The Experts

The last few years has reminded us that investing comes with risk. But while it’s scary and difficult after a long tough period, we also need to recognise that successful investing is ultimately about using opportunities to generate returns. In this regard I am endlessly amazed at the capacity of many to see disaster around the corner of everything.

Some commentators having given up on an immediate return to the GFC (the fabled "double dip") are simply now saying that the global economic recovery and rebound in share markets is simply setting us up for the next disaster around the corner. But given markets always go in cycles, this is a bit like saying "I didn't expect the sun to rise today, but it doesn't make any difference because it will only set again this evening" and so the darkness will return.

Another example is Japan. For decades it has been chastised for its lack of action in dealing with its slump. But now that its finally doing something, many are now worrying its actions will simply cause another crisis.

Another concerns the phenomenon of “risk on/risk off”, which is the topic of this article. Since the GFC, listed growth assets such as shares, commodities and the Australian dollar have been moving pretty much together, and inversely to government bonds in so called "safe" countries. In recent times, this simple relationship seems to be breaking down. And yet again many fear it’s a bad sign. Or is it really just a sign that things are returning to normal?

Risk on, risk off – what is it?

Since around the time of the GFC, listed growth assets like shares, corporate debt, commodity prices and the Australian dollar have all been moving closely together but inversely versus assets like government bonds in so-called “safe” countries and the $US and the Yen.

In other words, when investor confidence was on the mend, the “risk on” assets (shares, corporate debt, commodities and the $A) would rise whereas the “risk off” assets (government bonds in safe countries, the $US and the Yen) would sell off. This was evident when the several rounds of quantitative easing (QE1 and QE2) were undertaken in the US. The opposite would occur when confidence slumped. As a result, investment markets simply rotated between periods of “risk off” and periods of “risk on”.

This can be seen in the next chart showing the relationship between the $A/$US exchange rate and the US share market.



As a result the correlation (or the extent to which they move together) between the “risk on” assets was very high. It basically reflected the macro forces – emanating largely from the US and Europe over the last few years – that have dominated other more asset specific influences. This has come to be known as “risk on/risk off” or RORO. It meant that macro forces have dominated everything, whereas industry or asset specific developments were subsumed.

RORO breaks down

Recently though RORO has shown signs of breaking down. This has become particularly evident since the commencement of the latest round of quantitative easing (QE3) in the US. Whereas the first two rounds in 2009-10 and 2010-11 saw rallies in all “risk on” assets, the latest has been messier with equities and corporate debt rallying and the Yen selling off but commodity prices falling, the $A falling and bond yields being range bound. This is evident in the next chart which shows the relationship between the US Federal Reserve’s holdings of US Treasuries and mortgage backed securities as a guide to quantitative easing and the value of the $A. The break down between US shares and the Australian dollar is also seen in the previous chart.




Some interpret this as a bad sign: that the fall in commodity prices and the $A, and the failure of bond yields to rise much beyond their recent ranges, is an indication that all is not well with global growth. In other words, shares have got it wrong.

However, there is a more benign, and in fact, positive interpretation and this is that the breakdown of the “risk on/risk off” relationship reflects a weakening of debilitating macro economic threats. Specifically:

The risks around a break-up in the euro are continuing to decline and this is reflected in an ongoing slide in bond yields in troubled Eurozone countries. Italian and bond yields have now fallen back to where they were in 2010. Two-year bond yields are now just 1.3 per cent in Italy and 1.7 per cent in Spain. Greek 10-year bond yields have fallen back to 7.95 per cent from a high last year of 37 per cent.



While public debt problems continue in the US, the budget deficit is at least falling faster than expected (now running around 5.5% of GDP, down from a peak of over 10 per cent and set to fall to 4 per cent of GDP in 2014) and the private sector is looking a lot healthier with consumer sentiment at its highest in almost six years, a recovery in housing activity set to contribute 1% or so to growth this year and capital spending looking stronger.



Japan is looking a lot stronger with growth rebounding in the March quarter and set to strengthen further as the massive monetary easing from the Bank of Japan, the sharp fall in the value of the Yen and fiscal stimulus start to impact. While some fret that a back up in Japanese 10-year bond yields from below 0.5% in early April to around 0.97 per cent is a concern, I think it’s a positive sign in that even bond investors are starting to think that there is a chance that Abenomics (the policies introduced by new PM Abe) will work and hence are starting to believe that inflation may rise to the targeted 2% level in a few years time. Japan is the world’s third largest economy so its resurgence is a very good sign.

Finally, Chinese growth seems to be settling around 7.5 per cent with less concern about a hard landing, although the weak HSBC manufacturing conditions PMI for May reminds us that it still faces some downside risks.

It should also be stressed that the RORO phenomenon wasn’t normal. Rather, it was a phenomenon of the GFC and the post GFC period, where macro threats were so immense that they drove all listed growth assets to move together. The correlation between the Australian dollar and US shares and between commodities and US shares was a lot lower prior to the GFC.

Now that we are just going back to something a bit closer to normality, the reduction in macro economic threats has meant that individual asset classes are being driven more by their own fundamentals. In this regard:

Share markets have benefitted from reduced risks regarding global growth, a surge in high yield stocks as investors seek out better yields than bonds and bank deposits are paying and a pick up in cyclical sectors like consumer stocks. By contrast material stocks have been held back by commodity worries.

Commodity prices are reacting to more negative supply and demand fundamentals - the supply of commodities is picking up after a world wide mining investment boom and this is occurring at a time when it increasingly looks like Chinese growth is settling around 7.5 per cent down from 10 per cent plus over the last decade.

The $A is reacting (at last) to the commodity price downtrend along with RBA interest rate cuts which are reducing the attractiveness of parking money in Australia at a time when the US is starting to look more attractive. More downside in the $A is likely.

Bond yields have remained low as it’s become clear that interest rates are going to stay down for longer, particularly as inflation continues to surprise on the downside. In the US inflation is now just 1.1 per cent, in Europe its 1.2 per cent, in Canada its 0.4 per cent and its now falling in the UK.

In other words, individual assets have gone back to better reflecting their fundamental drivers. This is healthy.

What does this mean for investors?

None of this is to say that macro economic risk has gone away. Problems still remain and it will be a continuing source of volatility, as for example gyrations around when the Fed will start to reduce its monetary stimulus attest. However, its influence is fading leading to a breakdown in the “risk on/risk off” correlations we have seen since around the time of the GFC. For investors this has several implications:

Firstly, it’s good news to the extent it signals the world is starting to return to normal after the mess of the past few years.

Second, macro economic factors will remain critically important for investors to monitor, but perhaps not as overwhelming as they have been.

This means that individual assets will start to better reflect their own fundamentals. This is already evident in the weak trend in commodity prices and the $A versus the strong trend in share markets. It’s also evident in the divergence in cyclical sectors in share markets, eg, consumer stocks up over the last year, but materials struggling.

This in turn means that the benefits of having a well diversified portfolio whether in terms of holding individual shares, across global share markets or in growth assets should be more evident in the years ahead.

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.

Key points

The positives in the Budget are more for education, disability care & roads & savings in middle class welfare.

However, the deficit is worse than expected, with a surplus pushed out at least three years.

While the Government has announced more Budget savings their impact is zero for the year ahead.

It’s hard to see major investment market implications.

Australia’s public finances are benign compared to other advanced countries, but given the biggest resources boom in our history they should be far stronger.  

Introduction

The 2013 Budget has seen a big shift in Government policy away from a focus on returning the Budget to surplus to send “a strong message of confidence” (quote from last year’s Budget) to focussing on “a strong economy”. The surplus projection is still there, but thanks to a huge revenue shortfall it’s been pushed out three years to 2015-16 and progress towards it will stall for the year ahead. While there will no doubt be lots of interest in the individual Budget measures the surplus or its lack, is the key issue.

