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Nine key lessons for today from the 1970s, 80s and 90s

Posted On:Feb 27th, 2023     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Introduction

In 1981 on a holiday with my parents to Hawaii we got into a discussion with some Americans about their new President, Ronald Reagan, and they said he had to deliver some tough economic medicine after years of policy mismanagement. At the time I dismissed them, but as

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Dr Shane OliverHead of Investment Strategy and Chief Economist, AMP Capital

Introduction

In 1981 on a holiday with my parents to Hawaii we got into a discussion with some Americans about their new President, Ronald Reagan, and they said he had to deliver some tough economic medicine after years of policy mismanagement. At the time I dismissed them, but as the years went by I concluded that they had a point. The 1970s were an economic mess as inflation was allowed to get out of control. In fact, things were so bad that there was a wave of nostalgia for the 1950s and early 60s when things seemed a lot better – starting with American Graffiti, Happy Days, Laverne and Shirley and the rise of retro radio stations playing hits from the 50s and 60s. With inflation surging lately, what lessons can be drawn from the 1970s and its aftermath in terms of today’s problems. This is important because if we don’t learn the lessons of the past, we are bound to repeat them. This is particularly pertinent now as I often hear the comment “why are we so worried about a bit of inflation?” and “why is the RBA inflicting so much pain?”

What went wrong in the 1970s?

But first it’s worth a brief recap. From around the mid-1960s inflation started rising. First in the US and then in Australia. It was driven by a combination of tight labour markets, more militant workers demanding higher wages, a big expansion in the size of government, disruption from the Vietnam War, easy monetary policies, social unrest and years of industry protection reducing competition and pushing up prices. It really blew out after the OPEC oil embargo of 1973 and the second oil shock after the Iranian revolution of 1979. The surge in inflation came in waves, reaching double digit levels. It also combined with frequent recessions as policy makers tightened monetary policy in response to high inflation but were too quick to ease when growth slumped only to see inflation take off again driving more tightening and another economic downturn. The end result was a decade of high inflation, high unemployment and slow economic growth from which it took a long time to recover. For investors it was bad as high inflation meant high interest rates, high economic volatility & uncertainty and reduced earnings quality all of which demanded higher risk premiums to invest (& low PEs). The 1970s were one of the few decades to see poor real returns from both shares and bonds.

Aust inflation, wages grth & unemployment, 1960 – early 90s

Source: ABS, AMP

So what broke it?

The malaise ultimately ended after voters turned to economically rationalist political leaders – like Thatcher, Reagan and Hawke and Keating in Australia. The policy response involved:

  • tight monetary policy which drove severe recessions, ultimately culminating in inflation targeting;

  • supply side reforms like deregulation, privatisation & competition laws to make it easier for the economy to meet demand;

  • this was aided by globalisation and then in the late 1990s the tech boom – which boosted the supply of low-cost goods and services;

  • in Australia, the prices and incomes Accord between Government, unions and business helped break the wage price spiral at the time.

This all broke the back of inflation with some in the 2000s calling it dead.

Key lessons

There are several lessons from the malaise of the 1970s and its aftermath and early 1990s recession in Australia for the inflation problem of today:

1.    What won’t work. First, the experience of the 1970s and 1980s provides a clear list of things that won’t work to solve the problem:

  • Higher wage growth to keep up with inflation – this just perpetuates high inflation making it harder to get back down.

  • Price controls – these were tried, eg, in the early 1970s in the US. But they restrict supply and when removed inflation was worse than ever.

  • Replacing the RBA Governor – doing this mid-way through the problem would risk shaking confidence in the RBA’s anti-inflation commitment at the worst time likely resulting in even higher interest rates. The US saw something similar in the 1970s when it replaced William Martin at the Fed with Arthur Burns which just perpetuated high inflation.

  • ·Raise the RBA’s inflation target – this would also reduce confidence in its ability to get inflation down and mean higher interest rates.

  • Shift responsibility for inflation control back to government – this sounds fine in theory as governments have more levers to pull (eg it could impose a 1% temporary income tax surcharge to cool demand which would spread the load more fairly beyond those with a mortgage). But unfortunately, politicians have shown an inability to inflict the pain necessary to slow inflation. So, it doesn’t work in practice. It was the way things were done in Australia in the 1970s and its failure led to the widespread adoption of central bank independence focussed on meeting an inflation target.

2.    Containing inflation expectations is key. Once inflation takes hold it gets harder to squeeze out. This relates to “inflation expectations”. Once inflation has been high for a while consumers and businesses expect it to stay high and so behave in ways – via wage demands, price setting and acceptance of price rises – that perpetuate it. A wage price spiral is a classic example of this where prices surge, workers demand wage rises to compensate which boosts costs & drives a new round of sharp price rises. This is an example of the “fallacy of composition” – while it is rational for an individual to demand a wage rise to match inflation if all workers do so it just leads to a further surge in prices.

3.    Whether its supply or demand, central banks have to respond. While the initial impetus to a surge in inflation may be constrained supply if it occurs when demand is strong or goes on for too long, central banks still have to respond to cool demand and signal they are serious about containing inflation. Central banks failure to do this after the 1973 OPEC oil shock contributed to inflation getting entrenched in the 70s.

4.    Avoid stop go monetary policy. There is a danger in easing monetary policy too early in a downturn if inflation expectations have not been tamed. This occurred in the 1970s with inflation slowing and central banks easing as growth slowed but inflation soon rising even higher. This underpins talk central banks will keep rates “higher for longer”.

5.    Entrenched high inflation will mean entrenched high interest rates. This is because investors will start to demand compensation for the fall in the real value of their savings by demanding higher rates. So interest rates rose through the 1970s into the 1980s. And this of course weighs on the valuation of shares and property. 10-year bond yields of around 3.5% to 4% are fine if investors expect inflation will fall to say 2-3% but if they believe inflation will stay high at 6-8% then they are too low.

Sustained high inflation = high interest rates

Source: ABS, AMP

6.    Entrenched high inflation is bad for the economy. Because it distorts economic decisions it can cut economic growth as in the 1970s, add to economic uncertainty which hampers investment & boost inequality.

7.    Once entrenched high inflation risks requiring a deep recession to remove it. This was seen in the deep recessions of the early 1980s and early 1990s in Australia which saw double digit unemployment. This was because by the late 1970s inflation expectations in the US as measured by the University of Michigan consumer survey were running around 10% following years of very high inflation making it harder to get inflation down. Australia was likely similar.

