Olivers Insights

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.

Key Points

• The RBA was right to cut interest rates again. Growth is too low and inflation is benign. Expect the cash rate to fall to 2% in the months ahead.

• Record low borrowing rates, the lower $A and the boost to spending power from lower fuel prices should help boost growth to 3% or just over into next year.

• For investors: bank term deposits offer poor returns; remain wary of the $A; favour Australian over global bonds; and shares, commercial property & infrastructure continue to offer attractive yields.

Ever since commodity prices and the mining investment boom peaked 3 or 4 years ago there has been a constant chorus of doom regarding the Australian economy: the reversal of the mining boom will knock the economy into recession, house prices will crash and banks will tumble.

This view was particularly prevalent amongst foreign commentators who seemed to think that resource extraction was the only thing Australians do.

While this tale of doom has not happened, the economy has been a bit lacklustre: growth has been sub-par, wages growth has fallen to record lows, unemployment has drifted up and confidence readings have remained poor. Against this background, the RBA has rightly cut interest rates again. This note looks at the key implications.

Interest rates and the economy

There are good reasons for the RBA to be cutting rates further:

• Growth is too low, running at around 2.75% through last year, which is well below potential (of around 3-3.25%) and the level needed to prevent a rise in unemployment.

• Confidence is subdued, having well and truly given up the post 2013 Federal election boost.

Source: Bloomberg, AMP Capital

Partly reflecting this, consumers have started to become more focused on paying down debt again, which is a sign of increasing caution and will threaten spending if sustained.

Source: Westpac/Melbourne Institute, AMP Capital

• Prices for iron ore and energy have collapsed resulting in a bigger hit to national income than expected a year ago.

Source: Bloomberg, AMP Capital

• Outside the US the predominant trend globally is still towards monetary easing and this is putting pressure on the RBA. Massive quantitative easing programs in Europe and Japan are forcing smaller countries to ease unless they want to see their currencies go higher. This should really be characterised as “easing wars” as opposed to “currency wars”. To the extent it is forcing monetary easing around the world, it adds to confidence that sustained deflation can be avoided. Australia is not immune. As the RBA wanted to see a continued broad based decline in the value of the $A it had to re-join the easing party lest the $A rebounded. Our interest rates are still high globally.

• Finally, benign inflation provides flexibility for the RBA.

The main risk in cutting rates again is that it further inflates the residential property market. However, strong property price gains are largely concentrated in Sydney and the RBA sees this as more of an issue for the prudential regulator, APRA.

Overall, we see the RBA’s cut as justified and, given that there is rarely just one move, we expect another 0.25% cut taking the cash rate to 2% in the months ahead.

Reasons for optimism

However, it’s not that I am bearish on the economy. Rather it makes sense for the RBA to be taking out some insurance to make sure growth holds up and improves. There are several reasons for optimism that growth will improve:

• Borrowing rates are at generational lows. This is bad for bank depositors but the latest rate cut will save someone with a $300,000 mortgage roughly an additional $15 a week. In total Australian households have $850bn in bank deposits but owe $2050bn in debt so the household sector is a net beneficiary of lower interest rates.

Source: RBA, Bloomberg, AMP Capital

• The fall in the $A is removing a major drag on growth. It needs to go down some more but this is very positive for sectors such as manufacturing, tourism, higher education, services, farming and mining.

• The collapse in oil prices has delivered huge savings to businesses and households. If petrol prices hold around current levels it means the average household will save around $19 a week from mid last year on their petrol bill.

Source: AMP Capital

• Stronger export volumes from completed resource projects will provide a partial offset to lower commodity prices.

Overall, we see growth picking up gradually as the year progresses to a 3-3.5% pace through next year, but the RBA’s latest rate cut and one more to come provide confidence that this will occur.

Implications for investors

There are several implications for investors. First bank term deposit rates are becoming even less attractive and will remain low at least into next year. As a result, there is an ongoing need to consider alternative sources of yield and return.

Source: RBA, AMP Capital

Second, remain cautious on the $A. While the $A is nearly back to the $US0.75 level that marks fair value on the basis of relative prices, past experience tells us it can overshoot and it hasn’t fallen nearly as much against the Euro and Yen putting more pressure on for further weakness against the $US. The RBA has indicated “a lower exchange rate is likely to be needed”, and it is likely to ease further till it gets this. The $A is oversold short term and so could have a short term bounce, but expect a fall to $US0.70 by year end. So continue to favour unhedged over hedged global shares.