Key measures

As is well known thanks, largely to a circa $16bn revenue shortfall and a spending blowout, last year’s Budget projection for a $1.5bn surplus this financial year has not been achieved with the Government now projecting it will be in deficit to the tune of $19bn. And with the revenue shortfall affecting the starting point for future years the Government now expects that a surplus won’t be achieved till 2015-16. However, to achieve this it has still had to announce savings, albeit they don’t kick in till 2014-15.



The revenue shortfall mainly reflects lower company tax collections reflecting the combination of lower commodity prices, the strong $A and apparently various corporate tax loopholes. To plug the gap and push the Budget back into surplus in the next few years the Government has announced net savings of $28bn over five years, but not commencing till 2014-15. Some of the savings were pre announced or well flagged and include:

• Various measures to tighten corporate tax loopholes.
• The cancellation of a rise in family benefit payments and replacement of the baby bonus.
• Postponing personal tax cuts that were due in 2015 as the carbon price assumption has been lowered.
• An extension of monthly income tax instalments to large taxpayers.
• An increase in the Medicare levy to fund disability care.
• Superannuation changes as already announced.
• Cuts to higher education funding.
• Cuts to planned foreign aid.

These measures were partly offset by welcome spending on roads and rail, the move towards the full start up of Disability Care in 2018-19 and increased funding for schools.

The Budget deficit - the good & bad

Given the coverage around the continuing Budget deficit it is worth putting it into context. First, some background. Just as with a household, a government’s Budget deficit is the difference between the amount it spends (on social welfare, defence, infrastructure, health, etc) and the amount it gets in revenue (from taxes, investment earnings, etc). It has to be financed by borrowing and to do this a government issues government bonds (to investors such as super funds, insurance companies and foreign investors) and the cumulative sum of all such borrowing is its public debt.

While the $19bn deficit for this financial year is a lot of money it needs to be compared to the size of the economy ($1.5 trillion) to put it into context. This puts it at 1.3 per cent of GDP and as can be seen in the first chart is a big fall from 2.9 per cent of GDP last financial year when the deficit was $43bn. This is in fact the biggest reduction in a deficit in modern history. So despite the failure to hit the surplus target (which was always a stretch to achieve anyway) the Budget deficit is still going in the right direction.

What’s more Australia’s Budget deficit is tiny compared to other advanced countries. At around 2 per cent of GDP across all levels of government it compares to around 3 per cent of GDP in the Eurozone, 6 per cent in the US and 10 per cent in Japan.



Similarly Australia’s gross level of public debt at around 28 per cent of GDP is very small compared to around 95 per cent in the Eurozone, 108 per cent in the US and 245 per cent in Japan.

However, comparing ourselves to a bad bunch is not necessarily wise. First, our level of net public debt (ie gross public debt less what the government is owed) is about where Ireland’s was in 2006 before a severe property crash necessitated the Irish government bailing out its banks which saw public debt skyrocket. This is unlikely in Australia, but the Irish experiences highlights just how quickly good times can turn sour. Second, after the biggest resources boom in our history, public finances should be in far better shape. Norway is a good example in this regard. Realising that its North Sea oil reserves would not last forever it has been running big Budget surpluses (around 10 to 18 per cent of GDP) and putting the money into a sovereign wealth fund for use when their boom is over. As a result Norway’s net public debt is negative, ie it is owed way more than it owes.



Australia is now projected to run Budget deficits for 7 years in a row totalling 16 per cent of GDP, which is almost identical to the 7 years of Budget deficits in the 1990s that totalled 17 per cent of GDP. The problem is that the 1990s episode could be excused on the grounds that it encompassed a deep recession whereas the current episode has seen no recession and the biggest resources boom in our history!

While the fiscal stimulus around the time of the GFC was justified, Australia ideally should have built up a bigger investment in sovereign wealth funds like the Future Fund in the years before the GFC and then cut back the GFC stimulus much faster. Clearly the revenue shortfall has played a role, but spending should also have been cut back more aggressively through 2010 and 2011 after it surged to around early 1990s highs in relation to GDP. See next chart.



Implications for interest rates

While there is a fiscal tightening in the Budget, it is actually zero this year and doesn’t kick in till 2014-15 at 0.4 per cent of GDP before rising to 0.7 per cent of GDP in 2015-16. This makes it somewhat academic (as it may not even occur) given past experience and is unlikely to have any impact on the RBA’s immediate thinking regarding interest rates. That said, our assessment remains that the RBA will cut interest rates again taking the cash rate at least down to 2.5 per cent, with the main drivers being the peaking of mining investment at a time when the rest of the economy remains subdued and inflation remains low.  

Against this background and assuming that rates are cut further, the Government’s growth forecast for 2013-14 of 2.75 per cent is reasonable and in line with our own view. However, its nominal GDP growth forecast of 5 per cent may be a little optimistic and we see unemployment pushing up to 6 per cent as against the Government’s 5.75 per cent forecast. Inflation is likely to remain low at around 2.25 per cent as the Government predicts.

Implications for Australian assets

It’s hard to see a major impact on Australian assets.
Cash and term deposits – can’t see much impact here at all. The RBA is likely to cut rates further which is likely to put more downwards pressure on term deposit rates. Expect term deposit rates to fall below 4 per cent in the months ahead.

Bonds – the delay in the return to surplus is probably not enough to threaten Australia’s AAA sovereign rating and continuing low interest rates should ensure bond yields remain low. But, the problem remains that with five year bond yields at 2.8 per cent it’s hard to see great returns from Australian sovereign bonds over the next few years.

Shares – while increased spending on roads and rail may help construction and building material stocks, the impact is likely to be minimal. It's hard to see much impact on the share market overall, where we see the broad trend remaining up thanks to reasonable valuations, easy monetary conditions and prospects for stronger profits.

Property – property prices are likely to continue gaining at a modest pace on the back of low interest rates and as domestic growth starts to pick up. 

The $A – while the initial response to the Budget saw the $A fall 0.5 per cent, the announcements in the Budget alone are not radical enough to have much of an impact on the $A. In the very short term the $A was oversold after last weeks sharp fall. However, with the commodity price boom fading, the interest rate differential in favour of Australia falling and the $A overvalued on a purchasing power parity basis, the trend in the $A is now likely to be down. 

Concluding comments

The good news is that Government has found ways to fund its commendable Gonski education reforms and Disability Care and superannuation has been left alone beyond what was already announced. But it would have been desirable to have a least some of the Budget savings kick in this year to provide more confidence that a surplus will eventually be achieved. As it turns out we are now looking at a Budget deficit blowout of virtually the same size as that seen in the 1990s despite having a much stronger economy than back then. To be sure Australia’s public finances are in good shape compared to other advanced countries. But having seen the biggest resources boom in our history we should have been able to put more aside for the inevitable rainy day.

For more Budget coverage, check out:

• Budget 2013 - what are the real issues?
• Budget special on Switzer TV
• CommSec's Craig James - Honey, who ate the surplus?
• Labor's trap for Tony Abbott

The Australian share market has closed at levels not seen in almost five years as a weakening domestic currency boosted the big miners.

But banking stocks finished in negative territory, despite the S&P/ASX 200 index closing at the highest point since June 2008.

A fall in the Australian dollar to an 11-month low of 100.47 US cents early on Friday helped BHP Billiton close 0.61 per cent, or 21 cents firmer, at $34.75 as Rio Tinto gained 0.43 per cent, or 25 cents, to $58.45.

CMC Markets chief market analyst Ric Spooner said the weakening Australian dollar helped the multi-national mining companies, whose profits and revenue are nominated in US dollars.

The big banks, however, finished in the red after the Reserve Bank of Australia expressed optimism about the health of Australia’s major trading partners and domestic consumption.

“Growth of Australia’s major trading partners is expected to continue to exceed that of the world, reflecting the faster growth of Australia’s trading partners in Asia,” the central bank said in its monthly monetary policy statement.