8.    Governments should focus on the supply side. The practical inability of governments to adjust fiscal policy much to control inflation means the best it can do in the short term is not add to the problem and this means reducing budget deficits and limiting new spending. Longer term there is a lot that government can do to help control inflation and its all about supply side reform to make the economy work more smoothly, ie deregulate, cut back government and competition reforms. Unfortunately, the political appetite for such reforms is low.

9.    Monetary policy operates with a lag. The early 1990s recession showed monetary policy works with a lag. This seems contradictory to the fourth point above but highlights the risk of overtightening. The lags arise as it takes time for rate hikes to be passed on to borrowers, that to slow spending and then for slower demand to lead to less employment and the flow on of this back to households and for all of this to cool inflation. This can take 12 months or more. So just looking at inflation and jobs data can be misleading as they are lagging indicators. In the late 1980s the RBA kept hiking and unemployment kept falling. But by early 1990 it was clear it had gone too far.

RBA rate hikes & unemployment in the late 1980s/early 1990s

Source: ABS, RBA, AMP

So what does it all mean for today?

The good news is that this is not 1980 and more like the early 1970s: inflation expectations are low; there is no evidence of a wage price spiral, notably in Australia; supply bottlenecks, freight costs and surging money supply which led inflation are now reversing; and high household debt ratios compared to the 1970s should make monetary policy more potent. But the lessons from the 1970s explain why central banks are so fearful of letting inflation get out of control and also the difficult balancing act facing them. As RBA Governor Lowe said they “are managing two risks…not doing enough [resulting in high inflation persisting & proving costly later] [and] that we move too fast, or too far” and trigger recession. Balancing these two risks is seen as resulting in a narrow path to low inflation and the economy continuing to grow. But what is too much or too little tightening is a judgement call. The RBA’s view has become more hawkish after the December quarter CPI and is signalling at least two more rate hikes and money markets and the consensus of economists have moved to reflect this with consensus rate expectations rising above 4%. Our view is that the RBA risks doing too much given the high vulnerability of a significant minority of indebted Australian households and that the impact of past rate hikes is just being masked by normal lags accentuated by revenge spending associated with reopening. Signs of slowing consumer spending and jobs growth along with there still being no evidence of a wages breakout in Australia are consistent with this. As such, it risks a re-run of the late 1980s/early 1990s experience where Australia was inadvertently knocked into a deep recession as the lagged impact of rate hikes took time to show up. So, while we believe rates are close to the top, the RBA’s tough guidance means that the risks are skewed to the upside. Further evidence of a slowing consumer and jobs data are necessary to cause the RBA to rethink so upcoming retail sales and jobs data are critical in this.

So what does it all mean for today?

The good news is that this is not 1980 and more like the early 1970s: inflation expectations are low; there is no evidence of a wage price spiral, notably in Australia; supply bottlenecks, freight costs and surging money supply which led inflation are now reversing; and high household debt ratios compared to the 1970s should make monetary policy more potent. But the lessons from the 1970s explain why central banks are so fearful of letting inflation get out of control and also the difficult balancing act facing them. As RBA Governor Lowe said they “are managing two risks…not doing enough [resulting in high inflation persisting & proving costly later] [and] that we move too fast, or too far” and trigger recession. Balancing these two risks is seen as resulting in a narrow path to low inflation and the economy continuing to grow. But what is too much or too little tightening is a judgement call. The RBA’s view has become more hawkish after the December quarter CPI and is signalling at least two more rate hikes and money markets and the consensus of economists have moved to reflect this with consensus rate expectations rising above 4%. Our view is that the RBA risks doing too much given the high vulnerability of a significant minority of indebted Australian households and that the impact of past rate hikes is just being masked by normal lags accentuated by revenge spending associated with reopening. Signs of slowing consumer spending and jobs growth along with there still being no evidence of a wages breakout in Australia are consistent with this. As such, it risks a re-run of the late 1980s/early 1990s experience where Australia was inadvertently knocked into a deep recession as the lagged impact of rate hikes took time to show up. So, while we believe rates are close to the top, the RBA’s tough guidance means that the risks are skewed to the upside. Further evidence of a slowing consumer and jobs data are necessary to cause the RBA to rethink so upcoming retail sales and jobs data are critical in this.

Source: AMP Capital February 2023

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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Seven key charts for investors to keep an eye on

Posted On:Feb 20th, 2023     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Introduction

Shares had a strong start to the year seeing gains into early February around or above what we expect for the year as a whole. But we still expect that it will be a volatile year given that: the process of getting inflation back down won’t be smooth;

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Dr Shane OliverHead of Investment Strategy and Chief Economist, AMP Capital

Introduction

Shares had a strong start to the year seeing gains into early February around or above what we expect for the year as a whole. But we still expect that it will be a volatile year given that: the process of getting inflation back down won’t be smooth; the topping process in central bank rates will take time with setbacks along the way as we have seen for both the Fed and the RBA recently; recession risks are high; raising the US debt ceiling around the September quarter won’t be smooth; and geopolitical risks around Ukraine, China (as highlighted by the balloon over the US) and Iran (which is getting close to nuclear weapon breakout capacity) are significant. With shares becoming overbought after the new year rally and seasonality turning less positive, shares both globally and in Australia are vulnerable to more of a pull back in the short term. This note updates seven charts we see as critical for the investment outlook.

Chart # 1 – global business conditions PMIs

Whether share markets fall back to new lows and resume the bear market in US and global shares that started last year will be crucially dependent on whether major economies slide into recession and, if so, how deep that is. Our assessment is that global growth will be around 2.5-3% this year. Global Purchasing Managers Indexes (PMIs) – surveys of purchasing managers at businesses – will be a key warning indicator.

Global Composite PMI vs World GDP

Source: Bloomberg, AMP Capital

They have slowed but are not at levels associated with recession. In January they rose, helped by China’s reopening. So far, they still look ok.

Chart 2 (and 2b) – inflation

A lot continues to ride on how far key central banks raise interest rates. And the path of inflation will play a key role in this. Recently the news has been better with inflation rates in key countries rolling over. US inflation is well down from its high last year and our US Pipeline Inflation Indicator – reflecting a mix of supply and demand indicators – has been falling, pointing to a further fall in inflation. The key is that US inflation continues to fall – if so, this should allow the Fed to stop hiking in either March or May and it could find itself needing to cut rates from later this year. 