Source: RBA, ABS, AMP Capital

Third, overweight Australian versus global bonds. While Australian bond yields are low they are high by global standards and likely to provide better returns than global bonds as the global search for yield results in ongoing convergence of Australian bond yields with the lower rates seen globally and as further RBA easing pulls down local bond yields. This should also benefit Australian corporate debt relative to global.

Finally, with low interest rates 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 relative to bank term deposits.

Source: RBA, Bloomberg, AMP Capital

About the Author

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

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

Key Points

• While Syriza has won the Greek election, a Grexit is not the most likely outcome.

• Even if Greece were to exit the Euro, peripheral Europe is now in far better shape than in 2010-12 and Eurozone defence mechanisms are stronger.

• While the Euro likely has more downside, Eurozone shares are attractive reflecting relatively cheap valuations, the likelihood of stronger growth ahead and very easy ECB monetary conditions.

With Greece back in the headlines after Syriza’s election win, it’s natural to wonder whether we are going to see a rerun of the Eurozone crisis that roiled global financial markets in 2010- 2012. However, much has changed since 2012. This note looks at the main issues.

Grexit not the base case

While left-wing Syriza won the election with 36.3% of the vote and has formed a coalition Government with the conservative Independent Greece party there is a long way to go yet before a Greek exit (Grexit) from the Euro will occur, if at all. First, it’s not clear how stable the new coalition will be, so another election cannot be ruled out. But assuming it holds, the next step is negotiations with the Troika of the IMF, EU and ECB that holds 80% of Greek debt regarding the ongoing debt support and reform program for Greece. Reaching an agreement could take months and will likely be the source of financial market volatility.

However, the likelihood is that an agreement will ultimately be reached. The Troika may be prepared to tolerate a slight softening in the Greek program, but not too much for fear of being seen to reward Greek voters and with the ECB embarking on QE the threat of a Grexit to the rest of Europe isn’t what it used to be. Rather the pressure will mainly be on Syriza to compromise. Failure to reach an agreement will mean the end of Troika funding for Greece resulting in even worse austerity and the withdrawal of ECB support for Greek banks. The latter would result in an instant banking crisis, causing a renewed lapse into recession. In order to get elected, Syriza is no longer seeking to leave the Euro as it recognised that 70% of Greeks want to stay in. As the realities of Government dawn on Syriza leader Tsipras, a further softening in its stance is likely to clear the way for an agreement. But this could take months and entail some difficult moments. However, markets will just have to get used to this, as they have with the Ukrainian conflict.

But even if there ultimately is no agreement thereby putting Greece on a path to exit the Euro, the threat of contagion to the rest of the Eurozone is far less than it was in 2010-12 as peripheral countries and defence mechanisms are stronger.

Stronger peripherals

Across a range of indicators, troubled Eurozone countries are in far better shape than they were when the crisis erupted.

• Budget deficits are coming under control in the main crisis countries. The average deficit in these countries was around 4% of GDP in 2014, versus 13% in 2010. This is set to see average public debt levels fall this year. Note the improvement is the same whether Greece is included or not.

Source: IMF, AMP Capital

• Despite scepticism, economic reform has been underway. One guide is unit labour costs which reflect productivity growth and labour costs. Spain and Portugal have made significant progress in cutting costs relative to Germany.

Source: OECD; AMP Capital

• Another guide is the ease of doing business. The ranking of peripheral countries relative to Germany in the World Bank’s Doing Business Survey has improved significantly since 2010. Eg, Spain has gone from 38 countries behind Germany to now 19. Greece’s improvement is even greater!

Source: World Bank, DB Global Markets Research, AMP Capital

• Bond yields in peripheral countries have collapsed to record or near record lows on the back of the ECB’s action to do “whatever it takes” to prevent a break-up of the Euro.

Source: Global Financial Data; AMP Capital

• Finally, while it remains shaky, confidence and business conditions have improved across the Eurozone since 2012.

Source: Bloomberg, AMP Capital

So put simply peripheral Europe is far stronger and less vulnerable to a Grexit than it was in 2012.

Eurozone defence mechanisms are stronger

Supporting this, defence mechanisms to support troubled countries are also stronger in the Eurozone with a strong bailout fund, a banking union and a more aggressive ECB. Of these the ECB is most important. Its QE program – €60bn/month in debt purchases out to September 2016 or until inflation is back on track – was well above expectations.

