Olivers Insights

 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.

Key points:

• 2014 has been a positive but somewhat constrained and messy year for investors as the global economy remained in a cyclical “sweet spot” despite various threats, but Australian shares underperformed.

• 2015 is likely to see okay but uneven global growth, low inflation and easy monetary conditions. While the US is likely to start gradually raising rates, other countries including Australia are likely to ease monetary policy.

• Against this backdrop the bull market in shares and most growth assets is likely to continue. However, with shares dependent on rising earnings, volatility is likely to be a bit higher and returns okay but constrained.

• The main things to keep an eye on are: when/if the Fed starts to raise rates, Europe, the Chinese property slump, and growth outside of mining in Australia.

Download pdf version " Review of 2014, outlook for 2015"  

Watch video     

2014 – a positive year for investors…mostly

2014 has had its share of worries with a range of geopolitical threats, uneven global growth, the end of quantitative easing in the US, plunging oil and iron ore prices and a debilitating debate about budget cuts in Australia. Yet again, events have conspired to indicate deflation as opposed to inflation is more of a risk. Despite all this it was still a reasonable environment for most assets. Key themes have been:

• Okay global growth. Global growth improved a bit to around 3.5%. However, it was uneven, with the US proving to be relatively strong, the Eurozone growth remaining weak, Japan having a tax driven setback, China growing around 7-7.5% and some emerging countries really struggling – notably Brazil and Russia. However, while the uneven nature of global growth has caused consternation it has still been okay, and stronger growth would bring inflation and interest rate worries.

• The threat of deflation. Yet again inflation failed to take off as many continue to fear. In fact it remained low or fell in developed countries as excess capacity and falling commodity prices continued to impact.

• Further global monetary easing. While the US Fed ended its quantitative easing program, central banks in Japan, Europe and China all eased in the face of sub-par growth and the threat from deflation.

• Collapsing commodity prices. Quite clearly the commodity super cycle has turned down as last decade’s excess demand for commodities has turned into this decade’s excess supply. This is bad for commodity producers but good for most developed countries providing a boost to growth and a dampener for inflation.

• Rising geopolitical threats. Conflicts in Ukraine and Iraq, protests in HK and Ebola all hit the headlines causing periodic fear. Maybe it’s just an ongoing reality.

• Flat low rates and subdued growth in Australia. While non-mining activity improved, the slump in mining investment and poor confidence saw sub-par growth of around 2.5% which in turn saw unemployment drift up. With inflation remaining low the RBA left rates at 2.5%.

The combination of okay but not too hot, not too cold global growth and low inflation meant the global investment cycle remained firmly in the “sweet spot” for investors. But as over the last few years, it was not a simple "risk on" environment. In particular, commodity related trades including the Australian share market were big underperformers.

Yr to date to Nov. Source: Thomson Reuters, Morningstar, REIA, AMP Capital

• Despite a few setbacks global shares saw solid returns reflecting the combination of okay global growth and further monetary easing.

• In the developed world US shares outperformed helped by strong profit growth, with Europe lagging.

• While Chinese shares had a strong rebound after a four year bear market and Indian shares did very well, emerging market shares have lagged, as commodity prices fell and political developments weighed in some.

• Commodities performed poorly again as Chinese growth remained constrained and supply surged. Notably the global oil price fell 32% and the iron ore price fell 47%.

• Australian shares, as expected, underperformed again, but performed even worse than expected as the slump in commodity prices weighed with worries about the impact on the economy and foreign investors retreating to the sidelines as the $A fell. Policy uncertainty out of Canberra likely also weighed. While health, utility, telco and financial sectors did well this was offset by a further slump in resources shares.

• Global and Australian bonds performed well as fading inflation and expectations of easier for longer monetary policy pushed bond yields back down.

• Real estate investment trusts and unlisted assets like commercial property and infrastructure had strong returns as investors sought decent sources of income yield in the face of low/falling interest rates.

• Australian residential property had a good year as the recovery in house prices continued on the back of low interest rates. However, gains were narrowly focused in Sydney and Melbourne and slowed through the year.

• Cash rates and bank term deposit returns were poor reflecting record low RBA interest rates.

• The $A fell against the $US on commodity price falls and a resurgence in the $US. However, it rose against the Yen and Euro as both ramped up monetary stimulus.

• Balanced superannuation funds had solid returns, albeit constrained compared to the previous two years thanks to the softer performance from Australian shares.

2015 – still in a global sweet spot

As always there seems to be plenty of calls for global recession in the year ahead based on everything from quantitative easing to demographics. However, there remains good reason for cautious optimism.