AMP Pipeline Inflation Indicator

Source: Bloomberg, AMP

Our Australian Pipeline Inflation Indicator also suggests that Australian inflation has peaked and will fall through this year, albeit Australian inflation and the RBA are lagging the US and the Fed.

Australia Pipeline Inflation Indicator

Source: Bloomberg, AMP

Chart 3 – unemployment and underemployment

Also critical is the tightness of labour markets as this will help drive wages growth. If wages growth accelerates too far it risks locking in high inflation with a wage-price spiral which would make it hard to get inflation down. Unemployment and underemployment are key indicators of this. Both remain very low in the US & Australia (putting upwards pressure on wages), but there is some evidence that labour markets have seen the best and may now be slowing.  And wages growth in the US looks to have peaked.

Labour market underutilisation rates

Source: Bloomberg, AMP

Chart 4 – longer term inflation expectations

The 1970s experience tells us the longer inflation stays high, the more businesses, workers and consumers expect it to stay high & then they behave (in terms of wage demands, price setting & tolerance for price rises) in ways which perpetuate it. The good news is that short term (1-3 years ahead) inflation expectations have fallen lately in the US and longer-term inflation expectations remain low. The latter is consistent with 2% or so inflation & suggests the job of central banks should be far easier today than say in 1980 when the same measure was around 10% and deep recession was required to get inflation back down. The key is that it stays low.

US University of Michigan Consumer Inflation Expectations

Source: Macrobond, AMP

Chart 5 – earnings revisions

Consensus earnings growth expectations for this year are around 11% for the US and around 7% for Australia. They look a bit too high, but a deterioration on the scale seen in the early 1990s, 2001-03 in the US and 2008 would be bad news. So far so good.

Earnings Revision Ratio

Source: Reuters, AMP

Chart 6 – the gap between earnings and bond yields

Over the last year rising bond yields have weighed on share market valuations. As a result, the gap between earnings yields and bond yields (which is a proxy for shares’ risk premium) has narrowed to its lowest since the GFC in the US. Compared to the pre-GFC period shares still look cheap. Australian share valuations look a bit more attractive than those in the US though helped by a higher earnings yield. Ideally bond yields need to continue to decline and earnings downgrades need to be limited in order to keep valuations okay.

Shares still offer a reasonable risk premium over bonds

Source: Reuters, AMP

Chart 7 – the US dollar

The US dollar is a counter cyclical currency, so big moves in it are of global significance and bear close watching as a key bellwether of the economic and investment cycle. Due to the relatively low exposure of the US economy to cyclical sectors, the $US tends to be a “risk-off” currency, ie, it goes up when there are worries about global growth and down when the outlook brightens. Last year the $US surged with safe haven demand in the face of worries about recession and war and more aggressive monetary tightening by the Fed. Since September though it has fallen back as inflation and Fed rate hike fears have eased and geopolitical risks receded a bit. A further fall in the $US would be consistent with our reasonably upbeat view of investment markets this year, whereas a sustained new upswing would suggest it may be vulnerable. So far so good.

The $US v major currencies & the $A

Source: Bloomberg, AMP

Source: AMP Capital February 2023

Important note:While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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The RBA hikes rates by another 0.25% – are we there yet?

Posted On:Feb 08th, 2023     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Introduction

The RBA raised its cash rate by another 0.25% taking it to 3.35%. This is the ninth consecutive rate hike in a row over ten months totalling 325 basis points and exceeds the 2002-2008 tightening cycle (of 300 basis points over 71 months) making it the biggest tightening

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Dr Shane OliverHead of Investment Strategy and Chief Economist, AMP Capital

Introduction

The RBA raised its cash rate by another 0.25% taking it to 3.35%. This is the ninth consecutive rate hike in a row over ten months totalling 325 basis points and exceeds the 2002-2008 tightening cycle (of 300 basis points over 71 months) making it the biggest tightening cycle since the 1980s. Prior to 1990 the RBA cash rate was not officially announced, and short-term rates were very volatile. In the period January 1988 to November 1989 the overnight cash rate rose from 10.6% to 18.2% but mortgage rates were more regulated then and “only” rose from 13.5% to 17%.

RBA rate hiking cycles since the 1990s


Source: RBA, AMP

In justifying another hike, the RBA noted that: inflation is at its highest since 1990 with underlying inflation higher than expected; the labour  market remains tight; wages growth is expected to pick up; and its “priority is to return inflation to [the 2-3%] target”. The RBA also reiterated that: monetary policy operates with a lag; and it wants to keep the economy on an even keel. It made no significant changes to its forecasts and still sees growth slowing to 1.5% this year, unemployment rising to 3.75% and inflation slowing to 4.75%. But compared to its last post meeting Statement in December the RBA has become more hawkish most likely as a result of the stronger than expected rise in underlying inflation. In particular, the RBA noted that “the Board expects to increase interest rates further over the months ahead,” but removed the qualifier that “it is not on a pre-set course” (which had been interpreted as opening the door to a pause).

Banks are likely to pass the hike on in full taking variable mortgage rates to their highest in 11 years.

Australian interest rates still on the rise


Source: RBA, Bloomberg, AMP

Are we there yet?

While the RBA stepped up its hawkishness and another rate hike now looks likely next month, its commentary is not necessarily a great guide to what happens with rates – just a bit more than a year ago it didn’t expect rates to start rising until 2024 at the earliest! What happens to inflation and growth will be key. Given the experience of the last year one has to be humble in trying to predict the cash rate peak. Prior to the December quarter CPI release we thought the RBA would leave rates on hold at this month’s meeting! And some argue there are still many hikes ahead of us. So, it’s worth considering both sides of the argument.

The case for much higher interest rates

The case for still much higher interest rates rests on the following:

  • Inflation in Australia is still rising.

  • The labour market remains very tight – with the sum of unemployment and underemployment near their lowest since the early 1980s potentially driving much higher wages and a wage-price spiral.

  • Against this backdrop and given the 1970s experience the RBA needs to keep demonstrating its resolve to get inflation back down to keep inflation expectations down – otherwise it will get harder to tame.

