The Experts

Shane Oliver
Financial markets
+ About Shane Oliver

Shane Oliver is head of investment strategy at chief economist at AMP Capital.

Crash calls for shares

Thursday, April 17, 2014

by Shane Oliver

  • Expect more volatility in shares this year as earnings take over as a key driver and Fed rate hikes gets closer.
  • While some are suggesting a crash is in on the cards, it’s hard to see as shares are not expensive, the global economic cycle is gradually improving, monetary
  • conditions are easy and we lack the euphoria that goes with major market tops.
  • As such, the trend in share markets is likely to remain up.


The past few weeks has seen several predictions of a share market crash by some perennial high profile bears. The broad claim is that share markets – namely US shares – have disconnected from fundamentals and that the Fed is to blame for a poor recovery and/or doesn’t know what it is doing. And of course this is all against the background of talk of some sort of “demographic cliff” that will contribute to a “great crash ahead.” This note takes a look at the risks.

A tougher, more volatile year for shares...

Our view is that this year will see more constrained returns from shares with increased volatility – including the likelihood of a 10-15% correction along the way – than we saw in 2012 and 2013. Shares are no longer dirt cheap, they are more dependent on earnings for gains, the prospect of Fed rate hikes are starting to loom and as usual there are numerous other “worries” that could give us that volatility: China, Ukraine, etc. And of course, the seasonal pattern in shares often sees corrections occur around mid-year.

...but the trend is likely to remain up

However, it’s too early in the economic and investment cycle to expect a new bear market or crash.* A typical cyclical bull market goes through three phases.

  • Phase 1 is driven by an unwinding of very cheap valuations helped by easy monetary conditions as smart investors start to snap up undervalued shares as investor sentiment moves from pessimism to scepticism.
  • Phase 2 is driven by strengthening profits. This is the part of the cycle where optimism starts to creep in.
  • Phase 3 sees euphoria with investors backing their bullishness by pushing cash flows into shares to extremes. The combination of tightening monetary conditions, overvaluation and investor euphoria then sets the scene for a new bear market.

At present we are likely in Phase 2. Some optimism regarding the economic outlook and share markets has returned but we don’t see the signs of euphoria that become evident in Phase 3 as precursors to a new bear market:

Valuations aren’t dirt cheap, but they’re far from expensive. Price to earnings ratios are only at long term average levels of 14.4 times in Australia (average of 14.1 since 1992) and 15.1 in the US (average of 15.9). Some tech stocks have rich valuations, but the tech heavy Nasdaq trades on a price to earnings ratio that is one third of the tech boom peak and the broader US share market on 15x forward earnings is way below its tech boom peak of 24. So it’s hard to see a tech driven crash.

*We are defining a bear market as a 20% plus fall in share markets that takes more than 12 months to recover its losses.

The gap between earnings yields & bond yields, a proxy for the excess return shares offer, remains above pre GFC norms. This is reflected in our valuation indicators which show markets slightly cheap. See the next chart.

Global economic indicators have been gradually heading higher which should be supportive of earnings growth. This is indicated in business conditions PMIs (next chart).

There are now more indicators pointing upwards in Australia and profits are now helping share market gains, as evident in the following chart that breaks down annual changes in the All Ords into that driven by profits and that due to changes in the ratio of share prices to earnings.

Inflation remains benign and monetary policy easy.

Ample spare capacity has meant that global inflation remains low. As a result even though the Fed is slowing its quantitative easing program, interest rates will likely remain low for some time.

Finally, there is no sign of the investor exuberance seen at major market tops. Short term measures of investor confidence in the US are around neutral levels. See next chart. The mountain of money that built up in bond funds in the US has yet to fully reverse. In Australia, investors still prefer bank deposits over shares and the share of cash in the super system is double pre GFC levels.

Of course there could be a left field shock – an escalation in Ukraine, a policy mistake in China or the Fed. But if you worry too much about such things you would never invest.

Is the Fed to blame?

One thing I find many of the perennial bears seem to have in common is a hatred of the Fed. They argue the Fed should have stood by and done nothing through the Global Financial Crisis – as advocated by whacky disciples of Austrian economics – to allow a full “cleansing” of the economy and that it is in some way causing the slow recovery seen over the last few years. There are several points worth noting on this.

First, just standing by and doing nothing through the GFC could have led to a re-run of the Great Depression which left an immeasurable human toll and scared a generation, many of whom were innocent bystanders during the excesses of the 1920s. Allowing the same so called “cleansing” to happen needlessly again after the GFC would have been immoral and pointless.

Second, while the Fed’s actions have not led to a boom in the US it has at least bought time to allow the economy to heal – much like keeping a coma patient on life support. The slow recovery is not the Fed’s fault but rather the desire to reduce debt and caution seen post the GFC.

Third, while the Fed’s quantitative easing program has helped support the US share market the main driver has been a surge in US company profits to record levels. In other words the rise in US shares has not detached from reality but reflects fundamental improvement. See the next chart.

Fourth, the Fed’s move to wind down or taper its quantitative easing program and talk of eventual rate hikes is a sign of success. In other words, extreme monetary easing has done its job and so can now start to be withdrawn. This is a good thing, not bad. And of course even when US interest rates do start going up next year it will be a long time before they reach levels that seriously threaten economic growth.

Finally, misinterpretations of Fed communications are inevitable and are not a sign that it does not know what it is doing. The Fed under Bernanke and Yellen have made it pretty clear what they are looking at and in this context their policy moves have made sense.

What about the demographic cliff?

Some have long tried to link demographic trends with share markets, but it is very messy. The basic thesis is that as the baby boomer wave moves through the population it will stop being a big positive for shares (as they either run-down savings or consume less depending on which demographic thesis you follow) and that this should start around 2009-10.

This approach predicted a big rally through the 1990s and 2000s and got it completely right in the former but disastrously wrong last decade in relation to US shares.

Given shares never got anywhere near the levels they were supposed to reach last decade (the biggest advocate of the demographic model had the Dow Jones going to 40,000 through the 2000s) it’s hard to see why they will now crash.

Concluding comments

While shares might see a brief 10-15% correction at some point this year, a new bear market is unlikely and as such returns should remain favourable through the year as a whole. The time to get really worried is when the topic of conversation with cabbies and at parties is about what a great investment shares are, but I have yet to find a cabbie talking about shares in recent years and at a party I attended last weekend the only person who mentioned shares told me he had just switched all his exposure to cash!

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Australian housing to the rescue – but is it too hot?

Friday, April 04, 2014

by Shane Oliver

Australian housing has seen a normal response to lower interest rates. House prices are up and a building boom is on the way. This will help the economy rebalance.

The home buyer market is a long way from the bubble conditions of ten years ago, but the risk of a bubble is rising. Further gains in house prices are likely this year.

But gains are likely to slow as the RBA steps up its warnings about excessively rising house prices.

The housing recovery tells us the next move in interest rates is up, probably from around September/October.


Two years ago some (mainly foreign) commentators were convinced Australian housing was in a bubble that was in the process of collapsing as the China driven mining boom faded. Instead, lower interest rates have led to the usual response of rising house prices & approvals for new homes.

But has it gone too far, taking us into another bubble?

Great news for the economy

While it took a bit longer than usual, the housing sector has responded just as it should to lower rates:

  • lower interest rates led to improved housing affordability;
  • which has led to increased home buyer demand (housing finance is up 23% year on year and new home sales are up 40% from their September 2012 low);
  • which in turn has led to higher house prices;
  • which has signalled to home builders to build new homes – with building approvals now about as high as they ever get pointing to a construction boom on the way; and
  • rising house prices, which boost wealth, and stronger housing construction are positive for retail sales.

This is all good news as a stronger housing sector is critical if the economy is to rebalance away from mining investment.

But is it turning into bubble trouble?

While a housing recovery is necessary to rebalance the economy, a concern is whether it’s becoming another bubble. The home buyer market has started the year strongly with auction clearances high and house prices surging.

According to RP Data capital city house prices are up 10.6% over the year to March with Sydney home prices up 15.6%.

Property prices are on the rise again in other comparable countries, eg the US and UK. The trouble is that Australian house prices are turning up from a high level.

Asset price bubbles normally see overvaluation, excessive credit growth and self-perpetuating exuberance. On these fronts the current readings for housing are mixed.

Australian housing is overvalued: Whilst real house price weakness through 2010 to 2012 saw this diminish the problem has returned again with a vengeance:

  • Real house prices are 13% above their long term trend.
  • According to the 2014 Demographia Housing Affordability Survey the median multiple of house prices to household income in Australia is 5.5 times versus 3.4 in the US.
  • The ratio of house prices to incomes in Australia is 21% above its long term average, leaving it toward the higher end of OECD countries. This contrasts with the US.
  • On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average, Australian housing is 27% overvalued.

So Australian house prices meet the overvaluation criteria for a bubble. Other criteria are less clear though.

Credit growth is a long way from bubble territory: over the year to February housing related credit grew 5.8%. This is up from recent lows, with 7.6% growth in credit for investors leading the charge. But it is pretty tame compared to 2003-04 when housing related credit growth was running at 20% plus and 30% for investors. Related to this we have yet to see much deterioration in bank lending standards.