Source: Bloomberg, AMP Capital

The ECB is now set to expand its balance sheet beyond the 2012 level – or €1trillion of QE – that President Draghi last year implied was the objective. With public debt now included there is little doubt this can be achieved. And the open ended nature of the program puts it on a par with the Fed’s successful QE3 program. As in the US, it is expected to work by boosting inflation expectations, displacing investors from low risk assets into higher risk assets and so boosting the availability of capital and asset values, helping support bank lending and via a lower than otherwise Euro.

All of this should help ensure that deflation will not be sustained in the Eurozone and that growth will get back onto a firmer footing. And it helps back up the ECB’s commitment to keep the Euro together even if a weak member like Greece “decides” to exit. This is good news for the global economy.

A boost to more radical anti-Euro parties?

No doubt Syriza’s victory will fuel fears of a shift to more radical parties in Europe. This is certainly worth keeping an eye on and highlights the need to speed up the recovery and push unemployment down faster. However, Greece aside, it’s surprising that after six years of pain non-centrist parties haven’t done much better. Spain is really the country to watch given the meteoric rise of far-left Podemos, but its election is not until December and by then support for Podemos may have faded if Syriza achieves little/makes things worse in Greece.

Overweight Eurozone shares

So while the change of Government in Greece could result in short term uncertainty, overall we don’t see a return to the Eurozone crisis. More broadly, there is a strong case to overweight Eurozone equities. First, they are relatively cheap. The next chart shows a composite valuation measure for European shares that indicates they are more than 2 standard deviations (or more than 20%) undervalued.

Source: Bloomberg, AMP Capital

Second, there is a good chance that growth in Europe will surprise on the upside in the short term thanks to: the collapse in oil prices; reduced fiscal drag as the worst of the austerity programs are behind us; the weaker Euro which will boost export growth; and as the ECB’s QE stimulus hits at a time when private sector credit has already started to increase.

Finally, thanks to the ECB ramping up QE, monetary conditions are easing in Europe which is positive for shares from a liquidity perspective.

However, with the ECB easing monetary policy at a time when the Fed is gradually edging towards rate hikes, and Greece throwing in some short term uncertainty, the Euro is likely to fall further against the $US. Against the $A, the Euro may also slip a bit but with the RBA also set to ease further any fall here may be limited.

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

• Falling inflation on the back of falling commodity prices and global spare capacity indicates deflation is more of a threat globally than a surge in inflation.

• Further monetary easing in Europe, Japan and elsewhere should help head the threat off but it’s worth keeping an eye on.

• Low interest rates will remain, with further easing likely outside the US and another RBA rate cut.

Download pdf version " The threat of global deflations"

While a constant concern since the Global Financial Crisis (GFC) has been that easy monetary policies would cause surging inflation it simply hasn’t occurred. The absence of inflationary pressures is a good thing, as it means the global "sweet spot" of okay economic growth, with low interest rates and bond yields can continue. But what if we end up with sustained deflation? A renewed plunge in bond yields over the last year to record or near record lows is warning of just that.

December has seen falling consumer price levels in many countries and annual inflation rates are now just 0.8% in the US, -0.2% in Europe, 0.5% in the UK, 0.4% in Japan (after removing the impact of higher sales taxes) and 1.5% in China. In Australia, inflation looks likely to fall below the 2-3% target. In fact, as can be seen in the next chart the collapse in the proportion of countries with hyperinflation is now being matched by a steady advance in the proportion seeing deflation.

Source: Thomson Reuters, AMP Capital

The rise in deflationary pressures is now starting to generate more social interest with Google showing a rising trend in searches for the word “deflation” relative to “inflation” to levels last seen at the time of the GFC. See the next chart.
But what is deflation? how likely is a sustained period of deflation? and what does it all mean for investors?

Source: Google Trends, AMP Capital

What is deflation?

Deflation refers to persistent and generalised price falls. It occurred in the 1800s, 1930s and the last 20 years in Japan.

Source: Global Financial Data, AMP Capital

Whether deflation is good or not depends on the circumstances in which it occurs. In the period 1870-1895 in the US, deflation occurred against the background of strong economic growth, reflecting rapid productivity growth and technological innovation. This can be called “good deflation”. Falling prices for electronic goods are an example of good deflation.