  • Simple monetary policy rules suggest the cash rate should be much higher. For example, the most common rule called The Taylor Rule – formulated by US economist John B Taylor 30 years ago – posits that the official interest rate should equal the inflation rate plus the neutral real interest rate plus 0.5 times the gap between the current and target inflation rate and 0.5 times the output gap (ie, the gap between actual & potential GDP) or alternatively the gap between the unemployment rate and the non-accelerating inflation rate of unemployment (NAIRU). In fact, given the high starting point for the inflation rate (7.8%), a neutral rate of 1% and the big gap between inflation and the target inflation rate (2.5%) and unemployment being below NAIRU a standard specification of the Taylor Rule suggests the cash rate should maybe be around 11% – a level not seen since the early 1990s!

  • Other central banks all have higher rates, viz US Fed 4.5-4.75%; the BoE 4%; BoC 4.5%, RBNZ 4.25%. The ECB is lower at 3% but it started later.

  • The economy so far has been resilient with households supported by $250bn or so in extra saving built up in the pandemic lock down years.

Based on this it can be argued that interest rates need to rise a lot further – with several economists expecting the cash rate to rise above 4%.

The case for rates being near the top

The counterargument suggesting that we may be at or close to the top on rates is based on the following:

  • First, monetary policy operates with a lag. It takes 2-3 months for RBA rate hikes to impact actual variable rate mortgage payments and then several months before this impacts spending. There are then flow on effects to jobs and businesses with feedback impacts on households which can take a year. And this lag may have been lengthened by the rise in fixed rate mortgages around 2020-21 and the reopening boost to spending. The lag was clearly evident in the late 1980s but ignorance of it contributed to the severity of the early 1990s recession.

  • Second, inflationary pressure is easing globally. This is evident in global business surveys showing reduced delivery times and falling work backlogs, lower freight costs, lower metal and grain prices, and falling input and output prices. US money supply which surged ahead of the US inflation spike is falling. US inflation peaked mid-year at 9.1% and has fallen to 6.5% and inflation in Europe, the UK and Canada appears to have peaked. Australian inflation appears to be following the US by six months (due partly to a later reopening in the economy and later surge in energy prices), suggesting it peaked here last quarter.

  • Third, there are signs Australian inflation is peaking with business surveys showing a downtrend in input and output price readings, low work backlogs & a falling capacity utilisation. Reflecting this and global indicators, our Australian Pipeline Inflation Indicator is falling sharply.

 

Australia Pipeline Inflation Indicator


Similar to our US Inflation Indicator but has more Aust components, Source: Bloomberg, AMP

  • Fourth, some of the components which drove inflation so high are unlikely to be repeated: the 10.9% December quarter rise in travel costs will start to fade as travel and travel industry capacity return to normal; dwelling purchase costs (up 18%yoy) are now slowing; petrol prices appear to be stabilising; and electricity prices this year may be lower than previously expected with falling gas and coal prices.

  • Fifth, while the Taylor Rule is a useful framework its prescription varies dramatically depending on the assumptions used, it makes no allowance for whether inflation psychology is entrenched or not (if it is like in the 1970s and 1980s then much higher rates are needed – but that looks unlikely) and it makes no allowance for the high level of household debt compared to the past and the degree of reliance of households on short dated mortgages compared to other countries (eg in the US 95% of mortgages are at fixed 30 year mortgage rates).

  • Specifically in relation to household debt, given the almost three-fold increase in the household debt to income ratios over the last 30 years, a 17% mortgage rate in 1989 – which preceded the early 1990s recession – is roughly equivalent to a 6% variable mortgage rate today and we are already pushing through that. A variable rate borrower on an existing $500,000 mortgage (which is the average) will see roughly another $80 added to their monthly payment from today’s RBA hike which will take the total increase in their monthly payments since April to nearly $1000 a month. That’s an extra $12,000 a year which is a massive hit to household spending power. And roughly two thirds of the 40% of mortgaged households with fixed rates (roughly about 1 million households) will see a 2 or 3 fold increase in their payments when their fixed term expires by the end of the year. And the RBA’s interest rate hikes have now exceeded the 2.5% mortgage rate serviceability buffer that applied up to October 2021 and the 3% since. The surge in interest rates has already pushed mortgage interest payments as a share of household income back to levels not seen since early last decade.  A rise in the cash rate to 4% would push the interest payment share to near a record high and total mortgage repayments (ie, interest and principal) as a share of income to record highs. The hit to spending power for households with a mortgage (who tend to vary their spending more than older Australian’s with big bank deposits) is likely to drive a big slowing in consumer spending.

Household housing interest payments v disposable income


Source: ABS, RBA, AMP

  • Sixth, there is increasing evidence rate hikes are getting traction: housing related indicators are all very weak; the 9% fall in home prices will depress consumer spending via a negative wealth effect; consumer confidence remains depressed; retail sales are falling in real terms; and there are some signs of slowing jobs growth. Slower demand in the economy will further reduce inflationary pressures. This may become more evident as the reopening bounce (“revenge” spending) wears off.

  • Finally, Australia is not acting alone as global rate hikes are slowing growth in advanced countries which in turn will slow global inflation pressures – so other central banks are doing part of the RBA’s job.

Concluding comment

On balance, while the RBA now looks likely to hike rates again by another 0.25% next month – continuing much further down the path of rate hikes in response to inflation which is a lagging indicator while ignoring the lagged flow through of rate hikes to the economy, signs of slowing demand and improving supply risks plunging the economy into a recession we don’t have to have. So, despite being premature so far, we still see the RBA as being close to the peak with rates. Our base case is now for one more 0.25% hike next month, followed by a lengthy peak as it becomes clearer that inflationary pressures are easing and growth is slowing, ahead of the start of rate cuts late this year or early next year.

Source: AMP Capital February 2023

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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Seven reasons why Australian shares are likely to outperform global shares over the medium term

Posted On:Jan 30th, 2023     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Introduction

Since the March 2009 Global Financial Crisis (GFC) low in share markets, Australian shares are up 138%, compared to a 310% gain in global shares in local currency terms and a 500% gain in US shares.

Australian and global shares

Source: Bloomberg, AMP

Last year though Australian shares outperformed global shares,

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Dr Shane OliverHead of Investment Strategy and Chief Economist, AMP Capital

Introduction

Since the March 2009 Global Financial Crisis (GFC) low in share markets, Australian shares are up 138%, compared to a 310% gain in global shares in local currency terms and a 500% gain in US shares.

