly but – it is relatively small (30% of banking assets versus 100% in the US) and lacks leverage, complexity and foreign exposure. So it’s not comparable to the risks around US shadow banking that drove the GFC.

Overall our assessment remains that these risks are manageable. Much of what goes on in China is controlled by the Government. And the Government has plenty of firepower to ensure growth holds up.

The Chinese share market

After a 77% gain from its June 2013 low Chinese shares listed in China (A shares) are no longer dirt cheap, with an historic PE of 15 times and forward PE of 13.5 times. However, they are still reasonable value, particularly against their own history.

Source: Thomson Reuters, AMP Capital

Meanwhile, Chinese companies listed in Hong Kong, or H shares, have lagged in the recovery and offer better value with a forward PE of around 8 times. Both mainland and HK listed Chinese shares will benefit from further monetary easing and so both offer good return prospects.

China and Australia

While China has slowed from last decade, it’s still consuming record quantities of Australian commodities. In fact, growth in volume demand from 7% GDP growth today is equivalent to 14% GDP growth a decade ago as the Chinese economy has more than doubled in size over that period. Rather the real problem for Australia is that the supply of commodities has now caught up with demand and this will continue to weigh on commodity prices going forward. The good news though is that the risk of a hard landing in China remains low and so a collapse in commodity demand is unlikely.

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:

• While Australian shares remain in a longer term period of underperformance relative to global shares and US shares are also relatively vulnerable in the short term to Fed rate hikes, European shares look attractive.

• Eurozone shares and growth assets generally are likely to benefit from a combination of aggressive monetary easing, the lower Euro, stronger economic growth and attractive valuations.

Despite all the doom laden commentary regarding the Eurozone, it has not only hung together since the Eurozone crisis first erupted in 2010 but expanded from 17 members to 19. Countries want to get in not out! And so far this year Eurozone shares are star performers, gaining around 14% compared to 2.6% for global shares (in local currency terms). This note takes a look at why Eurozone shares are attractive particularly against Australian and US shares.

Constraints for Australian and US shares

For some years our view has been that Australian investors should consider having a higher weighting in global shares relative to Australian shares, compared to what they might have had a decade or so ago. While I am not in the bearish camp regarding the Australian economy and I love the franked dividends Australian shares pay, the reality is that the commodity/resources cycle has gone from being a tailwind to a headwind for the Australian economy. With this the $A is likely to fall further which will serve to enhance the returns from unhedged global shares and after the outperformance last decade, Australian shares remain vulnerable to a bout of mean reversion against them.

The rebound in the Australian share market this year has not changed this view. If anything, it has left the Australian share market vulnerable to a correction. Looking beyond that I am not bearish on Australian shares but see the period of relative underperformance versus global shares that has been underway since 2009 continuing.

But having made the decision to allocate more equity funds to global shares one naturally wonders whether the US share market is also a bit vulnerable in the short term. The US economy has led the way out of the global financial crisis (GFC) and looks solid and I remain of the view that US shares have entered a new secular bull market.

However, since the GFC low US shares have outperformed global shares by around 34% and this outperformance is at risk of some reversal. On several valuation measures US shares are relatively expensive compared to other global markets and history tells us that the period around the first Fed monetary tightening can cause volatility. This was the case around the time the Fed last started to raise rates after major easing cycles: in 1994 (which was associated with a 9% correction in US shares) and in 2004 (associated with an 8% correction).

While Fed tightening may cause volatility and US shares are not overvalued if low bond yields are allowed for, it’s worth noting that valuations for non-US global shares remain attractive whether or not low bond yields are allowed. For example, while the so-called Shiller price to earnings multiple – which compares share prices to a rolling ten year moving average of earnings to smooth out the earnings cycle – puts US shares at 26 times, global shares excluding the US are only trading on 15 times. This measure, which is often referred as a cyclically adjusted PE (or CAPE), is shown in the next chart.