Source: Bloomberg, AMP Capital

• Leading indicators of global growth including business conditions PMI’s point to continued reasonable growth.

• While this growth is likely to remain uneven between countries, which can be unnerving, it does mean we are a long way from global overheating associated with excessive growth in credit, inflation etc. In many ways the current environment is a bit like the mid to late 1990s where US growth was good but subdued conditions elsewhere kept inflation and interest rates relatively low.

• Falling commodity prices in response to a positive supply response are adding to this. Recall the oil price falling to $US10/barrel in 1998. It could conceivable now fall to $US40/barrel.

• As a result monetary conditions are set to remain relatively easy as major central banks seek to head off deflationary pressures.

In short, the next global recession looks to be a long way off – maybe not until later this decade in accordance with the cyclical pattern that has prevailed since the 1970s of major recessions every 8-10 years: mid 1970s, early 1980s, early 1990s, early 2000s, late 2000s, later this decade?

Reflecting all this:

• Global growth is likely to remain around 3.5%, ranging from 1-1.5% in the Eurozone and Japan, 3.5% in the US and China at 7%.

• Inflation is likely to remain benign on the back of significant spare capacity and weak commodity prices.

• Global interest rates are likely to remain low, with the US starting to raise rates gradually from mid-year, but continuing monetary easing in Europe, Japan and China. Europe is likely to expand its QE program and China is likely to cut its benchmark lending rate to around 4.5%.

For Australia, non-mining activity is likely to continue to pick up pace but in the face of falling national income and subdued confidence this will likely require further monetary stimulus in the form of a lower $A and a further RBA interest rate cut. If this occurs then improving conditions in sectors like housing construction, consumer spending, tourism, manufacturing and higher education should see GDP growth move up to around 3%. At the same time inflation is likely to remain benign. The RBA is expected to cut the cash rate to 2.25% early in the year with a 50% chance of another cut in the June quarter.

Implications for investors?

The continuing sweet spot combination of okay global growth, but still low inflation and easy money is positive for growth assets. But an eventual rate hike by the Fed and ongoing geopolitical flare ups are likely to cause volatility.

• Global shares are likely to continue to push higher as global growth continues and monetary conditions remain easy. But shares are no longer dirt cheap and so are dependent on earnings growth. This and the ongoing debate about when the Fed will start to raise rates is likely to lead to a more constrained and volatile ride.

• For shares at present we favour: Europe (which is still cheap, unloved and likely to see more monetary easing), Japan (which will see continued monetary easing) and China (which also remains cheap) over the US (which may be constrained by a Fed rate hike) and emerging markets generally (which are cheap but messy).

• Australian shares are likely to pick up pace as interest rates remain low and growth continues to rebalance away from resources, but will probably lag global shares again as the $A remains under pressure and commodity prices remain in a long term downtrend. Expect the ASX 200 to rise to around 5800 by end 2015.

• Commodity prices may see a bounce from very oversold conditions, but excess supply for many commodities is expected to see them remain in a long term downtrend.

• Very low bond yields point to a soft return potential from sovereign bonds, but it’s hard to get too bearish in a world of too much saving, spare capacity & low inflation.

• Commercial property and infrastructure are likely to benefit from the ongoing search by investors for yield.

• Australian house prices are likely to see a continued upswing on the back of low interest rates.

• Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 3%.

• The downtrend in the $A is likely to continue as the $US trends up and reflecting the long term downtrend in commodity prices and Australia’s relatively high cost base. Expect a fall to around $US0.75. However, the $A is likely to be little changed against the Yen and Euro.

What to watch?

The main things to keep an eye on in 2015 are:

• when/if the Fed starts to raise interest rates (as history shows the first rate hike can cause volatility);

• whether Europe can avoid sustained deflation & the ECB ramps up its quantitative easing program (I think it will);

• a possible Greek election early in the year as a threat to whether it remains in the Euro (although the risk of contagion to other countries is likely to be minimal now given ECB action);

• the Chinese property slump;

• whether non-mining economic activity continues to pick up in Australia. A failure to do so could see even more aggressive RBA rate cuts;

• ongoing geopolitical flare ups; and

• whether the search for yield and return in the face of ongoing low interest rates sets off a bubble in equity markets. This might be nice – but only while it lasts!

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:

• 2014 has been a positive but somewhat constrained and messy year for investors as the global economy remained in a cyclical “sweet spot” despite various threats, but Australian shares underperformed.

• 2015 is likely to see okay but uneven global growth, low inflation and easy monetary conditions. While the US is likely to start gradually raising rates, other countries including Australia are likely to ease monetary policy.