Australian and global shares

Source: Bloomberg, AMP

Last year though Australian shares outperformed global shares, helped by strong commodities and a less hawkish RBA. The big question is whether the structural underperformance by Australian shares since 2009 is over?

Why have Australian shares underperformed?

To get a handle on the future, it’s useful to understand the past. The underperformance of Australian shares since 2009 reflects a mix of:

  • Payback for its huge outperformance in the 2000s – Australian shares go through periods of relative out & underperformance. This can be seen in the next chart that shows the relative decade by decade real returns of global and Australian shares since 1940. Australian shares outperformed in the 1940s, unperformed in the 1950s, outperformed in the 1960s resources boom years, underperformed in the high inflation 1970s and 80s, outperformed in the 1990s (although this was marginal and Australia underperformed in the second half of the 1990s when the tech boom raged), outperformed dramatically in the resources boom of the 2000s and underperformed in the 2010s.

Australian versus global shares returns – mean reversion

Source: ABN-Amro Global Investment Returns Yearbook, Bloomberg, AMP

The swings in relative performance can also be seen in the next chart which shows the ratio of Australian share prices to global share prices.

Australian shares prices relative to global share prices

Source: Bloomberg, AMP

  • After underperforming global shares in the tech boom in the second half of the 1990s, Australian shares came roaring back in the 2000’s resources boom. This meant the 2007 high for Australian shares was a much higher high than for global shares which spun their wheels in the 2000s. So, the poor relative performance of Australian shares since 2009 is partly payback for their outperformance in the 2000s.

  • The slump in commodity prices from 2011 – this weighed heavily on Australian resources shares through much of last decade.

  • Relatively tighter monetary policy in Australia for much of the post GFC period – whereas the US, Europe and Japan had near zero interest rates and quantitative easing, Australia has had much higher rates and no money printing until the pandemic. In fact, the relative underperformance started in October 2009 when the RBA raised rates post GFC which wasn’t followed by other major countries.

  • The surge in the $A to $US1.10 in 2011 – this reduced the competitiveness of Australian companies which takes time to reverse.

  • Property crash phobia – foreign investor fear of a crash in Australia’s expensive housing market has been a periodic theme over the last decade leading many foreign investors to be cautious of Australia.

  • Worries about the deteriorating relationship with China – this started in 2018 with President Trump’s trade war but was accentuated through the pandemic. It arguably resulted in foreign investors demanding a risk premium to invest in the $A and Australian shares.

  • A low exposure to pandemic winners – like tech stocks, which helped the US share market and hence global shares in 2020 & 2021.

Are high dividend payouts to blame?

An often expressed view is that Australian companies are not investing because shareholders want high dividends and this could be causing poor profit growth & share returns. This is unlikely. The dividend payout ratio (ie dividends relative to earnings) is not out of line with its historic norm.

Australian dividend payout ratio

Source: Bloomberg, RBA, AMP

Australia’s high dividend payouts are in fact healthy from a long-term perspective. There is evidence that high payouts actually drive higher earnings growth and share returns as: high dividend payouts mean less risk of poor investment decisions from retained earnings; they are indicative of corporate confidence about future earnings; & they indicate earnings are real and not an accounting fiction.

In fact, because Australian shares pay relatively high dividend yields (around 4.4%) compared to global shares (2.5%) they should be included in comparisons of Australian with global share market returns. The next chart compares the relative performance of Australian to global shares since 1970 in terms of: relative share prices in local currency terms (green line); relative total returns ie with dividends added in (blue line); and relative total returns with global shares in Australian dollars (red line).

Australian shares relative to global shares allowing for dividends and currency movements

Source: Thomson Reuters, Bloomberg, AMP

A rising ratio means Australian outperformance and vice versa. Several things stand out. First over long periods of time and when dividends are allowed for Australian shares have had better returns than global shares. Since 1970 Australian shares have returned (capital growth plus dividends) 10.1% per annum compared to 8.2% pa for global shares in local currency terms. The falling $A over this period has enhanced the return from global shares to 9.8% pa but they still underperformed Australian shares. Second, the swings in the relative performance of Australian shares are apparent if dividends and currency movements are allowed for or not – in particular in the big outperformance in the 2000s and underperformance since 2009. Since October 2009, when Australian shares peaked relative to global shares, Australian shares have returned 7.7% pa compared to 9.7% pa from global shares in local currencies or 11.3% pa in $A terms (as the $A fell).

Seven reasons Australia’s underperformance is likely over

Over the last year Australian shares have outperformed global shares and the various comparisons in the last chart have hooked higher. It could just be noise, but several fundamental considerations suggest that the structural relative underperformance since 2009 is likely to be over:

  1. Mean reversion – after 12 years of underperformance & the reversal of the 2000s outperformance Australian shares are due for a lengthy period of outperformance. Consistent with this, Australian shares are trading on a lower forward price to earnings multiple of 14.5 times than global shares on 15.3 times & US shares on 17.1 times.

  2. A new super cycle in commodities – the commodity price slump from their 2008-2011 highs looks to be over with commodities embarking on a new super cycle bull market driven by constrained supply after low levels of investment and low inventories for most commodities, decarbonisation driving increased demand for metals and increased defence spending on the back of increased geopolitical tensions which is metal intensive. This will benefit Australia’s resource stocks.

  3. The $A is no longer expensive – the surge in the $A to $US1.10 of 2011 has long ago reversed with the $A hitting a low of $US0.57 in 2020 & $US0.62 last year making Australian companies more competitive.

  4. Stronger growth potential – Australia’s potential growth rate remains higher than the US, Europe & Japan due to higher population growth.

  5. Relatively high dividends – Australian shares pay a higher dividend yield than traditional global shares: 4.4% versus 2.5%. This is important because dividend payments are a big chunk of the return an investor will get and so the higher the better. Franking credits add around 1.3%pa to the post tax return for Australia-based investors.

  6. Less aggressive monetary tightening – RBA monetary policy is no longer relatively tight compared to other major central banks, notably the Fed. It has been taking a more balanced approach to returning inflation to target. Higher than expected December quarter inflation is a concern and is now likely to see the RBA hike rates by another 0.25% in February. But its likely to be the peak in inflation as supply is improving, freight costs have fallen and demand is slowing and its unlikely to see the RBA adopt a more aggressive policy compared to other major countries.

  7. A thawing in the China relationship – the risk of a sharp deterioration in the trade relationship with China appears to be receding (at least for a while) helped by a change of Government in Australia.