However, falling prices are not good if they are associated with falling wages, rising unemployment, falling asset prices and rising real debt burdens. For example, in the 1930s and more recently in Japan, deflation reflected economic collapse and rising unemployment made worse by the combination of high debt levels and falling asset prices. This was “bad deflation”.

In the current environment sustained deflation could cause problems. Falling wages and prices would make it harder to service debts. Lower nominal growth will mean less growth in public sector tax revenues making still high public debt levels harder to pay off. And when prices fall people put off decisions to spend and invest, which could threaten economic growth.

Deflation drivers

The decline in inflation globally has raised concerns we may see sustained deflation. Several factors are behind this:

• First, commodity prices have been in a downtrend since 2011 as emerging countries have slowed and the supply of commodities has improved. This decline has been across most industrial commodities but has been noticeable lately in relation to oil prices. This lowers inflation via lower energy prices but also via lower raw material and transport costs.

• More fundamentally the sup-par recovery globally since 2009 means the world has plenty of spare capacity. Normally after a recession we see a period of above trend growth but so far this hasn’t really happened and so excess capacity remains. A rough estimate shown below is that global economic activity is nearly 3% below potential. When there is excess capacity it means companies lack pricing power and workers lack bargaining power.

Source: IMF, AMP Capital

• While the US is less at risk as its more pro-active monetary policies have put its economy in a stronger position, it is not immune from deflationary pressures globally. It is now importing deflationary pressures from the rest of the world as the rising $US is pushing import prices down.

Unless you are an energy producer, deflation flowing from lower oil prices is not a problem because it provides a boost to real spending power. However, the danger is that the plunge in inflation driven by the fall in oil prices will drive inflationary expectations down at a time when inflation is already weak leading to a greater risk of entrenched deflation.

Deflationary forces will also be felt in Australia as global prices fall. This may be partly offset by the lower $A pushing up import prices. However, as we have seen over the last year inflation has remained low despite the lower $A.

How likely is a sustained period of “bad deflation”?

The risks of deflation have clearly increased. However, notwithstanding a short term period of deflation in some countries, a sustained 1930s or Japanese style bout of bad deflation is still likely to be avoided:

• While goods prices are at risk of deflation, services price inflation is relatively resilient. This is partly because services prices have a higher wage element and wages are often sticky downwards, and there is less excess capacity in services industries.

• In the US, the Fed is likely to delay its first interest rate hike if core inflation continues to fall.

• The ECB looks set to embark on more aggressive quantitative easing including both public and corporate debt.

• Similarly Japan looks likely to continue with its aggressive quantitative easing program.

• China & India are likely to ease monetary conditions further.

• A further interest rate cut is likely in Australia.

More global monetary easing should help ensure global growth continues and in turn prevent a slide into sustained deflation. So our base case remains that global inflation remains low rather than collapsing into sustained deflation. Key to watch will be the success of the ECB and Bank of Japan in boosting their countries’ growth rates.

Implications for investors?

Were sustained deflation to take hold it would favour government bonds and cash over equities, property and corporate bonds for investors. As can be seen in the next chart low inflation is generally good for shares as it allows shares to trade on higher price to earnings multiples. But when inflation slips into deflation, it can be bad as it tends to go with poor growth and profits and as a result shares trade on lower PEs.

* Shows price to a 10 year trailing average of earnings (ie Shiller PE). Source: Global Financial Data, Bloomberg, AMP Capital

Some see gold doing well in a period of deflation, but I doubt this and more likely would see it falling further as demand for gold as an inflation hedge will evaporate in a deflationary world.

However, as discussed the most likely outcome is that inflation will remain low over the year ahead with improving growth helping it bottom but still significant spare capacity preventing much of a rise. This has several implications for investors.

First, the environment of low interest rates will remain in place for some time to come. The Fed may well delay its first rate hike till later this year and when it does move it will be gradual. Elsewhere, rate cuts are more likely including in Australia. This means continued low returns from cash and bank deposits.

Second, given the absence of significant monetary tightening a bond crash like we saw in 1994 remains as distant as ever. The most likely outcome is just low returns from government bonds reflecting record or near record low yields in many countries.

Source: Global Financial Data, AMP Capital

Third, the low interest rate and bond yield environment means that the chase for yield is likely to continue supporting commercial property, infrastructure and high yield shares.

Finally, as the generally easy global and Australian monetary environment continues it will help underpin further gains in growth assets like shares, albeit with more volatility.