• Against this backdrop the bull market in shares and most growth assets is likely to continue. However, with shares dependent on rising earnings, volatility is likely to be a bit higher and returns okay but constrained.

• The main things to keep an eye on are: when/if the Fed starts to raise rates, Europe, the Chinese property slump, and growth outside of mining in Australia.

Download pdf version " Review of 2014, outlook for 2015"  

Watch video     

2014 – a positive year for investors…mostly

2014 has had its share of worries with a range of geopolitical threats, uneven global growth, the end of quantitative easing in the US, plunging oil and iron ore prices and a debilitating debate about budget cuts in Australia. Yet again, events have conspired to indicate deflation as opposed to inflation is more of a risk. Despite all this it was still a reasonable environment for most assets. Key themes have been:

• Okay global growth. Global growth improved a bit to around 3.5%. However, it was uneven, with the US proving to be relatively strong, the Eurozone growth remaining weak, Japan having a tax driven setback, China growing around 7-7.5% and some emerging countries really struggling – notably Brazil and Russia. However, while the uneven nature of global growth has caused consternation it has still been okay, and stronger growth would bring inflation and interest rate worries.

• The threat of deflation. Yet again inflation failed to take off as many continue to fear. In fact it remained low or fell in developed countries as excess capacity and falling commodity prices continued to impact.

• Further global monetary easing. While the US Fed ended its quantitative easing program, central banks in Japan, Europe and China all eased in the face of sub-par growth and the threat from deflation.

• Collapsing commodity prices. Quite clearly the commodity super cycle has turned down as last decade’s excess demand for commodities has turned into this decade’s excess supply. This is bad for commodity producers but good for most developed countries providing a boost to growth and a dampener for inflation.

• Rising geopolitical threats. Conflicts in Ukraine and Iraq, protests in HK and Ebola all hit the headlines causing periodic fear. Maybe it’s just an ongoing reality.

• Flat low rates and subdued growth in Australia. While non-mining activity improved, the slump in mining investment and poor confidence saw sub-par growth of around 2.5% which in turn saw unemployment drift up. With inflation remaining low the RBA left rates at 2.5%.

The combination of okay but not too hot, not too cold global growth and low inflation meant the global investment cycle remained firmly in the “sweet spot” for investors. But as over the last few years, it was not a simple "risk on" environment. In particular, commodity related trades including the Australian share market were big underperformers.

Yr to date to Nov. Source: Thomson Reuters, Morningstar, REIA, AMP Capital

• Despite a few setbacks global shares saw solid returns reflecting the combination of okay global growth and further monetary easing.

• In the developed world US shares outperformed helped by strong profit growth, with Europe lagging.

• While Chinese shares had a strong rebound after a four year bear market and Indian shares did very well, emerging market shares have lagged, as commodity prices fell and political developments weighed in some.

• Commodities performed poorly again as Chinese growth remained constrained and supply surged. Notably the global oil price fell 32% and the iron ore price fell 47%.

• Australian shares, as expected, underperformed again, but performed even worse than expected as the slump in commodity prices weighed with worries about the impact on the economy and foreign investors retreating to the sidelines as the $A fell. Policy uncertainty out of Canberra likely also weighed. While health, utility, telco and financial sectors did well this was offset by a further slump in resources shares.

• Global and Australian bonds performed well as fading inflation and expectations of easier for longer monetary policy pushed bond yields back down.

• Real estate investment trusts and unlisted assets like commercial property and infrastructure had strong returns as investors sought decent sources of income yield in the face of low/falling interest rates.

• Australian residential property had a good year as the recovery in house prices continued on the back of low interest rates. However, gains were narrowly focused in Sydney and Melbourne and slowed through the year.

• Cash rates and bank term deposit returns were poor reflecting record low RBA interest rates.

• The $A fell against the $US on commodity price falls and a resurgence in the $US. However, it rose against the Yen and Euro as both ramped up monetary stimulus.

• Balanced superannuation funds had solid returns, albeit constrained compared to the previous two years thanks to the softer performance from Australian shares.

2015 – still in a global sweet spot

As always there seems to be plenty of calls for global recession in the year ahead based on everything from quantitative easing to demographics. However, there remains good reason for cautious optimism.

Source: Bloomberg, AMP Capital

• Leading indicators of global growth including business conditions PMI’s point to continued reasonable growth.