Mr Spooner said the RBA’s statement hurt the banks, as investors interpreted it as a sign that interest rates would not be cut further.

“They have people thinking that we’re not as likely to see more rate cuts in the near future as they may have thought a couple of days ago,” he told AAP.

“That’s a bit of a negative for some of these high-yield stocks, and banks generally because they benefit from a falling rate environment.”

ANZ led the banks lower, losing 1.5 per cent, or 46 cents, to end at $30.13.

Westpac also finished worse off, relinquishing 1.2 per cent, or 40 cents, to $32.95 while the Commonwealth Bank lost 0.66 per cent, or 47 cents, to end at $70.57 as National Australia Bank shed 0.64 per cent, or 21 cents, to hit $32.47.

Key facts:

• On Friday, the benchmark S&P/ASX200 index was up 7.7 points, or 0.15 per cent, at 5,206.1 points.
• The broader All Ordinaries index was up 10.5 points, or 0.2 per cent, at 5,191.1 points.
• At 1620 AEST, the June share price index futures contract was six points higher at 5,200 points, with 22,738 contracts traded.
• National turnover was 1.827 billion securities worth $4.45 billion.

Key points

The RBA has cut interest rates again and they are likely headed even lower, probably to 2.5 per cent. Global interest rates also look like remaining low for an extended period.

Low & falling interest rates mean low & falling bank deposit rates. The chase for yield will continue.

Introduction

When interest rates in major countries fell to zero through the course of the GFC, most investors would have thought it would be temporary. But here we are five years later and there is no end in sight. The global economy is growing but not at a pace that uses up spare capacity, inflation is actually falling and there is still a debate in the US, Europe and Japan as to whether even more monetary stimulus is required. Similarly in Australia interest rates are still falling with the RBA cutting the cash rate to a record low of 2.75 per cent and likely to have to cut even lower.

Global rates to stay low

The risks to global growth have receded with Eurozone financial risks coming under control as evident by sharp falls in Italian and Spanish bond yields, strength in US housing providing an offset to fiscal tightening and China appearing to stabilise. However, global growth indicators are pointing to growth only slightly up from that seen last year. For example, global business conditions PMIs are running around levels consistent with around 3-3.5 per cent global growth.



This is far better than the feared return to recession of the last few years. But it’s still below potential and not enough to use up spare capacity. Put another way the world is still awash in excess savings. Reflecting this, there is no sign of the hyperinflation some had feared would follow from monetary printing. In fact, quite the reverse, inflation rates are now falling with US inflation just 1.5 per cent in the year to March and Eurozone inflation just 1.2 per cent. This is being reinforced by a downtrend in commodity prices.



Against this back drop, it’s virtually impossible to see global interest rate hikes this year and hard to see them next year.

Australian interest rates still headed lower

The basic issue in Australia is that the slowdown in mining investment growth is now looming and we need to see a pick up in non-mining activity to fill the gap in terms of the contribution to GDP growth. While this was never expected to occur smoothly, the evidence to date points in the direction of non-mining activity not picking up quickly enough. To be sure interest rate cuts have got some traction: the home buyer market has improved with increased sales, auction clearances and house prices, consumer confidence is up and retail sales are up. But the response has been tentative and weak. It’s now 18 months since the RBA first started cutting the cash rate from 4.75 per cent in November 2011. The next table shows the level or percentage gain in key economic indicators 18 months after the first rate cut for the current and last three interest rate cutting cycles that started in July 1996, February 2002 and September 2008.



Apart from auction clearance rates, which look solid, all of these indicators are currently below the average level they attained this far into past easing cycles. Importantly:

• While consumer confidence has picked up, business confidence remains subdued;
• Retail sales picked up in January and February but the level of sales is still well below where it would normally be this far into an easing;
• It’s the same story with dwelling approvals which are off their lows but haven’t seen the average 20 per cent gain they would have normally seen by now;
• Employment growth is also lagging; and
• House prices are up, but their rate of increase is modest.

Several factors are driving the subdued response to interest rate cuts. Post GFC caution is a big part of the explanation. Immediately after the GFC Australian business and consumers responded as if it was back to normal. The last few years have shown that it’s not. Households are worried about job security after rounds of layoffs and asset price volatility which as affected their wealth. This has all led to a more cautious approach to debt and spending. This along with the strong $A has affected business confidence outside the mining sector.

In short, post the GFC the neutral level of interest rates has arguably fallen and bank lending rates need to fall back to the lows seen around early 2009, which saw the standard variable mortgage rate fall to around 5.75 per cent.



In addition the downtrend in commodity prices is acting as an ongoing drag on national income, but so far its not been offset by a fall in the $A which remains strong and inflation remains benign at around 2 per cent after adjusting for the impact of the carbon tax providing plenty of scope for further easing.

Against this backdrop the RBA has now cut the official cash rate to a record low of 2.75 per cent and a further fall looks likely. I expect the cash rate to fall to 2.5 per cent in the next few months, but to get standard variable mortgage rates back to the lows of 2009 may require another cut again.

Implications for investors

Continuing low interest rates with more to come in Australia has several implications for investors. First, term deposit rates are likely to remain low or fall further. For the major banks in Australia they are currently averaging around 4 per cent for 12 months and 4.4 per cent for 3 years. They are likely to head down towards 3 per cent.



This means tthe desire for better performing investments and specifically higher yielding investments will remain. In this regard:

Sovereign bond yields are likely to remain low. While their low yields point to low medium term returns, in the absence of expectations for higher short term interest rates it hard to see bond yields rising much. However, in the absence of significant further declines in yield boosting capital returns their low yields make them a relatively unattractive investment in terms of return potential. See the next chart



Housing rental yields are also relatively low at around 4 per cent (or less once allowing for costs) and while prices are likely to rise over the next year or two, returns are likely to be constrained by still high price to income ratios.

Corporate bond yields have already fallen a long way, but their yields remain above term deposit rates and are a good alternative.

Commercial property (office, retail and industrial) continues to offer relatively attractive income yields, particularly for unlisted property.

Australian shares have rallied strongly over the last year which has seen average dividend yields decline, but once allowing for franking credits at around 5.5 per cent they remain well above the yield available on term deposits. Lower interest rates will also help boost the outlook for profits and may help by lowering the value of the Australian dollar taking pressure off trade exposed companies. The broad rising trend in the share market is likely to continue.

While valuations for high yield shares like banks have been pushed to extremes, with interest rates still falling they are likely remain well supported.

Key events of the past week and implications

US shares made it to a new record high and Australian shares made it to new post GFC highs early in the week, but worries about soft business conditions PMIs caused a bit of volatility. “Sell in May and go away” fears on the back of concern about a global growth soft patch may also be impacting. This saw bond yields and some commodity prices fall.

The announcement of a new Italian Government, with PM Enrico Letta declaring a focus on growth, set the week off on a positive tone. While it's unlikely to be smooth sailing for the coalition led Letta Government with Mr Berlusconi likely to try and use any opportunity to return to power at least the near term uncertainty has been removed. This has seen a further fall in Italian bond yields with the 2 year bond yield at a new record low of just 1.02 per cent. Ten yield bond yields in both Italy and Spain have collapsed to near pre crisis lows underlining the continued retreat of the Eurozone crisis.

There were no real surprises from the US Fed which left monetary policy unchanged, continuing with $US85bn of asset purchases a month. However, it did suggest a slightly more dovish tone in its comment that it is prepared to “increase or reduce” the pace of quantitative easing suggesting that the softer tone of some recent data releases has seen many Fed officials back away from a desire to start slowing the pace of QE.

Dampening market sentiment though was the confirmation of soft April manufacturing conditions PMIs in the US, China, the Eurozone, India and Australia further raising concerns of another mid year soft spot in global growth. However, it’s worth noting that PMIs rose in Japan, the UK, Korea and even Greece so it's not all bad.