Finally, while Australian property prices likely have more downside there is no sign of a property crash dragging down banks and the economy into recession. In the absence of much higher interest rates this looks unlikely.

Concluding comment

The period of underperformance in Australian shares compared to global shares since 2009 is likely to be over. Expect a 5-10 year period of trend outperformance, albeit there will be bumps along the way.

Source: AMP Capital January 2023

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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2023 – a list of lists regarding the macro investment outlook

Posted On:Jan 18th, 2023     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

Introduction

After very strong returns in 2021 thanks to reopening from Covid restrictions and stimulatory fiscal and monetary policies, 2022 was a rough year reflecting high inflation, a surge in interest rates and bond yields, geopolitical issues (notably the invasions of Ukraine) and recession worries.  This saw average balanced

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Dr Shane OliverHead of Investment Strategy and Chief Economist, AMP Capital

Introduction

After very strong returns in 2021 thanks to reopening from Covid restrictions and stimulatory fiscal and monetary policies, 2022 was a rough year reflecting high inflation, a surge in interest rates and bond yields, geopolitical issues (notably the invasions of Ukraine) and recession worries.  This saw average balanced growth super funds lose around 5% (or around 12% after inflation), as both shares and bonds lost value, after returning 14% in 2021. Over the last five years, they have returned around 5.5% pa with a pattern of successive strong followed by weak years, etc, since 2017.

Balanced growth superannuation fund returns

Source: Mercer Investment Consulting, Morningstar, AMP

Will the poor returns continue, or can we expect a rebound? Here is a simple point form summary of key insights and views on the outlook.

Five lessons for investors from 2022

  • Inflation was not dead (just resting) – the pandemic driven surge in money supply and reopening driven surge in demand against a backdrop of supply constraints released it from its long slumber.

  • To control inflation, central banks have to act and sound very tough. They started a bit late initially, but got there eventually in 2022.

  • Share markets go through periodic rough patches – and high inflation and rapidly rising interest rates are not good for them.

  • Geopolitics matters – particularly if war disrupts commodity supply.

  • Turn down the noise – investors are now bombarded with irrelevant, low quality and conflicting information which confuses and adds to uncertainty. This was particularly evident in 2022. The best approach is to turn down the noise and stick to a long-term investment strategy.

Nine reasons for optimism

2022 was not so good and economic growth will slow sharply this year thanks to rate hikes and cost of living pressures (with a high risk of recession in the US and Europe), but there are several reasons for optimism.

  • Long term inflation expectations remain low – while they were a bit slow initially central banks swung into inflation fighting action with rapid rate hikes and tough rhetoric showing they learned the key lesson of the 1970s – which is to keep inflation expectations down.

  • Inflation has likely peaked – this is most evident in the US where inflation led on the way up & is likely now leading on the way down. US inflation peaked mid last year & our Pipeline Inflation Indicator points to a sharp fall ahead. Labour market tightness is showing signs of easing which should take pressure of wages – this is flowing from slowing demand and in Australia will be helped foreign workers returning.

AMP Pipeline Inflation Indicator

Source: Bloomberg, AMP

  • Key central banks have likely seen or are close to peak hawkishness – this flows from the likely fall in inflation and signs of cooling demand.

  • China’s move away from zero Covid will provide an offset to weaker US and European growth – albeit after an initial set back as new cases surged, much like they did in other countries that reopened.

  • The US dollar looks to have peaked – which should ease debt servicing pressure in emerging countries with US dollar denominated debt.

  • Vaccines, anti-virals and with less harmful mutations have allowed the world to start moving on from Covid. China is now playing catch up.

  • In Australia, the less aggressive RBA along with other factors (see below), should help us avoid recession. 

  • Geopolitics may not be as threatening. Western democracies united and authoritarianism/strongmen leaders took a hit in 2022 – with Putin weakened by the mess in Ukraine, China’s difficulties exiting zero-Covid and Trump on the nose after the US mid-terms. The war in Ukraine may not get any more threatening, there are signs of a thaw in China relations & there are no major elections in key countries in 2023.

  • While US mid-term election years are often poor for shares (as seen in 2022), the 12 months after the US mid-terms is normally strong.

Five reasons Australia is likely to avoid a recession

A slump in consumer spending (thanks to rate hikes, cost of living pressures and falling property prices) along with weaker global growth will see Australian growth slow to around 1.5% this year. The risk of recession is high, but it’s likely to be avoided.

  • The RBA is less aggressive and less likely to overtighten compared to other major central banks.

  • Thanks to poor weather, material and labour shortages, there is a large pipeline of home building approved but yet to be completed.

  • The business investment outlook remains solid.

  • A rebound in Chinese growth is likely to support export volumes and prices. After a rough start to the year due to the surge in Covid cases with reopening, Chinese growth is expected to rebound to around 6% this year thanks to reopening providing an offset to weakness in other countries. The return of Chinese students, tourists and relaxation of export bans (notably on coal) could add around 1% to Australian growth spread over a couple of years.

  • Immigration is rebounding rapidly, which means more workers and support for economic growth.

These considerations should also support a continuation of the relative outperformance of Australian shares compared to global shares.

Key views on markets for 2023

Easing inflation pressures, central banks moving to get off the brakes, the anticipation of stronger growth in 2024 and improved valuations should make for better returns in 2023. But there are likely to be bumps on the way – particularly regarding recession risks – & this could involve a retest of 2022 lows or new lows in shares before the upswing resumes.

  • Global shares are expected to return around 7%. The post mid-term election year normally results in above average gains in US shares, but US shares are likely to remain a relative underperformer compared to non-US shares reflecting higher PE multiples. The $US is likely to weaken further which should benefit emerging and Asian shares.

  • Australian shares are likely to outperform global shares again, helped by stronger economic growth than in other developed countries and ultimately stronger growth in China supporting commodity prices helped by the grossed-up dividend yield of around 5.5%.

  • Bonds are likely to provide returns around running yield or a bit more, as inflation slows and central banks become less hawkish.

  • Unlisted commercial property and infrastructure are expected to see slower returns, reflecting the lagged impact of weaker share markets and higher bond yields on valuations.

  • Australian home prices are likely to fall another 9% or so as rate hikes continue to impact, resulting in a top to bottom fall of 15-20%, but with prices expected to bottom around September, ahead of gains late in the year as the RBA moves toward rate cuts.