Similarly, the self-perpetuating exuberance that accompanies bubbles seems mostly absent at present:

  • House price strength is not broad based. Whereas prices in Sydney (+15.6% year on year) and Melbourne (+11.6% year on year) are very strong in every other capital city they are up 5% or less;
  • Related to this there has been only one year of strong gains, whereas the surge into 2003 ran for seven years;
  • Australian’s don’t seem to be using their houses as ATMs at present (ie where mortgages are drawn down to fund consumer purchases and holidays). Rather they still seem very focused on paying down debt.
  • We have yet to see property spruikers out in a big way.
  • There is little sign of buyers rushing in for fear of missing out.
  • The cooking shows are still out rating the home related shows on TV!

For these reasons I don’t think it’s a bubble yet. However, the acceleration in price gains means the risks are rising.

What’s to blame for high house prices?

Whenever house prices take off and affordability deteriorates there is a tendency to look for scapegoats. A decade ago it was high immigration and negative gearing. Now it looks to be foreign buyers (from China), self-managed super funds and as always negative gearing. However, none explain the relative strength in Australian house prices:

  • Foreign and SMSF buying is no doubt playing a role in some areas but looks to be relatively small overall.
  • Chinese interest in Sydney seems to be concentrated away from first home buyer suburbs.
  • Such simplistic explanations ignore the fact that when interest rates go down, Australian’s borrow to buy houses and prices go up. We don’t need to resort to foreigners to find a reason why house prices have gone up!
  • Negative gearing has been around for a long time. It was removed in the 1980s but was reinstated as it was clear its removal worsened the supply of dwellings. Restricting it for property would also distort the investment market as it would still be available for other investments.

Rather the fundamental problem is a lack of supply. Vacancy rates remain low and there has been a cumulative construction shortfall since 2001 of more than 200,000 dwellings. The reality is that until we make it easier for builders and developers to bring dwellings to market – and hopefully decentralise our population in the longer term – the issue of poor affordability will remain.

Implications for monetary policy

As things currently stand the risks to financial stability flowing from the surge in house prices are more than balanced by sub trend economic growth, falling mining investment and risks to Chinese economic growth. As such it remains appropriate for the RBA to keep interest rates on hold at 2.5% for now. However, our expectation is that the RBA is likely to step up its jawboning of the home buyer market by warning buyers not to take on too much debt and not to expect ever rising prices, ahead of a move to higher interest rates probably starting around September/October once economic growth has started to pick up.

While talk of so-called macro prudential controls, such as limits on loan to valuation ratios for mortgages may hot up, the RBA would probably prefer to avoid such retrograde approaches (they didn’t work in the days pre-deregulation) in favour of jawboning and an eventual rate hike.

Against this backdrop we expect further gains in house prices but at a slowing rate over the remainder of the year, particularly once interest rates start to rise again.

Longer term, the overvaluation of Australian housing will likely see real house prices stuck in a 10% range around the broadly flat trend that has been evident since 2010. This is consistent with the 10-20 year pattern of alternating long term bull and bear phases seen in real Australian house prices since the 1920s. See the fourth chart in this note.

Housing as an investment

Over long periods of time, residential property adjusted for costs has provided a similar return for investors as Australian shares. Since the 1920s housing has returned 11.1% pa compared to 11.5% pa from shares. Both have been well above the returns from bonds and cash.

They also offer complimentary characteristics: shares are highly liquid and easy to diversify but more volatile whereas residential property is illiquid but less volatile and shares and property tend to be lowly correlated to each other. As a result of their similar returns and complimentary characteristics there is a case for investors to have both in their portfolios over the long term. At present though, housing looks somewhat less attractive as an investment being overvalued on several measures and offering lower (cash flow) yields.

The gross rental yield on housing is around 3.3%, compared to yields of 6.5% on unlisted commercial property, 5.7% for listed property (or A-REITs) and 5.8% for Australian shares (with franking credits). So for an investor, these other assets continue to represent better value.

Concluding comments

The recovery in the housing sector is playing a key role in helping to rebalance the Australian economy. However, while the house price recovery does not appear to have entered bubble territory yet, the risks are rising. The RBA’s first line of attack is likely to be more intensive jawboning, warning home buyers not get too giddy in their house price expectations and not to take on too much debt. Later this year though this is likely to be followed up by a couple of interest rate hikes, all of which will likely see house price gains slow.

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Common myths and mistakes of investing

Friday, March 28, 2014

by Shane Oliver

  • Investors frequently employ common sense rules of thumb that often turn out to be wrong.
  • Because investment markets are forward looking it often makes sense to turn common sense logic on its head.


The increasingly complex nature of investment markets leads many to adopt simple rules of thumb often based on common sense, when making investment decisions.

Unfortunately though, the forward looking nature of investment markets means such approaches often cause investors to miss out on opportunities at best or lose money at worst. This note reviews some of the common myths and mistakes of investing.

Myth #1: Rising unemployment means growth can’t recover

Whenever there is a downturn this argument pops up. But if it were true then economies would never recover from recessions or slowdowns. But they do. Rather, the boost to household spending power from lower mortgage rates and any tax cuts or stimulus payments during recessions eventually offsets the fear of unemployment for those still employed. As a result they start to spend more which gets the economy going again. In fact, it is normal for unemployment to keep rising during the initial phases of an economic recovery as businesses are slow to start employing again fearing the recovery won’t last. Since share markets lead economic recoveries, the peak in unemployment usually comes after shares bottom. In Australia, the average lag from a bottom in shares following a bear market associated with a recession to a peak in unemployment has been twelve and a half months.

Hence the current cycle where the share market has gone up despite rising unemployment and headline news of job layoffs is not unusual.

Myth #2: Business won’t invest when capacity utilisation is low

This one is a bit like the unemployment myth. The problem is that it ignores the fact that capacity utilisation is low in a recession simply because spending is weak. So when demand turns up, profits rise and this drives higher business investment which then drives up capacity utilisation.

Myth #3: Corporate CEOs, being close to the ground, should provide a good guide to where the economy is going

Again this myth sounds like good common sense. However, senior business people are often overwhelmingly influenced by their own current sales but have no particular lead on the future. Until recently it seemed Australian building material CEOs saw no sign of a pick-up in housing construction even though it was getting underway. Now it’s widely accepted.

This is not to say that CEO comments are of no value – but they should be seen as telling us where we are rather than where we are going.

Myth #4: The economic cycle is suspended

A common mistake investors make at business cycle extremes is to assume the business cycle won’t turn back the other way. After several years of good times it is common to hear talk of “a new paradigm of prosperity”. Similarly, during bad times it is common to hear talk of a “new normal of continued tough times”. But history tells us the business cycle will remain alive and well. There are no such things as new eras, new paradigms or new normals.

Myth #5: Crowd support indicates a sure thing

This “safety in numbers” concept has its origin in crowd psychology. Put simply, individual investors often feel safest investing in a particular asset when their neighbours and friends are doing so and the positive message is reinforced via media commentary. But it’s usually doomed to failure.

The reason is that if everyone is bullish and has bought into the asset there is no one left to buy in the face of more good news, but plenty of people who can sell if some bad news comes along. Of course the opposite applies when everyone is bearish and has sold – it only takes a bit of good news to turn the market up. And as we have often seen at bear market bottoms this can be quite rapid as investors have to close out short (or underweight) positions in shares. The trick for smart investors is to be sceptical of crowds.

Myth #6: Recent returns are a guide to the future

This is a classic mistake investors make which is rooted in investor psychology. Reflecting difficulties in processing information and short memories, recent poor returns are assumed to continue and vice versa for strong returns. The problem with this is that when it's combined with the “safety in numbers” myth it results in investors getting into an investment at the wrong time (when it is peaking) and getting out of it at the wrong time (when it is bottoming).

Myth #7: Strong economic/profit growth is good for stocks and vice versa

This is generally true over the long term and at various points in the economic cycle, but at cyclical extremes it is invariably very wrong. The big problem is that share markets are forward looking, so when economic data is really strong – measured by strong economic growth, low unemployment, etc – the market has already factored it in. In fact the share market may then fret about rising costs, rising inflation and rising short term interest rates. As an example, when global share markets peaked in October/November 2007 global economic growth and profit indicators looked good.

Of course the opposite occurs at market lows. For example, at the bottom of the global financial crisis (GFC) bear market in March 2009, economic indicators were very poor. Likewise at the bottom of the mini-bear market in September 2011 economic indicators were poor and there was a fear of a “double dip” back into global recession. But despite this “bad news” stocks turned up on both occasions, with better economic and profit news only coming along later to confirm the rally. History indicates time and again that the best gains in stocks are usually made when the economic news is poor and economic recovery is just beginning or not even evident, as stocks rebound from being undervalued and unloved.

Myth #8: Strong demand for a particular product or stock market sector should see stocks in the sector do well and vice versa

While this might work over the long term, it suffers from the same weakness as Myth #7. By the time demand for a product (eg, new residential homes) is really strong it should already be factored into the share prices for related stocks (eg, building material and home building stocks) and thus they might even start to start to anticipate a downturn.