Source: Global Financial Data, AMP Capital

In fact, global shares ex the US are about as cheap as they ever get on this measure and whereas the US is edging towards monetary tightening with higher interest rates, the predominant trend in the rest of the world is still towards monetary easing. This tells us that there are still plenty of opportunities in global shares for investors (even if there are worries about the US share market) and a major one of these is Eurozone shares. There are others – but since that is our favourite I’ll focus on that in this note.

Five reasons for optimism regarding European assets

There are basically five reasons for optimism regarding Eurozone shares. First, the Euro is here to stay. Yes it has not fully delivered the economic benefits originally espoused for it, but each crisis over the last five years has seen “more Europe, not less”. Who would have thought that Germany would support a bailout fund across Europe that could potentially expose German taxpayers or a central bank engaged in money printing. But that’s what we now have. And 70% of Greeks want to stay in the Euro not exit which is why there is all the pressure on the new Greek Government to compromise. What many miss is that the Euro is the culmination of a 60 year political project motivated by a desire for European strength in an unstable political world.

While many fret that radical anti-Euro parties are on the rise, the reality is that after six years of economic pain they haven’t really done that well. Spain is really the only country to watch given the rise of far-left Podemos, but its election is not until December and by then support for Podemos may have faded.

This all means that the risk premiums attached to assets in some peripheral Eurozone countries will continue to decline over time.

Second, the troubled Eurozone peripheral countries are now in better shape with lower budget deficits, peaking public debt to GDP ratios and improved competitiveness (see Greece and the ECB – is the Eurozone crisis about to make a comeback?, Oliver’s Insights, January 2015).

Source: IMF, AMP Capital

Thirdly, monetary conditions are easing aggressively with the ECB running negative interest rates, engaging in a broad based quantitative easing program involving the purchase of €60bn in debt securities a month and the Euro having fallen to its lowest level since 2003. This is in contrast to the US where QE has stopped, the Fed is getting closer to rate hikes and the $US is at its highest since 2003. At the same time Eurozone fiscal austerity has slowed.

Source: Bloomberg, AMP Capital

Fourthly, helped along by monetary easing, reduced fiscal drag and lower oil prices Eurozone economic conditions are looking up. The December quarter saw a slight pick-up in GDP growth, but more importantly confidence and business conditions PMIs have improved and bank lending has picked up. Eurozone growth could push up to 2% this year – which is pretty good for Europe.

Source: Bloomberg, AMP Capital

Finally, Eurozone shares are unambiguously cheap trading on a cyclically adjusted PE of 14 times compared to 26 times in the US. See the first chart. This is partly reflective of Eurozone shares having significantly underperformed US shares since the GFC low point back in 2009. See the next chart.

Source: Bloomberg, AMP Capital

Since the GFC low US shares are up 202% whereas Eurozone shares are up only 116%.

What about Greece?

Risks remain around Greece as it has yet to unlock funding agreed as part of the 4 month extension of its existing loan program and will then have to agree a longer term program. Despite the risk of political instability in Greece itself, as Syriza struggles, our view remains that a ‘Grexit’ is unlikely as amongst other things 70% of Greeks want to stay in the Euro. More significantly though, there has been zero flow on to other peripheral countries through the recent bout of Greek uncertainty as they are now much stronger and ECB bond buying is keeping their bond yields down. So even if there is to be a Grexit it’s unlikely to destabilise other Eurozone countries.

Implications for investors?

There are several implications for investors. First, there remains a strong case to favour global over Australian shares on an unhedged basis for Australian based investors.

Second, while US shares may be a bit vulnerable to a bout of global underperformance, particularly as the Fed moves closer to raising interest rates, there are plenty of attractive opportunities outside the US for investors.

Thirdly, on this front Eurozone shares stand out as attractive: they are cheap, the economy is improving and this will help profits and monetary conditions are easing. The same is likely to apply to Eurozone commercial property and infrastructure.

Finally, while the Euro may remain under downwards pressure against the $US, any fall against the $A is likely to be limited with the RBA set to ease further. So currency is not a major issue for investors.

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:

• Australian economic growth remains weak at 2.5%.

• Expect another one or two RBA cash rate cuts and the $A to fall to around $US0.70 by year end.