• While this growth is likely to remain uneven between countries, which can be unnerving, it does mean we are a long way from global overheating associated with excessive growth in credit, inflation etc. In many ways the current environment is a bit like the mid to late 1990s where US growth was good but subdued conditions elsewhere kept inflation and interest rates relatively low.

• Falling commodity prices in response to a positive supply response are adding to this. Recall the oil price falling to $US10/barrel in 1998. It could conceivable now fall to $US40/barrel.

• As a result monetary conditions are set to remain relatively easy as major central banks seek to head off deflationary pressures.

In short, the next global recession looks to be a long way off – maybe not until later this decade in accordance with the cyclical pattern that has prevailed since the 1970s of major recessions every 8-10 years: mid 1970s, early 1980s, early 1990s, early 2000s, late 2000s, later this decade?

Reflecting all this:

• Global growth is likely to remain around 3.5%, ranging from 1-1.5% in the Eurozone and Japan, 3.5% in the US and China at 7%.

• Inflation is likely to remain benign on the back of significant spare capacity and weak commodity prices.

• Global interest rates are likely to remain low, with the US starting to raise rates gradually from mid-year, but continuing monetary easing in Europe, Japan and China. Europe is likely to expand its QE program and China is likely to cut its benchmark lending rate to around 4.5%.

For Australia, non-mining activity is likely to continue to pick up pace but in the face of falling national income and subdued confidence this will likely require further monetary stimulus in the form of a lower $A and a further RBA interest rate cut. If this occurs then improving conditions in sectors like housing construction, consumer spending, tourism, manufacturing and higher education should see GDP growth move up to around 3%. At the same time inflation is likely to remain benign. The RBA is expected to cut the cash rate to 2.25% early in the year with a 50% chance of another cut in the June quarter.

Implications for investors?

The continuing sweet spot combination of okay global growth, but still low inflation and easy money is positive for growth assets. But an eventual rate hike by the Fed and ongoing geopolitical flare ups are likely to cause volatility.

• Global shares are likely to continue to push higher as global growth continues and monetary conditions remain easy. But shares are no longer dirt cheap and so are dependent on earnings growth. This and the ongoing debate about when the Fed will start to raise rates is likely to lead to a more constrained and volatile ride.

• For shares at present we favour: Europe (which is still cheap, unloved and likely to see more monetary easing), Japan (which will see continued monetary easing) and China (which also remains cheap) over the US (which may be constrained by a Fed rate hike) and emerging markets generally (which are cheap but messy).

• Australian shares are likely to pick up pace as interest rates remain low and growth continues to rebalance away from resources, but will probably lag global shares again as the $A remains under pressure and commodity prices remain in a long term downtrend. Expect the ASX 200 to rise to around 5800 by end 2015.

• Commodity prices may see a bounce from very oversold conditions, but excess supply for many commodities is expected to see them remain in a long term downtrend.

• Very low bond yields point to a soft return potential from sovereign bonds, but it’s hard to get too bearish in a world of too much saving, spare capacity & low inflation.

• Commercial property and infrastructure are likely to benefit from the ongoing search by investors for yield.

• Australian house prices are likely to see a continued upswing on the back of low interest rates.

• Cash and bank deposits are likely to continue to provide poor returns, with term deposit rates running around 3%.

• The downtrend in the $A is likely to continue as the $US trends up and reflecting the long term downtrend in commodity prices and Australia’s relatively high cost base. Expect a fall to around $US0.75. However, the $A is likely to be little changed against the Yen and Euro.

What to watch?

The main things to keep an eye on in 2015 are:

• when/if the Fed starts to raise interest rates (as history shows the first rate hike can cause volatility);

• whether Europe can avoid sustained deflation & the ECB ramps up its quantitative easing program (I think it will);

• a possible Greek election early in the year as a threat to whether it remains in the Euro (although the risk of contagion to other countries is likely to be minimal now given ECB action);

• the Chinese property slump;

• whether non-mining economic activity continues to pick up in Australia. A failure to do so could see even more aggressive RBA rate cuts;

• ongoing geopolitical flare ups; and

• whether the search for yield and return in the face of ongoing low interest rates sets off a bubble in equity markets. This might be nice – but only while it lasts!

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: 

• For the first time since 2012 China has cut interest rates. Borrowing costs have been too high in China so rate cuts will help support economic growth. Expect more interest rate cuts ahead.

• The rate cut is positive for Chinese shares which remain relatively cheap.

• China’s rate cut highlights that global monetary conditions are still easing with monetary easing in Japan, Europe and China taking over from the end of quantitative easing in the US.

• Chinese easing is also positive for commodities and Australian shares.