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:

Download pdf version " 2015 – a list of lists regarding the macro investment outlooks"  

Balanced super funds look to have had returns of around 9%, which is pretty good after the double digit returns of the previous two years. This note provides a summary of key insights on the global economic and investment outlook in simple point form.

Four lessons from 2014

• Turn down the noise – despite talk of recessions & crashes encouraging you to head for cash, returns were good.

• Markets lead economies – this was most evident in China where fears of a hard landing intensified, but Chinese shares gained 50% after a four year bear market.

• Surging inflation still MIA – an inflation take-off has been a common fear for years but remained as distant as ever.

• Diversification and active asset allocation are critical – the uneven return environment (with more underperformance by Australian shares) provided a reminder of the benefits of diversification and dynamic asset allocation strategies.

Key themes for 2015

• Okay but uneven global growth of around 3.5%, with the US being the world's locomotive, Europe and Japan lagging and China running around 7%. Global growth continues to help earnings, but it’s a long way from overheating.

• A continuing secular downtrend in commodity prices in response to excess supply.

• Low inflation, with the threat of deflation, on the back of global spare capacity and falling commodity prices.

Source: Bloomberg; AMP Capital

• Continuing sub-par real growth in Australia of around 2.5-3% in response to falling mining investment, the commodity price slump and budget cutbacks but with improved momentum by year end helped along by non-mining activity.

• Easy monetary conditions with the US starting to gradually raise rates mid-year, but on going easing in Europe, Japan, China and Australia. The RBA to cut the cash rate further.

• A further rise in the $US and corresponding weakness in the Euro, Yen and $A, with the $A falling to around $US0.75.

• Further gains in shares, but with increased volatility and with global shares outperforming Australian and emerging market shares.

Key risks for 2015 – there’s always something!

• Concerns about Fed rate hikes could trigger share market weakness, possibly with higher bond yields.

• The slump in oil prices could trigger problems in energy producers, eg energy companies, Russia, Arab countries.

• A return of the Eurozone crisis if ECB quantitative easing is not enough, deflationary pressures intensify or in response to political problems (eg, in Greece or Spain).

• China’s property slump could trigger a hard landing there.

• The loss of national income from lower commodity prices and the continuing unwind in mining investment could overwhelm the fledgling pick up in non-mining activity resulting in much weaker Australian economic growth.

• Bubble trouble – the ongoing search for yield and returns could set off a bubble in various assets.

• More geopolitical flare ups – eg, ISIS/terror threat.

• Factor X – there is always something from left field.

Six indicators to watch

• Global business conditions indicators (or PMIs) – these have been averaging around reasonable levels.

• Wages growth in the US as a guide to how quickly the Fed may move on rates – so far it remains low.

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

• The ECB's balance sheet – it should start to rise with QE.

• Chinese property prices – for signs of stabilisation.

• Confidence indicators in Australia – these are a good guide to the state of non-mining activity and need to improve.

Four reasons why low inflation/deflation is more likely than a surge in inflation

• Sub-par growth means there is still plenty of spare capacity, which means ongoing low pricing power.

• The fall in commodity prices is still feeding through.

• The consensus is still for higher bond yields (& the crowd is often wrong).

• A strong $US will import low inflation into the US.

Five reasons to be optimistic on the US and $US

• US Congress has been more constructive since the Tea Party was sidelined after the 2013 debt ceiling debate.

• Low energy and labour costs have led to a renaissance of US manufacturing.

• The post GFC deleveraging process has come to an end and rising wealth is supporting consumer spending.

• The US budget deficit has fallen to around 3% of GDP.

• The Fed looks set to raise interest rates at a time when other central banks are still easing policy (good for $US).

 Three reasons why China will see growth around 7%

• Potential growth is trending down from 10% pa plus last decade to around 6% pa by 2020 as the population slows and the easy gains of industrialisation are over, but…

• Mini-stimulus measures over the last year or so highlight the Government has no tolerance for a collapse in growth.

• Chinese inflation is very low (with producer prices deflating) indicating plenty of scope for further monetary easing.

Four reasons for optimism about Europe

• Eurozone shares are relatively cheap.

• The ECB is stepping up quantitative easing.

• Greece is a short term threat, but there is less threat of contagion now as Portugal, Ireland and Spain are now all stronger and defence mechanisms in Europe are stronger with a bailout fund, a banking union and an aggressive ECB.