The strength in US housing, the fact that central banks are easing in the US, Europe and Japan and less acute risks in Europe argue against another mid year global growth scare. This won’t necessarily stop investors from worrying but suggests any pull back in shares is likely to be limited to the 5 to 10 per cent range rather than anything worse particularly as the chase for yield continues to boost high yield shares.

In Australia, the focus was back on the budget with the Government announcing a $12 billion revenue short fall for this year and a 0.5 per cent boost to the Medicare levy to fund a national disability insurance scheme. While the revenue shortfall is disappointing and highlights the more difficult environment facing the Australian economy, it is not surprising and is consistent with our own expectation for a $15bn deficit this financial year. Moreover it should be borne in mind that the budget deficit will still be well down from last year’s $44bn and the turnaround in the budget deficit from 3 per cent of GDP to  around 1 per cent this year will still be the fastest turnaround on record (since 1980).

The financing of the NDIS has also caused some concern with the increase in the Medicare levy to 2 per cent equivalent to a 0.25 per cent interest rate hike for someone earning $100,000 with a $250,000 mortgage. Bear in mind though that it's not planned to start till mid next year and any debate about the financing of the NDIS should not distract from what is a very worthy initiative.

Major global economic events and implications

US data was a mixed bag. On the negative side the ISM manufacturing index slipped further in April, a survey of private employment was weak for the second month in a row and construction spending fell. On the positive side, consumer confidence rose, personal spending was stronger than expected, house prices and pending home sales rose and jobless claims fell to a five year low contradicting concerns about a growth slowdown.

The US profit reporting season continued to roll on with 390 S&P 500 companies having reported and 73 per cent coming in better than expected resulting in profit growth now tracking at +4 per cent versus an expected decline a few weeks ago. Against this only 47 per cent have exceeded sales expectations and guidance has been soft.

In Europe, the ECB finally cut interest rates taking the official rate to 0.5 per cent. While this is unlikely to have a big impact as the ECB should really be doing something more proactive in terms of pumping cash into the economy like quantitative easing, President Draghi did leave the door open to doing more. Certainly the need for more aggressive easing in Europe is evident in business sentiment indicators falling in April, unemployment rising to a record 12.1 per cent and inflation slumping to just 1.2 per cent.

While consternation about Slovenia needing a bailout got a boost by Moody’s decision to downgrade its debt to junk, it's worth noting that it's another very small economy at just 0.4 per cent of Eurozone GDP and partly reflecting its small banking sector if it were to seek a bailout it would be small at maybe just €3-7bn.

Japanese economic data was more positive suggesting reflation efforts may be getting traction. Industrial production rose by less than expected but its trend is up and more importantly the manufacturing conditions PMI rose, household spending rose strongly, housing starts are up and the labour market looks stronger.

China's official manufacturing PMI confirmed the fall in April reported in the flash HSBC PMI. However, it’s still at a level consistent with 7.5 to 8 per cent growth in China. While the rise in bird flu deaths in China may have slowed, it’s unclear whether fear regarding it may have adversely affected consumer related activity over the last month.

Australian economic events and implications

Australian economic data was disappointingly weak. While new home sales rose in March they are still below January levels and remain low historically. Moreover, the AIG’s manufacturing PMI fell to its lowest since May 2009, its services PMI also fell sharply, credit growth remains very weak, dwelling prices fell in April, albeit after a strong quarter, and building approvals fell 5.5 per cent in March led by a fall in multi dwelling approvals with private house approvals remaining weak. This all points to the need for another cut in interest rates.

Major market moves

Most share markets saw gains over the past week. Australian shares made it to a new post GFC high particularly helped by good profit reports and dividend hikes from several banks.
Commodity prices were flat to down with falls in metal prices and the iron ore price not helped by worries about a global growth. This along with heightened expectations for another RBA rate cut saw the $A fall slightly.

Bond yields fell on growth concerns and low inflation.

What to watch over the next week?

In Australia, the big focus will be on the Reserve Bank, which hopefully will cut interest rates by another 0.25 per cent on Tuesday. The past month has seen some softer news regarding the global economy, falls in commodity prices and a range of disappointing data in Australia including for various business surveys, building approvals, consumer confidence and job vacancies. So with the response to the rate cuts of the past 18 months proving to be very tentative and the mining investment slowdown now looming close it would make sense for the RBA to provide a bit more insurance for the economy by cutting interest rates again. Benign inflation in the March quarter provides it with plenty of scope to do so. Ideally the RBA should cut on Tuesday but it may prefer to get a look at the Budget the week after and March quarter business investment data to be released later in May. So while I expect a cut in the cash rate to a record low of 2.75 per cent, I am agnostic as to whether it’s on Tuesday or next month. The money market also appears to be agnostic with just a 54 per cent chance of a cut priced in for Tuesday.

On the data front in Australia, anecdotal evidence points to another rise in retail sales in March (due Monday), ANZ job ads are expected to remain soft (also Monday), house prices are expected to have increased 1.5 per cent in the March quarter (Tuesday) and employment is expected to have increased by 5000 in April leaving unemployment unchanged at 5.6 per cent (Thursday).

Chinese economic data for April will start to flow on Wednesday with growth in exports expected to remain around 10 per cent. Inflation (Thursday) is expected to have remained low at around 2.2 per cent and lending and money supply growth is expected to have slowed from the surge seen in March.

Outlook for markets

Shares are at risk of a correction in the next few months, particularly if fears about a global growth soft patch continue to escalate and given we are now coming into a seasonally weak time of year for shares. However, any set back in shares is likely to be mild (say 5-10 per cent rather than the 15 – 20 per cent falls seen around mid 2010 and mid 2011) and the trend is likely to remain up. Shares are still far from expensive, monetary conditions are very easy, the gradually strengthening global growth outlook led by the US points to stronger profits ahead and investors are likely to increasingly switch from low yielding cash and bonds ensuring solid “buy on the dips” demand. A pick up in mergers, buybacks and dividends from cashed up companies is also likely to be a positive for shares this year. So notwithstanding usual volatility, this points to a positive backdrop for shares.

Sovereign bonds will be helped by Japanese monetary reflation and any further correction in shares. However, they remain fundamentally vulnerable as the improving global, and Australian, growth outlook will likely see bond yields move higher over the year ahead resulting in capital losses for investors in them.

The renewed softness in commodity prices is acting as a strong offset to the impact of monetary printing in the US and Japan on the $A. As a result the $A looks like remaining stuck in the $US1.02 to $US1.06 range that has prevailed since July last year, with the risks on the downside.

Key points

After doubling in value against the $US over the last decade, the best is likely behind for the Australian dollar.

The commodity price boom is starting to fade in response to a moderation in Chinese growth as commodity supply starts to increase, the impact of quantitative easing in the US is being blunted by rate cuts in Australia with the prospect of more to come and the rise in the $A has exposed the high cost base of the Australian economy.

While further gains are likely in the value of the $A against the Yen (to around ¥110 by year end), the $A is likely to remain range bound this year against the $US with the risks on the downside, particularly over the next few years.

For Australian based investors, this means less need to hedge global exposures back to Australian dollars.

Introduction

The last decade saw a huge surge in commodity prices on the back of rapid growth in demand, as China industrialised, and as the supply of commodities was constrained. This hugely benefitted assets geared to commodity prices including emerging market shares in South America, resources companies and of course the Australian dollar which were all star performers. 

For the $A it meant a rise from a low in 2001 of $US0.48 to a high in 2011 of $US1.10 and a 70 per cent gain on a trade weighted basis. However, since 2011 the outlook for the Australian dollar has become more confused: commodity prices are high but have been sliding recently; monetary easing (particularly money printing) in the US and Japan is positive for the $A but has been blunted slightly by rate cuts in Australia and the chance of more to come; safe haven flows from central banks looking to diversify have helped support the $A but I get the feeling that they are late to the party and some would question Australia’s safe haven status; and the damage to Australia’s international competitiveness has become more evident.