  • Cash and bank deposits are expected to provide returns of around 3%, reflecting the back up in interest rates through 2022.

  • A rising trend in the $A is likely this year, reflecting a downtrend in the overvalued $US, the Fed moving to cut rates and solid commodity prices helped by stronger Chinese growth.

Five reasons to expect continuing volatility

While investment returns should improve, volatility is likely to stay high.

  • Growth is slowing in key advanced countries – with uncertainty about the depth of any downturn and the flow on to profits.

  • Inflation – while its likely to slow further it will still be high for a while.

  • Quantitative tightening (withdrawing the cash pumped into economies through the pandemic) will accentuate monetary tightening to an uncertain degree.

  • Geopolitical risk around Ukraine, China and Iran is still high.

  • Raising the US debt ceiling as needed around mid-year could be fraught given the increased power of fiscal conservatives in the House of Representatives.

Five things to watch

  • Inflation – if it continues to rise, central banks will be more hawkish than we are allowing for, risking deep recession.

  • Recession – a mild recession in US and Europe should be manageable but a deep recession will mean significantly more downside in shares.

  • US politics – the return to divided government, with GOP controlling the House, means a high risk of brinkmanship around raising the debt ceiling, causing volatility in markets as we saw in 2011 and 2013. 

  • Geopolitics – with the war in Ukraine, China tensions around Taiwan and the risk of increased tensions around Iran are the main risks.

  • Australian home prices – a sharper than expected fall as fixed rates reset and unemployment rises, could cause financial stability issues.

Nine things investors should remember

  • Make the most of compound interest to grow wealth. Saving regularly in growth assets can grow wealth significantly over long periods. Using the “rule of 72”, it will take 144 yrs to double an asset’s value if it returns 0.5%pa (ie, 72/0.5) but only 14 yrs if the asset returns 5%pa.

  • Don’t get thrown off by the cycle. Falls in asset markets can throw investors of a well-considered strategy, destroying potential wealth.

  • Invest for the long-term. Given the difficulty in timing market moves, for most it’s best to get a long-term plan that suits your wealth, age & risk tolerance & stick to it.

  • Diversify. Don’t put all your eggs in one basket.

  • Turn down the noise. This is critical with the information overload coming from social media, and mainstream media going down the clickbait path.

  • Buy low, sell high. The cheaper you buy an asset, the higher its prospective return will likely be and vice versa.

  • Avoid the crowd at extremes. Don’t get sucked into euphoria or doom and gloom around an asset.

  • Focus on investments you understand offering sustainable cash flow. If it looks dodgy, hard to understand or has to be justified by odd valuations or lots of debt, then stay away.  There is no free lunch!

  • Seek advice. Investing can get complicated and its often hard to stick to a long-term investment strategy on your own.

Source: AMP Capital January 2023

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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Review of 2022, outlook for 2023

Posted On:Dec 13th, 2022     Posted In:Rss-feed-oliver    Posted By:Provision Wealth
Expect a rough ride, but better returns

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

2022 – from Covid to inflation & surging interest rates

The good news is that 2022 finally saw the world shake off the grip of Coronavirus as it transitioned from a pandemic to endemic (albeit it’s still causing problems in China). However,

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Expect a rough ride, but better returns

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

2022 – from Covid to inflation & surging interest rates

The good news is that 2022 finally saw the world shake off the grip of Coronavirus as it transitioned from a pandemic to endemic (albeit it’s still causing problems in China). However, the past year turned out far more difficult for investors than might have been thought a year ago:

  • Inflation, which already rose in 2021 surged to levels not seen for decades, largely reflecting pandemic related distortions to supply and reopening & a stimulus driven surge in demand & floods in Australia.

  • Russia invaded Ukraine, leading to a surge in energy & food prices.

  • Central banks moved to aggressively withdraw monetary stimulus and raised interest rates at the fastest pace seen in decades to deal with inflation and rising inflation expectations.

  • Bond yields surged in response to the rise in inflation & interest rates.

  • Chinese growth fell sharply, reflecting its zero-Covid policy and a continuing property downturn despite policy stimulus.

  • Geopolitical tensions surged with war in Ukraine and worries about a Chinese invasion of Taiwan following President Xi Jinping’s power consolidation, although there were hopes of a thaw near year end.

  • As a result of all this, investors increasingly fretted about recession.

  • Tech stocks and crypto currencies, having been the biggest winners of the Covid lockdowns & easy money, were hit hard by reopening and monetary tightening, ultimately proving no hedge against inflation.

Growth was still ok – but a lot weaker than expected

Despite these problems, global GDP is still expected to have come in at around 3.2% which is weaker than the 5% or so growth expected a year ago and down from 6% in 2021, but still reasonable as reopening and stimulus helped. And in Australia, GDP is expected to have been around 3.5%, lower than expected a year ago and down from 4.8% in 2021, but still reasonable. The growth slowdown saw a slowdown in profits. But the main problem for investment markets was the rise in inflation, interest rates and bond yields.

Investment returns for major asset classes

Total return %, pre fees and tax

2021 actual

2022* actual

2023 forecast

Global shares (in Aust dollars)

29.6

-7.4

4.0

Global shares (in local currency)

24.3

-11.9

7.0

Asian shares (in local currency)

-6.8

-18.0

10.0

Emerging mkt shares (local currency)

-0.2

-13.8

10.0

Australian shares

17.2

2.2

10.0

Global bonds (hedged into $A)

-1.5

-11.1

3.0

Australian bonds

-2.9

-7.8

4.0

Global real estate investment trusts

30.9

-23.0

9.0

Aust real estate investment trusts

26.1

-17.1

9.0

Unlisted non-res property, estimate

12.3

11.5

4.0

Unlisted infrastructure, estimate

12.0

10.0

5.0

Aust residential property, estimate

23.0

-7.0

-7.0

Cash

0.0

1.0

3.1

Avg balanced super fund, ex fees & tax

14.3

-3.0

6.3

* Year to date to Nov. Source: Thomson Reuters, Morningstar, REIA, AMP

  • Global shares had a rough year with a plunge of 23% into October on inflation, interest rate and recession worries, before a rally cut losses.

  • Chinese shares led the weakness, not helped by its zero Covid policy, followed by Asian shares, given their exposure to China and cyclical sensitivity. US shares also underperformed reflecting its high-tech exposure & aggressive Fed tightening.

  • Australian shares outperformed, helped by strong commodity prices and a relatively less hawkish RBA.