• Record low borrowing rates, the falling $A, lower fuel prices and rising wealth should help boost growth to 3% or just over next year. 

• The recent profit reporting season was better than feared, but stronger economic growth will be needed to meet market expectations.

Through 2013-14 it seemed the Australian economy was starting to transition away from a reliance on mining investment to more broad based growth. Unfortunately this transition has wavered a bit recently and growth has remained below trend. Fortunately, the RBA has recognised the problem and resumed cutting interest rates. This note looks at the outlook for growth and rates and what it means for profits and investors.

Growth remains too slow

December quarter GDP growth in Australia was soft at just 0.5% quarter on quarter or 2.5% year on year. In fact over the last six months growth has averaged just 1.8% annualised.

Source: ABS, AMP Capital

This is well below potential growth of 3-3.25% and explains why unemployment is trending up. While home construction has picked up (+8.1% year on year), consumer spending is solid (+2.8% yoy) and net export volumes contributed 1.5 percentage points to GDP growth through 2014, this has been partly offset by a rundown in inventories, weak public spending (-1.1% yoy) and falling business investment (-3.2% yoy). While the negative contribution from de-stocking is likely to be temporary, the weakness in business investment is more concerning. Business investment (or capex) plans from ABS surveys point to more weakness ahead. Comparing the first estimate of investment for 2015-16 with that made a year earlier for 2014-15 points to a 12% fall in business investment in 2015-16 (see the next chart) and another approach points to a 16% fall.

Source: ABS, AMP Capital

While the investment plans have tended to exaggerate the actual weakness lately, what is concerning is that the outlook for non-mining investment has turned back down.

The basic dynamic now in Australia is that mining investment, having risen from around 2% of GDP to 6%, is now falling rapidly back to 2% as large projects complete, with falls running at around 20% pa. To offset this we need to see growth in other parts of the economy pick up and we have seen some success with housing and consumer spending springing to life and more recently, improvement in tourism and higher education. However, non-mining investment remains disappointing. While it was starting to stabilise, it now looks to be turning back down again (see the next chart). This in turn is threatening growth.

Source: ABS, AMP Capital

More broadly, several factors seem to be behind continued sub-par growth in the economy, including: steeper than expected falls in commodity prices that have cut into nominal growth (nominal GDP growth was just 1.7% through last year); the ongoing threat of more budget austerity; and too tight monetary policy, as particularly reflected in the $A remaining too high. Indeed business confidence has now followed consumer confidence back down after an election-related boost in 2013.

Source: Bloomberg, AMP Capital

RBA rate cuts

Reflecting the continued delay in the return to decent growth, the RBA cut rates again in February to 2.25% and signalled a clear easing bias after its March meeting, with the comment that "further easing of policy may be appropriate over the period ahead". We expect at least one more cut in the cash rate in the months ahead. This is necessary to boost confidence and spending power in the economy both directly and indirectly via continued downwards pressure on the value of the $A.

Source: RBA, Bloomberg, AMP Capital

While interest rates have fallen to record or near record lows, it is clear that lower rates aren’t generating quite the same response they used to. This reflects more cautious attitudes to debt, the difficulty in turning non-mining related activity up again after it was supressed through the mining boom and the fact that the $A has been very high until recently. In short, the neutral cash rate has fallen from the 5% or so norm that prevailed prior to the GFC. It is probably now closer to 3%, implying a 2.25% cash rate is not really that easy. While our base case is that rates will bottom at 2%, there is a good chance rates will slip below 2% by year end.

But what about surging Sydney property prices? No doubt this was again a point of debate at the RBA’s March Board meeting, but strong property price gains are concentrated in Sydney with prices rising only around 4% year on year, on average, elsewhere. So this should be seen as more of an issue for the prudential regulator APRA to bring under control.

But it's not all gloomy

While growth is sub-par it’s not the recession some continue to fear and there are reasons for optimism.

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

• The fall in the $A is a big positive for manufacturing, tourism, higher education, services, farming and mining. As BlueScope CEO Paul O’Malley said recently: "As the $A gets into the 70s we get competitive, and with a year or two of that… you start to get the confidence to invest."