Myth #9 Countries with stronger economic growth will see stronger equity market returns

In principle this should be true as stronger economic growth should drive stronger revenue growth for companies and hence faster profit growth. It’s the basic logic why emerging market shares should outperform developed market shares over time. But it’s not always the case for the simple reason that often companies in emerging countries may not be focussed on maximising profits but rather may be focused on growing their market share or social objectives such as strong employment under the influence of their government.

Myth #10: Budget deficits drive higher bond yields

It's common sense that if the government is borrowing more (higher budget deficits) then this should push up interest rates (the cost of debt) and vice versa, but it often doesn’t turn out this way. Periods of rising budget deficits are usually associated with recession or weak economic growth and hence weak private sector borrowing, falling inflation and falling interest rates so that bond yields actually fall not rise.

This was evident in both the US and Australia in the early 1990s recessions and evident through the GFC that saw rising budget deficits and yet falling bond yields.

Myth #11: Having a well diversified portfolio means that an investor can take on more risk

This mistake was clear through the GFC. A common strategy had been to build up more diverse portfolios of investments with greater exposure to alternative assets such as hedge funds, commodities, direct property, credit, infrastructure, timber, etc, that are supposedly lowly correlated to shares and to each other. Yes, there is a case for such alternatives, but last decade this generally led to a reduced exposure to truly defensive asset classes like government bonds. So in effect, investors actually began taking on more risk helped by the “comfort” provided by greater diversification. But unfortunately the GFC exposed the danger in allowing such an approach to drive an increased exposure to risky assets overall. Apart from government bonds and cash, virtually all assets felt the blow torch of the global financial crisis, as supposedly low correlations amongst them disappeared.

Myth #12: Tax should be the key driver of investment decisions

For many, the motivation to reduce tax is a key investment driver. But there is no point negatively gearing into an investment to get a tax refund if it always makes a loss.

Myth #13: Experts can tell you where the market is going

I have to be careful with this one! But the reality is that no one has a perfect crystal ball. And sometimes they are badly flawed. It is well known that when the consensus of experts’ forecasts for key economic or investment indicators are compared to actual outcomes they are often out by a wide margin. Forecasts for economic and investment indicators are useful, but need to be treated with care. And usually the grander the call – eg prognostications of “new eras of permanent prosperity” or calls for “great crashes ahead” – the greater the need for scepticism as such strong calls are invariably wrong.

Like everyone, market forecasters suffer from numerous psychological biases and precise point forecasts are conditional upon information available when the forecast is made but need adjustment as new facts come to light. If forecasting the investment markets was so easy then everyone would be rich and would have stopped doing it.

The key value in investment experts’ analysis and forecasts is to get a handle on all the issues surrounding an investment market and to understand what the consensus is.

Experts are also useful in placing current events in their historical context and this can provide valuable insights for investors in terms of the potential for the market going forward. This is far more useful than simple forecasts as to where the ASX 200 will be in a year’s time.


The myths cited here might appear logical and consistent with common sense but they all suffer often fatal flaws, which can lead investors into making poor decisions. As investment markets are invariably forward looking , common sense logic often needs to be turned on its head when it comes to investing.

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Weekly market and economic update

Sunday, March 23, 2014

by Shane Oliver

Investment markets and key developments over the past week

The past week has seen worries about Ukraine fade but concerns the Fed will raise rates earlier than expected take centre stage. This saw bond yields push higher, but equity markets were mixed with US shares and European shares up helped in part by better economic data and European agreement on a banking union but Asian and Australian shares generally flat to down a bit as worries about China continue to impact. The bring forward to Fed rate hike expectations pushed the $US higher against the Yen and Euro, but the $A bucked the trend moving up slightly helped by a continuing reduction in prospects for further rate cuts in Australia.

The risks regarding Ukraine seem to be receding. Russia does not appear to be interested in moving on other parts of Ukraine, Ukraine seems to have accepted Crimea’s move to Russia and is pulling its military out of the region, US and European Union sanctions and tit for tat moves from Russia will have close to zero economic impact and comments from the Ukrainian PM appear more conciliatory towards Russia with commitments to not join NATO and to decentralise power to its regions. Key to watch now will be: any escalation in ethnic violence in east Ukraine as it could still lead to civil war and Russian intervention on the grounds of "protecting Russians"; more substantial sanctions from the US and Europe; and of course how the Ukrainian elections turn out in May. The risks are still high but I remain of the view that the crisis in Ukraine is just another distraction. It won't derail the European or global economic recoveries or the bull market in shares.

From taper talk to “dot plots”. Fed Chair Janet Yellen has been misinterpreted as more hawkish than she is, just like Bernanke was last year when he first raised tapering. Fed rate hikes still look a fair way off, but with the end of quantitative easing in sight, their timing will become an increasing focus for investors. There were no surprises from the Fed's decision to continue winding down its quantitative easing program, which at the current rate means it will come to an end either in October or December. There were also no surprises with its move to drop the 6.5% unemployment threshold and replace it with a qualitative assessment that it will be appropriate to maintain the current Fed Funds rate for a considerable time after quantitative easing ends. This was all pretty dovish. Against that though, an upwards revision in the median Fed meeting participant's rate expectations - the so-called “dot plot” - by 0.25% for end 2015 and by 0.5% for end 2016 along with Fed Chair Yellen's comment that the first rate hike may come 6 months after QE ends led to fears of an earlier and sharper tightening by the Fed. I suspect that Janet Yellen actually meant to sound more dovish than she came across as so a move to clarify her comments from the Fed is likely in the weeks ahead. My assessment is that Fed rate hikes are still at least a year away, but as we saw with taper talk last year it will likely be a source of debate and market as the year progresses. But the key is to always keep the big picture in mind:  the Fed is only tapering and discussing when rates will start going up because the US economy is on the mend. This is a good thing, because it means stronger profits. And when rates do start going up it will be a long time before they reach levels that fundamentally threaten profit growth and the share market outlook.

Major global economic events and implications

US data revealed more of the same with messy weather affected readings for housing starts, the NAHB's home builders' conditions index and existing home sales but better than expected growth in industrial production and good gains in manufacturing conditions according to surveys in the New York and Philadelphia regions consistent with a rebound in growth in the months ahead. Meanwhile the current account deficit fell to its lowest level in 16 years as a percentage of GDP helped by collapsing oil imports and inflation remained benign at just 1.6% year on year for core in February, highlighting no rush for the Fed to raise rates.

In China, a default by a small property developer, Zhejiang Xingrun Real Estate, has added to concerns about a broader property collapse. It’s worth putting it in context though. First, the default was due to illegal activities with both the Chairman and his son being arrested and has nothing to do with property related stress. Second, in any case there have been numerous defaults from property developers in recent years. Third, fears of a mass collapse in property related businesses are overdone. The absence of a surge in house prices relative to incomes and low household debt levels suggests there is no generalised housing bubble that’s about to burst. But there are pockets of oversupply and many property developers have taken on too much debt which leaves them vulnerable as house price growth slows. So more defaults are likely amongst property developers as well as in industries with excess capacity such as cement, coal, steel, solar cells and ship building. This shouldn't be a major problem, unless the Government keeps its foot on the brakes for too long. As China's savings rate is huge by global standards - savings which mostly have to be recycled via debt - encouraging or allowing a deleveraging cycle would be very dangerous. I think the Chinese authorities realise this. As result, slowing growth and low inflation appears to be resulting in gradual policy easing with the Government announcing a speeding in construction activity following moves in recent weeks towards a lower Renminbi and lower interest rates. The authorities have already indicated that they will not allow defaults to become a systemic threat.

Meanwhile under its New Urbanisation Policy, by 2020 China plans to shift another 110 million workers to cities. This amounts to about 15 million workers a year. At the same time it is gradually reforming its hukou (welfare registration system) that will transfer guest workers in cities over time from dormitory workers to full city citizens wanting everything that goes with that. This means ongoing strong growth in demand for urban property, infrastructure, consumer services, etc. Notwithstanding short term cyclical swings - like the inventory cycle now affecting iron ore demand - Chinese raw material demand is likely to remain strong long term as a result.

Australian economic events and implications

The minutes from the last RBA Board meeting offered little that was new with the Bank repeating that "a period of stability in interest rates" remains prudent and that the $A remains "high". The RBA’s comment that it had discussed macro prudential controls with respect to house prices sounds like nothing more than a statement of the obvious given their use in New Zealand. Apart from their obvious problems - ie they are a return to the more regulated and less successful past and some hit first home buyers hardest - it seems the RBA is not too concerned about the housing market at present seeing little sign of relaxing lending standards, no risk at present to financial system stability and little sign of speculative behaviour. Apart from the need to involve APRA which would take time I suspect that the imposition of macro prudential controls on the housing market are way off, if at all. Meanwhile, car sales rose only fractionally in February and skilled vacancies trended higher for the sixth month in a row adding to evidence that the jobs market is stabilising.

What to watch over the next week?

Monday is PMI day, with a bounce in MNI’s Chinese business survey pointing to a bounce in China's flash HSBC manufacturing conditions PMI, Europe's PMIs likely to confirm ongoing economic recovery although it will be interesting to see whether the uncertainty regarding Ukraine has had any impact and the Markit PMI in the US expected to remain around a solid reading of 57.

In the US, expect to see further gains in house prices, a fall back in new home sales after a near 10% bounce in February and a slight improvement in consumer confidence (all due Tuesday), a modest gain in durable goods orders (Wednesday) and soft weather affected pending home sales (Thursday).