Download pdf version "China cuts interest rates" 

After resisting traditional monetary stimulus measures in favour of various “mini stimulus” initiatives the People’s Bank of China (PBOC) has finally cut interest rates, reducing the 12 month benchmark lending rate by 0.40% to 5.6% and the 12 month benchmark deposit rate by 0.25% to 2.75%.

Source: Bloomberg, AMP Capital

Our assessment is that this is a good, overdue move as relatively high interest rates have been holding back Chinese growth this year. This note looks at the main issues and implications for investors.

Chinese growth has slowed

Chinese growth has slowed significantly compared to the 10% plus rate seen last decade and for the last few years has been running around 7 to 8%. The downshifting in growth reflects several factors:

• The Chinese Government has come to the view that 10% plus growth is not sustainable as it has led to various social and economic imbalances in the economy, including strong growth in debt, inequality, pollution and corruption. In particular the new leadership has been focused more on economic reform than growth for growth’s sake.

Source: Bloomberg, AMP Capital

• Soft global growth has weighed on Chinese exports.

• More recently, a downturn in the property market – in terms of construction & prices – has weighed on growth.

Source: Bloomberg, AMP Capital

• Monetary policy has arguably been too tight as the PBOC has sought to rein in growth in credit through the “shadow banking” sector (ie outside of the more regulated banks).

Reflecting the last two factors, the slowdown in growth has become more noticeable this year with a range of indicators losing momentum including industrial production, retail sales, fixed asset investment and money supply and credit.

Source: Thomson Reuters, AMP Capital

While assuring that growth would come in “around” the 7.5% target for this year, the current Government has been keen to distance itself from the previous government and the negative connotations that the “stimulative policy” response to the global financial crisis has. As such it has focused more on structural reforms to revitalise long term growth and responded to periods of weaker data with “targeted easing” and “mini stimulus” measures. These include: rebuilding shanty towns; increased railway spending; accelerated depreciation and other policy support for small business; the relaxation or removal of measures designed to slow the property market; lower money market interest rates; and liquidity injections into the banks.

However, the continued loss of growth momentum lately despite these measures has suggested that they are not enough and that the risks to growth may be shifting below 7%. In particular with private sector investment slowing rapidly, inflation falling and producer prices in deflation for nearly three years it was clear that monetary conditions were too tight and interest rates too high. For example, anecdotes suggest smaller private firms have been facing an effective cost of borrowing of 15 to 20% from the shadow banking system. While the Government may have been prepared to tolerate this as long as employment growth held up, slowing economic growth will eventually hit employment as it is a lagging indicator, Furthermore, employment readings in business conditions surveys have been trending down.

So at last the PBOC has recognised this and started to cut interest rates. Our assessment is that:

• The rate cut clearly signals that the Chinese Government is determined to support growth.

• More rate cuts are likely as borrowing costs remain too high and in any case the PBOC rarely cuts just once. The lending rate could fall to 4.5% next year.

• Cutting rates is the most effective way to cut borrowing costs as bank lending rates are still largely priced off the benchmark rate and are mostly above it. 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 that China will avoid the hard landing many still see around the next corner. After growth of around 7.5% this year, expect growth of around 7% next year.

• Reform remains the main focus in China, but it was always contingent on growth holding up.

The China worry list

But what about the China worries we regularly hear about from China bears regarding: the need to rebalance the economy; falling competitiveness; a housing bubble; excessive growth in debt; and the shadow banking system. Our assessment has been that these problems are exaggerated¹. In particular:

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. So any adjustment needs to be gradual.

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 has been no generalised housing bubble – household debt is low at 30% of GDP, house prices have not kept up with incomes and there is an undersupply of affordable housing. Yes there has been excessive development in some cities, but this not the first tier cities.

Rapid rise in debt, with credit up 22% pa over the last decade, is a concern but – total debt relative to GDP is not excessive globally 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 lowering saving will risk recession and deflation.

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

Overall our assessment is that these risks are manageable, provided the Government does not make a policy mistake. Its move to cut interest rate is a sign that it is well aware of this risk. Unlike in western countries, much of what goes on in China is controlled by the Government, and this includes the current slowdown. And the Government has plenty of firepower to ensure growth holds up.

The Chinese share market

After a long bear market since August 2009 which left them very cheap, Chinese share are up around 18% so far this year. Despite this they remain relatively cheap with a price to historic earnings ratio of 10.9 and a forward PE of 9.1. The PBOC rate cut adds to their attractiveness from a valuation perspective and in terms of providing confidence regarding future earnings growth.