• The collapse in oil prices has delivered savings to businesses and households.

• Rising wealth levels are benefiting spending.

• The household savings rate remains relatively high at 9% and has scope to drift down supporting spending.

• Export volumes are rising solidly on the back of completed resource projects and as the lower $A makes exports more competitive. In fact, the current account deficit as a share of GDP is around its lowest in the last 30 years.

So growth should pick up in time. We see the economy returning to a 3% pace, or slightly above, by early next year. But this does assume another rate cut and a lower $A.

Profits better than feared

While the economy has remained sluggish, earnings reports for the second half of 2014 were better than feared. Yes overall profit growth this financial year looks flat thanks to a roughly 25% fall in resources profits on the back of lower commodity prices and revenue growth is sluggish at around 2%. But banks are seeing solid profit growth of around 8% and industrials around 10%. 55% of December half profit results beat expectations against a norm of 45%, 66% saw profits rise from a year ago, 52% saw their share price outperform the day results were released, and 62% increased dividends. Key themes include ongoing cost control and solid growth in dividends of around 5% which is resulting in a rising payout ratio, albeit this is mainly in the resources sector.

Source: UBS, AMP Capital

While market expectations for 8% earnings growth next financial year look optimistic, providing overall economic growth does start to improve a bit going into 2016, as expected, profit growth should improve. The fall in the $A alone over the last year should add at least 3 percentage points to profit growth.

Implications for investors

There are several implications for investors. First, bank term deposit rates are likely to get even lower, further fuelling the search for yield.

Second, further rate cuts will contribute to the downtrend in the $A. Expect a fall to $US0.70 by year end. So continue to favour unhedged over hedged global shares.

Third, overweight Australian versus global bonds as the gap in yields is likely to narrow further.

Finally, Australian shares have run ahead of earnings taking the forward PE to 16 times, which is above its long term average of 14, resulting in the risk of a short term correction. However, the broad trend in shares is likely to remain up supported by low rates and an eventual pick-up in economic growth.

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.

The market and cycles

“The stock market is the story of cycles and of the human behaviour that is responsible for overreactions in both directions.” Seth Klarman

Cycles are an investing reality. Not just shares – but also bonds, property, infrastructure, term deposits, whatever. They all go through cyclical phases of good times and bad which are driven by the combination of fundamental economic & financial developments invariably magnified by investor behaviour that has a habit of extrapolating current conditions into the future. Some cycles are short term, such as those that relate to the 3 to 5 year business cycle. Some are longer, such as the secular swings seen over 10 to 20 year periods in shares.

Source: Global Financial Data, AMP Capital

“In the old legend the wise men finally boiled down the history of mortal affairs into a single phrase: ‘This too will pass.’” Benjamin Graham

Just as historical experience tells us there are investment cycles, it also tells us that they pass. Despite all the “new eras”, “new paradigms” and “new normal” commentators wheel out at cycle extremes, all cycles contain the seeds of their own reversal. When someone tells you about a new whatever, it’s probably already run its course. So when, after a major share market collapse in the midst of recession, it seems there is no hope, just remember “this too will pass.”

“It’s so good it’s bad, it’s so bad it’s good”. Anon

In every cycle there comes a point where fundamental conditions are so good that they are bad: economic growth is so strong that its causing inflation to rise and central banks to run ever tighter monetary policies; shares have become overvalued; and investors have piled in at such a rate that there is no one left to invest. This then sets up a market top and a new bear market. And the reverse applies during economic and market downturns. Which brings us to contrarian investing.

Contrarian investing

“The way to make money is to buy when blood is running in the streets.” John D Rockefeller

This is a bit extreme, but it illustrates a key point. The best time to buy shares and other growth assets is after a sharp fall and a good guide is the economic and financial pain around you. When it is at an extreme and it all looks hopeless then that’s usually a good sign that there is long term value to be found!