• The lower and still falling Euro will provide support.

Four reasons not to despair on Australia

• Interest rates are at generational lows and likely to fall.

• The fall in the $A is removing a major drag on growth.

• There are signs of life in non-mining sectors of the economy: dwelling construction, retailing, tourism, higher education and manufacturing is also likely to see a boost.

• Stronger export volumes (from resource projects) will provide a partial offset to lower commodity prices.

Four implications of the commodity price downtrend

• Favour advanced countries (where commodity users dominate) over emerging countries..

• Favour Asia (commodity users, economic reformers) over South America and Russia (commodity producers, reform resisters) when investing in emerging markets.

• Favour global shares over Australian shares, as the trend in commodity prices has gone from a tailwind last decade to a headwind this decade for Australia.

• Favour the $US over the $A, with the latter likely to fall to around $US0.75.

Five reasons pointing to the risk of a share market correction in the first half of the year…

• Uncertainty around the impact of plunging oil prices on energy producers is likely to get worse before it gets better.

• Uncertainty about a Greek exit from the Euro and Eurozone deflation may also get worse before they get better.

• The last time the Fed started to raise rates (in mid-2004) saw a weak first half 2004 in US shares.

• Given the parallels between now and second half of the 1990s (stronger US, weaker rest of world, falling commodity prices), it is noteworthy that as the bull market back then continued volatility picked up.

• Shares are no longer dirt cheap and there is a greater dependence on earnings.

…but five reasons why the trend in shares likely remains up

• Share valuations are still okay, particularly against the reality of low bond yields and interest rates.

• Global growth is continuing and this should help profits.

• As there are more consumers of oil than producers the lower oil price will ultimately be positive for growth & shares.

• Monetary conditions globally and in Australia are very easy and likely to get easier still as while the Fed may start to tighten other central banks are still easing.

• US shares which set the scene normally do well in the third year of the Presidential Cycle (which it is now) and in the fifth year of each decade. Since the 1880s all years ending in five (ie 1885, 1895, etc) have seen US shares rise.

Source: Bloomberg; AMP Capital

Eight things investors should always remember

• The power of compound returns – saving regularly in growth assets can grow wealth substantially over long periods.

• The cycle lives on – markets cycle up and down and we need to allow for it.

• Starting point valuations matter – so buy low and sell high.

• Focus on investments providing sustainable and decent cash flows – not financial engineering.

• Invest for the long term where possible.

• Avoid the crowd – because at extremes its invariably wrong.

• Accept that it’s a low return world to avoid disappointment – low nominal growth & lower bond yields and earnings yields mean lower long term returns. When inflation is 2.5% an 8% return is pretty good.

• Always diversify and consider active asset allocation to enhance returns/protect against falls in market values.

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:

Download pdf version " The plunging oil price – why and what it means"  

The past year has seen the world oil price fall by more than 50%. Late last year as the fall accelerated this started to act as a drag on share markets and this has resumed at the start of this year as the oil price has continued to slide. But what’s driving the oil price plunge and isn’t a fall in oil prices meant to be good news? :

Why has the oil price collapsed?

Put simply the oil price has collapsed because the global supply of oil has surged relative to demand. Last decade saw the price of oil go from $US10/barrel in 1998 to $US145 in 2008.

Black lines show long term bull & bear phases. Source: Bloomberg, AMP Capital

This sharp rise in the oil price both in nominal and real terms encouraged greater fuel efficiencies (use of ethanol, electric cars, etc) and more importantly encouraged the development of new sources of oil. A significant example of this has been the surge in US shale oil production this decade which has taken US oil production back to 1980s levels. We are now seeing benefit of this.

Source: Bloomberg, AMP Capital

This is similar to what occurred in response to sharp rises in oil prices in the 1970s, which then resulted in much weaker prices through the 1980s and most of the 1990s.

Other factors playing a role in the oil price collapse include:

• Slowing growth in the emerging world. The emerging world was a key source of growth in oil demand last decade but emerging country growth has slowed over the last few years in response to various economic problems. In particular Chinese economic growth has slowed to around 7% compared to 10% or so last decade.

• A rise in the value of the $US in response to relatively stronger economic conditions in the US. This weighs on most commodity prices as they are priced in US dollars. However, the oil price has also collapsed in euros, Yen and the $A so its not just a strong US dollar story.