Source: Thomson Reuters, AMP Capital

Global and Australian implications

China’s rate cut adds to the determination of global policy makers to avoid deflation and support growth. While US quantitative easing may have ended, it’s being replaced by QE in Japan and Europe and rate cuts in China. And rate hikes are a fair way off in the US and a long way off in Australia. This in turn augurs well for shares and other growth assets.

The Chinese rate cut and the signal of determination to support growth it provides is also positive for commodity prices and the Australian share market. While a return to a secular bull market in commodities and relative outperformance by Australian shares is unlikely, both have been oversold lately and China’s move could provide the trigger for a decent rally into year end.

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

¹See “Chinese debt worries and growth”, Oliver’s Insights, February 2014.

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: 

• For the first time since 2012 China has cut interest rates. Borrowing costs have been too high in China so rate cuts will help support economic growth. Expect more interest rate cuts ahead.

• The rate cut is positive for Chinese shares which remain relatively cheap.

• China’s rate cut highlights that global monetary conditions are still easing with monetary easing in Japan, Europe and China taking over from the end of quantitative easing in the US.

• Chinese easing is also positive for commodities and Australian shares.

Download pdf version "China cuts interest rates" 

After resisting traditional monetary stimulus measures in favour of various “mini stimulus” initiatives the People’s Bank of China (PBOC) has finally cut interest rates, reducing the 12 month benchmark lending rate by 0.40% to 5.6% and the 12 month benchmark deposit rate by 0.25% to 2.75%.

Source: Bloomberg, AMP Capital

Our assessment is that this is a good, overdue move as relatively high interest rates have been holding back Chinese growth this year. This note looks at the main issues and implications for investors.

Chinese growth has slowed

Chinese growth has slowed significantly compared to the 10% plus rate seen last decade and for the last few years has been running around 7 to 8%. The downshifting in growth reflects several factors:

• The Chinese Government has come to the view that 10% plus growth is not sustainable as it has led to various social and economic imbalances in the economy, including strong growth in debt, inequality, pollution and corruption. In particular the new leadership has been focused more on economic reform than growth for growth’s sake.

Source: Bloomberg, AMP Capital

• Soft global growth has weighed on Chinese exports.

• More recently, a downturn in the property market – in terms of construction & prices – has weighed on growth.

Source: Bloomberg, AMP Capital

• Monetary policy has arguably been too tight as the PBOC has sought to rein in growth in credit through the “shadow banking” sector (ie outside of the more regulated banks).

Reflecting the last two factors, the slowdown in growth has become more noticeable this year with a range of indicators losing momentum including industrial production, retail sales, fixed asset investment and money supply and credit.

Source: Thomson Reuters, AMP Capital

While assuring that growth would come in “around” the 7.5% target for this year, the current Government has been keen to distance itself from the previous government and the negative connotations that the “stimulative policy” response to the global financial crisis has. As such it has focused more on structural reforms to revitalise long term growth and responded to periods of weaker data with “targeted easing” and “mini stimulus” measures. These include: rebuilding shanty towns; increased railway spending; accelerated depreciation and other policy support for small business; the relaxation or removal of measures designed to slow the property market; lower money market interest rates; and liquidity injections into the banks.

However, the continued loss of growth momentum lately despite these measures has suggested that they are not enough and that the risks to growth may be shifting below 7%. In particular with private sector investment slowing rapidly, inflation falling and producer prices in deflation for nearly three years it was clear that monetary conditions were too tight and interest rates too high. For example, anecdotes suggest smaller private firms have been facing an effective cost of borrowing of 15 to 20% from the shadow banking system. While the Government may have been prepared to tolerate this as long as employment growth held up, slowing economic growth will eventually hit employment as it is a lagging indicator, Furthermore, employment readings in business conditions surveys have been trending down.

So at last the PBOC has recognised this and started to cut interest rates. Our assessment is that:

• The rate cut clearly signals that the Chinese Government is determined to support growth.

• More rate cuts are likely as borrowing costs remain too high and in any case the PBOC rarely cuts just once. The lending rate could fall to 4.5% next year.

• Cutting rates is the most effective way to cut borrowing costs as bank lending rates are still largely priced off the benchmark rate and are mostly above it. 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 that China will avoid the hard landing many still see around the next corner. After growth of around 7.5% this year, expect growth of around 7% next year.

• Reform remains the main focus in China, but it was always contingent on growth holding up.

The China worry list

But what about the China worries we regularly hear about from China bears regarding: the need to rebalance the economy; falling competitiveness; a housing bubble; excessive growth in debt; and the shadow banking system. Our assessment has been that these problems are exaggerated¹. In particular:

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. So any adjustment needs to be gradual.