“Markets are in a constant state of uncertainty and flux and money is to be made by discounting the obvious and betting on the unexpected.” George Soros

There are two insights in this. First, markets are always bouncing around – minute by minute, day by day, year by year – because they are trying to discount the future. We just have to get used to it. Second, investment markets can be perverse. If the economy and profits are obviously bad then that is likely already reflected in the share prices and you are better off betting on what is not, eg an economic recovery. And vice versa when things are obviously good.

“In investing, what is comfortable is rarely profitable.” Rob Arnott

The problem with contrarian investing is that in going against the crowd you lose that warm fuzzy feeling that comes with safety in numbers. You have to go against what you are hearing at BBQ’s or from the media and that can be very uncomfortable.

“The share market’s role is to make the majority of investors wrong” Ned Davis

This sounds rather bleak and is a bit simplistic, but it reflects the fact that most don’t invest on a contrarian basis – by definition markets top out when most investors are long and they bottom when most are short or underweight. Hence the comment about the market proving the majority of investors wrong. There are two ways around it: either adopt a contrarian approach which takes positions counter to the crowd at extremes or take a long term approach that looks through cyclical fluctuations. But whatever you do don’t get sucked in (or out) when everyone else is.

Pessimism

“More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other to total extinction. Let us pray we have the wisdom to choose.” Woody Allen

I love this quote. Because often the financial commentary around investment markets can only see disaster. Eg, we have been inundated with commentary over the last five years to the effect that the Eurozone will soon blow itself apart or that if it stays together it is doomed to a horrible outlook. And yet not only has it stayed together but it has got bigger!

Process

“A great company is not a great investment if you pay too much for the stock.” Benjamin Graham

The key to successful investing is not to buy great companies or investments, but to invest well. Shares can give you horrible returns if when you buy they are overvalued and overloved. So you need an investment process that avoids this.

“When the facts change I change my mind. What do you do sir?” John Maynard Keynes

This is the classic economists’ defence for when their forecasts don’t pan out! But it also highlights that any investment process needs to have a bit of flexibility for when the facts change.

“Don’t look for the needle in the haystack, just buy the haystack!” John C Bogle

The key insight here is that trying to beat the market by stock picking can be hard and so if you want to grow wealth over time the key is to get a broad exposure to the market and letting compound interest do its job.

“There seems to be a perverse human characteristic that makes easy things difficult.” Warren Buffett

Whatever you do, don’t overcomplicate your investments. Avoid investments you don’t understand and try and keep your investment process relatively simple and commensurate with the amount of effort you want to put in. You need to be able to see the wood for the trees and understand what’s happening.

“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” J.K. Galbraith

While that may be a bit harsh – you might say I would say that being an economist – the reality is that forecasts as to where the share market, currencies, etc, will be at a particular time have a dismal track record. Hence the jokes about economists! Good experts will help illuminate and point you in the right direction, but don’t over rely on expert forecasts.

“Stop trying to predict…” Warren Buffett

Basically, the same point. If you are going to actively move your investments around the key is to have a process that helps identify extremes – when assets are undervalued, underloved and oversold and vice versa. Or if you don’t have the time or inclination to put the effort in, it’s best to take a long term approach and let others manage cyclical market fluctuations.

Cash flow and time

“Do you know, the only thing that gives me pleasure? It’s to see my dividends coming.” John D Rockefeller

There have been lots of investments over the decades that have been sold on promises of high returns or low risk but were underpinned by hope based on hot air (the tech boom) or financial alchemy (AAA rated sub-prime trash). By contrast, assets that generate sustainable cash flows (dividends, rents, interest payments) and don't rely on excessive gearing or financial engineering are more likely to deliver.

“Our favourite holding period is forever.” Warren Buffett

In investing time is on your side and the more you have of it the better. So while short term market fluctuations can take you away from your objectives – think the first chart in this note, the longer the perspective you take the great the chance you have of achieving them – as per the next chart.

Source: Global Financial Data, AMP Capital

Right mindset

“In the business world, the rear view mirror is always clearer than the windshield.” Warren Buffett

We are all subject to behavioural biases, the most serious perhaps being a tendency to extrapolate recent developments off into the future regarding investment returns. So if the recent past has been poor you assume this will continue and want to get out and vice versa. But this just causes us to get wrong footed by the cycle. Just as spending too much time focussed on the rear view mirror will get you wrong footed by the road.