Japanese economic activity data (Friday) is likely to show continued reasonable growth albeit it is distorted by the pull forward associated with the coming GST rate hike. Inflation will likely show ongoing signs of tracking higher.

In Australia, the RBA's bi-annual Financial Stability Review (Wednesday) will likely reiterate that the Australian financial system remains in reasonably good shape. Speeches by Governor Stevens and Deputy Governor Lowe will also be watched for any clues regarding the outlook for interest rates.

Outlook for markets

The combination of emerging market worries - notably China and Ukraine at present – along with growing uncertainty as to when the US Fed will start to raise interest rates are likely to ensure that 2014 will be a more volatile year for shares.  Investors should allow for the likelihood of a 10 to 15% correction at some point along the way this year. However, the broad trend in share markets is likely to remain up reflecting the combination of reasonable valuations, better earnings on the back of improved economic growth and easy monetary conditions helping to entice investors to switch out of cash and bonds and into shares. Our year-end target for the ASX 200 remains 5800.

A slow rising trend in bond yields on the back of gradually improving global growth combined with low yields to start with means pretty subdued returns from government bonds. Cash and bank deposits also continue to offer pretty poor returns.

Notwithstanding the potential for a bounce in the $A back to around $US0.95 on the back of excessive short positions, the broad trend in the $A remains down reflecting softer commodity prices, a reversion to levels that offset Australia’s high cost base and a decline in Australia’s growth relative to that in the US.

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The critical role of asset allocation for investors

Thursday, March 13, 2014

by Shane Oliver

Key points

  • While the global economy is gradually mending, returns will still be constrained and volatile relative to the long term bull market that got underway in the 1980s.
  • As a result asset allocation will remain critically important for investors – particularly for those who can’t take a long term approach and those looking to enhance returns.
  • Improved approaches to asset allocation, in particular dynamic asset allocation, and the use of highly liquid and low cost futures and exchange traded funds (ETFs) further enhance the significance of asset allocation.


One of the big swings in thinking around investment management relates to the perceived importance of asset allocation, ie the relative exposure to asset classes like global shares, Asian shares, Australian shares, bonds, unlisted property and cash. Through the long strong secular bull market that went from 1982 through to 2000 (or up to 2007 in Australia) the investment management industry increasingly moved away from worrying about asset allocation to focussing on manager selection at the asset class level. This partly reflected the times where most asset classes did well and so asset allocation was seen as less important and many thought it was too hard.

This all got turned on its head with the GFC and its aftermath of messy markets, coming after a decade of poor returns from global shares, providing a reminder of just how important asset allocation is. As a result asset allocation has made a comeback. This is likely to remain the case even as the global economy and financial outlook continues to heal.

What is asset allocation?

But first some technicalities. The return a traditional fund or mix of assets generates will be a function of three things:

  • The fund’s medium to long term allocation to each asset class and the market return they generate – traditionally referred to as the Strategic Asset Allocation (or SAA);
  • any short term deviation in the asset mix from the SAA – this is known as Tactical Asset Allocation (or TAA); and  the contribution from active management of the underlying asset portfolios. This is often referred to as security selection. It used to be done by one manager but increasingly a range of fund managers are being used.

As discussed below, newer approaches to asset allocation are tending to combine SAA and TAA into what is increasingly called Dynamic Asset Allocation or DAA.

Numerous studies have shown asset allocation is the key driver of the return an investor will get. *In fact, if you believe active management of the individual asset classes will add no value, then asset allocation will drive 100% of the return.

* For articles on the importance of asset allocation see R.G. Ibbotson. “The Importance of Asset Allocation”, Financial Analysts Journal. Mar/Apr 2010.

New ways of doing asset allocation

Apart from a long period of strong returns through the 1980s and 1990s during which most assets did well and bonds and equities tended to move together, another reason why asset allocation seemed to fall out of favour prior to the GFC related to the perceived mixed track record from traditional tactical asset allocation approaches. The problems with these approaches were that they were often constrained by a desire to minimise peer risk and decision making was poor, reflecting a committee based approach that was usually dominated by asset class managers who only focused on asset allocation on a part time basis and lacked the skills to assess the potential between asset classes. And whilst the TAA approach evolved into Global Tactical Asset Allocation this tended to be short term trading focussed, and ran the risk of missing out on big picture moves in markets.

After the GFC, the focus of asset allocation has shifted towards taking advantage of extreme swings in the relative performance of different asset classes through the business cycle. This approach, referred to as Dynamic Asset Allocation, sits between the short term trading focus of TAA or GTAA and the medium to long term focus of SAA. An advantage of this approach is that it can be entirely implemented via highly liquid futures, exchange traded funds or index funds, and can replicate a diversified mix of assets for a fraction of the cost but with more flexibility in varying the asset mix than in a traditional fund. Such approaches also tend to be run by dedicated teams avoiding the “committee of part timers” approach that worked poorly in the past.

But why have active asset allocation?

There are two fundamentals in investing that investors should always be aware of: the power of compound interest and that there is always a cycle. The power of compound interest is demonstrated in the next chart.

Whilst shares are more volatile than cash and bonds, the compounding effect of their higher returns over time results in a much higher wealth accumulation from them. The average return since 1900 from Australian shares at 12% pa is only double that of Australian bonds at 5.9% pa but over the whole period $1 invested in shares would have compounded to $395,550 today versus only $727 if that $1 had been invested in bonds. Over all rolling 40 year periods and virtually all 20 year periods shares trump bonds and cash. This argues for a long term approach to investing.

The problem is that there is always a cycle. Cycles encompass both secular malaises like those seen in the 1930s, 1970s and last decade for global shares that can last a decade or so before giving way to better times, and normal business cycles that result in three to five year cyclical swings in share markets. See the next chart for the latter.

And the problem with cycles is that they can throw investors out of a well thought out investment strategy that aims to take advantage of long term returns and can cause problems for investors when they are in or close to retirement. Cycles also create opportunities for investors to enhance returns.

So for these reasons cyclical variations in asset class returns ideally need to be managed and the best approach to doing this is a rigorous dynamic asset allocation process.

How to manage cycles?

There are essentially three ways to manage cycles:

  • Ignore them & adopt a set and forget approach to asset allocation. This may be okay for long term investors but not for those who are older or have a short term focus.
  • Forecast them using economic forecasts – this is difficult as the track record of economists’ point forecasts shows.
  • Use their rhyming elements to manage them. While investment cycles do not repeat precisely they do rhyme.

Each cycle has common elements – eg downswings in equities are usually preceded by overvaluation, tight monetary conditions and investor euphoria. These rhyming elements can be captured and combined to provide warning of swings in the cycle and hence are a solid foundation for a DAA process. This is our approach.

But what if the world continues to heal

An obvious issue is whether the improving global outlook will reduce the need for asset allocation. Our view remains that the cyclical bull market in equities has further to run reflecting still reasonable valuations, better earnings on the back of improving global growth, easy monetary conditions and an absence of the sort of euphoria normally seen at major market tops. ** More importantly, after a 13 year secular bear market, a new secular bull market in global shares appears to be developing led by the US reinventing itself, aggressive reflation in Japan and structural change in Europe.***

However, while there will be periods of very strong returns as we have seen over the last two years, asset allocation is likely to remain critically important going forward:

  • First, medium term investment returns are likely to be relatively constrained with not all asset classes doing well. The starting point for returns today is much less favourable than when long term bull markets last started in bonds and equities in 1982. The income yields are lower on all assets. Both equities and bonds won’t have the combined tailwind from falling inflation, which thirty years ago benefitted both as falling inflation meant falling interest rates and yields, providing a valuation boost to returns. In fact our medium term return projections, shown in the next table, imply a 7.8% pa return from a diversified mix of assets. This is well below the 11.9% pa return that Australian diversified funds provided over the 1982-2007 period. So getting the right asset allocation will remain critically important.
  • Second, the potential return range between the major asset classes is likely to be wide ranging as can be seen in the table. This will only add to the importance of getting the asset allocation right. Being loaded up on low yielding bonds and cash could mean very low returns.
  • Third, volatility is likely to be relatively high. Public debt problems may still flaring up periodically, the world has become more reliant on naturally volatile emerging countries and extremely easy monetary policy conditions will provide a source of volatility when they start to reverse, probably led by the Fed. This will all result in bouts of volatility in relative asset class returns, providing opportunities for asset allocation to add value.
  • Finally, bond and equity returns will likely remain negatively or lowly correlated, providing an opportunity for asset allocation to enhance returns by moving between the two. Through the 1980s & 90s, the two assets classes tended to move together reflecting the common driver of the adjustment to a low inflation world. But this has run its course.

Concluding comments

While the world is gradually healing and this should support equities, asset allocation will remain critical for investors reflecting likely constrained returns, a large variation in returns between major asset classes and ongoing volatility.

Improved approaches to asset allocation utilising highly liquid and cheap ETFs and futures make accessing asset allocation easier and more cost effective.