  • Government bonds slumped as yields surged on high inflation & rate hikes. Australian bonds had their worst year since 1973 or the 1930s.

  • Real estate investment trusts fell with the surge in bond yields.

  • Unlisted property & infrastructure returns remained strong, being less sensitive to short-term share market and bond yield moves.

  • Home prices fell sharply reflecting poor affordability after a boom &, particularly, as mortgage rates rose, reducing home buyer capacity.

  • Cash and bank term deposit returns improved but were still low.

  • The $A fell with share markets on growth concerns and relatively aggressive Fed rate hikes into October, before a partial recovery.

  • Balanced super funds had negative returns reflecting poor share and bond returns. This followed very strong returns in 2021.

2023 – lower inflation and lower growth

First the bad news: inflation is still way too high at around 7 to 11% in many advanced countries; tight labour markets risk wage-price spirals; central banks are still warning of more rate hikes; the risk of recession is high with inverted yield curves and weak confidence largely in response to rate hikes; the US has returned to divided Government with the risk of debt ceiling and funding standoffs; war continues in Ukraine; and tensions remain with China and Iran. Even Covid continues to disrupt – but mainly in China as cases surge as it reopens. These all suggest another volatile year and possibly continuation of the bear market in global shares.

Global Composite PMI vs World GDP

PMIs are surveys of business confidence and conditions. Source: Bloomberg, IMF, AMP

However, there is reason for optimism. First, inflationary pressures may have peaked and are slowing rapidly (as reflected in our Pipeline Inflation Indicator): supply chain pressures have eased; demand is cooling; and labour markets are showing signs of topping out. In fact, it may only require a slight pull back in demand (to push capacity utilisation back down to normal & unemployment above the NAIRU – or non-accelerating inflation rate of unemployment, with the return of immigration helping in Australia) to further depress inflationary pressure significantly. This suggests inflation could fall faster than central banks expect in 2023.

AMP Pipeline Inflation Indicator

Note that this is more a guide to direction than level. Source: Bloomberg, AMP

Second, central banks are likely nearing the peak in rates. The Fed is already moving to slow hikes, but conditions are likely to be soft enough to allow it to pause from around March ahead of rate cuts later in 2023. Sure, its signalling more but just as its signals were too dovish a year ago its signals now are likely too hawkish! In Australia, we see the RBA as being at or close to the top (3.1% is our base case for the peak with 3.35% our risk case) as by February/March conditions are likely to be weak enough to allow a pause, ahead of rate cuts in late 2023/early 2024.

Third, it seems everyone is talking about recession for 2023, such that it’s a consensus call. The risk is very high (probably over 50% in the US and Europe) and this will likely keep markets volatile given the threat to earnings. But it may not turn out to be as bad as feared.

  • In the US it may just be a sharp slowdown or mild recession in 2023 – if the Fed starts to ease up on the brake soon and given the absence of other excesses that need to be unwound, eg, there has been no overinvestment in housing & capex and leverage is low.

  • Europe has moved away from Russian gas very quickly and providing its winter is mild, may continue to hold up better than feared.

  • Or lags in the way rate hikes impact may mean recession does not hit till 2024, meaning its too early for share markets to discount just yet.

  • After initial Covid related setbacks, Chinese growth is likely to rebound in 2023 as it reopens. Just like occurred in other countries upon reopening (recall Australia’s Omicron disruptions earlier in 2022) China is likely to see a surge in cases initially. But markets are likely to largely look through this to the reopening boost ahead which will provide an offset to slower growth in the US and Europe.

  • Australian growth is likely to slow but avoid recession, reflecting the less aggressive RBA, the pipeline of home building work yet to be completed and the strong business investment outlook.

Finally, geopolitics may not be so bad in 2023: there are no major elections in key countries in 2023; the war in Ukraine may not get any more threatening; and the Cold War with China may see a bit of a thaw.

Overall, global growth in 2023 is likely to be around 2.5%, well down from 6% in 2021, but not recession in aggregate. In Australia, growth is expected to slow to 1.5% in the year ahead. And inflation is likely to fall.

Implications for investors

Easing inflation pressures, central banks moving to get off the brakes, economic growth proving stronger than feared and improved valuations should make for better returns in 2023. But there are likely to be bumps on the way – particularly regarding recession risks – & this could involve a retest of 2022 lows or new lows in shares before the upswing resumes.

  • Global shares are expected to return around 7%. The post mid-term election year normally results in above average gains in US shares, but US shares are likely to remain a relative underperformer compared to non-US shares reflecting still higher price to earnings multiples (17.5 times forward earnings in the US versus 12 times forward earnings for non-US shares). The $US is also likely to weaken which should benefit emerging and Asian shares.

  • Australian shares are likely to outperform again, helped by stronger economic growth than in other developed countries and ultimately stronger growth in China supporting commodity prices and as investors continue to like the grossed-up dividend yield of around 5.5%. Expect the ASX 200 to end 2023 at around 7,600.

  • Bonds are likely to provide returns around running yield or a bit more, as inflation slows and central banks become less hawkish.

  • Unlisted commercial property and infrastructure are expected to see slower returns, reflecting the lagged impact of weaker share markets and higher bond yields (on valuations).

  • Australian home prices are likely to fall further as rate hikes continue to impact, resulting in a top to bottom fall of 15-20%, but with prices expected to bottom around the September quarter, ahead of gains late in the year as the RBA moves toward rate cuts.

  • Cash and bank deposits are expected to provide returns of around 3%, reflecting the back up in interest rates through 2022.

  • A rising trend in the $A is likely over the next 12 months, reflecting a downtrend in the now overvalued $US, the Fed moving to cut rates and solid commodity prices helped by stronger Chinese growth.

What to watch?

The main things to keep an eye on in 2023 are as follows:

  • Inflation – if it continues to rise, central banks will tighten more than we are allowing for risking deep recession.

  • US politics – the return to divided government, with GOP controlling the House, runs the high risk of a return to brinkmanship around the debt ceiling, causing volatility in markets as we saw in 2011 and 2013.

  • China issues – increased tensions around Taiwan are the main risk.

  • An escalation of the Ukraine conflict could adversely impact Europe.

  • Australian home prices – a sharper than expected fall as fixed rates reset and unemployment rises, could cause financial stability issues.

Source: AMP Capital December 2022

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make 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 document 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 document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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