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 has been no generalised housing bubble – household debt is low at 30% of GDP, house prices have not kept up with incomes and there is an undersupply of affordable housing. Yes there has been excessive development in some cities, but this not the first tier cities.

Rapid rise in debt, with credit up 22% pa over the last decade, is a concern but – total debt relative to GDP is not excessive globally 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 lowering saving will risk recession and deflation.

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

Overall our assessment is that these risks are manageable, provided the Government does not make a policy mistake. Its move to cut interest rate is a sign that it is well aware of this risk. Unlike in western countries, much of what goes on in China is controlled by the Government, and this includes the current slowdown. And the Government has plenty of firepower to ensure growth holds up.

The Chinese share market

After a long bear market since August 2009 which left them very cheap, Chinese share are up around 18% so far this year. Despite this they remain relatively cheap with a price to historic earnings ratio of 10.9 and a forward PE of 9.1. The PBOC rate cut adds to their attractiveness from a valuation perspective and in terms of providing confidence regarding future earnings growth.

Source: Thomson Reuters, AMP Capital

Global and Australian implications

China’s rate cut adds to the determination of global policy makers to avoid deflation and support growth. While US quantitative easing may have ended, it’s being replaced by QE in Japan and Europe and rate cuts in China. And rate hikes are a fair way off in the US and a long way off in Australia. This in turn augurs well for shares and other growth assets.

The Chinese rate cut and the signal of determination to support growth it provides is also positive for commodity prices and the Australian share market. While a return to a secular bull market in commodities and relative outperformance by Australian shares is unlikely, both have been oversold lately and China’s move could provide the trigger for a decent rally into year end.

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

¹See “Chinese debt worries and growth”, Oliver’s Insights, February 2014.

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: 

• Starting point valuations – eg yields and price to earnings multiples – are a key driver of potential medium term investment returns. This is particularly so for cash and bonds, and for shares and growth assets at extremes. 

• At present valuation starting points for term deposits and bonds suggest low medium term returns. For shares they suggest okay returns.

Download pdf version " Starting point valuations matter, a lot" 

The cheaper the better

A valuation measure for an asset is basically a guide to whether it’s expensive or cheap. Simple valuation measures are price to earnings ratios for shares (the lower the better) and income yields, ie the ratio of dividends, rents or interest payments to the value of the asset (the higher the better).

An obvious example of where the starting point valuation matters critically is cash. If the yield or interest rate on offer from a term deposit rate is relatively high then that is good because that is precisely the return you will get. For example, five years ago average term deposit rates for multiyear bank term deposits were around 7% pa with some banks offering deals around 8%. This was not bad for a safe asset in a world of inflation averaging around 2.5%. So the starting point for term deposits then was attractive. Now by contrast, term deposit rates are averaging closer to 3% suggesting that they are not such good value anymore.

Source: RBA, AMP Capital

For government bonds the yield is similarly a good guide to starting point value. Over short term periods bond prices can move up and down and so influence short term returns, but over the medium term the main driver of the return a bond investor will get is what bond yields were when they invested. If the yield on a 10 year bond is 5%, then if you hold the bond to maturity your return will be 5%. Of course a portfolio of bonds will reflect a range of maturities and so the relationship is not as perfect, but it can be seen in the next chart which shows a scatter plot of Australian 10 year bond yields since 1950 (along the horizontal axis) against subsequent 10 year returns from Australian bonds based on the Composite All Maturities Bond index (vertical axis).

Source: Global Financial Data, Bloomberg, AMP Capital

Put simply when bond yields are high they drive high bond returns over the medium term and vice versa. For example when Australian 10 year bond yields in January 1982 were 15.2% it’s not surprising that returns from bonds over the subsequent ten years were 15.4%. Similarly when bond yields were just 3.1% in January 1950, it’s no surprise that returns from bonds over the next 10 years were 3.1%.

For shares a similar relationship holds. The following chart shows a scatter plot of the price to earnings ratio for US shares since 1900 (along the horizontal axis) against subsequent 10 year total returns (ie dividends plus capital growth) from US shares. While the relationship is not as smooth as that for bonds because there is much more involved in share returns, it can be seen that it is a negative relationship, ie when share prices are relatively high compared to earnings subsequent returns tend to be relatively low and vice versa. The best time for shares seems to be when PEs are in single digits. At the end of the mid- 1970s bear market the PE had fallen to 7.6 times and over the next ten years US shares returned 15.6% pa.