“You get recessions, you have stock market declines. If you don’t understand that’s going to happen then you’re not ready, you won’t do well in the markets.” Peter Lynch

If you can’t handle volatility associated with investment markets then either they are not for you or you should just take a long term approach and leave it to someone else.

“Individuals who cannot master their emotions are ill suited to profit from the investment process.” Benjamin Graham

This is all about knowing yourself. The reality is that we all suffer from the behavioural biases that give too much weight to recent developments in forming expectations regarding future returns, seek safety in the crowd and give too much weight to loss relative to gain. But smart investors have an awareness of their weaknesses and seek to manage them. One way to do this is to take a long term approach to investing. But this is also about knowing what you want to do. If you want to take a day to day role in managing your investments then regular trading may work, but you need to recognise that this requires a lot of effort to get right and will need a rigorous process.

Reality

“There is no free lunch.” Anon

If an investment looks too good to be true in terms of return or risk, then it probably is. Rather, focus on investments offering sustainable cash flows (dividends, rents, interest) that don’t rely on excessive gearing or financial engineering.

“Money can’t buy me love.” The Beatles

And finally, just remember that money isn’t everything. Numerous studies show that people with good wealth and incomes are happier than those without, but beyond a certain level more money won’t necessarily make you any happier.

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

• Bond yields at/around record lows reflect a combination of low inflation, low growth, low interest rates, safe haven demand and falling bond supply.

• Long term they won’t be sustainable at these levels, but given the historic experience after past periods of falling yields they could linger for a while.

• Super low bond yields imply a low medium-term return potential from government bonds. There are better opportunities in other higher yielding assets.

When I started my career over thirty years ago, Australian ten year Government bonds offered a yield of around 14% and global bond yields were similarly high. The big question then was why they were so high? Now, it is why are they so low? The ten year bond yield in Australia is just 2.6%. In the US its 2%, Spain 1.6%, Germany and Japan just 0.4% and in Switzerland it’s actually -0.04%. (Yes in Switzerland you pay the Government to lend them money – as the Swiss central bank has set short term interest rates even more negative).

This is an important issue because if you buy these bonds and hold them to maturity those yields are the annual returns you will get! This note looks at why bond yields are so low, whether it’s ultimately sustainable and what it means for investors.

Source: Global Financial Data, AMP Capital

How bonds work

But first it’s worth a reminder as to how bonds provide returns. Like most investments, bonds have a price and a yield, but most commentary occurs in terms of the yield. If the government issues a bond for $100 and agrees to pay $4 a year in interest, this means an initial yield of 4%. Obviously the higher the yield the better in terms of return potential, but in the short term the value of the bond will move inversely to the yield. So if growth or inflation slows and interest rates fall investors might snap up bonds paying 4% till the yield is pushed down to say 3%. In the process the value of the bond goes up giving a capital gain for investors. This is what’s happened lately. But, if growth and inflation pick up and bond yields rise, investors suffer a capital loss. And if for the remainder of the life of the bond the yield remains 3% that will be the return, ie 3% pa.

Why are bond yields so low?

Ultimately it’s anyone’s guess as to the precise reason why bond yields are so low but it likely reflects some combination of:

• Worries about deflation, which is causing investors to buy bonds pushing their yields down. When inflation is low or negative, bond yields don’t need to be so high to compensate for any loss of purchasing power over time.

• Investors extrapolating current very low official interest rates off into the future – on the grounds that the longer rates stay low the longer they are expected to stay low – and so are pushing long term bond yields down to match. This is classic behavioural finance stuff.

• Worries that economic growth will slow necessitating further monetary easing and/or even lower official interest rates.

• Scepticism that the recovery in the US economy is sustainable.

• Safe haven investor demand for bonds in response to geopolitical concerns (Ukraine, the Insane State, etc).

• An increasing demand for safe income yielding assets as populations in developed countries age.