** See “The risk of a correction…”, Oliver’s Insights, January 2014.
*** See “The US reinvents itself, yet again”, Oliver’s Insights, February 2014

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The Australian economy – looking beyond the gloom

Thursday, March 06, 2014

by Shane Oliver

  • While headline news regarding the economy has been bleak, December quarter GDP showed the economy is not collapsing and lower interest rates & the lower $A do seem to be boosting forward indicators for the economy.
  • As a result growth should pick up to around 3% by year end which should help profit growth continue to improve.
  • Improving growth but from a soft base is likely to see interest rates remain on hold for an extended period.


February seemed full of bad news in Australia with layoffs coming from various companies including Toyota, Alcoa and Qantas, unemployment rising to 6% and very poor business investment intentions. And yet, the share market rose 4.2% last month and has had two good years and December quarter GDP growth even perked up a bit. So is the outlook as bad as the headlines suggest or has the share market got it right? In part the share market has taken comfort from earnings results released in February so we will start there.

Profits tuning up

The December half profit reporting season just ended was effectively make or break because for market expectations for a circa 13% uplift in profits to be delivered this financial year, after two years of falls, profits needed to have started to turn up in the December led by resources stocks.

In the event, the profit cycle has turned up right on cue, albeit led by the large miners and the banks, and so market expectations look to be on track. Overall results were solid:

  • 50% of companies exceeded expectations (compared to a norm of 43%);
  • 66% of companies saw their profits rise from a year ago, with strong results from miners and banks seeing overall earnings rise nearly 15% over the year to the December half, with a near 40% gain for miners. This compares to a 0.5% fall over the year to the June half;
  • 64% of companies have increased their dividends from a year ago and only 13% have cut them. A year ago only 53% were boosting dividends. Aggregate dividends rose nearly 14% over the year to the December half; and
  • 56% of companies have seen their share price outperform the day they released results.

Key themes have been:

  • a continued focus on cost control, but also a 7% rise in revenue, versus less than 2% revenue growth over the year to the June half. Industrials saw sales growth of 5%;
  • help from a lower $A, which boosted the value of foreign earnings & makes Australian firms more competitive;
  • a massive turnaround for resources stocks leaving them on track for circa 40% earnings growth this financial year;
  • signs of life in cyclicals like housing related stocks (Boral, Stockland) and retailers (JB HiFi, Harvey Norman);
  • continuing strong results from the banks; and of course
  • strong dividend growth, which is usually a sign companies are confident about the outlook.

Consensus earnings expectations for 2013-14 rose slightly through the reporting season with earnings now expected to gain 15%, led by 40% from resources. This is expected to slow to 7% in 2014-15 with resources slowing and nonresources picking up. A key driver of whether this will be delivered will be whether the economy picks up.

Growth still soft, but signs of improvement

Since the June quarter 2012 Australian economic growth has been poor, averaging around a 2.5% annualised pace. This is well below the level necessary to absorb workforce entrants and hence unemployment has risen from 5% to 6%.

A recent spate of layoff announcements is only adding to fears, not helped by the rapidly deflating mining investment boom. This is also highlighted by the latest ABS survey of investment intentions with a conventional interpretation of investment intentions that adjusts for the average gap between actual and expected investment pointing to an 11% contraction in investment next financial year. An alternative approach based on comparing the estimate of investment for the next financial year to the corresponding estimate made a year earlier points to a 17% fall – worse than seen in the early 1990s recession. See the next chart.

This has all led to a sense of gloom about Australia. However, the time to be really gloomy was two years ago – when the RBA was stubbornly slow to cut interest rates. Now interest rates are at generational lows and the $A is down more than 20%. And household wealth is up. Importantly, the normal play out from falling interest rates is unfolding:

  1. House prices have risen solidly over the last year. Auction clearances holding at 80% in Sydney and 72% in Melbourne despite bad news in February is a good sign.
  2. This has flowed on to near record building approvals, which will see rising housing construction this year.
  3. Partly reflecting this, consumer and business confidence are trending up particularly the latter.
  4. The lower $A should start to boost demand for local goods and services, eg US tourists to Australia seem to be rising again. This is likely to occur as the third and final phase of the resources boom – rising export volumes from completed projects – is getting underway.
  5. Lower interest rates, rising wealth levels and rising housing construction is likely to drive a pick-up in retail sales. In fact retail sales growth did pick up last year.
  6. Eventually this is likely to help non-mining investment.

We appear to have reached the fourth or fifth points, which provides grounds for confidence. What’s more December quarter GDP saw an uptick in GDP growth to 0.8% quarter on quarter and 2.8% year on year, but more importantly it showed growth is far from collapsing and that other sectors of the economy – notably consumption, housing and trade - are helping the economy grow despite falling investment. But what about the weak jobs and investment outlook news?

  • The jobs headlines lately have certainly been bleak but: the labour market always lags the economic cycle; the announced job losses (totalling less than 20,000 across the car makers, Alcoa, Qantas, etc) are small relative to total employment of 11.5 million and are spread over several years; and leading employment indicators such as ANZ job ads and employment intentions according to the National Australia Bank’s business survey are all stabilising or pointing up. See the next chart.

  • Mining investment is falling off a cliff, but the broader investment outlook may not be as bleak as suggested by recent data. First, the approach of comparing estimates exaggerated the weakness this financial year initially pointing to a 9% decline, which now looks like coming in flat. Secondly, investment intentions in industries outside of mining are starting to improve. In fact, the NAB business survey’s investment intentions index has actually started to rise. See the next chart. Thirdly, the impact on overall economic growth of the slump in mining investment will be partly offset by a slump in imports of mining equipment. This is already occurring.

Drawing these factors together and allowing for a tough May budget focussed on spending cuts, our assessment remains that Australian economic growth will rise to 3% by year end.

Concluding comments

First, the outlook for the economy is not nearly as gloomy as headlines of job layoffs and the end of the mining investment boom suggest. Growth is likely to pick up this year to 3%.

Second, the improving growth outlook should help head off further RBA rate cuts. But 3% growth by year end may still not be enough to make much of a dent on unemployment so while we expect rate hikes later this year the risk is that they will not occur till next year.

Finally, the combination of rising economic growth and continuing low interest rates should underpin a pick-up in non-resources earnings growth over the year ahead, which in turn should support further gains in the Australian share market. Our year-end target for the ASX 200 remains 5800.

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Investment markets and key developments over the past week

Monday, March 03, 2014

by Shane Oliver

It’s been another somewhat mixed week for global and Australian shares as indexes flirt with post GFC highs and the situation regarding Ukraine remains uncertain, economic data continues to be rather confusing and Fed Chair Janet Yellen left the door open for a pause in slowing its monetary stimulus if needed. US shares saw good gains with the S&P 500 making a new record closing high, Japanese and European shares were little changed and Australian shares fell slightly not helped by poor business investment data. Most share markets, bar China and Japan, had a solid February though making up for the declines seen in January.

Reflecting mixed economic data and worries about Ukraine, bond yields mostly fell over the last week and commodity prices were soft. The $A was little changed.

Despite the demise of the Yanukovych government, Ukraine remains a source of uncertainty for markets. It’s way too small and its problems too specific to be a threat to global economic growth. The main risk worth keeping an eye on though is that it triggers some sort of conflict between the West and Russia, as Russia sees it as a brotherly country and does not appear happy at its recent swing back to the West, as evident by troop exercises along its border. That said while there may be a lot of bluster from Russia its doubtful that it can afford to do anything too drastic (like an invasion).

Is the PBOC easing? Falling Chinese money market rates and a decline in the value of the Renminbi (RMB) seem to have created a bit of confusion over the last week. Both of these could just be normal market noise, eg the RMB  is only down around 2%, and the People’s Bank of China could just be providing a reminder that it can be volatile and is not a one way bet higher. Then again it could signal a slightly easier stance on monetary policy, which may be consistent with recent mixed economic data and clear signs that Chinese home price growth is cooling down. Time will tell.

More jobs layoffs in Australia. News that Qantas will lay off 5000 workers adds to the sense of gloom hanging over the Australian jobs market. But it’s worth noting that the layoffs do not reflect a lack of demand but rather competitive pressures Qantas is facing, that they will be spread out over the next three years and that the coming housing construction recovery, the lower $A and improved business confidence and general hiring plans all point to a strengthening in jobs growth most likely during the second half of this year. So it’s not all doom and gloom.

Hot internet start-ups and takeovers of such stocks with little revenue or earnings along with talk that the “number of users is the dominant driver” is all very reminiscent of 1999 in the tech space. Fortunately while there may be pockets of 1999 around, the broader US market is a long way from late 1990s valuations or euphoria with the forward PE today at 15 times compared to 24 at its tech boom peak and Nasdaq valuations around one third of tech boom peak levels.

Major global economic events and implications

US economic data remained messy with soft readings for the Markit services conditions index, consumer confidence, regional manufacturing conditions surveys, mortgage applications (although falls here may be partly seasonal) and jobless claims but a surprisingly strong gain in new home sales, continued strength in home prices which rose 13.4% last year and slightly better than expected durable goods orders after allowing for volatile aircraft orders.  Fed Chair Yellen essentially repeated her message that tapering remains on track but indicated the Fed is trying to get a handle on whether the weather is driving recent soft data or something more worrying, with the implication being that the taper could be delayed or slowed if needed.

Eurozone confidence indicators confirmed the ongoing economic recovery but weak lending and money supply data highlight the case for more ECB stimulus.