Purchasing power parity

One of most common ways to value a currency is to compare relative prices. According to purchasing power parity theory, exchange rates should equilibrate the price of a basket of goods and services across countries, such that 100 Australian dollars would buy the same basket of goods in other countries as it does in Australia when translated into their currencies. A rough guide to this is shown in the chart below which shows the $A/$US rate against where it would be if the rate had moved to equilibrate relative consumer price levels between the US and Australia over the last 110 years or so.



Quite clearly purchasing power parity doesn’t work for extended periods with huge divergences evident at various points in time when the $A was fixed such as in the 1950s and 1960s and/or when other factors come into play. In fact, the $A as has gone from being dramatically undervalued in 2001 to similarly overvalued now on this measure now. However, it does provide a guide to where exchange rates are headed over very long periods of time. Such an approach has been popularised over many years by The Economist magazine’s Big Mac index.

An obvious problem with such measures is that they can give different results depending on the estimation period and the types of prices used. The relative consumer price measures used in the chart above would suggest that the $A is currently around 35 per cent overvalued, whereas according to the Big Mac index it is only about 12 per cent overvalued.

However, the broad impression is that the $A is overvalued on a purchasing power parity basis. This is consistent with current perception and news stories recently appearing about how Australia has gone from being a relatively cheap country a decade ago when the $A was much lower to an expensive country today. This suggests the $A could face downward pressure if some of the factors that have been holding it up reverse.

The major factors on this front are commodity prices, relative monetary policies and perceptions of Australia as a safe haven.

Commodity price boom starts to fray

Over the last forty odd years swings in commodity prices have been perhaps the main driver of the big picture swings in the $A. Rising commodity prices helped the $A into the mid 1970s, falling commodities correlated with a fall in the $A until around 2000 and over the last decade rising commodity prices explained the huge surge in the $A. The logic behind this is simple. 70 per cent or so of Australia’s exports are commodities and moves in commodity prices are key drivers of our export earnings. However, the commodity price story is starting to fray at the edges. The pattern for raw material prices over the past century or so has seen roughly a 10 year secular or long term upswing followed by a 10 to 20 year secular bear market, which can sometimes just be a move to the side.



The upswing is normally driven by a surge in global demand for commodities after a period of mining underinvestment. The downswings come when the pace of demand slows but the supply of commodities picks up in lagged response to the price upswing. After a 12 year bull run since 2000 this pattern would suggest that the commodity price boom may be at or near its end. Specifically, growth in China remains strong but it has slowed a bit (from 10 per cent plus growth to 7 to 8 per cent growth) just at the time when the supply of commodities is about to surge after record levels of mining investment globally. And a basing in the $US is also not helping: the falling $US helped boost commodity prices from around 2002 as they tend to be priced in US dollars. Now with the $US looking a bit stronger this affect is fading.

The chart below shows an index of prices for industrial metals such as copper, zinc, lead, etc, against the $A and suggest that they have gone from a positive influence, leading on the way up last decade, to potentially a negative.



Relative monetary policies

Quantitative easing in the US, Japan and elsewhere should be positive for the $A as it means an increase in the supply of US dollars, Yen, etc, relative to the supply of Australian dollars. And indeed it has been. Various rounds of QE in the US have been associated with $A strengthening, and the heightened efforts by Japan on this front only add to this pressure and have helped to push the $A up 25 per cent over the last six months and the trade weighted value for the Australian dollar up to its highest since early 1985. Our assessment remains that as the value of the Yen continues to fall in response to aggressive monetary stimulus from the Bank of Japan, the $A will see further gains against the Yen, taking it to around ¥110 by year end.

However, against the $US the impact of quantitative easing may be starting to wain a bit. As can be seen in the chart below, while the first two rounds of quantitative easing in the US were associated with strong gains in the value of the Australian dollar, QE3 has just seen the $A continue to track sideways in the same $US1.02 to $US1.06 range it has been in since last July.



This may be partly because QE3 has not seen a rise in commodity prices. But the main reason that the impact of quantitative easing may be starting to wain for the $A is that the interest rate differential in favour of Australia has fallen dramatically as the RBA has cut rates. With the Australian economy still struggling this may have further to go.

What about central bank buying and safe haven demand?

Buying by central banks looking to diversify their foreign exchange reserves and by investors allocating to a diminishing pool of safe AAA rated countries has no doubt played a role in boosting the $A. However, one can’t help but think that after a decade long bull market in the $A (or bear market in the $US) central banks are late to the $A party. And with the fading of the mining boom and the Government struggling to bring the budget back into surplus it has to be recognised that Australia is not without risk. So my feeling is that this source of support for the $A will start to fade.

Implications for investors

The bottom line is the best has likely been seen for the $A and the risks are on the downside over the years ahead as the commodity price boom fades, allowing the $A to correct some of its overvaluation on a purchasing power parity basis.

Currency is very important for investors as soon as they invest in foreign countries. Most global investments offered by fund managers come with a choice of being unhedged, ie exposed to fluctuations in the value of foreign currencies, or hedged, where the value of the investment is locked back into Australian dollars.

Over the last decade unhedged international shares returned 2.7 per cent pa whereas hedged international shares gained 9.5 per cent pa. The difference largely reflects the rise in the $A (+4.4  per cent pa), but also the interest rate differential between Australia and the rest of the world (+2.4 per cent pa). But if the $A is likely to go sideways or down there is much less need to hedge and with the interest rate gap between Australia and the rest of the world narrowing there is much less incentive to hedge.

In other words the reward versus risk equation in favour of the $A is diminishing so it makes more sense for investors now to consider taking an exposure to foreign currencies (ideally with the exception of the Yen) beyond the Australian dollar and obtaining the diversification benefits they provide. 

Key events of the past week and implications

Share markets rebounded over the past week continuing the volatile trading seen through much of April. While some economic indicators disappointed, earnings results were generally positive in the US and expectations of interest rate cuts provided a boost in Europe and Australia. A return of capital to investors including via dividends was a major theme with Apple and Woodside announcing big plans on this front.

The US earnings reporting season is now nearly half way through. The good news has been that of the 237 S&P 500 companies to have reported so far 73 per cent have exceeded expectations for profits. Against this though only 44 per cent have exceeded revenue expectations

Preliminary business conditions PMIs for April for the US, Europe and China were all on the soft side, boosting fears of another mid year growth scare much as we have seen in each of the last three years but at this stage the indicators aren’t weak enough to be too concerned and could be just normal statistical noise.

Italian and Spanish bond yields fell sharply with Italian two year bond yields falling to a record low, at least for the past 20 years. This was helped by the re-election of the existing President in Italy who in turn designated Enrico Letta, a moderate from the Democratic Party, to form a new government. But more broadly the settling of bond yields in Spain and Italy adds to confidence that the euro financial crisis is gradually fading.

In Australia, softer than expected inflation coming on the back of a softer tone to recent global and Australian economic data along with weak commodity prices has strengthened the case for another rate cut, possibly as early as next month.

Major global economic events and implications

Economic data released in the US continued to provide evidence of a bit of a soft patch in growth going into the June quarter. The Markit business conditions PMI fell to 52 in April from 54.6 in March consistent with softer readings from various regional manufacturing surveys and durable goods orders were weaker than expected in March. Against this though: the level of the PMI is still consistent with okay growth; the durable goods report is not as bad as it looks given the sharp rise reported in January and given that core durable goods orders actually rose; the broad trend in housing indicators including home sales, prices and mortgage applications is up; weekly retail sales rose; and a solid fall in weekly jobless claims suggests the labour market is not slowing. Overall it seems that US growth may be slipping back to 2 per cent or so growth, ie, not as good as it could be but not bad and at least it reduces talk of the Fed winding back its stimulus just yet.