However, the surge in the supply is probably the main factor. In fact it was arguably OPEC’s decision last November not to cut production but rather to maintain it and try and force other producers to cut that has accelerated the fall.

In a big picture sense oil is just part of the commodity complex with all major industrial commodities – metals, gold, iron ore – seeing sharp price falls over the last few years as the commodity super cycle has shifted from excess demand to one of excess supply.

How far could the oil price fall?

How far the oil price will fall is anyone’s guess just as how much it would rise last decade was. However, history tells us that it can fall much further than you think until supply is finally cut back. In the 1980s and 1990s the oil price fell more than 70% before the bottom was hit (see the next chart). More recently oil prices plunged 78% through the GFC but the fall was short lived and supply in recent years has expanded not fallen as a result of the US shale oil revolution.

Source: Bloomberg, AMP Capital

So a fall back to around $US40 a barrel or just below, ie a roughly 75% fall from the 2008 high is reasonably likely. This level should start to force supply cutbacks amongst more marginal producers but, as we saw in the 1980s and 1990s, once prices bottom its likely to be followed by a period of base building rather than a quick surge back up.

What's the impact of low oil prices?

The plunge in oil prices has both positive and negative implications. This has been reflected in sharp falls in energy share prices and a back up in high yield debt yields in the US, reflecting concerns about indebted US energy companies, and a collapse in the Russian sharemarket and Ruble on worries about the oil dependent Russian economy and a re-run of the 1998 Russian debt default. And it’s these more visible impacts that have dominated the broad share market reaction to the oil price plunge over the last few months.

However, lower oil prices are a huge positive for the global economy generally. Oil price hikes lift business costs and are like a tax on households and so a surge in oil prices played a big role in the recessions of the mid 1970s, early 1980s, early 1990s and in 2008-09. This all works in reverse for oil price slumps as business costs fall and the lower price of fuel provides a boost to household spending power. Rough estimates suggest a boost to growth in industrialised countries and in Australia from the 50% fall in the price of oil of around 0.7% if the fall is sustained. Asia is likely to see a slightly bigger boost as most of Asia is a net importer of oil.

Lower energy prices will also bear down further on inflation, which in turn will mean more pressure on China, Japan and Europe to ease further and a possible further delay in the timing of the first Fed rate hike. In Australia the December quarter CPI to be released later this month is likely to show inflation running around 2% providing plenty of scope for further RBA easing.

For Australian households, the plunge in the global oil price adjusted for moves in the Australian dollar indicates average petrol prices have further to fall towards $1/litre (see next chart), as the usual lags work through. In fact some service stations have already dropped the petrol price to 99.9 cents a litre.

Source: Bloomberg, AMP Capital

Current levels for the average petrol price of around $1.13/litre represent a saving for the average family petrol budget of around $14 a week compared to mid last year. If sustained this will amount to $728 a year, which is a significant saving. If the 99.9 cent/litre price becomes the norm then the saving will rise to $988 a year (see next chart). Some of this extra discretionary income will likely be spent.

Source: AMP Capital

So the fall in oil prices should provide a solid boost to growth over the year ahead.

Implication for share markets

Share markets have initially reacted negatively to the fall in oil prices because the negative impact on energy producers is what is most visible and this is being magnified by the steepness of the fall. To be sure this impact could linger for a while yet and some sort of blow up – like further problems in Russia or a default by a more marginal energy company – cannot be ruled out.

However, the risk of a major threat to the global economy or share markets from energy producers is low:

• US energy production was a bigger share of the US economy in the 1980s and yet the mid 1980s collapse in oil prices helped boost the economy and share markets back then;

• While the Russian economy is facing a crisis (made worse by its own actions in Ukraine), a 1998 style Russian public debt default looks unlikely. Russian public debt is low at around 9% of GDP compared to more than 50% of GDP in 1998, public debt in foreign currency is trivial and foreign exchange reserves are much higher now. Private debt is more of an issue now but much of it is owed by just two companies (Gazprom and Rozneft) who have foreign exchange earnings and the Russian central bank has indicated it will help out companies meet foreign exchange obligations.

More broadly, its likely that over time the positive impact on global growth and hence profits from lower oil prices will dominate and this will help drive share markets higher by year end. After oil prices plunges into 1986, 1998 and 2008 US shares gained an average 23% over the subsequent 12 months.

As a result any significant dip in share markets in response to lower oil prices should be seen as a buying opportunity.

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.