Source: Global Financial Data, Bloomberg, AMP Capital

The next chart shows the same for Australian shares but only back to 1962 as an Australian PE series is not available prior to the 1960s. Again there is the expected negative relationship between the level of the PE and subsequent total returns (based on the All Ords Accumulation index). For example, at the end of the mid-1970s bear market in September 1974 the PE was just 5.4 times which was a great time to buy shares as over the next ten years Australian shares had a total return of 21.8% pa.

Source: RBA, Global Financial Data, AMP Capital

There is a dividend yield for Australian shares back to 1900 and the rough relationship in the next chart indicates the higher it is the better the subsequent 10 year share return.

Source: Global Financial Data, Bloomberg, AMP Capital

The key point is that the starting point matters. Critically for cash, bank deposits and bonds but also for growth assets like shares. Put simply, the higher the yield on offer the better and the lower the price to earnings ratio the better.

Why valuation is often forgotten

But while this seems obvious it’s often forgotten for three reasons.

The first relates to shares but is rather academic and goes back to the efficient market hypothesis which basically posits that the share market rationally reflects all publicly available information at any point in time. From this it follows starting point valuation measures will be no guide to future returns. Quite clearly this is not the case. But for a long time the argument that share markets were efficient drove a set and forget mentality to much investment strategy.

The second reason relates to the unfortunate reality that many investors pay too much attention to recent performance, so after a run of strong years investors gain confidence and expect it will continue and vice versa after a run of poor years. This leads many to buy only after good times only to find they have bought when shares are overvalued and therefore find themselves locked into poor returns. And vice versa after bad times. So just when starting point valuations matter the most, they tend to be ignored.

Finally, using valuation alone to drive investment decisions can involve pitfalls that can erase confidence in them.

Complications to be aware of

There are several potential pitfalls with valuation measures that investors should be aware of. First, sometimes assets are cheap for a reason (value traps). This is more often a phenomenon associated with individual shares, eg, a tobacco company subject to impending law suits even though its current earnings are fine. Or high yields may be being financed by debt. These traps can really only be picked up by thoroughly researching the investment.

Second, valuation measures are often a poor guide to timing. Eg, in 1996 US shares were starting to look expensive on some measures with Fed Chair Alan Greenspan and Economist Robert Shiller referring to “irrational exuberance” but if an investor sold shares short then they would have lost out as they rose for another four years. The best way to guard against this is to have a thorough asset allocation process that depends on more than just valuations.

Third, there is a huge array of valuation measures particularly when it comes to shares. For example the “earnings” in the PE calculation can be actual historic earnings, consensus earnings for the year ahead or earnings that have been smoothed in some way to remove cyclical distortions. All have their pros and cons. For example, the historic PE is based on actual data with no forecasting or manipulation but it can give the wrong signal during a recession as earnings may have collapsed more than share prices and so the PE may not give a reliable buy signal.

Finally, the appropriate level of valuation can vary depending on the environment. For example, in a period of low inflation it’s well-known that assets can trade on lower yields as the interest rate/yield structure in the economy falls. This in turn means higher PEs. So low inflation, say down to around 2%, can be good for shares via higher PEs as evident in the next chart for the US. But if inflation goes from “low” to deflation it can be bad as it tends to be associated with poor economic growth and as a result shares trade on lower PEs.

Source: Global Financial Data, Bloomberg, AMP Capital

The message from all this is that valuation is important but you ideally need to assess it with other indicators if you are trying to time market moves. The key is to allow that when a range of valuations measures are at an extreme then they are probably providing a signal that should not be ignored.

Current valuation signals

Right now starting valuation signals are as follows:

Bank term deposits – term deposit rates are low so returns will be low, at around 3%. This will remain the case until interest rates start to rise again.

Bonds – bond yields are now very low at 2.8% for Australian five year bonds and 3.3% for 10 year bonds and even less internationally pointing to low medium term returns from government bonds. In a world of excess savings, spare capacity and uneven growth it’s hard to get bearish on bonds but low yields nevertheless point to low medium term returns.

Shares – PE ratios for shares are no longer dirt cheap, but nor are they at the extreme expensive end suggesting that they are not providing strong signals at present. For US and Australian shares they are in ranges suggesting okay returns. This is particularly so relative to low bond yields.

Property – while this note has not focused on property the same basic principles apply, ie the higher the rental yield the better. Over the last few decades property yields have fallen with inflation and interest rates, but this is more so for residential property where gross rental yields are now quite low at around 3-4% compared to commercial property where yields average around 6-7%. So the starting point for commercial property is arguably much better.

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

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