Eurozone flash business conditions PMIs for April were a little bit worse than expected, coming in up slightly for services compared to March but down slightly for manufacturing and unchanged at a composite level. They are at levels consistent with recession, although they remain up from last year’s lows. The main disappointment was in Germany which saw falls. The ECB’s bank lending survey showed an improved willingness to lend but weak demand for credit. Meanwhile, Spain’s unemployment rate rose to 27.2 per cent, with youth unemployment now 57.2 per cent, highlighting the need to do more to boost growth.

In Japan, continuing consumer price deflation highlights the need for the BoJ’s stepped up reflation efforts.

In China the HSBC flash manufacturing conditions PMI for April disappointingly slipped. However, at 50.5 it is still well up from last year’s lows and remains at a level consistent with Chinese growth of around 7.5 to 8 per cent.

Good news in Asia was provided by Korea which saw its strongest pace of quarterly GDP growth in two years helped by investment and exports. Given low inflation and the strong Won a further interest rate cut is likely, but the improvement in growth is a positive sign.

Australian economic events and implications

Lower than expected inflation in the March quarter, coming on the back of a softer tone in recent global and Australian economic data have left the door wide open for another RBA interest rate cut to help shore up the economy as the mining investment boom slows. While health and education costs saw their normal seasonal increase this was more than offset by falls in prices for a range of items including food, clothing, household equipment and cars. As a result, the RBA’s preferred measures of underlying inflation are running at an average 2.4 per cent year on year and inflation excluding the effect of carbon pricing is probably close to 2 per cent. To be sure the strong $A is clearly playing a dampening role with tradeables inflation running at -0.2 per cent year on year but non-tradeables inflation at 4.2 per cent. However, it should be noted that the strength in non-tradeables inflation is distorted upwards by strong rises in prices for things like health (up 6.1 per cent year on year), education (up 5.8 per cent), utilities (up 13.5 per cent) and urban transport fares (up 4.5 per cent) all of which are heavily influenced by government decisions as opposed to market forces.

The bottom line is that inflation is not a problem and given the patchy and tentative nature of the response to interest rate cuts so far and the impending mining investment slowdown, the RBA should act on its easing bias and cut interest rates another 0.25 per cent. This could occur as early as next month, but the June meeting may be more likely.

Major market moves

Most share markets had solid gains over the past week with reasonable earnings results helping US shares, and talk of rate cuts helping European and Australian shares.

Commodity prices had a bounce after the sharp falls of the previous week. The bounce in the gold price could take it back to the $1500-$1550/ounce breakdown zone, before the downtrend likely resumes.

The $A rose modestly despite reinvigorated RBA interest rate cut expectations, but is still just bouncing around in the same $US1.02 to $US1.06 range it has been in since last July.

What to watch over the next week?

In the US, the focus will be on the Fed’s monetary policy meeting on Wednesday. While there may be more debate about when to start slowing quantitative easing, it’s likely that the recent round of softer economic activity data and inflation in the US will have left the doves at the Fed in the ascendancy. So we don’t expect the Fed to foreshadow any impending changes in its $US85bn a month quantitative easing program.  On the data front the main focus will be on the ISM manufacturing conditions index (Wednesday) which may have drifted fractionally lower in April and payrolls (Friday) which are expected to show a 160,000 jobs gain for April after just 88,000 in March. Unemployment is expected to remain at 7.6 per cent. In other data, expect a 1 per cent gain in pending home sales, a 0.8 per cent gain in house prices and a slight rise in consumer confidence (all Tuesday). Trade data and the non-manufacturing ISM index will also be released and March quarter earnings results will continue to flow.

Thursday is likely to see the ECB cut its official interest rate from 0.75 per cent to 0.5 per cent. ECB officials have indicated a willingness to act and recent data has been worse than expected. Eurozone economic confidence measures for April (Monday) are likely to have remained subdued, but still in the context of a gradual rising trend.

In China, the official manufacturing conditions PMI (Wednesday) and the final HSBC PMI (Thursday) are expected to confirm the slight lost of momentum in April already seen in the flash HSBC PMI.

In Australia, expect growth in private credit (Tuesday) to have remained soft in March, a modest further rise in April house prices (Wednesday), a rebound in new home sales (Wednesday) after a set back in February and a 1.5 per cent gain in building approvals (Thursday). Producer price inflation (Friday) is likely to be benign. 

Outlook for markets

While shares remain at risk of a resumption of the correction as we come into the seasonally weak period around mid year, as we have seen recently any set backs in shares are likely to remain mild and the broad trend is likely to remain up. Shares are still far from expensive, the gradually strengthening global growth outlook led by the US points to stronger profits ahead and investors are likely to increasingly switch from low yielding cash and bonds into shares as confidence continues to build ensuring solid “buy on the dips” demand. A pick up in mergers and buybacks from cashed up lowly geared companies is also likely to be a big positive for shares this year. So notwithstanding the usual bumps along the way, this all adds up to a positive backdrop for share markets.

Sovereign bonds will be helped by Japanese monetary reflation and any further correction in shares. However, they remain fundamentally vulnerable as the improving global, and Australian, growth outlook will likely see bond yields move higher over the year ahead resulting in capital losses for investors in them.
The renewed softness in commodity prices is acting as a strong offset to the impact of monetary printing in the US and Japan on the $A. As a result the $A looks like remaining stuck in the $US1.02 to $US1.06 range that has prevailed since July last year.

March quarter inflation came in at just 0.4 per cent, which is less than the 0.7 per cent rise that the consensus of economists had expected and left annual inflation at 2.5 per cent which is right in the middle of the RBA's 2-3 per cent target range.
 


While health and education costs saw their normal March quarter seasonal surge and electricity costs rose another 2.4 per cent (bringing their annual increase to a ridiculous 17.1 per cent), this was more than offset by falls in prices for food, clothing, furnishings and household equipment, cars, electronic goods and holiday travel.
 

As a result underlying inflation is running at just 2.4 per cent year on year according to the average of the RBA's mean and median inflation measures and annual price increases in the market sector of the economy are running at just 1.3 per cent year on year.
 


Quite clearly the strong $A is still playing a role in holding inflation down, but the weakness in prices for things like furniture and household appliances also tells us that underlying demand in the economy remains weak and that companies lack pricing power.
 


Over the past few weeks we have seen a softer tone to global economic data, sharp falls in commodity prices which will put more downwards pressure on Australia's terms of trade and national income and mixed economic data in Australia. While past interest rate cuts are getting some traction the economy remains vulnerable and in need of more support ahead of the slowdown in mining investment that will occur this year. The weaker than expected inflation readings for the March quarter tells us that inflation is not an issue and is certainly not a barrier to further easing. It should see the RBA act on its easing bias, and cut interest rates another 0.25 per cent, hopefully at its May Board meeting.

Key events of the past week and implications

China got the past week off to a bad start with growth coming in at 7.7 per cent in the March quarter against expectations for 8 per cent growth and industrial production and fixed asset investment also coming in a bit weaker than expected. What’s more, continued gains in home prices with virtually all cities seeing price gains in March and average property price growth rising to 3.6 per cent year on year have raised the prospect of more property tightening measures although it may be the case that the measures already announced have yet to impact.

The weakness in March quarter GDP growth in China appears to at least partly reflect a failure to allow for the leap year a year ago and also the public sector frugality campaign weighing on consumption. And the difference between 7.7 per cent growth and 8 per cent growth is not really that much. However, many appear to have been expecting a deep V recovery in China and those misplaced expectations are now being dashed which may partly explain recent sharp falls in commodity prices.

More generally it’s becoming increasingly clear that the generalised commodity price boom that dominated last decade is over as growth in China, India and Brazil looks like running at levels below the averages seen last decade at a time when growth in advanced countries remains constrained and the supply of commodities is picking up. This means that some of last decade’s relative investment winners, such as commodities, emerging markets in South America, resources stocks and the $A may not fare as well this decade. Rather global shares led by a resurgent US and Japan and financial shares look like they will be better placed, at least relatively. Asia and Asian shares will also benefit relatively if commodity prices are weaker.