• A shortage in the supply of bonds as budget deficits are falling at a time when central banks are buying increasing amounts of sovereign bonds. In fact on some estimates net government bond issuance in the US, UK, Japan and Europe after allowing for central bank buying will be negative for the first time this year.

• Yields in "safe" high yielding countries like Australia being pushed towards convergence with low yielding countries by global investors chasing yield.

While many seem tempted to put all the blame on central banks on the grounds they are "artificially" keeping short term interest rates down and supressing the net available supply of bonds, I give more primacy to subdued economic growth and inflation/deflation. Central banks have only responded to these influences and the supply of bonds has a messy unreliable relationship with bond yields anyway.

In some ways the current environment strikes me as a mirror image of the early 1980s. Back then the big concern was that another 1970s inflation surge was just around the corner so investors demanded a huge premium (ie higher bond yields relative to actual inflation) to compensate for inflation risk. Now the fear is that sustained deflation, is just around the corner and so any positive yields are seen as attractive.

..but is it sustainable?

Ultimately, super low and in some cases negative bond yields are not sustainable. Over the long term nominal bond yields tend to average around long term nominal GDP growth. And on the basis of our long term nominal economic growth expectations current 10 year bond yields in major countries are running well below long term sustainable levels. See next table.

Source: Bloomberg, AMP Capital

However, I and many others have been saying this for years and yet bond yields have continued to fall. Ultimately, a return to more normal levels for bond yields depends on central banks being successful in achieving their inflation targets and economic growth returning to more normal levels. The US is arguably further along this path but the rest of the world still has a fair way to go.

It’s noteworthy that historically bond yields have remained very low after a long term downswing for around 10-20 years, as it takes a while for growth and inflation expectations to really turn back up again. This can be seen clearly in Australian and US bond yields over the last two centuries with lengthy periods of low bond yields in the period 1890 to 1910 and in the 1930s to 1950s. See circled areas on chart below.

Source: Global Financial Data, AMP Capital

In a world of too much saving, spare capacity and deflation risk it’s hard to get too bearish on bonds (see The Threat of Global Deflation, Oliver’s Insights, January 2015). So notwithstanding periodic bounces in yields (eg bonds did have a tough year in 2013 and a US Fed rate hike this year could cause a spike in yields), yields could remain low for a while yet. At least until inflationary momentum really builds up again & there is a return to excess demand relative to supply in commodity markets.

What does it mean for investors?

There are several implications for investors. First, while Australian and global bonds returned 10 to 11% last year (as bond yields fell driving capital gains) don’t expect this to be sustained. The lower yields go, the lower the return potential from bonds. Over the medium term the return an investor will get from a bond will basically be driven by what the yield was when they invested. This can be seen in the next chart which shows a scatter plot of Australian 10 year bond yields since 1950 (on the horizontal axis) against subsequent bond returns based on the Composite All Maturities Bond Index (vertical axis). At 2.6% now we are off the bottom of the chart (ie record low yields) meaning record low returns for the next ten years.

Source: Global Financial Data, Bloomberg, AMP Capital

Second, low government bond yields (along with low interest rates and term deposits) mean there is an ongoing need for investors to consider alternative sources of yield and return, including corporate debt, property, infrastructure and shares.

Third, low bond yields have the potential to drive a further upwards revaluation of other higher yielding assets. This is because lower bond yields allow other assets to also trade on lower earnings or rental yields and hence higher prices. This will have the effect, for example, of pushing price to earnings multiples for shares above longer term averages.

Source: Bloomberg, AMP Capital

Fourthly, the search for yield will favour higher yielding government bonds over lesser yielding bonds resulting in an ongoing pressure for convergence. This could see the gap between Australian and global bond yields continue to narrow, resulting in higher returns from Australian bonds over global bonds. It could also benefit Greek bonds (which currently yield 10.2%) if the new Greek government gets its act together and agrees a new debt support and reform program with the rest of Europe -but don’t touch them with a barge pole if they don't!

Finally, very low bond yields highlight a benefit of active fixed income management in that the portfolio manager can vary the exposure of the fund to credit and reduce the portfolio exposure to any rise in yields in order to protect investors once yields start to rise.

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.