Japanese activity for data for January was a good with very strong industrial production, a solid PMI pointing to more gains ahead, stronger than expected retail sales and household spending, unemployment remaining down at 3.7%, the job vacancy to applicants ratio rising a bit and core inflation remaining at 0.7% year on year. The main uncertainty though is around to what degree the approaching sales tax hike has pulled demand forward.

While emerging market uncertainties still linger, it was good to see Brazilian GDP growth come in stronger than expected in the December quarter leaving it up 2.3% for the year. That said Brazil’s growth isn’t what it used to be and structural challenges remain and with the central bank raising interest rates yet again there are still downside risks to Brazilian growth.

Australian economic events and implications

Australian construction and business investment data was depressingly soft pointing to a broad based fall in investment in the December quarter and intentions data pointing to sharp fall in business investment in 2014-15 as mining investment really starts to wind down. Comparing intentions for 2014-15 with those made a year ago for 2013-14 suggests a 17% fall in investment led by a 25% fall in mining and a 20% fall in manufacturing. However, the final outcome may not be that bad as such an approach looks to have exaggerated weakness this financial year. Secondly, investment intentions in industries outside of mining and manufacturing are starting to stabilise and improve. Thirdly, the impact on overall economic growth of the slump in mining investment will be partly offset by a slump in related imports, just as the mining investment boom was partly offset by surging mining related imports. Finally, while residential investment looks to have fallen in the December quarter, the strength in building approvals points to a strong upturn in dwelling related construction ahead.

The Australian corporate earnings season has now wrapped up. As is often the case the companies with great results often go first followed by those not doing so well. That said, overall results remain pretty good and confirm the profit cycle has now turned up with large companies, notably the resources and banks, playing a bigger role than normal in driving growth. 54% of companies exceeded expectations (compared to a norm of 43%); 65% of companies have seen their profits rise from a year ago (compared to a norm of 66%); 64% of companies have increased their dividends from a year ago (which is up slightly from around 62% in the last two years); and 56% of companies have seen their share price outperform the day they released results. Key themes have been a massive turnaround for the resources stocks (notably Rio and BHP) leaving the sector on track for circa 40% earnings growth this financial year, banks doing very well (with good results from CBA, ANZ and NAB), help coming through from the lower $A, ongoing cost control making up for still soft revenue growth, signs of improvement from some cyclicals (like Boral, JB Hi Fi, Fairfax and Seek) and strong growth in dividends. A 14% surge in dividends from a year ago was mainly driven by big companies such as Rio, CBA and Telstra. At 64% the dividend payout ratio is still not excessive for the overall market and higher dividends are usually a sign that companies are confident about the outlook. The bottom line is that Australian earnings look to be on track for growth of around 15% this financial year, with a 40% surge in resources’ profits, a 10% rise in financials’ profits and a 6% rise in profits for the rest of the market.

Source: AMP Capital

Source: AMP Capital

Source: AMP Capital

Source: AMP Capital

What to watch over the next week?

In the US, the main focus is likely to be on February manufacturing conditions indicators (due Monday) and employment data (Friday), but unfortunately both are likely to present a confusing picture given poor weather in February. The manufacturing conditions PMIs are likely to present a divergent picture with the ISM index likely coming in around 52 but the broader Markit index remaining solid around 56.7 in line with its advance reading. With a snowstorm affecting some of the US when the February employment survey was undertaken, payroll growth is likely to have remained relatively soft at 150,000 and unemployment is likely to be unchanged at 6.6%.

In the Eurozone, the ECB (Thursday) is likely to finally act on its easing bias, possibly cutting interest rates a bit further and maybe announcing a form of quantitative easing involving the purchase of bank loans. While GDP is growing again it is still gradual, lending growth remains depressed and there is a risk of deflation. The Bank of England (also Thursday) is likely to leave monetary policy unchanged.

In China, the National People's Congress (starting Wednesday) will likely set a growth target for this year of 7.5%, but the key focus will be on the approval and enactment of further financial deregulation and various fiscal, administrative and welfare reforms flowing from the 3rd Plenum last year. Chinese data for February will also start to flow with trade figures (due March 8th) likely to be looked at very closely to see whether the circa 10% growth in exports and imports reported for January continued in February.

The Reserve Bank of Australia (Tuesday) is expected to leave interest rates on hold for the sixth meeting in a row. The RBA has clearly indicated that with growth remaining low but tentative signs of improvement in some indicators, a period of stability in interest rates is appropriate. Since not enough has really changed since the last meeting, this remains the case. Soft jobs news and the poor business investment outlook do suggest though that our expectation for rate hikes to commence later this year may be premature with the risk being that they won't occur till next year. Governor Steven’s Parliamentary testimony (Friday) will be watched closely for his views on the jobs and investment front.

Meanwhile, there will be a data avalanche in Australia with the AIG manufacturing PMI, house prices, new home sales and ANZ job ads all due Monday, January building approvals likely to gain 1% (Tuesday), December quarter GDP (Wednesday) expected to show just 0.3% quarterly growth (or 2.1% year on year) thanks in part to solid retail sales and trade offsetting poor investment, and retail sales (Thursday) expected to have fallen slightly after eight months of gains.

Outlook for markets

This year will likely see returns from shares a bit more constrained and volatile than was the case last year, but the trend for share markets is likely to remain up nonetheless reflecting a combination of reasonable valuations, better earnings on the back of improved economic growth and easy monetary conditions helping to entice investors to switch out of cash and bonds and into shares. With the just concluded earnings reporting season in Australia confirming that the market is on track of good earnings growth this year, the ASX 200 is on track to meet our year-end target of around 5800.

The recent decline in global bond yields should be seen as a correction against the backdrop of a slow rising trend in yields on the back of gradually improving global growth. This will mean subdued returns from government bonds. Cash and bank deposits also continue to offer pretty poor returns given low interest rates/yields.

The broad trend in the $A remains down on the back of softer commodity prices, a reversion to levels that offset Australia’s relatively high cost base and a decline in Australia’s growth relative to that in the US. However, short positions in the $A still remain excessive and so it could still have a bit more of a bounce before the downtrend resumes.

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The US reinvents itself, again!

Thursday, February 27, 2014

by Shane Oliver

  • The US economy is yet again reinventing itself. This has been helped along by a determination to get the US economy moving again after the global financial crisis but the real drivers are an energy boom, a manufacturing renaissance and American innovation.
  • Together these drivers could add as much as 0.5% to annual US economic growth in the decade ahead.
  • For investors, while a return to the sustained double digit share market returns seen through the 1980s and 1990s is unlikely, the turn for the better in the US is likely driving a new secular bull market in traditional global shares.


The problems with the US economy are well known. Its level of public debt is too high, its spending on social security and health is unsustainable, its health system is woefully inefficient – spending more relative to GDP than most OECD countries but with worse life expectancy – its level of savings is too low, its transport infrastructure is becoming run down, its political system seems dominated by ideology and its share market has had a rough time over the last 14 years as the tech and housing credit booms burst.

But it is dangerous to write the US off. Every two or three decades it seems to reinvent itself. It did it with electricity and mass production in the 1920s, with consumerism, petrochemicals and aviation in the 1950s and 1960s and with deregulation and the IT revolution in the 1980s and 1990s.

Don’t write the US off

The US was written off by many during the 1930s only to see it emerge as the world’s major super power and strongest economy in the post war years. The same occurred in the 1970s after the debacles of the Vietnam War, Watergate and stagflation only to see it reinvigorated by Ronald Reagan.

Both the 1950s-1960s and the 1980s-1990s saw strong returns from the US share market.

After the debacle of the tech wreck and credit bust of last decade and the loss of its AAA credit rating by S&P, amidst dysfunctional politics, many have been tempted yet again to write the US off. But once more it seems to be bouncing back. This time around the drivers include: American policy makers’ determination to fix their problems; an energy boom; a manufacturing renaissance; and ongoing innovation.

The Fed and the shrinking US budget deficit

American policy makers are criticised a lot, eg for first undertaking quantitative easing and now for slowing it! But they do show a determination to fix things up once they go wrong and for moving a lot faster than other countries. This has been evident since the GFC with the Federal Reserve trying one approach after another to stabilise and then get the US economy moving again and the forced recapitalisation of US banks, which helped restore confidence. That these policies are working is evident in the Fed now moving to slow down its quantitative easing program, effectively taking the US off life support as it
appears to be getting to the point where it no longer needs it.

But perhaps the big surprise for many is the massive slump in the US budget deficit over the last few years, which basically explains why you don’t hear much about it these days. As can be seen in the next chart the US Federal budget deficit has shrunk from more than 10% of GDP In 2009 to less than 3% of GDP this year. This reflects a combination of stagnant government spending over the last few years and surging revenue growth.

It is expected to start rising again beyond 2015 to around 4% of GDP by 2022 (according to the Congressional Budget Office) as an aging population really starts to boost spending on social security and health, so there is still more to do. But the savings from the 2011 debt agreement, the scaled back “fiscal cliff” and the “sequester” spending cuts add up to almost $US4 trillion over 10 years and should not be ignored.

It’s a long way from the fiscal mess of a few years ago.