Why the sharp fall in the gold price? The past week has seen further falls in the gold price. There are several reasons leaving it down by around 27 per cent from its all time high of $US1900 an ounce reached in September 2011. Firstly, just over a week ago it broke through technical support at around the $US1550 an ounce level, which triggered technical selling. Second, and more fundamentally there is no sign of the hyperinflation or $US collapse that “gold bugs” had expected to follow quantitative easing in the US. Thirdly, the financial crisis in Europe appears to have settled down a bit further reducing safe haven demand. And finally, gold is also part of the commodity complex that has been under pressure since 2011.

While there was much talk about competitive currency devaluations following Japan’s reinvigorated reflation efforts and in the run up to the G20 finance ministers meeting the latter looks like simply reiterating its commitment to refrain from competitive devaluations. It's hard to expect anything else as after all Japan is simply trying to get its economy moving again which is something the world has been imploring it to do for years and since the last G20 finance ministers meeting Japan has refrained from making comments about the Yen.

The IMF’s downwards revision to its forecast for world growth this year to 3.3 per cent from 3.5 per cent didn’t really say anything new and just brings it into line with our own view.

Major global economic events and implications

Economic data released in the US was messy. While there was a further slight fall in the NAHB home builders conditions survey, housing starts were much stronger than expected and weekly mortgage applications continue to rise. While industrial production rose more than expected in March, manufacturing conditions deteriorated slightly in the New York and Philadelphia regions and leading indicators fell after six months of gains. Jobless claims rose 4000, but this followed a 40,000 fall the previous week. Meanwhile, the Fed’s Beige book characterised the economy as expanding at a moderate pace, which on balance seems about right. Finally, there is still no sign of the much feared inflation surge on the back of quantitative easing: in fact headline inflation fell to 1.5 per cent in March and core inflation was just 1.9 per cent.

The US earnings reporting season is good at a headline level with 74 per cent of the 90 S&P 500 companies to have reported so far exceeding expectations, but only 50 per cent have exceeded revenue expectations and guidance has been soft.

Eurozone data remains weak with falls in construction activity and imports and core inflation of just 1.5 per cent. Interestingly even the German representative on the ECB suggested another rate cut is possible. Hopefully soon.

Indian inflation surprise on the downside, providing more scope for rate cuts from the Reserve Bank of India.

Brazil’s 0.25 per cent interest rate hike, which took its official interest rate to 7.5 per cent, doesn’t signal the start of a global tightening cycle. Brazil’s inflation rate is 6.4 per cent and trending up whereas global inflation is running around 2 per cent and falling at a time of sub par global growth and falling commodity prices.

Australian economic events and implications

In Australia, housing finance picked up in February leaving in place a modest rising trend. The Westpac leading index also rose 0.6 per cent month on month in February, but car sales surprisingly fell. Despite its easing bias the minutes from the RBA’s last board meeting indicated it retained a wait and see approach. However, a softer run of global and Australian data over the last few weeks could motivate it to act on its easing in the next few months.

Major market moves

Most major share markets fell on the back of softer growth in China and mixed economic and earnings news in the US. Resources shares led the falls in Australia but with high yield and defensive stocks holding up reasonably well. Surprisingly, despite setting off the latest bout of weakness, Chinese shares rose over the past week.

Commodity prices fell sharply on the back of softer than expected Chinese economic growth. The continuing slump in the gold price led the declines 

The fall in commodity prices saw the $A coming under pressure, although it’s still stuck in the $US1.02 to $US1.06 range it has been in since last July.

Bonds rallied on safe haven demand, even in Spain and Italy, making the latest bout of risk aversion seem very different to the Eurozone driven fear outbreaks of the last three years.

What to watch over the next week?

In the US, expect continuing gains in existing home sales (Monday), new home sales (Tuesday) and house prices (Tuesday), a slight bounce in core durable goods orders (Wednesday) after a fall in February and March quarter GDP data to show growth of around 3 per cent annualised. The flash Markit business conditions PMI (Tuesday) is likely to have fallen slightly, but remaining solid. Consumer sentiment data will also be watched for a bounce back on Friday. March quarter earnings results will continue to flow.

In Europe, the focus will be on preliminary business conditions PMIs for April (Tuesday) to see if there is any improvement after falls in the previous few months. UK March quarter GDP data will also be released.

In China, the flash HSBC manufacturing conditions PMI index (Tuesday) will be watched closely to see if it maintains the improvement seen in March, particularly after the softer than expected March quarter growth.

Japanese inflation data (Friday) is expected to show continued consumer price deflation.

In Australia, the focus will be on March quarter inflation data due to be released Wednesday. We expect that the combination of constrained demand and downwards pressure on import prices from the strong $A will have offset seasonal rises in health and education costs to ensure that inflation has remained benign. As a result we expect the CPI to have increased by 0.6 per cent quarter on quarter or 2.7 per cent year on year and underlying inflation to have risen 0.5 per cent in the quarter or 2.4 per cent year on year. Continued benign inflation will leave the door wide open for further RBA rate cuts. In fact an outcome of 0.4 per cent or below for underlying inflation could bring forward a rate cut to the May meeting given the soft run of global and Australian data we have seen lately.    

Outlook for markets

Shares remain at risk of a further correction as we come into the seasonally weak period around mid year. China, Europe, a further soft patch in US economic growth, North Korea, bird flu and continued softness in the non-mining parts of the Australian economy are all risk factors. However, any set backs in shares are likely to remain mild and the broad trend is likely to remain up. Shares are still far from expensive, the strengthening growth outlook led by the US points to stronger profits ahead and investors are likely to increasingly switch from low yielding cash and bonds into shares as confidence continues to build ensuring solid “buy on the dips” demand. A pick up in mergers and activity from cashed up lowly geared companies is also likely to be a big positive for shares this year. So notwithstanding the usual bumps along the way, this all adds up to a positive backdrop for share markets.

Sovereign bonds will be helped by Japanese monetary reflation and any further correction in shares. However, they remain fundamentally vulnerable as the improving global, and Australian, growth outlook will likely see bond yields move higher over the year ahead resulting in capital losses for investors in them.

The softness in commodity prices is acting as a strong offset to the impact of monetary printing in the US and Japan on the $A. As a result the $A looks like remaining range bound, but with a bit of a downwards bias into mid year if shares and commodities continue to correct.

Four investment market realities: there is always a cycle; it’s a mad, mad, mad world; starting point valuations matter a lot for returns; and the power of compound interest. 

Keys to successful investing: know yourself; seek advice; invest for the long term; diversify; turn down the noise; avoid short termism; focus on investments offering sustainable cash flow; recognise there is no free lunch; buy low, sell high; don’t fret the small stuff; don’t over rely on experts; recognise the aim is to make money, not to be right; beware the crowd at extremes; and if you have the right strategy, never despair.

Introduction

The last five years have been difficult for investors. The GFC and its aftermath of private sector deleveraging, public sector debt problems and household, business and investor caution have led to poor and volatile returns from shares. It seems we are constantly on edge with prognostications of doom getting constant replay with every twitch in markets. Just like The Rolling Stones single last year "all I hear is doom and gloom". Methods of investing that seemed to work well for years have seemingly broken down, or at least many have lost faith in them.

So what should investors do? The following is a list of things that are critical for investors to know and do. Obviously when it comes to investing everything is debatable to some degree, but I hope you find this list to be of value. First, some investment market realities.

Investment market realities

There are four key things to bear in mind about investment markets.

There is always a cycle. The historical experience of investment markets - be they bonds, shares, property, infrastructure, whatever - constantly reminds us they go through cyclical phases of good times and bad. Some are short term, such as those that relate to the 3 to 5 year business cycle. Some are longer, such as the secular swings seen over ten to twenty year periods in shares. But all eventually contain the seeds of their own reversal. Ultimately there is no such thing as new eras, new paradigms and new normals. Such jingles - as wheeled out through the tech boom and more recently through the post GFC gloom - make good marketing spin. But markets tell us there is nothing new under the sun. In fact, when someone tells you about a new whatever, it’s probably already run its course.

It’s a mad, mad, mad world. It’s well known that investment markets are prone to bouts of irrationality which take them well away from levels that may be justified on a long term basis. This is rooted in investor psychology, which is far from rational and flows from a range of behavioural biases investors suffer from. These include the tendency to overreact to the current state of the world, the tendency to look for evidence that confirms your views, overconfidence (particularly amongst males!), an erroneous feeling of safety in numbers and a lower tolerance for losses than gains. While shifts in fundamentals may be at the core of cyclical swings in markets, they are usually magnified by investor psychology if enough people suffer from the same irrational biases at the same time. This in turn creates opportunities for investors who can take a longer term approach and look through extremes of market madness either on the upside or the downside.

Starting point valuations matter, a lot. It stands to reason that the cheaper you buy an asset the higher its prospective return will be and vice versa. Good guides to this are price to earnings ratios (the lower the better) and yields, ie the ratio of dividends, rents or interest payments to the value of the asset (the higher the better). But while this seems obvious, the reality is that many find it easier to buy after shares have had a strong run because confidence is high, and sell when they have had a strong fall because confidence is low.

The power of compound interest. Although the average annual return on Australian shares (11.9% pa) is just double that on Australian bonds (6% pa) over the last 113 years, $1 invested in bonds in 1900 would today be worth $704 whereas $1 invested in shares would now be worth $350,356. Yes there were lots of rough periods along the way for shares just like the last few years (eg the 1930s, 1970s, 1987-96), but the impact of compounding at a higher long term return is huge over long periods of time.

What should investors do?

So given these market realities what should investors do?

Know yourself. Now I know we all like to think that everyone is mad except you and me, but the reality is that we all suffer from the psychological weaknesses referred to earlier. But smart investors have an awareness of their weaknesses and seek to manage them. One way to do this is to take a long term approach to investing. But this is also about knowing what you want to do. If you want to take a day to day role in managing your investments then regular trading and/or a self managed super fund (SMSF)  may work, but you need to recognise that investing is not easy. If you are going to trade or run your own investments with, for example, an SMSF, then recognise that this requires a lot of effort to get right and will need a rigorous process. If you don't have the time and would rather do other things like sailing, working at your day job, or having fun with the kids then it may be best to use managed funds

Seek advice. Flowing on from the last point, given the psychological traps we fall into as investors and the fact it is not easy, a good approach is to simply seek the advice of a coach such as a financial adviser, in much the same way you might use a specialist to look after other aspects of your life like fixing the plumbing, your medical needs or helping you get fit. Even I’ve got one.

Invest for the long term. In the 1970s a US investment professional named Charles Ellis observed that for most of us investing is a loser’s game. A loser’s game is a game where bad play by the loser determines the victor. Amateur tennis is an example, where the trick is to avoid stupid mistakes and thereby win by not losing. The best way to avoid losing at investments is to invest for the long term. Get a long term plan that suits your level of wealth, age, tolerance of volatility, etc, and stick to it. This may involve a high exposure to shares and property when you are young or a focus on funds targeting a particular return outcome or level of cash lows when you are close to or in retirement.

Diversify. This is another no brainer. Don’t put all your eggs in one basket as the old saying goes. But plenty do. It seems that common approaches in SMSF funds are to have one or two high yielding and popular shares and a term deposit. This could potentially leave an investor very exposed to either a very low return or if something goes wrong in the high yield share they are invested in.

Turn down the noise. Once you have worked out a strategy that is right for you, it’s important to turn down the noise on the information flow surrounding investment markets. The past couple of decades have seen an explosion in the volume and ease of access to information surrounding economies, investment markets and individual investments. This is great in a way. But there is little evidence that it’s helping investors make better decisions and hence earn better returns. We seem to lurch from worrying about one crisis after another. Just think about this year: already we have seen a long list of worries starting with the US fiscal cliff, then worries the Fed may exit monetary easing too early, then the Italian election, the US budget sequester, Cyprus, bird flu, North Korea, China, etc. In fact the combination of too much information has turned investing into a daily soap opera - as we lurch from worrying about one thing after another. You'd be better off turning the financial soap opera off and watching The Days of Our Lives or Home and Away!

Avoid short termism. Flowing from the last point, the ease with which information on returns can be accessed is likely reinforcing shorter and shorter investment horizons for investors. An end result of taking a shorter and shorter investment horizon is an ever higher allocation to perceived safe assets such as bonds and cash/term deposits. This may have been fine through the GFC and its aftermath, but will ultimately mean locking into ever lower returns given the low yields now prevailing for bonds and bank deposits. Well might you say, at least I won't lose money on term deposits. But the point is that low yielding deposits will lock in low returns making it hard to meet long term financial goals.

Focus on investments offering sustainable cash flow. This is very important. There’s been lots of investments over the decades that have been sold on promises of high returns or low risk but were underpinned by hope based on hot air (eg, many dot com stocks in the 1990s, resources stocks periodically) or financial alchemy where rubbish was supposedly turned into AAA yield generators (the sub-prime CDOs of last decade). But the key is that if it looks dodgy, hard to understand or has to be based on obscure valuation measures to stack up then it’s best to stay away. By contrast, assets that generate sustainable cash flows (profits, rents, interest payments) and don't rely on excessive gearing or financial engineering are more likely to deliver.

Recognise there is no free lunch. Related to the last point, if an investment looks too good to be true in terms of the return and/or riskiness on offer, then it probably is.

Buy low, sell high. If you do have to trade or move your investments around then remember to buy when markets are down and sell when they are up. This seems like a no brainer, but most people do the opposite. There’s an old saying in investment markets: “flows follow returns”! In other words inflows are strongest after periods of strong returns and outflows are strongest after weak returns. It should be the other way around.

Don't fret the small stuff. It’s easy to spend lots of time worrying about an individual share investment or whether to use this fund manager over that fund manager. But the reality is that the key driver of your return is the assets (shares, bonds, cash, property, infrastructure, listed/unlisted, onshore/offshore, hedged/unhedged) that you are exposed to. In other words asset allocation is paramount and it’s very hard to avoid this.

Don't over rely on expert forecasts. The well known economist J.K. Galbraith once observed that there are two types of economists "those who don't know and those who know they don't know". While that may be a bit harsh - you might say I would say that being an economist - the reality is that point forecasts as to where the share market will be at a particular time or as to its short term return have a dismal track record. Hence all the bad jokes about economists! Good experts will help illuminate and point you in the right direction, but this is what they should be used for.

Recognise the aim is to make money, not to be right. Many investors miss this. Lots of people have lost money doggedly following some assessment that they were sure would be right. But the key is to recognise that getting some view right is not what it’s about. What it’s about is making money. Don’t get hung up on extreme views about where markets are going.

Beware the crowd at extremes. For periods of time the crowd can be right and safety in numbers provides a degree of comfort. However, at extremes the crowd is invariably wrong. Whether it’s lemmings running off a cliff, or investors piling into Japanese shares at the end of the 1980s, Asian shares into the mid 1990s, IT stocks in the late 1990s, US housing and dodgy credit in the mid 2000s. The problem with crowds is that eventually everyone who wants to buy will do so and then the only way is down (and vice versa during crowd panics). As Warren Buffet once said the key is to "be fearful when others are greedy and greedy when others are fearful".

Finally, if you have the right long term strategy, never despair. Things normally turn out ok eventually. Fortunes are invariably made out of tough times.