The energy boom

It seems only yesterday that the “peak oil” fanatics were raving on (yet again) about how global oil production would soon peak and we would have to ditch the car and return to the horse and buggy. It was nonsense then and even more so now. The basic thing they missed is that rising oil prices will both lead to more fuel efficiencies (just look at all the hybrid cars now available) and make economic access to new supplies of energy viable. This is happening in the US with a vengeance as fracking technology – drilling down and then sideways into shale beds and then pumping in a mix of water and chemicals to fracture the rock allowing gas and oil to be extracted – is leading to a massive energy production boom. US oil production is up around 45% over the last five years which has taken it back to 1990s levels and total energy production including gas is back to late 1980s levels.

See the next chart. By around 2020, US oil production is likely to have returned to 1970 levels and the US will be back to being the world’s biggest oil producer.

The energy boom is providing a huge boost to the US economy by boosting demand for drilling services and infrastructure, lowering energy costs & reducing the US trade deficit. US oil is trading around $US7 a barrel below global prices and US natural gas prices are tending to run around one third below European levels and one fifth of Japanese levels. Rough estimates put the boost to US economic growth from the energy boom at 0.2% per annum. The decline in US oil imports can be seen in the next chart. This also means less dependence on the volatile Middle East.

Numerous companies have announced that they plan to expand manufacturing production capacity in the US. This ranges from a plant to build a Honda super car to Apple bringing some component manufacturing home. The drivers have been a combination of:

  • lower energy costs as cheap gas has seen electricity suppliers switch to gas, depressing the price of electricity;
  • very low unit labour costs – as solid productivity growth and low wages growth have seen unit labour costs for manufacturers remain around 1980 levels; and
  • the low $US after a decade long decline, which is still down 30% or so from 2001/2002 levels.

As yet this has only resulted in a tentative rise in manufacturing production relative to overall GDP, but it is likely to improve further as the manufacturing base starts to expand again. Very different to Australia, but then again we have seen a doubling in the value of the $A over the last decade, somewhat higher wages growth and surging electricity prices…but that’s a different story!

American ingenuity
Finally, underpinning all of this is American ingenuity and an economic system that encourages it and provides it with finance. The bulk of the new gadgets we get are developed in the US, it remains at the forefront of the IT revolution and its companies are world beaters. Since 1975, the Eurozone has given rise to just one of the firms to join the world’s top 500 companies, whereas 26 of them came from the US.

What does it mean for investors?

The key message is that the US is getting back in business (putting aside the winter freeze) with a potential to grow maybe as much as 0.5% pa more over the medium term compared to what otherwise would have been the case.

There are several implications for investors. First, a stronger US economy is good for the global economy and supports the view that global share markets have entered a new secular (or longer term) bull market. Consistent with this, US shares have broken out to a new record high – both in terms of the S&P 500 price index and in terms of real returns after spinning their wheels since March 2000. See the next chart.

Second, the US looking stronger at a time when several emerging countries have hit a more difficult patch favours traditional global shares over emerging market shares.

Finally, whilst US and hence global shares appear to have entered a new secular bull market, returns are likely to be more constrained than was the case during the last secular bull market that started in 1982. This is because starting point valuations for shares are not as attractive as in 1982 and the boost from falling inflation and interest rates won’t be repeated again in the years ahead as inflation is already low.

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Investment markets and key developments over the past week

Saturday, February 22, 2014

by Shane Oliver

Global shares had a mixed week as investors digested the 5% or so rebound since early February amidst weather affected US data, signs the Fed will soon change its forward interest rate guidance with respect to unemployment, another fall in a Chinese manufacturing conditions PMI and as turmoil continued in the Ukraine and Thailand providing a reminder that issues remain in the emerging world. While US and Eurozone shares were basically flat, Japanese and Asian shares nevertheless saw good gains. Bond yields were also little changed, but commodity prices did see some strength with a strong rise in oil prices (partly due to poor US weather) and higher metal prices. The $A fell on the poor news from China, but only marginally.

Australian shares continue their sprint higher gaining more than 7% from their early February low with mostly good earnings results over the last few weeks providing confidence that the long hoped for rebound in earnings is finally happening and as shareholders like the news of higher dividends.

The minutes from the Fed’s last meeting point to ongoing tapering. Cleary the Fed viewed the recent run of soft US data as largely due to poor weather, which along with comments by various Fed officials suggest little change in the pace of tapering. Of course this could change in a few months if US data has still not improved. The Fed does appear to likely soon change its forwards guidance on interest rates with the unemployment approaching the Fed’s 6.5% threshold, but at this stage there appears to be little agreement on what form the new guidance will take. Looking further out, while markets may have become a bit concerned about the reference to “a few participants” raising the possibility that it may need to raise interest rates relatively soon, this is likely to refer to the usual hawkish regional presidents of Fisher, Plosser, Lacker and George and is likely to be of little consequence for now given they don’t drive Fed policy. That said, once the US exits its weather related soft patch and as the Fed nears the end of its QE program later this year, talk of sooner than expected interest rate hikes may start intensifying...maybe later this year.

Major global economic events and implications

US economic data presents a confusing picture at present. Freezenomics clearly played a role in depressing the NAHB home builders’ survey (along with a lack of supply), housing starts and manufacturing conditions in the New York and Philadelphia regions. But against this the broad-based Markit manufacturing conditions PMI rose 3 points to a very solid 56.7 in February with strong gains in new orders and employment suggesting the overall manufacturing sector is in good shape and on top of this jobless claims fell and the leading index rose pointing to solid growth ahead. On top of all this inflation readings remain benign, with core and headline inflation of just 1.6% year on year. So beyond the freeze the US economy still looks ok.

Eurozone flash PMIs slipped in February but only marginally (from 52.9 to 52.7 for the composite) and do nothing to change the outlook for continued gradual economic recovery. That said growth is still not strong enough to reduce deflation risks, so more ECB easing is still likely.

Japanese December quarter GDP growth was much weaker than expected at just 0.3%, but this was due to a surge in imports as growth in domestic demand was a solid 0.8% driven by consumption and investment. As expected the Bank of Japan made no changes to its asset purchase program or its money supply targets but it did extent or expand various measures to boost bank lending, which could be interpreted as a baby step towards further easing which we expect to see in the next few months.

China’s flash HSBC manufacturing PMI fell yet again in February pointing to the possibility of a further slowing in economic growth. That said it could have been distorted by the Lunar New Year holiday and pollution related factory suspensions and it’s still bouncing up and down in the same range it’s been in for the last two years, which period has seen GDP growth stuck in a range around 7.5% to 8%. So at this stage we see no reason to change our 2014 growth forecast of 7.5%.

Australian economic events and implications

In Australia, a fall in annual wages growth to a record low of 2.6% through 2013 provides further confirmation that the labour market is very weak and means that poor household income growth will remain a constraint on consumer spending. Fortunately it also adds to confidence that inflation will remain low thanks to soft growth in wages costs and so adds to confidence the RBA can keep interest rates down. There is also a bit of light at the end of the tunnel for the labour market with skilled vacancies rising for the fifth month in a row in January

The minutes from the RBA’s last meeting provided nothing new but by dropping any reference to the possibility of further easing, they confirmed that its bias on interest rates is now neutral. We remain of the view that the RBA will keep interest rates on hold out to around September with gradual rates hikes thereafter.

The corporate earnings news was a bit more mixed over the last week. As is often the case the companies with great results often go first followed by those not doing so well. That said, with around 70% of companies having reported, overall results remain pretty good and confirm the profit cycle has now turned up. So far 54% of companies have exceeded expectations (compared to a norm of 43%); 67% of companies have seen their profits rise from a year ago (compared to a norm of 66%); 70% of companies have increased their dividends from a year ago (compared to an average of around 62% in the last two years); but only 52% of companies have seen their share price outperform the day they released results. Key themes are a massive turnaround for the resources stocks (notably Rio and BHP) leaving the sector on track for circa 35% earnings growth this financial year, banks doing very well (with good results from CBA, ANZ and NAB), help coming through from the lower $A, ongoing cost control, signs of improvement from some cyclicals (like Boral, JB Hi Fi, Fairfax and Seek) and strong growth in dividends. The surge in dividends – which are up about 15% from a year ago - is a good sign that companies are confident about the outlook. The bottom line is that Australian earnings look to be on track for growth of around 15% this financial year, with a 35% surge in resources’ profits, a 10% rise in financials’ profits and a 6% rise in profits for the rest of the market.

What to watch over the next week?

In the US, house price data (due Tuesday) for December is expected to show continued strength but poor weather is likely to have weighed on January new home sales (Wednesday) and possibly consumer sentiment (Friday). Poor weather could also give a subdued result in durable goods orders (Thursday) and December quarter GDP growth is likely to be revised down to 2.5% annualised from the 3.2% initially reported thanks to softer trade and retail sales data than had originally been allowed for. Fed Chair Yellen’s delayed Senate testimony (Thursday) will be watched closely for any hint of a taper slowing following recent mixed data.

In the Eurozone, confidence data (Thursday) is likely to confirm the continuing gradual economic recovery. Unfortunately the recovery to date is unlikely to have been strong enough to have pushed the January unemployment rate (Friday) below the 12% level.

Japanese January data for household spending, the labour market and industrial production are likely to show continued growth, and a continuing rising trend in inflation (all due Friday).

The official Chinese manufacturing PMI (Friday) is likely to have followed the HSBC flash PMI slightly weaker.

In Australia, December quarter construction (Wednesday) and business investment data (Thursday) will provide important building blocks for the December quarter GDP data to be released on March 5. Both are likely to be a bit softer than was the case in the September quarter. The capex data will also provide a guide as to how quickly mining investment is slowing and whether non-mining investment is picking up. Private credit growth (Friday) is likely to have shown a continuing modest pick-up in growth. A speech by RBA Governor Glen Stevens (Wednesday) will likely reiterate the case for interest rates to remain on hold for now.

This will be the final week of the Australian December half 2013 earnings reporting season with 60 major companies due to report, including Worley Parsons, Harvey Norman and Woolworths.

Investment markets will also digest the outcome of the G20 finance ministers meeting to be held on February 22-23. G20 meetings are a great opportunity for a talkfest – and this one will see lots of interesting discussion around issues such as the impact of Fed tapering on emerging countries, global growth targets, boosting infrastructure investment, financial regulation and tax base erosion - but in the absence of a global crisis to fix, it’s hard to see it having much impact on financial markets. While ongoing concerns from some emerging markets about the Fed’s tapering of its stimulus program create interest, there’s virtually zero chance that the Fed will do anything differently and nor should it as it has to do the right thing by the US economy and emerging market problems are largely of their own making. And it can hardly be claimed that the Fed failed to communicate its plans to start tapering – in fact then Fed Chair Bernanke started flagging his tapering plans back in May last year, nearly six months before the Fed started doing anything.

Outlook for markets

While returns will be more constrained and volatile, shares will nevertheless push higher this year helped by reasonable valuations, improving earnings on the back of improved economic growth and easy monetary conditions helping to entice investors to switch out of cash and bonds and into shares. With the current earnings reporting season pointing to solid earnings growth this year, the ASX 200 is on track to meet our year-end target of around 5800 by year end.

The recent decline in global bond yields should be seen as a correction against the backdrop of a slow rising trend in yields on the back of gradually improving global growth. This will mean subdued returns from government bonds. Cash and bank deposits also continue to offer pretty poor returns given low interest rates/yields.

The broad trend in the $A remains down on the back of softer commodity prices, a reversion to levels that offset Australia’s relatively high cost base and a decline in Australia’s growth relative to that in the US. However, short positions in the $A still remain excessive and so it could still have a bit more of a bounce before the downtrend resumes.

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Chinese debt worries and growth

Thursday, February 20, 2014

by Shane Oliver

  • Chinese debt levels are rising too fast and the growth of its shadow banking sector poses risks. However, providing the authorities continue to gradually try and slow both down the risks should be manageable.
  • Chinese growth looks like coming in around 7.5% this year. No boom, but no bust either.
  • Chinese shares remain very cheap, providing the prospect of good medium term returns.


China bears have always been around. At their core seems a disbelief a so called “communist” country could grow so fast.

But with China now being the world’s second biggest economy and the largest contributor to global growth their concerns get a lot of airplay. Last year it seemed “ghost cities” were the big worry. This year it’s shaping up as debt, shadow banking and wealth management products – particularly following defaults in the latter. To be sure China is not without risk – it will one day have a bust like all countries do periodically – but concerns still look overdone.

The China worry list

Putting politics aside, the concerns of China bears are primarily structural and relate to four key areas: excessive investment; falling competitiveness; a housing bubble; and excessive growth in debt. Putting the debt issue aside for now, our view on the first three remains relatively benign.

Rebalancing growth to consumption needs to be slow.

First, China’s investment share of GDP is overstated as its national accounts system grossly understates services.

Second, China’s urbanisation rate at 50% is still low with a move to Korea’s urbanisation rate of 80% over say 30 years meaning an extra 400 million people moving to cities. This will require a lot of infrastructure investment. Second, China’s level of investment per person is around one third of US and German levels. So it’s hard to say it’s over investing.

Third, China has been able to grow strongly and avoid the inflation and balance of payments problems of countries like India, Indonesia and Brazil because it has invested a large share of its GDP. The bottom line is that claims that China is overinvested and too reliant on investment are misplaced.

China is not losing its competitiveness. Chinese wages are rising rapidly but there is no evidence this is causing a loss of global competitiveness: rapid productivity growth in China, which is far stronger than in other emerging countries, is offsetting labour cost increases; Chinese exporters have been moving to higher value adding exports; and Chinese exports are continuing to gain share, rising from around 3% of total global exports in 1997, to 10% in 2008 to nearly 12% now. And with inflation stuck around 2.5% there is no sign of inflation trouble.

No generalised housing bubble. Yes there are ghost cities where excessive development has occurred. But the real issue is an undersupply of affordable housing. Household debt is very low at 30% of GDP, average deposits are around 40% of values, 20% of buyers pay in cash and 90% of new home buyers are owner occupiers. There is very little securitization of mortgage debt so it is not packaged and sold to investors everywhere like US mortgages which caused so much strife. Over the period 2006-13 household incomes rose 12% pa on average and house prices rose 9% pa, which is hardly the stuff of bubbles.

But what about debt and shadow banking?

Perhaps the biggest concern relates to debt. On this front there are three main worries. First, debt has grown rapidly in recent years. Total outstanding credit or “Total Social Financing”, rose an average 22% pa over the last decade.

Second, as China gradually deregulates it will mean higher interest rates. Current rates around 3-6% are way below normal levels for an economy with nominal growth around 10%. The adjustment will mean bouts of nervousness.

Thirdly, much of the growth in credit has occurred outside the more regulated banking system, ie via what is called the “shadow banking” system. And much of this has been channelled though wealth management products. There has been rapid expansion in the latter in recent years as investors have sought higher returns than available from bank deposits. Recent defaults or near defaults by some of these products related to coal companies have raised concerns of broader problems in the sector.

However, there are several points to note. First, while China’s growth in debt is excessive, its aggregate debt level is not high by global standards. See the next table.

Second, the rapid rise in outstanding debt in China partly reflects a very high savings rate and those savings being recycled via the credit system rather than via the share market. It’s not that China is borrowing internationally, which has led many emerging countries into trouble in the past.

Third, the People’s Bank of China is more than aware of the risks noting that “growth has become increasingly dependent on…debt accumulation” and has been seeking to slow it.

Fourth, China’s shadow banking system is relatively small. At around 30% of Chinese banking sector assets it is less important than is the case in most major economies. In the UK, Brazil, Korea and the Eurozone it’s 50% or more and the US shadow banking is around 100% of official banking (150% prior to the GFC!). What’s more Chinese shadow banking companies like trusts are not particularly leveraged, cross holdings of assets between institutions is low, products are very simple and securitisation (or the repackaging of loans and on selling them) is virtually non-existent. This all serves to limit counterparty risks and contagion and stands in stark contrast to the problems that arose in the US with subprime debt where the combination of securitisation, massive gearing and financial complexity led to major problems.

Fourth, while the growth of lending via wealth management products is concerning, the potential investments at risk is small. The next table shows a breakdown of wealth management products by institutions that manage them.

Those ran by banks and insurance companies tend to be low risk whereas those run by fund managers and brokerage firms are mostly tied equities, with no default risk. That largely leaves the RMB10 trillion in trust companies most at risk. Of this, around a third is equity related and so not subject to default and of the remainder the portion invested in loans to industrial and commercial companies (like coal ventures) is at most risk of defaults – of which there will surely be more. But the point is that the total amount of trust assets most at risk is likely no more than RMB5 trillion, which compared to China’s RMB70 trillion in bank loans is unlikely to be enough to constitute a systemic threat. It should also be noted that most trusts are state owned and the authorities have unlimited resources to respond if a crisis develops.

It is also hard to see a big direct global threat from problems in the Chinese shadow banking system. China’s shadow banking system is only around 3-4% of that globally, compared to a 37% share for the US and global institutions have very little exposure given low levels of gearing. If a Chinese shadow banking crisis is going to threaten the global economy it would likely be via trade flows.

Growth no longer 10% plus – get used to it

Chinese authorities have clearly come to the view that GDP growth of 10% plus is not sustainable. But the conscious slowing in GDP growth and the PBOC’s often opaque efforts to slow credit growth has unnerved investors and so the Chinese share market has gone from being about the world’s most expensive several years ago to amongst its cheapest.

However, Chinese leaders have repeatedly stated that the floor to acceptable growth is around 7 to 7.5%. And despite occasional volatility GDP growth seems to have settled around this level. Consistent with this the much watched Chinese business conditions PMIs also look range bound.

The overall impression is that growth is stable with no sign of a boom or a bust. Our expectation remains for Chinese growth this year of 7.5%, little changed from last year’s 7.7%.

Chinese shares trade on a price to historic earnings ratio of 11 and a forward PE of 7.5. This makes it one of the cheapest share markets globally and suggests good returns in the years ahead as Chinese growth remains solid.

Concluding comments

China faces various risks, but these look to be manageable.

While a return to the China driven commodity boom of last decade looks unlikely, Chinese growth around 7.5% should still provide reasonable support to global growth and provide a reasonable backdrop for Australian resources shares.

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